Zhao, Jinhua

Journal of Public Economics Vol. 87 (2003): 2765-2789.

A major concern with tradable emission permits
is that stochastic permit prices
may reduce a firm's incentive to invest in abatement capital
or technologies relative to other policies
such as a fixed emissions charge.
However,
under efficient permit trading,
the permit price uncertainty is
caused by abatement cost uncertainties
which affect investment under both permit and charge policies.
We develop a rational expectations general equilibrium
model of permit trading
and irreversible abatement investment
to show how cost uncertainties affect investment under permits.
We compare the resulting investment incentive with
that under charges.
After controlling for the assumption that random shocks
affect the abatement cost linearly,
we find that
firms' investment incentive decreases
in cost uncertainties,
but more so under emissions charges than under permits.
Therefore,
tradable permits in fact may help maintain firms' investment
incentive under uncertainty.