A BLIND EYE TO INDUSTRY-LEVEL CORRUPTION? THE RISK OF FAVOURING DOMESTIC INDUSTRIES IN THE EU ETS Urs Steiner Brandt 1 and Gert Tinggaard Svendsen 2 1 Associate Professor, PhD, Department of Environmental and Business Economics, University of Southern Denmark, Denmark, usb@sam.sdu.dk 2 Professor, PhD, Political Science and Government, Aarhus University, Bartholins Allé 7, 8000 Aarhus C, Denmark, gts@ps.au.dk ABSTRACT We investigate the risk of favouring domestic industries in the current European Union Emission Trading System (EU ETS). As the EU forms a weak federal structure compared to the US, there is a risk that single countries may free ride on the others by choosing to take a blind eye to industry-level corruption when tempted to favour their own industries. In other words, the optimal level of national cheating may not take into account the external cost it imposes upon other countries and the risk of wide-scale cheating and the possibility of an EU ETS collapse. Such national incentives to cheat correspond to a well-known transnational externality problem from international environmental problems and multiplayer prisoners’ dilemma games. Thus, there is a strong need for systematic empirical analysis of whether cheating actually occurs in the EU ETS as predicted by theory. Keywords: European Union Emission Trading System (EU ETS), enforcement, corruption, federal structure, US Acid Rain Program. 1. INTRODUCTION The European Emission Trading system (EU ETS) is the world’s first framework for international greenhouse gas emissions trading. This possibility of emission trading in the EU originates from the Kyoto Protocol (article 17). It was conceived in the late 1990s as a means of ensuring that the then fifteen members of the European Union (EU15) could meet their commitments under the Kyoto Protocol in the First Commitment Period (2008-12) following the pilot period (2005-07) (Brandt and Svendsen 2006). Also, the EU ETS is by far the largest cap-and-trade system in the world. It covers approximately 12,000 sources and they have been allocated more than 2 billion permits (allowances), corresponding to almost half of the CO 2 emissions originating 263