An imperfectly competitive permit market under a rate-based scheme

Imperfect competition in permit markets has a negative impact on the cost-effectiveness of emission trading schemes. Currently, imperfect competition is mainly explored under mass-based schemes. In contrast to mass-based schemes, under rate-based schemes, both caps and allowance allocations depend on firm production. This paper examines theoretically the effect of imperfect competition under a rate-based scheme on market efficiency by developing two-stage game models where a dominant firm and some price takers are included. We find that although the dominant firm has market power only in the permit market, the output market efficiency can be impacted due to the output-based cap. Moreover, the overall efficiency loss will vanish only if the free allowances allocated to the dominant firm equal the number of allowances required by the firm in equilibrium. However, when the dominant firm also has market power in the output market, the permit market may be still inefficient under the above condition and the overall efficiency loss cannot be removed. Finally, a case study of China's iron and steel industry is conducted to illustrate the theoretical discussion.