EPA's New Emissions Trading Mechanism: A Laboratory Evaluation

The EPA has designed a new call auction institution for trading allowances to emit sulfur dioxide. This paper reports twelve laboratory markets that investigate trader behavior in this new institution and evaluate its performance relative to the more commonly observed uniform price call market. We find that the uniform price call market (1) is more efficient, (2) induces more truthful revelation of underlying values and costs, (3) provides more accurate price information, and (4) is more responsive to and recovers more quickly from changes in underlying market conditions. All of these differences result from the intense strategic manipulation incentives of the EPA auction. Under -the EPA auction rules both buyers and sellers misrepresent their true value of the emission permits, which biases market-clearing prices downwards. This suggests that the EPA auction will provide poor price signals to the evolving allowance market.