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Essays in Market Design for Emissions Trading Schemes THE UNIVERSITY OF NEW SOUTH WALES ESSAYS IN MARKET DESIGN FOR EMISSIONS TRADING SCHEMES Phillia A. Restiani Supervisors: Dr. Regina Betz Professor Robert Marks A THESIS SUBMITTED FOR THE DEGREE OF DOCTOR OF PHILOSOPHY SCHOOL OF ECONOMICS THE UNIVERSITY OF NEW SOUTH WALES September 2010 Originality Statement ‘I hereby declare that this submission is my own work and to the best of my knowledge it contains no materials previously published or written by another person, or substantial proportions of material which have been accepted for the award of any other degree or diploma at UNSW or any other educational institution, except where due acknowledgement is made in the thesis. Any contribution made to the research by others, with whom I have worked at UNSW or elsewhere, is explicitly acknowledged in the thesis. I also declare that the intellectual content of this thesis is the product of my own work, except to the extent that assistance from others in the project's design and conception or in style, presentation and linguistic expression is acknowledged.’ Signed ……… …………………………… Date ……7 December 2011………………………………… i Copyright Statement ‘I hereby grant the University of New South Wales or its agents the right to archive and to make available my thesis or dissertation in whole or part in the University libraries in all forms of media, now or here after known, subject to the provisions of the Copyright Act 1968. I retain all proprietary rights, such as patent rights. I also retain the right to use in future works (such as articles or books) all or part of this thesis or dissertation. I also authorise University Microfilms to use the 350 word abstract of my thesis in Dissertation Abstract International (this is applicable to doctoral theses only). I have either used no substantial portions of copyright material in my thesis or I have obtained permission to use copyright material; where permission has not been granted I have applied/will apply for a partial restriction of the digital copy of my thesis or dissertation.' Signed ………… …………………………………… Date …………7 December 2011………………………………… ii Authenticity Statement ‘I certify that the Library deposit digital copy is a direct equivalent of the final officially approved version of my thesis. No emendation of content has occurred and if there are any minor variations in formatting, they are the result of the conversion to digital format.’ Signed ………… …………………………………… Date …………7 December 2011……………………………… iii Acknowledgement I would like to express my deepest gratitude to my supervisors, Dr. Regina Betz and Professor Robert Marks, for their tremendous guidance, patience, and invaluable advice throughout this research. It has not been an easy journey and their continuous support and encouragement have led me to the end of the journey. I am especially grateful to A.J. Bostian, Ben Greiner, and Marc Adam who have given me significant advice and help with the experiment. I am also indebted to Christoph Heinzel, Paul Twomey, Iain MacGill, and other colleagues at the Center for Energy and Environmental Markets (CEEM) for their constructive comments and stimulating discussion on my research. In particular, I thank Adeline Tubb and Johanna Cludius with the help in running the experiment and Sussanne Nottage for her important administrative assistance. This thesis would not have been possible without the enabling financial resources. I would like to acknowledge the financial support provided by the Australian government through the Australian Development Scholarship Fund (ADS), CEEM through the Commonwealth Environmental Research Facility (CERF), thesis support fund from the School of Economics, and the Tokyo Foundation through the Sasakawa Young Leaders Fellowship Fund (SYLFF). During my research time, I have been privileged by the friendship of my colleagues in the School of Economics and other friends from UNSW. Especially, I would like to thank my best friend, Zaida Contreras, for her unfailing support, coffee chat and companionship. A very big thank you goes to Jean-Michel Rapin and Raul Zimmerman who have been there through the difficult times and cheered me with their sense of humour. Finally, I thank specially my mother and siblings for their enduring love and faith in me. I also thank my partner Daniel for his understanding, patience, and support for the completion of this dissertation. iv Abstract This dissertation explores the issues of market design for emissions trading schemes by focusing on penalty designs and initial allocation mechanisms. Penalty design is defined in terms of penalty types and levels and the allocation mechanism compare free allocation with auctioning. The first essay employs a theoretical model to examine compliance incentives and market efficiency under three penalty types: the fixed-penalty rate (FPR), the make-good provision (MGP), and the mixed penalty design. Using a simple two-period model of firm’s profit maximisation, we analyse compliance decisions and the efficient penalty level under each penalty type. Our findings indicate that the penalty type does not affect compliance decisions provided that the efficient penalty level is applied. Market efficiency is retained regardless of penalty types. These findings are used as the hypotheses for the second essay. The behavioural implications of penalty designs on market performance are investigated in the second essay using an experimental method. Three penalty types and two penalty levels are enforced in a laboratory permit market with auctioning wherein subjects make compliance decisions by undertaking irreversible abatement investment decisions or by buying permits. In contrast to theory, we find that penalty levels serve as a focal point that indicates compliance costs and affects compliance strategies. The MGP penalty provides stronger compliance incentives than the other penalty types. Most importantly, a trade-off between investment incentives and efficiency is observed. Using a laboratory experiment, the third essay studies how the initial distribution of permits through free allocation or auctioning, may affect price discovery, allocative and static efficiency under the presence of three penalty designs. Price discovery is not influenced by the initial allocation mechanism. Permit prices remain above the efficient level due to the presence of irrational bidding and trading behaviour as well as risk aversion. Uncertainty regarding permit prices results in a modest allocative efficiency as over-investment prevails. Auctioning evidently generates higher static efficiency due to stronger price signals. This result supports the majority of literature which argues for auctioning. An appropriate auction design is crucial to avoid the risk of overbidding which will inflate the auction price and diminish efficiency. v Table of Contents Chapter One: Introduction ................................................................................................................... 1 Chapter Two: A Theoretical Model of Profit-Maximising Compliance Decisions under Different Penalty Designs in Emissions Trading Markets ................................................... 5 2.1. Introduction ........................................................................................................................ 5 2.2. Enforcement in Emissions Trading Schemes ..................................................................... 6 2.3. Penalty Design.................................................................................................................. 10 2.4. Model Assumptions .......................................................................................................... 14 2.5. Fixed Penalty Rate ........................................................................................................... 17 2.6. Make-Good Provision ...................................................................................................... 24 2.7. Mixed Penalty Design ...................................................................................................... 32 2.8. Discussion ........................................................................................................................ 39 2.9. Conclusion ........................................................................................................................ 42 Chapter Three: The Effects of Penalty Design on Market Performance: Experimental Evidence from an Emissions Trading Scheme with Auctioned Permits ........................................... 43 3.1. Introduction ...................................................................................................................... 43 3.2. Literature Review ............................................................................................................. 44 3.3. Experimental Design ........................................................................................................ 48 3.4. Hypotheses ....................................................................................................................... 54 3.5. Results .............................................................................................................................. 55 3.5.1. Subject Risk Preferences ........................................................................................... 55 3.5.2. Convergence Path and Statistics Summary ............................................................... 56 3.6. Test of Treatment Effects ................................................................................................
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