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Auction or Allocate

The great debate over emissions allowance distribution.

Fortnightly Magazine - February 2009

decisions about allocations and other program details proved to be instrumental in getting the program off the ground without major delays.

Several years later, EPA had the opportunity to revisit the allocations process and examine alternatives under the NO x SIP call, a regulatory program in which states were required to revise their state air quality implementation plans (SIPs) to reduce summer time regional NO x emissions. To cost effectively achieve the emissions reductions required under the SIP call, EPA developed a model cap-and-trade program (NBP) to implement jointly with participating states in the eastern United States. States participating in the NBP were responsible for allocating allowances to their sources within certain parameters established by EPA, including the requirement that allowances be allocated at least three years in advance of their first-use date. EPA provided an optional allocation methodology that distributed allowances based on recent actual heat input data, and included a small new source set-aside. While each state adopted its own methodology, most opted for heat input-based allocations, while three states chose electricity output-based. Several states also included some small degree of auctioning.

EPA’s latest experience in allocating allowances came during the development of CAIR, which sought to further reduce SO 2 and NOx. EPA continued Congress’s distribution approach for SO 2 allowances under Title IV of 1990 amendments of the Clean Air Act. However, NO x allowance allocations were again the purview of the states within general parameters set forth in the regulation.

As different as these three experiences with allocations appear in some respects, the processes similarly were contentious with no clear right answer emerging for all of the stakeholders.

Distribution Schemes

Looking forward, while the shift in focus to a possible nationwide GHG-trading program substantially amplifies the total value of allowances, many aspects of the program remain similar for the electric power sector. EPA’s extensive experience with this sector offers insights that can inform the allowance distribution discussion. As in the past, various methods are available to distribute allowances: free allocations, auctions, or a combination of the two. Distributional issues remain a key consideration, particularly since GHG reductions will depend primarily on the generation mix, which varies substantially by company and geographic region (and likely will change over time).

It is important to keep in mind, particularly with the electric power sector, that the allowance market does not function in a vacuum. The status of price regulation in electricity markets plays a significant role in the treatment of allowances by firms. In traditionally price-regulated markets, history suggests that most generators have to pass on costs and savings from allowance transactions to their customers, so allowances that are freely given help to lower customer prices and don’t directly benefit the companies. However, generators in restructured markets bid their full marginal costs, including the opportunity costs of allowances, regardless of how they were obtained, into dispatch bids. The market price for all successful bidders is the marginal cost of producing the last kilowatt hour, including the opportunity cost of allowances. Thus, in each load segment, consumers in restructured states face