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

Open Access Article

Abstract:
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: Q41: Energy: Demand and Supply; Prices, Q40: Energy: General, Q54: Climate; Natural Disasters and Their Management; Global Warming, Q52: Pollution Control Adoption and Costs; Distributional Effects; Employment Effects

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.