Carbon sequestration and permit trading on the competitive fringe

Abstract

This paper makes two contributions to the carbon-sequestration policy literature. First and foremost, we develop a theoretical framework in which sequestration and permittrading markets are analyzed jointly in the context of a competitive fringe model. Our framework formalizes the linkage between regulatory policy changes (as they manifest themselves in the permit market) and subsequent equilibrium allocations in the sequestration market. Second, we perform a numerical analysis demonstrating the role market structure, or market power, might play in the determination of the equilibrium sequestration allocation and carbon price. Both our analytical and numerical results demonstrate the importance of incorporating into empirical supply-side models demandside information that is reflective of an underlying market structure. 2 IntroductionThe main focus of carbon sequestration research has thus far been the empirical estimation of supply functions, both for specific countries and globally.1 Although the supply estimates themselves vary, the general opinion emerging from this literature is that scope exists for cost-effective policies fostering both the curtailment of deforestation and promotion of reforestation in support of carbon sequestration at national, regional, and international levels. 2 What has not yet been considered in this analysis, however, is the role that market structure, or market power, might play in the determination of an equilibrium sequestration allocation. This paper is a first attempt at characterizing the role of market structure in the context of a carbon sequestration model that alsoincorporates an existing permit-trading market, and is thus in keeping with the multiinstrument policies promulgated in recent international climate-change agreements spurred by the Kyoto Protocol (UNFCCC, 1998).A similar issue was faced roughly 20 years ago with respect to permit trading, when Hahn's (1984) seminal article demonstrated the importance of market power in determining an equilibrium outcome. Hahn's principle result was that if a single firm with market power purchases(sells) permits in an otherwise competitive market it will behave as a monopsonist(monopolist). Thus, the degree of market inefficiency is systematically related to the initial distribution of the permits. Since then, permit-trading research has attempted to quantify the extent to which monopoly and monopsony power 1 With respect to country-specific studies, see Stavins (1999) andLubowski, et al. (2006) for the US, Xu (1995) for China, Fearnside (1995) for Brazil, Ravindranath and Somashekhar (1995) for India, de Jong, et al. (2000) for Mexico, and Sedjo (1999) for Argentina. See Benitez, et al. (2007) and Sohngen and Sedjo (2004) 3 influence the trading equilibrium, most notably in the field of experimental economics using auction-type environments. 3 Contrary to these earlier works, which assume the existence of monopoly and monopsony power, we develop a competitive fringe model of carbon sequestration in the presence of ...