Possible Inefficiencies in a Duopoly Trading Emission Permits

We consider a duopolistic industry in which pollution is a by-product of production and firms are given emission permits that they can trade. The common wisdom is that allowing for trade in emission permits promotes efficiency. We demonstrate that this common wisdom cannot automatically be extended to a duopolistic market structure. The main idea of this paper is that emission permits are used as a commitment device in order to manipulate the equilibrium of the goods market. In particular we show that allowing for permit trade may result in lower output and higher prices, and may shift production from the low to the high cost firm. In addition, it may induce the firms to choose an inferior abatement technology and a more polluting production technology.