Conference Agenda

The efficiency of carbon pricing hinges on markets broad enough to encompass heterogeneous economies and sectors. Linking carbon markets is gaining increasing attention, in particular for advanced systems in which caps are rapidly decreasing and prices are rising. Paradoxically, realizing linking surfaces economic and political threats that tend to be more severe the more advanced a system is. One is an immediate convergence of prices due to intertemporal arbitrage opportunities that emerge already when firms anticipate linking in the future. This paper shows that ensuring gradual price convergence across linked markets requires two instruments -- one to establish the exchange rate at which permits trade in each period, another to align intertemporal arbitrage incentives with the targeted sequence of exchange rates -- and characterizes how they should be calibrated jointly. These tools may enable policymakers to control price convergence while initiating linking, and offer more flexibility to manage the distributional and environmental impacts of linking, thus overcoming a main barrier to higher stringency. A calibrated numerical application to the EU ETS1 and ETS2 illustrates the different price paths and emission levels under various gradual linking policies.