An Endogenous Emission Cap Produces a Green Paradox


The Market Stability Reserve (MSR), implemented in 2018 to complement the EU emission trading system (EU ETS), is designed such that the supply of allowances responds endogenously to demand. We show that an endogenous cap such as the MSR produces a Green Paradox. Abatement policies announced early but realized in the future are counter-effective because of the MSR: they increase cumulative emissions. We present the mechanisms in a two-period model, and then provide quantitative evidence of our result for an annual model disciplined on the price rise in the EU ETS that followed the introduction of the MSR. Our results point to the need for better coordination between different policies, such as the European Green Deal. We conclude with suggestions to improve the workings of an endogenous cap, ahead of the MSR review scheduled for 2021.

Economic Policy