Unintended consequences of price controls: An application to allowance markets

Price controls established in a cap-and-trade allowance market are intended to reduce cost uncertainty by constraining allowance prices between a ceiling and floor; however, they could provide opportunities for strategic actions by firms that would lower government revenue and increase emissions. In particular, when the ceiling price is supported by introducing new allowances into the market, firms could choose to buy allowances at the ceiling price, regardless of the prevailing market price, in order to lower the equilibrium price of all allowances. Those purchases could either be transacted by firms intending to manipulate the market price or be induced through the introduction of inaccurate information about the cost of emissions abatement. Theory and simulations using allowance elasticity estimates for U.S. firms suggest that the manipulation could be profitable under the stylized setting and assumptions evaluated in the paper, although in practice many other conditions will determine its use.

► Cap-and-trade proposals in the U.S. suggest price controls can reduce uncertainty.
► Instead, they offer opportunities for strategic action by participating firms.
► The price ceiling is supported by introducing new allowances into the market.
► Firms that induce the purchase of new allowances into the market lower all prices.
► Theory and data on market structure suggests manipulation likely to be profitable.