Monetary Emissions Trading Mechanisms

Emissions trading mechanisms have been proposed, and in some cases implemented, as a tool to reduce pollution. We argue that emission-trading mechanisms share some similarities with monetary mechanisms. Both attempt to implement desirable allocations under various frictions, including risk and private information. In addition, implementation relies on the issue and trading of objects whose value is at least partially determined by expectations, namely money and permits, respectively. We use insights from dynamic mechanism design in monetary economics to derive properties of dynamic emissions trading mechanisms. At the optimum, the price of permits increases over time. E¢ cient tax policies are state-contingent, and there is an equivalence between such state-contingent taxes and emissions trading. Restrictions resulting from the money-like feature of permits can break this equivalence when there is endogenous progress in clean technologies. These restrictions must be taken into consideration in actual policy implementation. First version: September 2010. We thank Peter Hartley and participants at the Environmental Economics and Law Conference at the University of Bern, the CESifo Area Conference on Energy and Climate Economics 2011, and Rice University for comments.