OPTIMAL ALLOCATION OF TRADABLE EMISSION PERMITS UNDER UPSTREAM–DOWNSTREAM STRATEGIC INTERACTION

In this paper, we analyze environmental regulation based on tradable emission permits in the presence of strategic interaction in an output market with differentiated products. We characterize firms' equilibrium behavior in the permits and in the output market and we show that both firms adopt "rival's cost-rising strategies". Then, we study the problem of the regulator that aims at maximizing social welfare, proposing an efficient criterion to allocate permits between firms. We find that the optimal allocation criterion requires a perfect balance between the difference on firms' price-cost margins in the permits market and the difference on firms' mark ups in the output market. In light of the previous result, we use a simulation to obtain the optimal allocation of permits between firms as a function of output market characteristics, in particular as a function of goods substitutability.

Market for tradable pollution permits

Structural changes that were following the transformation from the centrally planed economy to market oriented one brought among other things new perceptions that of the hither to mainly reglected environmental issues. The Czech Republic as one of the few developed countries has achieved a tremendous decline in a emission production by huge investments. Because of the Kyoto protocol ratification by the EU, this issue is getting more important. The practical consequence of this ratification process is the creation of the unified European market for tradable emission permits that should be fully functioning by the year 2005. It is essential to fully understand basic theoretical principles of tradable emission permits market for homogenous and heterogeneous pollutions to achieve maximal benefits out of it.