April 7, 2008
Series Editor: Ian Parry
Managing Editor: Felicia Day
Assistant Editors: John Anderson and Adrienne Foerster
Welcome to the RFF Weekly Policy Commentary, which is meant to provide an easy way to learn about important policy issues related to environmental, natural resource, energy, urban, and public health problems.
Policymakers are increasingly interested in auctioning the emissions allowances in cap-and-trade systems, rather than giving them all away for free. This makes economic sense if the revenues are used productively (for example, to lower other taxes that distort the economy); it also avoids the prospect of large windfall gains for firms receiving (for free) allowances with substantial market value. But how should allowance auctions actually be implemented in practice? This issue is discussed in this week's insightful commentary by RFF Senior Fellow Karen Palmer.
Next week's commentary, by George Tolley and Sabina Shaikh, will discuss how environmental considerations are playing an increasingly important role in building design.
How Should Emissions Allowance Auctions Be Designed?
As more and more governments, both here and abroad, start to implement cap-and-trade programs to reduce emissions of carbon dioxide (CO2), interest in emissions allowance auctions is growing. Several of the states involved in the Regional Greenhouse Gas Initiative (RGGI) plan to auction 100 percent of their allowances when the program takes effect in 2009. And the European Commission is now proposing that 100 percent of the CO2 allowances allocated to electricity generators be sold in an auction, starting in 2013, with a phase-in to 100 percent auctioning for other sectors by 2020. Auctioning is also a central component in the national cap-and-trade proposals currently before the U.S. Congress. The Lieberman-Warner Bill (S. 2191), the current leading contender, includes a provision to auction just over 25 percent of the allowances initially, ultimately growing to nearly 70 percent. Several other federal bills envision a similar increasing reliance on auctions over time.
Policymakers are seeking an approach that will achieve a number of policy objectives, including a competitive market with no collusion and good price discovery, an efficient allocation of emissions allowances, minimal interference with operation of the secondary allowance market, minimal price volatility, and low administrative and transaction costs. Maximizing revenue - a common goal in most government auctions of public assets, like drilling rights for oil - is not a priority here.
Given these diverse needs, what's the best approach to designing an auction? Research, including economic experiments conducted to guide the design of the RGGI allowance auction, suggests that the most effective design is a sealed-bid, uniform price auction where all winning bidders pay the first rejected bid. This way, auction participants who place a high value on allowances can feel free to bid their true value, knowing that they will only have to pay the highest rejected bid (the market-clearing price) for the allowances that they win. Uniform price auctions do a better job at tracking changes in market conditions and revealing the true market price. Simplicity also suggests that a one-round auction is preferable to a more complicated multi-round approach that is both time consuming and more susceptible to collusion.
However, this approach could yield inconsistent prices. If allowances from more than one year are auctioned at the same time, the price of the later vintage (for example, 2010) could potentially exceed the price of the earlier one (2009). (The vintage of an allowance defines the first year or time period when it can be used for compliance with the emissions cap.) One possible solution is a combined vintage auction, based on the idea that allowances are bankable and that a bid for a later vintage should be treated as a request to purchase either that vintage or an earlier one, whichever is less expensive.
Allowance auctions should be held frequently enough to maintain liquidity in the allowance market, but not so often as to raise administrative and transaction costs unnecessarily. Having large infrequent auctions could pose a financial challenge to firms that need to acquire large quantities of allowances at each auction and consequently must put up substantial amounts of capital to participate. Such auctions also could disrupt secondary market trading because large quantities of allowances would be introduced at the time of the auction.
Palmer received her Ph.D. in economics from Boston College in 1990. She specializes in the economics of environmental regulation and of public utility regulation. Palmer's research interests include electricity restructuring, environmental regulation of the electricity sector, and the cost effectiveness of energy efficiency programs.
Well-designed auctions should include a minimum, or reserve, price below which no allowances would be sold (reserve prices are common in auctions like those on eBay). This feature helps to limit the gains to bidders from collusion and could be used to prevent allowances from being sold for less than the minimum value that regulators or society places on a ton of CO2 emissions. Reserve prices must be backed up by a commitment not to sell allowances for less and a rule about whether and how unsold allowances could be reintroduced into the market. Reserve prices could be set at some absolute level that would presumably grow over time as CO2 caps grow tighter or, after a secondary market has developed, at some fraction of a well-established index of recent prices in the secondary market.
Auctions should be open to all qualified participants, namely any entity that can provide assurance of the financial resources to follow through on its bid to purchase allowances. Restricting participation will limit competition in the auction and could help facilitate collusive behavior, driving a wedge between prices in the auction and the true market price of allowances.
Contrary to the open auction principle, some have tried to argue that restricting participation in allowance auctions to entities that are required to comply with the cap-and-trade regulation will have several beneficial effects. For example, advocates of this line of thinking suggest that restricting participation would prevent a large bidder with no CO2 emissions from hoarding allowances in the auction. Limiting auction participation is also seen as a way to prevent outside entities from purchasing allowances for use as CO2 emissions offsets in other voluntary or regulatory programs.
However, this line of argument is not sufficient. Restricting access to the auction will not by itself limit access to the allowance market and hoarding behavior could be effected in the secondary market as well. Opportunities for hoarding can be reduced through other design features, such as frequent small auctions and limits on the proportion of allowances in a single auction that can be purchased by a single entity. The fact that hoarding or cornering the market is likely to be an expensive and risky strategy is perhaps the greatest deterrent.
On March 17, the states participating in RGGI released a synopsis of the design elements in the upcoming auction and announced that the first auction is expected to take place this September. The initial RGGI design is largely consistent with that recommended here. That historic event will begin the real world test of how well the auction design elements adopted by RGGI work in practice for CO2 allowances. Stay tuned for the rest of the story.
Views expressed are those of the author. RFF does not take institutional positions on legislative or policy questions.
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