Using Supply-Side Policies to Raise Ambition: The Case of the EU ETS and the 2021 Review

Unlike standard supply-side policies, the market stability reserve (MSR) can be used as a potent means of raising climate ambition. We calibrate an emissions trading model to the EU ETS and show that allowing firms to use rolling finite planning horizons can replicate past annual price and banking developments well compared to a standard infinite horizon, including the 2018 price rally. When firms have bounded foresight, indirectly raising ambition through the MSR is not equivalent to directly raising ambition through the emissions cap trajectory. Leveraging the MSR to raise ambition can be efficiency improving as it partially compensates for bounded foresight by frontloading abatement efforts so we analyze its interdependence with the cap trajectory to exploit synergies and minimize regulatory costs. Additionally, we quantitatively assess and compare changes in the MSR parameters for the 2021 review. In any case, MSR-induced resilience to demand shocks remains limited and one-sided by design.