A strategic trading model under rate-based emissions trading schemes: Market power, driving factors, and a comparison with mass-based schemes

Abstract

Some evidence has shown the presence of strategic permit trading, which can reduce the cost-effectiveness of emissions trading schemes (ETSs). In contrast to most strategic trading models that focus on mass-based schemes and assume the existence of price-taking firms, in this study, we develop a two-stage model under a rate-based scheme where all firms are allowed to trade permits strategically by employing the supply function approach. We identify a unique refined equilibrium in permit trading and examine firms’ strategic behavior and the factors influencing market power. We find that both a flatter marginal production cost curve and a larger gap between firms’ emission intensities and the emission benchmark tend to strengthen market power. A similar impact is observed for permit sellers when marginal abatement costs are flatter, whereas the effect for buyers depends on a trade-off between the impact on permit purchases and the slope of the residual permit supply curve. We also conduct numerical simulations of China’s nationwide ETS. The results reveal that the effect of market power on production differs significantly between rate- and mass-based schemes. Additionally, rate-based schemes strengthen sellers’ market power relative to mass-based schemes. Finally, policy implications are proposed to prevent market power.