Endogenous Market Power in an Emissions Trading Scheme with Auctioning

This paper contributes to the literature in market power for emissions permits, modeling an emissions trading scheme in which polluters differ only in their business-as-usual emissions. They play a two-stage static complete information game in which their market power arises endogenously from the business-as-usual emissions. In the first stage the polluters bid in an auction for the distribution of the fixed supply of permits and in the second stage they trade these permits in a secondary market. For compliance, they can also engage in abatement activity at a quadratic cost. In equilibrium all polluters are successful in the auction. In the secondary market the low emitters are net sellers and the high emitters are net buyers. Moreover, the secondary market price is unambiguously above the auction clearing price. The welfare analysis shows that the aggregate compliance cost when polluters act strategically increases in the heterogeneity of their business-as-usual emissions. Furthermore, there exists a threshold of the fixed supply of permits above which strategic behavior is socially preferable. Finally, for certain distributions of the business-as-usual emissions, strategic behavior is cost-effective, regardless of the level of the available supply of permits.