Compensation rules for climate policy in the electricity sector

Most previous cap and trade programs have distributed emission allowances for free to incumbent producers. However, in the electricity sector the value of CO2 allowances may be far in excess of costs to industry and giving them away to firms diverts allowance value from other purposes. Using a detailed simulation model, this paper shows that compensation to firms losing asset value under a climate cap and trade policy can be achieved for a small fraction of total allowance value, if targeted carefully. However, the economic efficiency cost of providing incremental compensation to reach the fully compensated level is many multiples of that incremental compensation. These considerations might move policymakers away from free allocation of CO2 emission allowances in the electricity sector. (C) 2008 by the Association for Public Policy Analysis and Management.