Allocation of Permits would likely make cutting GHG emissions more expensive

As climate legislation once again gains prominence in the US Congress, so does the question of auctioning versus allocating emission allowances. President Obama’s budget proposal calls for 100‐percent auctioning while proposals by USCAP and others call for mostly allocation. The current Waxman‐Markey draft bill is silent on the issue.

Outside a narrow range of circumstances, free allocation of allowances, especially to electric power generators and integrated utilities, would lower the efficiency of cap‐and‐trade and likely produce windfall profits for some companies at the expense of consumers. Free allocation to regulated electric utilities would dilute the consumer price signal needed to stimulate not only direct reductions in energy use, but also investment and innovation in end‐use efficiency improvement. This runs counter to the widespread agreement that energy efficiency improvements will need to play a major role in combating climate change risk. Full auctioning of allowances may increase the cost of capital of regulated utilities. But that is more a feature of cap‐and‐trade induced volatility than of auction versus allocation, and it is likely less important than the demand effect.

As the European experience has shown, free allocation to non‐regulated electric utilities will, in most cases, lead to windfall profits and a corresponding tax on consumers, the revenues of which get sent to the shareholders of those companies. In narrow cases, an argument for allocation can be made to avoid emissions (and job) leakage and to potentially compensate non‐regulated emitters constrained by existing longterm contracts from passing on carbon costs. However, in the former case, the use of import tariffs would be more appropriate than simply allocating allowances.

All in all, any carbon cap and trade regime should be based on the principle of auctioning and only deviate under exceptional circumstances. Allocation of allowances will not only redistribute wealth (away from consumers), it would also likely make any carbon market less efficient and therefore raise the cost of lowering our greenhouse gas emissions.

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