Market power in an exhaustible resource market: The case of storable pollution permits

Motivated by the structure of existing pollution permit markets, we study the equilibrium path that results from allocating an initial stock of storable permits to an agent, or a group of agents, in a position to exercise market power. A large seller of permits exercises market power no differently than a large supplier of an exhaustible resource. However, whenever the large agent’s endowment falls short of its efficient endowment —allocation profile that would exactly cover its emissions along the perfectly competitive path— market power is greatly mitigated by a commitment problem, much like in a durable-good monopoly. We illustrate our theory with two applications: the U.S. sulfur market and the global carbon market that may eventually develop beyond the Kyoto Protocol. JEL classification: L51; Q28. Liski is at the Economics Department of the Helsinki School of Economics. Montero is at the Economics Department of the Pontificia Universidad Católica de Chile (PUC Chile). Both authors are also Research Associates at the MIT Center for Energy and Environmental Policy Research. We thank Denny Ellerman, Bill Hogan, John Reilly, Larry Karp, Juuso Välimäki, Ian Sue-Wing and seminar participants at Harvard University, Helsinki School of Economics, IIOC 2006 Annual Meeting, MIT, PUC Chile, Stanford University, UC Berkeley, Universidade de Vigo, Universite Catholique of Louvain-CORE, University of CEMA, University of Paris 1 and Yale University for many useful comments. Part of this work was done while Montero was visiting Harvard’s Kennedy School of Government (KSG) under a Repsol YPF-KSG Research Fellowship. Liski gratefully acknowledges funding from the Yrjö Jahnsson Foundation and Nordic Energy Research Program, and Montero from Instituto Milenio SCI (P05-004F) and BBVA Foundation.