Curbing price fluctuations in cap-and-trade auctions under changing demand expectations

Thomas Jeitschko, Soo Jin Kim and Pallavi Pal

Energy Economics, 2024, vol. 139, issue C

Abstract: In recent years, the carbon credit market has experienced significantly higher price volatility than initially predicted. To understand the factors driving these fluctuations, it is crucial to analyze the market within a repeated-period dynamic framework. We delve into dynamic auction design, examining how future demand expectations impact price volatility. Additionally, we propose a method to mitigate price volatility amid changing expected future demand. Our equilibrium analysis reveals that modifying the cap on per-period supply can reduce price fluctuations. Currently, either the government or the auctioneer sets a per-period limit on supply, which decreases at a fixed rate over time. However, we advocate for a flexible cap on per-period supply as a superior alternative. Specifically, we demonstrate that aligning the supply rate with expected future demand yields a more stable price. Furthermore, simulation data indicates that the optimal flexible cap should reduce supply at a faster rate than the rate of change in expected future demand. Additionally, we find that the optimal cap varies depending on auction characteristics such as competition intensity among firms.

Keywords: Dynamic mechanism design; Auctions; Emissions permits; Environmental regulation; Climate change (search for similar items in EconPapers)
JEL-codes: D43 L11 L42 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:eneeco:v:139:y:2024:i:c:s0140988324005127

DOI: 10.1016/j.eneco.2024.107804

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