Pollution Abatement Using Cap-and-Trade in a Dynamic Supply Chain and its Coordination

Abstract

We study a two-period supply chain consisting of a manufacturer, who participates in a cap-and-trade scheme and faces an uncertain emission permit price, and a retailer, who sells the product from the manufacturer to consumer and faces a price-sensitive demand. In the face of uncertain future permit prices, the manufacturer determines the wholesale price and pollution abatement in each period that reduces pollutants per unit of output one period later. We model the problem as a two-period Stackelberg game, obtain a feedback Stackelberg equilibrium, and investigate the effects of emissions trading on the manufacturer's abatement investment, supply chain performance, and social welfare. We obtain a revenue-and-cost-sharing contract that coordinates the dynamic stochastic supply chain. We show that the abatement level increases in the permit price and decreases in its uncertainty. Moreover, the dirtier the supply chain is, the less is the effect of permit price and the more is the effect of its uncertainty. Both the manufacturer and the channel may benefit from the permit price uncertainty. For a dirty supply chain, a lower price and higher uncertainty intensify the double marginalization effect. If the second-period sales revenue is low enough, the manufacturer benefits and the retailer loses under the coordinating contract. Finally, when the toxicity of pollutants is relatively low (high), the effect of emissions trading on social welfare might be stronger in a cleaner (dirtier) supply chain.

Keywords: Abatement investment; cap-and-trade scheme; stochastic permit price; supply chain coordination; social welfare.

JEL Classification: C61, D24, Q56,