The Impact of Uncertainty on Banking Behavior: Evidence from the US Sulfur Dioxide Emissions Allowance Trading Program

In this paper, we study empirically whether uncertainty has an influence on trade in the US sulfur dioxide allowances market. In particular, we investigate the role of uncertainty on banking behavior. To do this, we introduce a tractable, structural model of trading permits under uncertainty. The model establishes a relation between banking behavior and risk preferences, especially prudence in the Kimball (1990) sense. We then test this model using data on allowances, for utilities submitted to the US Environmental Protection Agency’s Acid Rain Program, carried over from one year to the next. Evidence is found of imprudence, namely, utilities bank permits in order to favor higher profits. Another finding is that larger utilities do not adopt behavior significantly different from that of smaller ones. This paper was presented at the “International Workshop on Uncertainty in Greenhouse Gas Inventories: Verification, Compliance & Trading” in Warsaw, Poland, September 2004, under the title “Portfolio Management of Emissions Permits and Prudence Behavior.”