Carbon Leakage and Capacity-Based Allocations. Is the EU right?

Competitiveness and carbon leakage are major concerns for the design of CO2 emissions permits markets. In absence of a global carbon tax and of border carbon adjustments, output based allocation is a third best solution and is actually implemented (Australia, California, New Zealand). The EU has followed a diff erent route; free allowances are allocated to existing or new capacities in proportion to a benchmark independent of actual production. This paper compares these two schemes and shows that the optimal one is actually a combination of both schemes, or output based allocation alone if uncertainty is limited. A key assumption of our analysis is that the short term import pressure depends both on the existing capacities and the level of demand, which is typical in capital intensive and internationally traded sectors. A calibration of the model is used to discuss the EU scheme for the cement sector in the third phase of the EU-ETS (2013-2020). This allows for a quanti cation of various policies in terms of welfare, investment, production, fi rms profi ts, public revenues and leakage.