Emission trading in an imperfectly competitive product market: A comparison of social welfare under mass- and rate-based schemes

Mass- and rate-based schemes are different types of emission trading schemes. Mass-based schemes are usually regarded as first-best market mechanisms for any given level of abatement compared with rate-based schemes. This paper focuses on whether mass-based schemes still achieve higher social welfare in the presence of an imperfectly competitive product market. Considering firms’ heterogeneity in marginal production costs and emission intensities, this paper develops a Cournot duopoly model and theoretically analyzes the relationship of social welfare under mass- and rate-based schemes in interior equilibria with equal total allowances. It is shown that the rate-based scheme leads to larger consumer surplus as a result of the subsidy to output under the scheme. More importantly, the subsidy can reduce the welfare loss caused by market power in the product market. In particular, the rate-based scheme will lead to higher social welfare than the mass-based scheme if the marginal production cost of one firm with a low emission intensity is not greater than that of another firm with a high emission intensity. Additionally, the analytic model is applied to China's iron and steel industry. The results show that the rate-based scheme achieves higher consumer surplus, producer surplus and social welfare under equal total allowances. These results can be explained by the theoretical analysis in this paper.