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Allocation of CO2 Emissions Allowances in the Regional Greenhouse Gas Cap-and-Trade Program

Dallas Burtraw, Karen L. Palmer, and Daniel B. Kahn

One key issue, in designing a cap-and-trade system to cut pollution, is deciding how to allocate of the emissions permits to be traded. Researchers at RFF have been studying the allocation options for the Regional Greenhouse Gas Initiative, an alliance of nine northeastern states to cut power generating plants' emissions of carbon dioxide.

If successful, "the program could serve as a model for a national cap-and-trade program" to reduce greenhouse emissions, the researchers, Dallas Burtraw, Karen Palmer and Danny Kahn, wrote in "Allocation of CO2 Emissions Allowances in the Regional Greenhouse Gas Cap-and-Trade Program."

The nine states are the six in New England plus New York, New Jersey and Delaware. Carbon dioxide emitted to produce electricity is projected to rise 20 per cent in those states by 2025, in the absence of restrictions. RGGI's goal is, instead, to prevent emissions from growing and ultimately reduce them.

To accomplish that, RGGI would set a ceiling each year for carbon dioxide emissions and allocate to power plants a number of emissions allowances equal to that ceiling. To hold down the cost of compliance, plants would be permitted to trade these allowances among themselves.

Plants that could stay below their permitted emissions at low cost, and had allowances to spare, could sell them to plants that found it more costly to cut their emissions or save allowances for future use, a practice known as allowance banking. Two similar cap-and-trade programs are already in operation in this country to control sulfur dioxide and nitrogen oxides.
                     

Link to Discussion Paper
Allocation of CO2 Emissions Allowances in the Regional Greenhouse Gas Cap-and-Trade Program
Discussion Paper 05-25
June 2005

Trading gives the allowances a cash value, and the method of allocating them affects a broad range of economic consequences.

There are basically three ways to allocate the allowances. The most common is grandfathering --- giving the allowances to CO2 emitting plants free of charge, in proportion to the electricity they generated or their emissions in some year in the past. Another possibility is to update the distribution formula over time, distributing the allowances free but in proportions that change over time with plants' share of total electricity output in a recent year or group of years. The third option is to auction the allowances off to the highest bidder, and an important issue becomes what to do with the revenue.

The updated distribution formula tends to be the most popular choice among electricity consumers because it results in lower electricity prices than the other two. But it also has the highest cost to society, the RFF researchers said, because it does not provide the same incentives, through higher prices, to consumers to use energy more efficiently.

Link to Web Feature
Regional Greenhouse Gas Initiative: Prelude to a National Program?
Web Feature by
Joseph Kruger and
William A. Pizer

Auctioning and grandfathering are the most efficient methods of distribution, they found. However, an important difference between the two is that grandfathering leads to a large allocation of wealth in the form of free allowances to the electricity industry, whereas an auction under which electricity providers must pay for the allowances they use yields revenue for government or some other trustee. Advocates of the latter approach suggest that revenue from an allowance auction could be used for a variety of purposes including providing incentives for cleaner technology and energy conservation or to compensate consumers who bear much of the cost of greenhouse gas policy.

In any case, the value of the allowances would be at least four times the cost to society of reducing emissions, they observed, "suggesting that the allowance distribution is a potentially important source of compensation."

Link to Presentation
Allocation of CO2 Emission Allowances in RGGI
(An Overview Presentation)

Presented by Dallas Burtraw to a RGGI Stakeholder Meeting on April 6, 2005

"We suggest that greater emphasis could be placed on compensation in the short run and on efficiency in the long run," the researchers concluded. "In the long run, on the national stage, a carbon dioxide cap-and-trade policy could impose significant costs on the economy. Hence, we suggest that efficiency should be a central consideration in the long-run policy design."

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