How it works 2 - Distributing Allowances

Step 2 – Distributing allowances

Once a cap on emissions is set, the allowances (permits) representing emissions under the cap become valuable. The next step is deciding on the allocation mechanisms, in other words, who gets the allowances and how?

The two most common methods of distributing allowances are a free allocation to regulated companies, or a government-run auction where regulated companies buy the permits:

Allowance Allocation Options: Giveaway or Auction

Giveaway: Emission permits are given to fossil fuel companies for free.

The more a corporation polluted in the past, the more permits it gets.

Result: windfall profits for the fossil fuel industry, and raises no revenues for public trust purposes

Auction: The state auctions permits to companies for whatever the market will bear.

The state can use the auction revenue for:
- Investment in new energy infrastructure, energy efficiency, R&D, transit, and other public goods
- Rebates or dividends to consumers

From an emissions rights perspective, the allocation looks like this:

Giveaway Auction
Who gets the emissions rights
Fossil fuel importers and producers
Government or trust on behalf of consumers

Previous cap and trade systems, such as the SO2 market for acid rain, and the European Emissions Trading System (ETS) gave allowances to regulated companies for free. For SO2, this was not a problem, because there were a limited number of companies involved, and there was a relatively cost-effective technological solution available for meeting the emissions cap. The free allowances in the SO2 market helped those companies keep costs down as they implemented the readily available scrubbers and fuel substitutes. However, CO2 differs from SO2 because CO2 is ubiquitous in the economy, and there is no simple technological fix for reducing it or removing it from the atmosphere.

Free allocation of allowances to companies in the ETS led to the following problems:
• The price of permits plummeted after it became known that too many permits had been allocated.
• Even though permits are allocated freely to companies, they still passed on costs to consumers
• Free allocation of permits to selected companies led to windfall profits for those companies when companies in certain sectors such as electricity and cement that were given free allowances turned around and raised prices to their customers.
• Since too many permitswere allocated, few emissions reductions resulted.
• Free allocation to established firms prevented new, cleaner firms from entering the market.
• The choice to regulate mid-stream facilities forced some hospitals, who were not allocated permits, to buy permits from coal companies, who were.

Sources from Deutsche Bank to Citigroup to The Economist (October 19, 2006), have stated that the ETS has had problems because “allowances were handed out free to companies, rather than being (as economists
wanted) auctioned.” In Phase 3 (2012-2017) the EU may increase the percentage of auction from a mere 5% to closer to 100%. For more information on the ETS, and the European proposal for Cap and Share in the ETS, click here.

Since 2005, American economists have realized that auctioning the permits to companies is a preferable method of allowance allocation for several reasons:

  • An auction avoids windfall profits and preferential treatment, and rewards early action. Every business is treated equally.
  • An auction captures the economic value which can be used for public purposes, and to reduce the social cost of the program.
  • Avoids political battles and lobbying over who should receive free permits (and unfair windfalls)
  • 100% auctioning facilitates linkages to other capped systems because the price signal is clearer, and not clouded by the subsidies of free allocation.
  • A phased-in auction only delays the price signal and provides incentives for regulated companies to "wait and see" rather than take early action.

An auction is clearly preferable to a giveaway to corporations, but another option is initial allocation of allowances to consumers on a per capita basis. Consumers would receive the allowances as a Share that they sell to upstream companies (the Carbon Share model). This method would provide the emission rights directly to people, and would achieve the same goal of consumer compensation as an auction with consumer dividends.

From an emissions rights perspective, the allocation looks like this:

Giveaway Auction Share
Who gets the emissions rights
Fossil fuel importers and producers
Government or trust on behalf of consumers Consumers

Carbon Share has the same economic effect as the auction, including revenue recycling to consumers, but involves the financial services industry, providing an alternative to a government-run auction.

There is a comparison of dividends and shares here.

Next: Step 3: Compensating Consumers




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