Social Sciences in China, 2017

Vol. ?, No. ?, ??-??, http:

A Study on the dynamic mechanism for allocating emission

permits under endogenous growth

Tang Weiqi,a Wu Libob, and Qian Haoqi Jianhui,c

a
The Center of BRICS Countries Studies of Fudan University
b and c
School of Economics, Fudan University

排放权分配是碳交易机制设计中的重要部分，不同分配机制会影响长期增长路径，后者反过来也减排政
策效果带来影响。本文分析结果表明，静态的分配机制能够实现当期收益最大化，然而在内生经济增长机制
下却会导致产出增速放缓。要实现跨期经济产出最优化，需要动态地对碳排放权的分配进行调整。在没有完
全信息的情况下，通过依据产出调整各期排放权分配的机制，可以引导市场交易的结果逐渐向长期的最优增
长路径逼近。

关键词：碳交易、排放权分配、干中学效应、CGE 模型、跨期优化

The allocation of carbon emission permits is one of the major components of designing carbon
trading schemes. The choice of allocation mechanisms can influence long-term growth path, which in
turn affects the effectiveness of the emission-cutting policy. The results of this article indicate that
while a static allocation mechanism can maximize the yields of the current period, in the meantime it
leads to a slowdown in output under the mechanism of endogenous economic growth. To optimize
the intertemporal economic output, the allocation of carbon emissions will need to be dynamically
adjusted. In the absence of complete information, the output-oriented adjustment for allocating
emission rights of different periods can guide the market trading toward approaching the long-term
optimal growth path.

Keywords: carbon trading allocation of emission permits, the effect of learning-by-doing, CGE
model, intertemporal optimization

I. Research Background

With the deepening of energy-saving emission reduction work, the pressure and resistance it
faces keep building up. Using the role of market mechanism for reduced costs to further promote the
emission cut has become an imperative policy objective. China is now in the middle of a dramatic
transformation of economic structure, where the industrial structure and layout as well as production
techniques are undergoing rapid change. Tremendous regional differences in stages of economic
development, resource endowment and technical levels lead to distinct growth paths. In such a
context, to construct a carbon trading system needs to consider not merely cutting short-term costs,
but also accommodating to the needs of economic growth and transform to achieve the dual objective
of both economic growth and emission reduction.
From a dynamic point of view, when there is an endogenous growth mechanism in the course of
economic growth (or in other words, there are cross-term impacts between economic productive

© Social Sciences in China Press

 Social Sciences in China

activities of different periods), the optimal decision for an economic agent in the current period needs
to consider its impacts on the future economic output. This article formulates a multi-regional
dynamic computable general equilibrium (CGE) model, which simulates under the scenario when the
learning-by-doing effects are taken into account, how the "static" and "dynamic" mechanisms for
allocating emission rights could influence China’s welfare growth paths and long-term potential for
reducing emissions. Our findings show that static allocation is able to maximize the current welfare
while failing to reach the intertemporal optimality under a mechanism of endogenous economic
growth. Aiming at “intertemporal optimization”, the dynamic allocation mechanism can produce an
optimal growth path; yet it is premised on the availability of complete information. In the economic
reality where the complete information is unavailable, we may use a “suboptimal” solution that
correlates the levels of output to the emission permits allocation, guiding the market equilibrium
toward approaching the long-term optimal growth path.
The rest of the article is organized into the following: Section II conducts a review of the
existing research; Section III introduces a theoretical model and its analytical results; Section IV
illustrates the structure and critical settings of the CGE module; Section V discusses the simulation
results given by the CGE model; Section VI runs a robustness test of the model’s key parameters; and
in Section VII, we come to the conclusions. (There are only six sections in the article; section IV for
parameter robustness test may have been removed)

II. Literature review

As carbon transactions equalize the marginal costs for cutting emissions between emitters, the
total expenditure has been minimized. However, with the broadened application of emissions trading,
with the deepening of the related research, scholars have paid increasing attention to the relationship
between carbon trading mechanism and the path of technical progress, or in other words, the
interplay between the two. On the one hand, change in production techniques is one of the significant
factors that decide the long-term impact of economic activity on the environment; on the other hand,
climate policy has largely influenced the path of technological progress. In this sense, when
designing a mechanism for carbon transactions, one needs not only to consider its static economic
efficiency, but to evaluate to what extent it is able to stimulate the development of new technologies
as well, so that the long-term environmental agenda can be fulfilled more efficiently. With the CGE
model, Böhringer et al. did a systematic analysis of the impact of various schemes of allocating
emission permits on the dynamic effect of carbon transactions. Their findings show that the allocation
free of charge (grandfathering-based schemes) will weaken the enterprises’ R&D incentives and
motivation for innovation. As a result, their long-term economic effects are no match for the
auctioning-based schemes1. Otto et al. constructed a dynamic CGE model with which they analyzed
the “directed technological change” brought about by climate policy. The simulation results from the
model suggest that the binding-target on emission cutting must be matched to the R&D subsidies in
order to produce higher dynamic efficiency2.
Some scholars have analyzed the dynamic interaction between climate policy and the costs for
1
Böhringer, C., Hoffmann, T. and Manrique-de-Lara-Penate, C., “The Efficiency Costs of Separating Carbon Markets
under the EU-ETS: A Quantitative Assessment for Germany”, Energy Economics, vol.28, no.1, 2006, pp.44-61.
2
Otto, V. M., Löschel, A. and Reilly, J., “Directed technical change and differentiation of climate policy”. Energy
Economics, vol.30, no.6, 2008, pp. 2855–2878.
 Tang Weiqi, Wu Libo, and Qian Haoqi Jianhui

emission reduction from the perspective of technical learning. For instance, Grubb pointed out that
raising the objective of short-term emissions reduction would help activate the “learning-by-doing”
effect, thus reducing the long-term expenditure on emission cutting3. Conversely, scholars such as
Goulder and Mathai believe that since the “learning-by-doing” effect will reduce the costs for carbon
abatement, the short-term objective can be loosened4. Kahouli-Brahmi has conducted a
comprehensive review of the learning effects of energy technologies5.
By constructing theoretical and quantitative models, this article uses the example of the
learning-by-doing effect, attempting to analyze how a carbon trading scheme under the mechanism of
endogenous economic growth can affect the economic growth path in the long run. And on this basis,
we discuss the optimal design of carbon emissions trading under China’s present economic
environment and provide reference for the climate-change policymakers.

III. A Theoretical Model

Consider a general equilibrium model covering i ∈ I industries, each of which contains an
infinite number of producers (in a perfectly competitive market). In each period （t ∈ {1, …, T}）,
these producers invest non-energy factors Kti and energy Eti to create their own products. We assume
that the production function obeys the Cobb-Douglas (C-D) form:
( )
α 1−α i
X it =A it ( Eit ) i ( K it )
t−1
Ait = A i { X is }s=1
； (1),
where the total factor productivity (TFP) is a function of the historical output of the industry, that is,
there exists the effect of "learning-by-doing". Assume for each unit of energy input, f units of
emissions are produced. Denote the emission constraint as Ft6, and initial quota of each producer as
ti （iti =1). Assume that emission permits are tradable in the current period, but are not allowed to
be deposited or advanced over different periods. The emission constraints can hence be expressed as
∑i fE it = F̄ t (2)
Denote the price of emission permits as et, the product price and unit production cost as pti and
cti, respectively. Then it gives

( )
F̄ t
pit =cit − θit e t
fX it
(3)
Assuming the model contains an infinite number of homogeneous consumers, similarly, the
utility function also follows the C-D form. Denoting M as the total budget constraint, the consumer's
behavior is given by

3
Grubb, M.. “Technologies, energy systems and the timing of CO2 emissions abatement: An overview of economic
issues”, Energy Policy, vol.25, no.2, 1997, pp.159-172.
4
Goulder, L.H. and Mathai, K.. “Optimal CO2 Abatement in the Presence of Induced Technological Change”. Journal
of Environmental Economics and Management vol.39, no.1, 2000, pp.1-38.
5
Kahouli-Brahmi, S. “Technological learning in energy–environment–economy modeling: A survey”, Energy Policy,
vol.36, no.1, 2008, pp.138–162.
6
For simplicity, we assume the constraints on emissions are tighter than those on the energy total, that is, energy
supply no longer restricts the behavior of producers.

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max U t =∏i ( X it ) i ,
μ

{ X it }
s .t .: M t =∑i p it X it
(4)
based on which the conditional demand function of each commodity can be derived as
M
X it =μ i it
pt (5)
(1) The optimal allocation of emission permits under the effect of “learning-by-doing”
The optimal emissions trading scheme is one that maximizes the total social output (at constant
prices), namely,
max Y =∑ i ,t R X t pt 0
t i i

{ }
θ it

s .t .: ∀ t , ∑i θit =1
(6)
where R is the subjective discount rate. Following the Euler theorem, the maximum of the above
function is obtained when Y/ti is a constant Ct.. Substituting equations (3) and (5) into (6), it gives
i i
∂ Y pt 0 Xt 0 +∞

∂θit
=
θit (
1+
s=t 0+1
)
∑ R s εit , s git , s =Ct ;∀ t , ∑i θit =1
(7)
where εit,s= (Asi/Xti)(Xti/Asi) represents the elasticity with which the current output affects the future
productivity, or in other words, the intensity of the learning-by-doing effect; and git,s=Xsi/Xti is the
future output growth relative to the current output, or simply the output growth. Denote prmti =
sRsit,sgit,s as the premium brought by the endogenous growth mechanism, which represents the
discounted value of the expected coming out of the improvement in the future productivity as a result
of output growth in the current period. The optimal allocated proportion of emission rights can be
obtained from (7), which gives
pit 0 X it 0 (1+ prmit )
θit =
∑i pit 0 X it 0 ( 1+ prmit ) (8)
Because variables like εit,s 、 git,s are time-variant, ti varies over time. For equal Y/ti, the
allocation needs to be adjusted dynamically to the change of prmti. To equalize Y/ti, dynamic
adjustments need to be made to the allocation of emission according to the change of prmti.
(2) The “suboptimal” dynamic allocation scheme with incomplete information
Over the course of intertemporal optimization, to calculate of the future premium (prmr,t)
requires the knowledge of the output and price levels of all future periods, calling each economic
entity for complete information. However, in the real process of economic operation, the complete
information hardly ever exists, particularly for China as an economy in transition, where with ever-
changing market and policy environment, neither the government nor consumers are able to
accurately predict the market condition in the future.
Assume that economic growth converges to a balanced growth path, that is, there is no economic
structural change, and that the progress in production technology remains Hicks neutral. Denote g as
the growth rate of the factors, gat as the growth rate of production efficiency, then the output growth
 Tang Weiqi, Wu Libo, and Qian Haoqi Jianhui

rates of all industries are equal, given by gxt = g﹒gat. Hence the relative scarcity, or in other words,
the relative price, remains the same. In this sense, the subscript t can be eliminated from the price
variable. In addition, it is assumed that the TFP increases according to the autoregressive function Ai,t
= σ Ai,t−1+ζ yi,t−1. Then prmti can be re-expressed as
X it ( s→∞ )
ζg X t
i
prmit =ζ g ∑ s ( σg ) s−t−1 = ⋅ i
A it 1−σg A
t (9)
ζ, σ and g are constants; the above equation is substituted into Eq. (8) as the basis for a dynamic
adjustment to the allocation mechanism, which enables the equilibrium of carbon trading market to
approach the optimal intertemporal solution such that a "sub-optimal" long-term economic growth
path is achieved. Since the left hand side (LHS) of Eq. (9) is monotonically increasing with respect to
s, and the LHS of (8) is monotonically increasing with respect to prmti, ti will rise gradually over
time. As s goes towards infinity, ti continues to approach the approximation of the optimal solution,
driving the evolution of the optimal intertemporal growth path of the total output.

Section IV the CGE model

To better simulate the process of the industrial restructuring and transformation of the country’s
economy, we build a multi-regional, multi-sectoral dynamic CGE model of intertemporal
optimization, with the introduction of the “learning-by-doing” effect. We also run a refined
simulation of the interregional economic linkage as well as the growth path of factor supply 7.
Under the BAU (business as usual) scenario, the regional binding targets for carbon intensity
reduction between 2007 and 2010 are based on the “Notice of Regional Progress towards Completion
of Energy Efficiency Targets during the Eleventh Five-Year Plan period”, issued jointly by the
National Development and Reform Commission and the Bureau of Statistics in June 20118. For the
regional targets between 2011 and 2015, we refer to the stipulation of the “Program for regulating
greenhouse gases during the Eleventh Five-Year Plan period” issued by the State Council; Last, for
the years from 2016 to 2020, we set the relative intensity cuts between the regions to maintain the
level from 2005 to 2015, while in the meantime adjusting the overall cut to the level that will fulfill
China’s “Copenhagen pledge” to reduce its carbon dioxide emission per unit of GDP by 40-45% by
2020 compared to 2005 levels. Under this baseline scenario, we record the national total of carbon
emissions, based on which the total binding targets are set to ensure the comparability between
policies.
We analyze the binding target for the total from three dimensions, namely, the tradability of the

7
In this section we will only concern the setting for the energy and climate policy. For detailed information about the
rest of the model, please contact the author.
8
With 2005 being the base year, the “Notice of Regional Progress towards Completion of Energy Efficiency Targets
during the Eleventh Five-Year Plan period” announced the decline in carbon intensity from 2005 to 2010. In order to
match the base year of this model, we assume that the annual carbon intensity of each region decreases exponentially
at constant rate, thereby obtaining the magnitude of each year’s decline relative to the last year. Then taking 2007 as
the base year, we calculate the decline of the following years relative to 2007.

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emission permits, the static criteria for their allocation, and whether the dynamic adjustment is
introduced. The static allocation criteria include base period emissions, base period output, and base
period consumption. The dynamic adjustment is to amend these static criteria according to the prmti
of each producer over different periods. Denote the share of one producer under the static criteria as
ti . By the mechanism of dynamic adjustment, ti can be expressed as

θ̄ it (1+ prmit )
θit =
∑i θ̄ it ( 1+ prmit ) (10)

In addition, we also use the model for analysis of a "suboptimal" dynamic allocation
mechanism.

Table 4.2 Scenario Settings for Varied Policies

Scenario Criteria for allocating

Dynamic Adjustment Tradability
Codes emission permits
BAU Set the targets according to the current policy
EMT_T_S Base Period Emissions
OPT_T_S Base Period Output
Yes
Base Period Household
CNS_T_S
Consumption
Static Allocation
EMT_NT_S Base Period Emissions
OPT_NT_S Base Period Output
No
Base Period Household
CNS_NT_S
Consumption
EMT_T_D Base Period Emissions
OPT_T_D Base Period Output
Yes
Base Period Household
CNS_T_D
Dynamic Adjustment for Consumption
EMT_NT_D Intertemporal Optimization Base Period Emissions
OPT_NT_D Base Period Output
No
Base Period Household
CNS_NT_D
Consumption
Suboptimal Dynamic Base Period Emissions +
SBD_T Yes
Adjustment Output of each period

Section V Simulation results and discussion

(1) Comparison in long-term economic effect between static allocation and dynamic adjustment for
emission permits
According to the analysis from previous articles on the above theoretical model, the economic
growth path by the static allocation would deviate from the optimal scenario of the intertemporal
 Tang Weiqi, Wu Libo, and Qian Haoqi Jianhui

optimization— an inference corroborated by the simulation results from the CGE model in this
article. In the histogram shown by Figure 5.1, the blue bars and red bars represent the GDP of 2020
by static allocation and by dynamic adjustment respectively. It is clear from the chart that the long-
term economic output levels (blue bars) by the static allocation are lower than that by dynamic
adjustment (red bars). Moreover, the static allocation also undermines the positive impact of the
emissions trading on economic output: under the mechanism of static allocation, using base period
emissions, output and consumption as criteria for allocating the carbon permits, the introduction of
carbon trading makes the long-term economic output outpaced by the corresponding scenarios with
dynamic adjustment.

635,000.0
静态分配
static 动态调整
dynamic
0.107%
632,000.0 0.235%
-0.089%
0.066% 0.615%
629,000.0
0.478%

626,000.0

623,000.0

620,000.0
BAU EMT_NT EMT_T OPT_NT OPT_T CNS_NT CNS_T

Fig 5.1：Comparison in long-term economic effect between static allocation and dynamic adjustment
for emission permits

The above comparison indicates that the carbon trading itself would improve the economic
efficiency of emission reduction. However, under the mechanism of static carbon right allocation, the
economic entities are unable to make adjustment between the current and future period. According to
the relationship between current output and future production efficiency, the long-term economic
growth would therefore deviate from the optimal path, making the carbon transactions incapable of
exerting their full influence over the long-term economic growth. If the gap between the tradable and
non-tradable scenarios under the dynamic adjustment mechanism, is taken as the potential economic
impact of carbon trading, and the gap between the allocation schemes with and without dynamic
adjustment under the same static-allocating criteria as the economic loss caused by “static
allocation”, then we can have ideas about the relative strength of this loss through the comparison
between the two. The curves in Figure 5.2 show the potential economic impacts of carbon emissions
under different allocation criteria, as well as the efficiency losses resulted from the static allocation
mechanism. It can be seen that when allocating carbon permits according to the base period

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emissions or output, the economic losses caused by the static allocation largely offset the economic
benefits provided by the carbon trading.
If dynamic adjustments cannot be made to the allocation of emission rights in line with the
principles of intertemporal optimization, the economic benefits from the carbon trading will be
significantly weakened, or even wiped out. Now in this period of China’s economic transformation,
given the high volatility and uncertainty in the market and policy environment, the “complete
information” required for intertemporal optimization is less than possible to be obtained. In such a
context, it appears particularly important to find a “suboptimal” allocation and adjustment
mechanism as an approximation to the long-term optimal growth path.

0.16%
f(x)EMT
= 0.751409978308025
0.885916203937406 x
Linear
（ dynamic adjustment Vs. static transac-

(EMT)
Economic Losses by static allocation

0.12%
f(x) = 0.182421732245097 x

0.08%
tion ）

0.04%

0.00%
-0.1% 0.0% 0.1% 0.2% 0.3% 0.4% 0.5% 0.6% 0.7%
The potential economic impacts of emission permit trading
(tradable Vs.non-tradable ）

Fig 5.2 The comparison of total economic efficiency with carbon transactions to efficiency loss
caused by myopic transactions

(2) The economic impacts of the “suboptimal” allocation scheme

With no "complete information" available in the market, the dynamic allocation scheme shown
in Eq. (9) can be used as an approximation to the optimal intertemporal solution under certain
conditions. To derive the exact adjustment factors, we need to know the equilibrium growth rate g, as
well as the coefficients of the autoregressive TFP function (ζ and σ). However, in the course of
China's rapid economic transformation, the industrial structure, production technology, industrial
layout, and so on continue to change; in addition, there are wide differences between regions as well
as sectors in their growth paths. We hence are unable to reach a unique equilibrium growth rate. To
this end, we test a group of adjustment coefficients w to compare their impacts on long-term
economic growth. We may calculate the share of emissions one producer is actually allocated to in
his region, which gives
 Tang Weiqi, Wu Libo, and Qian Haoqi Jianhui

( 1−w ) iemr , i ,0 + w⋅OPT r , i , t −1

Sharer , i , t =
cemr , 0 rem¿
∑i [ ( 1−w ) iemr , i , 0 +w⋅OPT r , i, t −1] + rem
¿ (11)
where iemr,i,0 is the emissions of the producer in the region r over the period t, OPTr,i,t is the output of
the producer over the same period t, cemr,0 is the emissions coming from the household consumption
in region r, and rem_cr,t is the total share allocated to region for period t. Figure 5.5 below shows the
impacts of the dynamic allocation scheme, subject to different adjustment factors w, on the growth
path of economic output.

1.006
1.004
1.002
1
0.998
GDP_T_F 19
1 7 20
W=0.1 15 20
W=0.3 1 3 20
W=0.5 11 20
W=0.7 09 20
W=0.9 0 7 20
20

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
2019 2020
Figure 5.5: Comparison of economic growth paths under the mechanism of dynamic allocation of
emission rights
Note: The values GDP under the EMT_T_M scenario are normalized to 1 for convenience. The optimal solution is
achieved under the GDP_T_F, presented here as a reference against the suboptimal solution.

Allotting the emission shares according to output of each producer, this dynamic allocation
scheme can activate the “learning-by-doing’ effect in a short period of time, thereby contributing to
promote the growth of production efficiency and output. Since 2015, nevertheless, the economic
growth brought by this dynamic allocation tended to slow down. This is because the
learning-by-doing” effect in the model is convergent. In this sense, to maintain the original
adjustment coefficients may result in over-adjustment, causing unnecessary distortion. With the
increase in the value of w, the short-term economic growth will be significantly improved, but the
long-term growth rate will drop dramatically. As a consequence, the role of dynamic allocation
scheme in promoting economic output will decline in the long run.
It can be seen that the output-level-oriented dynamic scheme for allocating emission permits can
effectively stimulate the endogenous economic growth in short terms, thus pushing up the economic
growth. However, this is only a makeshift solution over the process of market transformation, as the
positive economic impacts of this dynamic mechanism will be weakened in the long run; the
mechanism may even decelerate economic growth.

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Section VI Conclusion
In this article, we use a general equilibrium model to study how different carbon trading
schemes under the endogenous growth mechanism–particularly schemes for allocating carbon
emission permits–can affect the long-term economic output. Our results show that in this context,
static allocation for emission rights will greatly weaken the potential positive impact of the carbon
trading mechanism and may even counteract the economic benefits brought by the carbon trading
system. During the course of China’s structural transformation, the country’s economic growth is
highly path dependent: the growth path and the pace of technological progress in the future are
closely related to the economic production at present. In decision making and policy formulation, if
we neglect the impacts of the current behavior on the growth of future economy and production
efficiency, the effectiveness of the policy could be seriously weakened, and negative consequences
may follow.
Adjusting the allocation of emission permits based on the output of producers over each period
can stimulate the role of endogenous growth mechanism, which helps improve the economic growth
significantly in a short term. However, due to the decline of endogenous growth, this “Suboptimal”
mechanism could lead to excessive adjustments, so that effect of economic growth starts tapering off.
This means that the method of approximating the intertemporal optimal solution by the dynamic
allocation of emission rights can only be used for short-term interests, and it is necessary to provide a
more stable market and policy environment for maintaining a long-term optimal economic growth
path after the carbon trading system has been introduced.
For China, a country at a crucial juncture of its economic transformation, to maintain the policy
looking to long-term growth is far more important than to minimize the costs for emission cuts in
current period. Yet in current pilot projects, allocation schemes for emission permits are often decided
by combined consideration of historical emission levels, industrial policy, technical levels,
preliminary work on carbon reductions, and so on. The results given by the theoretical and
quantitative models referred in this article, for instance, when combined with the high level of
uncertainty in the current market and policy environment, will lead to deviation of the economic
growth from the optimal path. During the transition period of these pilot programs, introduction of
dynamic adjustments to emission rights allocation brings short-term economic growth. In the long
term, there is a need to focus on improving the stability of the market and policy, such as setting
longer-term targets for emission reductions, developing a definitive allocation mechanism for
allocating emission permits, setting longer emissions settlement cycles, allowing carbon permits to be
deposited and advanced intertemporally, and so on.