Weitzman meets Taylor: EU allowances futures price drivers and carbon cap rules

Permit price volatility can undermine the effectiveness of cap-and-trade systems by creating uncertainty that discourages long-term investments in low-carbon technologies. Unpredictable prices distort market signals, making it harder for firms to plan their emissions reduction strategies and manage compliance costs, which can lead to economic inefficiencies and higher welfare losses.

The authors develop a two-sector structural model that pinpoints the primary drivers of price variability—namely, emissions abatement efforts, energy prices, the demand for permits during the transition, and regulatory supply shocks. They also propose a new method to estimate less-observable shocks, particularly those related to abatement costs. Their analysis reveals that the observed price variability is about 80 times greater than what would be expected under an optimal carbon pricing scenario aligned with the social cost of carbon, leading to significant welfare losses.

To address this inefficiency, the paper introduces the "Carbon Cap Rule" (CCR), a rule-based cap adjustment mechanism that dynamically responds to deviations in actual emissions and abatement costs. When compared with the existing EU ETS cap, the CCR reduces price volatility by 55% and decreases welfare losses by 40% in consumption equivalence terms. By aligning the cap more closely with market fundamentals, the CCR not only stabilizes the carbon market but also supports long-term investments in emissions reduction, offering a more effective transition toward a low-carbon economy. This approach draws parallels with the Taylor rule in monetary policy and echoes Weitzman's advocacy for contingent climate policies.

Key points for decision-makers

• The authors identify emissions abatement, energy prices, transition demand for permits, and regulatory supply shocks as the key drivers of permit prices in the third phase of the EU ETS (2013–2019).
• They quantify the contribution of each factor to carbon price variability, which they find to be approximately 80 times greater than it would be under an optimal carbon pricing scenario aligned with the social cost of carbon. This excess volatility leads to welfare losses.
• To address this, they propose a ‘Carbon Cap Rule’ (CCR) – a rule-based cap adjustment mechanism that dynamically responds to deviations in emissions and abatement costs.
• The CCR reduces volatility by 55% compared with the current EU ETS cap, and cuts welfare losses in consumption equivalence terms by 40%.
• By aligning the cap more closely with key market fundamentals, the CCR enhances the efficiency of the carbon market, supporting long-term investments in emissions reduction and contributing to a more effective transition to a low-carbon economy.
• Like the Taylor (1993) rule in monetary policy, the CCR responds to current economic conditions; the CCR also echoes the principles advocated by Weitzman (1974), who highlighted the importance of contingent climate policy.

Full paper

Read the full paper: Weitzman Meets Taylor: EU Allowances Futures Price Drivers and Carbon Cap Rules

Authors

Ghassane Benmir, Josselin Roman and Luca Taschini

Luca Taschini is Chair in Climate Change Finance and Director of the Centre for Business, Climate Change and Sustainability.