Pollution permits, Strategic Trading and Dynamic Technology Adoption

TL;DR

This paper examines how firms strategically trade permits and adopt new technologies in a dynamic setting, showing that permit trading influences technology adoption and permit prices, with policy implications for market design.

Contribution

It introduces a model where permit trading and technology adoption are endogenously linked, demonstrating equilibrium conditions and policy effects on permit prices and incentives.

Findings

Existence of a pure-strategy Nash equilibrium in permit trading.

Policy can create a floating price floor for allowances.

Self-financing policy criteria are proposed and validated.

Abstract

This paper analyzes the dynamic incentives for technology adoption under a transferable permits system, which allows for strategic trading on the permit market. Initially, firms can invest both in low-emitting production technologies and trade permits. In the model, technology adoption and allowance price are generated endogenously and are inter-dependent. It is shown that the non-cooperative permit trading game possesses a pure-strategy Nash equilibrium, where the allowance value reflects the level of uncovered pollution (demand), the level of unused allowances (supply), and the technological status. These conditions are also satisfied when a price support instrument, which is contingent on the adoption of the new technology, is introduced. Numerical investigation confirms that this policy generates a floating price floor for the allowances, and it restores the dynamic incentives to invest. Given that this policy comes at a cost, a criterion for the selection of a self-financing policy (based on convex risk measures) is proposed and implemented.