Environment is a global public good with high demand for and limited supply of, which requires proper regulations of environmental security. Economic instruments for environmental regulations become popular both among policy-makers and scientific communities. Prominent example of adopted economic instruments is emissions trading schemes. These schemes play important role in climate change policy negotiations. Unfortunately, existing carbon markets are volatile and operate at disequilibrium prices, which do not ensure cost-efficient and environmentally safe trades.

About Emission Trading Model
The model is an exploratory market environment for carbon emissions trading. It allows trading parties (countries or emitting entities) to investigate the conditions of their cost-efficient trades. The model suggests cost efficient and environmentally safe equilibrium solution that can be implemented in reality. Key questions the model addresses:

• Under which conditions is carbon trading environmentally safe (i.e. to actually achieve the emission reductions with a certain probability) and cost-effective in the long-term, if considered in the context of a stochastic market?
• How the knowledge about uncertainties may affect portfolios of technological and trade policies of the parties?
• If uncertainties may affect the structure of the market?
• By how much differ marginal abatement costs calculated from technology parameters and the spot carbon price in the existing stochastic market?
• By how much trading Parties may decrease the chances of lock-in solutions and “irreversible” trades at spot market?

How Emission Trading Model works
The proposed multi-agent stochastic model of emissions trades/exchanges is a modeling environment that connects computers of trading “parties” with the computer of a “central agency”. In an anonymous manner it stores information on the “parties”, e.g. their cost functions and other characteristics of the underlying optimization model including specific characteristics of uncertainties. The procedure deriving equilibrium solution is the following: two parties “meet” (e.g. picked at random) and exchange emission permits in a mutually beneficial way accounting for actual costs. At the next step, a new pair is picked and the procedure is repeated. At each step of the bilateral trades, the actual costs will differ between the sequential trades, but finally the trading system converges to an equilibrium with marginal costs of all parties equal to an equilibrium price. The model derives the solution in a decentralized manner without revealing information of the parties.

Background
The international emission trading (IET) scheme under the Kyoto protocol was devised to lower the cost of achieving sets of greenhouse gas emission reductions for different countries with the price of tradable emissions equal to the marginal cost of emissions reductions to meet the cap. However IET was implemented through a market similar to financial markets. “Disequilibrium” carbon prices exhibit periods of high volatility. They react to and are the result of political decisions, information disclosure, speculations, bubbles, uncertainties around emissions and emissions reduction costs. The underlying, actual cost of GHG reduction, i.e. the marginal costs of abatement technologies is only of secondary importance. The existing emission trading, therefore, does not necessarily minimize abatement costs and achieve emission reduction goals. The model has been developed as a result of collaboration between IIASA EMS, MAG, ASA programs within GGI activity. The model may support decisions regarding a trade-off between technological and economic mitigation and adaptation measures to reduce CO2 emissions and combat climate change without compromising economic development goals.

Challenges:
The model studies limitations of the existing emission trading markets. It identifies the conditions when carbon trading is environmentally safe and cost-effective under inherent uncertainties. The model explicitly incorporates various uncertainties and detectability of emissions and permits to derive solutions that are cost-effective and ensure environmental safety/security concerns are met.

Fast Facts:
The project links into IIASA research activities that study implications of uncertainties on environment, water, food, energy security. It incorporates concepts of emissions detectability (verifiability) and discounting being developed with ESM, ASA, MAG, RAV programs. The developed model is in essence a market model for pricing limited resources under increasing competition and uncertainties, e.g., water, land, environment, to avoid their uncontrollable use. The model has been implemented with the data from GAINS model for USA, EU27, Australia, Canada, Japan, Russia, Ukraine and other countries, to show how much uncertainties may affect market structure, e.g. turn permits’ “buyer” into “seller”.

Responsible for this page: Elisabeth Preihs
Last updated: 22 Dec 2011