On the Scope for Output-Based Rebating in Climate Policy

The allocation of tradable emissions permits has important efficiency and distributional effects in the presence of preexisting distortions. Three such imperfections are noteworthy for the “downstream” implementation of a domestic emissions trading program for greenhouse gases: 1) distorting labor taxes in the economy, 2) emissions “leakage” due to the lack of comparable emissions pricing abroad, and 3) incomplete coverage of the trading program, which allows domestic leakage. Because regulations that raise the price of covered sector goods exacerbate these problems, a potential response is to combine the emissions price with a rebate to production, such as by output-based allocations (OBA) of emissions permits. We employ a multi-sector computable general equilibrium model based on the GTAP framework to compare different rules for allocating carbon allowances among the major emissions-intensive sectors within a trading program in the U.S. economy. We find that OBA for energy-intensive, trade-exposed sectors can dominate auctioning with revenue recycling, both from a domestic and a global welfare perspective. Granting similar rebates to the electricity sector tends to reduce welfare when those revenues would otherwise be recycled, but it can enhance welfare if the allowance values would otherwise be grandfathered.