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Market Design for Emission Trading Schemes
IFOR Events
Seminar:
'Optimization & Applications'
(see information & program)
Feb 20 - May 28, 2012
IFOR Mitteilungen
This booklet informs about ongoing projects and future events at the IFOR and appears once at the end of the year.
| Author | Max Fehr |
| Abstract |
Emission trading schemes are regulatory frameworks designed to reduce and to control pollution level by creation of economic incentives for responsible emission sources. Currently, there are several systems of this type in operation, with the European Union Emission Trading Scheme (EU ETS) as the largest multi-national mandatory mechanism for trading of carbon dioxide allowances. This thesis is concerned with the mathematical analysis of cap-and-trade schemes and other emissions regulations. We review the existing quantitative analysis on the subject and introduce some of the mathematical challenges posed by the implementation of the new phase of the European Union Emissions Trading Scheme as well as the cap-and-trade schemes touted by the US, Canada, Australia and Japan. From a theoretical point of view, the main thrust of the thesis is the introduction of a new mathematical framework for competitive equilibrium, in which a broad range of emission regulations can be analyzed. From a practical point of view, particular focus is given to the design and numerical analysis of new cap-and-trade schemes for the control and the reduction of atmospheric pollution. We develop tools intended to help policy makers and regulators understand the pros and cons of different regulations. As some fundamental differences between regulations do not occur in a deterministic setting we propose a stochastic equilibrium model for an economy where firms produce goods to satisfy an inelastic demand and are endowed with permits in order to offset their pollution at compliance time and avoid having to pay a penalty. Thereby we consider risk neutral (as opposed to risk averse) firms with the aim to obtain stronger equivalence results between different emission regulations. Firms that can easily reduce emissions do so, while those for which it is harder buy permits from firms which anticipate they will not need all their permits, creating a financial market for pollution credits. Our equilibrium model elucidates the joint price formation mechanism for goods and pollution allowances, capturing most of the features of the first phase of the European Union Emissions Trading Scheme. We show existence of an equilibrium and show that its solution reduces to an optimal stochastic control problem. We also prove uniqueness of emission credit prices and characterize the equilibrium prices of goods as well as the optimal production and trading strategies of the firms. Thereby it is shown that standard cap-and-trade schemes, designed in the spirit of the EU ETS are socially optimal (also in a stochastic setting!). However this does not imply that such schemes are inexpensive for consumers. In particular it is proven that standard cap-and-trade schemes increase consumer costs through a notable price increase for products, whose production causes pollution (for instance electrical power for EU ETS). This observation is evident, since the regulation shifts production towards cleaner, hence more expensive technologies, while the cost of pollution is factored into the prices of those products. One of the main targets of this thesis is to quantify such effects as well as other qualitative properties of emission regulations in a realistic framework. To this end we use the Japanese electricity market to numerically simulate the equilibrium in different regulatory settings. For this market it turns out that on one hand reduction costs are astonishingly low while on the other hand it is shown that consumers burden exceeds by far the overall reduction costs, giving rise for huge windfall profits for electricity companies, which was also observed in EU ETS. Moreover we use this numerical illustration to show that even tax based regulations and standard cap-and-trade schemes with a 100% auction can fail to reduce windfall profits to a reasonable level. This fact demonstrates the strong need for an improvement of generic cap-and-trade mechanisms. We show how to adapt the regulatory framework of an emission trading scheme in such a way that the final consumer costs are reasonably low, preserving the social optimality of the mechanism at the same time. The resulting relative and hybrid allocation schemes demonstrate that an apparently innocuous small change in the design can have a dramatic economic impact. |
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