A differential game of intertemporal emissions trading with market power

In international emissions trading schemes such as the Kyoto Protocol and the European Union Emissions Trading Scheme, the suboptimal negotiation of the cap with respect to total pollution minimization leads us to critically examine the proposition that generous allocation of grandfathered permits by the regulator based on recent emissions might pave the way for dominant positions. Stemming from this politically given market imperfection, this paper develops a differential Stackelberg game with two types of noncooperative agents: a large potentially dominant agent and a competitive fringe whose size are exogenously determined. The strategic interactions are modelled on an intra-industry permits markets where agents can freely bank and borrow permits. This paper contributes to the debate on initial permits allocation and market power by focusing on the effects of allowing banking and borrowing. A documented appraisal on whether or not such provisions should be included is frequently overlooked by the debate to introduce the permits market itself among other environmental regulation tools. Results are presented under perfect information.