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Abstract
The use of cap-and-trade to regulate air pollution promises to achieve environmental
goals at lower cost than traditional prescriptive approaches. Cap-and-trade has been
applied to various air pollutants including sulphur dioxide, nitrogen oxides and volatile
organic compounds in the United States and carbon dioxide (CO
2
) in the European
Union. This corresponds to what is likely to become the most expensive environmental
undertaking in history – the effort to reduce the heating of the planet. However, the
efficacy of a cap-and-trade policy for CO
2
depends in large part on the design of the
program. In addition to the level of the cap, the most important decision facing
policymakers will be the initial allocation of emissions allowances. The method used
to allocate tradable emissions allowances will have significant influence on the distributional
impact and efficiency of the program.