## **V.(iii)  Policy Implications**

It is generally concluded that uncertainty about the cost of controlling carbon dioxide emissions make price instruments preferable to quantity instruments because the cost of limiting one ton of emissions is expected to rise as the abatement increases, while the expected benefit of each ton of carbon reduced is roughly constant because climate change is driven by stock effects rather than flow effects.(Hoel and Karp, 2001; Pizer, 2002).<sup>30</sup> However, for a multi-period emission control, when marginal abatement costs are also uncertain for regulated sources, a tradable quota system that allows banking creates incentive for early abatement and generates substantial higher environmental benefits than a tax schedule. In addition, since the initial caps on carbon emissions are likely to be relatively undemanding, the expectation of later, more stringent caps will tend to produce even higher reduction in initial years even when the cap is non-binding.<sup>31</sup> On the other hand, when the marginal benefits of abatement are steeper compared with the marginal costs, a quantity instrument without restrictions on the temporal transfer of emissions, may not necessarily be preferable to a price regulation. This is because a quota system exposes firms to volatile market prices, which encourages reallocation of emissions in response to observed uncertainty. When marginal damaging effects increase rapidly along with the increase of emission flows, a price instrument would be advisable to directly control the marginal social cost. Another potential solution is to employ a hybrid approach that combines a tradable quota system with some safety measures, such as restricting the intertemporal trading ratio and/or applying discounting to banked permits. The government may also consider incorporating multiple polluting industries into a national trading program so that uncertainties facing one industry can be diversified, and the importance of building up a bank to buffer unexpected price strike may be reduced.

# **VI. Summary and Conclusions**

In this paper, I study the theory and empirical behavior of intertemporal emission trading under uncertainty, and its implications for policy instrument choice and banking regime design. The theoretical analysis suggests a positive relationship between industry-wide uncertainty and emission banking. In an intertemporal emission trading system, increased output or input price uncertainty induces larger emission reductions and higher allowance prices. Empirical analysis based on data from the U.S. SO2 allowance market provides consistent time-series evidence. The results suggest that increased price volatility induced by electricity market restructuring could have contributed to 8-11% of the extra emission reductions during Phase I of the trading program. Numerical simulations yield similar elasticity estimates.

> 30 The conclusion follows from Weitzman (1974) that when the slope of the marginal cost function is greater than the slope of the marginal abatement function, price instruments are preferable to quantity instruments because they are much more likely to minimize the adverse consequences of choosing the wrong level of control. 31 Currently, the transfer of unused allowances from the period 2005 - 2007 to the first commitment period under the Kyoto Protocol, i.e. 2008–2012, is not allowed under an EU-wide ban on banking, which from an  environmental point of view, seems to be a troubling decision.

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