Price Volatility and Risk Exposure: On the Interaction of Quota and Product Markets

We consider an industry with firms that produce a final good emitting pollution to different degree as a side effect. Pollution is regulated by a tradable quota system where some quotas may have been allocated at the outset, i.e. before the quota market is opened. We study how volatility in quota price affects firm behaviour, taking into account the impact of quota price on final-good price. The impact on the individual firm differs depending on how polluting it is-whether it is 'clean' or 'dirty'aEuro"and whether it has been allocated quotas at the outset. In the absence of long-term or forward contracting, a grandfathering regime-where clean firms are allocated no quotas and dirty firms are allocated quotas for a part of their emissions-minimizes the impact on firm behavior relative to a risk-neutral benchmark.With forward contracts and in the absence of wealth effects initial quota allocation has no effect on firm behaviour. Allowing for abatement does not change the qualitative nature of our results.