Carbon price interaction between allocated permits and generated offsets

The Kyoto Protocol established targets for curbing greenhouse gas emissions in order to mitigate climate change, and it introduced two kinds of market-based mechanisms: the emission allowance market and the carbon offset market. We identify stylized features of the two mechanisms with a partial equilibrium model. Our work is the first to derive a closed form solution incorporating most policy instruments, such as abatement and offset usage, and delivery risks in offsets. We show that policy changes will impact one market directly and the other indirectly, generating unequal price responses that affects the spread between the two compliance instruments. We show how the price spread between allowances and offsets is affected by market conditions such as the offset import limit, abatement and offset cost, penalty rate, emission cap, and baseline emissions.