Dynamic Climate Policy Under Firm Relocation: The Implications of Phasing Out Free Allowances

The allocation of free allowances for firms within the European Union Emissions Trading Scheme was found to lead to substantial overcompensation, which is why some stakeholders recently called for phasing out of free allowances in the near term. This paper analyzes the consequences of phasing out free allowances in a two-period model when one country unilaterally implements climate policies. A carbon price induces firms to invest in abatement capital, but may lead to the relocation of some firms. The regulator addresses the relocation problem by offering firms transfers, i.e. free allowances, conditional on maintaining the production in the regulating country. If transfers are unrestricted in both periods, then the regulator implements the first best by equalizing the carbon price with the marginal environmental damage and using transfers to prevent any relocation. However, if transfers in the future period are restricted, the planner optimally implements a declining carbon price path with the first period price exceeding the marginal environmental damage. A high carbon price triggers investments in abatement capital and thus creates a lock-in effect. With a larger abatement capital stock, firms are less affected by carbon prices in the future and therefore less prone to relocate in the second period.