Free allocation rules in the EU Emissions Trading System: what does the empirical literature show?

Abstract

This paper analyses the rules for free allocation in the EU Emissions Trading System (EU ETS). The analysis draws on the empirical evidence emerging from two literature strands. One group of studies sheds light on the following questions: how efficient are free allocation rules in minimizing the risk of carbon leakage? Have they become more efficient over the trading periods? What are the technical limits to making them more efficient? Further: is firm behaviour neutral to allowance allocation? Did specific provisions induce strategic behaviour with unintended effects? Studies from the second group estimate sectoral pass-through rates for the costs imposed by the EU ETS. Taking cost pass-through into account is necessary for properly targeting free allocation. The difficulty of accurately quantifying sectoral differences in cost pass-through ability is the main obstacle to achieving further efficiency in allowance allocation. The new rules defined in the reform for Phase IV (2021-2030) make some progress in this direction nevertheless. In any case, with carbon prices expected to rise and the total volume of allowances shrinking, free allocation - however efficient may it be - cannot be the only or main measure for preventing carbon leakage in the future.