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Efficiency versus equity in tradable emission permit systems

Economists advocate tradable emission quota as an ideal policy instrument to tackle environmental externalities because they would allow separating efficiency from equity considerations. An efficient allocation of abatement efforts is ensured by the operation of a competitive permit market; equity objectives can be pursued by the choice of a suitable initial distribution of emission quota. However, in reality there are often restrictions on the permissible set of initial allocations of emission quota because of political feasibility. We show in this paper that if such restrictions on the initial allocation of permits are binding, the dichotomy between efficiency and equity breaks down. The total number of permits is distorted away from the first-best allocation. The direction of the distortion depends on the correlation between willingness-to-pay for environmental improvement, net equilibrium permit trades and the marginal social valuation of consumption. In a stylized numerical simulation model of the Kyoto carbon emission permit market, we show that the welfare optimal total amount of emission permits is decreasing in the World planner’s inequality aversion.