Barriers to efficient carbon pricing: policy risk, myopic behaviour, and financial constraints

Abstract We investigate the limitations of cap-and-trade systems in driving investments in low-carbon industrial technologies. Investments may be delayed, and technology choices may be suboptimal, due to myopic behaviour, financial constraints, and policy risk. We develop a partial-equilibrium model that explicitly captures these imperfections and, uniquely, represents multiple sectors with heterogeneous foresight horizons. This structure enables us to distinguish short-sightedness in emission trading from that linked to green investment hold-up. We illustrate these dynamics through a case study of green investment decisions in the steel sector. We quantify how these frictions and their interactions shape allowance banking, carbon price trajectories, and irreversible industrial investment decisions. We find that such imperfections can distort price paths, delay low-carbon investments, and lead to suboptimal technology choice. Conversely, imperfect investment behaviour may itself influence the carbon price trajectory when the affected sector is sufficiently large. The results highlight the need for complementary policy instruments and underscore the importance of modelling approaches that represent heterogeneous foresight and imperfect market behaviour.