Strategic Excess? The Model

It’s hard to get an intuitive grasp on the strategic reserve design, so I built a model (which I’m not posting because it’s still rather crude, but will describe in some detail). First, I’ll point out that the model has to be behavioral, dynamic, and stochastic. The whole point of the strategic reserve is to iron out problems that surface due to surprises or the cumulative effects of agent misperceptions of the allowance market. You’re not going to get a lot of insight about this kind of situation from a CGE or intertemporal optimization model – which is troubling because all the W-M analysis I’ve seen uses equilibrium tools. That means that the strategic reserve design is either intuitive or based on some well-hidden analysis.

Here’s one version of my sketch of market operations (click to enlarge):

It’s already complicated, but actually less complicated than the mechanism described in W-M. For one thing, I’ve made some process continuous (compliance on a rolling basis, rather than at intervals) that sound like they will be discrete in the real implementation.

The strategic reserve is basically a pool of allowances withheld from the market, until need arises, at which point they are auctioned and become part of the active allowance pool, usable for compliance:

Reserves auctioned are – to some extent – replaced by recycling of the auction revenue:

Refilling the strategic reserve consumes international forestry offsets, which may also be consumed by firms for compliance. Offsets are created by entrepreneurs, with supply dependent on market price.

Auctions are triggered when market prices exceed a threshold, set according to smoothed actual prices:

(Actually I should have labeled this Maximum, not Minimum, since it’s a ceiling, not a floor.)

The compliance market is a bit complicated. Basically, there’s an aggregate firm that emits, and consumes offsets or allowances to cover its compliance obligation for those emissions (non-compliance is also possible, but doesn’t occur in practice; presumably W-M specifies a penalty). The firm plans its emissions to conform to the expected supply of allowances. The market price emerges from the marginal cost of compliance, which has long run and short run components. The LR component is based on eyeballing the MAC curve in the EPA W-M analysis. The SR component is arbitrarily 10x that, i.e. short term compliance surprises are 10x as costly (or the SR elasticity is 10x lower). Unconstrained firms would emit at a BAU level which is driven by a trend plus pink noise (the latter presumably originating from the business cyle, seasonality, etc.).

So far, so good. Next up: experiments.