AbstractThe choice of mechanism for allocating tradable emissions permits has important efficiency anddistributional effects when tax and trade distortions are considered. We present different rules forallocating carbon allowances within sectors (lump-sum grandfathering, output-based allocation [OBA],and auctioning) and among sectors (historical emissions and value-added shares). Using a partialequilibrium model, we explore how OBA mitigates price increases, limits incentives for conservation infavor of lowering energy intensity, and changes relative output prices among sectors. We then use acomputable general equilibrium model from the Global Trade Analysis Project, modified to incorporate alabor/leisure choice, to compare overall mechanism performance. The output subsidies implicit in OBAmitigate tax interactions, which can lead to higher welfare than grandfathering. OBA with sectoraldistributions based on value added generates effective subsidies similar to a broad-based tax reduction,performing nearly like auctioning with revenue recycling, which generates the highest welfare. OBAbased on historical emissions supports the output of more polluting industries, which more effectivelycounteracts carbon leakage but is more costly in welfare terms. Industry production and trade impactsamong sectors that are less energy intensive are also quite sensitive to allocation rules.