Simulating the Carbon Permit Market with Imperfect Observations of Emissions: Approaching Equilibrium through Sequential Bilateral Trade

It is still unclear how the Parties of the Kyoto Protocol will deal with emission trading and compliance given the fact that emissions of greenhouse gases are not perfectly observable and underreporting of emissions may occur. This paper gives an analytical and numerical analysis of the carbon permit market given imperfect observation of emission levels. Our setting is such that Parties must undershoot their emission targets to be able to verify compliance with the Protocol if unreported emissions are accounted for. Targets can be met by traditional emission abatement, by investing in monitoring (reducing unreported emission) or by trading in permits. The paper proves that sequential bilateral trade converges to an equilibrium where marginal abatement costs equal marginal monitoring costs across all Parties. The method is applied for the fossil fuel related carbon emissions of the Parties of the Kyoto Protocol. Our numerical findings indicate that USA, Japan and the European Union could increase their compliance costs significantly when uncertainty in the emission levels is included. Although Central Eastern Europe, Russia, Ukraine are assigned to have larger uncertainties in emission levels, their net costs may be reduced as they can sell emission reductions at a higher price. Compared to the no trade case, we find that emissions trading may lead to somewhat lower aggregate uncertainty in greenhouse gas accounts