Risk Management and Regulation Compliance with Tradable Permits under Dynamic Uncertainty

In this paper, we explore the effects of dynamic uncertainty on the risk management of regulated industries and emission market. We consider as major sources of uncertainty the stochastic growth of demand for the industry output (e.g. electric energy) and the ensuing lack of information on the pollution levels of individual firms, their behavior and the behavior of the regulator. These sources of uncertainty are common in pollution permit trading as not only does the market respond to the volatility of fundamentals but also to the vagaries of the institutional structure, created by public policy and enforced through regulation. The paper shows that in the presence of strategic behavior on the part of the agents involved, even though both the level and the volatility of output increases over time, trading of permits is a highly effective instrument of risk management, since it allows the firms to pool the risks arising from the volatile environment, thereby simplifying enforcement, reducing emissions and improving resource allocation. Moreover, uncertainty plays a subtle influencing role, since on one hand it broadens the regulator’s deterrent power over potential polluters, while on the other it reduces the expected value of the sanction for the individual firm.