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Auction or Allocate

The great debate over emissions allowance distribution.

Fortnightly Magazine - February 2009

in cap-and-trade programs where initial reductions are far less than the remaining emissions ( e.g., many climate proposals) the overall cost of actual mitigation measures initially is smaller than the face value of allowances. 2

Importantly, how the allowances are given out doesn’t substantially impact a program’s results in human health and environmental protection; the emissions cap and banking provisions are the key program elements determining emissions levels over time.

Conventional Pollutants

The Environmental Protection Agency (EPA) has garnered a great deal of experience in allocating allowances for sulfur dioxide (SO 2) and nitrogen oxide (NO x) emissions from the electric power sector, beginning with the acid rain program (ARP) and continuing through subsequent rulemakings on the NO x budget trading program (NBP) and the Clean Air Interstate Rule (CAIR).

Allowance distribution under the ARP was tackled by Congress in conjunction with the Clean Air Act Amendments (CAA) of 1990. These amendments created the ARP under a new CAA Title IV, producing a bold concept in reducing air emissions: the cap-and-trade program. Nearly 20 years later, cap and trade widely is recognized as an effective, efficient tool to reduce emissions significantly, but in 1990, it was a national experiment. The concept of emission allowances as a tradable commodity was new and the first exercise in allocation of these allowances was intense and political.

One important point to note at the outset is that allocation issues in Title IV were addressed after the cap was set. Further, the cap was held inviolable so distribution was a zero-sum game. That the allowances would be distributed at no cost to affected sources never was questioned seriously because it was vital to have the electric power industry on board with the new concept and desirable to achieve least-cost reductions. Also, due to the regulatory environment at the time of the legislation, the power sector faced a rate structure uniformly characterized as cost of service (unlike today’s environment, which is a hybrid of both restructured and traditionally regulated states) and savings were passed through to consumers. As a result, giving allowances away in 1990 meant smaller increases in energy bills, not creating potential windfall profits. The question facing Congress was more a matter of how to distribute the allowances most fairly.

After much debate, legislators agreed to allocate SO 2 allowances on a permanent basis, primarily based on historic fossil-fuel utilization. Each source’s share of total allowances under the cap generally was determined by the product of an SO 2 performance standard and average heat input. Ultimately, though, there were over 20 formulas used to account for a variety of different situations and political compromises, making it critical that specific allocations were spelled out in the legislation to provide much-needed certainty. Title IV also provided several set-asides of allowances under the cap to reward specific behavior. New sources did not receive any allocations in the statute, but annual government auctions of approximately three percent of the total allowance pool ensured at least one source of allowances outside the secondary market. That Congress made key