PERMIT MARKETS AND INVESTMENT IN POLLUTION ABATEMENT
Gizem Keskin, Rice University, 2813529854, gizem@rice.edu
Overview
Production processes that use energy from fossil fuels as an input result in an unwanted byproduct, that is, air
pollution. In the absence of government regulation (such as a standard, a tax, or a market), firms would not be
willing to take on pollution control as it would be against their objective of profit maximization. Therefore, the
regulator needs to step in and restrict emissions or create a market where the pollution can be priced. The
policymaker may use either command and control (CAC) types of instruments (such as an emission standard or a
technology standard) or market incentives for regulation. Although CAC instruments provide the policymaker with
more control on the outcome of the regulation, they fail to utilize differences in firms’ abatement costs. Therefore,
the overall cost of the regulation is not minimized. Alternatively, cap and trade systems can achieve the minimum
cost to the economy by setting firms free to choose the way to comply as long as the overall emission target in the
economy is met. Depending on their costs, firms may choose to purchase allowances on the market to cover
emissions or invest in pollution abatement technologies to cut them.
Although economic theory has proved that cap and trade systems are able to achieve pollution targets at the lowest
cost (Montgomery, 1972), the real outcome may be different. In order for the policy tools to result in the planned
outcome, the agents must behave in the way predicted by the policy makers. However, uncertainty inherent in the
market may cause firms to be unwilling to participate and choose other options to comply while they may not be the
lowest cost alternatives. This may reduce the cost advantage of a cap and trade system over alternative types of
regulations. Therefore, it is worth analyzing the firm’s decision to choose alternative methods, such as investment in
pollution abatement technologies, to comply with the regulation under a cap and trade system. This paper aims to
look at the pollution abatement investment decision of a firm operating under a permit market. The paper aims to
illustrate the optimal amount of investment for a base model and see the effects of regulatory uncertainty on firm’s
investment decision.
Methods
Dynamic optimization techniques
Results
The production decision turns out to be a static one. As expected, higher price of output, higher stock of abatement
capital, lower cost of input and lower price of permits lead to more production. The investment decision is dynamic.
The results so far are for the base model and the effects of regulatory uncertainty are yet to be determined.
Conclusions
Permit markets assures that the target level of emissions will be met at a minimum cost to the economy. The firms
are free to choose the compliance option that is to their best interest. They can choose to purchase permits or invest
in pollution abatement, or combine both. However, the regulatory uncertainties (such as possible threat towards
continued operation of the market, or intervention to market mechanism) may cause firms to favor safer options over
the others, such as investment in abatement capital. As this would affect the cost advantage of a permit market
compared to other regulatory options, it is worth analyzing the investment behavior of a firm operating in a cap and
trade environment. This paper aims to fill this gap in the literature by looking at the pollution abatement investment
of a firm in a dynamic set up.
References
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