Linking Carbon Markets with Different Initial Conditions

Despite the global nature of climate change, carbon pricing is driven by regional and sectoral carbon taxes or trading programs, each with unique features and disparate marginal costs. Linking these fragmented regional or sectoral programs could improve environmental and economic outcomes, but differing initial conditions pose a challenge to linking. We explore the use of an allowance exchange rate, which denominates the compliance value of an emissions allowance differently in each program. In a theoretical model, we find that linking with an exchange rate in the politically plausible range—between traditional 1:1 trading (without an exchange rate) and the autarky price ratio—yields lower total abatement costs and greater economic surplus in each region, compared to autarky. Linking in this range also achieves greater emissions abatement than the (equal) amount achieved at each bookend. For this reason, 1:1 linking, which achieves a uniform allowance price and marginal cost, is nonetheless rarely socially optimal. When program caps achieve inefficiently low abatement, it would be welfare-improving to link at an exchange rate that increases total abatement in the linked system, so the socially optimal exchange rate lies within the politically plausible range. We further illustrate these results, and identify additional outcomes of interest to policymakers, using a simulation model of electricity markets.