MARKET FAILURE IN INCENTIVE-BASED REGULATION - THE CASE OF EMISSIONS TRADING

Among the existing evaluations of the US EPA's emissions trading program, a consensus has emerged. While the program has resulted in significant cost savings, it has not even approximately achieved a cost-effective allocation of the control responsibility. The cost savings have been smaller and the trades fewer than might have been expected at the outset of the program. In this article we explore one hypothesis which purports to explain the divergence between the cost-minimizing and the observed pattern of trades for nonuniformly mixed pollutants. The "trading process hypothesis" attributes some significant proportion of this divergence to the nature of the process by which emission reduction credits are traded under the bubble policy. An examination of actual bubble trades reveals that the actual trading process is sequential and bilateral and, hence, differs considerably from the implicit process modeled in the existing empirical studies. Simulations of this more realistic trading process suggest that the resulting equilibria deviate considerably from cost-effective allocations of the control responsibility. © 1991.