John E. Parsons, A. Denny Ellerman and Stephan Feilhauer, January 2009
In this paper we focus on one component of the cap-and-trade system: the markets that arise for trading allowances after they have been allocated or auctioned. The efficient functioning of the market is key to the success of cap-and-trade as a system. We review the performance of the EU CO2 market and the US SO2 market and examine how the flexibility afforded by banking and borrowing and the limitations on banking and borrowing have impacted the evolution of price in both markets. While both markets have generally functioned well, certain episodes illustrate the importance of designing the rules to encourage liquidity in the market.