An Emissions Trading Scheme with Auctioning

This paper models an emissions trading scheme with auctioning in which risk averse polluters and non-polluters respond idiosyncratically to an economy-wide shock. A polluter’s willingness to pay for permits increases in her risk aversion and in the shock volatility when aggregate and individual sensitivities to this shock satisfy certain conditions. In addition, there is a region of low sensitivity and high emissions rates where the polluter’s willingness to pay for permits decreases in the expected secondary market price. Numerical simulations show that, ceteris paribus, dirtier firms overvalue the permits in the auction and become net sellers. When all polluters emit at the same rate, a wealth transfer takes place from the most sensitive to the least sensitive polluters, through the secondary market. The risk aversion exacerbates polluters’ sensitivity to the shock when forming their valuations: the more risk averse, the lower the valuations for the same sensitivity. The model predicts that, in a world with polluters only and homogeneous responses to the shock, the secondary market trading volume decreases in the uncertainty faced by the economy due to the tight competition at the initial allocation stage.