Trading Frictions in Dynamic Cap-and-Trade Markets
Why carbon markets get expensive and inefficient when trading costs money and information spreads slowly
When companies buy and sell pollution permits in cap-and-trade systems, high transaction costs and unequal access to market information create artificial price spikes that make these markets work worse at reducing emissions. Using seven million trades from Europe's carbon market over 17 years, researchers found that 40% of regulated companies don't trade at all in a given year, prices spike predictably in April when returns are highest, and the interaction of multiple trading obstacles amplifies price distortions far more than any single friction alone.
Carbon markets are supposed to efficiently price pollution and drive companies toward cleaner methods, but if frictions push prices up artificially, some firms simply stay out of the market instead of finding cheaper ways to reduce emissions. The finding that access decisions themselves reshape how these price spikes form means policymakers could lower transaction costs or improve information access to unlock real emissions reductions that the market currently leaves on the table.