EFFICIENCY LOSS AND TRADABLE PERMITS

will also be a “cap and trade” regime and the “grandfathering” rule will be used for
initial permit allocation. We assume that each firm will be required to reduce its
emission by 10% of its baseline, which is determined by the firms’ NOx emission
levels in the year 2000, Each permit, called Emission Reduction Credit (ERC), gives
the firm the right to emit one ton of NOx. When the firm’s actual emission is lower
than the initial permit allocation or the emission reduction is greater than the required
amount, the firm is allowed to sell the unused permits. Unused permits cannot be
banked for future use to prevent the possibility of a hot spot problem in this area. In
order to lower possible transaction costs and to avoid monopoly, we further assume
that mandatory participants of this system are those firms with historical annual NOx
emissions of 5 tons or above. Smaller firms that are excluded from KPERMS will be
regulated under the current air pollution fee system.

The Model

In order to determine an efficient technology adoption and trading pattern, a
mixed-integer programming model is developed. The model reflects the perspective
of a social planner who wants to achieve the targeted emission reduction levels in the
most economical way. The objective of the social planner’s model is to minimize the
total emission control cost, including variable costs of technology use and fixed costs
of installing equipments, by all firms. Each firm can either choose to install an
expensive but more efficient technology to comply with its emission reduction
requirement and sell excess permits or buy required permits from other participants in
the market. The model assumes that all these decisions are controlled by the social
planner who has full information about the individual producers’ cost structure. This
means implicitly that all participants cooperate among themselves and with the social
planner to adopt the socially optimum solution. Clearly this is not a true
representation of the reality, but the purpose here is to determine a socially optimum
solution which provides a benchmark against other alternatives.

A mathematical representation of the social planner’s model is given as follows:

Min' ∑∑∑ δ ( v cos t_τ USEFYT + f cos t_τ ∙ Dfyt )                               (1)

FYT

such that:

BUYFY + ∑Dfty ∙ emisFτ ∙ baselineFY = SELLfy + SURPLUSFY + emislimFY
τ

for all F, Y                                                                            (2)

∑BUYFY=∑SELLFY  for all Y                                         (3)

FF

∑ DFYτ ≤ 1 for all F and τ                                                    (4)

^y

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