Intertemporal abatement decisions under ambiguity aversion in a cap and trade
By Simon Quemin
We study intertemporal abatement decisions by an ambiguity averse firm covered under a cap and trade. Ambiguity aversion is introduced to account for the prevalence of regulatory uncertainty in existing cap-and-trade schemes. Ambiguity bears on both the future permit price and the firm’s demand for permits. Ambiguity aversion drives equilibrium choices away from intertemporal efficiency and induces two effects: a pessimistic distortion of beliefs that overemphasises ‘detrimental’ outcomes and a shift in the effective discount factor. Permit allocation is non neutral and the firm’s intertemporal abatement decisions do not solely depend on expected future permit prices, but also on its own expected future market position. In particular, pessimism leads the expected net short (resp. long) firm to overabate (resp. underabate) early on relative to intertemporal efficiency. We show that there is a general incentive for early overabatement and that it is more pronounced under auctioning that under free allocation.
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