Impacts of Initial Allocation on the Efficiency of Emissions Trading: Lessons from EU ETS

Abstract

Allocation methods in the EU Emissions Trading Scheme (ETS) are examined with respect to the conditions to be met in order for the scheme to achieve its goal of efficient reduction of CO₂ emissions. To achieve efficient CO₂ reduction, marginal costs for emissions reduction must be equalized not only among the direct abatement means but also among the reductions in the consumption of the products with CO₂ emissions at the production stage. The effects of five kinds of allocation methods on the efficiency of emissions reduction activities are analysed under three kinds of product market conditions. The five allocation methods are (i) allocation independent of output or emissions, (ii) allocation based on present output, (iii) allocation based on present emissions, (iv) allocation based on past output, and (v) allocation based on past emissions. The three product market conditions are (i) perfect competition (ii) Cournot model oligopoly, and (iii) oligopoly under full-cost pricing. In the light of the results, the actual allocation methods in the EU ETS are examined. It is made clear that the marginal abatement costs in the direct abatement activities in a few sectors which receive allowances on the basis of present or past output level would be equal to the allowance price, but the marginal costs of emissions reduction in the other activities would be much lower and not equal to each other. The allocation methods in the EU ETS are interpreted as seeking to maintain the competitiveness of the EU industries as well as avoiding the problem of fairness with free allocation, at the cost of giving up efficiency of the emissions trading scheme.