Discretionary Intervention Destabilizes the EU Emissions Trading System: Evidence and Recommendations for a Rule-Based Cap Adjustment

The EU is currently preparing a major overhaul of its climate policy framework to deliver on the Green Deal's new climate targets of a 55 percent cut in greenhouse gas (GHG) emissions relative to 1990 by 2030 and GHG neutrality by 2050. Extending and strengthening the role of carbon pricing, implemented through the EU Emissions Trading System (EU-ETS), will play an important role in this framework. Accordingly, the design and governance of the EU-ETS will be ever more crucial. In this article, we focus both on the 2018 EU-ETS reform as the first step on a slippery slope of increasing discretionary intervention and on the upcoming reform risks reinforcing this trend. In their seminal work, Kydland and Prescott (1977) caution against such interventions, because of their ability to destabilize the market and engender recurring interventions. This limits the capacity of policymakers to credibly commit to long-term targets, which undermines the dynamic efficiency of intertemporal emissions trading systems like the EU-ETS. To counteract this trend, we provide recommendations for rule-based adjustments to the EU-ETS.