Linking emissions trading systems: are price collars the way forward?

A post by Stefano F. Verde

A consequence of linking two or more emissions trading systems (ETSs) is that the respective prices of emission allowances are co-determined. In a bilateral linkage – as in a multilateral one – allowance prices of each ETS are co-determined by the partner ETS. The extent to which prices are determined by the partner ETS depends on the relative size of the two systems (in emissions terms) and on the type of linkage, which can be a ‘full’ linkage or one of its ‘restricted’ alternatives (Mehling and Haites, 2009). This dependency in price formation generates a price risk which may carry an important weight when a jurisdiction evaluates the pros and cons of linking its ETS to another (Grubb, 2009).

The price risk of linking, as we call it, specifically refers to the eventuality that allowance prices deviate from an acceptable range because of changes in allowance demand or supply in the partner ETS. For a jurisdiction, the attractiveness of keeping some control over allowance prices explains why this type of risk can be an obstacle to the establishment of linkages. Analysing linking decisions, including price risk as one of the key factors, seems ever more relevant today, given the increasing number of ETSs globally (ICAP, 2020) and, hence, of linking opportunities.

The price risk of linking can be reduced by choosing one of the forms of restricted linking. Risk reduction is particularly clear with the imposition of quotas on the number of allowances that can be transferred between ETSs. In this case, the effects of changes in allowance demand or supply on allowance prices of the partner ETS are limited by the constraint on allowance transfers. The downside of the quota approach, or any other form of restricted linking for that matter (exchange rates, discount rates and taxes on transfers), is in an efficiency gain from trade which is only partial compared to that of full linking (Schneider et al., 2017; Quemin and de Perthuis, 2018).

A possible alternative approach to both restricted linking and ‘free-price’ full linking is full linking with a fluctuation band for allowance prices (note: under full linking, allowance prices of the different ETSs converge to the same level). The lower limit of the price band is usually referred to as ‘floor’, the upper limit as ‘ceiling’, and the two together make a ‘price collar’. The upside of this approach is in allowing for the maximum efficiency gain from trade, while removing the price risk of linking, if the collar corresponds to the intersection between the acceptable price ranges of participating jurisdictions.

Realising linkages with a collar implies that jurisdictions are able to agree on a price band. This is a task for policymakers and, of course, agreements may not be reached. Linking decisions are indeed complex, many factors are weighed up which transcend the compatibility of ETS designs and differences in stringency. Still, ‘linking with-a-collar’ can offer greater economic benefits than restricted linking as well as lower risks than free-price full linking. Above all, this approach may facilitate the establishment of new linkages and improve coordination of carbon prices across jurisdictions. With a little imagination, if it became the standard way of integrating ETSs, the international emissions market could structure itself according to price fluctuation bands. Today, the linkage between the ETSs of California and Québec is the example that comes closest to the idea of linking with-a-collar (Purdon et al., 2014; Galdi et al., 2020).

Of course, all this rests on the assumption that a jurisdiction wants to adopt a price collar for its ETS in the first place. In the literature, price collars have been mainly analysed with reference to single ETSs, as design features (‘safety valves’) that can foster low-carbon investments by reducing price uncertainty (Burtraw et al., 2010; Fell, 2016). By contrast, the potential role of price collars in facilitating ETS linking and, more generally, carbon prices coordination, is little explored (Edenhofer et al., 2015).

Increasingly, ETSs around the world are equipped with price control mechanisms (floors and/or ceilings) that are activated when allowance prices hit predetermined thresholds. A notable exception is the EU ETS, whose Market Stability Reserve (MSR) mechanism adjusts allowance supply in response to volumetric market imbalances. As such, the MSR does not identify limits for allowance prices. In the debate on whether to introduce a price floor in the EU ETS (Flachsland et al., 2020), the arguments concerning the potential enlargement and greater integration of the international emissions market should find more space. These are particularly relevant arguments for the EU ETS, which so far has played a central role in the formation of this market and has the ambition to continue to have it.