Enforcement and price controls in emissions trading

This paper examines how enforcement affects the structure and performance of emissions trading programs with price controls under uncertainty about firms' abatement costs. The analysis highlights how an enforcement strategy can cause abatement-cost risk to be transmitted to enforcement costs via the price of permits. When this occurs, accommodating the effect of abatement-cost risk with an optimal policy results in higher expected emissions and lower expected permit price than their second-best optimal values. However, it is possible to design an enforcement strategy that shields enforcement costs from abatement-cost risk by tying sanctions directly to permit prices. This enforcement strategy stabilizes enforcement effort, the optimal permit supply and price controls are independent of enforcement costs, and the policy produces the second-best optimal outcome.     

Tying enforcement to prices in emissions markets: An experimental evaluation

We present results from laboratory emissions permit markets designed to investigate the transmission of abatement cost risk to firms' compliance behavior and regulatory enforcement strategies. With a fixed expected marginal penalty, abatement cost shocks produced significant violations and emissions volatility as predicted. Tying the monitoring probability to average permit prices effectively eliminated noncompliance, but transmitted abatement cost risk to monitoring effort. Tying the penalty to average prices reduced violations, but did not eliminate them. Some individuals in these treatments sold permits at low prices, presumably in an attempt to weaken enforcement. While tying sanctions directly to prevailing permit prices has theoretical and practical advantages over tying monitoring to prices, our results suggest that tying sanctions to prices may not be as effective as predicted without additional modifications.     

Modeling the impact of uncertainty in emissions trading markets with bankable permits

The various forms of uncertainty that firms may face in bankable emission permit trading markets will affect firms’ decision making as well as their market performance. This research explores the effect of increased uncertainty over future input costs and output prices on the temporal distribution of emission. In a dynamic programming setting, the permit price is a convex function of stochastic prices of coal and electricity. Increased uncertainty about future market conditions increases the expected permit price and causes a risk neutral firm to reduce ex ante emissions in order to smooth out marginal abatement costs over time. Finally, safety valves, both low-side and high-side, are suggested to reduce the impact of uncertainty in bankable emission trading markets.     

An experimental analysis of compliance in dynamic emissions markets

Two important design elements for emission trading programs are whether and to what extent firms are able to bank emissions permits, and how these programs are to be enforced. In this paper we present results from laboratory emissions markets designed to investigate enforcement and compliance when these markets allow permit banking. Banking is motivated by a decrease in the aggregate permit supply in the middle of multi-period trading sessions. Consistent with theoretical insights, our experiments suggest that high permit violation penalties have little deterrence value in dynamic emissions markets, and that the main challenge of enforcing these programs is to motivate truthful self-reports of emissions.     

An experimental analysis of compliance in dynamic emissions markets

Two important design elements for emission trading programs are whether and to what extent firms are able to bank emissions permits, and how these programs are to be enforced. In this paper we present results from laboratory emissions markets designed to investigate enforcement and compliance when these markets allow permit banking. Banking is motivated by a decrease in the aggregate permit supply in the middle of multi-period trading sessions. Consistent with theoretical insights, our experiments suggest that high permit violation penalties have little deterrence value in dynamic emissions markets, and that the main challenge of enforcing these programs is to motivate truthful self-reports of emissions.     

Emissions Trading with Shares and Coupons when Control over Discharges Is Uncertain

Two important decisions in designing markets for tradable emissions permits are whether to allow banking of permits (coupons) and whether to allow trading in entitlements to future permits (shares). Banking is predicted to reduce price instability when firms trade in a reconciliation market after the quantity of emissions has been determined. Tradable shares are a common feature in proposals for emissions trading in Canada. We conduct a laboratory experiment to investigate how bankable coupons and tradable shares affect efficiency and prices under uncertainty. Cognitive demands on the subjects are reduced by computerized advice on the optimal allocation of coupons across periods and the implied marginal values of coupons and shares. Banking, share trading, and uncertainty conditions are introduced in a complete factorial design with three observations per cell. High efficiencies are observed across all treatments. Uncertainty in the control of emissions leads to substantial price instability when banking is not allowed. Banking virtually eliminates the instability, but reduces the efficiency of the market institution. Share trading reduces trading volumes, increases price stability, and improves efficiency.     

Linking permit markets multilaterally

We formally study the determinants, magnitude and distribution of efficiency gains generated in multilateral linkages between permit markets. We provide two novel decomposition results for these gains, characterize individual preferences over linking groups and show that our results are largely unaltered with strategic domestic emissions cap selection or when banking and borrowing are allowed. Using the Paris Agreement pledges and power sector emissions data of five countries which all use or considered using both emissions trading and linking, we quantify the efficiency gains. We find that the computed gains can be sizable and are split roughly equally between effort and risk sharing.     

Non-compliance and the quota price in an ITQ fishery

This paper examines the effects of non-compliance on quota demands and the equilibrium quota price in an ITQ fishery. I show that whereas lower quota prices are implied unambiguously by expected penalties which are a function of the absolute violation size, the expectation of penalties based upon relative violations of quota demands can, under certain conditions, produce higher quota prices than in a compliant quota market. If there are both compliant and non-compliant firms in the fishery, the result would then be a shift in quota demand from compliant to non-compliant firms, rather than the reverse. The findings are generally applicable to quota markets in other industries, including pollution permit markets.     

The Economics of Pollution Permit Banking in the Context of Title IV of the 1990 Clean Air Act Amendments

This paper presents a model of the collective emission permit banking behavior of electricity-generating units affected by Title IV of the Clean Air Act Amendments of 1990. A rigorous treatment of the constraint that pollution permits cannot be borrowed from future allocations is introduced. This approach enables an analysis of the impact of future changes in electricity demand, regulations, and technologies on the present permit price and emissions level. The effect of uncertainty on the banking behavior is also explored.     

A Model of Intertemporal Emission Trading, Banking, and Borrowing

This paper provides a general treatment of emission trading, banking, and borrowing in an intertemporal, continuous-time model. Using optimal-control theory, the decentralized behavior of firms is shown to lead to the least-cost solution attainable under joint-cost minimization. Explicit solutions for the time paths of emissions and permit prices are derived when firms are allowed to both bank and borrow and when firms are only allowed to bank emission permits. The policy implications of emission banking and borrowing are discussed.     

Comparing policies to confront permit over-allocation

Instability in cap-and-trade markets, particularly with respect to permit price collapses, has been an area of concern for regulators. To that end, several policies, including hybrid price-quantity mechanisms and the newly introduced “market stability reserve” (MSR) systems, have been introduced and even implemented in some cases. I develop a stochastic dynamic model of a cap-and-trade system, parameterized to values relevant to the European Union׳s Emission Trading System (EU ETS) to analyze the performance of these policies aimed at adding stability to the system or at least at reducing perceived over-allocations of permits. Results suggest that adaptive-allocation mechanisms such as a price collar or MSR can reduce permit over-allocations and permit price volatility in a more cost-effective manner than simply reducing scheduled permit allocations. However, it is also found that the performance of these adaptive allocation policies, and in particular the MSR, are greatly affected by assumed discount rates and policy parameters.     

Unintended consequences of price controls: An application to allowance markets

Price controls established in a cap-and-trade allowance market are intended to reduce cost uncertainty by constraining allowance prices between a ceiling and floor; however, they could provide opportunities for strategic actions by firms that would lower government revenue and increase emissions. In particular, when the ceiling price is supported by introducing new allowances into the market, firms could choose to buy allowances at the ceiling price, regardless of the prevailing market price, in order to lower the equilibrium price of all allowances. Those purchases could either be transacted by firms intending to manipulate the market price or be induced through the introduction of inaccurate information about the cost of emissions abatement. Theory and simulations using allowance elasticity estimates for U.S. firms suggest that the manipulation could be profitable under the stylized setting and assumptions evaluated in the paper, although in practice many other conditions will determine its use.     

Carbon trading across sources and periods constrained by the Marrakesh Accords

We examine the potential effects on permit prices and abatement costs of four compliance rules governing emissions trade across sources and periods in the Kyoto Protocol: The banking rule that allows excess permits to be used later; the restoration rate rule that penalizes borrowing; the commitment period reserve rule that limits sales; and finally, the suspension rule that restricts borrowing and sales. Our framework is a two-period model where parties may be out of compliance in the Kyoto period, but are assumed to comply at a later time. Under varying assumptions about market power and US participation, we find that the rules may have pronounced effects on individual costs, but overall efficiency is not severely affected.     

Stochastic Pollution, Permits, and Merger Incentives

Pollution permit regulations introduce nonlinearities into the objective function of a polluting firm. We develop a microeconomic model to show the effects these nonlinearities might have upon firm decisions when emissions are stochastic. Under perfect competition the fraction of planned pollution covered by permits is shown to be separable from planned production. We also demonstrate that permit management incentives may motivate a merger of otherwise independent firms. Incentives to petition for “bubble” coverage are also considered. The model is studied under risk neutrality and risk aversion. Imperfectly competitive situations in the output and permit markets are also analyzed.     

The higher price of cleaner fuels: Market power in the rail transport of fuel ethanol

This paper provides evidence of market power in the transportation of ethanol used in reformulated gasoline and alternative transportation fuels. I estimate a reduced form model for railroad route-level prices. My identification strategy instruments for railroad entry, controls for selection and explicitly models capacity constraints. A detailed understanding of this industry is important because U.S. environmental policies seek to substantially expand ethanol use. Evidence of market power may alter the types of policies pursued by lawmakers. I find that ethanol shipment prices are lower for more competitive routes. I also find evidence that railroads price discriminate based on environmental regulation at route destinations. Monopolist prices for shipments to carbon monoxide non-attainment areas are 3% higher than shipments to other destinations. This price premium falls sharply with increased competition. This suggests a perverse result where environmental regulation increases the price of a clean input.     

Fishing quota markets

In 1986, New Zealand responded to the open-access problem by establishing the world's largest individual transferable quota (ITQ) system. Using a 15-year panel dataset from New Zealand that covers 33 species and more than 150 markets for fishing quotas, we assess trends in market activity, price dispersion, and the fundamentals determining quota prices. We find that market activity is sufficiently high in the economically important markets and that price dispersion has decreased. We also find evidence of economically rational behavior through the relationship between quota lease and sale prices and fishing output and input prices, ecological variability, and market interest rates. Controlling for these factors, our results show a greater increase in quota prices for fish stocks that faced significant reductions, consistent with increased profitability due to rationalization. Overall, this suggests that these markets are operating reasonably well, implying that ITQs can be effective instruments for efficient fisheries management.     

Do lower electricity storage costs reduce greenhouse gas emissions?

In the electricity sector, innovation in large-scale storage is anticipated to reduce costs and improve performance. The effect on greenhouse gas emissions of lower storage costs depends on the interactions between storage and the entire grid. The literature has disagreed on the role of storage in reducing emissions. In this paper we present a stylized model, which suggests that the effect of storage costs on emissions depends on the supply responsiveness of both fossil and renewable generators. Under common conditions in the United States, lower storage costs are more likely to reduce emissions when wind investment responds to equilibrium electricity prices and when solar investment does not. Simulations of a computational model of grid investment and operation confirm these intuitions. Moreover, because of its effect on coal and natural gas–fired supply responsiveness, introducing a carbon dioxide emissions price may increase the likelihood that lower storage costs reduce emissions.     

Incentives and prices in an emissions trading scheme with updating

Emissions trading schemes where allocations are based on updated baseline emissions give firms less incentive to reduce emissions for a given quota (or allowance) price. Nevertheless, according to Böhringer and Lange [On the design of optimal grandfathering schemes for emission allowances, Europ. Econ. Rev. 49 (2005) 2041–2055], such allocation schemes are cost-effective if the system is closed and allocation rules are identical across firms. In this paper, we show that the cost-effective solution may be infeasible if marginal abatement costs grow too fast. Moreover, if a price cap or banking/borrowing is introduced, the abatement profile is no longer the same as in the case with an auction (or lump-sum allocation). In addition, we show that with allocation based on updated emissions, the quota price will always exceed marginal abatement costs, possibly misguiding policy makers and investors about abatement costs. Numerical simulations indicate that the quota price most likely will be several times higher than marginal abatement costs, unless a significant share of allowances is auctioned.     

Emissions targets and the real business cycle: Intensity targets versus caps or taxes

For reducing greenhouse gas emissions, intensity targets are attracting interest as a flexible mechanism that would better allow for economic growth than emissions caps. For the same expected emissions, however, the economic responses to unexpected productivity shocks differ. Using a real business cycle model, we find that a cap dampens the effects of productivity shocks in the economy on all variables except for the shadow value of the emissions constraint. An emissions tax leads to the same expected outcomes as a cap but with greater volatility. Certainty-equivalent intensity targets maintain higher levels of labor, capital, and output than other policies, with lower expected costs and no more volatility than with no policy.     

Emissions targets and the real business cycle: Intensity targets versus caps or taxes

For reducing greenhouse gas emissions, intensity targets are attracting interest as a flexible mechanism that would better allow for economic growth than emissions caps. For the same expected emissions, however, the economic responses to unexpected productivity shocks differ. Using a real business cycle model, we find that a cap dampens the effects of productivity shocks in the economy on all variables except for the shadow value of the emissions constraint. An emissions tax leads to the same expected outcomes as a cap but with greater volatility. Certainty-equivalent intensity targets maintain higher levels of labor, capital, and output than other policies, with lower expected costs and no more volatility than with no policy.