Investment Incentives in Tradable Emissions Markets with Price Floors

Abstract

Concerns about cost containment and price volatility have led regulators to include price controls in many cap-and-trade markets. We study how these controls affect firms’ incentives to invest in the adoption of abatement technologies in a model with abatement cost uncertainty. Price floors increase investment incentives because they raise the expected benefits from lowering abatement costs. We also report a market experiment that features abatement cost uncertainty and the opportunity for cost-reducing investment, with and without a price floor. Consistent with the theoretical model, investment is significantly greater with the price floor in place. Emissions permit prices also respond as predicted to abatement investments and emissions shocks. In particular, prices are only responsive to investment and shocks when the price floor is not implemented.