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A Cap-and-Trade Commitment Policy with Allowance Banking

Olli-Pekka Kuusela () and Jussi Lintunen ()
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Olli-Pekka Kuusela: Oregon State University
Jussi Lintunen: Natural Resources Institute Finland (Luke)

Environmental & Resource Economics, 2020, vol. 75, issue 3, No 2, 455 pages

Abstract: Abstract We examine the planner’s dynamic regulation problem in an emission trading system (ETS) with allowance banking. The planner sets the emissions cap for the next period after the current period allowance market has cleared, but before knowing the next period’s abatement cost realization. This creates a time consistency problem when banking is possible. We examine two policies to overcome the consistency problem: a commitment solution and the Markov perfect solution. We show that the endogenous price floor generated by the banking demand becomes an integral feature of the two policies. Hence, they can be best described as hybrid policies that combine elements from emissions taxes and tradable allowances. This reveals new welfare implications that have an influence on instrument choice in the traditional prices versus quantities setup. We compare the expected welfare outcomes of four different policy instruments: the commitment policy, the Markov policy, a Pigouvian tax, and a no-banking ETS. We show that allowing banking can yield welfare gains compared to tax and quantity regulation, with or without commitment.

Keywords: Prices versus quantities; Dynamic consistency; Markov perfect solution; Price quantity hybrid; Rational expectations; Emissions tax (search for similar items in EconPapers)
JEL-codes: E32 Q54 Q58 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1007/s10640-019-00395-y

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