Allocation, incentives and distortions: the impact of EU ETS emissions allowance allocations to the electricity sector

Abstract

The allowance allocation under the European emission trading schemes differs fundamentally from earlier cap-and-trade programmes, such as SO2 and NOx in the USA. Because of the sequential nature of negotiations of the overall budget, the allocation also has to follow a sequential process. If power generators anticipate that their current behaviour will affect future allowance allocation, then this can distort today's decisions. Furthermore, the national allocation plans (NAPs) contain multiple provisions dealing with existing installations, what happens to their allocation when they close, and allocations to new entrants. We provide a framework to assess the economic incentives and distortions that provisions in NAPs can have on market prices, operation and investment decisions. To this end, we use both analytic models to illustrate the effects of the incentives, and results from numerical simulation runs that estimate the magnitude of impacts from different allocation rules.

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