Impact of carbon permit allocation rules on incentive contracts for carbon emission reduction

Purpose - The purpose of this paper is to examine the impact of carbon permit allocation rules (grandfathering mechanism and benchmarking mechanism) on incentive contracts provided by the retailer to encourage the manufacturer to invest more in reducing carbon emissions. Design/methodology/approach - The authors consider a two-echelon supply chain in which the retailer offers three contracts (wholesale price contract, cost-sharing contract and revenue-sharing contract) to the manufacturer. Based on the two carbon permit allocation rules, i.e. grandfathering mechanism and benchmarking mechanism, six scenarios are examined. The optimal price and carbon emission reduction decisions and members' equilibrium profits under six scenarios are analyzed and compared. Findings - The results suggest that the revenue-sharing contract can more effectively stimulate the manufacturer to reduce carbon emissions compared to the cost-sharing contract. The cost-sharing contract can help to achieve the highest environmental performance, whereas the implementation of revenue-sharing contract can attain the highest social welfare. The benchmarking mechanism is more effective for the government to prompt the manufacturer to produce low-carbon products than the grandfathering mechanism. Although a loose carbon policy can expand the total emissions, it can improve the social welfare. Practical implications - These results can provide operational insights for the retailer in how to use incentive contract to encourage the manufacturer to curb carbon emissions and offer managerial insights for the government to make policy decisions on carbon permit allocation rules. Originality/value - This paper contributes to the literature regarding to firm's carbon emissions reduction decisions under cap-and-trade policy and highlights the importance of carbon permit allocation methods in curbing carbon emissions.