Impact of carbon market on production emissions

Abstract

The aim of this paper is to address the effect of the carbon emission allowance market on the production policy of a large polluter production firm. We investigate this effect in two cases; when the large polluter cannot affect the risk premium of the allowance market, and when it can change the risk premium by its production. In this simple model, we ignore any possible investment of the firm in pollution reducing technologies. We formulate the problem of optimal production by a stochastic optimization problem. Then, we show that, as expected, the market reduces the optimal production policy in the first case if the firm is not given a generous initial cheap allowance package. However, when the large producer activities can change the market risk premium, the cut on the production and consequently pollution cannot be guaranteed. In fact, there are cases in this model when the optimal production is {\it always} larger than expected, and an increase in production, and thus pollution, can increase the profit of the firm. We conclude that some of the parameters of the market which contribute to this effect can be wisely controlled by the regulators in order to diminish this manipulative behavior of the firm.