Weitzman meets Taylor: EU allowance price drivers and carbon cap rules

Using a two-sector structural model, we identify abatement, energy prices, transition demand for permits, and regulatory supply shocks as the key drivers of permit prices in the third phase of the EU Emission Trading System (ETS). Through an innovative approach, we estimate unobservable abatement shocks and quantify the contribution of each factor to carbon price variability, which we find t o b e approximately eighty times greater than it would be under an optimal carbon pricing scenario aligned with the social cost of carbon. To address this, we propose the Carbon Cap Rule (CCR) – a rule-based cap adjustment mechanism that dynamically responds to deviations in emissions and abatement costs. The CCR reduces volatility by 55% compared to the current EU ETS cap, and cuts welfare losses in consumption equivalence terms by 40%.