A Safety Valve for Emissions Trading

This paper considers the optimal design of an emissions trading program that includes a safety valve tax that allows pollution sources to escape the emissions cap imposed by the aggregate supply of emissions permits. I demonstrate that an optimal hybrid emissions trading/emissions tax policy involves a permit supply that is strictly less than under a pure emissions trading scheme and a safety valve tax that exceeds the optimal pure emissions tax as long as expected marginal damage is an increasing function. While the expected level of emissions under a hybrid policy may be more or less than under pure emissions trading or a pure emissions tax, under the assumption that uncertainty about aggregate marginal abatement costs is symmetric the most likely outcome is that emissions will turn out to be less under the hybrid. Finally, a steeper expected marginal damage function calls for higher permit supply and safety valve, which reduces expected aggregate emissions and the probability that the safety valve will be employed.