International Trading of Emissions Rights: Pricing under Accountability and Uncertainty

The purpose of this analysis is to explore a firm's demand for uncertain pollution emissions under agreements such as the Kyoto Protocol, which allow for emissions permit trading among parties. This article extends the literature with the development of a generalized penalty structure that can be implemented by the overseers of such agreements. This includes market-based modifications to the Kyoto Protocol, which has not been adopted by the United States, and which will expire soon. The countries' demand or supply of emissions rights is derived as based on profit maximization that utilizes an opportunity cost function. The parties' emission decision rules are shown to depend on the policy parameter values chosen as well as the probability distribution of observable emissions.