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Abstract
This dissertation explores the issues of market design for emissions trading schemes by focusing on penalty designs and initial allocation mechanisms. Penalty design is defined in terms of penalty types and levels and the allocation mechanism compare free allocation with auctioning. The first essay employs a theoretical model to examine compliance incentives and market efficiency under three penalty types: the fixed-penalty rate (FPR), the make-good provision (MGP), and the mixed penalty design. Using a simple two-period model of firm’s profit maximisation, we analyse compliance decisions and the efficient penalty level under each penalty type. Our findings indicate that the penalty type does not affect compliance decisions provided that the efficient penalty level is applied. Market efficiency is retained regardless of penalty types. These findings are used as the hypotheses for the second essay.
The behavioural implications of penalty designs on market performance are investigated in the second essay using an experimental method. Three penalty types and two penalty levels are enforced in a laboratory permit market with auctioning wherein subjects make compliance decisions by undertaking irreversible abatement investment decisions or by buying permits. In contrast to theory, we find that penalty levels serve as a focal point that indicates compliance costs and affects compliance strategies. The MGP penalty provides stronger compliance incentives than the other penalty types. Most importantly, a trade-off between investment incentives and efficiency is observed.
Using a laboratory experiment, the third essay studies how the initial distribution of permits through free allocation or auctioning, may affect price discovery, allocative and static efficiency under the presence of three penalty designs. Price discovery is not influenced by the initial allocation mechanism. Permit prices remain above the efficient level due to the presence of irrational bidding and trading behaviour as well as risk aversion. Uncertainty regarding permit prices results in a modest allocative efficiency as over-investment prevails. Auctioning evidently generates higher static efficiency due to stronger price signals. This result supports the majority of literature which argues for auctioning. An appropriate auction design is crucial to avoid the risk of overbidding which will inflate the auction price and diminish efficiency.