The state of California has implemented an economy-wide program to regulate its greenhouse gas emissions. A significant share of the emission reductions will be obtained via a cap and trade program with a mix of auctioning and free allocation of allowances. This program has a number of novel design features added to address concerns over price volatility and over the possibility of market manipulation. These mechanisms include a price containment reserve, a limit on ownership of allowances, and the forced consignment to auction of some of the share of freely allocated allowances. In earlier experiments we found that the use of asset holding limits can have counterproductive effects on market function and can increase the probability of price manipulation.

We use a series of laboratory experiments to test the ability of larger market participants to manipulate prices. We examine mechanisms by which large holders might take advantage of the existing market design for competitive advantage, driving prices away from the marginal cost of abatement. We then explore how two modest changes in market design can change participant incentives for price manipulation. We test how a small change in the schedule of allowance auctions and how a hard price cap as part of a price collar change the likelihood of manipulation. We examine whether either of these changes can reduce the need for costly limits on asset holding by market participants. We discuss the implications for the design of price containment reserves.