Does emission permit allocation affect CO2 cost pass-through? A theoretical analysis

- CO2 cost pass-through rate is affected by emission permit allocation.
- CO2 cost pass-through rates are the same for grandfathering and auctioning rules.
- We suggest that benchmarking is used first and then auction is used in an ETS.

Carbon emissions trading may result in CO2 cost pass-through and its rate is influenced by a number of factors. This paper theoretically investigates how emission permit allocation affects CO2 cost pass-through rate by developing a Nash-Cournot oligopolistic market equilibrium model. We find that the derived CO2 cost pass-through rates are consistent when grandfathering and auctioning rules are used for permit allocation, which are higher than that for benchmarking rule. It has also been found that the magnitude of CO2 cost pass-through rate is relevant to the type of definition, product market structure and average carbon intensity of the industry. We suggest that policy makers first use benchmarking rule to attract firms to participate at the early stage of emissions trading system (ETS) and then take auctioning rule when ETS is well developed.