Policy interactions, risk and price formation in carbon markets

Abstract

Carbon pricing is an important mechanism for signalling to individuals and companies societal concerns about climate change, and for providing an incentive to invest in carbon abatement. Price formation in carbon markets involves a complex interplay between policy targets, dynamic technology costs, and market rules. Carbon pricing may under-deliver investment due to R&D externalities and so additional policies may be needed which themselves affect carbon price formation. Also, future abatement costs depend on the extent of technology deployment due to learning-by-doing, leading to some circularity in the analysis of investment, learning, costs and prices. This paper introduces an analytical framework based on marginal abatement cost (MAC) curves with the aim of providing an intuitive (rather than complete) understanding of the key dynamics and risk factors in carbon markets. The framework extends the usual static MAC representation of the market to incorporate policy interactions and some technology cost dynamics. The analysis indicates that supporting large-scale deployment of mature abatement technologies suppresses the marginal cost of abatement, sometimes to zero, whilst increasing total abatement costs. However, support for early stage R&D may reduce both total abatement cost and carbon price risk. It is anticipated that the intuitive framework introduced here may help in policy design issues around cost containment measures and other market design options such as banking and borrowing (factors that are not currently incorporated into the model).