Carbon Markets in Dynamic Perspective: The Optimal Duration Problem

Abstract

The effectiveness of carbon markets in the reduction of emissions at minimal cost requires several conditions. In a dynamic context the inter-temporal dimension adds new conditions for the desirable performance of the market, and some tradeoffs. One tradeoff is related to the duration of permits. A long permit allows the private agent to optimize using a longer time horizon, but increases the risk associated with the initial allocation of the permits, for example the risk of generating market power. A short permit generates problems with the private agent's planning horizon but allows the planner to correct initial misallocations, in particular in new markets or those that face important uncertainty. These issues are important in the implementation of these systems, especially in developing countries such as the Latin American ones studied in this paper.