Strategic underproduction and ownership limit policy in cap-and-trade

Abstract

Cap-and-trade regulations enable tacit coordination and strategic underproduction of a regulators targeted cap. Strategic underproduction increases industry profits but lowers consumer surplus and creates cost inefficiency. These outcomes are prevented by limiting the quantity of production/emissions permits owned by individual firms. Ownership limits that are too stringent or too lax however can reduce welfare below levels that obtain without ownership limits. We demonstrate these results for the U.S. west coast groundfish fishery. Fishing permit ownership limits currently range between 2%-5% of total available permits. Welfare maximizing limits range between 10% - 50%. We predict a 25% reduction in welfare, due to foregone consumer surplus, under limits that are too lax. Results find that overly stringent ownership limits create scale inefficiency in groundfish production. Our results provide new directions for preventing market power inefficiency under cap-and-trade regulations.