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Auction or Allocate

The great debate over emissions allowance distribution.

Fortnightly Magazine - February 2009

There may be no more sure way to increase interest in a cap-and-trade policy discussion than to broach the subject of distributing allowances. Frequently it’s one of the first issues stakeholders want to talk about, and one of the last resolved. The value of allowances makes distributing them one of the most challenging aspects of setting up a trading program, despite the fact that other program design features carry far more weight in determining the program’s ultimate success. In fact, the allowance distribution methodology has very little indeed to do with achieving the environmental and human health goals of cap-and-trade programs. However, given the level of importance understandably ascribed to allowance distribution, stakeholders should consider carefully the choices and the implications of alternatives, particularly in the context of a potential nationwide greenhouse gas (GHG) policy.

Cap-and-Trade Fundamentals

A cap-and-trade program first sets a cap, or maximum limit, on emissions that is below the business-as-usual level. Emission allowances, or authorizations to emit (usually 1 ton or 1 metric ton), are created by the government, with the total amount limited by the cap. Allowances function as the program currency, holding real value because of their scarcity and ensuring total emissions remain within the cap. Each regulated source can design its own compliance strategy to meet the overall reduction requirement, including sale or purchase of allowances, installation of pollution controls, fuel switching, or implementation of efficiency measures. Sources also completely and accurately measure and report all emissions. In order to comply, each emissions source must surrender allowances equal to its actual emissions to guarantee that the overall cap is achieved. 1

There are two principal methods by which the allowances created under a cap-and-trade program can be distributed: They can be auctioned off, or they can be assigned free of charge to select entities (also known as “grandfathering” when given to those with compliance obligations). Of course, a hybrid of the two systems is another option. If allowances are auctioned, the government must decide how to design the auction and what to do with the proceeds; if allocated freely, the government must decide how to identify which sectors and entities should receive them, and how many each should receive.

Decisions relating to auction and allocation methodologies can be highly contentious, since they involve the distribution of valuable commodities and may affect some stakeholders differently than others. Governments often focus on the social cost of direct compliance, such as equipment installations and fuel switching. However, discussion of allowance-distribution methodologies also should consider the impacts related to compliance investments. Distribution methodologies that hinder the pass-through of allowance value ( e.g., free allocation in cost-of-service states) or otherwise subsidize production ( e.g., updating) may impact the program’s total cost by shifting the compliance response away from those able to achieve reductions at the lowest cost. Regardless,