Production Capacity and Abatement Technology Strategies in Emissions Trading Markets

Two common approaches to emissions trading are “cap-and-trade”, in which an absolute 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 (which are often defined relative to output using emissions intensity targets). This paper reports on an experiment designed to test the theoretical predictions of the two approaches in a long-run laboratory environment in which subjects representing firms choose emission abatement technologies and output capacities. Subjects participate in vertical markets for emission rights and for output. Our evidence supports the theoretical prediction that aggregate output and emissions are inefficiently high in baseline-and-credit markets compared to corresponding cap-and-trade markets. A surprising finding is that it is clean firms that lead the inefficient output and emissions expansion in baseline-and-credit markets.