Edited by Stefan E. Weishaar
Chapter 5: Emissions trading and market manipulation
If firms participating in an emissions trading scheme (ETS) perceive market power, the permit price and the distribution of abatement and production is a function of the initial permit allocation, which contrasts with the case of perfect competition. The underlying reason is that abatement does not happen where it is cheapest, but where it maximizes firm profits, which is generally not the same if firms act strategically. As a result, society pays more to reduce emissions to a given emissions cap than it would in the absence of ETS market manipulation. This chapter reviews the literature about market power in emission markets. The earlier theoretical work abstracts from an interaction between permit and product markets. This makes the problem tractable and leads to an intuitive result: Net permit sellers will use their market power to increase the permit price, whereas the opposite holds for net buyers. The more recent literature shows that if firms are able to pass on emission costs to product prices, even net permit buyers can have an incentive to increase the permit price, provided that they receive a sufficiently generous free allocation of permits. Another important result is that if firms are able to bank but not borrow permits, as is typically the case in real-world ETS, downward price manipulation is unlikely to be a concern. The empirical literature about this topic is much more scarce, however, because firm-specific data about abatement costs are not available. Instead, the empirical literature has focused on firms’ permit holdings over time and compared them to counterfactual scenarios where firms act competitively. Whereas the studies about the US Acid Rain Program find no evidence for the exercise of market power, analyses of the RECLAIM market and the EU ETS are consistent with strategic behavior by large firms.
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