Bankable Pollution Permits Under Uncertainty and Optimal Risk Management Rules: Theory and Empirical Evidence

Abstract

The well known economic advantage of tradable permits over command and control obviously vanishes if firms do not trade because of regulatory uncertainty. In fact, uncertainty about political decision changes in the permits program could make firms reluctant to participate in tradable permits markets. Based on a two-period partial equilibrium framework, our results suggest that the banking provisions may be used as a tool of policy risk control and that it is possible to define optimal risk sharing rules in order to respond to political decision changes. Finally, our empirical discussion attempts to put the theoretical results concerning firms' banking and pooling behaviors in the context of the recent development of the European Union Emisions Trading scheme (EU ETS).

Keywords: Firm behavior, Tradable permits, Policy risk, EU ETS

JEL Classification: D21, D80, Q58