Irreversible Abatement Investment Under Cost Uncertainties: Tradable Emission Permits and Emissions Charges

A major concern with tradable emission permits (TEPs) is that stochastic permit prices may reduce firm incentive to invest in abatement capital or technologies relative to other policies such as a fixed emissions charge. However, under efficient permit trading, the price uncertainty is caused by abatement cost uncertainties which affect investment under both permit and charge policies. The authors develop a rational expectations general equilibrium model of permit trading to show how cost uncertainty affects investment. Differences between the two policies can be decomposed into a general equilibrium effect and a price-versus-quantity effect. Except for the curvature of the payoff functions, uncertainties reduce both effects so that tradable permits in fact help maintain firms' investment incentive under uncertainty.