Endowment effects, expectations, and trading behavior in carbon cap and trade

Abstract

We explain agents' trading behaviors and market outcomes in the presence of endowment effects intensified by expectations-based loss aversion in carbon cap and trade. Building on Kőszegi and Rabin (2006)’s model with forward-looking reference points, we show how firms' concerns about high future compliance costs (through loss aversion and uncertainty) can cause a gap between Willingness-to-Pay and Willingness-to-Accept for allowances. This leads to limited allowance trading and deviation from the socially desirable paths. The problem can be exacerbated under a substantial proportion of free allocation, a fixed (or inflexible) cap as well as uncertain regulatory ambitions, particularly in emerging economies under a variety of uncertainty. Recognizing the regulator's role in dealing with firms' expectations (or concerns) and facilitating innovation investments, we discuss potential alternative systems (e.g., with auction and flexible supply) for decarbonization that incorporate flexibility in terms of innovation timing and realized costs.