The European Union has a system for tradable permits' for the emission of greenhouse gases. The authorities initially set the cap on emiss.ons at a level that was expected to generate a permit price of about 20t pet tonne of emissions, and during the early 2000s the equilibrium price was close to 20€.
a. During the global recession of 2008-2009, man) European firms reduced their output of goods and services. Why would this also reduce their demand for emission permits?
b. Could this explain why the market price for permits fell to as low as 7€ per tonne during this period? Explain.
c. Some commentators have argued that the observed price volatility within the European trading system shows that a cap-and-trade system does not work in practice, even though it has theoretical appeal. Does a properly functioning cap-and-trade system display constant permit prices? Why or why not?
d. Is there a particular problem associated with volatile permit prices in a cap-and-trade system?