Department of Economics Working Paper Series Can Auctions Control Market Power in Emissions Trading Markets? Can Auctions Control Market Power in Emissions Trading Markets?

Using eight sessions (twenty-four ten-period markets) in a double ABA cross-over design, we demonstrate clear evidence of market power in double-auction emission trading markets (agents who are not constrained to only buy or sell). Conventional theory predicts that in half of the market-power environments monopsony should emerge and in half monopoly should emerge. Market-power outcomes are frequently observed, most often in the form of price discrimination, and most effectively by monopsonists. Corresponding author: R. Andrew Muller Department of Economics McMaster University Hamilton, Ontario Canada L8S 4M4 [email protected] 1 The funding for the laboratory sessions described in this paper were from a McMaster University Arts Research Board grant to R. Andrew Muller. The paper has benefited from comments by Tim Cason, Dan Friedman, and Rob Moir. 2 See Table 13 and sources cited there. Can Auctions Control Market Power in Emissions Trading Markets? Introduction Emissions trading is frequently advocated as an instrument for market-based environmental regulation. Unfortunately many potential emissions trading markets are likely to be sufficiently concentrated to create market power. In particular, it is frequently thought that the United States will effectively be a monopsonist in any international emissions trading under the Kyoto protocol. If market power is exercised, emissions trading may fail to achieve an efficient allocation of responsibilities for abatement. Moreover, the gains from trade may be reallocated inequitably. The exercise of market power may be constrained by the trading institution within which contracts are formed. In particular, it has been suggested that the double auction market is particularly resistant to market power. This suggestion is based on laboratory evidence. Smith (1981) found that monopolists trading in a double auction market experienced difficulty in maintaining monopoly prices. Monopolists in his double oral auctions were able to obtain only about 25 percent of the potential monopoly price increase (for the last period), in contrast to their ability to achieve 100 percent of the potential increase under a posted bid institution. Smith and Williams (1989) replicated this experiment and found much lower prices; on average their monopolists achieved only about 6 percent of the potential price increase in the last period. Smith and Smith and Williams explain this result by postulating that buyers’ resistance to high prices is