The current system for tradable carbon emission permits in Europe suffers from severe shortcomings. EU member states hand out these permits without charge using criteria that result in perverse behavioural effects. For instance, some member states distribute permits based on current production. This provides an incentive to expand production capacity in order to obtain additional, valuable emission rights. The additional capacity results in additional pollution, which must be reduced by other, less efficient measures. Furthermore, companies that invest in additional capacity for a coal-fired power plant receive valuable emission rights whereas companies investing in wind power do not. These rules induce too much investment in relatively dirty capacity. Finally, member states treat the distribution of permits as an instrument of industrial policy thereby distorting the internal market.
Auctioning the emission rights would eliminate these problems. Emissions reduction would take place where it is least costly while the internal market is not distorted. However, we ought to compensate firms that face severe international competition from countries that do not (yet) reduce greenhouse emissions. Without this compensation, production capacity would move to these pollution havens. This could well exacerbate climate change because production in those pollution havens typically yields more greenhouse emissions than EU production does.
To compensate specific industries, production subsidies should be used instead of giving emission rights to energy-intensive industries for free. Moreover, these production subsidies should be strongly targeted as well as uniform across member states of the European Union within each industry to create a level playing field in the internal market. European harmonisation would prevent member states from using the production subsidy to favour their own industries.
Limiting the production subsidy to a selective set of industries implies that auctioning emission rights would yield additional revenues for the public treasury. These resources could be used to reduce the overall tax burden, thereby expanding activity in all sectors of the economy rather than just in the polluting sectors. Accordingly, compared to giving the rights away for free on the basis of current production in polluting industries, auctioning carbon emission rights would produce a more efficient allocation of assets over polluting and non-polluting activities.
Auctioning harms profits in the polluting sectors. This fall in profits could be alleviated by grandfathering in some of the emission rights -- based not on current production but on historical data about emission levels, which cannot be influenced by the industries. Accordingly, profits could be protected without discouraging the desired shift towards less pollution-intensive production.