For a market-based trading program to be effective, it must be perceived as being fair. Key to a fairness perception is the method used to assign emission allowances. In most previous programs, including the acid rain SO2 emissions-trading program, fairly simple principles served to guide the regulatory process. The general principle was to allocate emission allowances on the basis of historical generation (heat input at the plant). This grandfathering approach provides cost-free allowances to larger emitting sources that will be most affected by the program. That can result in giving larger allowances to those facilities that have not taken action to reduce—in effect penalizing those utilities that have taken earlier actions.
A second method is an allowance allocation program based on output. Fixed numbers of allowances are allocated on the basis of the percentage of electricity (or other product) generated by each source. Typically, the allocations are updated as the generation mix changes. Many stakeholders argue that this method encourages greater efficiency than the grandfathering method (EPA 1999g).
A third method is to hold an auction where all affected sources must go to purchase allowances to cover their emissions. An analysis of allocating CO2 allowances under the three methods found that the auction is the least costly to society (Burtraw et al. 2001b). A series of important general equilibrium studies over the last decade also focused on the virtues of an auction for allocating emission permits (Goulder et al. 1997, 1999). The social cost of an allowance auction is expected to be dramatically less than allocation at zero cost. The reason is that the regulatory program (regardless of how allowances are allocated) raises costs similar to a new tax and thereby serves to exacerbate distortions from preexisting taxes. However, an auction provides a source of revenue that can be used to reduce preexisting distortionary taxes. The main criticisms of auctions are that they increase the cost of a program from the viewpoint of companies, which have to pay for emission allowances, as they pay for other inputs to productive activity, such as fuel and labor.
The concept of placing an overall limit on total emissions was an important innovation in the cap-and-trade approach in environmental policy. A shortcoming of the approach as currently practiced is the absence of a mechanism for changing the cap in response to new scientific and economic information. During the 1990s, for example, the cost of controlling SO2 emissions from coal-fired power plants fell to less than half of the amount predicted at the time of the 1990 CAA Amendments (Ellerman et