Emissions Trading with Offset Markets and Free Quota Allocations

We study optimal climate policy for a "policy bloc" of countries facing a market where emissions offsets can be purchased from a non-policy "fringe" of countries (such as with the CDM). Policy-bloc firms benefit from free quota allocations, which are updated according to either firms' past emissions, or outputs. We show that the resulting abatement and its allocation between policy bloc and fringe are both inefficient. When all quotas are traded freely at a single price, the policy bloc chooses to either not constrain the offset market, leading to suboptimal policy-bloc mitigation; or ban offsets completely. The former (latter) case occurs when free allocation of quotas is not (very) generous, and the offset market is large (small). It is preferable for policy-bloc countries' governments to instead buy offsets directly from the fringe at a quota price below marginal damage cost of emissions, while the policy-bloc quota price will be above this cost. With maximization of global welfare and a unified quota price, this price is higher, and offsets constrained in fewer cases, but the solution still inefficient. Full efficiency then requires a higher quota price in the policy bloc than in the fringe.