Corbett Grainger, University of Wisconsin

Natural resources such as carbon, water, forests, and fish are increasingly managed with environmental markets. The first step in implementing such a market is the initial allocation of property rights; these rights are often “grandfathered” based on historical use. We ask how grandfathering, or any other allocation rule, impacts extraction incentives, resource stocks, and welfare before the market goes into place. We show theoretically that if currently-unregulated firms anticipate a future market where rights will be grandfathered, this distorts incentives and induces a race for

allocation before the market goes into effect. This behavioral response to the anticipation of grandfathering exacerbates externalities and reduces welfare, even below the unregulated equilibrium. We derive an alternative allocation rule called “Reverse- Grandfathering” that rewards prudence from the past; this significantly improves on unregulated outcomes and, under certain conditions, can replicate first-best, marketlike firm behavior before the market is implemented. Like traditional grandfathering, Reverse-Grandfathering…