Skip to main content

Contingent certificate allocation rules and incentives for power plant investment and disinvestment


The electricity generation mix of many countries is strongly dominated by fossil fuelled power plants. \(\hbox {CO}_{2}\) certificate trading is then advocated as a first best instrument for emission abatement in Europe, the US and beyond. An important element of the trading scheme is the initial allocation of allowances. This article is to show how permit allocation rules, applied within an Emission Trading System (ETS), interfere with the long-term pricing and investment on power markets. In particular it is demonstrated that free allocation of certificates contingent on plant availability and fuel used is likely to provide distorting incentives both for continued operation of existing plants and for investments. Consequently, marginal abatement costs within the ETS are increased above efficient levels and new power plant investments may crowd out excessively older power plants. Analytical results are derived for two technology cases and a numerical case study is devoted to the EU 27 power sector.

This is a preview of subscription content, access via your institution.

Fig. 1
Fig. 2
Fig. 3
Fig. 4
Fig. 5
Fig. 6
Fig. 7


  1. 1.

    We thereby follow the definition given by Buchanan (2008, p. 198): “Opportunity cost is the evaluation placed on the most highly valued of the rejected alternatives or opportunities”. The alternative to the usage of the \(\hbox {CO}_{2}\) certificates is to sell them—and the opportunity cost is consequently the market price of the certificates.

  2. 2.

    Note that this is no longer true if Grandfathering is repeatedly applied using updated reference years. If the emissions of the reference year for the second period are affected by actions during the first period, the opportunity costs for the operators change. The benefits of future allocation may then be taken into account in current operation (cf. Neuhoff 2006b).

  3. 3.

    These costs can also be labeled opportunity costs—again in line with the quoted definition by Buchanan (2008). The alternative of not closing the power station provides freely allocated certificates. The opportunity costs of closing the power station thus correspond to the value of the freely allocated certificates minus the avoidable costs associated with the continued operation capability.

  4. 4.

    Note that the Clean Energy Law started in July 2012 with a 3 year fixed price which rather corresponds to a carbon tax. Only from 1st July 2015, the transition to a flexible price is planned. A partly free certificate allocation is foreseen for coal units based on historical generation for a transitional period throughout until Mid-2017, but only in the case of continued operation. After the 2013 elections, the new Australian government has however announced to abolish the Clean Energy Law and replace it by a carbon credit purchase arrangement.

  5. 5.

    The actual emission trading legislation has retained a general “one for two surrender obligation” for all industry sectors and energy usages. Electricity generators do not receive free certificates beyond this reduced certificate submission obligation (which rather corresponds to a devaluation of industrial \(\hbox {CO}_{2}\) emissions compared to deforestation and afforestation activities). Yet free allocation contingent on operation is provided to emissions-intensive, trade-exposed industries.

  6. 6.

    At first sight, this may seem an over-complication of little practical relevance. Yet with \(\hbox {CO}_{2}\) prices being ex ante unknown, the reduction factor \(r\) is needed to ensure that possible overcapacities do not lead to excess \(\hbox {CO}_{2}\) emissions.

  7. 7.

    Such a reduction factor has e.g. been implemented in Germany during the second trading period of the European ETS.

  8. 8.

    Results could also be derived for the more general case with price-elastic demand, yet the analytical treatment is considerably simplified by dropping the price-responsiveness of demand.

  9. 9.

    Note that this somewhat clumsy definition of the inverse demand curve is due to the fact that we are formulating the problem in discrete time, considering time segments of arbitrary length.

  10. 10.

    This obviously only holds true as long as certificate allocation does not overcompensate the \(\hbox {CO}_{2}\) disadvantage of the second technology.

  11. 11.

    This reasoning does not take into account “pathological” specifications where certificate allocation inverts the ranking of capital costs of the technologies.


  1. Australian Government, Department of Industry, Innovation, Climate Change, Science, Research, Tertiary Education. (2011a). Carbon pollution reduction scheme–overview and design features.

  2. Australian Government, ComLaw. (2011b). Clean Energy Bill 2011-C2011B00166.

  3. Bartels, C., & Müsgens, F. (2006). Do technology specific \(\text{ CO }_{2}\)-allocations distort investments? In IAEE (Ed.), Proceedings of the 29th IAEE international conference, 7–10 June 2006 in Potsdam, Germany

  4. Betz, R., Rogge, K., & Schleich, J. (2006). EU emissions trading: an early analysis of national allocation plans for 2008–2012. Climate Policy, 6(4), 361–394.

    Article  Google Scholar 

  5. Betz, R., Sanderson, T., & Ancev, T. (2010). In or out: Efficient inclusion of installations in an emissions trading scheme? Journal of Regulatory Economics, 37(2), 162–179.

    Article  Google Scholar 

  6. Bode, S., Hübl, L., Schaffner, J., & Twelemann, S. (2006). Discrimination against newcomers: Impacts of the German Emission Trading Regime on the Electricity Sector. HWWA Discussion Paper No. 316.

  7. Böhringer, C., Voß, A., & Rutherford, T. F. (1998). Global CO\(_2\) emissions and unilateral action: Policy implications of induced trade effects. International Journal of Global Energy Issues, 11, 18–22.

  8. Böhringer, C., & Lange, A. (2005a). Economic Implications of Alternative Allocation Schemes for Emission Allowances. Scandinavian Journal of Economics, 107, 563–581.

    Article  Google Scholar 

  9. Böhringer, C., & Lange, A. (2005b). On the design of optimal grandfathering schemes for emission allowances. European Economic Review, 49, 2041–2055.

    Article  Google Scholar 

  10. Boiteux, M. (1960). Peak Load Pricing. Journal of Business, 33, 157–179.

    Article  Google Scholar 

  11. Buchanan, J. M. (2008). Opportunity cost. In In: S. N. Durlauf & L. E. Blume (Eds.), The New Palgrave Dictionary of Economics (Vol. 6). New York: Palgrave Macmillan.

  12. Burtraw, D., Palmer, K., Bharvirkar, R., & Paul, A. (2001). The effect of allowance allocation on the cost of carbon emission trading. Resources For the Future Discussion Papers dp-01-30.

  13. Coase, R. (1960). The problem of social cost. The Journal of Law & Economics, III, 1–44.

  14. Cramton, P., & Kerr, S. (2002). Tradable carbon permit auctions: How and why to auction not grandfather. Energy Policy, 30, 333–345.

    Article  Google Scholar 

  15. Delarue, D., & D’haeseleer, W. D. (2006). Price determination of ETS allowances through the switching level of coal and gas in the power sector. International Journal of Energy Research, 31, 1001–1015.

    Article  Google Scholar 

  16. Demailly, D., & Quirion, P. (2006). CO\(_2\) abatement, competitiveness and leakage in the European cement industry under the EU ETS: Grandfathering vs. Output-based allocation. Climate Policy, 6, 93–113.

    Article  Google Scholar 

  17. Diekmann, J., & Schleich, J. (2006). Auktionierung von Emissionsrechten. Eine Chance für mehr Gerechtigkeit und Effizienz im Emissionshandel. Zeitschrift für Energiewirtschaft, 30, 259–266.

    Google Scholar 

  18. Dijkstra, B. R., Manderson, E., & Lee, T.-Y. (2011). Extending the sectoral coverage of an international emission trading scheme. Environmental and Resource Economics, 50, 243–266.

    Article  Google Scholar 

  19. Ellerman, A. D. (2008). New entrant and closure provisions: How do they distort? The Energy Journal, 29(Special Issue), 63–78.

  20. Ellerman, A. D., & Buchner, B. (2008). Over-allocation or abatement? A preliminary analysis of the EU ETS based on the 2005–06 emissions data. Environmental and Resource Economics, 41, 267–287.

    Article  Google Scholar 

  21. Ellerman, A. D., Convery, F., & De Perthuis, C. (2010). Pricing carbon: The European Union Emissions Trading Scheme. Cambridge: Cambridge University Press.

    Google Scholar 

  22. European Commission. (2005). European Energy and Transport: Trends to 2030- Update 2005.

  23. European Environmental Agency. (2007). Europe’s environment—the fourth assessment.

  24. European Union. (2009). Directive 2009/29/EC of the European Parliament and of the Council of 23 April 2009 amending Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance trading scheme of the Community.

  25. Ferris, M. C., & Pang, J. S. (2007). Engineering and economic applications of complementarity problems. SIAM Review, 39, 669–713.

    Article  Google Scholar 

  26. Fischer, C. (2001). Rebating environmental policy revenues: Output-based allocations and tradable performance standards. Resources for the future. Discussion Paper 01-22, Washington DC.

  27. Fischer, C. (2003). Combining rate-based and cap-and-trade emissions policies. Climate Policy, 3, 89–103.

    Article  Google Scholar 

  28. Fowlie, M. (2011). Allocating emissions permits in cap-and-trade programs: Theory and evidence. Working Paper.,%203-24-11.pdf.

  29. Goulder, L. H. (1995). Environmental taxation and the double dividend: A readers’ guide. International Tax and Public Finance, 2, 157–183.

    Article  Google Scholar 

  30. Goulder, L. H., & Parry, W. H. (2008). Instrument choice in environmental policy. Review of Environmental Economics and Policy, 2, 152–174.

    Article  Google Scholar 

  31. Laan, Rvd, & Nentjes, A. (2001). Competitive distortions in EU environmental legislation: Inefficiency versus inequity. European Journal of Law and Economics, 11, 131–152.

    Article  Google Scholar 

  32. Möst, D., & Fichtner, W. (2010). Renewable energy sources in European energy supply and interactions with emission trading. Energy Policy, 38, 2898–2910.

    Article  Google Scholar 

  33. Neuhoff, K., Grubb, M., & Keats, K. (2005). Impact of the allowance allocation on prices and efficiency. Cambridge Working Paper in Economics, CWPE No. 0552.

  34. Neuhoff, K., Martinez, K., & Sato, M. (2006a). Allocation, incentives and distortions: The impact of EU ETS emissions allowance allocations to the electricity sector. Climate Policy, 6, 73–91.

    Article  Google Scholar 

  35. Neuhoff, K., et al. (2006b). Implications of announced Phase II National Allocation Plans for the EU ETS. Climate Policy, 6, 411–422.

    Article  Google Scholar 

  36. New Zealand Government. (2009). Emissions trading bulletin No 12—Industrial allocation update.

  37. Pahle, M., Fan, L., & Schill, W.-P. (2011). How emission certificate allocations distort fossil investments: The German example. Energy Policy, 39, 1975–1987.

    Article  Google Scholar 

  38. Schwarz, H. G. (2006). The European emission trading system and the present draft of the German national allocation law: A critical evaluation of the effects on electricity production and investment patterns. Working Paper, University of Erlangen.

  39. Sunderkötter, M., & Weber, C. (2012). Valuing fuel diversification in power generation capacity planning. Energy Economics, 34, 1664–1674.

    Article  Google Scholar 

  40. Sterner, T., & Muller, A. (2008). Output and abatement effects of allocation readjustment in permit trade. Climatic Change, 86, 33–49.

    Article  Google Scholar 

  41. Tietenberg, T. H. (1985). Emissions trading, an exercise in reforming pollution policy. Washington DC: Resources for the Future.

  42. US House of Representatives. (2009). The American Clean Energy and Security Act (H.R. 2454).

  43. Weber, C. (2005). Uncertainty in the electric power industry: Methods and models for decision support. New York: Springer.

    Google Scholar 

  44. Zhao, J., Hobbs, B. F., & Pang, J. S. (2010). Long-run equilibrium modeling of alternative emissions allowance allocation systems in electric power markets. Operations Research, 58, 529–548.

    Article  Google Scholar 

Download references


We thank an anonymous referee and the editor for very helpful comments and suggestions. The usual disclaimer applies.

Author information



Corresponding author

Correspondence to Christoph Weber.

Electronic supplementary material

Below is the link to the electronic supplementary material.

Supplementary material 1 (pdf 180 KB)

Rights and permissions

Reprints and Permissions

About this article

Verify currency and authenticity via CrossMark

Cite this article

Weber, C., Vogel, P. Contingent certificate allocation rules and incentives for power plant investment and disinvestment. J Regul Econ 46, 292–317 (2014).

Download citation


  • Emission trading
  • Allocation of emission permits
  • Electricity markets
  • Power plant portfolio
  • Mixed complementary program

JEL Classification

  • Q54
  • Q58
  • Q56