Expecting the Unexpected: Emissions Uncertainty and Environmental Market Design

We analyze the demand for emissions allowances and the supply of allowances and abatement opportunities in California's 2013-2020 cap and trade market for greenhouse gases (GHG). We estimate a cointegrated vector autoregression for the main drivers of greenhouse gas emissions using annual data from 1990 to 2011. We use these estimates to forecast businss-as-usual (BAU) emissions during California's program and the impact of the state's other GHG reduction programs. We then consider additional price-responsive and price-inelastic activities that will affect the supply/demand balance in the allowance market. We show that there is significant uncertainty in the BAU emissions levels due to uncertainty in economic growth and other factors. Our analysis also suggests that most of the planned abatement will not be very sensitive to the price of allowances, creating a steep abatement supply curve. The combination of BAU emissions uncertainty and inelastic abatement supply implies a high probability that the price of allowances in California will either be at the price floor, or high enough to trigger a safety valve mechanism called the Allowance Price Containment Reserve (APCR). We estimate a low probability that the price would end up in an intermediate range between the price floor and the APCR. The analysis suggests that cap-and-trade markets, as they have been established in California, the EU and elsewhere may be more likely to experience price volatility and extreme low or high prices than is generally recognized.