Modeling Intertemporal Trading of Emission Permits Under Market Power

In this work, we examine the effects of inter-temporal trading on the permit price and the existence of market power in the EU ETS. We contribute to the literature by dynamically modeling an emission trading system, taking into account (a) the interplay between dominant firms (leaders) and their competitive counterparts (followers), (b) intertemporal emission trading and (c) linkage between the permit and the output market. We provide equilibrium conditions for both leaders and followers. We conclude that leaders can affect followers’ decisions both in the permit and the output market, since they control the overall emission abatement. Leaders’ dominance may push followers to decrease their business-as-usual emissions and consequently their production levels by adjusting their overall abatement across periods. Further investigation through the actual emission data from the EU Transaction Log (EUTL) supports our theoretical findings. Finally, to examine model’s accuracy, we perform simulations recreating realistic scenarios. The simulation results show that our modeling reproduces the system’s behaviour and captures the changes in price, banking amount and emission levels with respect to variations on the output product and initial allocation.