Dynamics of optimal carbon prices with inter-temporal regulation

This paper aims to calibrate carbon price trajectories that maximize social welfare where banking and borrowing rules are applied.

Typically, there has been a consensus that banking and borrowing rules within the cap-and-trade system improve social welfare. This additional flexibility can achieve compliance cost smoothing by transferring carbon permits inter-temporally; however, there is also a side effect. Regulated agents have the freedom to escape from the given emissions limit by reallocating previously granted permits.

The market system’s flexibility can cause environmental damage by deviating annual or periodic emission limits, which can invalidate the original purpose of cap-and-trade. This paper demonstrates how the socially desirable price trajectory differs from the one that favors the private sector.

Few studies have focused on the negative effects of combining the cap-and-trade with the inter-temporal regulation (banking and borrowing), which most policymakers and regulated firms can easily miss.