Capacity coordination and strategic underproduction under cap-and-trade
© Author(s) 2021
Is Version Of
This paper presents a two-stage game of cap-and-trade (CAT) regulated production. We show how quantity-based regulation, in the form of individual production or pollution emissions permits, can function as a credible commitment device allowing firms to coordinate their own-production levels and underproduce the quantity cap set by the regulator. Under strategic underproduction equilibria, consumer surplus and production cost efficiency declines, but industry profits increase. This channel for exercising market power under CAT has been overlooked and requires new regulatory countermeasures. Limiting permit accumulation by individual firms can restore first best efficiency but only under specific industry and cost conditions. We show that a poorly designed ownership limit policy can reduce welfare below levels attained without limits. A case study of the U.S. west coast groundfish fishery which is currently regulated under CAT with strict limits on ownership of fishing permits is presented. Evidence of strategic underproduction is inconclusive. We find current ownership restrictions likely prevent firms from realizing economies of scale in production. Alternate policies to counter strategic underproduction forces are recommended.
JEL Classification: C13, Q22. Length: 66 pages Original Release Date: December 21, 2021.
Cap-and-trade regulation, market power, strategic underproduction, permit ownership limits