Welfare maximizing emission permit allocations under constraints.

This paper examines equity and efficiency properties of voluntary international environmental agreements. A classical welfare economics framework is used while focusing on one particular instrument, i.e. emissions trading. It is demonstrated that if emission permit allocations face no constraints, that is if the allocation of ‘hot air’ and negative permit endowments are allowed, the classical efficiency rule is preserved and we obtain a ‘first best’ solution. This result however breaks down when permit allocation constraints are imposed. If one of these constraints is binding, the global abatement target and the permit distribution are determined simultaneously. An empirical application confirms this result and reveals that binding allocation constraints shift the abatement target away from the first best solution. When more stringent stability concepts are imposed, the constraints on endowments become less binding. The welfare loss due to these constraints however gets larger as we become more inequality averse.