1. Why Would Polluting Firms Want to Bank Credits (co.) Saving Purchase/Sale Transactions Costs – if polluting firms don’t know if they will need an excess credit for future use, banking may mean that they will avoid some purchase/sale-related transactions costs. Example – Assume 50/50 if excess allowance in future (at time t2) will be needed by the firm to cover its t2 emissions. If firm sells allowance now (at time t1), 50% chance the firm will have to buy an allowance at t2, 50% chance that the firm won’t have to. If any sale or purchase transaction means $100 in transactions costs, expected transaction costs of selling at t1 plan is $100 + (.5 X $100) or $150. If firm banks credit at t1, expected transactions costs are (.5 X $100) or $50. The greater the purchase/sale transactions costs per purchase/sale, the more compelling is this transactions costs explanation of banking.

2. Why Would Polluting Firms Want to Bank Credits (co.) Tax-related advantages of banking excess allowances. If the firm sells at t1 and then needs to buy an allowance at t2, it will post a gain at t1 and a loss/expense at t2. If it turns out the firm doesn’t need another allowance at t2, the firm will just post a gain at t1. By contrast if the firm banks at t1 and then sells at t2, it will post a gain at t2. If the firm banks and then uses the credit at t2, the firm will have no tax gain or losses to post. From a tax minimization/avoidance perspective, the tax possibilities associated with the banking plan (50% prospect of a late/t2 gain, and 50% prospect of no gain or loss) are preferable to those associated with the no banking/sell in time t1 plan (50% prospect of an early/t1 gain, and 50% prospect of an early/t1 gain combined with a late/t2 loss)

3. Why Would Polluting Firms Want to Bank Credits (co.) Banking allowances also may reflect an anti-competitive strategy If established firms “hoard” allowances, it will be difficult for new entrants to buy bulk of allowances necessary to begin new production operations Banking allowances also may reflect fear of firms that they will be unable to buy allowances they may need at time 2, some firms may be very risk averse regarding hold-ups to meeting future production demand For example, power provider may worry that it wont be able to find enough allowances to cover emissions in t2, if its an unusually hot (heat) or cold (air conditioning) year

4. Banking and Industry-Wide Political Economy Question: If a polluting/regulated industry has firms with substantial banks of allowances, can we predict that the industry, as a political actor, will act differently than if firms in the industry had not built substantial banks? Prediction: An industry with firms with many banked credits will be (all else being equal) less politically supportive of government efforts to mandate and/or encourage the development of new pollution control/reduction technologies than an industry with firms that have banked no or very few credits. Why: The development of new, diffusible pollution technology translates into a reduction in the market price of pollution credits, and a reduction in that market price represent a loss in asset value for firms that have banked allowances

5. Political Economy co. Industry may be less supportive of regulatory experiments that offer industry rewards for experiments with new prevention technology as in Project XL model Industry may be less supportive of – at least work less intensely to obtain -- favorable tax treatment for investments in prevention technology Industry may be less supportive of – at least work less intensely to obtain -- government subsidies/funding for prevention technology efforts

6. Hypothetical Example -- New pollution reduction/control technology means fewer allowances sold in marketplace, and a lower market price for those allowances sold -- e.g.: before diffusion of new technology, quantity sold is 1 million allowances at $10 per allowance, afterwards, 800,000 allowances at $8 per allowance -- so industry saves $3.6 million in allowance costs [(1million)($10)- (800,000)($8)] -- but if firms in industry had (for example) 800,000 allowances banked at the time of the diffusion of new technology and the corresponding drop in market price, then those firms will experience a $1.6 million loss in asset value, and that loss in asset value will in effect “eat up” half of industry savings from new technology Ex ante, prospective loss in asset value (the asset being banked credits) will make industry less enthusiastic about government efforts to promote new pollution technology than if the industry had no firms with banked credits and hence faced no prospective loss in asset value

7. Banking and Individual Firm Investment Decisions Question: does the fact that a polluting firm has banked a substantial number of allowances make it less likely (all else being equal) that the firm will make an investment in a the development of a potentially diffusible pollution control/reduction technology? Answer: yes, because expected value of investment will be lesser, reflecting loss in asset value (in the asset of banked allowances, the value of which will drop if new, diffusible technology is in fact developed).

8. Banking and Individual Firms, co. Question: does the fact that an individual firm (Firm X) knows that other firms in the industry have banked allowances make it less likely (all else equal) that the firm will invest in pollution reduction/control technology? Answer: yes but analysis not entirely straightforward

9. Greater Upside Part of Analysis On one hand, Firm X will assume that other firms will be less interested in investing themselves (because of their banked allowances) and the potential for Firm X to be a first-inventor, and capture invention rents, will seem greater. Thus, to the extent Firm X is concerned primarily with upsides in considering whether to make the investment decision, the fact that other firms have banked credits will make the firm more likely to invest in pollution reduction/control technology.

10. Lesser Downside Part of the Analysis But Firm X will also understand that the fact that other firms have banked allowances means that the other firms are less likely to invest in new technology, and that means Firm X, if it makes no investment in research, will face a lesser risk of being in the difficult market position of having to catch up or pay rents to other firms that develop a new technology. Thus, the downside risk of not making the research investment will be reduced as a result of the fact that other firms have banked.