Christopher Costello and Corbett Grainger

Externalities are increasingly regulated with environmental markets where pollution or extraction rights are traded across firms. Implementing an environmental market requires an initial allocation of rights — these are almost always grandfathered to existing firms in proportion to historical output. We ask how grandfathering alters production incentives, welfare, and environmental outcomes before the market goes into place. We show that if firms anticipate a future market where rights will be grandfathered, this creates a strong incentive to overproduce before the market goes into effect; this lowers both welfare and environmental quality to points that are potentially much worse than even the completely unregulated equilibrium. We then show that this same incentive can be reversed. We derive an alternative allocation rule, called “reverse-grandfathering” that rewards prudence from the past; this can improve on unregulated outcomes, but raises its own challenges around entry and participation. We apply this theory to a structural model of a hypothetical, but plausible, property rights system regulating fishing activity of the universe of 4,039 individually-tracked industrial fishing vessels on the high seas. We estimate that compared to an unregulated setting, the expectation of future grandfathering lowers welfare by 50% and fish stocks by 45%, but that by implementing our proposed allocation rule, these results reverse so welfare increases by 15% and stocks increase by 18% relative to the unregulated state.