On the efficiency of competitive markets for emission permits

It is typical for economists and policy makers alike to presume that competitive markets allocate emission permits efficiently. This paper demonstrates that competition in the emission permits market cannot assure efficiency when the product market is oligopolistic. We provide the conditions under which a bureaucratic mechanism is welfare superior to a tradeable emission permits system. Price-taking behaviour in the permits market ensures transfer of licenses to the less efficient in abatement firms, which then become more aggressive in the product market, acquiring additional permits. As a result, the less efficient firms end up with a higher than the welfare maximizing share of emission permits. If the less efficient in abatement firms are also less efficient in production, competitive trading of permits may result in lower output and welfare.