Curbing price fluctuations in cap-and-trade auctions under changing demand expectations

Abstract

In recent years, the carbon credit market has experienced significantly higher price volatility than initially predicted. To understand the factors driving these fluctuations, it is crucial to analyze the market within a repeated-period dynamic framework. We delve into dynamic auction design, examining how future demand expectations impact price volatility. Additionally, we propose a method to mitigate price volatility amid changing expected future demand. Our equilibrium analysis reveals that modifying the cap on per-period supply can reduce price fluctuations. Currently, either the government or the auctioneer sets a per-period limit on supply, which decreases at a fixed rate over time. However, we advocate for a flexible cap on per-period supply as a superior alternative. Specifically, we demonstrate that aligning the supply rate with expected future demand yields a more stable price. Furthermore, simulation data indicates that the optimal flexible cap should reduce supply at a faster rate than the rate of change in expected future demand. Additionally, we find that the optimal cap varies depending on auction characteristics such as competition intensity among firms.