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A Leader-Follower Model for Tradable Performance-Based CO2 Emissions Standards

The U.S. Clean Power Plan stipulates a state-specific performance-based CO_2 emission standard and delegates considerable flexibility to the states for using either a tradable performance-based or a mass-based permit program. This paper analyzes these two instruments when they are subject to imperfect competition. We show that while the cross-subsidy inherent in the performance-based instrument might effectively reduce power prices, it could also inflate energy demand, thereby rendering permits scarce. A dominant firm with a relatively clean endowment under the performance-based policy would be able to manipulate the electricity market as well as to lower permit prices, which might worsen market outcomes compared to its mass-based counterpart. On the other hand, the "cross-subsidy" could be the dominant force leading to a higher social welfare if the leader has a relatively dirty endowment.