Allowances associated with a cap-and-trade system represent an asset with considerable monetary value, perhaps $100 billion or more annually. The method by which allowances are allocated therefore has important implications for both the efficiency and the distributional impacts of climate policy.
There are two major approaches to allocation: giving allowances away freely, or auctioning them. If given away freely, allowances are often "grandfathered" to regulated entities based on past emissions or related historic benchmarks. Arguments for grandfathering frequently center on the need to compensate vulnerable economic sectors or make asset owners "whole".
On the other hand, because the cost of emissions permits (whether actual or in terms of opportunity costs) will be largely passed on to consumers, giving allowances to producers freely often leads to windfall profits and makes them better off under climate policy than before. An important exception is among regulated utilities - roughly half the United States market - where the benefits of grandfathered permits would be passed on to consumers. In an allowance auction, the government receives the auction revenue from the firms that purchase the allowances. Arguments for auctioning include reducing the program's overall economic cost and raising revenues that the government can use to reduce other taxes or fund other programs.
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