Pollution Permit Systems and Firm Dynamics: Does the Allocation Scheme Matter?

Most cap-and-trade systems allocate permits for free. However, they differ dependent on whether closing plants and new entrants get free permits. I use a dynamic model with heterogeneous firms and equilibrium conditions in the output and emission market to quantify the effect on exit/entry, investment and welfare of different allocation rules. I calibrate the model with data from the power plants participating in the US SO2 program and quantify the effects of two allocation schemes: The US SO2 case, in which closing plants keep their permits and new entrants do not get any of them; The EU-ETS case, in which plants lose permits upon exit and new entrants get allowances. If the US switched to the EU-ETS allocation scheme, the price of output would be 1:5% lower, the price of permits 7.6% higher, and there would be a distribution of dirtier and less productive plants. Consumers are better off if the US switched to the EU-ETS system (lower price), while producers are better off with the US SO2 system (higher profits).