Emissions trading with transaction costs

Abstract

We develop an equilibrium model of emissions permit trading in the presence of fixed and proportional trading costs in which the permit price and firms' participation in and extent of trading are endogenously determined. We analyze the sensitivity of the equilibrium to changes in the trading costs and firms' allocations, and characterize situations where the trading costs alternatively depress or raise permit prices relative to frictionless market conditions. We calibrate our model to annual transaction and compliance data in Phase II of the EU ETS (2008)(2009)(2010)(2011)(2012) which we consolidate at the firm level. We find that trading costs in the order of 10 ke per annum plus 1 e per permit traded substantially reduce discrepancies between observations and theoretical predictions for firms' behavior (e.g. autarkic compliance). Our simulations suggest that ignoring trading costs leads to an underestimation of the price impacts of supply-curbing policies, this difference varying with the incidence on firms.

Is environmental degradation linked to transaction cost in Sub-Saharan Africa?

“…This confirms the general view that regulating emissions upstream through a CO2 tax entails lower transaction costs than regulating downstream through emissions trading. Baudry et al (2021) push the frontiers of research on permit markets with transaction costs and make three contributions to the literature. First, they are developing a consolidation procedure for annual transaction and compliance data, which allows them to examine the behavior of companies in the market during Phase II of the Emissions Trading System.…”

Market Design for the Environment

“…Allowances were initially allocated freely to regulated entities based on past CO2 emissions. This was found to discourage participation by small compliance traders who faced high transaction costs and could save unused allowances or to borrow the equivalent of one year of allowances instead of interacting with the market (Jaraitė-Kažukauskė and Kažukauskas, 2015; Baudry et al, 2021).…”

The Market Stability Reserve in the EU Emissions Trading System: A Critical Review

“…As we explain below, this has important implications for ex post assessments of market performance and firm behavior as well as for ex ante assessments of market design elements and reforms, such as the MSR. We also refer the reader to Abrell et al (2022), Baudry et al (2021), andQuemin &Trotignon (2021) for recent reviews of the empirical, experimental, and theoretical literature on these topics.…”

“…In static models, firms' trading behavior depends on (a) transaction costs, whose fixed and variable components capture various types of frictions, and (b) their evaluation of the opportunity costs of holding allowances. Transaction costs can rationalize firms' observed participation in and intensity of trading (Naegele 2018, Baudry et al 2021, and their compliance and trading behavior is strongly related to their size, market position net of allocation, sector, productivity, and location ( Jaraitė-Kažukauskė & Kažukauskas 2015, Abrell et al 2022). Illustrating the importance of these factors, Baudry et al (2021) find that ignoring transaction costs can lead to underestimating the price increase in response to a reduction in supply (as is the case under the current MSR withdrawal mode).…”