In international emissions trading schemes such as the Kyoto Protocol and the European Union Emissions Trading Scheme, the suboptimal
negotiation of the cap with respect to total pollution minimization
leads us to critically examine the proposition that generous
allocation of grandfathered permits by the regulator based on recent
emissions might pave the way for dominant positions.
Stemming from this politically given market imperfection, this paper
develops a differential Stackelberg game with two types of noncooperative
agents: a large potentially dominant agent and a competitive
fringe whose size are exogenously determined. The strategic
interactions are modelled on an intra-industry permits markets where
agents can freely bank and borrow permits.
This paper contributes to the debate on initial permits allocation
and market power by focusing on the effects of allowing banking and
borrowing. A documented appraisal on whether or not such provisions
should be included is frequently overlooked by the debate to introduce
the permits market itself among other environmental regulation tools.
Results are presented under perfect information.