Emissions Markets with Price Stabilizing Mechanisms: Possible Unpleasant Outcomes

There is a large consensus that low levels of carbon price cannot provide adequate incentives to invest in cleaner technologies and abate emissions. Since carbon demand and price tend to decrease during recessions, economists and policy makers have proposed different types of price stabilizing mechanisms (PSM) for emissions markets to prevent carbon price from falling too low. We investigate the effects of a PSM on investments and emissions and show that when unfavorable macroeconomic conditions reduce emissions, adjusting the supply of allowances to sustain their price may inhibit investments. Moreover, when firms invest in an integrated abatement technology, not only can emissions increase - an effect previously examined in the literature - but a PSM can exacerbate this effect when an exogenous negative shock curbs the demand of carbon.