Financial Markets and Cap-and-Trade System in a General Equilibrium Model

In this paper, I study the impact of a global cap-and-trade system for greenhouse gas emissions on financial markets. The analysis is conducted using a general equilibrium production economy with two countries. One of the countries (developed country) introduces the system from the very beginning while the other country (developing country) can join it later. Firms in the first country are divided into two types with either high or low emission levels. Therefore, this setup allows me to study both cross-country and within-country differences. Producers face shrinking caps on their emissions and can reduce these emissions by installing a cleaner technology. Three main results are obtained in this setting. First, producers that have lower emissions at the start-up date have consistently higher expected returns on equity. Second, this return spread depends on the fraction of emission permits given for free, and on the efficiency of the cleaner technology. The higher the fraction of free permits and the reduction in the emissions after installment of the cleaner technology, the lower the spread. Further, I show that if the second country joins the cap-and-trade agreement at the start-up date, and if it is given a high enough number of permits, both countries are better off in terms of consumption streams. But they might be worse off in terms of emissions after taking into account the long-lasting impact of the greenhouse gases. So, I derive the level of permits that makes the second country break-even in terms of consumption stream and show that this level leads to higher long-term emissions than in the case of the first country with caps only. The results are stable to a range of parameters. I obtain preliminary empirical results which support the implications of the model