Bankable emission permits under uncertainty and optimal risk-management rules

This article proposes a theory of banking of emission permits under conditions of regulatory uncertainty. Based on a two-period partial equilibrium framework, we examine the effects of increasing risk–in the sense of a mean preserving spread–regarding a future permit allocation at the firm level. We also examine the role of an agency to pool risks by re-allocating permits for a group of firms. Our results are twofold. First, an increase in risk may lead to changes in a firm’s banking strategy, depending on the third partial derivative of its production function with respect to pollution. Second, we define an optimal risk-sharing rule between agents to respond to political decision changes. Our results overall suggest that the bankability of permits may be used as a risk-management tool.

► We propose a theory of banking of emission permits under conditions of regulatory uncertainty.
► We examine the effects of an increasing risk regarding a future permit allocation and the role of an agency to pool risks.
► Increasing risk may lead to changes in a firm’s banking strategy, depending on the third partial derivative of its production function with respect to pollution.
► The bankability of permits may be used as a risk-management tool.