EU ETS, Free Allocations, and Activity Level Thresholds: The Devil Lies in the Details

AbstractIt is well known that discontinuous jumps or thresholds in tax or subsidies are socially inefficient, because they create incentives to make strategic behavioral changes that lead to substantial increases in private benefits. This paper investigates these distortions in the context of the EU Emissions Trading Scheme, where activity level thresholds (ALTs) were introduced in Phase 3 to reduce the overallocation of free allowances to low-activity installations. Using installation-level data, we find evidence that cement producers indeed respond to such thresholds when confronted with low demand, by strategically adjusting output to obtain more free allocation. We estimate that in 2012, ALTs induced excess cement clinker production of 6.4 Mt (5% of total EU output), and in affected regions this further distorted trade patterns and reversed carbon intensity improvements. As intended, ALTs reduced free allocation by 4%; however, a linear scheme (output-based allocation) would have achieved a 32% reduction.