Emissions Trading with Profit-Neutral Permit Allocations

Abstract

This paper examines the operation of an emissions trading scheme (ETS) in a Cournot oligopoly. We study the impact of the ETS on industry output, price, costs, emissions, and profits. In particular, we develop formulae for the number of emissions permits that have to be freely allocated to firms in order to neutralize any adverse impact the ETS may have on profits. These formulae tell us that the profit impact of the ETS is usually limited. Indeed, under quite general conditions, industry profits are preserved so long as firms are freely allocated a fraction of their total demand for permits, with this fraction being lower than the industry's Herfindahl index.Emissions trading, permit allocation, profit-neutrality, cost pass-through, abatement, grandfathering