Correlated Emissions Variability in Tradable Permit Markets with Imperfect Enforcement
Unexpected variation in emissions can have an enormous impact on the prices of emission permits and the efficiency achieved in tradable permit markets. Shocks to emission levels can be correlated across firms; for example, most firms require more emission permits than planned for following a widespread, hot summer. In this paper we report results from a laboratory experiment in which subjects participate in an emissions trading market in the presence of emissions uncertainty. Subjects face exogenous, random positive or negative shocks to their emission levels after they make production and emission control plans for that period. In one treatment subjects face correlated shocks and in another they face uncorrelated shocks. In some sessions we allow subjects to bank their permits for future use. In all sessions, subjects can trade in a reconciliation period to buy or sell extra permits following the shock realization. Subjects then report their emissions to the regulatory authority and they are placed in different inspection groups depending on their compliance history. The design of our experiment allows us to identify important interactions between emission shocks, banking and enforcement. Preliminary results suggest that the relationship between emission shocks and price changes is significantly stronger without banking, and that price volatility is two to three times greater without banking. Banking therefore helps in smoothing out the price variability arising from the imperfect control of emission
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