ISETS Working paper No. 21-0001

Capacity permit trading scheme, economic welfare and energy insecurity: Case study of coal industry in China

Xunpeng Shi, Yifan Shen, Ke Wang, Yanfang Zhang

Abstract: Cutting the overcapacity in coal industry is a current critical issue in China and is a matter for the world. However, inappropriate capacity cut policies may induce huge fluctuations of energy price, creating a threat to energy security and even economic stability. This paper designs a capacity permit trading scheme to minimize the compliance cost of production capacity cut, and proposes the operational details of capacity permit trading scheme using China’s coal industry as an example. We also construct a simple partial equilibrium model to examine the benefits and firm behaviors when adopting the permit trading scheme. The results demonstrate that the permit trading scheme will generate overall positive social welfare as well as reduce firms’ cheating incentives. The results confirm that the more heterogeneous of the firms in terms of compliance costs, the higher the social welfare gains and the trade volume there will be. Our findings show that the proposed permit trading scheme is feasible and beneficial in achieving the capacity cut target in China.