Price containment in emissions permit markets: Balancing market risk and environmental outcomes

ABSTRACT

While cap-and-trade policies have been advocated as an efficient market-based approach in regulating greenhouse gas (GHG) emissions from the power sector, a major criticism is that the resulting prices of emissions permit may be volatile, adding more uncertainty to market participants, and hence deter their interests in participating the electricity market. To ease such a concern, various permit price-containment instruments, such as a price ceiling, floor, or collar, have been proposed. Though such instruments may prevent permit prices from being extreme, they may incur inadvertent results such as underinvestment in low-emission technologies or little reduction of system-wide GHG emissions, hence defeating the purpose of establishing a cap-and-trade policy in the first place. To address such issues, this article examines the effect of imposing various price-containment policies on investment decisions and spot market equilibria in an electricity market. Our major contribution is that, unlike other work in this area in which the price-containment schemes are exogenous to their market models we endogenously incorporate a price ceiling/floor in our models and hence can analyze the interactions between the policies and their corresponding market outcomes. We further introduce uncertainties in our market models and use California's data as a case study.

KEYWORDS:

• Cap-and-trade
• price containment
• safety valve
• price collar
• price floor
• climate change

Additional information

Notes on contributors

Andrew L. Liu

Dr. Andrew L. Liu is currently an Associate Professor in the School of Industrial Engineering, Purdue University, West Lafayette, Indiana. He received his B.S. degree in Applied Mathematics from Beijing Institute of Technology, Beijing, China, in 2000 and his Ph.D. degree in Applied Mathematics and Statistics from the Johns Hopkins University, Baltimore, Maryland, in 2009. Before joining Purdue, he was a Senior Associate with the Wholesale Power Group at ICF International, Fairfax, Virginia. His research interests include optimization, game theory and their applications in power systems, smart grid, and environmental policy analysis.

Yihsu Chen

Dr. Yihsu Chen is an Associate Professor with the Department of Technology Management at the University of California, Santa Cruz. He is also affiliated with UCE3 (University of California Center for Energy and Environmental Economics). He received his master's degree from Harvard University in Public Health as well as a Ph.D. degree from the Johns Hopkins University in Environmental and Energy Economics. His research focuses on sustainability. In particular, he examines the impact of energy and environmental regulation on electricity, biofuel, and transportation and water resources sectors. His research takes interdisciplinary approaches: quantitative bottom-up models built upon economic principles and solved with operations research techniques.