Why would the Obama administration allow new drilling in U.S. coastal areas, and what will it mean for greenhouse gas reductions? My colleague Frank Ackerman has a posting on the TripleCrisis blog today on off-shore drilling, peak oil, and how they relate to a carbon tax:

Solving our energy problems, without a change in direction, will lead to increasingly costly and environmentally destructive production – either deep offshore, or deep in the rocks below existing communities and watersheds. We need a tax (or a fee resulting from an allowance system) on energy, to keep the cost to consumers high enough to encourage conservation, while holding the price for producers low enough to discourage the pursuit of the worst fossil fuel deposits.

This is another way in which the distributional consequences of carbon permit giveaways (i.e., who gets the revenue – see Alejandro Reuss’ Public Goods posting from earlier this week) differ from those of permit auctions. A cap and trade system will increase the price of oil exploration only if businesses have to pay for their permits; if permits are given to the largest polluters for free, there will be no incentive to limit fossil fuel extraction from areas where underground reserves are not very rich and the environmental consequences of extraction are enormous.

Most economic analyses of “cap-and-trade” policies – under which the government sets a target amount of emissions and then issues tradable permits totaling that amount – take it for granted that it would not make any difference, in the reduction of emissions, if the government were to sell the permits or give them away. A 2008 report on cap-and-trade climate policies from the MIT Center for Energy and Environmental Policy Research puts it like this: “Economic theory suggests that the method of distributing emission allowances, i.e., through grandfathering or auctioning, will not affect an individual source’s output decisions or emissions.”

If firms always make optimal decisions, maximizing their profits, as mainstream “neoclassical” economists assume they do, this conclusion should be correct. It shouldn’t make any difference to a profit-maximizing firm whether, by reducing its emissions, it avoids the cost of buying emissions permits or reaps the benefit of selling permits. Either way, it will reduce emissions as long as the cost of doing so is less than the price of the permit.

But are real-life firms really the perfectly rational profit maximizers of the neoclassical economists’ imagination? Some insights from behavioral economics suggest they may not be, and therefore that they may react differently to a policy that makes them buy emissions permits compared to one that gives them permits for free.