Carbon leakage: Grandfathering as an incentive device to avert relocation

Emission allowances are often distributed for free in an early phase of a cap-and-trade scheme (grandfathering) to reduce adverse effects on the profitability of firms. If the grandfathering scheme is phased out over time, firms may nevertheless relocate to countries with a lower carbon price once the competitive disadvantage of their home industry becomes sufficiently high. We show that this is not necessarily the case. A temporary grandfathering policy can be a sufficient instrument to avert relocation in the long run, even if immediate relocation would be profitable in the absence of grandfathering. A necessary condition for this is that the permit price triggers investments in low-carbon technologies or abatement capital.