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A Theoretical Model of Optimal Compliance Decisions under Different Penalty Designs in Emissions Trading Markets

  • Phillia Restiani

    (The School of Economics and Centre for Energy and Environmental Markets at UNSW)

  • Regina Betz

    ()

    (Centre for Energy and Environmental Markets (CEEM), School of Economics, Australian School of Business, University of NSW)

This paper employs a theoretical model to examine compliance incentives and market efficiency under three penalty types: the fixed penalty rate, which uses a constant marginal financial penalty; the make-good provision (quantity penalty), where each missing permit in the current period is to be offset with a ratio (restoration rate) in the following period; and a mixed penalty, which combines the two penalty types. Using a simple two-period model of firm‟s profit maximisation, we analyse compliance decisions and the efficient penalty level under each penalty type. Firms‟ compliance strategies are modelled as an irreversible investment in abatement measures and permit buying in the market. Our findings indicate that the penalty type does not affect compliance decisions provided that the efficient penalty level is applied. Market efficiency is retained regardless of penalty types. Nevertheless, the mixed penalty design provides the strongest compliance incentives. Hence this finding supports the practice in which this penalty design is widely used in the existing and the proposed trading schemes. Furthermore, we discuss the policy implications of the findings with regard to permit price discovery process and the Australian proposal of tying the penalty level to the permit price.

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Paper provided by Environmental Economics Research Hub, Crawford School of Public Policy, The Australian National University in its series Environmental Economics Research Hub Research Reports with number 1086.

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Date of creation: Dec 2010
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Handle: RePEc:een:eenhrr:1086
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