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Suppose that, in order to address climate change, a country has an emissions trading scheme comprising the following elements:

  1. The scope of the scheme is defined to include most industries that produce large quantities of emissions, eg steel, cement, electricity generation.
  2. There is an annual cap on total emissions by industries within the scope of the scheme. Emissions permits are issued only up to the amount of the cap. Carry-forward of unused permits to a later year is not allowed.
  3. Trading of emissions permits is allowed, so that at any time there is a market price of permits determined by demand and supply.
  4. Emissions are reliably measured and effective enforcement action is taken to prevent a firm's emissions exceeding its permits.

Suppose further that the cap on emissions is progressively reduced, year by year, as part of the country's plan to achieve net zero emissions by 2050.

Question: Should it be expected that, while there may be short-term fluctuations in the market price of emissions permits, the general trend will be for the price to increase?

My thoughts: If the quantity of permits supplied is reduced but demand for permits remains unchanged, the price will increase. The key question then is what will happen to demand for permits. One possibility is that demand increases due to economic growth with increased demand for steel, cement, etc. Another possibility is that demand falls due to technological innovations enabling such goods to be produced by low-carbon methods at no extra cost. So the trajectory of the price of permits appears indeterminate. However, I suspect there is much more that could be said, eg where the cost of low-carbon production is somewhat more than conventional production, and wonder if any papers have addressed the question.

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  • $\begingroup$ Just to be absolutely clear: is banking of permits allowed? $\endgroup$
    – Maarten Punt
    Jun 22, 2022 at 6:59
  • $\begingroup$ @MaartenPunt I realise that actual schemes sometimes allow banking of permits, ie carry-forward of unused permits to a later year, but to keep the question as simple as possible I prefer to assume this is not allowed and am editing accordingly. $\endgroup$
    – Adam Bailey
    Jun 22, 2022 at 10:22

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