What ails the European Union׳s emissions trading system?

The European Union has adopted economists׳ idea of curbing carbon emissions by establishing markets where bankable emissions allowances can be traded. Implicit in proofs that cap-and-trade minimizes the expected discounted cost of capping emissions, however, is that the regulator not intervene once the market is established. Otherwise market participants encounter uncertainties beyond what a social planner faces. This paper discusses the equilibrium that results when private agents bank tradable allowances in the face of ongoing risk of future regulatory intervention and shows that the cap will be achieved at unnecessarily high cost even if no regulatory intervention actually occurs. Evidence that such risks are currently distorting EU ETS comes from the depressed current spot price, from the findings of Schopp and Neuhoff (2014) that speculators require multiples of the riskless rate of interest to bank permits, and from the sensitivity of prices to votes and announcements about proposed future regulatory changes.