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A Cap-and-Trade Commitment Policy with Allowance Banking

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  • Olli-Pekka Kuusela

    (Oregon State University)

  • Jussi Lintunen

    (Natural Resources Institute Finland (Luke))

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.

Suggested Citation

  • Olli-Pekka Kuusela & Jussi Lintunen, 2020. "A Cap-and-Trade Commitment Policy with Allowance Banking," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 75(3), pages 421-455, March.
  • Handle: RePEc:kap:enreec:v:75:y:2020:i:3:d:10.1007_s10640-019-00395-y
    DOI: 10.1007/s10640-019-00395-y
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    More about this item

    Keywords

    Prices versus quantities; Dynamic consistency; Markov perfect solution; Price quantity hybrid; Rational expectations; Emissions tax;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming
    • Q58 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environmental Economics: Government Policy

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