Testing for Efficiency of the SO2 Allowance Market

EPA Grant Number: R831775
Title: Testing for Efficiency of the SO2 Allowance Market
Investigators: Helfand, Gloria , Moore, Michael R.
Institution: University of Michigan
EPA Project Officer: Hahn, Intaek
Project Period: September 1, 2004 through August 31, 2006
Project Amount: $133,194
RFA: Market Mechanisms and Incentives for Environmental Management (2003) RFA Text |  Recipients Lists
Research Category: Environmental Justice


Efficiency – whether profit opportunities are being fully realized in a market – is a key criterion for evaluating a market mechanism for environmental regulation. Evidence on the efficiency of the sulfur dioxide (SO2) allowance market is mixed, with early evidence of inefficiency via unrealized gains from trade in 1995-1996 and recent evidence of relatively efficient allowance banking during 1995-2001. The proposed research seeks to explain the evolution of SO2 allowance prices as a basis for testing SO2 market efficiency. First, it develops four novel empirical models to explain the time path of SO2 prices. Second, it will test the alternative models – and test for market efficiency – using econometric methods and SO2 price data from 1994-2003. The research will attempt to explain the puzzle of volatile SO2 prices and, as well, to discern a transition in the SO2 market from an “immature” to a “mature” stage, that is, from inefficiency to efficiency.


The SO2 program allows banking of current-year allowances for future use. Rubin (1996) and Schennach (2000) demonstrate that, if allowance banking occurs, the SO2 market should follow the Hotelling (1931) principle: SO2 allowances can be modeled as an exhaustible asset, and their use should be allocated efficiently over time through a Hotelling price path. The proposed research starts with Schennach’s theoretical model of the SO2 market under uncertainty, and then brings in finance models and approaches (Mankiw and Summers, 1984; Slade and Thille, 1997) to develop a general model of the SO2 price path. Four models are nested in the general model: Hotelling under uncertainty; the addition of unexpected information; the addition of risk aversion via the Capital Asset Pricing Model; and additional investment alternatives via the Asset Pricing Model. Monthly data will be gathered on SO2 allowance prices, prices of goods that affect the SO2 market (such as electricity and low-sulfur coal prices), and market returns on other financial assets. Hypothesis tests with the general model will provide insights into whether the SO2 market is efficient, how unexpected information from related markets affects the SO2 market, whether risk aversion plays a role in this market, and whether the market has evolved from inefficient to efficient. This will comprise the first econometric tests of SO2 market efficiency; previous research compares actual behavior and simulated efficient behavior in the SO2 market and in SO2 allowance banking.

Expected Results:

The SO2 program is serving as a model for design of new cap-and-trade programs to control emissions of air pollutants and greenhouse gases. Testing whether actual behavior in markets reflects the behavior assumed in economic theory provides insights that might: (1) identify limitations in the ability of the current program to achieve its potential; (2) contribute to better design of market-based environmental programs in the future; (3) provide a better understanding of the role of related markets in the demand for marketable permits; and (4) suggest the need for further research into the environmental implications of these programs.

Supplemental Keywords:

public policy, economics, air, sulfur dioxide, tradable permit, RFA, Economic, Social, & Behavioral Science Research Program, Scientific Discipline, Air, Air Quality, Economics, Market mechanisms, Environmental Law, market incentives, equilibrium analysis, policy making, auctioning permits, impact of federal policy instruments, decision making, air pollution, socioeconomics, Sulfur dioxide, cost benefit, environmental Compliance, cap and trade systems, pollution fees, tradable pollution permits, emissions trading, cost effective, pollution allowance trading, allowance allocation, environmental economics, econometrics, permit trading

Progress and Final Reports:

  • 2005
  • Final