Permit banking in emission trading: Competition, arbitrage and linkage

Abstract

Several existing or proposed climate policies have considered bankable permits in a cap-and-trade (C&T) program that covers beyond a single sector, e.g., electric power, or allows the program to link to external C&T programs in other regions. This paper develops a model of permit banking under imperfect competition and imperfect inter-temporal arbitrage, in which the firms in one dominant sector can exert market power in both product and permit markets, while those in other sectors or linked programs are perfectly competitive. A simple analytical model is developed to generate contestable hypothesis. We further extend the model to account for the physical power system, institutional rules and market conditions, and then apply it to the Pennsylvania-Jersey-Maryland (PJM) market. We show that if the dominant firm has market power, then the permit price rises at a higher rate than the discount rate, contrary to perfectly competitive permit market, where the permit price rises at the discount rate following the classic Hotelling's rule. Furthermore, under a declining emissions cap system with the permits front-loaded in early time periods, the dominant firm has an incentive to suppress the permit prices (monopsony) when buying the permits in early periods, and then inflate the permit prices (monopoly) when selling them in later periods. Numerical results of the PJM case are consistent with the analytical conclusion.