ABSTRACT
Emission trading is now well established as a method for regulating emissions of uniformly mixed pollutants. The classic analysis assumes that the regulatory authority sets an aggregate cap on emissions from a set of sources and then divides the cap into a number of tradable permits (frequently called allowances), each of which authorizes the discharge of a unit quantity of emissions. Although the allowances could be sold at auction to raise revenue, the most frequently discussed plans assume that the permits will be distributed to the regulated firms on some ad hoc basis. Firms then trade the allowances, establishing a market price. In equilibrium, individual firms choose emissions such that the marginal cost of abating pollution equals the allowance price, thereby minimizing the cost of maintaining the mandated level of emissions. They redeem allowances equal to the emissions discharged, selling or banking the remainder. If emissions exceed the initial distribution of allowances the firm must purchase allowances to cover the excess. Such plans are generally known as cap-and-trade plans. A good example is the US EPA’s sulfur dioxide auction.
