Endowment Effects, Expectations, and Trading Behavior in Carbon Cap and Trade

We explain agents’ trading behaviors and market outcomes in the presence of expectation-based endowment effects in carbon cap and trade. Building on Kőszegi and Rabin (2006)’s reference-dependent model with forward-looking reference points, we show how firms’ concerns about high future compliance costs (through loss aversion and uncertainty) can cause a gap between marginal Willingness-to-Pay and marginal Willingness-to-Accept for allowances. This leads to limited allowance trading and prices deviating from the socially desirable paths, compromising cost-effectiveness. The problem can be exacerbated under inflexible supply policies, such as a fixed cap or depleted market stabilization reserves, as well as uncertain regulatory ambitions. We discuss potential alternative systems for decarbonization that incorporate flexibility in terms of innovation timing and realized costs. Given that firms’ concerns could largely arise from cost-related characteristics, such as limited pass-through emission costs, we also propose that cap-and-trade systems could generate synergistic effects with complementary polices for a low-carbon economy, such as strengthening markets and demand for low-carbon products or supporting the adoption of clean technologies