In the comments, Mike asks
How does this square with something like Coase’s Invariance Theorem? It will matter short run, for the principles themselves short-term profit, how they get their permits. But once given, the market should move them around to the optimal allocation, no? How much work does market power and rent-seeking have to do to overhaul this?
Simply put the invariance version of “Coase’s” theorem is not correct. The same outcome will not prevail regardless of distribution. The general objection is that the distribution of permits affects wealth, but it also affects market power.
I put Coase’s in quotation marks because there are some suggestions that Coase himself did not approve of the common statement of his proposition. His original piece begins with a description of a world of perfect competition and zero transactions costs. He then adds transactions cost. To my recollection he makes no mention of the role of market power.
The long run raises some interesting implications. In the first case, one firm having monopoly power in the permit market and raising the price, you have an increased incentive for other firms to invest in pollution reduction technology. So, in the long run higher prices lead to less demand for permits. There still must be some efficiency loss but it will be reduced. Optimally, the holder of the permits would use the calculus of variations to figure the time path of permit sales. In practice, I am guessing they would try to assess the investment strategy of other firms and adjust their permits sales accordingly.
The monopoly power case, however, is mostly academic. I don’t see it as a real danger. What is a danger is creating a special interest lobby invested in keeping the value of permits high and its allocation of permits free.
In this case the problem is more difficult. It is the long run interest of the firm receiving free permits to prevent innovations from coming to market. How well they can do this, and trying to model their lobbying power is complex. My sense is that based on current agricultural and resource lobbying efforts, the firms will have some degree of success.
It should be noted that the stakes are probably high. As the number of permits decreases and as GDP rises the price of permits will rise quickly. There are huge incentives for firms to try to maintain those rights. There is also an intuitive political argument. Failing to give away these permits will impose huge costs of these firms. The idea that the government is going to drive a company out of business always drums up lots of political opposition.