Optimal strategies for emissions trading in a Putty-Clay Vintage Model

Abstract

In December 2002, the European Union decided to set up a carbon dioxide trading system to meet the goals of the Kyoto protocol. The trading system applies to energy producing companies and to firms with high energy usage. Firms will obtain the allowance to emit a given amount of carbon dioxide which will be reduced step by step on a yearly basis. The firms will have to buy additional allowances if the given amount does not satisfy their actual needs and they can sell allowances if they have excess allowances. In order to improve their market position, companies may invest in technical progress leading to fewer emissions.

The article examines which strategy companies should choose to adjust optimally to the trading system. The theoretical background builds Solow’s hypothesis that technical progress is embodied in capital goods which leads to different production functions in each period (Vintage Production Functions). In combination with the Putty-Clay Model, it is shown that technical progress rates, timing of investment and prices of allowances play an important role in defining the optimal strategy of firms in order to cope with emissions trading.