Weitzman Meets Taylor: EU Allowances Futures Price Drivers and Carbon Cap Rules

We examine the determinants of European Union Allowances (EUA) futures prices and the market design of the European Trading System (ETS) using a macro-finance framework. We introduce an innovative approach to estimate the impact of abatement and climate sentiment shocks, leveraging the information contained in the price of EUA futures. Our analysis reveals that during the third phase of the ETS, the price has been primarily influenced by energy fluctuations, climate sentiment, and abatement shocks. When compared to the social cost of carbon (SCC), representing the optimal policy scenario, we find that the ETS price is 100 times more volatile. Furthermore, we observe that volatility in ETS prices generates monthly losses of 0.22\% in consumption-equivalent terms compared to the SCC case. We conclude by illustrating how implementing a carbon cap rule can significantly reduce this price volatility and welfare losses, bringing it closer to the first-best policy.