Rajesh Singh, associate professor of economics, and Quinn Weninger, John F. Timmons Professor of Environmental and Resource Economics, published an update to their working paper #14008, titled "Cap and trade under transactions costs and factor irreversibility" to be published soon in the journal, Economic Theory.
Cap-and-trade environmental regulations are used extensively throughout the world to control pollution and to sustainably manage natural resources. Cap-and-trade is credited with stopping acid rain in the eastern United States, and for protecting marine fish stocks throughout the world. It is currently used to limit carbon dioxide emissions in California and in 28 European countries, plus Iceland, Liechtenstein, and Norway.
This article develops new results for cap-and-trade markets when permit trading is hampered by transactions costs, such as finding trading partners, negotiating trade terms, and, in some cases, meeting oftentimes onerous legal and/or administrative hurdles. These costs can prevent the trade component of cap-and-trade. When this happens, the crucial advantage of the cap-and-trade approach--meeting environmental goals at lowest economic cost--is lost.
Previous work in this area has relied on restrictive and overly simplistic descriptions of production technologies, market interactions, and permit trading outcomes. In this article, Singh and Weninger show, within a more realistic framework, that trading, emission, and production outcomes under transactions costs are substantially different than earlier studies suggest. Their results provide a more complete picture of transactions costs’ role in permit market trading and derive several new insights for the implications of cap-and-trade regulation.
According to Singh and Weninger, the take-home message is that cap-and-trade designs should weigh the benefits of imposing additional reporting and monitoring requirements, and thus increasing transactions costs, against the economic losses that arise when transactions costs become onerous.
“Our results help understand the role of transactions costs in cap-and-trade markets, and will help policy makers design more effective regulations.”