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Carbon market design and market sentiment

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  • Perino, Grischa

Abstract

Concerns about systematic price distortions in the EU Emission Trading System (ETS) have risen in recent years. This paper shows how carbon-market design affects the impact of market sentiment, i.e. systematic deviations of price expectations from fundamentals by at least some market participants, on equilibrium prices. The Market Stability Reserve (MSR) of the EU ETS that adjusts supply based on past allowance banking undermines self-stabilization of the carbon market by discouraging rational intertemporal arbitrage. The MSR increases vulnerability of the EU ETS to market sentiments. Initially, the allowance price responds more to distorted expectations while the MSR (partially) prevents the distortion to spread across periods. Making the MSR more responsive to banking decisions increases the likelihood that distorted expectations turn out to be correct ex post. In contrast, a mechanism that adjust the cap based on the current allowance price does not face a trade off between stabilizing prices in the present and the future.

Suggested Citation

  • Perino, Grischa, 2024. "Carbon market design and market sentiment," Journal of Environmental Economics and Management, Elsevier, vol. 128(C).
    • Handle: RePEc:eee:jeeman:v:128:y:2024:i:c:s0095069624001311
    DOI: 10.1016/j.jeem.2024.103057
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    More about this item

    Keywords

    Cap-and-trade; EU ETS; Market stability; Market sentiment; Speculation;
    All these keywords.

    JEL classification:

    • D47 - Microeconomics - - Market Structure, Pricing, and Design - - - Market Design
    • H23 - Public Economics - - Taxation, Subsidies, and Revenue - - - Externalities; Redistributive Effects; Environmental Taxes and Subsidies
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming
    • Q58 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environmental Economics: Government Policy

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