Auctioning vs Free Allocation
Once you have set the cap, a crucial question remains: how do allowances get into the hands of regulated entities? Should government sell allowances at auction, give them away for free, or use some combination? This choice has major implications for revenue, equity, and efficiency.
Two Ways to Distribute Allowances
Auctioning
Government sells allowances to the highest bidders. Entities that need allowances pay for them.
Free allocation
Government gives allowances to entities at no charge, based on historical emissions, production, or other criteria.
Most systems use a combination, evolving over time from predominantly free allocation toward more auctioning.
How Auctioning Works
In an auction, the government offers a certain number of allowances for sale. Bidders submit bids indicating how many allowances they want and at what price.
Common auction formats:
Sealed-bid, single-price auction
All bidders submit bids privately. The clearing price is set where supply meets demand. All successful bidders pay the same price.
Ascending-price (English) auction
The price starts low and rises. Bidders drop out as the price exceeds their willingness to pay. The auction ends when the number of remaining bidders equals the allowances available.
Simple auction example:
Government offers 100 allowances. Bidders submit:
- Company A: 40 allowances at up to $50
- Company B: 50 allowances at up to $45
- Company C: 30 allowances at up to $40
- Company D: 20 allowances at up to $35
Starting from highest bids:
- First 40 go to A (at any price up to $50)
- Next 50 go to B (at any price up to $45)
- Only 10 remain, so C gets 10 of its 30 requested
Clearing price: $40 (the price where demand equals supply) All three successful bidders pay $40 per allowance.
How Free Allocation Works
Free allocation gives allowances to entities without charge. But how many? Two main methods:
Grandfathering
Allocate based on historical emissions. If you emitted 100,000 tons in the baseline period, you receive 100,000 allowances (or a percentage of that).
Benchmarking
Allocate based on production levels and efficiency benchmarks. If you produce 50,000 tons of steel and the benchmark is 1.5 tons CO2 per ton of steel, you receive 75,000 allowances.
We will explore these methods in detail in the next lesson.
Comparing the Two Approaches
| Feature | Auctioning | Free allocation |
|---|---|---|
| Revenue to government | Yes | No |
| Cost to entities | Direct purchase cost | None (allowances free) |
| Price discovery | Transparent market price | Still occurs in secondary market |
| Windfall profits | No | Possible (can pass costs and sell allowances) |
| Competitiveness concerns | Higher | Lower |
| Administrative simplicity | Moderate | Complex (allocation rules) |
| Public perception | "Polluters pay" | "Polluters subsidized" |
The Case for Auctioning
1. Revenue generation
Auctions generate government revenue. The EU ETS auctions generated over €40 billion in 2023 alone. This revenue can fund climate programs, cut other taxes, or support affected communities.
2. Polluter pays principle
Auctioning means emitters pay for the right to pollute. This aligns with the ethical principle that those who cause harm should bear the cost.
3. Avoids windfall profits
When allowances are given free, companies can still pass carbon costs to customers (since products have a carbon value) while receiving free allowances. This creates windfall profits. Auctioning eliminates this.
4. Incentivizes new entrants
Free allocation often favors existing facilities. Auctioning provides a level playing field for new, potentially cleaner competitors.
Economic theory generally favors auctioning. It generates revenue, avoids windfalls, and creates cleaner incentives. But political and competitiveness concerns often lead to significant free allocation in practice.
The Case for Free Allocation
1. Eases transition costs
Regulated entities do not face the immediate cost of purchasing allowances. This smooths the economic transition.
2. Competitiveness protection
Industries competing with producers in regions without carbon pricing can receive free allowances to level costs.
3. Political feasibility
Free allocation reduces industry opposition. Many ETS systems could not have launched without significant free allocation.
4. Addresses leakage concerns
If production shifts to unregulated jurisdictions (carbon leakage), free allocation can help retain domestic production.
Think of the choice like introducing road tolls. Auctioning is like charging full tolls from day one. Free allocation is like giving existing drivers free passes initially and phasing in tolls over time. Both eventually put a price on driving, but the transition is different.
Trends Over Time
Most ETS systems start with significant free allocation and shift toward auctioning:
EU ETS evolution:
- Phase 1 (2005-2007): 95% free allocation
- Phase 2 (2008-2012): ~90% free allocation, power sector auctioning begins
- Phase 3 (2013-2020): 57% auctioned
- Phase 4 (2021-2030): Increasing auction share, full auctioning for power sector
California: Started with significant free allocation, transitioning to more auctioning over time. Auction share has grown from about 10% initially to over 30%.
RGGI: 100% auctioning from the start (power sector only, with limited competitiveness concerns).
Economists generally prefer auctioning, but free allocation remains common. Why?
Political economy: Industries lobby heavily for free allowances. They have concentrated interests and political power. The beneficiaries of auction revenue (taxpayers, climate programs) are diffuse and less organized.
Competitiveness fears: Whether justified or not, industries argue that carbon costs will drive production overseas. Free allocation addresses these concerns, even if imperfectly.
Transition fairness: Facilities built before carbon pricing existed did not anticipate these costs. Free allocation is seen as fair to stranded asset owners.
Gradualism: Starting with free allocation and transitioning to auctioning allows adjustment time. Sudden full auctioning might trigger backlash.
International asymmetry: Until all major economies have carbon pricing, competitiveness concerns remain valid. Border adjustments (like the EU CBAM) may eventually allow full auctioning.
Hybrid Approaches
Most systems combine methods:
Sector differentiation:
- Power sector: Full auctioning (cannot relocate, can pass through costs)
- Trade-exposed industry: Free allocation based on benchmarks
- Heating: Varies by jurisdiction
Transition over time:
- Start with high free allocation
- Phase down by sector risk category
- Reach full auctioning when competitiveness concerns are addressed
New entrant reserves: Set aside allowances for new facilities entering the market, preventing free allocation from only benefiting incumbents.
Revenue from Auctions
Auction revenue can be substantial:
| System | 2023 auction revenue | Primary use |
|---|---|---|
| EU ETS | ~€40 billion | Climate programs (50%+), general budget |
| California | ~$4 billion | Climate investments, rebates |
| RGGI | ~$500 million | Energy efficiency, renewables |
| UK ETS | ~£6 billion | General budget, climate programs |
As systems mature and auction shares increase, revenue becomes a significant fiscal resource. How this revenue is used matters greatly for public acceptance and policy effectiveness.
Deciding Your Approach
When choosing between auctioning and free allocation, consider:
1. Competitiveness context
Are major trading partners pricing carbon? If not, free allocation may be needed to prevent leakage.
2. Revenue needs
Does government need revenue for climate programs, transition support, or deficit reduction?
3. Political constraints
What level of industry burden is politically sustainable at launch?
4. Sector characteristics
Can sectors pass costs to consumers (power)? Are they trade-exposed (steel)?
5. Timing
What evolution path makes sense? Start free and transition? Or auction from the start?
Looking Ahead
The next lesson dives deeper into free allocation methods. Grandfathering and benchmarking each have strengths and weaknesses, and the choice matters greatly for efficiency and equity.