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Cost Containment

In an Emissions Trading System (ETS), time-varying market prices provide the signals that will allow firms to achieve a given quantity of emissions at least cost. Just as in many commodity markets, it may be hard to predict longer-term ETS prices accurately, because they depend on variations in economic activity, volatility and variability in fuel markets, uncertain marginal abatement cost estimates, and potential policy changes.

Persistently low prices in an ETS could arise because mitigation turns out to be easier than expected, because other climate and energy policies also contribute to lower emissions and therefore reduced demand for allowances, or because of a recession that lowers economic activity and thus emissions; the reverse could be true for high prices. Policy uncertainty and other market or regulatory failures could depress demand for banking, inhibiting the formation of long-term credible carbon prices.

ETS design can reduce this potential volatility and uncertainty about prices. Design options can vary according to whether they adjust the quantity of allowances or place constraints on the price, and the extent of discretion they give policy makers.These design parameters aim to make prices predictable enough to support investment in mitigation and new technologies, and guide a gradual transition toward a low-carbon economy while avoiding costs that are politically or socially unacceptable.

Prior to ETS implementation, the concerns of policy makers have typically focused on the possibility of high prices. However, in some of the ETSs currently in operation, low prices have actually become a greater source of concern. There is growing recognition that appropriate market management approaches can help sustain prices to promote investment and maintain auction revenue, control costs, and ensure mitigation is consistent with long-term goals. A range of different approaches are being trialled: allowance reserves are becoming a more common tool to contain costs and manage prices while limiting emissions; and introducing a price floor at auction can help secure the value of mitigation investments by ETS participants and offsets providers.

Further Reading

Emissions Trading In Practice: A Handbook on Design and Implementation | 2016
Cutting Carbon and Costs | June 6, 2016
Implications of California Offset Limit Reduction | July 24, 2016
Price Controls without Cost Controls | July 17, 2016

Attribution: Content from Partnership for Market Readiness (PMR) and International Carbon Action Partnership (ICAP). 2016. Emissions Trading in Practice: a Handbook on Design and Implementation. World Bank, Washington, DC. License: Creative Commons Attribution CC BY 3.0 IG