An Experimental Comparison of Cap- and Intensity-based Pollution Markets

Markets are an increasingly popular regulatory choice to cost effectively control negative externalities. Traditionally, market designs have employed a cap-and-trade format that places an absolute limit on the quantity of emissions. In contrast, many new schemes—including the world’s largest in China—limit the aggregate emissions intensity of production. This article theoretically and experimentally compares intensity- and capbased markets. We design a novel laboratory experiment, where firms choose both output and allowance exchange. Consistent with our theoretical predictions, we find that employing an intensity-based market rather than an equivalent cap-and-trade scheme significantly increases aggregate output, average allowance prices, aggregate abatement, and decreases industry profits. Overall, both markets perform as expected and close to the cost effective allocation of pollution abatement but with lower levels of aggregate profit as high production costs types produce significantly more output than predicted.