Accounting for permit price differentials in the European Union emissions trading system

Abstract

Since 2005, industrial installations regulated by the European Union Emissions Trading Scheme (EU ETS) have been required to surrender a permit for every ton of CO₂ they emit. In addition to the standard EU ETS permit - the European Union Allowance (EUA) - installations are allowed to surrender limited numbers of offsets. Offsets currently trade at a discount relative to EUAs. While it is well known that an offset limit theoretically results in a permit price differential, the current offset limit is not binding in aggregate. This thesis reconciles this nonbinding offset limit with the EUA - offset price differential. It is shown how such a limit can cause a price differential by binding for individual installations even when it is not binding in aggregate. At the same time it is shown how, under certain circumstances, barriers to entry in the offset market result in two types of behavior: installations either use offsets up to what they believe is their cap or forego them entirely. This appears consistent with empirical EU ETS behavior. Results suggest navigating the regulatory process makes up a significant portion of these barriers to entry.