Pollution permits and compliance strategies

Abstract

This paper analyzes the impact of spot and futures markets for tradeable pollution permits on the potential polluters' compliance decisions. Polluters can buy permits, invest in pollution abatement, or else stop production or source out. We show that stand-alone spot markets induce excessive investment. The introduction of a futures market reduces this incentive to invest, but is not the optimal way to control pollution. A menu of options on pollution rights, possibly coupled with intertemporally bundled sales, yields higher welfare. Because of its focus on long-run demand elasticities and rent extraction, this paper can be applied to a variety of situations such as demand-side management, public transportation, bypass in telecommunications, or forward sales by a private monopolist.