Emissions trading with profit-neutral permit allocations

Abstract

This paper examines the operation of an emissions trading scheme (ETS) in a Cournot oligopoly. We study the impact of the ETS on industry output, price, costs, emissions, and profits. In particular, we develop formulae for the number of emissions permits that have to be freely allocated to firms in order to neutralize any adverse impact the ETS may have on profits. These formulae tell us that the profit impact of the ETS is usually limited. Indeed, under quite general conditions, industry profits are preserved so long as firms are freely allocated a fraction of their total demand for permits, with this fraction being lower than the industry's Herfindahl index.JEL Classification Numbers: D43, H23, Q58

Emission Reduction and Profit-Neutral Permit Allocations

“…These results are consistent with Hepburn et al (2013) [8] who examine the impact of pollution permits on equilibrium emissions, output, price, market concentration, and profits in a generalized Cournot model. They identify a formula for the number of emission permits that have to be freely allocated to firms to neutralize the impact on profits of pollution permits and show that it is lower than the Herfindahl index.…”

“…Considering an exogenous permits price, the authors also demonstrate that in some cases free allowances are not required on the ground of profit neutrality. The present paper is complementary to Hepburn et al (2013) [8] since it endogenizes the permit price and analyzes the profit-neutral policy according to the level of emission reduction.…”

Pollution Permits, Imperfect Competition and Abatement Technologies

“…The paper closest to our analysis is Hepburn et al (2012), who independently study the eect of introducing a market for emission permits on a product market with imperfect competition. They focus on the free allocation of permits and show that in oligopolistic industries, prot-neutral allowances are partial, as the level of permits allocated for free is lower than total emissions.…”

“…Although we obtain similar results, there are important dierences between the two papers, and the eects at stake are, therefore, orthogonal. Indeed, Hepburn et al (2012) focus on the eect on prots of cost asymmetries among rms in the market, whereas we consider a market with identical rms but focus on the role of abatement technologies.…”

“…Thus, Hepburn et al (2012) do not disentangle abatement costs from production costs but merely assume that the lower a rm's total cost is, the lower its emission intensity, i.e., the level of pollution per unit of output, is. In this framework, introducing a market for permits allows for a more ecient allocation of production, from the industry point of view, as the market share of more ecient rms increases, which increases the joint prots in the nal market.…”