Testing the Dynamic Theory of Emissions Trading: Experimental Evidence for Global Carbon Trading

Klaassen, G., Nentjes, A., & Smith, M.G. (2001). Testing the Dynamic Theory of Emissions Trading: Experimental Evidence for Global Carbon Trading. IIASA Interim Report. IIASA, Laxenburg, Austria: IR-01-063

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Abstract

Simulation models and theory prove that emission trading converges to market equilibrium. This paper sets out to falsify these results using experimental economics. Three experiments are conducted for the six largest carbon emitting industrialized regions. Two experiments use auctions: the first single-bid auction and the second a Walrasian auction. The third relies on bilateral, sequential trading. The paper finds that, in line with the standard theory, both auctions and bilateral, sequential trading capture a significant part (88 to 99 percent) of the potential cost savings of emission trading. As expected from dynamic trade theory, all experiments show that the market price converges (although not fully) to the market equilibrium price. In contrast to the theory, the results also suggest that not all countries will gain from trading. In both the bilateral trading experiment and the Walrasian auction, one country will actually be worse off with trade. In particular, bilateral, sequential trading leads to a distribution of gains significantly different from the competitive market outcome. This is due to speculative behavior, imperfect foresight and market power.

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