Price volatility and risk exposure: on the interaction of quota and product markets

Baldursson, Fridrik M. and Fehr, Nils-Henrik M. von der (2009): Price volatility and risk exposure: on the interaction of quota and product markets.

Abstract

We consider an industry with firms that produce a final good emitting pollution to different degree as a side effect. Pollution is regulated by a tradable quota system where some quotas may have been allocated at the outset, i.e. before the quota market is opened. We study how volatility in quota price affects firm behaviour, taking into account the impact of quota price on final-good price. The impact on the individual firm differs depending on how polluting it is - whether it is `clean' or `dirty'- and whether it has been allocated quotas at the outset. In the absence of long-term or forward contracting, the optimal initial quota allocation turns out to resemble a grandfathering regime: clean firms are allocated no quotas - dirty firms are allocated quotas for a part of their emissions.With forward contracts and in the absence of wealth effects initial quota allocation has no effect on firm behaviour.

• Item Type: MPRA Paper
• Language: English
• Keywords: regulation, effluent taxes, tradable quotas, uncertainty, risk aversion, environmental management
• Subjects: Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q3 - Nonrenewable Resources and Conservation > Q38 - Government Policy; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty; L - Industrial Organization > L5 - Regulation and Industrial Policy > L51 - Economics of Regulation; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q2 - Renewable Resources and Conservation > Q28 - Government Policy; D - Microeconomics > D9 - Intertemporal Choice; H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H23 - Externalities ; Redistributive Effects ; Environmental Taxes and Subsidies

References

Abel, Andrew B (1983), Optimal investment under uncertainty, American Economic Review, 73, 228-33.

Adar, Z and J M Griffin (1976): Uncertainty and the choice of pollution control instruments, Journal of Environmental Economics and Management, 3, 178-88.

Baldursson, Fridrik M and Nils-Henrik M von der Fehr (2004a): Price volatility and risk exposure: on market-based environmental policy instruments, Journal of Environmental Economics and Management, 48(1), 682-704.

Baldursson, Fridrik M and Nils-Henrik M von der Fehr (2004b): Prices vs. quantities: the irrelevance of irreversibility, Scandinavian Journal of Economics, 106(4), 805-821.

Baldursson, Fridrik M and Nils-Henrik M von der Fehr (2007): A whiter shade of pale: on the political economy of regulatory instruments, Journal of the European Economic Association, 5(1), 37-65.

Baldursson, Fridrik M and Nils-Henrik M von der Fehr (2008): Prices vs quantities: public finance and the choice of regulatory instruments, European Economic Review, 52, 1242-1255.

Batra, Raveendra N and Aman Ullah (1974): Competitive firm and the theory of input demand under price uncertainty, The Journal of Political Economy, 82(3), 537-48.

Baumol, William J and Wallace Oates (1988): The Theory of Environmental Policy, Second Edition, Cambridge: Cambridge University Press.

Baron D.P. (1970): Price uncertainty, utility, and industry equilibrium in pure competition, International Economic Review, 11, 463-480.

Barradale, Merrill Jones (2008): Impact of policy uncertainty on renewable energy investment: wind power and PTC, USAEE WP 08-003, University of California at Berkeley.

Chao, Hung-po and Robert Wilson (1993): Option value of emission allowances, Journal of Regulatory Economics, 5, 233-49.

Dixit, Avinash and Robert Pindyck (1994): Investment under Uncertainty, Princeton NJ: Princeton University Press.

von der Fehr, Nils-Henrik (1993), Tradable emission rights and strategic interaction, Environmental and Resource Economics, 3, 129-151.

Fishelson, G (1976): Emission control policies under uncertainty, Journal of Environmental Economics and Management, 3, 189-97.

Goldberg, Victor P (1990): Aversion to risk aversion in the new institutional economics, Journal of Institutional and Theoretical Economics, 146, 216-22.

Green, Richard (2008), Carbon tax or carbon permits: the impact on generators' risks, The Energy Journal, 69 (3), 67-89.

Hartman, Richard (1972): The effects of price and cost uncertainty on investment, Journal of Economic Theory, 5, 258-66.

Lerner, A P (1971): The 1971 report of the president's council of economic advisers: priorities and efficiency, American Economic Review, 61, 527-30.

Magnusson, Gudmundur (1969): Production under Risk, Acta Universitatis Upsaliensis, Studia Oeconomica Upsaliensia, 2, Uppsala University.

Meyer, Margaret A (1984): Prices vs. Quantities with Risk Aversion and Bankruptcy, unpublished manuscript, Nuffield College.

Montero, Juan-Pablo (2002): Prices vs. quantities with incomplete enforcement, Journal of Public Economics, 85(3), 435-454.

Newbery, David M (2008): Climate change policy and its effect on market power in the gas market, Journal of the European Economic Association, 6 (4), 727-51.

Nickell, Stephen J (1977): The influence of uncertainty on investment, The Economic Journal, 87, 47-70.

Norstrøm, Carl J (1974), Optimal capital adjustment under uncertainty, Journal of Economic Theory, 8, 139-48.

Ogden, Joseph P, Frank C Jen and Philip F O'Connor (2002): Advanced Corporate Finance - Policies and Strategies, Upper Saddle River NJ: Prentice Hall.

Pezzey, John (2003): Emission Taxes and Tradeable Permits: A Comparison of Views on Long-Run Efficiency, Environmental and Resource Economics 26, 329--342.

Pindyck, Robert S (1982): Adjustment costs, uncertainty and the behavior of the firm, The American Economic Review, 72(3), 415-27.

Roberts, Marc J and Michael Spence (1976): Effluent charges and licences under uncertainty, Journal of Public Economics, 5, 193-208.

Sandmo, Agnar (1971): On the theory of the competitive firm under uncertainty, American Economic Review, 61, 65-73.

Schmalensee, Richard, Paul L Joskow, Denny Ellerman, A, Montero, Juan Pablo and Bailey, Elizabeth (1998): An interrim evaluation of Sulfur Dioxide Emissions Trading, Journal of Economic Perspectives, 12, 53-68.

Stavins, Robert N (1996): Correlated uncertainty and policy instrument choice, Journal of Environmental Economics and Management, 30, 218-32.

Upton, C W (1971): The Allocation of Pollution Rights, University of Chicago, Urban Economics Report No 59.

Varian, Hal (1990): The role of risk aversion in economic modelling, Journal of Institutional and Theoretical Economics, 146, 223-5.

Viaene, Jean-Marie and Itzhak Zilcha (1998): The behavior of competitive exporting firms under multiple uncertainty, International Economic Review, 39(3), 591-609.

Weitzman, Martin L (1974): Prices vs. quantities, Review of Economic Studies, 41, 477-91.

Xepapadeas, Anastasios (1999): Environmental policy and firm behavior: abatement investment and location decisions under uncertainty and irreversibility, NBER Technical Working Papers 0243, National Bureau of Economic Research, Inc.

Yohe, Gary W (1977): Comparison of price and quantity controls: a survey, Journal of Comparative Economics, 1, 213-234.

Yohe, Gary W (1978): Towards a general comparison of price controls and quantity controls under uncertainty, Review of Economic Studies, 45, 229-238.

Zhao, Jinhua (2003): Irreversible abatement investment under cost uncertainties: tradable emission permits and emissions charges, Journal of Public Economics, 87, 2765-2789.