The Political Economy of Free Allocations in Revenue Recycling: Six Position Papers on the Options for Recycling Carbon Pricing Revenue

Abstract

This report contributes to the Ecofiscal series on revenue-recycling instruments by discussing the free allocation of emissions permits. Free allocation has similarities to other forms of revenue recycling in that it confers a benefit upon its recipients, reducing their financial burden associated with climate policy. There are three main reasons for using free allocation: (1) it is a more precise mechanism to compensate those who are harmed the most from the introduction of carbon pricing; (2) it can help build political support by ameliorating competitiveness risks for vulnerable firms and building constituencies with a vested interest in seeing carbon markets maintained; and (3) free allocations are a useful tool for managing through a period of patchwork climate policy by mitigating emissions leakage—the shifting of polluting industry from jurisdictions with stringent climate regulations to those with lax or non-existent policies. The manner in which permits are allocated matters and we contrast two main methods: grandfathering and output-based allocations. While in the case of grandfathering, firms are incentivized to reduce emissions, which allows them to sell their allowances, it also creates a moral hazard, as firms might discount the value of free allowances or reduce production for the purpose of selling unused allowances, potentially exacerbating the problem of emissions leakage. Under an output-based allocation, firms are incentivized to reduce their emission intensity (i.e., produce more while emitting less), but the incentive to reduce emissions by simply curtailing their production is weakened. To realize the full economic advantages of free allocations, including limiting emissions leakage, it is important that they be allocated on an output basis that is updated regularly rather than grandfathered on the basis of historical emissions.