Rate of Return Regulation and Emission Permits Trading under Uncertainty

This paper analyzes the dynamic effects of rate-of-return regulation on firms’ emissions compliance behavior when the price of emissions permits is uncertain. The paper shows that uncertainty regarding the price of permits would motivate a regulated firm to adopt a more self-sufficient strategy and would reduce the cost-effectiveness of emission allowance trading. When allowance transactions are treated as capital investments, uncertainty could reverse the classic Averch-Johnson effect, so that a regulated firm would purchase fewer permits in the ex ante period than its unregulated counterpart. These results are driven by the asymmetric impact of a price change on the expected marginal value of allowances under rate-of-return regulation. A wider variation in the permit price and a decline in the regulated rate of return would amplify the asymmetry. These results have implications for the efficiency of the proposed global carbon trading system