In recent years many countries have adopted or are considering incentive approaches to environmental regulation such as tradable permit schemes to control pollution. Although emissions trading programs are more cost effective in theory than traditional regulations, significant uncertainty exists regarding the actual implementation of these programs. In this paper we use laboratory experiments to study the design features of tradable permit programs, focusing on the transaction costs incurred by participants. In the absence of transaction costs, in a competitive market the initial distribution of permits affects equity but has no impact on the efficiency of final allocations. In the presence of transaction costs, however, even in a competitive market the initial distribution of permits can affect both efficiency and equity. We study treatments in which marginal transaction costs are zero, constant and declining. Traders transact through the continuous double auction institution. Preliminary results indicate that allocative efficiency is lower when the "misallocation" of the initial permit distribution is greater, but only when marginal transaction costs are positive and constant.

JEL Classification: C91, Q20, Q28

Key Words: Emission Trading, Transaction Costs, Experiments, Allocation Mechanisms

Co-author Timothy N. Cason