Cap-and-Trade Climate Policies with Price-Regulated Firms: How Costly Are Free Allowances?

We examine the impacts of alternative cap-and-trade allowance allocation designs in a model of the US economy where price-regulated electric utilities generate 30 percent of total CO2 emissions. Our empirical model embeds a generator-level description of electricity production—comprising all 16,891 electricity generators in the contiguous US—in a multiregion multi-sector general equilibrium framework that features regulated monopolies and imperfectly competitive wholesale electricity markets. The model recognizes the considerable heterogeneity among households incorporating all 15,588 households from the Consumer and Expenditure Survey as individual agents in the model. Depending on the stringency of the policy, we find that distributing emission permits freely to regulated utilities increases the welfare cost of the policy by 40-80 percent relative to an auction if electricity rates do not reflect the opportunity costs of permits. Despite an implicit subsidy to electricity prices, efficiency costs are disproportionately borne by households in the lowest income deciles.