Tradable Performance-Based CO2 Emissions Standards: Walking on Thin Ice?

Climate policy, like climate change itself, is subject to debate. Partially due to the political deadlock in Washington, DC, US climate policy, historically, has been driven mainly by state or regional effort until the recently introduced federal Clean Power Plan (CPP). Instead of a traditional mass-based standard, the US CPP stipulates a state-specific performance-based CO2 emission standard and delegates considerable flexibility to the states in achieving the standard. Typically, there are two sets of policy tools available: a tradable performance-based and a mass-based permit program. We analyze these two related but distinct standards when they are subject to imperfect competition in the product and/or permit markets. Stylized models are developed to produce general conclusions. Detailed models that account for heterogenous technologies and the transmission network are developed to evaluate policy efficiency. Depending on the scenarios under consideration, the resulting problem could be either a complementarity problem or a Stackelberg leaderfollower game, which is implemented as a mathematical program with equilibrium constraints (MPEC). We overcome the nonconvexity of MPECs by reformulating them as mixed integer problems. We show that while the cross-subsidy inherent in the performance-based standard that might effectively reduce power prices, it could inflate energy demand, thereby rendering permits scarce. When the leader in a Stackelberg formulation has a relatively clean endowment under the performancebased standard, its ability to manipulate the electricity market as well as to lower permit prices might worsen the market outcomes compared to its mass-based counterpart. On the other hand, when the leader has a relatively dirty endowment, the "cross-subsidy" could be the dominant force leading to a higher social welfare compared to the mass-based program. This paper contributes to the current policy debates in regulating emissions from the US power sector and highlights different incentives created by the mass- and performance-based standards