Paying for pollution: Permits and charges

Tradeable emission permits are becoming an increasingly important instrument for controlling emissions. For a variety of reasons, emission permits are often allocated gratis, conferring a windfall gain on the first generation of permit holders. This paper examines how a regulator may capture this rent. Four different methods of rent capture - profit, output and input charges and an emission permit rental charge - are compared with respect to their effects on efficiency and the relative burden placed on "cleaner" and "dirtier" firms. In addition to generating revenue for the regulator, certain charges coupled with emission permits may result in a better instrument than permits alone.