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.