Dynamics of optimal carbon prices with inter-temporal regulation

Purpose - This paper aims to calibrate carbon price trajectories that maximize social welfare where banking and borrowing rules are applied. Design/methodology/approach - Typically, there has been a consensus that banking and borrowing rules within the cap-and-trade system improve social welfare. This additional flexibility can achieve compliance cost smoothing by transferring carbon permits inter-temporally; however, there is also a side effect. Regulated agents have the freedom to escape from the given emissions limit by reallocating previously granted permits. Findings - The market system's flexibility can cause environmental damage by deviating annual or periodic emission limits, which can invalidate the original purpose of cap-and-trade. This paper demonstrates how the socially desirable price trajectory differs from the one that favors the private sector. Originality/value - Few studies have focused on the negative effects of combining the cap-and-trade with the inter-temporal regulation (banking and borrowing), which most policymakers and regulated firms can easily miss.