Allocation and leakage in regional cap-and-trade markets for CO2

The allocation or assignment of emissions allowances is among the most contentious elements of the design of emissions trading systems. 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 allowance allocation, where the allocation is tied to the ongoing output 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, some forms of allocation updating can also inflate allowance prices, thereby limiting the benefits of such schemes to high emissions firms. Thus, the anticipated benefits from allocation updating can be diluted and further distortions introduced into the trading system.