Allocation of emission permits with leakage through capital markets

This paper analyses how tradable emission permits should be allocated to firms when capital is internationally mobile. When international environmental problems are attempted solved through uncoordinated policies between countries, it might be desirable for the home country to issue free emission permits in proportion to the use of capital in order to prevent leakage through international capital movements. The desirability of free emission permits will however be reduced if capital also can be employed in a domestic non-polluting sector. In this case, it may even be optimal to tax the use of capital in the polluting sector. It is also shown that it is always optimal to subsidise the use of capital in the polluting sector if the use of labour is taxed at an optimal rate. Finally, leakage does not affect the optimal domestic emission limit as long as appropriate capital subsidies and labour taxes are implementeed.