Endogenous market power in an emissions trading scheme with auctioning

• I propose an emissions trading scheme in which all polluters exercise market power.
• Permits are allocated via a uniform price auction followed by a secondary market.
• The secondary market price is above the auction clearing price.
• The high emitters are worse off from strategic behavior.
• For a low enough variance of the marginal abatement cost at the business-as-usual emissions, strategic behavior is compliance cost-saving for the polluters.

This paper contributes to the literature on market power in emissions permits markets, modeling an emissions trading scheme in which polluters differ with respect to their marginal abatement costs at the business-as-usual emissions. The polluters play a two-stage static complete information game in which their market power arises endogenously from their characteristics. In the first stage all polluters bid in an auction for the distribution of the fixed supply of permits issued by the regulator, and in the second stage they trade these permits in a secondary market. For compliance, they can also engage in abatement activity at a quadratic cost. Under the assumptions of the model, in equilibrium all polluters are successful in the auction. In the secondary market the low-cost emitters are net sellers and the high-cost emitters are net buyers. Moreover, the high-cost emitters are worse off as a result of the strategic behavior. In addition, the secondary market price is unambiguously above the auction clearing price. I find that the aggregate compliance cost when polluters act strategically increases in the heterogeneity of their marginal abatement costs at the business-as-usual emissions, but there exists a threshold of the fixed supply of permits above which strategic behavior is compliance cost-saving for the polluters. Finally, for a low enough variance of the marginal abatement cost at the business-as-usual emissions, strategic behavior is compliance cost-saving for the polluters, regardless of the level of the available supply of permits.