Dynamic Incentives and Permit Market Equilibrium in Cap-and-Trade Regulation

I evaluate the welfare consequences of cap-and-trade regulation by considering permit banking and estimating transaction costs in permit trading. I construct a dynamic equilibrium model of emissions abatement and permit trading with banking. Applying it to the US Acid Rain Program, I simulate the impacts of transaction costs and alternative regulatory design. Transaction costs affect both inter-temporal and cross-sectional distribution of emissions, leading to greater health and environmental damage. Permit banking mitigates the negative effect of transaction costs on abatement costs and shifts the timing of emissions. Emissions tax can achieve an outcome close to dynamic capand-trade without transaction costs.