This paper introduces a theoretical model of an emissions trading scheme with auctioning as the method of initial allocation of permits. Risk-averse polluters and speculators, participating in the scheme, respond idiosyncratically to an economy-wide shock. The model suggests that a polluter’s willingness to pay for permits in the auction increases in her risk aversion and in the shock volatility only if aggregated and individual sensitivities to this shock satisfy certain conditions. For a particular region, of low sensitivity and high emissions rate, the polluter’s willingness to pay for permits decreases in the expected secondary market price. Numerical comparative statics show that, generally, only if polluters are significantly more risk averse than the speculators, the former pay a risk premium to the latter through the secondary trade. Intuitively, this results from polluters’ need for permits which overcomes their risk aversion and strengthens their bidding power relative to that of the speculators.
This raised the problem of a trade-off between the hedging role of the speculators and their influence over the auction price.

This seminar has been jointly organized by FEEM and ICCG (International Center for Climate Governance).