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Abstract

A major concern with TEPs is that stochastic permit prices may discourage abatement investment relative to other policies such as a fixed emissions charge. However, the price uncertainty is fundamentally caused by abatement cost uncertainties, which affect investment under both policies. We develop a rational expectations general equilibrium model of permit trading to show how uncertainty reduces investment. Differences between the two policies can be decomposed into a general equilibrium effect and a price-vs-quantity effect. Except for the curvature of the payoff functions, uncertainties reduce both effects: tradable permits in fact helps maintain firms' investment incentives under uncertainty.

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