Pollution permits, Strategic Trading and Dynamic Technology Adoption

This paper analyzes the dynamic incentives for technology adoption under a transferable permits system, which allows for strategic trading on the permit market. Initially, firms can both invest in low– emitting production technologies and trade permits. In the model, technology adoption and allowance prices are generated endogenously and are inter–dependent. It is shown that the non–cooperative permit trading game possesses a pure–strategy Nash equilibrium, where the allowance value reflects the level of uncovered pollution (demand), the level of unused allowances (supply), and the technological status. These conditions are also satisfied when a price support instrument (dubbed European–cash– for–permits), which is contingent on the adoption of the new technology, is introduced. Numerical investigation confirms that this policy generates a floating price floor for the allowances, and it restores the dynamic incentives to invest. Given that this policy comes at a cost, a criterion for the selection of a self–financing policy (based on convex risk measures) is proposed and implemented. Preliminary Comments Welcome JEL classification: D8, H2, L5, Q5.