Implications of Alternative Emission Trading Plans

Abstract

<p>Two approaches to emissions trading are cap-and-trade, in which an aggregate cap on emissions is distributed in the form of allowance permits, and baseline-and-credit, in which firms earn emission reduction credits for emissions below their baselines. Theory suggests the long-run equilibrium of the cap-and-trade plan is socially optimal, whereas the corresponding baselineand- credit equilibrium is inefficient, since the baseline creates a subsidy to output. In the short-run, however, when output capacity is fixed, the two plans are predicted to be identical. Surprisingly, despite the long-run predictions, both approaches are used around the world.</p> <p>To test whether these predictions hold in real markets, we developed a computerized laboratory environment in which subjects, representing firms, can adjust their emission technology and capacity levels. Subjects trade emission rights in a uniform price sealed bid-ask auction. The demand for output is simulated. All decisions are tracked through a double-entry bookkeeping system. Full documentation of the software is attached as an appendix.</p> <p>Primarily, this dissertation presents results from the first ever experimental economic analysis comparing the two most commonly proposed and implemented emission trading policy instruments: cap-and-trade and rated-based baseline-and-credit emission permit trading. After creating a laboratory implementation of the theoretical setting, we report results from simulations with robot traders in a long-run environment. These simulations verify the long-run predictions. Simulations and pilot experiments provide interesting evidence on permit market volatilities and effects of various accounting rules. As a first step towards testing the long-run model with human subjects, this dissertation reports on a laboratory experiment designed to test the short-run predictions. The short-run experiments support the theoretical prediction that the two mechanisms yield similar outcomes, however both exhibit significant deviation from the predicted equilibrium.</p>