Firms facing regulatory environment are unlikely to maintain the optimal combination of input rates subject to market prices while bearing the costs incurred by this allocative inefficiency. The distance function approach widely used in previous literatures fails to capture the costs of this allocative inefficiency, resulting in the underestimation of CO₂ abatement costs. In this paper, we test for allocative efficiency of inputs for the Korean steel industry over the period 1990-2010 by estimating the shadow cost function along with unobservable shadow input prices. The effect of CO₂ reduction on allocative inefficiency costs is then analyzed. Empirical results indicate that the hypothesis of allocative efficiency for all inputs is rejected and a 1% reduction in CO₂ emissions would result in a 0.22% increase in allocative inefficiency costs at the median year.