Working Paper Series,
Norwegian University of Life Sciences, School of Economics and Business

Abstract: The allowances in an emission trading system (ETS) are commonly allocated for free to the sector, e.g., in the form of output-based allocation (OBA). The reason is the risk of carbon leakage exposure such as relocation of emission-intensive and trade-exposed industries (EITE). A prime example of this is the EU ETS, where the policymakers have stated that they will continue this practice. However, lately a third approach, combining OBA with a consumption tax, has been proposed to mitigate carbon leakage, and it has been shown to have an unambiguously global welfare improving effect. This paper presents the potential outcome of climate policy, by examining the Nash equilibrium of a policy instrument game between regions who regulate their emissions separately. In particular, we investigate the case when a policymaker can choose to supplement her ETS with OBA and/or with a consumption tax, based on another policymaker’s optimal choice for her ETS. We show analytically the optimal rate of OBA and consumption tax in the presence of a climate polices in another region. Finally, we present the results from a numerical simulation in the context of the EU ETS and the Chinese ETS.

Keywords: Emission price; Output-based allocation; Consumption tax; Carbon leakage; Emission trading system; Unilateral policy

JEL-codes: C70; D61; F18; H23; Q54

42 pages, August 20, 2018

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