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Coordinating Separate Markets for Externalities

Jose Miguel Abito, Christopher R. Knittel, Konstantinos Metaxoglou, and André Trindade

July 2018

We show that inefficiencies from having separate markets to correct an environmental externality are significantly mitigated when firms participate in an integrated product market. Firms take into account the distribution of externality prices and reallocate output from markets with high prices to markets with low prices. Investment in cleaner and more efficient capacity serves as an additional mechanism to reallocate output, which increases the marginal bene t of investment, and consequently improves longer-term outcomes. Using data from an integrated wholesale electricity market, we estimate a dynamic structural model of production and investment to bound the loss from separate markets for carbon dioxide emissions, and quantify the extent to which optimal investment can compensate for the loss. Despite the lack of the "invisible hand" of a single emissions market, pro fit-maximizing firms can play a crucial role in coordinating otherwise uncoordinated environmental regulations.

Keywords: Incomplete regulation, Investment, Emissions, Energy, Externalities.

JEL codes: L1, L5, L9, Q4, Q5.

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