Welfare Ranking of Emissions Taxes, Cap & Trade, and Banking & Borrowing

Abstract

Under asymmetric information between firms and a regulator, intertemporal trade of pollution permits can increase welfare relative to both emissions taxes and cap and trade (quotas). In the subgame perfect equilibrium, banking and borrowing dominates taxes and quotas for a large region of parameter space provided that cost shocks are positively correlated and the trading phase is not too long. We show how to determine the optimal length of a trading phase, and explain why it is typically short. In the open loop setting banking and borrowing is likely to be a good alternative for quotas but not for taxes.