Two approaches to emissions trading are cap-and-trade, in which an aggregate cap on emissions is distributed in the form of allowance permits, and baseline-and-credit, in which firms earn emission reduction credits for emissions below their baselines. Theory suggests the long-run equilibrium of the cap-and-trade plan is socially optimal, whereas the corresponding baselineand- credit equilibrium is inefficient, since the baseline creates a subsidy to output. In the short-run, however, when output capacity is fixed, the two plans are predicted to be identical. Surprisingly, despite the long-run predictions, both approaches are used around the world.
To test whether these predictions hold in real markets, we developed a computerized laboratory environment in which subjects, representing firms, can adjust their emission technology and capacity levels. Subjects trade emission rights in a uniform price sealed bid-ask auction. The demand for output is simulated. All decisions are tracked through a double-entry bookkeeping system. Full documentation of the software is attached as an appendix.
Primarily, this dissertation presents results from the first ever experimental economic analysis comparing the two most commonly proposed and implemented emission trading policy instruments: cap-and-trade and rated-based baseline-and-credit emission permit trading. After creating a laboratory implementation of the theoretical setting, we report results from simulations with robot traders in a long-run environment. These simulations verify the long-run predictions. Simulations and pilot experiments provide interesting evidence on permit market volatilities and effects of various accounting rules. As a first step towards testing the long-run model with human subjects, this dissertation reports on a laboratory experiment designed to test the short-run predictions. The short-run experiments support the theoretical prediction that the two mechanisms yield similar outcomes, however both exhibit significant deviation from the predicted equilibrium.