Abstract

The establishment of a tradable permit market requires the regulator to select a level of aggregate emissions and then distribute the associated permits to specific groups. Both these decisions create opportunities for rent seeking. In this paper, we use a contest model to analyse the incentives to rent seek for pollution permits and to analyse the consequences for social welfare. We find differences in firms' rent-seeking choices compared to a conventional rent-seeking contest. We see that a fundamental aspect of firms' incentives to rent seek depends on the market value of the permits, that is, the value of the ex post reallocated rents. This impact depends on the responsiveness of the regulator to aggregate rent-seeking effort. The responsiveness, in some cases, may improve welfare by reducing the per-unit value of permits, which may lower the rent-seeking effort more than it increases the damages experienced from the additional emissions.