Intertemporal links in cap-and-trade schemes

In a two-period general equilibrium model, I study the effects of intertemporal emission permit trading in a cap-and-trade scheme when firms' investments in abatement have long-term effects. To meet their caps, firms optimally choose levels of trading and investment in each period by equalizing the marginal benefit of abatement to the marginal cost of abatement in each period. The fact that investments have long-term effects introduces new effects: investments in period 1 have both an additional benefit (the reduction of emissions in period 2) and an additional cost (the decrease in abatement opportunities in period 2). This changes the standard condition of equalization of marginal costs across periods for cost-effectiveness. Without intertemporal trading, some investments in period 1 are entirely driven by second-period abatement needs. In that case, allowing intertemporal trading may reduce investment in period 1 as some long-term investments are substituted by intertemporal permit trading. Descriptive evidence from the EU Emissions Trading System (ETS) illustrates this potential effect. © 2013 Elsevier Inc.