Reassessing the Importance of Initial Allocation Methods in Emission Permit Markets

One of the most controversial aspects of a tradable permit market is the initial allocationof pollution permits. On the one hand, standard economic theory prescribes thatthe method of allocation does not matter, apart from second-order effects due to thepossibility of reducing distortionary income taxes by recycling revenue from permitsales. Incentives for abatement, the market-clearing permit price and overall welfareshould be the same regardless of whether grandfathering, auctioning or some othermethod is used to allocate permits. On the other hand, this prescription depends ona set of rather stringent assumptions. We discuss a number of departures from thesebaseline assumptions which cause the method of permit allocation to impact efficiencyand/or overall social welfare, and all of which may be present to some extent in theworld’s largest emissions permit market to date, the European Union Emissions TradingScheme (EU ETS).We critically analyze the evidence for using auction and grandfatheringapproaches in these situations. We show that the choice between grandfatheringand auctioning crucially depends on many factors which include the specific typeof grandfathering (e.g. pure grandfathering vs. allocation ”updating”, benchmarking,or output-based) and auctions (e.g. structure, use of revenue), the existence of marketpower and speculative uncertainty. Furthermore, we discuss the political acceptabilityof both approaches and explain, under policy implementation, which mechanism providesthe highest social welfare. We provide an outlook on future issues and challengesand discuss other feasible alternative mechanisms.