ABSTRACT

Cap and trade system is a common regulatory design element of compliance carbon markets to establish a carbon price. Its underlying concept is that of tradable emission rights, while the availability of emission rights is limited (the cap) to the desired national pollution levels (Dales, 1968). This system aims to incentivize private sector emission reduction since companies that achieve a cut in their carbon emissions (or carbon allowances) can sell them to the market. Moreover, it can imply a source of revenue for governments that can auction emissions credits. As the first and one of the most significant emissions trading markets, the EU Emissions Trading System (EU ETS) operates under a cap and trade system (ICAP, 2021; European Commission, 2021). In a cap and trade system, the central authority defines an absolute emission limit (cap) for all emitters subject to the carbon price for a given period, for example, one year. In the case of the EU ETS, the European Union set the total absolute cap to 1.572 MtCO2e per year for 2021 with a linear annual reduction factor of 2.2% until 2030 for all emissions stemming from the power sector, eligible industrial plants, and aviation. For each unit of emitted carbon dioxide equivalent, for example, 1.0 tCO2e, the central market authority issues one emission right. These rights are auctioned centrally or awarded as free allowance allocation, known as tradable emission right, tradable emission permit, carbon allowance, emission allowance, or carbon credit with some nuances, to the different emitters. By the end of the year, each emitter must hold enough emission rights for all of its occurred emissions, either by purchasing them in centralized auctions or by trading emission rights with other emitters. Hence, a single carbon price is set by matching the supply and demand of available emission rights. In the case of phase IV of the EU ETS, 57% of the emissions rights are auctioned. The remaining 43% are allocated for free based on industry-specific benchmarks and flexible free allocation based on technological progress and carbon leakage rules. Industry-specific benchmarks are based on the 10% most efficient installations. Hence, an efficient industrial emitter below the benchmark receives more allocations than needed and can sell the remainder. An industrial emitter above the benchmark has to buy emissions rights that correspond to the difference between received free allowances and actual emissions. The cap and trade mechanism of the EU ETS results in the formation of a single carbon price at any given moment in time. However, industry-specific free allowance allocation results in de-facto industry-specific emission prices, which can be described by the difference between the actual carbon price and the value of free allowance allocation based on industry-specific benchmarks. Free allowance allocation provides a mechanism to protect industries exposed to global markets from carbon leakage. Emission pricing increases operational costs and jeopardizes their competitiveness compared to companies based in jurisdictions without a carbon price. Alternatively, carbon leakage could be addressed by a carbon border adjustment mechanism or national consumption charges for carbon-intensive goods, which would allow for a phase-out of free allowance allocation (Acworth et al., 2020; Neuhoff et al., 2022). Carbon leakage in the power sector is negligible if the limited physical interconnector capacity constraints imports and exports to other jurisdictions. Hence, the power sector does not receive free allowance allocation in the EU ETS and is the only sector subject to the full carbon price. In the case of the EU ETS, purchased or received emission rights that have not been used do not expire. The main difference between baseline and credit mechanisms compared to a cap and trade system is that a baseline and credit system only generates credits for achieved emission reductions that can be used to offset current or past emissions. In the cap and trade system, emission allowances are generated based on the cap and independently from the potential implementation of emission reduction measures (BMWK, 2022).