Output-Based Allocations of Emissions Permits: Efficiency and Distributional Effects in a General Equilibrium Setting with Taxes and Trade

The choice of mechanism for allocating tradable emissions permits has important efficiency and distributional effects when tax and trade distortions are considered. We present different rules for allocating carbon allowances within sectors (lump-sum grandfathering, output-based allocation [OBA], and auctioning) and among sectors (historical emissions and value-added shares). Using a partial equilibrium model, we explore how OBA mitigates price increases, limits incentives for conservation in favor of lowering energy intensity, and changes relative output prices among sectors. We then use a computable general equilibrium model from the Global Trade Analysis Project, modified to incorporate a labor/leisure choice, to compare overall mechanism performance. The output subsidies implicit in OBA mitigate tax interactions, which can lead to higher welfare than grandfathering. OBA with sectoral distributions 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. OBA based on historical emissions supports the output of more polluting industries, which more effectively counteracts carbon leakage but is more costly in welfare terms. Industry production and trade impacts among sectors that are less energy intensive are also quite sensitive to allocation rules.