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We conduct a laboratory experiment to investigate whether the double auction institution can suppress market power in emissions trading markets. We study 24 markets with varying market structure in a ABA crossover design which controls for subject effects. We find clear evidence of successful use of market power. Average prices rise under monopoly and fall under monopsony. Opening prices are affected much more than closing prices. Profits are redistributed in favor of the agent with power. Efficiency is not affected significantly. Analysis of convergence trends suggests that this is not a transitory phenomenon. We interpret our results as evidence of successful price discrimination within a double auction market.

Emissions trading is frequently advocated as an institution for market-based environmental regulation; however, practical implementations were rare and unique to the United States until the 1990s. 2 Since then, the success of American initiatives, in particular the U.S. EPA SO 2 emission permit market, has increased international enthusiasm for this institution. It may be optimistic, though, to expect that American successes will be easily replicated elsewhere. The SO 2 market hasbeen characterized by large numbers of sellers and buyers and trading has taken place using transparent institutions. These features have been important in gener- ating the competitive market outcomes and benefits which the approach promises. Application of the institution in other countries or in an international arena may, however, involve markets with less competitive characteristics. In particular, they could be sufficiently dominated by large sellers or buyers to create market power. At the international level, it is frequently thought that the United States will be a dominant buyer and the states of the former Soviet Union dominant suppliers in Annex I trading under the Kyoto protocol. Nordhaus and Boyer [17, p. 121] estimate that the United States will account for approximately 44% of carbon emis- sions permit purchases by 2010 while the former Soviet Union will account for nearly 56% of sales. By 2050 the share for the United States will fall to 39% while the share for the former Soviet Union will rise to 68% (in both 2010 and 2050 eastern Europe will account for the balance of sales). These estimates are based on competitive market pricing. Bernstein et al. [1, p. 250] estimate that full exploita- tion of monopoly power by Eastern Europe and the former Soviet Union could induce a monopoly markup of 180% and raise international carbon permit prices from US$90/ton to $129 per ton. These concentration concerns are particularly relevant if trading under the Kyoto protocol is implemented on a country-to-country basis. If countries delegate trading authority to polluting firms, concentration in world greenhouse gas markets could be significantly lessened. High market concentration may still be a problem in trad- ing permits for other pollutants, however, particularly in markets for regionally restricted air and water pollutants. For example, the Ontario Ministry of Environ- ment [22] has announced a mandatory cap on nitrogen oxide (NO x ) and sulphur oxide (SO x ) emissions from six fossil fuel generating stations at the beginning of 2001. The generating stations are all owned by Ontario Power Generation (OPG), but these may be sold in the future. Current production of NO x is about 50 kton per year, well in excess of the cap of 36 kton. The shortfall can be made up by pur- chases of emission reduction credits from sources in the non-capped sector. The market for these credits is geographically restricted by a requirement that they be generated by sources in or (to a limited extent) upwind from Ontario. Specific mea- sures are proposed for discounting credits generated more than 300 km upwind of the region. OPG has undertaken an extensive program of amassing and banking these credits. There are no other purchases. Off-the-record comments from indus- try observers suggest that OPG is paying distinctly less for these credits than might be expected in the United States. This is consistent with the exercise of monopsony power. The effective exercise of market power in emissions trading markets might raise concern on two distinct grounds. First, of course, market power may restrict the net sales of permits and lead to an inefficient allocation of responsibilities for abate- ment. Second, market power may redistribute the gains from trade in a direction that may or may not be viewed favorably, depending on one’s political perspective. Note that it is possible to have the second effect without the first if the traders with market power are able to practice price discrimination. Porter [20] has conjectured that this is a possibility in double auction markets.Referring to laboratory evidence, Bohm [2, p. 55] has suggested that potential market power in emissions trading may be controlled by using double auctions. 3 The relevant laboratory evidence consists of papers by Smith [22], Smith and Williams [23], Ledyard and Szakaly-Moore [13], Brown-Kruse et al. [3], and Godby [7–9]. In fact, this work provides only mixed support for relying on double auctions to con- trol market power. First, only Ledyard and Szakaly-Moore [13] and Godby [7–9] capture an important aspect of field markets for emissions permits, namely that participants may act as traders (alternatively buying or selling permits according to changes in cost conditions and price levels). The remaining studies designate some traders as buyers and some as sellers. The trading environment may differ from the buyer and seller environment because in the former, potential sellers of emissions permits generally have the option of earning profits by using unsold per- mits in their own operations. This opportunity may make sellers less vulnerable to counter-withholding by buyers. Moreover, trading environments allow speculation and consequently may introduce more noise into prices. In fact, the laboratory stud- ies with trading seem to detect more successful exploitation of market power than the studies with buyers and sellers. Second, even the seminal work by Smith [22], which shows that the double auction can largely control deviations from competitive prices, detects evidence of output restrictions under monopoly conditions. Third, Brown-Kruse et al. [3] and Godby [7–9], in the two studies which examine both monopoly and monopsony power, provide some suggestion that monopsonists have more success than monopolists in exploiting power in laboratory markets. 4 Because the theories of monopoly and monopsony are symmetric, this asymmetric result is surprising. In addition to the mixed support shown for the control of market power by the double auction pricing institution, these studies suffer from some important method- ological drawbacks. They all have a small number of market power sessions. 5 They use between-subject rather than within-subject designs, which would have greater statistical power. Finally, they do not provide a direct comparison of competition with market power under identical conditions of supply and demand. In short, the limited laboratory evidence suggests that it is premature to be san- guine about the ability of double auctions to control market power in emissions trading markets. The suggestion that monopsony power may pose a greater threat than monopoly power is particularly disturbing because, as we have seen, there is a real possibility of high concentration on the buying side of many emerging emissions trading markets. It is important to discover whether this asymmetry in performance reappears in related laboratory environments. Moreover, given the many contextsin which concentrated emissions markets may arise, it is important to confirm that market power actually does emerge in well-controlled laboratory environments. In this paper we present a laboratory experiment which permits a controlled con- trast of competition with monopsony and monopoly power in a double auction mar- ket with common cost parameters. The statistical power of the contrast is enhanced by a within-subject design and a larger number of markets than in previous studies. We capture the emission trading environment by letting our subjects act as traders rather than designating them as buyers and sellers and by ensuring that the emis- sion permits have value to the traders even if they do not trade their permits. The results of the experiment suggest that both monopolists and monopsonists can cause average prices to diverge from competitive levels and shift the trading surplus in their favor. However, efficiency is not significantly reduced from competitive levels. Monopolists and monopsonists have comparable success in appropriating surplus.

Our results clearly establish that both monopoly and monopsony subjects were able to manipulate prices to their advantage despite any limitations placed on themby the double auction institution. This is not a transient effect which is eliminated with experience. We confirmed this by estimating the asymptotic median price for each market and testing for treatment and market effects. The insignificant effect of market structure on efficiency and the relatively small constraint on net purchases, together with the observed price patterns, strongly suggest that efficiency losses were mitigated by price discrimination. As a result, subjects with market power were able to increase their share of the profits substan- tially (relative to the competitive environments) without greatly harming efficiency. The sustained spread between median and closing prices in the convergence anal- ysis suggests that subjects with market power were systematically able to practice price discrimination. Our experiment differed from those of Brown-Kruse et al. [3], Smith [22], and Smith and Williams [23] because our subjects could trade on both sides of the mar- ket. It differed from that of Ledyard and Szakaly-Moore [13] because it considered both monopsony and monopoly power. It differed from all previous research in thearea because it included a competitive baseline against which the effect of market power could be measured and because it included more monopoly and monopsony markets than any of the others. Our results generally confirm the findings of Brown-Kruse et al. [3], Godby [7–9], and Ledyard and Szakaly-Moore [13], all of which present evidence that double auctions provide an ineffective constraint on market power. Unlike Godby [7–9], however, we find very little evidence of asymmetry between monopolists and monop- sonists. Our results exhibit a stronger effect of market power in double auctions than was observed in most previous work. Table XII compares the price results across our experiment and five predecessors. To allow for the possibility of conver- gence to competitive equilibrium in a session we examine only the mean prices in the last periods reported (we shift from median prices here because the data from other experiments are described this way). In the present experiment, monopolists achieved 55% of the potential price increase while our monopsonists achieved 65% of the potential price declines. The monopolists were more successful than thosein previous experiments (particularly those of Godby, for whom the introduction of agents who could work both sides of the market led to a reduction in the ability to exert market power). The monopsonists were somewhat less successful in com- parison. Particularly noteworthy, however, is the success of the monopolists, which suggests that Godby’s results may be anomalous. Our finding that price discrimination can persist in a double auction when all prices are public information challenges the hypothesis, suggested by Smith [22], that buyers’ resistance to high prices is increased once the monopolist reveals him- self prepared to sell at lower prices. A possible explanation of this difference may lie in the nature of our markets. Unlike those in Smith’s experiments, our markets allowed speculative activity which, combined with the changing market “fundamen- tals” associated with within-session treatment changes, could have created an envi- ronment in which it was easier for price discrimination to persist. Because naturally occurring emissions markets would also be characterized by speculative activity and changing market conditions, our results suggest that market-power pricing and price discrimination may be serious problems in the field.Our work has somewhat conflicting implications for emissions trading policy. On the one hand, it suggests that double auction markets for emissions permits can be quite efficient, even when the buying or selling side is highly concentrated. On the other hand, it suggests that agents with market power may be able to use it to capture substantially increased shares of the gains from emissions trading. This may pose a problem in the context of international Greenhouse Gas trading if some countries directly trade their assigned amounts rather than delegating them to domestic entities. This may make negotiations of international trading arrangements more difficult. The problem of market power may be even greater in affecting the political feasibility of regional emissions trading markets in which there are likely to be single buyers.