Tradable pollution permits in dynamic general equilibrium: Can optimality and acceptability be reconciled?

•How to decentralize optimal growth when tradable pollution permits are issued for free?•Permits must be given to all firms on the basis of their pollution intensity.•Optimal growth can be decentralized with free permits, provided an adequate accompanying fiscal policy.•Whether optimality and acceptability can be reconciled is then an empirical question.

In this paper we study the dynamic general equilibrium path of an economy and the associated optimal growth path in a two-sector overlapping generation model with a stock pollutant. A sector (power generation) is polluting, and the other (final good) is not. Pollution is regulated by tradable emission permits. The issue is to see whether the optimal growth path can be replicated in equilibrium with pollution permits, given that some permits must be issued free of charge for the sake of political acceptability. We first analyze the many adverse impacts of free allowances, and then we propose a policy rule that allows optimality and acceptability to be reconciled.