Policy credibility is a key component for an effective and efficient EU Emissions Trading System

Abstract

If actors do not consider the long-term cap on emissions to be credible, they will minimize their costs to achieve the short-term cap only, missing intertemporally efficient emission reductions and potentially creating stranded assets from misinvestments. The two ETS reforms increased commitment to the cap, and thus instilled policy credibility that elevated prices to a level of around €80 per tCO2, consistent with what model results suggest is dynamically cost-effective. The price effect of policy credibility is substantial, as near-term price levels in a farsighted market (high credibility) are about three times higher than in a short-sighted market (low credibility). Policymakers should take precautions to sustain high credibility and consider suitable interventions if prices drop again to levels that signal low credibility.