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Optimal Trading Ratios for Pollution Permit Markets

  • Stephen Holland
  • Andrew J. Yates

We analyze a novel method for improving the efficiency of pollution permit markets by optimizing the way in which emissions are exchanged through trade. Under full-information, it is optimal for emissions to exchange according to the ratio of marginal damages. However, under a canonical model with asymmetric information between the regulator and the sources of pollution, we show that these marginal damage trading ratios are generally not optimal, and we show how to modify them to improve efficiency. We calculate the optimal trading ratios for a global carbon market and for a regional nitrogen market. In these examples, the gains from using optimal trading ratios rather than marginal damage trading ratios range from substantial to trivial, which suggests the need for careful consideration of the structure of asymmetric information when designing permit markets.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19780.

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Date of creation: Jan 2014
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Publication status: published as Holland, Stephen P. & Yates, Andrew J., 2015. "Optimal trading ratios for pollution permit markets," Journal of Public Economics, Elsevier, vol. 125(C), pages 16-27.
Handle: RePEc:nbr:nberwo:19780
Note: EEE
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