Optimal trading ratios for pollution permit markets

•We model trading ratios in a pollution permit trading market.•With full information, marginal damage trading ratios are optimal.•With asymmetric information, marginal damage trading ratios are not optimal.•Estimated gains from optimal trading ratios range from trivial to substantial.

We demonstrate a novel method for improving the efficiency of pollution permit markets by optimizing the exchange of emissions through trade. Under full-information, it is optimal for emissions to exchange according to the ratio of marginal damages. Under asymmetric information, we derive necessary conditions for the marginal damage trading ratios to be optimal, illustrate that the marginal damage trading ratios are generally not optimal, and show how to improve efficiency using optimal trading ratios. We calculate the optimal trading ratios for a global carbon market. The gains from using optimal trading ratios rather than marginal damage trading ratios range from substantial to trivial, which suggests the need for careful consideration of asymmetric information when designing permit markets.