Internal Carbon Markets and Carbon Emissions in the EU ETS

Firms operating internal carbon markets in the European Union Emissions Trading System reallocate more carbon allowances from subsidiaries with generous free allowance allocated to those with modest free allowance allocated by the regulator, and vice versa, after allowances become relatively scarce. In response to allowance scarcity, subsidiaries of firms with internal carbon markets also become 15% more carbon intensive. The increase in carbon intensity is consistent with an agency conflict based explanation related to the reallocation of resources within a firm. The paper presented in this QUEST seminar documents further the negative effect of such agency frictions on emissions when the carbon markets are expanded. Overall, the paper highlights a novel mechanism that can undermine the effectiveness of market-based climate policies.