This paper studies inefficiencies arising in oligopolies subject to environmental regulation based on tradable emission permits. We propose a duopoly model of upstream–downstream strategic competition: in the permits market a leader sets the price, whereas in the output market Cournot competition occurs. We find that strategic interaction in the output market gives rise to an additional distortion in the permits market where both firms adopt ‘rival's cost-rising’ strategies to gain a competitive advantage in the output market. As a result, the price of permits is always higher than firms' marginal abatement costs.
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