Regulation, allocation, and leakage in cap-and-trade markets for CO2

Abstract

Among the most contentious elements of the design of cap-and-trade systems for emissions trading is the allocation or assignment of the emissions credits themselves. Policy-makers usually try to satisfy a range of goals through the allocation process, including easing the transition costs for high-emissions firms, reducing leakage to unregulated regions, and mitigating the impact of the regulations on product prices such as electricity. In this paper we develop a detailed representation of the US western electricity market to assess the potential impacts of various allocation proposals. Several proposals involve the 'updating' of permit allocation, where the allocation is tied to the ongoing output, or input use, of plants. These allocation proposals are designed with the goals of limiting the pass-through of carbon costs to product prices, mitigating leakage, and of mitigating the costs to high-emissions firms. However, allocation updating can also inate permit prices, thereby limiting the benefits of such schemes to high emissions firms. Rather than mitigating the impact on high carbon producers, the net operating profit of such firms can actually be lower under input-based updating than under auctioning. This is due to the fact that product prices (and therefore revenues) are lower under input-based updating, but overall compliance costs are relatively comparable between auctioning and input-based updating. Thus, the anticipated benefits from allocation updating are greatly reduced and further distortions are introduced into the trading system.