Abstract:
By extending carbon pricing to buildings and road transport through ETS2, the European Union is undertaking a major policy experiment in market creation. ETS2 overlaps national emissions budgets and technology requirements, raising a general question: when does a legal market govern allocation? We distinguish three functions of market effectiveness: scarcity, exchange, and allocation authority. Completing exchange and allocation authority lowers present-value EU policy costs over 2028-2048 by 25.5%, or EUR 1.33 trillion relative to legal market creation only. Allocation authority accounts for 76% of savings; 88% of member states benefit. Compensating remaining losses requires EUR 6 billion, only 0.2% of ETS2 revenues. Restoring allocation authority raises the allowance price but lowers policy cost, implying that the endogenous carbon price in an ETS is not a sufficient statistic for welfare across institutional designs.
