Whether Emission Permits Are Auctioned or Handed Out Free

The Design in One Paragraph

A cap and trade system sets a total quantity of emissions permitted in a period, issues that quantity of allowances, and requires every covered emitter to surrender one allowance per unit emitted. Allowances trade freely, so any emitter that can reduce emissions more cheaply than the market price of an allowance will do so and sell the surplus.

The cap determines the environmental outcome. The trading determines that reductions happen wherever they are cheapest, which is the entire efficiency argument for the design.

Neither of those depends on who receives the allowances at the start.

The Result That Makes Allocation Purely Distributional

Because allowances trade, an emitter that receives one free faces the same decision as one that bought it. Using an allowance means forgoing the ability to sell it, so the opportunity cost is the market price either way.

A rational firm therefore behaves identically whether it was given the allowance or paid for it, and abatement decisions across the economy are unchanged. The initial allocation is a transfer of wealth, not a change in behaviour.

That is a genuinely important result and it is frequently misunderstood in public debate, where free allocation is described as weakening the scheme. It does not weaken the cap. It decides who gets the money the cap creates.

Windfall Profits and Where They Came From

The clearest demonstration came from the early phases of the European emissions trading system, where allowances were distributed largely free based on historical emissions, a method called grandfathering.

Power generators received allowances at no cost and then, correctly, included the opportunity cost of those allowances in the price of electricity, because using an allowance meant not selling it. Consumers paid higher power prices reflecting a carbon cost the generators had not paid, and the difference was profit.

The effect was large, well documented, and entirely predictable from the theory. It also produced the political reaction that drove the shift toward auctioning in later phases, at least for power generation.

Why Free Allocation Persists Anyway

Two arguments defend it, and one of them is substantially stronger than the other.

The weaker argument is transition assistance: firms made capital investments under a prior regime and imposing a full cost immediately strands that capital. This has force at launch and decays over time, which is why free allocation is usually designed to phase down.

The stronger argument is carbon leakage. A trade exposed industry facing a carbon price its foreign competitors do not face may lose market share to production in unregulated jurisdictions, which reduces domestic emissions and raises global ones while destroying domestic industry. Free allocation to genuinely trade exposed sectors addresses this by removing the cost disadvantage while preserving the marginal incentive to abate, since the allowances are still worth selling.

The difficulty is that identifying which sectors are genuinely at risk is empirical, contested, and lobbied over intensively, and schemes have generally been more generous in defining the category than the evidence supports.

Benchmarking as the Middle Path

The refinement most systems adopted is output based allocation against a benchmark: allowances are granted in proportion to production multiplied by an emissions intensity standard, typically set at the level achieved by the best performing installations in the sector.

This is a meaningful improvement over grandfathering. Allocating on historical emissions rewards having been dirty, since a plant with high past emissions receives more. Allocating on a best in class benchmark rewards efficiency, because a firm below the benchmark receives more allowances than it needs and can sell the surplus.

It also removes the perverse incentive in grandfathering to maintain emissions in order to protect a future allocation.

What Happens to Auction Revenue

Once a government auctions allowances, it holds a substantial revenue stream, and how that revenue is used determines much of the public reception.

The main options are recycling through reductions in other taxes, which economists generally favour because it offsets the deadweight cost of the taxes replaced; direct rebates to households, which addresses the regressive incidence of higher energy costs and builds durable political support; and spending on clean energy investment, which is popular and harder to justify on efficiency grounds since the carbon price is already meant to drive that investment.

Systems that returned revenue visibly to households have generally proved more politically durable than those that did not, which is a finding about political economy rather than about environmental economics.

The Border Adjustment Response

The alternative to protecting trade exposed industry through free allocation is to impose an equivalent cost on imports, through a border carbon adjustment. Doing so allows free allocation to be phased out entirely without creating a leakage problem, which is precisely how the European scheme has been designed to transition.

Border adjustments carry their own difficulties, including measuring the embedded carbon in imported goods, trade law compatibility, and the reaction of exporting countries. They are the logical endpoint of the design and they are considerably harder to administer than the domestic scheme they complete.

The Bottom Line

In a cap and trade system the cap does the environmental work and the allocation decides who receives the value that the cap creates. Free allocation does not lower prices for consumers, it redirects the money to incumbents, which is why early schemes produced large windfalls. Benchmarked output based allocation is the sensible compromise where leakage is real, and border adjustment is what would make free allocation unnecessary. The recurring lesson is that the fight is almost never about the cap.