Trading for the Future: Signaling in Permit Markets

Tradable permits are celebrated as a political instrument since they allow (i) firms to equalize marginal costs through trade and (ii) the government to distribute the burden in a politically fair and feasible way. These two concerns, however, may conflict in a dynamic setting. Anticipating the government's temptation to give more permits to high-cost firms in the future, the firms purchase permits excessively today to signal high costs. This raises the price above marginal costs and distorts abatements. If the government redistributes permits frequently and the (shadow) price for permits is large, the distortions can be greater than the gains from trade, implying that non-tradable quotas may be better.