Quantities with Prices: Price-Responsive Allowance Supply in Environmental Markets

• Price-responsive emissions allowance supply is more efficient than a pure quantity (cap) or price-based (tax) approach to environmental regulation in the presence of compliance cost uncertainty.
• Emission reductions from companion policies become additional to an emissions cap under a price-responsive allowance supply, enabling companion policies to help ratchet up program stringency over time.
• Price-responsive supply is generally introduced as a step function. More price steps in the allowance supply schedule will tend to reduce price and revenue variability under uncertainty.
• In the electricity sector, a flatter allowance supply schedule has less revenue variability when demand for allowances falls below expected levels although it brings greater emissions variability.
• Price-responsive supply can reduce the costs of administrative program adjustments, making the policy more durable, and increasing the influence of carbon pricing in driving emissions reductions moving forward.
• Simulation modeling and behavioral experiments demonstrate price-responsive supply schedules are easy for actors to understand and practical to implement.

Environmental policy with uncertainty is often posed as a choice between price and quantity instruments. Paradoxically, this economic advice employs architecture derived from a first-best global framework that applies imperfectly to the partial-equilibrium, multifaceted regulatory policy setting where it is applied. This paper evaluates instrument design and the evolution of environmental pricing in this sequential policy environment. Quantity “cap” instruments are more often used in practice. Recently, however, automatically adjusting emissions allowance supply schedules have been emerging in existing trading programs. We propose a conceptual framework for a price-responsive supply schedule and use simulation modeling and laboratory experiments to explore its performance and design, including its application in a specific regional market. A price-responsive supply schedule offers efficiency advantages over either a price or a quantity instrument and preserves the roles for technology and energy policies that are expected to lower costs over time.