Advice on a price cap for NOx emissions trading

In the run-up to the NOx emissions trading scheme launched on 1 June 2005, several industries queried the liquidity of such a market. Current expectations are that until 2010 the NOx market is likely to be oversupplied rather than tight, owing partly to upcoming implementation of the IPPC directive. Some companies are nonetheless concerned about their market position, fearful of being confronted by a deficit of emission allowances, leading in turn to unacceptably high prices. This would hit firms without any cost-effective abatement options, who in the coming years find themselves forced to buy emission allowances. Against this background, the question arose of whether it would not be wise to introduce a price cap.

What is a price cap and how does it work?
In the context of emissions trading, introducing a price cap (or ‘safety valve’) entails a maximum limit being set on the price of an emission allowance. In practice this means the government guaranteeing that once this ceiling has been reached it will bring extra allowances onto the market at that maximum price, as a means of controlling the cost of emissions reduction to those participating in the scheme. The idea of a price cap is from the United States, where it has helped create support for participation in and ratification of the Kyoto Protocol. In the US the high cost of abatement measures is still one of the main arguments for ignoring ‘Kyoto’.

As things stand at present it is does not make economic sense to intervene in the price mechanism of the NOx emissions market. All the conditions for an optimally functioning market are now in place and failure of the NOx market is an unlikely scenario. In this study a number of hypothetical causes of market failure were examined. The conclusion drawn is that any undesirable developments in the NOx market can best be addressed by tackling the root causes of market imperfections rather than introducing a price cap in the hope of controlling the impacts of market failure.

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