Cap and Trade: Auctions and Games
In 2013, California implemented a cap and trade program to reduce greenhouse gas emissions. Cap and trade is a market-based regulation that “caps” total emissions in certain sectors of industries. The state allocates enough allowances for that capped amount of emissions, and the allowances are either given for free or sold in auctions by the state. Businesses must have enough allowances to match their emissions each year or else will face a steep penalty. A business that has extra allowances can sell them to others (the “trade”).
The state auctions have a single-round, sealed-bid, uniform-price format. Participants submit a “bid schedule” consisting of a bid for a specific number of allowances. The highest bidders are sold their requested allowances until allowances run out, but all bidders pay the bid of the lowest winning bidder (the amount called the auction clearing price). This auction is a variation on a second-price sealed-bid auction as shown in this class, as the bidders all pay the same price that is determined not by the highest bid, but by a lower bid. However, cap and trade auctions have multiple items for sale instead of a single item, and each buyer can buy many items. The valuations for buying nothing at all are also different, as businesses will face a penalty if they do not buy enough allowances.
One problem with California’s cap and trade program is leakage. Since California’s program only covers a single state, businesses can move to another state or country if it is cheaper to move than to participate in the program, causing “leakage” of emissions out of the state. A possible solution is to implement a global cap and trade, where no leakage can occur. This would result in a very different situation than a local system, since there is no worldwide government to impose a global cap like California can do in the state. A representation of this cap and trade as a simple game would have each country choose a target amount of emissions to reduce, and if its target were met with extra emissions reduced, it would be able to sell permits to countries that did not meet their target. The payoff of a country depends on the total amount of emissions reduced worldwide minus the cost of its emission reduction.
The game was modeled and analyzed in 2010 by an energy policy research group, and the Nash equilibrium found indicated that global permit prices would actually fall to less than ideal, while total emissions may increase. This outcome was considered to be very similar to the outcome of the public goods game, where the equilibrium strategy is to contribute nothing to a global “pot” that is divided among the players. Even though this analysis used ideal “rational” strategies for countries, while also making other assumptions, the general conclusion was that global cap and trade alone is insufficient for reducing emissions. Small countries will tend to want benefits without reducing emissions, and since each country sets their target individually, they can just set their target to a value that maximizes their own profits. This ruins the climate benefits of cap and trade, so treaties or some other method may be needed to set targets for each country.
Links:
http://www.edf.org/sites/default/files/content/ca-cap-and-trade_1yr_22_web.pdf
http://www.global-energy.org/international/games/cap-price-games