This paper reviews fundamental concepts in environmental economics and explores theoretical results regarding the choice of the key policy instruments for the control of externalities: taxes, subsidies and marketable permits. The paper explains why today market mechanisms are increasingly being used as a tool for allocating unpriced rights and scarce resources. We survey how significant market imperfections, a pre-existing regulatory environment and concentration in both permit and output markets can impede the proper functioning of a permit system. The main factors that affect the effectiveness of marketable permits are then discussed. Given the importance of understanding the emission permit price formation, we overview recent attempts at developing valid price models for emission permits, taking into account banking and borrowing opportunities, pollution abatement measures, strategic trading interactions and the presence of asymmetric information in the permit market
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