Carbon market is established to achieve CO2 emission reduction targets cost efficiently. However, the pilot carbon markets in China emerged market downturn to certain degree with big variation of carbon price and low liquidity in trading market. The existence of transaction cost and market power affect the cost-effectiveness of the carbon market. Do different carbon emission permit allocation methods cause different efficiency losses? This paper explores whether the choice of emission permit allocation method affects the cost effectiveness of ETS when transaction cost and market power exist in carbon market, considering China pilot ETSs settings. By Stackelberg model, we find that transaction cost leads to the efficiency loss of ETS and the efficiency loss from benchmarking and grandfathering are less than auctioning. Market power causes the efficiency loss of ETS, the efficiency loss is proportional to the gap between the market power firmâ€™s carbon emissions and its free emission permits. If both transaction cost and market power exist in carbon market, market power further exacerbates the efficiency loss caused by transaction cost. The further efficiency loss caused by grandfathering and benchmarking are less than auctioning.
Keywords cost-effectiveness, carbon emission permit allocation, transaction cost, market power