Do Emission Markets Reallocate Production Efficiently?

This project investigates how emissions trading markets influence firm level production decisions, focusing on Alberta’s electricity and carbon markets. While emissions markets like the EU ETS and California’s Cap-and-Trade are central to climate policy, empirical evidence on their real-world production effects remains limited. Two key challenges may distort market outcomes: transaction costs in the emissions market and market power in the production market. Transaction costs, which may vary across firms, can distort the efficient reallocation of production that emissions markets are designed to achieve. For instance, dirtier producers might face lower costs, undermining policy goals. Additionally, firms with market power in electricity markets may adjust their production strategically in response to emission costs. Alberta offers a unique setting with rich, high-frequency electricity auction data and a flexible carbon pricing system—where firms choose between a carbon tax and trading. Leveraging this data and exogenous policy changes, the researchers will estimate how carbon markets influence production and reallocation efficiency.

“To efficiently reduce CO₂ emissions, economists propose two main policy approaches: emissions trading markets and carbon taxes. In theory, both should have similar effects on firms’ emission and production decisions. However, in practice, these policies may not perform as expected. A key difference is that emissions markets can involve inherent market frictions, which may lead to unintended consequences. For example, dirtier producers may face fewer frictions while cleaner producers face more. This study aims to identify and quantify these frictions and examine how they influence firms’ emissions and production decisions using empirical data. This project will help policymakers understand the gap between theory and reality and inform the design of more effective climate policies.”

Keisuke Ito, PhD Student, Harris Public Policy at the University of Chicago