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Path Dependence in Bilateral Emission Trading
Dallas Burtraw, Ken Harrison, Paul Turner
RFF Discussion Paper 95-17 | March 1995
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Abstract
When environmental damages from emissions are spatially nonuniform, permit trading has been modeled most often as a "pollution offset program" in which emission permits are traded between agents, subject to constraints on ambient air quality. To date the institution envisioned to implement such a program involves trading on a bilateral and sequential basis. However, recent simulation studies indicate that this trading process is path dependent. The high sensitivity to the sequence of trades has the potential to seriously undermine the cost savings that are theoretically achievable from a pollution offset program. This paper identifies a design for the trading institution that tends to overcome the path dependence problem in a simulation model. We model a bilateral trading process for the reduction of sulfur dioxide emissions with a stochastic description of the sequence of trades within groups of nations in Europe. When trading takes place between disaggregated, stylistic representations of economic enterprises, rather than between national governments, a significantly greater portion of potential savings is achieved. In fact, under most sets of assumptions approximate first order stochastic dominance is achieved wherein the more decentralized the trading agents, the greater the expected savings from a trading program.
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