Auctions or Grandfathering: The Political Economy of Tradable Emission Permits

Abstract

Despite the prevalence of grandfathered permits, we still observe that a hybrid policy, in which a fraction of initial emission permits is distributed through auctions, is adopted in some cases. We also observe that some polluting industries support auctioned permits, and that most environmental groups support grandfathered permits. This paper attempts to explain these phenomena from the perspective of political economy, and investigates the conditions under which grandfathering, auctions, or a hybrid instrument will be the equilibrium policy. By constructing a two-stage lobbying game, in which the type of policy instrument (auction, grandfathering, or a hybrid instrument) is determined in the first stage, and then the number of permits is decided in the second stage, we highlight the strategic interaction of the lobbying activities between the two stages in explaining the behavior of the lobbying groups.