Linkage between the Emission Allowance Market and the Offset Credit Market in Partial Equilibrium

Abstract

The Kyoto Protocol established targets for curbing greenhouse gas emissions in order to mitigate climate change, and it introduced two kinds of market-based mechanisms: the emission allowance market and the carbon offset market. We identify stylized features of the interaction between the two mechanisms. Our partial equilibrium model is the first analytic work that derives a closed form solution incorporating most policy instruments, such as abatement and offset usage, and delivery risks in offsets. The equilibrium solution enables to show an asymmetric price change of allowances and offsets in both directions and magnitude. We show how the price equilibrium and the price spread between allowances and offsets are affected by market conditions, such as the offset import limit, abatement and offset cost, penalty rate, emission cap, and base emissions.