The role of output reallocation and investment in coordinating environmental markets

Abstract

We examine the inefficiency of uncoordinated environmental regulation of CO2 emissions from electricity generation for a large regional U.S. wholesale electricity market that spans multiple states. We estimate a dynamic structural model of production and investment to compare the social welfare of two counterfactual regulatory scenarios. In both scenarios, emissions targets set by the regulator are met via endogenously determined CO2 prices in markets aiming to correct the externality. In the first scenario, the CO2 prices are state-specific. In the second scenario, there is a regional CO2 price. According to our social welfare estimates, the inefficiency of uncoordinated regulation is mitigated substantially because of the firms’ participation in an integrated product market in two main ways. First, firms reallocate output from states with high CO2 prices to states with low prices. Second, this reallocation spurs investment in cleaner capacity that is exempt from CO2 regulation. Our finding regarding the mitigation and, potentially, elimination of the inefficiency is robust to alternative models of optimal investment behavior.