OPTIMAL INVESTMENT IN POLLUTION ABATEMENT UNDER A CAP AND TRADE
SYSTEM
GizemKeskin, Rice University, 2813529854,
[Lead Author’s Name, Affliation, Phone, email]
[2nd Author’s Name, Affliation, Phone, email]
[Other Author’s Name, Affliation, Phone, email]
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Overview
Cap and trade systems are lower cost alternatives to environmental regulations compared to command and control approaches as the firms have the freedom to choose their lowest cost strategy to comply with the regulation. So long as the cap is set at an appropriate level and violations are prosecuted effectively, the overall emission goal of the system will also be 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. Excess allowances can be banked or sold. Although firms have several options, the achievement of lower cost depends on whether these options are utilized optimally. In reality, uncertainities regarding prices and future regulations may prevent the firm from behaving optimally. This paper builds a model where the firm maximizes profit while meeting the emission constraint it faces now and expects to face in the future. The firm is allocated allowances and is allowed to use, to trade or to bank them as it can in reality. The paper aims to illuminate the policy issue that proposed or threatened command and control regulations may affect the efficiency of the cap and trade market.
Methods
Dynamic optimization
Results
The results show that as allowance price or input price increases, optimal production drops. However, an increase in the price of output will result in an increase in optimum production. Similarly, an increase in stock of abatement capital will lead to more production. Results of how expectations affect current behavior are yet to be determined.
Conclusions
For cap and trade systems to achieve their goal of pollution control at the lowest cost, it is crucial that firms utilize available options optimally. This paper determines optimal investment in pollution abatement that firms should undertake as a function of capital cost, demand, allowance price and expectations. It addresses the policy issue of direct controls possibly reducing the efficiency of the allowance market. Whether the firms undertake this optimal amount of investments is yet to be tested using data from EPA’s Acid Rain Program, which established a tradable permits market for sulfur dioxide (SO2), and successfully took emissions of SO2 under control nationwide.
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