Irreversible abatement investment under cost uncertainties: tradable emission permits and emissions charges

A major concern with tradable emission permits is that stochastic permit prices may reduce a firm’s incentive to invest in abatement capital or technologies relative to other policies such as a fixed emissions charge. However, under efficient permit trading, the permit price uncertainty is caused by abatement cost uncertainties which affect investment under both permit and charge policies. We develop a rational expectations general equilibrium model of permit trading and irreversible abatement investment to show how cost uncertainties affect investment under permits. We compare the resulting investment incentive with that under charges. After controlling for the assumption that random shocks affect the abatement cost linearly, we find that firms’ investment incentive decreases in cost uncertainties, but more so under emissions charges than under permits. Therefore, tradable permits in fact may help maintain firms’ investment incentive under uncertainty.     

Setting trigger price in emissions permit markets equipped with a safety valve mechanism

This study develops an analytical model of emissions markets equipped with a safety valve mechanism. It examines how a regulator can control emission reductions by emitters by setting two policy parameters: emission targets and trigger prices. I demonstrate that the capabilities of these two policy parameters are greatly affected by uncertainty regarding unconstrained aggregate emissions. I also show that there exists a specific combination of target and trigger-price settings that eliminates the need to consider uncertainty regarding unconstrained aggregate emissions when regulators set emission reduction goals. The model and its findings identify a rule for setting trigger prices with respect to the total design of tradable permit systems and thus offer practical guidance in designing a permit market.     

Prices Versus Quantities: Technology Choice,Uncertainty and Welfare

Technological improvements have proven essential in mitigating environmental problems such as climate change, depletion of the ozone layer and acid rain. While it is well-known that price- and quantity-based regulatory instruments provide different investment levels, the effects on the choice between different technologies have received scant attention. This paper expands on the prices versus quantities literature by investigating firms’ technology choice in the face of demand and supply side uncertainty. I show that the regulator can not design tradable emissions permits and an emissions tax such that the two regimes are equivalent, even in terms of expected values. Moreover, a tax encourages the most flexible abatement technology if and only if stochastic costs and the equilibrium permit price have sufficiently strong positive covariance, compared with the variance in consumer demand for the good produced. Finally, the firms’ technology choices are socially optimal under tradable emissions permits, but not under an emissions tax.     

Carbon Trading with Imperfectly Observable Emissions

The Kyoto Protocol foresees emission trading but does not yet specify verification of (uncertain) emissions. This paper analyses a setting in which parties can meet their emission targets by reducing emissions, by investing in monitoring (reducing uncertainty of emissions) or by (bilaterally) trading permits. We derive the optimality conditions and carry out various numerical simulations. Our applications suggest that including uncertainty could increase compliance costs for the USA, Japan and the European Union. Central Europe and the Former Soviet Union might be able to gain from trading due to higher permit prices. Emissions trading could also lower aggregate uncertainty on emissions.     

Economic criteria for using wetlands as nitrogen sinks under uncertainty

If the environmental damages that are caused by excessive nitrogen load to the sea depend on the timing of emissions, then monitoring the stochastic variation of emissions is crucial for controlling eutrophication damages. A significant problem of nonpoint source (NPS) nitrogen pollution is that emissions are stochastic and difficult to control. The main purpose of this paper is to examine under what criteria wetlands are economically rational to use for controlling stochastic NPS pollution. Three criteria are identified using a simplified stochastic watershed model. It is suggested that wetlands are economically rational to use, especially when monitoring the uncertainty of emissions is a part of the decision problem. The theoretical findings are illustrated with an example from southwestern Sweden.     

Abatement and Permits when Pollution is Uncertain and Violations are Fined

This paper considers a firm’s choice of abatement and of the number of permits if actual pollution is stochastic such that full compliance cannot be ensured. This straightforward extension induces non-trivial and unexpected comparative static properties, such as: permits and abatement can be either substitutes or complements, higher fines can lower the number of acquired permits (or abatement), and higher permit prices can reduce abatement. Yet integrating these reactions into a (competitive) permit market eliminates puzzling features. This is an additional justification of tradable permits over standards, where regulators must cope with potentially counterproductive firm reactions. A first version of the paper was written at the School of Finance and Economics, University of Technology, Sydney and I am grateful for the enjoyed hospitality. I am also grateful for the valuable comments from an anonymous referee.     

Market Power,Permit Allocation and Efficiency in Emission Permit Markets

Market power in permit markets has been examined in some detail following the seminal work of Hahn (Q J Econ 99(4):753–765, 1984), but the effect of free allocation on price manipulation with market power in both product and permit market has not been fully addressed. I show that in this case, the threshold of free allocation above which a dominant firm will set the permit price above its marginal abatement costs is below its optimal emissions in a competitive market, and that overall efficiency cannot be achieved by means of permit allocation alone. In addition to being of general economic interest, this issue is relevant in the context of the EU ETS. I find that the largest German, UK and Nordpool power generators received free allowances in excess of the derived threshold. Conditional on having price-setting power in both the electricity and permit markets, these firms would have found it profitable to manipulate the permit price upwards despite being net permit buyers.     

Admissible market data structures: A complete characterization

This paper characterizes the market data which, if observed by traders in a stochastic exchange environment, will permit the general existence of (rational) expectations equilibria. It is proved that if a trader observes and conditions his expectations on some nonconstant market data, he must observe at least the equilibrium price and his own equilibrium trade. Any data which do not satisfy this requirement, such as the price alone, or the price and the volume of trade, will fail to permit the existence of an expectations equilibrium for some otherwise well-behaved stochastic environment.     

The Brave New World of Carbon Trading

Human-induced climate change has become a prominent political issue, at both national and international levels, leading to the search for regulatory ‘solutions’. Emissions trading has risen in popularity to become the most broadly favoured government strategy. Carbon permits have then quickly been developed as a serious financial instrument in markets turning over billions of dollars a year. In this article, I show how the reality of permit market operation is far removed from the assumptions of economic theory and the promise of saving resources by efficiently allocating emission reductions. The pervasiveness of Greenhouse Gas emissions, strong uncertainty and complexity combine to prevent economists from substantiating their theoretical claims of cost-effectiveness. Corporate power is shown to be a major force affecting emissions market operation and design. The potential for manipulation to achieve financial gain, while showing little regard for environmental or social consequences, is evident as markets have extended internationally and via trading offsets. At the individual level, there is the potential for emissions trading to have undesirable ethical and psychological impacts and to crowd out voluntary actions. I conclude that the focus on such markets is creating a distraction from the need for changing human behaviour, institutions and infrastructure.     

Firm Scale and the Endogenous Timing of Entry: a Choice between Commitment and Flexibility

This paper presents a model of stochastic oligopoly with demand uncertainty where firms endogenously choose entry timing. We examine two extreme types of market structure and show that the equilibrium correspondence that connects them is continous. With two identically sized firms, there are symmetric, Cournot type equilibria where the probability of early entry declines with greater uncertainty, and for low uncertainty two asymmetric equilibria. With one large firm with a continuum of nonatomic firms, there is a unique Stackelberg equilibrium. We conclude that the behavior of a dominant firm with a finite fringe can be approximated by Stackelberg equilibrium.Journal of Economic LiteratureClassification Numbers?: D21, L11.     

Allowing for Household Preferences in Emission Trading – A Contribution to the Climate Policy Debate

In the context of emission trading it seems to be taken as given that people's preferences can be ignored with respect to the whole process of fixing emission targets and allocating emission permits to polluters. With this paper we want to reopen the debate on how citizens can be involved in this process. We try to show how citizen preferences can be included in the process of pollution control through emission trading. We propose an emission trading system where all emission permits are initially allocated to households who are then allowed to sell them in the permit market or to withhold (at least some of) them in order to reduce total pollution. This proposal tries to overcome the fundamental disadvantage of traditional permit systems which neglect consumer preferences by solely distributing emission permits to producers / polluters. In our system the property right to nature is re-allocated to the households who obtain the opportunity of reducing actual emissions according to their personal preferences by withholding a part or all of the emission permits allotted to them. Such a change in environmental policy would mark a return to the traditional principles of consumer sovereignty by involving households (at least partially) in the social abatement decision process instead of excluding them. Another advantage of admitting households to the TEP market as sellers or buyers of permits is that this increases the number of agents in the permit market and thus significantly reduces the possibilities of strategic market manipulations.     

DESIGNING POLLUTION MARKET INSTRUMENTS: CASES OF UNCERTAINTY

This paper examines design alternatives for emissions trading credits and assesses their relative performance given several sources of uncertainty endemic to market-based environmental regulatory programs. Facilities regulated in such programs face significant uncertainty about their total emissions. Uncertainty arises due to changes in production-demand schedules for their product, imperfect knowledge of abatement efficiency, and other informational lags. Depending on the design of the trading credit, this uncertainty can result in significant market price volatility and undesirable increases in peak emissions (in the absence of additional costly market institutions, such as contingent contracts and brokered insurance). In addition to the design alternatives, the paper considers allocation alternatives to alleviate these unintended effects and also discusses the value of properly designed reconciliation markets .     

Permit Trading and Credit Trading: A Comparison of Cap-Based and Rate-Based Emissions Trading Under Perfect and Imperfect Competition

This paper compares emissions trading based on a cap on total emissions (permit trading) and on relative standards per unit of output (credit trading). Two types of market structure are considered: perfect competition and Cournot oligopoly. We find that output, abatement costs and the number of firms are higher under credit trading. Allowing trade between permit-trading and credit-trading sectors may increase welfare. With perfect competition, permit trading always leads to higher welfare than credit trading. With imperfect competition, credit trading may outperform permit trading. Environmental policy can lead to exit, but also to entry of firms. Entry and exit have a profound impact on the performance of the schemes, especially under imperfect competition. We find that it may be impossible to implement certain levels of total industry emissions. Under credit trading several levels of the relative standard can achieve the same total level of emissions.     

Ex-post efficient permit markets: a detailed analysis

This paper provides a detailed analysis of ex-post efficient permit markets. After a short review of institutional designs that can achieve ex-post efficiency under uncertainty and asymmetric information, we analyze the effects of an ex-post efficient regulation on the expected costs of the regulated firms, on their investment behavior, and on the incentives for strategic behavior on imperfectly competitive permit markets. Also we inquire about the budget effects of the regulation. Our results show that ex-post efficient permit markets have considerable benefits beside the direct increase in expected social welfare.      

Prices versus quantities: environmental regulation and imperfect competition

By exercising market power, a firm will distort the production, and therefore the emissions decisions, of all firms in the market. This paper examines how the welfare implications of strategic behavior depend on how pollution is regulated. Under an emissions tax, aggregate emissions do not affect the marginal cost of polluting. In contrast, the price of tradable permits is endogenous. I show when this feedback effect increases strategic firms’ output. Relative to a tax, tradable permits may improve welfare in a market with imperfect competition. As an application, I model strategic and competitive behavior of wholesalers in a Mid-Atlantic electricity market. Simulations suggest that exercising market power decreased emissions locally, thereby substantially reducing the regional tradable permit price. Furthermore, I find that had regulators opted to use a tax instead of permits, the deadweight loss from imperfect competition would have been even greater.     

Market Power in Emission Permit Markets: Theory and Evidence from the EU ETS

A well-known result about market power in emission permit markets is that efficiency can be achieved by full free allocation to the dominant firm. I show that this result breaks down when taking the interaction between input and output markets into account, even if the dominant firm perceives market power in the permit market alone. I then examine the empirical evidence for price manipulation by the ten largest electricity firms during phase I of the EU ETS. I find that some firms’ excess allowance holdings are consistent with strategic price manipulation, and that they cannot be explained by price speculation or by precautionary purchases to insure against uncertain future emissions. My results suggest that market power is likely to be an empirically relevant concern during the early years of emission permit markets.     

Structural Uncertainty and Pollution Control: Optimal Stringency with Unknown Pollution Sources

We relax the common assumption that regulators know the structural relationship between emissions and ambient air quality with certainty. We find that uncertainty over this relationship can manifest as a unique form of multiplicative uncertainty in the marginal damages from emissions. We show how the optimal stringency of environmental regulation depends on this structural uncertainty. We also show how new information, like the discovery of previously unknown emission sources, can counterintuitively lead to increases in both optimal emissions and ambient pollution levels.     

Multinational taxation and international emissions trading

Many studies have shown that the activities of multinational corporations are quite sensitive to differences in income tax rates across countries. In this paper I explore the interaction between multinational taxation and abatement activities under an international emissions permit trading scheme. Four types of plans are considered: (1) a single domestic permit system with international offsets; (2) separate national permit systems without trade; (3) separate national permit systems with limited offsets; and (4) an international permit trading system. For each plan, I model the incentives for the multinational firm to choose abatement activities at home and abroad and to transfer emissions credits between parent and subsidiary. Limits on trading across countries restrict efficiency gains from abatement, as is well known. But if available offset opportunities are limited to actual abatement activities, those activities are also more susceptible to distortions from incentives to shift taxable income. Transfer-pricing rules can limit but not always eliminate these distortions. In a system of unlimited international trading, abatement is efficiently allocated across countries, but tax shifting can still be achieved through intra-firm transfer pricing. From the basis of efficiency for both environmental and tax policies, the best design is an international permit trading system with transparent, enforceable transfer-pricing rules.     

Conserving biodiversity with tradable permits under changing conservation costs and habitat restoration time lags

Tradable permits are a common environmental policy instrument that has recently been applied also to the conservation of biodiversity. Biodiversity conservation differs in many respects to the classical applications of tradable permits like emissions control. One particularity is that, even if the permit system maintains a constant total amount of species habitat, habitat turnover (the destruction of a habitat and restoration elsewhere) affects the ecosystem. Another particularity is that the restoration of habitats often takes much time, leading to time lags between the initiation of restoration activities and the time when restored habitat is available for trading. We use an agent-based model of a tradable permit market to study the influence of heterogeneous and dynamic conservation costs and habitat restoration time lags on key variables of the market, such as the costs incurred to the market participants and the amount of habitat turnover. Our results show that there may be trade-offs between these key variables. We also find that restoration time lags can lead to fluctuations in permit prices that reduce the efficiency of the permit market. We conclude that temporal lags deserve a careful analysis when implementing tradable permit systems for the preservation of natural habitats and biodiversity.     

The effects of regulation on stochastic systematic risk

There is recent evidence that systematic risk measures for most firms are stochastic, and that non-stationarity in systematic risk characteristics for regulated firms is related to the presence of regulation. Prior empirical evidence, which suggests that regulation reduces risk, did not incorporate the stochastic nature of the risk/return relationship. There are also problems with the modeling of regulation in this earlier work, and there is evidence that regulated firms may have recently grown riskier. These issues are addressed here by examining a stochastic model that structurally incorporates regulation. Differences in the risk structure of regulated and unregulated firms are identified. Analytic results, simulation results, and actual empirical estimates provide evidence that regulation reduces, but does not eliminate, stochastic systematic risk. The actual empirical results suggest that regulators do reduce stochastic systematic risk, which should lead to lower required rates of return for utilities.