The Effect of Market Power in Emission Permit Markets

Abstract

<p>Emission permit markets are being actively implemented as a regulatory method to control various types of pollution in the United States because of the potential efficiency improvements they offer. In Canada, regulators have been more cautious, frequently citing concern that proposed Canadian markets are expected to be thin and/or dominated by a single firm. In these circumstances, such a firm could manipulate prices to reduce its own emission control costs while increasing the total cost of pollution control across the market. Such activity might also cause emission permit markets to be viewed as unviable on efficiency and equity grounds. This thesis investigates the potential problems such markets might experience if one firm (or a group of firms) has the ability to manipulate market prices to their advantage. Given the lack of empirical data, experimental economic methods are used in an attempt to determine whether it is reasonable to assume violations of the basic competitive market assumptions should be expected to seriously undermine the efficiency benefits emission permit markets offer in a controlled setting.</p> <p>The experiments reported here show that in double auction markets with one dominant firm and a number of fringe firms, strategic manipulation occurs repeatedly in the laboratory. The dominant firm uses emission permits in a socially inefficient manner in order to reduce its costs, increase its profits and exclude rivals in downstream product markets. Far from finding increased market efficiency and decreased cost of pollution control, this study confirms that implementing permit markets when there are firms with market power may decrease efficiency. The resultant loss in gains from trade could also reduce the political viability of emission trading programs.</p>