IMPROVING EFFICIENCY IN BILATERAL EMISSION TRADING

When environmental damages from emissions are spatially nonuniform, pe rmit trading has been modeled most often as a ''pollution offset progr am'' in which emission permits are traded between agents, subject to c onstraints on ambient air quality. To date the institution envisioned to implement such a program involves trading on a bilateral and sequen tial basis. However, simulation studies indicate that the sequence of trades may alter the outcome and undermine the cost savings from a pol lution offset program. This paper identifies a design for the trading institution that tends to overcome this phenomenon and improve the eff iciency of equilibria obtained in a simulation model. We model a bilat eral trading process for the reduction of sulfur dioxide emissions wit h a stochastic description of the sequence of trades within groups of nations in Europe. When trading takes place between disaggregated, sty listic representations of economic enterprises, rather than between na tional governments, a significantly greater portion of potential savin gs is achieved. In fact, under most sets of assumptions, approximate f irst order stochastic dominance is achieved wherein the more decentral ized the trading agents, the greater the expected savings from a tradi ng program.