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The only thing about the palette is that you actually need two palettes per character, so you can have two players and distinguish them.
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Yes, but that would be only needed in 2 Player mode if both players choose the same character.
So an easy way to solve this problem is not to allow the same character for both players.
But also it is possible to switch character colors with a Blitz "Remap" command, and this way there can be two versions of the same character in memory, both having the same palette, but with different color usage. So for example if both players choose Ryu, one can have a blue outfit and the other one can be red.