The Optimal Distribution of Pollution Rights in the Presence of Political Distortions

Abstract

A critical issue in designing a system of tradable emission permits concerns the distribution of the initial pollution rights. The purpose of this paper is to investigate how the initial rights should be optimally set, when the determination of the number of tradable permits is subject to the influence of interest groups. According to the Coase theorem, in the case where there are low transaction costs, the assignment of the initial rights does not affect the efficiency of the final resource allocation. In the presence of political pressure, we show that the distribution of the initial rights has a significant effect on social welfare. In contrast to the conventional results, we find that grandfathered permits may be more efficient than auctioned permits, even after taking into consideration the revenue-recycling effect.