Carbon leakage: Grandfathering as an incentive device to avert firm relocation

Emission allowances are sometimes distributed for free in an early phase of a cap-and-trade scheme to reduce adverse effects on the profitability of firms. This paper investigates whether grandfathering can also be used to avert the relocation of firms to countries with lower carbon prices. We show that under certain conditions, relocation can be averted in the long run, even if the grandfathering scheme is phased out over time and immediate relocation is profitable in its absence. This requires that the permit price triggers sufficient investments into low-carbon technologies or abatement capital that create a lock-in effect which makes relocation unprofitable.