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Emissions Trading in the Presence of Price-Regulated Polluting Firms: How Costly Are Free Allowances?

We study whether to auction or to freely distribute emissions allowances when some firms participating in emissions trading are subject to price regulation. We show that free allowances allocated to price-regulated firms effectively act as a subsidy to output, distort consumer choices, and generally induce higher output and emissions by price-regulated firms. This provides a cost-effectiveness argument for an auction-based allocation of allowances (or equivalently an emissions tax). For real-world economies such as the Unites States, in which about 20 percent of total carbon dioxide emissions are generated by price-regulated electricity producers, our quantitative analysis suggests that free allowances increase economy-wide welfare costs of the policy by 40-80 percent relative to an auction. Given large disparities in regional welfare impacts, we show that the inefficiencies are mainly driven by the emissions intensity of electricity producers in regions with a high degree of price regulation.

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Energy Specializations: Energy Investment and Finance – Public and Private Risks, Risk Management; Electricity – Other; Energy and the Economy – Energy as a Productive Input; Energy Modeling – Energy Data, Modeling, and Policy Analysis; Renewables – Policy and Regulation; Renewables – R&D and Emerging Technologies; Petroleum – Policy and Regulation

JEL Codes:
D81 - Criteria for Decision-Making under Risk and Uncertainty
Q49 - Energy: Other
O13 - Economic Development: Agriculture; Natural Resources; Energy; Environment; Other Primary Products
E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination
Q52 - Pollution Control Adoption and Costs; Distributional Effects; Employment Effects
O32 - Management of Technological Innovation and R&D
E60 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook: General

Keywords: Tradable Pollution Permits, Climate policy, Auctioning, Free Allocation, Price Regulation, Electricity Generation

DOI: 10.5547/01956574.37.1.blan

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Published in Volume 37, Number 1 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.