This policy brief outlines various options for distributing greenhouse gas emission allowances under a cap-and-trade program. Allowances represent a significant source of value and can be used to compensate firms or individuals affected by climate change policy or to raise funds for other socially desirable policy objectives. The basic allocation decision involves whether to freely allocate emission allowances, and if so, to whom, and whether to auction allowances, and if so, how to distribute the revenues. A number of recent cap-and-trade proposals begin with a combined approach that provides some allowances for free and auctions the rest, with the share of auctioned allowances rising over time. If free allocation is chosen, the basis for distribution must be determined. Options include granting allowances based on historical emissions (“grandfathering”), on levels of an output or input, or on an environmental performance “benchmark;” each has implications in terms of who benefits from the value of the allowances. If allowances are auctioned, in addition to deciding how the revenue generated by the auction will be used, policymakers will need to determine the type and frequency of the auction. Many of the same objectives can be met using either auction revenues or free allocation, including easing transition for affected firms and consumers and supporting new technologies. However, allocation decisions will sometimes entail trade-offs among the competing goals of achieving an equitable distribution of economic impacts, ensuring political feasibility, and minimizing overall program cost. Allowance allocation presents both a challenge and an opportunity: no allocation formula will satisfy everyone, yet allocation decisions can be made in ways that ease the transition to a low-carbon economy and enhance the likelihood of meaningful action on climate change.
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