As shown by R. Hahn (1984), free allocation to a firm with market power equal to the amount of permits the firm uses in a competitive equilibrium can prevent welfare losses under market power. In this paper an alternative option to mitigate market power is proposed. If the regulating authority is unwilling or unable to hand out ’full’ free allocation to a firm with market power, it may alternatively alter the economy wide emissions constraint (cap). Changing the cap can lead to a situation where the firm with market power will choose a price similar to the competitive equilibrium. As a consequence, marginal abatement costs of regulated firms are equated and the least cost solution is achieved.
If the cap is chosen efficiently, so that marginal benefits and marginal costs of regulation are equated, changing the cap may decrease social welfare. To account for this effect, marginal social damages from changing the cap are balanced to marginal gains from mitigating market power. By doing so, a second-best solution to mitigate market power in permit markets is derived.