To auction or not to auction

In the comments to a recent post, Red Desert raises a good question about the application of cap-and-trade to greenhouse gases. Red points to this report in The Wonk Room of a letter signed by 14 Democratic senators asking that the leadership “ensure that emission allowances allocated to the electricity sector – and thus, electricity consumers — be fully based on emissions as the appropriate and equitable way to provide transition assistance in a greenhouse gas-regulated economy.” The signatories want allowances to be distributed on the basis of past emissions, rather than on the basis of electricity sales or (gasp!) an auction.

Red’s question: “Does anyone from the Planet have a perspective on this letter? What does this kind of policy do for clean energy states like California? Perhaps, this once, it’s time to ask, what would Schwarzenegger say?”

I’ll take a first crack at that, although other Planeteers are more expert on this topic and may well have different perspectives. Cara and Dan have both dealt with this issue before. Cara’s post has a helpful link to economist Rob Stavins’s defense of free allocation. His bottom line:

the allocation of allowances – whether the allowances are auctioned or given out freely, and how they are freely allocated – has no impact on the equilibrium distribution of allowances (after trading), and therefore no impact on the allocation of emissions (or emissions abatement), the total magnitude of emissions, or the aggregate social costs.

To translate that out of economist-speak, how allowances are allocated is an important distributional issue, but should be irrelevant to the effectiveness of the policy. It matters a great deal to those who must have allowances whether they get them for free or have to buy them from the government or someone else. Coal-fired power plants are going to need a lot of allowances, so this is a critical point for them. But the total emissions under a cap-and-trade regime depend only on the level of the cap, and that decision is formally independent of how allowances are allocated.

Not surprisingly, since this issue is so important to current emitters, give-aways to them have been the rule, rather than the exception. About 10 years ago, Yale law professor Tom Merrill found that all U.S. emission trading programs to that point had given credits away. One conspicuous recent exception is the northeast Regional Greenhouse Gas Initiative, which says that participating states auction “a majority” of the allowances.

Although it doesn’t directly affect the ultimate emission level, allowance allocation is an important issue in a number of respects. In the realm of raw politics, allocation schemes can build political support or undermine it. Emitters might be convinced to climb aboard, or at least to temper opposition, by promises of free allowances. On the other hand, coalitions can be built on promises to devote some portion of auction revenues to one cause or another. (Take a look at the details in Waxman-Markey of how the share of auction revenues that would be devoted to adaptation would be divided up. It looks to me like more care was devoted to those negotiations than to setting the cap or anything else.) And natural supporters of emission limits can be turned off by the appearance or reality of a fat give-away to polluters.

A little more subtly, as I indicated in the comments to Dan’s earlier post, I think giving away allowances can enhance the already strong pressures on legislatures and regulators to over-allocate allowances. If allowances are free, there’s nothing to discipline initial demands for them. Since historically over-allocation has been a serious problem for trading schemes like RECLAIM, it may be important not to add weight on that side of the political scale.

The distribution issues are also not trivial. There’s a moral hazard aspect to giving away allowances on the basis of past emissions, as the letter writers are demanding. Under that scheme the worst polluters, who have done the least to address the problem in the past, end up with the biggest reward. That problem can be solved without necessarily auctioning allowances, by basing allocations on past electricity production rather than CO2 emissions.

Finally, auctioning can provide revenues to support things like development of green tech, and adaptation. It may well be fair to impose at least some of the costs of those response efforts on the polluters most responsible for the GHG problem (and, of course, on their customers).

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Reader Comments

4 Replies to “To auction or not to auction”

  1. “To auction or not to auction” — that is not the question. Free allocation is entirely compatible with 100% auctioning, because auction revenue can be distributed in lieu of allowances.

    Allocating allowances (or auction revenue) based on past electricity production would not solve a fundamental problem of allocation based on past emissions: It would discriminate against new, low-emission energy sources. Making the allocation proportionate to current electricity production would solve that problem; but whether it is based on past or current electricity generation, it would not solve the basic problem that emissions-based allocation addresses: Allocation based on electricity production would induce huge revenue flows, mainly from fossil fuel sources to legacy renewables (large hydro, nuclear), not to new renewables that are in need of capital for capacity expansion.

    An alternative approach would be to focus cross-subsidies from fossil fuels on new-source subsidies. This kind of regulatory system could give new renewables an immediate, high price advantage relative to fossil fuels (e.g, on the order of $100/ton), even though the net regulatory cost to fossil-fuel generators would initially be near-zero (because there would initially be no “new” sources).

  2. Holly,

    Thank you for the prompt and very detailed response. A lot of thought (and effort, too, no doubt) always goes into your posts.

    To my reading, Stavins makes the case that free allowances are no less effective than auctioned allowances because the use of free allowances represents an opportunity cost. But Stavins doesn’t present a clear argument that the effectiveness of cap and trade is independent of the distribution of allowances, or “how they freely allocated”. In fact, he cites specific ways that the distribution of allowances will reduce the effectiveness of cap and trade:

    “. . . of most concern in the context of the Waxman-Markey legislation, “output-based updating allocations” provide perverse incentives and drive up costs of achieving a cap. . . . output-based allocations are used in Waxman-Markey for merchant coal generators, thereby discouraging reductions in coal-fired electricity generation, another significant and costly distortion. . . questioning should continue about the output-based allocation elements, because of the perverse incentives they put in place.”

    If the distribution of allowances has no effect on emissions abatement, why didn’t Henry Waxman write a bill where all the free allowances are given out according to past emissions? He compromised on many other things, why not that?

    The other thing I was struck by in the Stavins post was his argument that negotiating the distribution of allowances builds support for the bill; building support by giving everyone a piece of the action.

    I think this is politically tone-deaf. Waxman-Markey balloons to 3000 pages the night before vote as Henry Waxman hands out amendments on the House floor. This is not my idea of good government. I suggest this kind of insider trading that is damaging the bill, damaging the Democratic Congress and damaging efforts to build broad consensus for action on environmental issues. The opposite is happening, it contributes to the idea outrage and the idea that those with money and access are writing the rules.

    (The LA Times just had a quote from someone running against Utah’s Republican incumbent in the Senate, Bob Bennett, “People are fed up with the way Washington has historically conducted its business: horse-trading and giving this to get that.”)

    Another caveat in the Stavins post is this:

    “Speaking of the conditional allocations, I should also note that some observers (who are skeptical about government programs) may reasonably question some of the dedicated public purposes of the allowance distribution, but such questioning is equivalent to questioning dedicated uses of auction revenues.”

    In the comment section, Stavins admits that auction revenues that go to the treasury to reduce spending or taxes would have more economic benefit.

    Who will be the perceived winners under cap and trade? The farm lobby? Rural electric cooperatives? Goldman’s “great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

  3. Of course I realize something after I posted yesterday:

    ‘To auction or not to auction’ isn’t the question, at least it wasn’t my original question. My question is specifically about the proposed way to divvy up the free allowances. Again, it’s the distribution of the free allowances (not the fact that they are free) that affects both the effectiveness of cap and trade and, I believe, fairness.

    The brown-state senators want the free emissions to favor dirty coal plants–an old power plant built in 1953–say the Kingston, TN plant where the big ash pond spill was last December and a plant that, to date, has no scrubbers or modern air pollution controls–would get twice the free allowances as a modern coal plant of the same size. That’s because the modern coal plant is nearly twice as efficient and btw, much, much cleaner. The Kingston plant would get 4 times the free allowances of a modern gas plant, which is even cleaner still. Tennessee and the TVA, which have resisted efforts to build clean energy infrastructure would tend to get many more free allowances than California, which has invested heavily in clean energy. The brown-staters would argue that California, with all its clean energy, doesn’t need them.

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Holly Doremus

Holly Doremus is the James H. House and Hiram H. Hurd Professor of Environmental Regulation at UC Berkeley. Doremus brings a strong background in life sciences and a comm…

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