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Climate Policy Design with Correlated Uncertainties in Offset Supply and Abatement Cost

  • Fell, Harrison

    ()

    (Resources for the Future)

  • Burtraw, Dallas

    ()

    (Resources for the Future)

  • Morgenstern, Richard

    ()

    (Resources for the Future)

  • Palmer, Karen

    ()

    (Resources for the Future)

Current and proposed greenhouse gas cap-and-trade systems allow regulated entities to offset abatement requirements by paying unregulated entities to abate. These offsets from unregulated entities are believed to contain system costs and stabilize allowance prices. However, the supply of offsets is highly uncertain and may be correlated with other sources of uncertainty in emissions trading systems. This paper presents a model that incorporates both uncertainties in the supply of offsets and in abatement costs. We numerically solve a dynamic stochastic model, with parameters relevant to the U.S. climate debate, under a variety of parameter settings, including a system that includes allowance price controls, risk aversion, and competitive offset purchasing. We find that as uncertainty in offsets and uncertainty in abatement costs become more negatively correlated, expected abatement plus offset purchase costs increase, as does the variability in allowance prices and emissions from the regulated sector. These results are amplified with risk sensitivity, larger annual offset limits, and competitive offset purchasing. Imposing an allowance price collar substantially mitigates cost increases as well as the variability in prices, while roughly maintaining expected environmental outcomes. In contrast with previous literature we find a collar may also mitigate emissions variability.

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Paper provided by Resources For the Future in its series Discussion Papers with number dp-10-01-rev.

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Date of creation: 09 Jun 2011
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Handle: RePEc:rff:dpaper:dp-10-01-rev
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  1. Thomas Tallarini, . "Risk-Sensitive Real Business Cycles," GSIA Working Papers 1997-35, Carnegie Mellon University, Tepper School of Business.
  2. Rubin, Jonathan D., 1996. "A Model of Intertemporal Emission Trading, Banking, and Borrowing," Journal of Environmental Economics and Management, Elsevier, vol. 31(3), pages 269-286, November.
  3. Cronshaw, Mark B & Brown-Kruse, Jamie, 1996. "Regulated Firms in Pollution Permit Markets with Banking," Journal of Regulatory Economics, Springer, vol. 9(2), pages 179-89, March.
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  5. Newell, Richard G. & Pizer, William A., 2003. "Regulating stock externalities under uncertainty," Journal of Environmental Economics and Management, Elsevier, vol. 45(2, Supple), pages 416-432, March.
  6. Pizer, William A., 2002. "Combining price and quantity controls to mitigate global climate change," Journal of Public Economics, Elsevier, vol. 85(3), pages 409-434, September.
  7. Brian C. Murray & Richard G. Newell & William A. Pizer, 2008. "Balancing Cost and Emissions Certainty: An Allowance Reserve for Cap-and-Trade," NBER Working Papers 14258, National Bureau of Economic Research, Inc.
  8. Fischer, Carolyn, 2004. "Project-Based Mechanisms for Emissions Reductions: Balancing Trade-offs with Baselines," Discussion Papers dp-04-32, Resources For the Future.
  9. Urvashi Narain & Klaas Veld, 2008. "The Clean Development Mechanism’s Low-hanging Fruit Problem: When Might it Arise, and How Might it be Solved?," Environmental & Resource Economics, European Association of Environmental and Resource Economists, vol. 40(3), pages 445-465, July.
  10. Fan, Lin & Hobbs, Benjamin F. & Norman, Catherine S., 2010. "Risk aversion and CO2 regulatory uncertainty in power generation investment: Policy and modeling implications," Journal of Environmental Economics and Management, Elsevier, vol. 60(3), pages 193-208, November.
  11. Fell, Harrison & Morgenstern, Richard, 2009. "Alternative Approaches to Cost Containment in a Cap-and-Trade System," Discussion Papers dp-09-14, Resources For the Future.
  12. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  13. Murray Fulton & James Vercammen, 2009. "Optimal Two-Part Pricing in a Carbon Offset Market: A Comparison of Organizational Types," Southern Economic Journal, Southern Economic Association, vol. 76(2), pages 513-532, October.
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