Market power with interdependent demand: Sale of emission permits and natural gas from the Former Soviet Union

With implementation of the Kyoto Protocol, the Former Soviet Union countries, and Russia in particular, will most likely be able to exert market power in the emission permit market. However, it can be argued that since these countries also are big exporters of fossil fuels, their incentives to boost the permit price in this way may be weak. This paper argues that the effect on the permit price of the Former Soviet Union being a fossil fuel exporter is more ambiguous than that. A significant share of Russia’s fossil fuel exports is in the form of natural gas. A high permit price may boost the demand for natural gas through substitution from more polluting fuels (coal and oil) and thus increase gas profits. Therefore, being a natural gas exporter may in fact increase the incentives to exert monopoly power in the permit market. Moreover, a large fossil fuel exporter may use its market position to influence the effective demand for permits and thereby their price. Hence, the relationship between permit income and fossil fuels exports runs in both directions. We explore the interdependence between the revenues of the Former Soviet Union from permit and fossil fuel exports both theoretically and empirically. A numerical general equilibrium model finds that the fact that the Former Soviet Union is a big gas exporter has a negligible effect on the incentives to exert monopoly power in the permit market. However, there are significant impacts on the optimal level of gas exports. JEL classification: Q4, D58, L12, Q28, Q48. Keywords: Climate policy, natural gas, market power, emission permits.