Does Uncertainty Matter? A Stochastic Dynamic Analysis of Bankable Emission Permit Trading for Global Climate Change Policy
Emission permit trading is a centerpiece of the Kyoto Protocol which allows participating nations to trade and bank greenhouse gas permits under the Framework Convention on Climate Change. When market conditions evolve stochastically, emission trad...
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| Language: | English |
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World Bank, Washington, DC
2012
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| Online Access: | http://documents.worldbank.org/curated/en/2007/04/7549905/uncertainty-matter-stochastic-dynamic-analysis-bankable-emission-permit-trading-global-climate-change-policy http://hdl.handle.net/10986/7070 |
| Summary: | Emission permit trading is a centerpiece
of the Kyoto Protocol which allows participating nations to
trade and bank greenhouse gas permits under the Framework
Convention on Climate Change. When market conditions evolve
stochastically, emission trading produces a dynamic problem,
in which anticipation about the future economic environment
affects current banking decisions. In this paper, the author
explores the effect of increased uncertainty over future
output prices and input costs on the temporal distribution
of emissions. In a dynamic programming setting, a permit
price is a convex function of stochastic prices of
electricity and fuel. Increased uncertainty about future
market conditions increases the expected permit price and
causes a risk-neutral firm to reduce ex ante emissions so as
to smooth out marginal abatement costs over time. The
convexity results from the asymmetric impact of changes in
counterfactual emissions on the change of marginal abatement
costs. Empirical analysis corroborates the theoretical
prediction. The author finds that a 1 percent increase in
electricity price volatility measured by the annualized
standard deviation of percentage price change is associated
with an average decrease in the annual emission rate by 0.88
percent. Numerical simulation suggests that high uncertainty
could induce substantially early abatements, as well as
large compliance costs, therefore imposing a tradeoff
between environmental benefits and economic efficiency. The
author discusses policy implications for designing an
effective and efficient global carbon market. |
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