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Input Choice under Carbon Constraint

This paper assesses the impact of emission trading on short-term input demand as well as on long-term production decisions, tacking into account uncertainty in the polluting input price and abatement by input substitution. We find that firms decisions depend on the interplay between three effects. First, the "average cost effect", due to the carbon price, causes a decrease in the input capacity with respect to a reference case where the permits market does not exist. Second, the "marginal variability effect" or the impact of price variability, which instead leads to an expansion of the installed equipment. Third, the "technology effect", i.e. the extent of substitution between polluting and clean inputs. Model simulations show that this interaction can result in weak emission reductions.