Unintended Consequences of Price Controls: An Application to Allowance Markets

Price controls established in an emissions allowance market to constrain allowance prices between a ceiling and a floor offer a mechanism to reduce cost uncertainty in a cap-and-trade program; however, they could provide opportunities for strategic actions by firms that would result in lower government revenue and greater emissions than in the absence of controls. In particular, when the ceiling price is supported by introducing new allowances into the market, firms could choose to buy allowances at the ceiling price, regardless of the prevailing market price, in order to lower the equilibrium price of all allowances. Those purchases could either be transacted by a group of firms intending to manipulate the market or be induced through the introduction of inaccurate information about the cost of emissions abatement that causes firms to purchase allowances at the ceiling. Theory and simulations using estimates of the elasticity of allowance demand for U.S. firms suggest that the manipulation could be profitable under the stylized setting and assumptions evaluated in the paper, although in practice many other conditions will determine its use.