A Cap-and-Trade Commitment Policy with Allowance Banking

Olli-Pekka Kuusela,Jussi Lintunen

doi:10.1007/s10640-019-00395-y

Olli-Pekka Kuusela, Jussi Lintunen

Open Access

https://doi.org/10.1007/s10640-019-00395-y

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Abstract

We examine the planner’s dynamic regulation problem in an emission trading system (ETS) with allowance banking. The planner sets the emissions cap for the next period after the current period allowance market has cleared, but before knowing the next period’s abatement cost realization. This creates a time consistency problem when banking is possible. We examine two policies to overcome the consistency problem: a commitment solution and the Markov perfect solution. We show that the endogenous price floor generated by the banking demand becomes an integral feature of the two policies. Hence, they can be best described as hybrid policies that combine elements from emissions taxes and tradable allowances. This reveals new welfare implications that have an influence on instrument choice in the traditional prices versus quantities setup. We compare the expected welfare outcomes of four different policy instruments: the commitment policy, the Markov policy, a Pigouvian tax, and a no-banking ETS. We show that allowing banking can yield welfare gains compared to tax and quantity regulation, with or without commitment.

Highlights

The relative performance of price and quantity policies in the presence of abatement cost uncertainty has been an active area of research since Weitzman’s (1974) seminal paper
The value of parameter depends on the type of speculators that are in the market, and it can vary depending on the length of the compliance period
Our results show that an emission trading system (ETS) with banking but no borrowing of allowances can in certain situations outperform an emissions tax and a quantity instrument with no intertemporal trading

Summary

Introduction

The relative performance of price and quantity policies in the presence of abatement cost uncertainty has been an active area of research since Weitzman’s (1974) seminal paper. Lintunen based on their expected welfare performance. Whether one instrument dominates over the other depends on the relative slopes of the marginal benefit and marginal damage curves. Such an information structure provides a relatively accurate description for many real world policies, such as those in the European Union Emissions Trading System (EU ETS), where the regulator must set the cap for the regulation period before knowing the true abatement cost realization

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