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Experimental research by Krannert economist explores investments in global pollution abatement

Tuesday, April 10, 2018

Emissions Trading

Countries across the globe now use emissions-trading systems as a policy to cost-effectively reduce pollution. But what incentives do these tradable-permit markets offer companies to invest in advanced pollution-abatement technology? Purdue University’s Tim Cason, the Gadomski Chair of Economics at the Krannert School of Management, is addressing that question through experimental economics.

Cason, who also serves as director of the Vernon Smith Experimental Economics Laboratory, most recently investigated the topic in a paper coauthored with UK colleague Frans de Vries from the University of Stirling that is forthcoming in Environmental and Resource Economics.

In “Dynamic Efficiency in Experimental Emissions Trading Markets with Investment Uncertainty,” the researchers used a lab experiment to assess how two methods of allocating tradable permits — auctioning or grandfathering them — might impact businesses’ decisions about making new technology investments to reduce pollution.

“Like a carbon tax, these trading systems are another way of putting a price on emitting pollution,” Cason says. “Among the things they do is provide incentives for firms to develop innovative, lower-cost methods of generating electricity or removing pollution. Similarly, this new set of experiments examines how specific details of these markets’ design will influence them to undertake the research and development needed to make those innovations.”

Although the U.S. federal government implemented emission trading policies to reduce acid rain in the 1990s, Congress has not adopted trading systems for greenhouse gas emissions. But Cason says they are common in Europe and other international markets as well as in individual states including California and those on East Coast.

“The idea behind emissions trading is that individual firms are provided the right to emit a certain amount of pollution, such as an electric power utility releasing carbon emissions. It’s when these emissions are tradable that the market comes into play,” he explains. “If these firms find a less expensive way of reducing pollution compared to others, they can make those reductions themselves and sell their excess permits to firms who are having more difficultly reducing emissions or facing higher costs.”

According to Cason, most economists favor emissions trading because it equalizes the marginal cost across firms and limits emissions less expensively than mandatory constraints. His research with de Vries specifically examines the two most common types of emissions trading — grandfathering and auctioning.

“In the European Union, for example, firms that polluted in the past were typically ‘grandfathered’ in to receive the permits for free,” Cason says. “But it’s transitioning to a system where the permits are auctioned off, which provides revenue for the government.”

The study’s findings also extend beyond experimental economics into the realm of behavioral economics, particularly with regard to how people treat opportunity costs.

“In theory, people should treat opportunity costs just like regular costs, but that doesn’t seem to apply to emissions trading,” he says. “Firms that receive emission permits for free through grandfathering consider them an implicit opportunity cost and trade them differently than permits that are purchased at auction with an explicit cost.”

Ultimately, the research indicates that while both types of permit allocation lead to significant investment, auctioning provides stronger research and development incentives to invest in pollution-abatement technology than grandfathering, which for Cason is a key takeaway.

“One of the most important features of environmental regulation is how much it spurs innovation,” he says. “We want to create regulations that give firms the incentives to undertake new ways of controlling pollution.”

Source: Tim Cason, 765-494-1737,