Output and abatement effects of allocation readjustment in permit trade

In permit trading systems, free initial allocation is common practice. A recent example is the European Union Greenhouse Gas Emission Trading Scheme (EU-ETS). We investigate effects of different free allocation schemes on incentives and identify significant perverse effects on abatement and output employing a simple multi-period model. Firms have incentives for strategic action if allocation in one period depends on their actions in previous ones and thus can be influenced by them. These findings play a major role where trading schemes become increasingly popular as environmental or resource use policy instruments. This is of particular relevance in the EU-ETS where the current period is a trial-period before the first commitment period of the Kyoto protocol. Finally, this paper fills a gap in the literature by establishing a consistent terminology for initial allocation.