The main thrust of the paper is the design and the numerical analysis of new cap- and-trade schemes for the control and the reduction of atmospheric pollution. The tools developed are intended to help policy makers and regulators understand the pros and the cons of the emissions markets. We propose a model for an economy where risk neutral firms produce goods to satisfy an inelastic demand and are endowed with permits by the regulator in order to offset their pollution at compliance time and avoid having to pay a penalty. Firms that can easily reduce emissions do so, while those for which it is harder buy permits from those firms anticipating that they will not need them, creating a financial market for pollution credits. Our model captures most of the features of the European Union Emissions Trading Scheme. We show existence of an equilibrium and uniqueness of emissions credit prices. We also characterize the equilibrium prices of goods and the optimal production and trading strategies of the firms. We choose the electricity market in Texas to illustrate numerically the qualitative properties observed during the implementation of the first phase of the European Union cap-and-trade CO2 emissions scheme, comparing the results of cap- and-trade schemes to the Business As Usual benchmark. In particular, we confirm the presence of windfall profits criticized by the opponents of these markets. We also demonstrate the shortcomings of tax and subsidy alternatives. Finally we introduce a relative allocation scheme which despite of its ease of implementation, leads to smaller windfall profits than the standard scheme.
