Trading emission permits under upstream-downstream strategic interaction

In this paper, we study how two strategic \u85rms under environmental regu-lation based on tradable emission permits interact in both the permits and the output market. We \u85nd that (i) the outcome in the permits market is deter-mined by the strategic interaction in the output market (and vice versa); (ii) a price-taker in the permits market can exploit the strategic linkages between the upstream and the downstream market to compensate for the fact that he has no direct inuence on the permits price; and (iii) the possibility of banking per-mits reinforces the ability of the price-taker to counterbalance the price-makers market power in the permits market. Accordingly, we illustrate with a numer-ical example how the welfare maximizing free allocation of permits depends on output market structure. Key Words: tradable emission permits; banking behavior; upstream-downstream strategic interaction