The effect of emission permit allocation in an early-stage cap-and-trade for a duopoly market

Cap-and-trade systems, or emission trading systems (ETS), are increasingly adopted by countries and regions to provide economic incentives for reducing greenhouse gas emissions. The majority of existing ETS are early-stage systems implemented in and after 2013. These early-stage ETS are typically characterised by a focus on few industry sectors, and the employment of free emission allocation schemes including grandfathering and benchmarking. In this paper, we investigate the impact of emission allocation schemes in an early-stage cap-and-trade system in a duopoly market. We show that benchmarking scheme may lead the energy-efficient firm to reserve part of its emission permits, while firms always use up their after-trading permits under grandfathering. We also find that a more stringent emission cap may increase firms' profits rather than decreasing them under both allocation schemes, suggesting a possible cause for windfall profits observed in early-stage ETS. Benchmarking is found to lead to lower emissions compared to those under grandfathering, while it may result in higher or lower firm profits, consumer surplus, and the overall social welfare. Furthermore, under either allocation scheme, allowing emission trading does not affect the total emissions, while it can increase firm profits and consumer surplus and therefore the overall social welfare.