Climate policy proposals based on cap and trade mechanisms with tight caps will likely lead to highly volatile CO2 prices. This volatility is ignored in many studies, even though it can be expected to exceed that of natural gas and to exceed the wide ranges in CO2 price forecasts. Volatility will significantly increase investment risk, raise the cost of capital, and make it valuable to defer investments. The net result could be that CO2 price volatility becomes an impediment to the very investments that the climate policy is attempting to encourage.

Compared to a carbon policy regime with more predictable carbon prices, we estimate that CO2 price volatility under current policy proposal could delay investment in low-carbon and carbon abatement technologies by 10 years or more. We propose that an effective policy to reduce this investment barrier would be a safety-valve mechanism that includes both a floor and a ceiling on CO2 prices. This would reduce volatility and protect both investors and customers from extreme carbon prices.

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