Endogenous Cap Reduction in Emission Trading Systems

Since its inception, the European Emission Trading Systems (EU ETS) has been struggling with an oversupply of emission allowances and a highly volatile allowance price. A demand reducing technological progress accelerates the accumulation of excess allowances in the EU ETS, which is only partially taken into account in the system. We suggest a benchmark approach that endogenously adjusts the supply of allowances aligned to the technological progress. Using a non-parametric approach (Data Envelopment Analysis), we measure country specific technology shifts to proxy the required adjustment of the allowance supply in order to avoid a steady price decline and thus keep the incentive to invest in low-carbon technologies up. Our results indicate that the endogenous allowance reduction scheme, aligned to technological progress, would intensify the competitive pressure and facilitate a higher cap reduction factor than the existing linear reduction factor in the EU ETS