Free allowances and the risk of carbon leakage in the beginning of the third phase of the EU ETS

Abstract

Since the third phase of the European Emission Trading system, sectors that are classified as carbon leakage risky receive all allowances for free up to a specific benchmark. In contrast, sectors that are not classified as being at risk, face an increasing share of allowances that are needed to be purchased by auction. The exact allocation rule based on a sharp cutoff value and historical data is exploited to estimate whether the allocation of free allowances has successfully addressed carbon leakage for sectors at the margin. Due to a time lag in the information publication and its implementation, it is possible to differentiate between firms' reactions in the transition to the third phase (2010-2012) and its actual implementation (2013-2014). Based on changes in the trends of trade flows, I find that sectors at the margin of receiving free allowances did not experience strong changes in trading patterns compared to sectors that were obliged to purchase the allowances by auction. Thus, sectors at the margin of receiving free allowances were similarly affected by the allocation rule in the beginning of the third phase of the EU ETS.