Effects of allowance allocation rules on green technology investment and product pricing under the cap-and-trade mechanism

Abstract

Grandfathering and benchmarking are two typical initial allowance allocation rules under the Cap-and-Trade (C&T) mechanism. They establish an emission limit which carbon emission generating enterprises is permitted. To avoid penalties caused by excessive emissions or to gain profits by selling saved portions of the allowance in the carbon trading market, enterprises can invest in green technology for achieving emission reduction which results in increasing cost and leads to a change in pricing strategies. This paper formulates mathematical models to quantify the optimal green technology investment and product pricing, and compare the effects of the two allocation rules on these operational decisions and total emission. The analytical results indicate that compared to benchmarking the optimal product price under the grandfathering rule is higher. Grandfathering will induce greater emission reduction. However, benchmarking is more likely to encourage enterprises to invest in green technologies for improving their energy efficiency. Moreover, the initial emission allowance under the grandfathering rule will not affect the green technology investment. However, the benchmark emission intensity will influence the green technology decision under the benchmarking rule. When choosing from two green technologies, investment in cleaner green technologies will not be authorized, in some instances, under a range of scenarios.