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Potential Faults of the Cap-and-Trade Model

Along with the lacking of the aforementioned requirements, there are a few other sources of trouble for this model. These include:

1. Adverse selection can take place in many different ways:

  •  Permit allocation might not be the efficient or equitable
  •  The cap can be set too high, where there is little participation in the market and minimal pollution abatement.
  • The cap can be set too low, which causes unacceptably high costs in the permit market. This increase in prices will translate into undesired increases in the prices of goods and services in related markets.
  • Individuals firms and power plant units can make the wrong decision based on the available data to invest in pollution control devices; or buy, sell, or bank their permits when they should be following a different strategy.

2. The regulatory body needs good information, or else it can fall prey to the moral hazard of incomplete/fraudulent data.
3. The government auction of the permits may prove to be irrelevant to the Tradable Pollution Permits (TPPs) market, which can lead to disinformation. As happened with the sulfur dioxide program (see Market Case Studies for more information), a more important and active permit market among covered firms can overshadow the government's auction market. Thus, the price would be set in the private market, and the government auction could prove to be either irrelevant (as it was with SO2) or detrimental to the overall market.

Cap-and-Trade Case Studies

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