Pricing mechanisms for cap and trade policies: computer-assisted smart markets for air quality

The process of calculating market clearing prices for cap and trade environmental pollution policies dealing with both air and water pollution remains problematic. The permit trading processes are designed to mimic the cost minimisation outcome. In the paper we design the market process for allocating permits to achieve the same type of behaviour we observe for each decision maker in the overall cost minimisation model. We aim to develop a modelling system that would be easy and efficient to operate. We use the method which is known as a computer-assisted ‘smart market’ and has been used in a number of electric energy pricing situations. This approach has also been proposed and applied to some types of environmental quality and resource management policies. In the paper the theoretical structure of the ‘smart market’ model is provided. After the review of different models that have been used to represent permit trading situations, the smart market model structure based on the shadow prices is developed.