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 Classification: C61; H23; Q49