Prices versus Quantities versus Bankable Quantities

Welfare comparisons of regulatory instruments under uncertainty have typically focused on price versus quantity controls. This is true even in dynamic analyses of cumulative pollutants and despite the presence of banking and to some extent borrowing provisions in existing emission trading programs. Nonetheless, many have argued that such provisions can reduce price volatility and lower costs in the face of uncertainty. This paper develops a model and solves for optimal banking behavior with baseline emission shocks that are correlated across time. We show that while banking does reduce price volatility and lower costs, the degree of these reductions depends on the persistence of shocks. A large initial bank will also depress price volatility, but optimal behavior will eventually draw down the bank and lead to higher emissions and continued price volatility. For plausible parameter values related to US climate change policy, we find that bankable quantities eliminates perhaps one-fourth of the cost difference between price and non-bankable quantities. We find larger improvements when we extend the model to include expected growth abatement and marginal costs as well as borrowing of permits. This latter result suggests an opportunity for additional welfare-improving policy adjustment