Environmental policy and speculation on markets for emission permits

Speculators are active in large markets for emission permits such as those developing under the Kyoto Protocol. Since speculators help risk averse firms hedging the risk stemming from uncertain future demand, their entry reduces permits' expected returns and volatility. We characterize the optimal environmental policy by the agency setting the total amount of permits when speculators are active. Whenever the agency is sufficiently risk tolerant, speculators improve aggregate welfare by fostering firms' production. On the other hand, under a moderately risk averse agency the increase in production volatility induced by speculators negatively affects social welfare.