To establish a basic framework for our discussion, here are basic definitions for “allowance” and “allocation” within a cap-and-trade program:
In a cap-and-trade program an “allowance” is a permit to emit a certain amount of pollution; typically in a greenhouse gas (GHG) context this would be equal to one ton of carbon dioxide (CO2). The number of allowances issued within a cap-and-trade program equals the total permitted level of emissions and is referred to as the “cap.”
“Allocation” is how the government or program representative distributes the allowances. Each allowance has a value, which depends on the supply of allowances and the demand to emit pollution. In order to achieve emission reductions, the number of allowances issued is reduced over time. These allowances can be distributed by various methods including: auctioning, benchmarking, and grandfathering.