Distortion effects of emissions trading system on intra-sector competition and carbon leakage: A case study of China

Abstract

Emissions Trading System (ETS) only regulates above-threshold emission sources in the covered sectors due of administrative costs consideration. Due to differentiated cost burdens on regulated- and unregulated-emission sources, ETS may give rise to intra-sector competition distortion and carbon leakage within a regulated sector. For developing countries where the industrial concentration is relatively low, such defects are more significant since unregulated emission sources as a whole accounts for an unneglectable portion of the regulated emission sectors' total production capacity and emissions. By applying a theoretical model, we conclude that unintended transfer payment from regulated emission sources' capital factor to unregulated emission sources’ labor factor causes intra-sector competition distortion. We find that the labor factor cost within a regulated sector remains homogeneous, while the homogeneity of capital factor cost is broken by ETS, causing unintended transfer payment. We have developed the I-SEE (Intra-Sector Equilibrium Evaluation) model to quantitatively assess the intra-sector effect caused by ETS. We suggest that sufficient attention should be paid to balancing the environmental costs borne by regulated and unregulated emission sources in ETS design to avoid unintended transfer payment. A properly designed carbon tax can help correct the intra-sector distortion caused by ETS.