Project-Based CO2 Trading

Abstract:     
The market mechanisms built into the Kyoto Protocol have the potential of significantly reducing the costs of meeting the aggregate emission target. But if trading proceeds on a project-by-project basis rather than on a frictionless market, the total cost saving potential of trading is unclear. This paper provides the first attempt to explain market-level implications of project-based CO2 trading by developing a many-polluter cap-and-trade model where trades are coordinated by a time-taking search process. Trading entails frictions that alter the total number and size of private trades, and basic properties of the CO2 market as a transfer-mechanism. Perhaps surprisingly, frictions can also increase, not only decrease, the size of private trades. A calibration using previous cost estimates of CO2 reductions shows that frictions need not damage both sides of the market.

Keywords: climate change, pollution permits, matching

JEL Classifications: C61; H23; Q49

Working Paper Series