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Rate of return regulation and emission permits trading under uncertainty

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  • Zhang,Fan
  • Huang,Tao

Abstract

This paper analyzes the dynamic effects of rate-of-return regulation on firms? emissions compliance behavior when the price of emissions permits is uncertain. The paper shows that uncertainty regarding the price of permits would motivate a regulated firm to adopt a more self-sufficient strategy and would reduce the cost-effectiveness of emission allowance trading. When allowance transactions are treated as capital investments, uncertainty could reverse the classic Averch-Johnson effect, so that a regulated firm would purchase fewer permits in the ex ante period than its unregulated counterpart. These results are driven by the asymmetric impact of a price change on the expected marginal value of allowances under rate-of-return regulation. A wider variation in the permit price and a decline in the regulated rate of return would amplify the asymmetry. These results have implications for the efficiency of the proposed global carbon trading system.

Suggested Citation

  • Zhang,Fan & Huang,Tao, 2015. "Rate of return regulation and emission permits trading under uncertainty," Policy Research Working Paper Series 7343, The World Bank.
  • Handle: RePEc:wbk:wbrwps:7343
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    Keywords

    Energy Production and Transportation; Debt Markets; Climate Change Mitigation and Green House Gases; Markets and Market Access; Climate Change Economics;
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