Compliance Strategies under Permits for Emissions

We characterize the trade‐offs among firms' compliance strategies in a market‐based program where a regulator interested in controlling emissions from a given set of sources auctions off a fixed number of emissions permits. We model a three‐stage game in which firms invest in emissions abatement, participate in a share auction for permits, and produce output. We develop a methodology for a profit‐maximizing firm to derive its marginal value function for permits and translate this value function into an optimal bidding strategy in the auction. We analyze two end‐product market scenarios independent demands and Cournot competition. In both scenarios we find that changing the number of available permits influences abatement to a lesser extent in a dirty industry than in a cleaner one. In addition, abatement levels taper off with increasing industry dirtiness levels. In the presence of competition, firms in a relatively clean industry can, in fact, benefit from a reduction in the number of available permits. Our findings are robust to changes in certain modeling assumptions.