Enforcing transferable permit systems in the presence of market power

Abstract

We derive an enforcement strategy for a transferable permit system in the presence of market power that achieves complete compliance in a cost-effective manner. We show that the presence of a firm with market influence makes designing an enforcement strategy more difficult than enforcing a perfectly competitive system. We also re-consider Hahn's (1984) suggestion that a firm with market influence should be allocated permits so that it chooses to not participate in the permit market. When enforcement and its costs are taken into account, Hahn's suggestion does not hold except in a very special case. The presence of market power will limit the extent to which transferable emissions permit systems can fulfill their theoretical promises. Hahn (1984) was the first to show that permit trading in the presence of market power cannot be expected to result in a distribution of emissions that minimizes aggregate abatement costs. Furthermore, the distribution of emissions will never be completely independent of the initial allocation of permits. Modeling a transferable permit system in which one firm has market power while the rest are perfect competitors (a dominant firm/competitive fringe model), Hahn demonstrated that aggregate abatement costs are minimized only when the dominant firm is allocated exactly the number of permits it will choose to hold in equilibrium. Simply, aggregate abatement costs are minimized only when a firm that can manipulate the permit price does not because it chooses to not trade permits. Like most of the theoretical literature on transferable permit systems, Hahn ignored the fact that compliance in a permit system must be enforced. Recognizing this important omission, van Egteren and Weber (1996) extended Hahn's work to