Allowances associated with a cap-and-trade system represent an asset with potentially considerable monetary value, perhaps $100 billion or more annually. The value of these allowances or permits is not a measure of the cost associated with meeting the cap, but rather a wealth transfer from those who pay higher energy or emissions prices under the cap-and-trade program to those who hold allowances.

While the U.S. Acid Rain program allocated sulfur dioxide (SO2) allowances gratis (for free) to regulated entities (in that case, electric utilities), cap-and-trade systems need not adopt this approach. Permits can be allocated gratis to entities other than those that are directly regulated under the program (including, for example, households or state government). Moreover, allowances need not be allocated gratis: they can be sold by the government, which can retain resulting revenues for other purposes.

Allocation decisions can affect both the efficiency (overall cost of meeting the cap) and the equity (distribution of the cost) of a cap-and-trade program. Generally, auctioning allowances and using the revenues to lower taxes, or offset particularly distorting taxes, increases efficiency and lowers the overall cost of the program to society. Awarding free allowances to certain stakeholders can address distributional concerns, but can sacrifice some efficiency.

Allocation can alter economic incentives and the behavior of firms. For example, an output-based, updating approach could award free allowances to firms on the basis of output. For example, free allowances could be distributed to firms within the electric-power sector on the basis of their share of total sector-wide electricity output. Because this approach rewards firms for producing a larger share of output, free allowances will act as an output subsidy, effectively incentivizing firms to produce more. This outcome may or may not be desirable depending on the sector and the policy goals being pursued.

Allocation to new entrants and retiring sources can be dealt with in a number of ways. However, care must be taken to ensure that the allocation methods used do not alter forward incentives for investment and retirement in ways that may not be immediately obvious but that lead to suboptimal technology choices (either in terms of encouraging new investments in carbon-intensive technologies or delaying the retirement of uneconomic facilities).

Arguments for free allocation are typically rooted in equity concerns: the desire to compensate sectors or regions that will otherwise bear a disproportionate share of the cost of regulation, or to blunt immediate impacts on the competitiveness of U.S. firms. As the economy adjusts to GHG constraints over time, these arguments become less compelling while the potential for economic distortions as a result of free allocation tends to grow, making it prudent to phase out free allocation in favor of auctioning allowances.