A LESS PERFECT WORLD FOR EMISSIONS TRADING: THE CASE OF WATER QUALITY TRADING WITH UNCERTAINTY AND TRANSACTION COSTS
Session Market-based Mechanisms and the Price Dynamics of Emission Permits (Special session)
Session ChairsMarc Chesney, University of Zurich and Luca Taschini, London School of Economics
Session OrganizersMarc Chesney, University of Zurich and Luca Taschini, London School of Economics

Market mechanisms are increasingly being used as a tool for allocating somewhat scarce but unpriced rights and resources, and the European Emission Trading Scheme is a prominent example. Despite the prevalence of cap-and-trade schemes, there are still many pending questions and issues such as: what is the relationship between the equilibrium price of the emission permits and the marginal costs of the cheapest pollution abatement solution; what are the optimal volume of emission permits in circulation and penalty level in order to improve the effectiveness of these markets; what is the impact of a cap-and-trade scheme on firms' investment decisions? Issues linked with market liquidity and with strategic behavior are also important. There is an increasing need to develop effective dynamic models for the price of marketable permits. In fact, a valid price model is an essential component for any decision-making process, and for constructing optimal hedging and purchasing strategies in a carbon constrained market. This session will focus on the contributions that quantitative approaches developed in finance and in real options can deliver in modeling the price dynamics of Emission Permits from an empirical and theoretical point of view.


Presenter(s) Jim Shortle, Penn State University
Discussant(s) Luca Taschini, London School of Economics
Co-Author(s) Nga Nguyen, ABARE, Patrick Reed, Pennsylvania State University and Trung Thanh Nguyen, University of British Columbia
WCERE Categorys Tradeable permits and Water management; Water Pollution
Keywords agent-based modeling, asymmetric information, emissions trading, transaction costs and water quality trading

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We address the question of “How well can the market do?” for water quality trading in a less perfect world with uncertainties and transaction costs. Our objective is to develop an agent-based simulation model to advance the understanding of (i) the complexities in attaining the equilibrium states of water quality markets, (ii) the challenges faced by the market in the process of transitioning to its expected performance from an initial design and (iii) the impacts of transaction costs and market design parameters on the performance of water quality markets. The results suggest that it is difficult for the market to gravitate to its “best- known” equilibrium when participants must make complex risk-based decisions in bilateral negotiations. The range of market equilibrium’s performance for a given market design shows that a market equilibrium induced by complex interactions among agents under multiple sources of uncertainties might not be the least cost solution to the planner’s deterministic problem assuming perfectly competitive markets. This range also affirms that the initial structure of a water quality market is a significant determinant of its outcomes. Transaction costs are found to reduce market efficiency and trading activities while market design parameters have mixed impacts on market outcomes.

 
When & Where
Thu 1 Jul 10
08:45 - 10:30
Room DS-M280
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