Compliance strategies under permits for emissions

We characterize the trade-offs among firms' compliance strategies in a market-based program where a regulator interested in controlling emissions from a given set of sources auctions off a fixed number of emissions permits. We model a three-stage game in which firms invest in emissions abatement, participate in a share auction for permits, and produce output. We develop a methodology for a profit-maximizing firm to derive its marginal value function for permits and translate this value function into an optimal bidding strategy in the auction. We analyze two end-product market scenarios – independent demands and Cournot competition. In both scenarios we find that changing the number of available permits influences abatement to a lesser extent in a dirty industry than in a cleaner one. In addition, abatement levels taper off with increasing industry dirtiness levels. In the presence of competition, firms in a relatively clean industry can, in fact, benefit from a reduction in the number of available permits. Our findings are robust to changes in certain modeling assumptions.