European Union Emissions Trading System – the Effect of Free Allowances on Greenhouse Gas Emissions

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School of Business | Bachelor's thesis
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This paper reviews the literature on free allowance allocation in the European Union Emissions Trading System (EU ETS). The objective is to shed light on how free allocation has affected global greenhouse gas emissions in the past trading phases of the EU ETS. I explain why emissions trading, in theory, is an economically efficient way to reduce greenhouse gas emissions. Also, I describe the rationale behind free allocation as a means of preventing carbon leakage. I provide a brief overview of the evolution of the EU ETS – focusing on allowance allocation –, and then review the relevant literature. The ETS has reduced emissions in the EU. Still, there seems to be no significant evidence of carbon leakage. Free allocation is one of the main reasons for this. However, especially in the first two trading phases, the number of allowances granted for free has been too high: with less generous free allocation, the EU could have achieved larger emission cuts. Many sectors have even benefited from free allocation, instead of being forced to pay for polluting. Moreover, those firms that have enjoyed overallocation have reduced emissions less, which means that emission cuts have not necessarily taken place where they are least costly. This calls into question the cost-effectiveness of the EU ETS in its previous phases. On the other hand, the number of free allowances has declined annually since 2013 and the method for free allocation has changed, so the results cannot be generalized to the current situation.
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Murto, Pauli
emissions trading, carbon leakage, free allocation, grandfathering, benchmarking
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