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Auction or Allocate

The great debate over emissions allowance distribution.

Fortnightly Magazine - February 2009

market participants by awarding allowances for, or subsidizing, the actions that the program is intended to reduce ( e.g., emissions, fuel use, or production, depending on the allocation basis). The ensuing over-production may result in a lower electricity price and higher allowance price. Updating also can be resource-intensive, requiring substantial data collection and review by the government.

Allowance Auctions

Under an auction, anyone who meets a predetermined set of criteria can purchase an allowance. Auctions are attractive because they present a number of advantages, including their relative simplicity and transparency, the immediate setting of a price signal, the internalization of costs by emitting sources, and the provision of equal access for all market participants. Auctioning also removes any need to choose an allocation method, create special provisions for prior emissions reductions activities or other desirable behavior, or to account for the commissioning or retiring of regulated facilities. However, auctioning raises compliance costs for emitters, the same group that will bear a large share of the cost burden to meet the program cap. In addition, policymakers must decide how to use auction proceeds. Some economists argue that using these revenues to cut other distortionary taxes ( e.g., income, investment) leads to the most efficient and least costly possible outcome from a cap-and-trade system (note this does not mean the cost of the program is reduced, but that the way costs are distributed can be used to reduce costs elsewhere in the economy). This notion that by raising revenue from emission allowances, the economy will benefit from a reduction in distortionary taxes and the environment will benefit from the introduction of a price signal that discourages pollution, commonly is referred to as the “double dividend.” On the other hand, various interests will be competing for a share of the revenues regardless of efficiency or ability to correct distortions. Revenue use can be progressive or regressive depending on how it is implemented.

Auction designs can vary widely, and selecting the auction format is one of the most critical decisions affecting the auction results. With the use of available technology and improved information systems, there is a great deal of flexibility in how auctions are conducted, and few geographical or physical limitations on participants. Prices can go up or down, bidding can occur all at once or over multiple rounds, bidders may or may not be able to see their competitors’ bids, and winning bidders all can end up paying the same price or the price at which they bid. There also can be a combination of grandfathered allowances and auctioned allowances and the mix can change over time.

There can be many different objectives favoring different auction designs, and priorities may include any of the following: simplicity and cost minimization, transparency, efficiency, price discovery, limitation of market volatility, adequate liquidity in the secondary market, and raising revenue. Appropriate design occasionally will require a tradeoff between competing goals: greater transparency, for example, can increase opportunities for collusion. 5 In the United States, we have had less experience with auctioning allowances than with allocating them,