Grantee Research Project Results
2007 Progress Report: The Market for RECLAIM Trading Credits: A Theoretical and Empirical Investigation of Intertemporal Trading and Cost Effectiveness
EPA Grant Number: R831773Title: The Market for RECLAIM Trading Credits: A Theoretical and Empirical Investigation of Intertemporal Trading and Cost Effectiveness
Investigators: Moore, Michael R. , Holland, Stephen P.
Institution: University of Michigan , University of North Carolina at Greensboro
EPA Project Officer: Hahn, Intaek
Project Period: November 1, 2004 through August 31, 2008
Project Period Covered by this Report: November 1, 2006 through August 31, 2007
Project Amount: $119,498
RFA: Market Mechanisms and Incentives for Environmental Management (2003) RFA Text | Recipients Lists
Research Category: Environmental Justice
Objective:
The project has three general objectives.
- Model the distinct features of the RECLAIM market to generate hypotheses about intertemporal trading and cost effectiveness.
- Analyze intertemporal trading, cost reduction, and cost effectiveness of the RECLAIM market.
- Compare the design and cost performance of the RECLAIM program to the federal SO2 allowance trading program.
The theoretical model will incorporate RECLAIM’s four distinct features: (1) two annual overlapping permit cycles, (2) two annual overlapping compliance cycles for facilities, which coincide with the permit cycles, (3) tradable permits across facilities, although the permits are not bankable for future use, and (4) a decreasing allocation of permits each year. In the model, regulated firms are assigned to one of two compliance cycles. The firms minimize discounted pollution abatement costs and permit costs while meeting annual compliance requirements with valid permits of either cycle. The goals are to characterize the market’s competitive equilibrium and to derive results on cost effectiveness, invariance of the equilibrium to parameter changes, delayed abatement, and the intertemporal pattern of prices.
To assess cost effectiveness, the model clarifies the opportunities for intertemporal arbitrage that arise from the two overlapping cycles. Data are collected on permits and emissions from all RECLAIM facilities from 1994 through mid 2006. The data will be used to evaluate several theoretical predictions of the model. First, using aggregate data, we will ask whether firms used all of the permits of each vintage, as predicted by the model, focusing on the years in which the program was clearly binding. We then will verify that firms do indeed trade across cycles. Second, using data on facility emissions, we will use difference-in-differences estimators to test two predictions: whether facilities delay abatement and whether there are no differences in emissions across compliance cycles. These predictions are consistent with cost effectiveness of the RECLAIM program.
We will extend the model to explore various market design options which arise with overlapping cycles. In particular, we will analyze multiple overlapping cycles, which will highlight the similarity of the RECLAIM model with a program having bankable permits. Bankable permits typically have varying initial dates of validity after which they can be used at any time. In any quarter, several overlapping permit vintages are valid. Thus, this extension of the RECLAIM model will yield a comparison to the federal SO2 allowance program.
Progress Summary:
We develop a theoretical model that captures the distinct intertemporal features of the RECLAIM market, namely: two overlapping permit cycles, two compliance cycles, tradable but not bankable permits, and decreasing annual permit allocations. We show that an equilibrium exists in the model and that it is cost effective, although not necessarily dynamically efficient. The equilibrium is invariant to merging two firms, reassigning a firm from one cycle to the other cycle, reallocating the initial endowment of permits, or requiring the firms to verify compliance quarterly. In equilibrium, firms have an incentive to delay abatement, so emissions are higher in earlier periods if the same vintages of permits are used in the two periods. Finally, we show that the present value price of any vintage permit is bounded above and below by the present value prices of the permits expiring immediately before and after that vintage. Extending the model to uncertain abatement costs, we also show that firms always minimize the cumulative number of unused permits, since permits have no option value once they have expired.
RECLAIM’s distinct features raise a variety of theoretical issues related to market design; we extend the model to address these issues. First, we prevent trading across cycles in the model and show that the equilibrium is no longer cost effective. Second, we analyze overlapping permit cycles versus overlapping compliance cycles. Although the equilibrium crucially depends on whether or not the permit cycles are overlapping, the equilibrium is invariant to whether or not the compliance cycles overlap. Analyzing compliance frequency more generally, we show that the equilibrium is invariant to compliance frequency. Finally, we extend the model to more than two overlapping permit cycles. By extending the validity of the permits, without changing the dates of initial validity, the model has more than two overlapping cycles. In fact, we show that if we extend the validity of the permits long enough, the equilibrium is equivalent to a market with bankable permits.
We test several predictions of the theoretical model using data from RECLAIM on permit allocation, trading, and use. With an aggregate analysis, we find mixed support for the model. Importantly, during the years when the RECLAIM program was clearly binding, the median number of unused permits held by facilities in the program was zero. In other words, over 50% of the facilities completely used or sold all their permits of each vintage before the permits expired. However, theory predicts that 100% of the facilities should completely use permits, and we find evidence that a few facilities held a substantial number of unused permits even of the most valuable vintages. Similarly, analyzing mismatched permits, we find that a substantial proportion of permits are held and used by facilities of the opposite cycle, i.e., firms do trade intertemporally. However, the sharper prediction of the model, namely, that 100% of unused permits should be mismatched, does not hold. We also develop a case study of emissions and permit usage for one firm, the Los Angeles Department of Water & Power. The analysis demonstrates an intertemporal compliance strategy of saving valid RTC’s for possible later use. This was optimal given the excess supply and regulatory uncertainty in RECLAIM.
Using quarterly data on facility emissions from 1994 through mid 2006, two further predictions of the theoretical model are tested using a difference-in-differences estimator. First is the prediction of delayed abatement: we find negative point estimates for delayed abatement, which is consistent with the theoretical predictions. However, the estimates are either marginally significant or insignificant. Second is the prediction of differences in emissions across cycles: we do not reject no difference across cycles (as predicted by theory), but the confidence intervals are not small enough for us to draw a sharp conclusion. As with the aggregate analysis, we conclude that the econometric evidence neither contradicts the theory nor provides conclusive support.
Future Activities:
We continue to refine the econometric models applied in the research in anticipation of submitting a manuscript to a peer-reviewed journal. Following submission of the manuscript, the main work on the project will be devoted to responding to comments from editors and referees.
Journal Articles:
No journal articles submitted with this report: View all 3 publications for this projectSupplemental Keywords:
Public policy, economics, air, nitrogen oxides, tradable permit,, RFA, Economic, Social, & Behavioral Science Research Program, Scientific Discipline, Economics, Market mechanisms, Social Science, Environmental Law, equilibrium analysis, auctioning permits, decision making, cost benefit, socioeconomics, air pollution, Sulfur dioxide, environmental Compliance, cap and trade systems, emissions trading, pollution fees, tradable pollution permits, allowance allocation, cost effective, pollution allowance trading, RECLAIM, econometrics, permit trading, intertemporal tradingRelevant Websites:
http://www.ucei.berkeley.edu/ Exit
Progress and Final Reports:
Original AbstractThe perspectives, information and conclusions conveyed in research project abstracts, progress reports, final reports, journal abstracts and journal publications convey the viewpoints of the principal investigator and may not represent the views and policies of ORD and EPA. Conclusions drawn by the principal investigators have not been reviewed by the Agency.