This paper argues that, in situations where choices are made between mutually exclusive investment projects and where there are economic rents, free allocation of tradable emission permits in emissions trading systems can weaken incentives for firms to invest in less carbon-intensive technologies compared to the case where permits would be auctioned. The reason is that permit allocation rules affect economic rents differentially when different product benchmarks apply to products that are close substitutes. Examples of permit allocation rules favouring more emission-intensive technologies for outputs that are close substitutes are found in the California Cap and Trade Program and in the European Union Emissions Trading System. This lack of technology-neutrality is exacerbated in the long run as future patterns of substitutability between technologies are uncertain. Free permit allocation can broaden support for carbon pricing, but this paper shows that this carries a cost in terms of environmental effectiveness if it discourages investment in low-carbon assets.
