From an awesomely meaty article on cap and trade from the San Francisco Chronicle, comes this pearl of wisdom (in bold at the bottom of the quote):

The thorniest issue for regulators in California and elsewhere is whether to give away credits to emit carbon dioxide or to sell them. Some European power producers reaped windfall profits when allowances were given away. Several Northeast states are now moving toward auctioning all the allowances. California officials are considering a mix of auction and allocation – and even carbon taxes or fees – and may use different approaches for different groups of emitters.

[Resources for the Future economist Dallas] Burtraw, who serves on a committee that’s advising California regulators, said the lesson of the acid rain program is to keep the plan simple and easy for all parties to understand.

“If it starts to employ a lot of special provisions to take care of every party’s special needs … and if it starts to look like the Chicago phone book, then throw it out,” he said. “A poorly designed market is worse than no market at all.

I’m not sure I’d go quite that far—a carbon market’s a pretty important thing, and I’d be willing to live with a less-than-perfect system if it’s the only one that’s politically feasible.

That said—Amen to the virtues of simplicity! In my view, politicians designing a cap and trade program should be extremely wary of special-interest loopholes, or a system that caters to any particular category of fossil fuel users. Over the long term, the political drawbacks of a clunky, unworkable program will far exceed any short-term benefits from handing out goodies to favored constituencies.

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  • Take, for example, the idea of “grandfathering” the right to pollute—a process that would hand out future emissions rights based on past pollution levels.

    As we’ve noted before, grandfathering raises all sorts of equity and fairness issues. But grandfathering is also terrifyingly complicated—which, in my view, is reason enough all by itself to avoid it.

    To make grandfathering work in an economy-wide cap, the government will have to require firms to provide evidence of their past emissions—which would be a data-intensive morass for lots of companies. Plus, there will have to be some sort of system to give extra credit to firms that took steps years ago to reduce their emission, so that they won’t be penalized compared with their more slow-moving competitors.

    On top of that, there will have to be some sort of process to reduce the pollution allotments to companies that aren’t doing so well for other reasons. A company with a failing business model & plummeting sales may see its emissions fall, but only because it’s losing business to competitors. There’s simply no reason to grant emissions rights to a failing business—so calculations of profitability, productivity and output may need to enter into any grandfathering system.

    And remember, the stakes involved are huge!!! Once we create a carbon market, emissions rights will be worth money—so pollution allotments could make or break a company’s bottom line. And to raise the stakes even higher: since the supply of emissions allowances will be fixed, any credits that a firm doesn’t get for itself could, in theory, go to their competitors. A company that fails to fight for its fair share will let its competitors gain an edge. (Time to lawyer up, CEOs!)

    So to me, “grandfathering” is synonymous with “endless lawsuits.” And it won’t serve anyone’s interests to create a emissions framework that virtually guarantees decades of legal wrangling over minutiae.

    More generally, any cap-and-trade system that directly regulates lots of small- to mid-sized businesses is going to create all sorts of administrative hassles; yet a system that exempts emissions from such businesses just won’t be effective at reaching emissions targets.

    Simplicity is one of the key reasons we’ve been supportive of upstream regulation, with full auctioning of emissions permits. An upstream auction would reduce administrative hassles for downstream businesses, limit loopholes, reduce complexity—and almost certainly prevent lots and lots of litigation.