Emissions trading with clean-up certificates: How carbon debt can increase climate ambition levels

Incentivizing and financing carbon dioxide removal (CDR) is a challenge for regulators. We show how introducing carbon debt – the obligation to remove carbon in the future – in an emissions trading scheme (ETS) can induce CDR and enable net-negative emission flows. For “clean-up certificates” that bundle emission permits with carbon debt, we characterize demand and pricing in an analytically tractable model. To ensure repayment of carbon debt, we derive the necessary value of collateral and discuss institutions as a lender of last resort. We find that introducing clean-up certificates does not reduce near-term carbon prices and mitigation efforts when they replace emission permits in the ETS, and that, by controlling the extent of carbon debt, clean-up certificates are more efficient than an ETS with full borrowing flexibility. In an exemplary calibration to a comprehensive EU ETS, we identify welfare-improving reforms that increase environmental ambition while simultaneously reducing compliance costs. With sufficiently rapid technological progress, the EU’s remaining cumulative carbon budget could be halved compared to the current budget or even become negative.