The US Environmental Protection Agency’s (EPA’s) Clean Power Plan is a central piece of the United States’ pledge to reduce harmful carbon dioxide (CO2) emissions and provides states with many options to reduce emissions. Creating an emissions budget (or cap) is the most straightforward of these options and will likely be the most popular. Under this structure, a number of emissions allowances are created, each corresponding to a unit of CO2, and entities can sell or buy allowances until they reach the lowest-cost way of reducing pollution.
The initial distribution of allowances can present a dilemma. Conventional wisdom argues that the emissions outcome, and therefore the efficiency of the market, is largely independent of how allowances are initially distributed. However, this may not hold, for example, when transaction costs are large, markets function imperfectly, or when firm behavior deviates from standard economic theory. Further, allowances constitute an enormous source of value, and their allocation will affect distributional outcomes that could impact the program’s success.
Economists usually favor the use of auction-based mechanisms to distribute allowances. One benefit of auctions is that they allow for the possibility of raising revenue, but that is not relevant to EPA’s decisions with respect to the Clean Power Plan (although it could be relevant for states). EPA’s proposed model rule suggests giving allowances away for free. About 10 percent of these would be used to provide production incentives to promote program goals; the remaining 90 percent would go to existing emitters based on their historic share of electricity generation. Although this 90 percent was meant to be a placeholder for states’ allocation choices, the suggestion has been treated as a default in many conversations.
Even when allowances are freely distributed, using an auction-based mechanism offers many benefits other than raising revenue. As we discuss in a new paper, consignment auctions offer a virtually zero-cost, market-based remedy that mitigates many issues associated with free allocation. In these revenue-neutral auctions, recipients of free allowances are required to sell those allowances and to repurchase what they need for compliance. This approach ensures that all allowances enter the market. In doing so, it improves the functioning of the market by improving the ability of firms to recognize and act upon the least expensive opportunities for compliance.
In the absence of consignment auctions, some firms receiving free allowances may not need to engage in the market for years. This is especially important in new or small markets where finding trading partners is difficult and even searching for a partner may reveal strategic information. In these markets, a fair price may not be evident, and the resulting uncertainty may lead to less trading, which further disguises market information. Consignment auctions address these issues by increasing the number of transactions and trading partners in the market and helping the market arrive at a stable price, which is essential to the functioning of nascent markets.
History provides evidence of the ability of consignment auctions to stabilize markets. In the early years of the sulfur dioxide (SO2) trading program, prices varied widely, reflecting uncertainty about the cost of compliance and making firms reluctant to join the market. However, the program required an annual consignment auction of 2.8 percent of the allowances, which ultimately proved to be a key element of the program’s success. The auction revealed a price that facilitated the subsequent development of an active market. Figure 1 shows how the auction fulfilled this role. There were few market trades and they had great variation in the price until the consignment auctions identified a market price that enabled the market to flourish. Consignment auctions are also in use today in California’s CO2 trading program.
Figure 1. Auction and Bilateral Trading Prices from 1992 to 1999
Source: Burtraw and McCormack (2016).
Consignment auctions provide equal access to the market and to market information, which can advance the perceived fairness of allowance markets. Small firms, firms that receive an allocation that is less than their compliance obligation, and firms that don’t have experience trading especially benefit from this access and from the accompanying reduction in transaction costs. The transparent price also facilitates regulatory oversight of the market. Consignment auctions are revenue neutral and do not need to be administered by the government for these benefits to accrue; indeed, for many years the SO2 auction was run at zero cost by the Chicago Board of Trade.
The institutional and behavioral context for allowance markets can influence compliance decisions because firms face regulatory and organization barriers to efficient trades, which may be exacerbated by free allocation. For example, regulated utilities may face asymmetric rewards for engaging in the allowance market—they may see limited benefits from economic transactions, but may face penalties for transactions that turn out to be uneconomic. These factors tend to preserve the status quo, even if it means holding onto allowances that would be worth more if sold in the market. Similarly, firms face internal constraints that may prevent the value of allowances from being salient and prevent decisions from being made on the basis of opportunity cost.
Consignment auctions bring firms into the market and present them with a visible price, increasing the salience of trading opportunities. The effect of these sales extends to the level of the individual decisionmaker. The tendency to preserve the status quo (termed status quo bias) and to place more value on something you own than something you’re buying (the endowment effect) is well recognized in psychology and behavioral economics. By creating an anticipation of resale, consignment auctions change the framing of free allocation and help overcome these effects.
The benefits of a consignment auction may at first seem unintuitive. A consignment auction is, by its very nature, revenue-neutral and undisruptive. However, due to market, organizational, and cognitive complexities, this simple element of market design may be essential to ensuring the success of the Clean Power Plan. Free allocation can affect the efficiency and fairness of the program, and even short-term inefficiencies and perceived unfairness can hinder future policy and lead to uneconomic long-term decisions. Consignment auctions offer a virtually zero-cost way to mitigate some of these concerns.
Darius Gaskins Senior Fellow