Trading Frictions in Dynamic Cap-and-Trade Markets

2026-06-02

AI Summary

This study investigates how multiple trading frictions—such as delayed participation, constrained intermediation, and information heterogeneity—affect the efficiency of externality correction in dynamic cap-and-trade markets. The authors develop a dynamic stochastic general equilibrium model featuring endogenous market entry and a feedback mechanism linking compliance-month price premia to trading behavior. Within this unified framework, they uncover non-additive interaction effects among frictions: while endogenous entry attenuates the impact of any single friction, it amplifies price sensitivity to their joint presence. Empirical analysis leveraging 2.7 million transaction and compliance records from the EU ETS (2005–2021) reveals that approximately 40% of regulated firms abstain from trading annually, with purchases heavily concentrated in April and systematically yielding high returns; moreover, firms’ trading flows predict future returns.

Abstract

We develop a dynamic stochastic model of markets with an externality and multiple trading frictions, and cap-and-trade as the leading application. Slow participation, limited intermediation, and heterogeneous information interact in equilibrium: agents choose costly market access, access determines residual compliance demand, intermediary constraints translate residual demand into a surrender-month premium, and the premium feeds back into access incentives. These interactions shape how effectively the market corrects the externality. We characterize access choices in closed form, prove that the equilibrium premium is unique, and show that endogenous access dampens the response to each friction in isolation, while the interaction of multiple frictions is non-additive and can amplify the price response. We quantify the model using 2.7 million EU ETS registry transactions and compliance records from 2005-2021. About 40% of operators do not trade annually, purchases concentrate in April when returns are systematically high, and operator flow predicts future returns.

Problem

• trading frictions
• cap-and-trade
• market participation
• information heterogeneity
• externality

Innovation

• dynamic stochastic model
• trading frictions
• cap-and-trade
• endogenous market access
• non-additive interactions