Initial allocation The major challenge for the regulator when creating a Cap-and-Trade program lies in the initial allocation of tradable permits. We detail below the two main allocation methodologies (Chevallier et al., 2009). Grandfathering consists in distributing permits for free to market agents, based on their previous pollution level. This allocation methodology is often preferred, because of the lobbying activities of market agents to the regulator. Actually, before the creation of the Cap-and-Trade program, pollution was free in the sense that the pollutant was not limited quantitatively. With the introduction of the environmental market, agents will necessarily need to respect the cap set by the regulator. Hence, pollution is not free anymore, and agents will need to limit their future pollution levels, which makes them even more reluctant to pay for each unit of pollution assigned to them. Auctioning is the alternative allocation methodology, whereby market agents need to pay for each permit assigned to them in the first place. The price of the permit purchased is determined by an auction mechanism, which is explained in advance to all market participants. The benefits of auctioning are twofold: 1. Agents are revealing their private information on how much they are willing to pay for one permit (i.e. what is the intrinsic value attached to one unit of pollution). 2. The regulator is getting some revenues from the auction, which it is then possible to recycle in the economy. For instance, the regulator may compensate financially some agents for the detrimental consequences of pollution (also known as double dividend). Most of the time, grandfathering is chosen during the creation of the Cap-and-Trade program. Then, progressively, the regulator is able to switch the allocation methodology to auctioning, as the main principle behind emissions trading becomes accepted among market agents.
Conclusion A Cap-and-Trade program is an innovative environmental regulation mechanism which resorts to the market to limit quantitatively a given pollution. This chapter demonstrates the central role played by the regulator to ensure that the cap-and-trade program will be successful. Among others, the regulator needs to be very cautious when designing the various provisions regarding geographical limits, temporal limits, and the initial allocation methodology. The most recent applications of cap-and-trade programs in121