ETS alignment: a price collar proposal for carbon market integration

Abstract:

The global carbon market landscape is fragmented and increasingly complex. The conclusions reached at COP26 in Glasgow on the Article 6 rulebook are expected to achieve further mitigation using market mechanisms, facilitate the coordination of international efforts and increase carbon market integration. Three sets of conditions are necessary for smoothing the linking of emissions trading systems (ETSs). Before negotiations, mutual trust is crucial to respond to unexpected developments in partners’ economic, social and political circumstances. During the linking negotiations, a degree of alignment of core design features of ETSs is necessary to harmonise the systems. After the completion of negotiations, built-in reviews and broad-based consultations, as well as mechanisms for revision, dispute resolution and potential future delinking, are fundamental to ensure that linking works over time.

The degree of alignment necessary for linking is a critical issue. Some ETS features (e.g., the price control mechanisms) require compatibility, whereas other key design elements (e.g., the stringency of the cap) may not require strict compatibility if they lead to comparable outcomes. Other ETS design features (e.g., the allocation phases and compliance periods) would benefit from coordination but do not need to be aligned. When ETSs are linked, the efficiency gains from allowance trade are enhanced compared to autarky (pre-link levels), as domestic and foreign allowance prices fully or partially (in case of linking with quotas) converge to an intermediate level. The price risk of linking could be constrained by enforcing a price collar (i.e., a price floor and a price ceiling) for the linked system. The price collar could be specified by the intersection between the two respective intervals representing acceptable post-link allowance prices.

Options for enforcing the price ceiling include releasing allowances from a joint cost-containment reserve. To enforce the floor, allowances can be allocated in auctions with a reserve price equal to the floor. Alternatively, a ‘top-up’ carbon tax could be applied to allowances that are auctioned at a price below the floor. The price collar could help jurisdictions to mitigate systemic shocks that may affect allowance prices like recession, unanticipated growth, technological leaps that lower the abatement cost of emissions, as well as changes in companion climate policies. Reducing price risk and uncertainty would be beneficial for regulators, regulated entities and investors. However, reaching an agreement on the parameters and rules of a price collar in the linked system can be difficult. Early and open dialogue between the ETSs is strongly recommended to overcome these challenges.

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