Optimal growth with pollution: how to use pollution permits?

We study the optimal growth path and its decentralization in an overlapping generation model. In the presence of externalities, decentralization of an optimal path needs some specific taxes in addition to lump-sum transfers. The introduction of a market for permits neutralizes the external environmental effects. We show that there is a unique management of permits such that the equilibrium coincides with the optimal path: all permits should be auctioned, i.e. no permits should be given to firms. This conclusion is in contradiction with the usual practice of grandfathering.