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2007-08 Seminars

Does Electricity Restructuring Benefit the Environment? Theory and Evidence from Intertemporal Emission Trading in the U.S. SO2 Allowance Market

Fan Zhang
Assistant Professor in Energy Policy and Economics
Pennsylvania State University

Intertemporal trading of emission permits allows for the banking of permits for future use or sale. In this paper, I explore the effects of increased uncertainty over future output prices, input costs and productivity levels on the temporal distribution of emissions. In a dynamic programming setting, the permit price is a convex function of each of these three sources of uncertainty. Increased uncertainty about future market conditions increases the expected permit price and causes risk-neutral firms to reduce ex ante emissions to smooth out marginal abatement costs over time. The convexity results from the asymmetric impact of changes in counterfactual emissions on marginal abatement costs. Empirical analysis corroborates the theoretical prediction. I find that increased price volatility induced by electricity market restructuring could explain 7-10% of the allowances banked during Phase I of the U.S. sulfur dioxide trading program. Numerical simulation suggests that high uncertainty may generate substantial initial compliance costs, thereby deterring new entrants and reducing efficiency; sharp emission spikes are also more likely to occur under high uncertainty scenarios. These results are subjected to a number of robustness tests.