Mitigation Measures: Free Allocation and Exemptions
Once you have identified sectors at risk of competitiveness harm, the question becomes how to protect them while maintaining the carbon price signal. This lesson examines the main mitigation measures available.
The Menu of Measures
Several tools can address competitiveness concerns:
Output-based allocation (OBA)
Free allowances or rebates based on production and efficiency benchmarks.
Exemptions
Full or partial exclusion from carbon pricing.
Reduced rates
Lower carbon prices for exposed sectors.
Rebates
Return of carbon costs after payment.
Tax expenditure support
Grants, credits, or subsidies to offset carbon costs.
Border adjustments
Applying carbon costs to imports (covered separately in the next lesson).
The goal is to protect competitiveness while preserving the incentive to reduce emissions. Poorly designed measures can eliminate the carbon price signal entirely, defeating the purpose of the policy.
Output-Based Allocation
OBA is the preferred approach in most ETS systems because it preserves incentives.
How it works:
- Set an emissions benchmark for the product (tons CO2 per ton of product)
- Allocate free allowances based on: Production × Benchmark
- Facilities more efficient than the benchmark have surplus allowances
- Facilities less efficient must buy additional allowances
Why OBA preserves incentives:
- Allocation is based on efficient production, not actual emissions
- Efficient producers benefit; inefficient producers pay
- Marginal production decisions still face carbon costs
- No incentive to reduce production to avoid carbon costs
OBA in action:
Two steel plants, both producing 1 million tons per year:
- Benchmark: 1.5 tons CO2 per ton of steel
- Plant A emissions: 1.3 tons CO2 per ton (efficient)
- Plant B emissions: 1.8 tons CO2 per ton (inefficient)
At $50/ton CO2:
| Plant | Production | Free allocation | Actual emissions | Net position |
|---|---|---|---|---|
| A | 1M tons | 1.5M allowances | 1.3M tons | Surplus: 200,000 × $50 = +$10M |
| B | 1M tons | 1.5M allowances | 1.8M tons | Shortfall: 300,000 × $50 = -$15M |
Plant A is rewarded for efficiency. Plant B pays for inefficiency. Both have incentive to reduce emissions below benchmark.
Free Allocation Based on Historical Emissions
Some systems allocate based on historical emissions (grandfathering) rather than benchmarks.
How it works:
Allocation = Historical emissions × Adjustment factor
Problems:
- Rewards past high emitters
- No incentive to improve efficiency (beyond cap)
- Does not penalize continued inefficiency
- May over-allocate if production declines
When it might still be used:
- Benchmarking data not available
- Transition period while developing benchmarks
- Simple administration priority
Many ETS systems started with grandfathering and transitioned to benchmarking:
EU ETS evolution:
- Phase 1-2 (2005-2012): Primarily grandfathered allocation based on historical emissions
- Phase 3 (2013-2020): Transition to EU-wide benchmarks
- Phase 4 (2021-2030): Fully benchmark-based with updated values
Why the transition was difficult:
- Industries resisted losing generous allocations
- Developing benchmarks required extensive data collection
- Political negotiations were contentious
- Some benchmarks needed multiple revisions
Lessons:
- Start with benchmarks if possible
- If starting with grandfathering, build in transition provisions
- Data collection should begin early
- Stakeholder engagement is essential
Exemptions and Reduced Rates
Some carbon taxes exempt certain sectors or apply reduced rates.
Full exemptions:
- Sector pays no carbon price
- Typically applied to agriculture, international aviation, or specific industries
- Eliminates any incentive to reduce emissions
- Revenue forgone
Reduced rates:
- Sector pays a lower carbon price (e.g., 50% of standard rate)
- Some incentive preserved
- Revenue partially forgone
Problems with exemptions:
- Undermines environmental effectiveness
- Creates pressure for more exemptions
- Distorts competition between covered and exempt sectors
- May conflict with trade rules (subsidies)
| Measure | Preserves incentive | Administrative complexity | Revenue impact |
|---|---|---|---|
| Output-based allocation | Yes | High | Partial loss |
| Grandfathered allocation | Partial | Moderate | Full loss |
| Full exemption | No | Low | Full loss |
| Reduced rate | Partial | Low | Partial loss |
| Rebates | Varies | Moderate | Partial loss |
Rebate Mechanisms
Rebates return carbon costs to affected sectors while maintaining the price signal.
Types of rebates:
Output-based rebates: Return carbon costs based on production (similar logic to OBA)
Efficiency-based rebates: Return more to efficient producers
Export rebates: Return carbon costs on exported goods
How rebates preserve incentives:
If rebates are based on output or efficiency benchmarks (not actual emissions), the marginal incentive to reduce emissions remains.
Output-based rebates work like a golf handicap. Everyone starts at the same benchmark (par). If you score below your handicap (emit below benchmark), you gain. If you score above (emit above benchmark), you pay. The handicap does not eliminate the incentive to improve your game.
Carbon Contracts for Difference
A newer approach uses "carbon contracts for difference" (CCfDs) to support low-carbon investment.
How CCfDs work:
- Government guarantees a carbon price for specific projects
- If market price is below the guaranteed price, government pays the difference
- Project gets predictable revenue for low-carbon investment
Advantages:
- Provides investment certainty without changing carbon pricing
- Targets support to actual emissions reductions
- Time-limited and project-specific
Example:
A hydrogen project needs $100/ton CO2 equivalent to be viable. Current carbon price is $50. The government agrees to pay $50/ton for 10 years. The project proceeds, knowing it will receive $100 total carbon value.
Design Principles for Mitigation Measures
1. Preserve marginal incentives
Measures should not eliminate the incentive to reduce emissions. Output-based approaches are preferred.
2. Target support narrowly
Only genuinely exposed sectors should receive assistance. Broad exemptions waste resources.
3. Build in phase-out
Competitiveness measures should decline as carbon pricing becomes more widespread internationally.
4. Regular review
Circumstances change. Measures should be reviewed and adjusted periodically.
5. Transparency
The value of support should be visible. Hidden subsidies are harder to evaluate and reform.
Avoiding Overcompensation
Measures can overcompensate if not carefully designed:
Windfall profits:
If free allocation exceeds what is needed to prevent leakage, facilities receive windfall profits.
Production subsidies:
If output-based allocation is too generous, it can subsidize production regardless of efficiency.
Perverse incentives:
If allocation depends on maintaining high emissions, facilities may avoid reductions.
The goal is to neutralize the competitiveness disadvantage, not to provide additional advantage. Regular review and adjustment helps ensure measures remain appropriate.
Looking Ahead
Border carbon adjustments offer another approach to competitiveness: rather than reducing carbon costs for domestic producers, apply them to imports. The next lesson examines how border adjustments work.