Cap-and-Trade Climate Policy, Free Allowances, and Price-Regulated Firms

Abstract

Firms subject to cost-of-service regulation cannot withhold windfall profits associated with free emissions allowances. This paper examines the efficiency and distributional impacts of two approaches to transfer free allowances to consumers: output subsidies and lump-sum payments. We employ an empirically calibrated model of the U.S. economy that features regulated monopolies in the electricity sector and many heterogeneous households. Under a carbon dioxide cap-and-trade policy, we find that using free allowances to subsidize regulated electricity prices increases aggregate welfare costs by 40-80 percent relative to lump-sum transfers. These inefficiencies are disproportionately borne by households in the tails of the income distribution.

Keywords: Climate policy, Cap-and-trade, Allowance allocation, Cost-of-service regulation, Electricity generation

JEL Classification: C61, C68, D58, Q43, Q54