• Random access (lotteries)

  • First come, first served

  • Administrative rules based on eligibility criteria

  • Auctions

All four of these have been used in one context or another. Both lotteries and auctions frequently are used in allocating hunting permits for big game. Lotteries are more common in allocating permits among residents while auctions are more common for allocating permits to nonresidents. First come, first served historically was common for water when it was less scarce. The most common method, however, for the applications discussed here is allocating access rights based on historic use.

Two justifications for this approach typically are offered.29 First, it enhances the likelihood of adoption.30 Not only does allocating entitlements to historic users cause the least disruption from historic patterns, but it involves a much smaller financial burden on users than an auction31 (Lyon, 1982; Tietenberg, 1985; Hausker, 1990; Grafton and Devlin, 1996). Second, it allocates permits to those who have made investments in resource extraction. In this sense it serves to recognize and to protect those investments.32

In the absence of either a politically popular way to use the revenue or assurances that competitors will face similar financial burdens, distributing the permits free of charge to existing sources could substantially reduce this political opposition. Though an infinite number of possible distribution rules exist, “grandfathered” rules tend to predominate. Grandfathering refers to an approach that bases the initial allocation on historic use. Under grandfathering, existing sources only have to purchase any additional permits they may need over and above the initial allocation (as opposed to purchasing all permits in an auction market).

Although politically the easiest path to sell to those subject to regulation, grandfathering has its disadvantages. The presence of preexisting distortions in the tax system implies that recycling the revenue can enhance the cost-effectiveness of the system by a large amount. This implies that from an efficiency or cost-effectiveness perspective, auctioned permits would be preferred to “grandfathered” permits (Goulder et al., 1999).

A second consideration involves the treatment of new firms. Although reserving some permits for new firms is possible, this option is rarely exercised in practice. As a result, under the free distribution scheme new firms typically have to purchase all permits, while existing firms get an initial allocation free. Thus the free distribution system imposes a bias against new users in the sense that their financial burden is greater than that of an otherwise identical existing user. In air pollution control, this “new user” bias has retarded the introduction of new facilities and new technologies by reducing the cost advantage of building new facilities that embody the latest innovations (Maloney and Brady, 1988; Nelson et al., 1993).33



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