Abstract This paper focuses on the impact of EUAs on the optimal policy of a competitive electricity producer. The effect of grandfathering is consistently shown to introduce significant distortions to the system. It is theoretically shown that there is a threshold value of carbon price so that, for prices above this, the EUA becomes an incentive for reduced production rather than a penalty for inefficient producers. These theoretical results are supported by the data of one producer from Italy and one from Germany. Furthermore, the empirical evidence concludes that the high level of free allowances may generate a shift in production from less to more polluting technologies.