Abstract
Pollution markets are an increasingly popular regulation to cost effectively control emissions. Traditionally, market designs have employed a cap-and-trade scheme that places an absolute limit on the quantity of emissions. In contrast, many new schemes,---including the world's largest in China---only limit the aggregate emissions intensity of production. This article theoretically and experimentally compares the relative performance of these two regulations. Theoretically, we show that compared to an equivalent cap-and-trade scheme (defined as one which achieves the same aggregate emissions in equilibrium), an intensity-based market increases aggregate output, allowance prices, aggregate abatement, and decreases industry profits. We then design a novel laboratory experiment, where firms choose both output and abatement (corresponding to emissions), to test our predictions. Consistent with our theoretical predictions, we find that employing an intensity-based market rather than an equivalent cap-and-trade scheme significantly increases aggregate output, average allowance prices, and aggregate abatement, and decreases industry profits. However, contrasting sharply with predictions, both the volume of allowance trades and final allowance holdings are virtually indistinguishable between the two scheme types at both the aggregate and individual firm type levels. This implies that while in aggregate an intensity-based scheme performs as expected, the insufficiency of trades has unexpected implications for the relative cost-effectiveness of the scheme compared to the standard absolute approach.