This thesis began in Chapter 2 by reviewing the literature that discussed the link between the initial allocation of permits and e¢ ciency in the permit market equi-librium. The chapter began by discussing the reasons behind the independence between market e¢ ciency to be independent and the initial allocation of permits (perfect competition, no transaction cost and a static market). The chapter focused on the attempts taken to relax the assumptions and it was shown that the introduc-tion of …rms’strategic behaviour, transacintroduc-tion costs or multiple periods may create a link between market e¢ ciency at equilibrium and the initial allocation.
Chapter 3 created a generalised allocation mechanism for the initial allocation of pollution permits in a dynamic setting. This mechanism allowed permits to be allocated based on historical emissions, output and a factor independent of both—
an ‘external’action. This mechanism could encompass auctions, benchmarking and updated grandfathering— the use of updated historical information on …rms’emis-sions and output levels. All these mechanisms were modelled through a relative performance approach where allocation to each …rm is based on their ‘action’rela-tive to the remaining …rms. In this chapter is was found that in a dynamic permit market the use of output as an allocation criterion is never optimal as an incentive to increase production always exists. The use of emissions as a dynamic criterion is generally not socially optimal. Instead it is argued that allocation should be based on the information of an external factor, such as the social bene…cial ‘actions’ of
…rms. This not only optimally allocates permits but creates a secondary bene…t which is a generalised ‘double dividend’e¤ect.
Chapter 4 considered the issue of lobbying activity over a permit allocation in a dynamic permit market. Each …rm had the ability to determine their future permit allocation by their choice of rent-seeking activity— the combined choice of emissions and lobbying activity. It was found that market e¢ ciency is altered by rent-seeking activity when the costs of emissions and lobbying activity are separable.
In such a case, a direct link exists between the choice of emissions and lobbying and future rent. However, when the costs of emissions and lobbying activity are non-separable market e¢ ciency may be maintained as lobbying can be chosen ‘ex-post’
to coincide with an e¢ cient tradeable permit market. The model was extended to include the cases where (i) the choice of emissions no longer altered a …rm’s permit allocation (static grandfathering) and (ii) the aggregate emissions cap is partly determined by …rms’rent-seeking activity. When the choice of emissions no longer alters permit allocation, it was found that the inter-temporal link between emissions and future permit rent was eliminated and the tradeable permit market was least-cost. Moreover, it was found that allowing for rent-seeking activity to partly determine the aggregate emissions cap did not vary the market e¢ ciency, however, an increase in the cap reduced social welfare.
Finally in Chapter 5, an alternative initial allocation is advocated— a rank-order contest. This mechanism allocates permit to …rms based on the rank ordering of
…rms based on some ‘socially bene…cial’ activity pre-determined by the regulator.
It was shown that the permit allocation contest e¢ ciently allocated permits so that the tradeable permit market was least-cost. Moreover, a symmetric strategy was created to illustrate each …rm’s optimal choice of external action. A …rm’s choice
of external action was found to be dependent on: the cost of the external action;
the expected permit allocation, the permit price and the …rm’s ability parameter.
The chapter was advanced by discussing the regulators problem in which it aimed to allocate the aggregate emissions cap to …rms to maximise some socially bene…cial goal. The chapter concluded by numerically simulating possible permit allocations and found that, with three …rms, two equal permit allocations will maximise the secondary bene…t.
6.3 Policy Implications
In general, this thesis can give guidance to policymakers and regulators on optimal methods of allocation in a dynamic setting. This research has produced a number of important policy implications that concentrate on the use of criterion and ini-tial allocation mechanisms. Three clear policy implications have resulted from this research:
The use of updated grandfathering— the use of updated historical informa-tion of …rms’emissions and output levels— as an initial allocainforma-tion mechanism should, in general, be avoided.
Regulators should be concerned with lobbying activity in a tradeable permit market.
An array of optimal initial allocation mechanisms do exist.
It was shown in Chapters 2 and 3 that the use of updated grandfathering allows an intertemporal link to be created between the choice of emissions and the future
rent each …rm receives which introduces an incentive to increase emissions above the socially optimal level. To eliminate this intertemporal link and improve market e¢ -ciency, regulators should avoid the use of historically updated emissions information.
However, this may be politically problematic. Consider a tradeable permit market which has a number of compliance periods. It is inevitable that at some point, there will be new entrants and plant closures. Updated grandfathering is politically viable as it allows for these changes to occur whilst adjusting permit allocations.
For example, new entrants and …rms that close plants, will obtain and lose future permit allocations, respectively. Contrast this with a static grandfathering case.
Under a ‘pure’static grandfathering case, permit allocation is …xed throughout all compliance periods. Therefore, new entrants may never receive permit allocations and …rms that close plants (factories) continue to receive permit allocation till the completion of the permit market.1 It may be possible for regulators to implement updated grandfathering if additional allocation rules can be implemented to reduce the distortionary incentive to increase emissions.
Regulators must also be concerned with respect to …rms’lobbying. As Chapter 4 has shown, lobbying activity, in conjunction with …rms’choice of emissions, can alter market e¢ ciency. Also, lobbying activity can increase the aggregate emissions cap and as a result, reduce social welfare. Regulators must identify lobbying activity and implement rules and mechanisms to counter such actions. For instance, to maintain social welfare, regulators should consider policies that pre-commit the regulator to a speci…c level of aggregate emissions cap.
1Of course, as seen in the EU-ETS and the SO2 market, it is possible for the regulator to
‘reserve’a proportion of aggregate emissions for new entrants.
Finally, auctioning and grandfathering are the most common techniques to dis-tribute permits to …rms. However, Chapter 5, considers an alternative to both, namely, a rank-ordered contest. A rank order contest has similar e¢ ciency prop-erties to an auction but has the potential to be more politically viable and obtain a secondary policy objective. Optimal mechanism design is heavily dependent on the heterogeneous circumstances of area of regulation and thus it is important for regulators to understand and investigate an array of mechanisms to suit their re-quirements.