Pew Center on Global Climate Change Response to:

"Design Elements of a Mandatory
Market-Based Greenhouse Gas Regulatory System"

Issued by Sen. Pete V. Domenici and Sen. Jeff Bingaman
February 2006

Question 2

Should the costs of regulation be mitigated for any sector of the economy, through the allocation of allowances without cost?  Or, should allowances be distributed by means of an auction?  If allowances are allocated, what is the criteria for and method of such allocation?

Pew Center Response
Download Response to Question 2 [1] (pdf)

The Pew Center believes that the costs of regulation can be mitigated through the free allocation of many allowances, as well as through other measures, as discussed in the section on “Cost Containment” in the Additional Topics. 

Resolving the question of how to allocate emission allowances will be fundamentally an issue of political acceptability.   As observed in the successful acid rain trading program and noted in the Pew Center’s previous analytical work (see, e.g., Ellerman et al), there is no appreciable difference in environmental effectiveness in using a free distribution, rather than an auction, to start a program.  The environmental benefits accrue from the timing and quantity of reductions – recognizing that a program that starts sooner would require less drastic reductions.  In other words, the allocation vs. auction debate is more relevant to political feasibility than environmental outcome.  However, there are a number of key considerations and tradeoffs among the various approaches to allocation.  The Pew Center does not have a position on the method of allocation, but has led workshops and discussions addressing these many considerations in developing an allocation method.  The following response lays out these areas of consideration, and in some cases makes recommendations.  It also describes the views of the surveyed corporations on these issues. More detail on the implications of various allocation options can be found in the attached documents (along with a lengthier discussion on the pros and cons of free allocation).

Pew Center Analysis

Covered entities, especially those with significant compliance obligations and those in energy-intensive industries, will bear costs associated with transitioning into a market-based system for emissions allowances.   To assist with this transition, a high percentage of allowances (e.g., 90% - 95%) should be allocated at no cost, rather than auctioned, at least in the initial years of a cap-and-trade system.  A small initial allowance auction can fund transition assistance and research, development and deployment of climate-friendly technologies.  This auction  may serve as a price discovery mechanism to give firms an initial idea of the market price for an emissions allowance.  Over time, the amount auctioned could increase, as firms successfully transition into the trading system and the associated expenditures decrease.  In providing federal funding for technology development, a competitive process, such as a “reverse auction” in which funding is allocated based on emission reduction potential, can reduce program costs.  In the early years of the program, the highest priorities for allocation should be transition assistance and technology development; over time the priorities should shift toward rewarding low-emitting technologies and practices. 

The choice of allocation approaches may have strong distributional impacts, and thus may be a very contentious decision.  For large point sources, allocation can be made either on the basis of historical emissions or against a sector-specific benchmark or set of benchmarks.  Power plant allocations, for example, may be made on an input, net output, or gross output basis.  The goal of allocation is to encourage the transition to a cleaner, more efficient generation fleet, but to do so in a way that recognizes that players in the industry have different starting points.

If the point of regulation is at the power plant level, policymakers must also decide whether to allocate allowances to non-emitting generators, and whether allocation will be fuel-specific or fuel-neutral.  Allocating allowances to non-emitting generation would create incentives for the expansion of these sources, but may increase the burden on emitting generation.  Fuel-neutral allocation may promote fuel switching and efficiency, while similarly increasing the burden on higher-emitting generation sources.

Another important issue is whether subsequent allocations should be fixed at the same level, or should be updated over time.  The argument for updating is that a fixed allocation may disadvantage new and growing businesses.  However, many economists argue that updating is economically inefficient because it encourages emitters to modify their behavior in order to increase future allocations, rather than  simply meet the emissions cap at the lowest cost [1] [2].  Updating also creates uncertainty for business decisions as well as emissions outcomes. Ultimately, however, the inefficiencies and behavioral consequences of updating are an empirical question.  While preliminary evidence on the Ozone Transport Commission NO_X program suggests that behavior is not significantly different in states that update versus those that do not, there is some consensus that the inefficiencies of updating grow as the magnitude of the program grows.  (See RGGI Allocation Workshop Summary and Proceedings for more detail on this question.)

A reasonable compromise might be to update over long time periods (e.g., 5 or 10 years), which should not affect economic efficiency significantly and would contribute to a fairer allocation over time. 

Another important issue is how to deal with new entrants.  Updating automatically does this, but there are other methods that may be useful, especially if updating only occurs infrequently.  The simplest is to require new entrants to purchase allowances on the open market.  To the extent that allowances are allocated largely to existing sources, this means that new sources would need to purchase allowances from existing sources. Allowances could also be set aside in a “reserve” at a fixed price – this was the approach taken under the U.S. acid rain program.  This reserve was never actually used because cheaper allowances were available on the market, but it was an important insurance policy for new entrants.  Finally, allowances for new sources could be set aside and given to eligible new sources for free.

A federal cap-and-trade system may either directly allocate allowances, or may “apportion” allowances to the states, which can individually decide how to allocate allowances.  (The Regional Greenhouse Gas Initiative does the latter.)  Alternatively, the federal government may foster some degree of harmonization by requiring a certain percentage of each state’s allowances go to certain purposes or entities, and then permitting states to allocate the remaining percentage as they wish. The Pew Center believes that it is preferable for the federal government to oversee the allocation process.  Allocation is politically very difficult; addressing it at the federal level would save considerable state-by-state trouble and create an uneven playing field.  In addition, although difficult, federal-level allocation can enable political solutions, which Congress may be able to utilize to reach agreement [2] [3].

Some analysts believe that a high level of free allocation will result in windfall gains for allowance recipients.  The potential for windfall gains depends, for each economic actor, on the relationships between its compliance obligation, its allowance allocation, and its ability to pass along price increases.  While windfall gain may accrue to some sectors that are able to pass along price increases (in excess of cost increases); it will not accrue to all firms within that sector and more importantly will not be available to all sectors.   Furthermore, because some firms will experience additional costs, free allocation can serve to minimize this impact while still sending the appropriate signal that emission reductions are valuable.  There is disagreement among analysts about the degree to which various sectors and firms are able to pass along price increases, and what level of free allocation may compensate those affected. 

[2] [5] Further analysis on allocation can be found in Nordhuas, R. 2003. Designing A Mandatory Greenhouse Gas Reduction Program for the United States [6]. Arlington, VA: Pew Center on Global Climate Change, pgs. 27 – 29.

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