Auction Design for Selling CO2 Emission Allowances under the Regional Greenhouse Gas Initiative

In 2009, the 10 northeastern states that comprise the Regional Greenhouse Gas Initiative (RGGI) will launch the first cap-and-trade program for greenhouse gas emissions within the United States. This program, which covers CO2 emissions from electricity generators within the region, is the result of a multi-year cooperative effort among states from Maryland to Maine. CO2 emissions will be capped at levels comparable to emissions levels at the beginning of this decade and then ramped down to 10% below initial cap levels by 2019. RGGI member states have developed an architecture that can serve as a model for a national program to limit greenhouse gas emissions.

The RGGI proposal represents a substantial break with the past. Rather than give the allowances away for free, as has been done in earlier cap-and-trade programs, the RGGI states agreed to allocate at least 25% of the emission allowances to benefit consumers and to support strategic energy investments. An allowance auction is the most straightforward way to implement this policy. More recently, several RGGI states have decided to auction 100% of their annual CO2 allowance budgets. The auction is expected to interact with a robust secondary (spot) market. Nonetheless, as the first greenhouse gas cap-and-trade program to start with a substantial auction of allowances, this major regional initiative will have a global impact.

A carefully designed allowance auction can help maximize the benefits of the RGGI program and can serve as a model for other states and ultimately for a federal program to control greenhouse gas emissions. The project investigators developed an auction design that meets several key criteria, including attaining economic efficiency, so that the auction delivers allowances to those who value them most; deterring collusive behavior by bidders; and providing good signals about market prices. The auction also should have low administrative costs, be perceived as fair, be transparent and simple, and help minimize price volatility. In addition, the auction should successfully raise revenue from the sale of a valuable public asset and be compatible with existing electricity and energy markets.

These findings were developed, using experimental economic methods, insights gleaned from the economics literature, and results from past experience with various types of auctions, including prior allowance auctions. Several auction types were explored, including the sealed bid, increasing price sequential (English clock), and decreasing price sequential (Dutch) auction forms. The question of whether sealed bid auctions should use the pay-as-bid (discriminatory) or uniform price rules was also addressed. In laboratory experiments, the auction formats were compared with respect to price discovery, that is, ensuring that the price of allowances at auction reflects their market value, and in limiting collusive behavior. The investigators also examined the effect of reserve prices and allowance banking, analyzed how the auction combines with secondary markets, and studied the effects of allowing participation in the auction by brokers or other traders not needing allowances for compliance.

Several recommendations on auction design follow from the findings of this study:

• There should be a joint and uniform auction for allowances sold from all RGGI states and allowances should be completely identical notwithstanding the state of origin.
• The RGGI auction should use a sealed-bid, uniform-price auction format, and the clearing price for the auction should be the value of the highest rejected bid.
• Separate auctions should be held for allowances issued in different years. Allowances for future years should be made available four years in advance of their vintage to assist generators in their planning for future investments.
• Auctions should be held quarterly. On each auction day, one auction should be held for a portion of current-year allowances and one auction for a portion of allowances for a future year.
• Reserve prices should be used at each auction. No bids under the reserve price should be accepted.
• Unsold allowances could be rolled into a contingency reserve account, and released into a future auction if the auction price rises above the first offset trigger price. Alternatively, unsold allowances could be rolled into the subsequent auction.
• RGGI should announce the auction clearing price, the identity of winners and the quantity they won. However, information about specific bids should be kept private, particularly prices, and the identity of losing bidders should not be revealed.
• Auctions should be open to anyone able to meet financial pre-qualification, but no single entity should be able to purchase (or take a beneficial interest in) more than 33% of the allowances for sale in any auction.
• RGGI should require that the authorized account representatives be obliged to disclose the party sponsoring or benefiting from the agent's activities in the allowance market if it was other than themselves or their immediate employer.
• RGGI market monitoring efforts should take advantage of existing monitoring activities by federal and state agencies and other interested parties.