Do Firms Respond to Market-Based Environmental Instruments?
Evidence from Bidding Behavior in Electricity Markets


Erin T. Mansur and Steven L. Puller




One of the major theoretical benefits of using market-based environmental instruments rather than command-and-control regulation is that the former gives firms incentives to achieve a specified level of emissions reductions at least cost, including by modifying production decisions in the short run. Although this result has been shown theoretically, little empirical work has examined whether firms consider the cost of these instruments when making production decisions. This paper asks whether firms consider the cost of tradable permits in the same way that they treat any other variable input cost. From 1999 to 2002, the Ozone Transport Commissionís nitrogen oxides (NOx) regulation required most electric generating firms in the New England electricity market to own tradable emission permits for each ton of NOx emitted from May 1 to September 30 of each year. As such, the marginal cost of generating electricity discretely rises on May 1 and falls on October 1 of each year. In the electricity spot market, New England generators offered bids to supply electricity to the grid. This paper measures the extent to which firms incorporate the marginal cost of permits into their bids. This allows us to evaluate the OTC cap-and-trade schemeís performance in inducing a shift from high emission to low emission electricity generation.