Within-Country Leakage due to the Exemption of Small-Source Emitters in an Emission Trading System

I analyse how the exemption of small-source emitters in an Emission Trading System with auctioned permits leads to within-country emissions leakage in an heterogeneous firm model: The asymmetric effect of emissions pricing on profits along the productivity distribution allows more and dirtier firms to survive in the domestic market. The leakage following an increase in the permit price is stronger if the exemption follows a fixed emissions limit instead of a fixed share of firms, and is weakened if firms get free allowances via a regressive grandfathering scheme. Adding international trade, the most polluting firms have to exit such that the aggregate emissions of unregulated firms are lower, but within-country emissions leakage given a change in the allowance prices is higher.