In discussions over how best to implement mandatory restrictions on carbon, the most commonly discussed option is a cap-and-trade system. One critical economic question surrounding cap-and-trade is how to distribute the permits. The two main competing mechanisms are free allocations to polluters (usually based on past emissions levels, output levels, or carbon intensity) and the auction of permits.

In this paper, we explore the differential economic impact of the two approaches. Our results show that the consumer price effects across regions of auctioning and free allocation are quite different. These differences arise due to the nature of electricity regulation. If permits are auctioned, regulators are likely to allow utilities to pass forward to consumers the electricity price increase due to the cost of permits. However, if permits are freely allocated, this forward shifting may not be allowed to take place.

These results suggest that giving the permits away in a world where state regulators don't allow utilities to pass forward the "cost" of free permits simply punishes consumers in those regions of the country that have moved to deregulation.

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Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI. Aparna Mathur is a research fellow at AEI. Gilbert E. Metcalf is a professor of economics at Tufts University and a research associate at the National Bureau of Economic Research.