3. Emissions trading systems

Explicit carbon pricing instruments (i.e. emissions trading and carbon taxes) are increasingly being used to price emissions, and in recent years, emissions trading systems (ETSs) have gained importance both in terms of emissions coverage and of carbon price levels. Among the 72 countries considered in this report, ETSs have gone from covering about 13% of carbon dioxide (CO2) emissions from energy use in 2018 to 27% in 2021. This is in large part due to the introduction of new ETSs in Canada, China and Germany within that time span. Since 2021, four new ETSs have been introduced, in Austria and Oregon in 2022 and in Mexico and Washington in 2023 (see section 3.3).1 Several other countries or regions across the world are developing new ones (ICAP, 2023[1]). New carbon taxes were introduced in Canada, Luxembourg, the Netherlands and South Africa between 2018 and 2021, but they hardly increased emissions coverage. Permit prices have also risen to levels above those of carbon tax rates. Indeed, permit prices rose in almost all ETSs between 2018 and 2021 and on average they almost increased by half over the period. While the average permit price was almost the same as the average carbon tax rate in 2018, the gap between ETS prices and carbon taxes has widened as carbon tax rates did not follow the same evolution over the following years (see Table 3.1).

The relative merits of carbon taxation and emissions trading systems have been considered both theoretically and from a policy perspective. Weitzman (1974[2]) established that both prices and quotas could lead to the same desired outcome, but not when there is uncertainty about compliance costs. In that case, depending on the shapes of the marginal abatement cost curve and of the marginal damage curve of carbon emissions, one instrument may be more effective than the other. This result has been widely discussed over the years, and hybrid regimes, that would combine both carbon pricing instruments2 have been shown to provide more benefits (see (Roberts and Spence, 1976[3]), (Nordhaus, 1994[4]) (Pizer, 1997[5]) (Flues and van Dender, 2020[6])). Several factors may influence the preference for one instrument over the other (see, e.g. Black et al. (2022[7])), including administrative capacity, political feasibility, preference for price or quantity certainty.

Carbon taxes may provide more price certainty than ETSs. Depending on how they are set, this can ensure certainty on carbon prices both today and in the future. However, taxes are also the result of political decisions and processes; rates may be frozen, or taxes cancelled (for instance, Slovenia cancelled its carbon tax in 2023, see Chapter 4). Moreover, uncertainty about abatement costs can make it hard to set the right tax rate – i.e. at a level that encourages cutting a desired quantity of emissions.

ETSs provide certainty on quantity of emissions but permit prices can be volatile. In most ETSs that do not have a fixed price, caps are pre-announced together with their future trajectory. For example, the European Union emissions trading system (EU ETS) has a total cap of 1 572 MtCO2e in 2021 (the first year of its fourth phase), subject to a linear reduction factor of 2.2% per year with no sunset clause (ICAP, 2022[8]).

Price stability mechanisms (further discussed in section 3.5) can help deal with price uncertainty. Providing stability mechanisms for carbon price levels and paths is important to help firms adapt and plan, as well for investors to be able to make long-term decisions. Price stability mechanisms include carbon price floors such as that which was introduced in the industry sector in the Netherlands in 2021 (OECD, 2021[9]) or which is currently being discussed in Denmark (Skatteministeriet, 2022[10]). They can also operate through market stability reserves, such as in the EU ETS (see section 3.5). Moreover, while it does not ensure price stability, auctioning is used in some systems such as the Chinese pilots of Fujian and Hubei for price discovery. Indeed, auctioning, by revealing a carbon price based on covered installations’ demand, can allow an alignment of carbon prices with abatement costs.

The administrative burden is generally lower for carbon taxes than for ETSs, as carbon taxes can easily build off existing fuel excise taxes for design and collection. ETSs, however, require more sophisticated monitoring, reporting and verification (MRV) systems. Their complexity also depends on whether they are applied upstream or downstream.3 These differences can help explain why in countries with less sophisticated administrative systems, explicit carbon pricing is administered through carbon taxation. Taxing non-energy related emissions does require emissions measurement systems (since such emissions do not depend on fuel use), which may also explain why most covered process emissions are priced through an ETS, where the MRV system is already in place.

Administrative considerations also include the ministry responsible for collecting revenue from different instruments. Carbon taxes generally fall within the purview of a country’s Ministry of Finance, whereas ETSs are generally linked to Ministries of Environment, with the former having more experience with revenue collection.

Both instruments have the potential to generate revenue; however, ETSs that exclusively rely on the free allocation of allowances with no auctions do not raise revenue and forgo revenue. Marten and Van Dender (2019[11]) characterise the revenue raising properties of these instruments in more detail. Excise tax revenues are commonly used in general budgets, carbon tax revenues are more often used in the context of a tax reform and ETS revenues are more likely to be earmarked for environmental purposes (Parry, Black and Zhunussova, 2022[7]; Marten and van Dender, 2019[11]). The use of revenues raised from the auctioning (or sale) of ETS permits can range from no earmarking (e.g. in Switzerland, the United Kingdom and most Chinese pilots) to partial (e.g. the EU ETS) or total earmarking (e.g. in Quebec, Germany or Korea). The difference in revenue use between the carbon taxes and ETSs can also be due to the conceptual difference between these instruments, in the sense that tax revenue has historically been assigned to countries’ general budget and that allocating it to a specific purpose requires modifying their tax system through legislative changes.

While earmarking the revenue raised from one type of tax does not necessarily guarantee the most efficient use of funds, it can contribute to political acceptance especially in the case of explicit carbon prices. Surveys or experiments show that revenue recycling has a positive effect on the political acceptability of environmental taxation (Douenne and Fabre, 2020[12]; Beiser-McGrath and Bernauer, 2019[13]; Kallbekken, Kroll and Cherry, 2011[14]). However, from an economic point of view, the fiscal budget should be considered in its integrity and assigned to different spending areas (e.g. environmental transition, but also health, education, security, etc.) in a way that is optimal to society. From a pure democratic principle point of view as well, some countries, such as France adhere to universality principles,4 which should guarantee that a particular tax revenue is not reserved for a particular expenditure type. This principle is in part meant to guarantee that the democratic process does not lose too much ground with respect to the administrative process. In practice, the numerous exceptions to these principles which exist for other taxes and the political feasibility argument may constitute good enough reasons to recycle revenue from carbon taxes.

ETSs are sometimes chosen over carbon taxes for constitutional or legal reasons (Parry, Black and Zhunussova, 2022[7]). For example, in the EU, voting on tax matters requires unanimity whereas regulations like an ETS require a qualified majority, so that passing the political process of an EU-wide carbon tax might have been harder. Similarly for California, passing an ETS required approval from half of the legislature as compared to two-thirds for a carbon tax.

While revenue recycling can foster political support, the provision of free allowances in ETSs can also help garner support for their introduction as they address competitiveness and carbon leakage concerns. However, this approach can mute the average carbon price signal provided by ETSs and discourage low-carbon investment (see section 3.4 and (Flues and Van Dender, 2017[15])). A noteworthy exception is the Regional Greenhouse Gas Initiative (RGGI), the United States’ first ETS, which was introduced in 2009 in Connecticut, Delaware, Maine, Massachusetts, Maryland, New Hampshire, New Jersey, New York, Rhode Island and Vermont. The RGGI managed to gain support with little or no free allocation shares. The political feasibility of such a policy can be explained by several factors, including the earlier experience of the EU ETS carbon market crash in 2006, which was attributed to the over-allocation of free permits, as well as the concerns over windfall profits in the power sector (see section 3.4). Another explanation revolves around the prior restructuring of the electricity market in many concerned states, which reduced the control an individual state had over the electricity rates paid by their residents, thereby influencing the alignment between states once a state decided to auction a higher share of allowances. This restructuring also created diverging incentives among energy utilities (Huber, 2013[16]).

Most carbon taxes are applied uniformly on a base, so they have the same marginal and average rates. Hence, except when they exempt part of the emissions base (as is the case in South Africa for example), their average price signal is unmuted. This maintains incentives for investment in clean technologies. This is not the case for ETSs where they provide free allocation of allowances, creating a gap between the marginal and the average price signals. Indeed, regardless of whether a firm’s emissions are covered by free permits, the incentive to abate an additional tonne of CO2 remains unaffected, as the firm can generate additional income by selling a permit on the market; the marginal price signal is maintained. However, if a firm’s emissions are covered by free permits, then the firm does not need to buy a certain share of permits, so the total cost of its CO2 emissions is lower, as is the average rate paid per tonne of CO2 emitted. Free allowances then imply higher profits for carbon-intensive projects and thus risk changing project ranking to the detriment of clean technologies (Flues and van Dender, 2020[6]).

Even though carbon taxes apply uniformly to a fuel base, they do not apply uniformly in sectors as they often only cover a subset of fuels. For instance, natural gas is not covered by the carbon tax in Argentina, so that about 77% (resp. 63%) of emissions in its electricity (resp. industry) sector face no carbon tax. Moreover, since carbon taxes are generally based on the CO2 content of fuels, they rarely apply to non-fuel-based GHG emissions (except in Denmark, Iceland, the Netherlands, Norway, Poland and Spain).

Lastly, when applied downstream, ETSs can mitigate carbon leakage in the aviation sector.5 While kerosene taxation provides broader coverage and greater certainty (Teusch and Ribansky, 2021[17]), it also requires international alignment, which carries the risk of significant carbon leakage. Indeed, in the context of international aviation, kerosene constitutes a highly mobile tax base, since if its taxation is higher in one jurisdiction than in another, the aircraft operator may recharge in the jurisdiction where the tax rate is lower.

Downstream ETS coverage can effectively address the issue of tax-base shifting, although competitiveness concerns may persist. These latter concerns can help explain the high share of free allocation in this sector: most countries with an ETS which covers aviation provide more than 50% of free allocation of allowances to the sector, and often overshoot verified emissions. New Zealand stands out as an exception, as it does not provide free allocation of allowances for aviation, and this is covered upstream by the national ETS. In December 2022, the European Parliament and the Council of the EU reached a provisional agreement on reforming the EU ETS as part of the negotiating process to deliver on the European Green Deal. This agreement included the gradual phase-out of free allocation for aviation by 2026 (ICAP, 2023[1]).6

In practice, the choice between a tax or an ETS is not clear-cut, and in several jurisdictions, both co-exist, sometimes on the same emissions base (either in a coordinated or uncoordinated way). The United Kingdom, for example, introduced the carbon price support in 2013, which initially complemented pricing by the EU ETS and now the UK ETS for the power sector (see section 3.5). Sweden has had a carbon tax covering its road transport emissions since 1991 and its emissions from the electricity and industry sectors are covered by the EU ETS. In Canada, since 2019, several provinces and territories have introduced carbon taxes and ETSs for compliance with sets minimum national stringency standards (the federal ‘benchmark’) that all systems must meet and that provide flexibility to the provinces and territories to choose either their own systems or the federal pricing one. This has resulted in emissions in all thirteen Canadian provinces and territories being covered by an ETS, a carbon tax or both in 2021, as opposed to only two provinces having a carbon tax and three an ETS in 2018. It has also led to a change in emissions coverage by instrument, with carbon tax coverage almost doubling (from 22% to 39% of CO2 emissions from energy use) and ETS coverage stagnating at 48% of CO2 emissions from energy use.

In some cases, the design of both instruments may be similar. The German and Austrian national ETSs present similar characteristics to a carbon tax as they are levied upstream (on fuel suppliers) and until 2025, have a fixed price. When carbon taxes exempt emissions below a certain threshold, this can be equivalent to free allocations.

In 2021, in the sample of 72 countries considered in this report, there were 33 ETSs, covering 35 of these countries. The ETSs were at city, province or state, country or even supranational level. Thirty-four countries7 of this edition’s sample had an ETS with positive permit prices8 in 2021. Their emissions account for 66% of the sample’s GHG emissions.

As compared to 2018, ETS coverage of CO2 emissions substantially increased in 2021, in China and in Germany. In these two countries, the shares of ETS coverage of CO2 emissions from energy use went up respectively from about 10% to 46% and from about 53% to 95%. In China, this is due to the introduction of the Chinese national ETS for its power sector (covering both main electricity generation plants and captive power plants). In Germany, the increase stemmed from the introduction of the German national ETS on transport and heating fuel distributors. In Canada, the introduction of the federal carbon pollution pricing backstop system in 2019 brought about the introduction of the federal Output-Based Pricing System (federal OBPS or FOBS) or provincial OBPSs in eight provinces or territories. This resulted in more provinces and territories being covered by an ETS in 2021 but resulting country-level ETS coverage remained the same as in 2018. In 2021, following Brexit agreements, the UK national ETS was launched, where the ETS coverage hardly changed, going from 32% to 29% of CO2 emissions from energy use. In 2021, the share of CO2 emissions from energy use covered by ETSs in different countries varies substantially, ranging from about 1.7% in Japan to 99.3% in New Zealand (Figure 3.1).

In 2021, ETSs mainly cover the electricity and industry sectors (Figure 3.2). About 56% of the 72 country-sample’s electricity sector emissions are covered by an ETS. This stems in large part from the newly introduced Chinese national ETS, which covers China’s power sector, and in a second instance from the EU ETS, which covers almost all of EU countries as well as Iceland’s, Liechtenstein and Norway’s power sector emissions. Indeed, the Chinese power sector accounts for about 46% of total emissions from the electricity sector and the EU ETS countries’ for about 5%. The industry sector comes next, with about 16% of total emissions covered by an ETS. All ETSs cover a part of the industry sector (Table 3.2). Even ETSs covering emissions from power plants only extend in part to the industry sector through their coverage of captive power plants (see ECR sector definitions in Table 2.1, with autogeneration of electricity included in the industry sector). Almost 8% of the buildings’ sector emissions are covered by an ETS, and this mostly comes from the introduction of the German nEHS. Indeed, the German buildings sector makes up 4.7% of total buildings emissions. The most targeted off-road transport emissions are from aviation (72% of covered emissions from off-road transport) and pipeline transport (10%). Other GHG emissions covered are mostly from process emissions – even when ETSs cover only CO2 emissions (see Table 3.2). The road transport sector is covered through upstream systems such as the California Cap and Trade, New Zealand’s ETS and the German national ETS. In total, this results in 68.7% of emissions covered by ETSs relating to the electricity sector, 20% to the industry sector, 4.7% to other GHGs, 3.5% to the road transport sector, 2.4% to buildings and less than 1% to the off-road transport sector.

Between the last Effective Carbon Rates edition (OECD, 2021[18]), which considered carbon pricing instruments in 2018 and this edition, which focuses on 2021, new ETSs were introduced, and many ETSs have also entered a new phase or compliance period (Figure 3.3). This has involved changes in caps (e.g. the EU ETS, RGGI, Kazakhstan ETS), increases in annual reduction factors or compliance factors (e.g. California Cap-and-Trade, Swiss ETS, EU ETS, Saitama and Tokyo Cap-and-Trade), changes in free allocation of allowance shares or calculations (e.g. the EU ETS, Korea ETS, Quebec Cap-and-Trade), changes in free allocation rules (Kazakhstan went from a mix of grandparenting and benchmarking to full benchmarking) or an expansion in scope (the Korean ETS started covering new sub-sectors such as freight, rail and shipping).

Some ETSs cover emissions domestic or regional aviation (Table 3.2). The EU ETS covers aircraft operators’ flights within the European Economic Area (EEA), the Swiss ETS, flights within Switzerland as well as to the EEA and the UK and the UK ETS, flights within the UK and to the EEA.9 Half of Chinese pilots cover domestic aviation. While these systems apply downstream to aviation, the New Zealand ETS applies upstream, by covering kerosene suppliers.

Permit prices taken in current local currency units (LCUs) increased in all ETSs between 2021 and 2022 but decreased in certain systems between 2022 and early 2023 (especially in the Chongqing Pilot ETS, Korea and New Zealand where permit prices decreased by more than 15%). When accounting for inflation, permit prices also increased or hardly changed in all systems between 2021 and 2022, but decreased in more systems between 2022 and 2023. There are important variations in the price change levels and directions between systems, even within a country (Table 3.3). In most Canadian ETSs, the price path was set at the federal level,11 and increased at a higher rate than inflation, implying a price increase over the whole period. In Quebec, where permit prices were determined by market forces (through auctions and secondary market transactions), the permit price has undergone a slight decrease in early 2023 in constant 2021 prices, like in California, to which it is linked. However, the EU and Swiss ETS have experienced permit price increases in early 2023, though less strong than between 2021 and 2022. Within China, one third of pilots experienced a price increase, even though the national ETS has undergone a slight price decrease when expressed in constant 2021 prices. After experiencing one of the highest permit price increases between 2021 and 2022, New Zealand has experienced one of highest permit price decreases in early 2023. In Korea, after a relative stagnation of permit prices between 2021 and 2022, permit prices have plummeted in early 2023, decreasing to 2015-2016 levels (in current terms).

With 2021 ETS coverage and 2023 permit prices, the average permit price in countries subject to an ETS has increased by 41.7% (in constant 2021 EUR) since 2021. The increase in most permit prices has resulted in 24.7% emissions priced by ETSs reaching the benchmark rate of EUR 30/tCO2 through permit prices only in 2023 and 18.3% the EUR 60/tCO2 benchmark (up from respectively 15.4% and 1.2% in 2021): the increase in permit prices has brought about 17% of emissions priced through ETSs above the benchmark rate of EUR 60/tCO2. As can be seen in Table 3.3, carbon pricing level progress implied by ETSs at a country level shows the most progress in Switzerland. Most EU ETS countries as well as Canada have also experienced significant progress with carbon pricing through ETSs in early 2023.

Between 2021 and 2023, three new ETSs were introduced or moved from a pilot to an implementation phase; they extend coverage of GHG emissions in sectors historically covered by ETSs such as electricity and industry, as well as to sectors usually mostly covered by taxes: transport and buildings. In 2022, Austria and the state of Oregon (United States) introduced ETSs which price transport, industry, electricity and buildings sectors. In 2023, the Mexican Pilot ETS is planned for moving to its operational phase12, and the state of Washington (United States) introduced a Cap-and-Trade program in January. These systems vary in their point of regulation (upstream for Austria and Oregon, mixed for Washington and downstream for Mexico) and in the sectors they cover (see Figure 3.4 and Figure 3.5).13 In Austria, this has increased the share of national GHG emissions covered by an ETS by about 47 percentage point (going from about 31% to 78%14), in Mexico by 4015 percentage points (starting from no ETS coverage) and in the United States (US), through the two state initiatives, by 1.5%. This scaling up of coverage is aligned with the headline statements of the AR6 Synthesis Report of the IPCC, which stresses how “regulatory and economic instruments can support deep emissions reductions and climate resilience if scaled up and applied widely” (IPCC, 2023[30]).

In 2022, five countries had established a mandate for a country-level ETS and were drafting rules for it (ICAP, 2022[8]). Two of these were in South East Asia (Indonesia and Vietnam), two in the Europe and Central Asia region (Montenegro and Ukraine) and one in Latin America (Colombia).16 Indonesia launched its intensity-based ETS for the power generation sector on 22 February 2023 (MEMR, 2023[33]), which introduces carbon pricing in its electricity sector (covering 13.5% of it), making it the second sector after road transport in the country to be covered by a carbon pricing instrument (Figure 3.6). Ukraine introduced a Monitoring, Reporting and Verification law in 2021 and its ETS may be launched by 2025 (ICAP, 2023[1]). The ETS would bring coverage of the industry sector from about 50% through fuel excise and carbon taxes to 87% with the ETS. Electricity sector CO2 emissions are currently already fully covered through effective carbon taxes, and the ETS would add on to those (Figure 3.7). Depending on permit price levels, the Ukrainian ETS could increase carbon prices in both the electricity and industry sectors, which in 2021 faced average ECRs implied by taxes of less than EUR 0.5/tCO2.

In December 2022, the European Council and the European Parliament reached a provisional agreement on the introduction of an EU ETS 2 for emissions from fuels used in buildings, road transport and certain industrial sectors not already covered by the existing EU ETS, with compliance obligation to start in 2027 (European Parliament Press Room, 2022[38]).17 Contrary to the current EU ETS, this ETS is to apply upstream, i.e. to fuel distributors. The introduction of the EU ETS 2 could increase road transport and building sectors coverage by up to 2.2% in the sample of 72 countries considered here and coverage of these sectors within EU ETS countries by up to 11.8%.18

New Zealand aims to introduce an emissions pricing scheme from 2024-25. Emissions will be priced via a farm-level split-gas levy, in which emissions from biogenic methane and long-lived gases (nitrous oxide and carbon dioxide) will be priced separately. The scheme will begin with mandatory reporting in the fourth quarter of 2024, followed by mandatory pricing in the fourth quarter of 2025. In line with this, the provisions in the Climate Change Response Act which oblige animal farmers to enter the NZ ETS from 1 January 2024 have recently been deferred; this will give the Government sufficient time to implement the alternative farm-level levy system. Political, social, food security and competitiveness concerns were raised during the process of introducing carbon pricing in this sector, whose emissions have so far generally been unpriced. The sector holds an important place in the country’s economy and contributes to about 50% of New Zealand’s GHG emissions.

Beyond these concerns, carbon pricing in this sector needs careful administrative and accounting design. Indeed, emissions measurement here is less straightforward than for CO2 emissions from energy use, which may rely on fuel use. New initiatives are emerging to measure non-CO2 emissions through satellite data19, though the quality and reliability of such data can be highly variable. The consultation document released in October 2022 by the New Zealand Ministry for the Environment and Ministry for Primary Industries (2022[39]) relies on a model for emissions measurement which accounts for farm area, stock reconciliation, livestock production data and total synthetic nitrogen fertiliser use. Moreover, pricing non-energy related emissions in the agricultural sector can also require including Agriculture Forestry and Other Land Use (AFOLU) considerations in the emissions accounting design (see Box 2.4 of OECD (2022[40])). The report released by the Ministry for the Environment and the Ministry for Primary Industries in December 2022 supports the principle of recognising all scientifically valid forms of on-farm sequestration being rewarded through the NZ ETS, or alternative appropriate mechanism for rewarding carbon removals (Ministry for the Environment and Ministry for Primary Industries, 2022[41]; He Waka Eke Noa, 2022[42]).

Accounting for affordability, social and political concerns can be key for the successful introduction of carbon pricing schemes in new sectors, especially the agricultural sector. In many countries, climate mitigation and reaching net-zero goals depends to a large extent on reducing GHG emissions in this sector (Figure 2.5, Figure 2.6). The current process taking place in New Zealand highlights the importance of accompanying farmers through the transition, of enabling them to measure their emissions20 and of proposing substitution possibilities – that is, viable solutions to decrease their emissions. For example, the promotion of new technologies and of better farming practices can provide options for farmers to switch to less emitting practices. Henderson and Verma (2021[43]) show that carbon taxes in the agricultural sector reduce global GHG emissions provided producers facing the tax can make use of GHG abatement technologies. The New Zealand proposal also includes payments to farmers using approved mitigation technologies or approved on-farm vegetation. For long-term purposes the proposal also includes revenue recycling to partly fund R&D to lower on-farm emissions (see OECD (2023[44])).

Most emissions trading systems distribute part or all of emissions allowances for free, at least during the inception phase. Auctioning or fixed price selling of allowances is generally gradually introduced into systems as they become more mature. In 2021, the share of free allocation of allowances varies widely across systems, ranging from a 100% in Japanese ETSs, for instance, to almost 0% in RGGI and the Massachusetts Limits on Emissions from Electricity Generators (310 CMR 7.74).21 Some systems have a provision for auctions to take place even when in practice most allowances are allocated for free. For instance, all Chinese pilot ETSs have the possibility of organising auctions, but only half of them held auctions in 2021 (Chongqing, Hubei, Shanghai and Tianjin). The shares of free allocation of allowances in total verified emissions are presented by country in Figure 3.8.

Most emissions trading systems are introduced with a high share of free allocation, for reasons including competitiveness and carbon leakage concerns as well as to build support from covered entities or sectors more generally. Allocating free allowances can ease the transition for industries with carbon-intensive processes into an ETS. They can also be used to protect firms against competitiveness losses and to avoid carbon leakage. Indeed, for trade-exposed industries, higher carbon prices due to the introduction of an ETS in one jurisdiction can induce a shift in production and investment to areas with less stringent climate policies. This in turn can hurt the domestic economy without reducing global emissions. Even though the evidence for carbon leakage and competitiveness impacts is mixed and in general of small amplitude (see Annex 3.A), it relies on past policies, when carbon prices were lower and widespread exemptions and free allocation (Ellis, Nachtigall and Venmans, 2019[45]; OECD, 2020[46]). As efforts are being ramped up to reach 2030 and 2050 goals, it is important to acknowledge that carbon leakage and competitiveness impact may be more significant.

In the EU ETS, the variability in the share of free allowances in total verified emissions across countries may be explained by countries’ sectoral compositions. The share of free allocation has substantially decreased since the introduction of the EU ETS. In 2010, almost no verified emissions faced compliance through auction, while in 2021, about 60% of verified emissions were covered through auctions. The country-level variation in free allocation by industrial subsector (other than heat sold to third parties and autogeneration of electricity) and for domestic aviation is presented in Figure 3.9. Industrial subsectors for which at least half of EU ETS countries receive more than 80% share of free allocation in verified emissions include the chemical subsector, mining, non-ferrous metals and non-metallic minerals subsectors, as well as paper production. In iron and steel, half of EU ETS countries receive more than 98% of free allocation, while in wood production, almost all countries receive 100% of free allocation. In general, these are energy intensive trade exposed (EITE) industries. Four of these sub-sectors are to be covered by the EU Carbon Border Adjustment Mechanism (CBAM) – for which an agreement was finalised in April 2023, and which was adopted in May 2023: iron and steel, cement (part of non-metallic minerals), fertilisers (part of the chemical industry) and aluminium (part of non-ferrous metals) (European Commission, 2023[47]).

Emissions allowances may be freely allocated using grandparenting, benchmarking or an output-based approach, with the first two being more common (see Table 3.2). Grandfathering adopts a historical approach: installations receive allowances based on their emissions in a base year or period. Benchmarking uses efficiency benchmarks: installations receive allowances based on performance indicators (e.g., the amount of allowances received by an installation can be determined by a certain share of the most efficient installations in a sector).

Grandparenting and benchmarking as allocation rules differ in many ways, including: 1) in the ease of calculation they offer; 2) in the incentives to reduce emissions they provide; and 3) in the smooth transition into carbon pricing they enable.

Using grandparenting as an allocation rule in the early stages of an ETS reduces initial costs, as installations receive a level of free allocation close to their pre-existing level of emissions. However, the base year or period should be set sufficiently back in time to avoid providing incentives to firms to increase emissions before the implementation of the ETS to increase the allocation they receive. At the same time, the base year should not be set too far back in time so that emissions estimations used to calculate allocation amounts are in line with current technologies and abatement opportunities. While relatively straightforward to calculate, grandparenting tends to provide more support to historically high emitters.

Benchmarking can make the transition into an ETS harder for emissions-intensive firms and can require more complex calculations as it relies on detailed production and emissions data at the firm or product level to develop sectoral benchmarks. However, it removes the link between historical emissions and allocation and rewards best performers, hence generating higher abatement incentives. In general, grandparenting tends to be found more frequently in earlier phases of ETSs, with a move to benchmarking as the system evolves (Kuneman et al., 2022[48]). For instance, since 2020, benchmarking is used in the Beijing Pilot ETS for new entrants and installations in heat production, cement, and data centres (ICAP, 2023[1]).

While free allocation of allowances does not affect the marginal price signal, it does affect the average price signal, which in turn affect economic rents and thus can influence investment decisions. Free allocations do not change the marginal price signal faced by firms because even if entities receive free allocations, reducing their emissions allows them to sell extra permits while emitting more requires them to buy additional permits. And even if they emit exactly what they have been allocated, they face an opportunity cost as they forgo the income they would have gotten from reducing their emissions and selling those extra permits. However, the average22 price paid by entities for permits does depend on the level of free allocation received. Flues and Van Dender (2017[15]) show that permit allocation rules affect economic rents and that in practice they tend to do so in a way that favours more carbon-intensive technologies.

As ETS caps are tightened, however, the potentially negative impact of free allocation on mitigation incentives decreases. Indeed, the tightening of a cap involves reducing space for free permits, as compliance then increasingly takes the form of abatement as opposed to relying on free allocation of allowances. A lower cap requires lower emission levels, so even if the share of free allocation of allowances does not change, its level does.

Free allocation can result in windfall profits in certain sectors. The mechanism is that even when receiving free allocation of allowances, firms still face opportunity costs, i.e. the marginal cost of carbon. If they can then pass-through this cost to consumers, the free allocation becomes a rent. In practice, this depends on many factors, including the allocation regime, the competition in the sector, demand and supply elasticities, carbon intensity of production, and international trade exposure of the sector (Quirion, 2007[49]; Hobbie, Schmidt and Möst, 2019[50]). These factors impact pass-through of carbon costs to consumer prices.

Evidence for high windfall profits of firms receiving free allowance allocation has been found in the power sector, as this sector is less exposed to international competition (e.g. Sijm, Neuhoff and Chen (2006[51]), Mercantonini et al. (2017[52])). Since 2013, free allocation for power sector installations has been almost entirely phased out in the EU ETS. RGGI and the Massachusetts 310 CMR 7.74 apply exclusively to the power sector and predominantly rely on auctioning. Following the same logic, it is argued that since the buildings and road transport sectors face no or low international competition and carbon leakage risk, allowances for these sectors should be solely allocated through auctioning under the EU ETS 2 (Council of the European Union, 2023[53]) (see section 3.3 for additional information on the EU ETS 2). Finally, the extent of the impact on rents may depend on the allocation regime, with benchmarking, if well designed, potentially inducing less windfall profits (Quirion, 2007[49]).23

Free allocation may also have equity impacts, whether among firms or between producers and consumers. Indeed, free allocation reduces average costs for installations receiving them, which may give them an advantage over installations ineligible for free allocation. This can also have an impact across regions, depending on the geographical composition of industries within a country (IEA, 2020[54]). Moreover, in the case of full cost pass-through, free allocation favour the producer at the expense of the consumer (Sijm et al., 2008[55]).

At a global level, the share of free allocation differs across sectors (Table 3.4). In the electricity and industry sectors, whose emissions are predominantly priced through ETSs (Figure 2.3), respectively 88% and 84% of allowances are allocated for free. Hence, while the average permit prices, hence the marginal price signals in ETS-covered electricity and industry are of EUR 11.54/tCO2 and EUR 27.14/tCO2, the average price signal in these sectors is muted.

The wedge created by free allocation of allowances between the marginal and average carbon prices may be captured using either the share of free allocation incurred by an installation, subsector, sector or country (e.g. Table 3.4) but it may also be captured by the Effective Average Carbon Rates (EACR) and Effective Marginal Carbon Rates (EMCR) indicators (e.g. Table 3.5). The EMCR is the main indicator used in this report: the ECR summarises the marginal carbon rates faced by subsectors, sectors or countries. The EACR, on the other hand, summarises the average carbon rates faced by subsectors. The EMCR thus represents the strength of the marginal incentive to reduce emissions while the EACR represents the strength of the incentives to invest in clean technologies (see Box 4.1, OECD (2021[18])).

In line with ETSs being the main pricing instrument in the electricity and industry sectors (Figure 2.3), these are the two sectors where the discrepancy between EMCRs and EACRs is the highest (Table 3.5). Off-road transport, which is also covered by some ETSs through aviation emissions pricing, can also present a non-negligeable gap between marginal and average carbon prices. The discrepancy between EMCR and EACR varies with the share of free allocation in the ETS systems countries face as well as the share of the sector’s emissions priced through ETSs. For instance, even though Japan allocates 100% of allowances for free, given that about 1.7% of its emissions are priced through the Tokyo and Saitama Cap-and-Trade systems (Figure 3.1), the high share of free allocation hardly lowers the EACR. In most countries or supranational jurisdictions, however, the EACR is at least halved as compared to the EMCR in the industry and electricity sectors. This can have important impacts on long-run investment in decarbonisation in these sectors, which represent an important share of global emissions (Figure 3.3) and will be key in reaching net zero objectives.

In contrast with free allocations, selling allowances (generally through auctions) has several advantages including raising revenue, better reflecting the need of installations for allowances, being simpler to administer than free allocation and ensuring more equity between installations. The sale of permits in the primary market (i.e. through auctioning or fixed price sales) as opposed to exchanges on the secondary market has the benefit of raising revenue for the government. Selling allowances enables to better reflect the need of installations for allowances in many ways. First, a considerable amount of overallocation can be found in many ETSs. For example, in 2019, 2020 and 2021, about 20% of EU ETS installations received more free allocation than the previous year reported emissions (Joltreau and Sommerfeld, 2019[56]). Hence, selling allowances can enable more coherence between permit possession and GHG emissions. Second, auctioning can allow price discovery other than through the secondary market, in a more transparent manner too as auction reports are generally published and publicly available.24 Moreover, while demanding a careful design, auctions can be administratively simpler than alternative free allocation approaches, as less data demanding. Finally, selling allowances can ensure more equity, as it provides entities covered by the ETS equal opportunities to buy allowances.

Revenues raised from selling allowances can be used to address distributional and affordability impacts of carbon pricing, to invest in further mitigation action through various means and to fund the general budget. In sectors where cost pass-through is high, so that the increase in carbon prices translates into higher prices for consumers, the revenue can be used to support lower-income households. In the California Cap-and-Trade system, 85% of the revenues from auctions in the power sector are used to offset customer cost increases (IEA, 2020[54]). The new Social Climate Fund to be introduced alongside the EU ETS 2 would receive part of the revenues from the allowance sales, to be used to support vulnerable households and micro-enterprises.

The revenue can also be used to support firms in the transition, for example by encouraging investment in green technologies. For example, a share of the EU ETS auction revenue is dedicated to its Innovation and Modernisation Funds, which were established in Phase 4 to support decarbonisation in EU ETS sectors. The Innovation Fund is meant to support the commercial demonstration of innovative low-carbon technologies and industrial solutions to decarbonise Europe’s energy-intensive industries. It can also support the development of renewable energy, energy storage, and carbon capture use and storage. The Modernisation Fund is meant to support investments in ten lower-income EU member states to help modernise energy systems, improve energy efficiency, and address social issues in the path to net-zero emissions (ICAP, 2023[1]). In Canada, proceeds collected from the output-based pricing system are to be used, at least in part, to help decarbonize industrial sectors (Environment and Climate Change Canada, 2020[57]). Subsidies and green tax incentives to encourage firms’ transition to net-zero emissions are increasingly being discussed.

While auctioning of allowances can present many advantages, careful consideration should go into their design and participation rules. Indeed, well-designed rules can help avoid manipulation through collusive behaviour of groups of bidders and limit the market power of single large buyers (ICAP, n.d.[58]). Depending on their design, auctions can also help dilute market power in the secondary market (Alvarez and Andrr, 2013[59]). RGGI, in which auctioning is the main way allowances may be acquired, presents market reports for each auction, which assess the auction process, and make sure there were no barriers to participation in the auction nor concerns related to the competitiveness of the auction results (e.g. Potomac Economics (2021[60])).

Finally, even with careful use of revenues, competitiveness and carbon leakage arising from asymmetric carbon mitigation efforts and lack of international coordination can remain an issue. An alternative to free allocation can be to implement a border carbon adjustment (BCA). Energy-intensive-trade-exposed (EITE) industries have lower ability to pass production cost increases into higher consumer prices than certain sectors such as power and transport. There is evidence for direct cost increases between 5 and 10 percent for aluminium and steel and up to 30 percent for cement (Black, Zhunussova and Parry, 2022[61]). Those industries hence typically do not receive windfall profits from free allocation but might experience international competitiveness pressure and incentives to relocate activities if facing full auctioning of allowances. BCAs, which impose a levy on embodied carbon in imports net of pricing on those emissions by the country of origin, can help ease the phase-out of free allocation (OECD, 2020[46]). This is the current approach of the EU Carbon Border Adjustment Mechanism (CBAM), which is meant to address the risk of carbon leakage for EU ETS firms while phasing out free allocations (ICAP, 2022[35]; Official Journal of the European Union, 2023[62]). Canada and the United Kingdom are also considering the introduction of BCAs (Clausing and Wolfram, 2023[63]; Government of Canada, 2021[64]; HM Treasury and Department for Energy Security, 2023[65]).

The substitutability of free allocation and border carbon adjustments, however, is not entirely straightforward, given potential issues related to the complexity of design and measurement, “reshuffling” of emissions, and potential trade wars (OECD, 2020[46]; Clausing and Wolfram, 2023[63]; Van Dender and Raj, 2022[66]). While the phasing out of free allocation in energy-intensive sectors strengthens incentives for marginal emissions abatement and induces the deep structural change that is needed to reach net zero emissions by mid-century, the potential for BCAs to address the resulting competitiveness impacts warrants some of the following considerations to ensure its effectiveness. These include the alignment of industries to which the BCA would apply and for which free allocation would be phased out, supply chain concerns, international competitiveness of exporting firms, difficulties in measuring carbon content, emissions reshuffling and the possibility of trade wars. As an alternative measure, clean energy subsidies can support the phase-out of free allocation in EITE sectors (Clausing and Wolfram, 2023[63]).

Permit prices have been increasing in a majority of ETSs (see Table 3.3) but primary and secondary markets prices tend to be volatile (see Figure 3.10). This affects long-term planning for firms and results in uncertainty for investors. Mechanisms aimed at providing price stability exist in many jurisdictions (Table 3.6).

Volatility of permit prices affects investors’ decisions and capacity for firms to plan. Indeed, investments in infrastructure and renewable energies require long time horizons. For instance, the horizon for investment in wind and solar power often exceeds 20 years. Hence, since investors need to form expectations about carbon prices over the entire lifetime of their investment, current carbon prices at the time of investment are only one piece of the information they need to make an investment decision (Flues and van Dender, 2020[6]). In this context, price uncertainty may reduce incentives to carry out long term investments required to reach net-zero goals. Berestycki et al. (2022[67]) show that more generally, climate policy uncertainty is associated with decreases in investment, particularly in pollution-intensive sectors that are most exposed to climate policies, and among capital-intensive companies.

Many ETSs have price stability mechanisms provisions (Table 3.6), which can help guarantee a minimum return on clean investment. These price stability mechanisms can be classified into measures that directly stabilise carbon prices, such as carbon price floors or ceilings and measures that indirectly stabilise them, through permit supply adjustments for instance (Flues and van Dender, 2020[6]). The EU ETS 2 discussions, for example, have planned to adapt the Market Stability Reserve to include an additional price stability mechanism to make sure that in the initial years of the ETS 2, prices do not exceed EUR 45 per tonne of CO2.

Direct and indirect market price stabilisation mechanisms are relatively evenly distributed across jurisdictions with an ETS (Table 3.6) and may be aimed at the primary or the secondary market. Very few ETSs have no such mechanism, and in general when this is the case introducing one is being discussed. Some ETSs present multiple stabilisation mechanisms. In Chinese Pilot ETSs, which mostly rely on free allocation of allowances, permit price levels are generally determined by the secondary market. Hence, in these ETSs, price stabilisation mechanisms are mostly applied by exchange. Many systems which have a minimum price level provision also set a trajectory for this price, generally meant to be aligned with inflation. Finally, within the EU ETS, some countries unilaterally set a minimum price level in certain sectors (e.g. the UK before 2021 and the Netherlands since 2021). While some argue that this can lead to political fragmentation and carbon leakage within the EU, such initiatives can also be seen as a driver for other countries to follow suit (Flachsland et al., 2018[68]). Flachsland et al. (2018[68]) also propose solutions such as auction reserve prices to avoid compliance costs diverging too much between sectors within Europe.


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The lack of internationally coordinated environmental policies has led to a number of studies examining carbon pricing impacts on competitiveness and carbon leakage. Most evidence points to no or low negative competitiveness impacts (with in some cases positive impacts) and carbon leakage. Evidence varies with the outcome, country or industry considered. In particular, where negative impacts are founds, this is generally on EITE firms. However, it is important to note that most of the evidence so far is based on historical data, where permit prices had not reached the close to EUR 100 per tonne of CO2 levels currently observed for the EU ETS and free allocation was widespread in the systems studied.

Various measures of competitiveness include employment, productivity, output, firm profits, investment location, trade flows, foreign direct investment (FDI) and market share.

In terms of mechanisms underlying the impact of asymmetric environmental policies on competitiveness (and hence carbon leakage), two theories stand out (Dechezleprêtre and Sato, 2017[69]). The first is the pollution heaven hypothesis, which stipulates that when competing companies only differ in terms of the environmental policy stringency they face, those facing stricter regulation lose competitiveness, since higher regulatory costs can result in higher product prices. This can lead firms in those countries with higher costs to lose market share to their competitors in countries with laxer environmental policies. In the long run, this can result in carbon leakage, through the opening of new production facilities or directing FDI to these countries, hence creating pollution heavens. The second is the Porter hypothesis (Porter and Linde, 1995[70]), which argues that more stringent environmental policies trigger investment in the development of new cleaner technologies. Part of firms’ compliance costs can then be offset by the input savings enabled by these technologies. These technologies can also lead to higher productivity and give them international leadership in clean technologies, which can then increase firms’ market share internationally.

Most empirical studies on the impacts of carbon pricing find that it results in lower emissions with no significant competitiveness impacts (see Arlinghaus (2015[71]) for evidence on the EU ETS as well as in the US and Canada, Verde (2020[72]) for evidence on the EU ETS).

Several papers find positive effects of carbon pricing on competitiveness indicators (see Dechezleprêtre, Nachtigall and Venmans (2018[73]) for evidence on impacts of the EU ETS on firms’ revenues and fixed assets in France, the Netherlands and Norway, Lutz (2016[74]) and Löschel, Lutz and Managi (2019[75]) for the causal effects of the EU ETS on economic performance of German firms in the manufacturing sector). Positive effects on innovation have been highlighted too – see Calel and Dechezleprêtre (2016[76]) for evidence that the EU ETS increased low-carbon innovation among regulated firms and Dussaux (2020[77]) for evidence that energy price changes in the French manufacturing industry led large firms to innovate more and all firms to invest more in end-of-pipe pollution abatement technologies

Regarding the EU ETS, Joltreau and Sommerfeld (2019[56]) and Naegele and Zaklan (2019[78]) present empirical findings that energy and carbon costs in most manufacturing industries represented low shares in their budget or material costs. This might be due to high shares of free allocation.

Evidence focusing on taxes which present no exemptions, also points to no and sometimes positive impacts on competitiveness. Increased fossil fuel prices were found to improve productivity for firms located close to the productivity frontier in Indonesia (Rentschler and Bazilian, 2016[79]) and for manufacturing firms in Indonesia and Mexico (Calì et al., 2022[80]) – the latter through the incentives these price increases induced to replace inefficient fuel-powered with more productive electricity-powered capital equipment. Flues and Lutz (2015[81]) find no impact of the electricity tax on German firms in terms of turnover, exports, value added, investment and employment.

Dussaux (2020[77]), however, finds that while energy price increases had no impact on French manufacturing industry net employment, this masks heterogeneous effects, in that output and workers were reallocated from energy-intensive firms to energy-efficient firms.

Evidence for firms participating in the EU ETS shows that on average they increase their asset base at home and with no relocation, with exceptions for subgroups of firms with low capital- or high trade-intensity that show a stronger increase in outward FDI than comparable firms that do not participate in the EU ETS. Aus dem Moore, Großkurth and Themann (2019[82]) observe that multinational firms whose production facilities are regulated by the EU ETS have on average increased their total asset base more strongly in countries regulated under the EU ETS than outside. Koch and Basse Mama (2019[83]) arrive at similar findings in terms of outward FDI for all German firms participating in the EU ETS, but do observe outward FDI for a subset of firms with low capital intensity in the EU ETS, in line with Koch (2016[84]). Borghesi, Franco and Marin (2019[85]) find that trade-intensive Italian firms participating in the EU ETS increased their sales from foreign affiliates significantly more strongly than firms not participating in the EU ETS. As relocation bears costs as well, production went up their existing subsidiaries abroad rather than through opening new subsidiaries. Garsous and Kozluk (2017[86]) provide further evidence for the impact of energy prices on FDI on a different set of countries, i.e. 23 OECD countries. They find a significant and positive effect of higher domestic energy prices on firms’ outward stock of FDI. However, the effect has a small magnitude.

Regarding import and export effects, the evidence is mixed, with generally low negative impacts (OECD, 2020[46]). Naegele and Zaklan (2019[78]) find no evidence that the EU ETS caused any increase in net import value or embodied carbon emissions. Focusing on two energy-intensive sectors (cement and steel) Branger, Quirion and Chevallier (2017[87]) find that there was no significant impact of the EU ETS on net import demand. Aldy and Pizer (2015[88]) find that energy prices negatively impact net imports only for energy-intensive sectors, particularly iron and steel, chemicals, paper, aluminium, cement and bulk glass. Sato and Dechezleprêtre (2015[89]) find that energy price differences between two trading partners do influence bilateral trade flows. Both papers, however, show effects of small magnitude.

Dechezleprêtre et al. (2022[90]) use data on multinational firms, which can easily shift production across existing subsidiaries and find no evidence that the EU ETS led to a displacement of carbon emissions from Europe to the rest of the world during the period 2007-2014. Using environmental policy stringency indicators more generally, Dussaux, Vona and Dechezleprêtre (2020[91]) find evidence for carbon offshoring in French manufacturing, but not due to a pollution heaven motive. Indeed, firms paying higher energy prices do not offshore emissions more than otherwise similar firms. Their results suggest that carbon offshoring resulted from other factors such as trade liberalisation and differences in labour costs between countries.


← 1. The Pilot ETS in Mexico is scheduled to enter its operational phase in 2023.

← 2. E.g. and ETS with a carbon price floor.

← 3. In the context of ETSs, upstream and downstream regulation have specific meanings. Upstream regulation generally focuses on fuel suppliers whereas downstream regulation generally applies at the point where CO2 or other GHGs are emitted (e.g. on industrial installations or power plants themselves). Hence, upstream regulation implies that distributors must acquire permits, whereas downstream regulation implies that operators must acquire permits.

← 4. E.g. (Vie Publique, 2022[92])

← 5. Similar issues are relevant for the international maritime sector.

← 6. Free allocation in other EU ETS sectors is to be phased out starting in 2026.

← 7. Austria, Belgium, Canada, China, Cyprus, Czechia, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Iceland, Italy, Japan, Kazakhstan, Korea, Latvia, Lithuania, Luxemburg, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Slovenia, Spain, Sweden, Switzerland, the United Kingdom, the United States.

← 8. This leaves out Mexico, which implemented the pilot phase of its ETS in 2020, for which there were no auctions and for which the secondary market price was at EUR 0 per tonne of CO2 in 2021.

← 9. Since 2023, flights to Switzerland have been included as well.

← 10. In this report, the stocktake of the evolution of carbon pricing policies for 2023 refers to the first half of 2023 only.

← 11. This is the case for all Canadian output-based pricing systems, which do not hold auctions and present a fixed, federally mandated, price.

← 12. At the time of writing this report, the Mexican Pilot ETS was planned to move to its operational phase in 2023, but this plan has been delay to 2024 (Carbon Pulse, 2024[93]).

← 13. Only country wide ETSs are presented in this section.

← 14. From 33% to 90% if restricting attention to CO2 emissions from energy use.

← 15. Almost 59% if restricting attention to CO2 emissions from energy use.

← 16. Colombia, Indonesia and Ukraine are part of the sample of countries covered by this edition. For lack of information, however, this section does not discuss Colombia.

← 17. This start date could be postponed to 2028 in the event gas or oil prices remain too high.

← 18. That is, assuming the EU ETS 2 would apply to all currently unpriced emissions in these sectors.

← 19. E.g., https://climatetrace.org/map, https://www.transitionzero.org/, https://www.unep.org/explore-topics/energy/what-we-do/imeo.

← 20. For example, programs such as OverseerFM can help farmers better manage their intrants and get a better grip of their environmental impacts.

← 21. In Massachusetts, the evolution from 75% of free allocation to 0% took place over 3 years, from 2019 to 2021.

← 22. i.e. overall price divided by the amount of emissions.

← 23. However, if benchmarking is based on benchmarks that date back too far in time, changes in production levels and evolution of technologies are not accounted for, and this can result in important overallocation and windfall profits.

← 24. E.g., Nova Scotia’s cap-and-trade website (https://climatechange.novascotia.ca/cap-trade-regulations#auctions) has an “Auction Notices and Results” section, or the Massachusetts Department of Environmental Protection presents an archive of market monitor auction and quarterly reports (https://www.mass.gov/lists/massachusetts-carbon-allowance-registry-document-repository).

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