Buyer Liability and Voluntary Inspections in International Greenhouse Gas Emissions Trading: A Laboratory Study

This paper reports a preliminary laboratory experiment in which traders make investments to increase the reliability of tradable instruments that represent greenhouse gas emissions allowances. In one half of the sessions these investments are unobservable, while in the other half traders can invite costless and accurate inspections that make reliability investments public. We implement a buyer liability rule, so that if emissions reductions are unreliable (i.e., sellers default), the buyer of the allowances cannot redeem them to cover emissions. We find that allowing inspections significantly increases the reliability investment rate and overall efficiency. Prices of uninspected allowances usually trade at a substantial discount due to the buyer liability rule, which provides a strong market incentive for sellers to invest in reliability. JEL Classification: Q25, L51 Acknowledgements: For helpful comments and discussions I would like to thank—without implicating—Chris Anderson, Rob Godby, Sally Kane, Andy Muller, Charlie Plott, Jay Shogren, Catherine Wilson, Tom Wilson, two anonymous referees, and participants in the Krannert behavioral economics brown-bag seminar. The Center for International Business Education and Research at Purdue University provided financial support. Buyer Liability and Voluntary Inspections in International Greenhouse Gas Emissions Trading: A Laboratory Study