CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

CBO

Managing 

Allowance 

Prices in a 

Cap-and-Trade 

Program

NOVEMBER 2010

180

100

140

60

20

160

80

120

40

0

Billions of Metric Tons

No Price Ceiling

Ceiling Price for Allowances

Cap

$20 $30 $40

Greenhouse Gas Emissions with a Price Ceiling as

One Option for Managing Allowance Prices
Pub. No. 4081
The Congress of the United States O Congressional Budget Office

A

STUDY

CBO

Managing Allowance Prices in a 

Cap-and-Trade Program

November 2010

Preface

CBO

Scientists generally conclude that rising concentrations of greenhouse gases are warming the Earth’s climate. Concern about the damage that might result has led policymakers and 

analysts to consider policies designed to restrict emissions of those gases. One type of policy, a 

cap-and-trade program, could minimize the cost of achieving a limit, or cap, on emissions by 

allowing market forces to determine where, how, and to some extent when the cuts in emissions necessary to achieve the cap would be made. (Other options include taxes on emissions 

and regulatory standards to reduce emissions, or a combination of the various approaches.) A 

cap-and-trade program would establish increasingly stringent annual limits on greenhouse gas 

emissions over the course of several decades. The government would distribute rights to emit 

such gases (allowances) by either selling them, possibly in an auction, or giving them away. 

Firms would be allowed to trade the allowances after they had been distributed and to shift 

them over time to some degree by “banking” unused allowances for future use or by “borrowing” allowances allocated to future years. 

The price of allowances would rise to the level necessary to ensure that the limit on cumulative emissions over the life of the policy (implied by the annual caps) was met. That price level 

would depend crucially on a variety of factors, including the growth of the economy and the 

development of new technologies to reduce emissions. Because policymakers cannot know in 

advance how high or low prices will be in any given year, they might consider adding features 

to the design of a cap-and-trade program that would limit the range of potential allowance 

prices. 

This Congressional Budget Office (CBO) study—prepared at the request of the Chairman of 

the Senate Committee on Energy and Natural Resources—examines the potential effects of 

features that would help manage allowance prices, and thus the cost of complying with a capand-trade program, by altering the number of allowances available to firms at various prices. 

In keeping with CBO’s mandate to provide objective, impartial analysis, the report contains 

no recommendations. 

The study was written by Terry Dinan of CBO’s Microeconomic Studies Division under 

the guidance of Joseph Kile and David Moore. Deborah Lucas, Damien Moore, Robert 

Shackleton, and Andrew Stocking, all of CBO, provided comments, as did Harrison Fell 

of Resources for the Future, Gilbert Metcalf of Tufts University, and Adele Morris of the 

Brookings Institution. (The assistance of external reviewers implies no responsibility for the 

final product, which rests solely with CBO.)
CBO

PREFACE

Leah Mazade edited the study, and John Skeen proofread it. Jeanine Rees prepared the report 

for publication, and Maureen Costantino designed the cover. Monte Ruffin printed the initial 

copies, Linda Schimmel coordinated the print distribution, and Simone Thomas prepared the 

electronic version for CBO’s Web site (www.cbo.gov). 

Douglas W. Elmendorf

Director

November 2010
Contents

CBO

Summary vii

An Overview of Cap-and-Trade Programs and Allowance Prices 2

Flexibility in Reducing Emissions 3

Allowance Prices 4

Rationales for Managing Allowance Prices 6

Managing Allowance Prices with a Price Ceiling, an Allowance Reserve, or a Price Floor 6

A Price Ceiling 7

An Allowance Reserve 9

A Price Floor 14

The Potential for Unintended Consequences from Managing Allowance Prices 17

Table

1. Allowance Prices and Emissions Under a Cap-and-Trade Program 

with an Allowance Reserve Relative to a Program with the 

Same Cap but No Reserve 10

Figures

1. The Daily Price of Selected Allowances Under the European Union’s 

Emissions Trading System 5

2. Greenhouse Gas Emissions and Allowance Prices Under Various 

Price Ceilings in a Cap-and-Trade Program 9

3. Greenhouse Gas Emissions and Allowance Prices Under Various 

Designs of a Supplemental-Allowance Reserve in a 

Cap-and-Trade Program 13

4. Greenhouse Gas Emissions and Allowance Prices Under Various 

Designs of a Withheld-Allowance Reserve in a Cap-and-Trade Program 15

Box

1. Recent Legislative Approaches to Managing Allowance Prices 7

CBO

Summary

The accumulation of greenhouse gases in the atmosphere—particularly carbon dioxide released as a result of 

deforestation and the use of fossil fuels—could create 

costly changes in regional climates throughout the world. 

Concern about the damage from such changes has led 

policymakers and analysts to consider policies designed to 

reduce emissions of those gases. 

Many proposals have focused on cap-and-trade programs, 

which would limit the number of tons of greenhouse 

gases emitted into the atmosphere over several decades 

from certain sectors of the U.S. economy. Under such a 

program, lawmakers would set gradually tightening 

annual caps on greenhouse gas emissions that together 

would imply a cumulative limit over the duration of the 

policy. Rights to emit the gases, referred to as allowances, 

would then be distributed to businesses or other entities, 

such as state governments, in amounts that corresponded 

to those limits. (One allowance would permit one ton of 

emissions.) The government could distribute the allowances by either selling them, possibly in an auction, or 

giving them away. Once the allowances were distributed, 

they could be bought and sold in the secondary market 

for them that would develop. 

Firms subject to the caps—for example, firms that emitted large quantities of greenhouse gases or that produced 

or imported fossil fuels that released emissions when 

burned—would be required to submit allowances to the 

agency charged with implementing the program. Under 

most proposed programs, firms could shift their use of 

allowances from one year to another by “banking” 

unused allowances for the future or, to a more limited 

degree, by “borrowing” allowances from future allocations. That trading and flexibility in timing would allow 

firms to undertake emissions reductions where, how, and 

to some extent when it was least costly for them to do so. 

In choosing the level of the annual caps on emissions, 

policymakers would be making decisions complicated by 

uncertainty about the damage that might result from 

greenhouse gas emissions, and thus the benefits to be 

gained from reducing them, and about the costs of such 

reductions. Those costs would increase what firms spent 

in producing goods and services and would be borne by 

households in the form of higher prices. In establishing 

a program’s annual limits on emissions, policymakers 

ideally would have reliable information about the allowance prices that would be associated with the various caps 

they might consider. Those prices would reflect the cost 

of the most expensive reduction in emissions made to 

comply with the program at a given point in time. But 

projections of allowance prices are inherently uncertain. 

Once a cap-and-trade program was in place, actual prices 

would vary on the basis of current conditions, such as the 

weather and the economy, and firms’ expectations about 

factors affecting their compliance costs over the duration 

of the policy. 

In fact, prices in the allowance market would be continually changing and could reach levels that were much 

higher or lower than policymakers had anticipated. 

Changes in prices that were caused by new information 

could help ensure that the caps on emissions were met at 

the least possible cost. Higher allowance prices, for example, would encourage firms to invest more in emissionsreducing equipment in the near term as a way to curtail 

their longer-term costs for meeting the caps. However, 

unexpectedly high (or low) allowance prices would make 

the cost of meeting the caps much higher (or lower) than 

policymakers had expected, which could alter the tradeoff between costs and benefits that policymakers had 

anticipated when they selected the caps. 

Concerns about unexpectedly high or low allowance 

prices have led to proposals to place upper or lower limits 

on those prices. The Congressional Budget Office (CBO) 

has examined the possible effects of several features that 

would change the number of allowances available to firms 
VIII MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM

CBO

at various prices and in so doing help limit the range of 

allowance prices. 

CBO’s Findings

CBO examined the effects on allowance prices and greenhouse gas emissions of three mechanisms that would help 

prevent allowance prices from reaching unexpected highs 

and lows: a price ceiling, which would be implemented by 

offering an unlimited number of allowances for sale at a 

given price, thereby placing an upper bound on allowance prices; an allowance reserve, in which a limited number of additional allowances would be offered to firms at 

or above a given price, thereby curtailing but not eliminating price increases beyond that level; and a price floor,

which would be implemented by decreasing the number 

of allowances available at a given time to maintain a lower 

bound on prices. 

An upper bound on allowance prices could prevent the 

policy’s costs to the economy from being unacceptably 

high, but it could also cause emissions to exceed the 

cumulative cap because the bound would be sustained by 

adding allowances to the program. The effects of a lower 

bound would depend on whether firms could bank 

allowances. If banking was not permitted, a lower bound 

could motivate firms to make additional cuts in emissions 

over the duration of the policy beyond those that would 

otherwise be required by the cap. If banking was permitted, firms would probably not make such additional cuts.

A Price Ceiling

Policymakers could set an upper limit, or ceiling, on 

allowance prices by allowing firms to buy an unlimited 

number of allowances, in addition to those created under 

the cap, at a specified “ceiling price.” Such a policy would 

have the following consequences:

B It would provide an upper limit on allowance prices 

but not on emissions. 

B The higher the ceiling price was set above the projected path of allowance prices, the less likely it would 

be that firms would buy additional allowances and if 

they did buy them, the fewer they would buy. As a 

result, a higher ceiling would generally lead to fewer 

additional emissions than would arise under a lower 

ceiling. 

B Provided that firms were able to shift allowances 

from one year to another—that is, bank and borrow 

them—a ceiling could dampen the price of allowances, even when the market price was below the ceiling price. Such price dampening, which would be 

most likely when the market price of allowances was 

near the ceiling price, would occur because firms 

would attach a lower value to an allowance today to 

reflect the fact that its price in the future could not rise 

above the ceiling price. 

B If the ceiling lowered allowance prices, it would 

diminish firms’ incentives to invest in equipment that 

reduced emissions and in efforts to develop new 

lower-cost emissions-reducing technologies. That 

decrease in investment would lower firms’ spending 

for emissions reductions in the near term but could 

increase it in the future, when firms’ compliance costs 

rose. 

An Allowance Reserve

Alternatively, policymakers could offer to sell firms a limited number of “reserve” allowances at or above a given 

price, referred to here as an “access price.” Such a reserve 

would have the following effects:

B It would impose an upper limit on emissions—which 

might be different from the cap—but would not set 

an upper limit on the price of allowances. 

B The environmental and economic consequences of 

using the allowances in the reserve would depend on 

whether the reserve increased or decreased the number 

of allowances that would otherwise be permitted 

under the cap. 

• A reserve created by supplementing the number of 

allowances supplied under the cap would allow a limited loosening of the cap when costs were high. A 

supplemental-allowance reserve would tend to 

increase emissions and lower allowance prices relative to a policy with the same cap but no reserve. 

All else being equal, the larger the reserve and the 

lower the access price for releasing the allowances it 

contained, the more likely that the reserve would 

dampen allowance prices and allow emissions to 

exceed the cap. 

• A reserve created by withholding allowances that 

would otherwise be distributed under the cap could 

increase firms’ compliance costs but allow fewer 

emissions than those under a program with the 

same cap but no reserve. All else being equal, the 
SUMMARY MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM IX

CBO

larger the reserve and the higher the access price, 

the more likely that the reserve would increase 

prices and curb emissions to a greater extent than 

would a similar program without a reserve. 

B The effect of a reserve on emissions and allowance 

prices might be greater but would be less certain if regulators could restock the reserve by using offset credits, which reflect reductions in domestic or overseas 

emissions that would not otherwise be subject to the 

cap. Under such an approach, regulators would purchase the credits, then retire them and add a corresponding number of allowances to the reserve. 

Allowing regulators to restock the reserve in that way 

could lower firms’ costs for compliance because the 

number of reserve allowances would rise. However, 

that reliance might also prompt questions about the 

credibility of the cap: Regulators could find it challenging to verify that offset credits represented actual 

reductions relative to projected emissions in the 

absence of the cap-and-trade program.

B If the federal government used auctions to sell the 

reserve allowances it created, it would capture their 

full value. Alternatively, if the reserve allowances were 

distributed by offering firms options to purchase them 

at a fixed price, the government and firms would share 

the allowances’ value. 

A Price Floor

Another approach, a price floor, would set a lower limit 

on the price of all traded allowances. With a “hard” price 

floor, the simplest form of such an approach, the government would be required to purchase an unlimited number of allowances at a predetermined price. Broadly 

speaking, including a price floor in a cap-and-trade program would tend to boost allowance prices in the near 

term but would probably not result in fewer emissions 

over the duration of the policy if firms were permitted 

to bank allowances. CBO’s analysis also indicates the 

following:

B The further below the projected path of allowance 

prices that the floor price was set, the less likely it 

would be that the floor would become binding—that 

is, prevent any further decline in prices. 

B At the time that it was binding, a price floor would 

increase firms’ compliance costs, relative to a policy 

with the same cap and no price floor, because it would 

require firms to reduce emissions more than they 

otherwise would.

B To the extent that a price floor increased the price of 

allowances, it would strengthen firms’ incentives to 

invest in emissions-reducing capital equipment and to 

develop new lower-cost technologies for reducing 

emissions. Those investments would boost firms’ 

spending in the near term but decrease their compliance costs (and lower allowance prices) in the future.

B If firms could shift allowances from one period to 

another, a price floor would probably not result in 

cumulative emissions over the life of the policy (typically several decades) that were less than the amount 

permitted under the policy’s cap. Instead, a floor 

would shift reductions forward in time. 

B Policymakers could try to set a lower limit on the price 

of allowances by establishing a minimum bid price for 

the allowances sold in a government-run auction. But 

that bid price would establish a floor for prices in the 

secondary market only if the demand for allowances 

was great enough that firms would want to buy at least 

some of the allowances being auctioned. 

Unintended Consequences of 

Managing Allowance Prices

Actual experience in managing allowance prices through 

the approaches that CBO examined is quite limited, 

which could make it harder to anticipate the effects of 

such features if they were included in a cap-and-trade 

program for greenhouse gas emissions. For example, a 

hard price floor might turn out to be very costly to implement. Also, some analysts are concerned that a price ceiling or an allowance reserve could result in allowances 

being added to the program under circumstances—

including firms’ attempts to manipulate allowance prices 

through those features—that in the end might not be justified by actual compliance costs. A further consideration 

is that the mere presence of a price ceiling or a price floor 

might cause allowance prices to gravitate toward those 

levels. Moreover, allowing firms to buy an unlimited 

number of allowances at a ceiling price could complicate 

possible efforts to tighten the annual caps in the future: 

Firms could bank allowances during the time that the 

price ceiling was in effect and then use those allowances 

to exceed the tighter caps established for future periods. 

CBO

Managing Allowance Prices in a 

Cap-and-Trade Program

Over the past several decades, growing quantities 

of greenhouse gases—produced in large part by human 

activities—have been accumulating in the atmosphere. 

Most experts expect that those accumulated gases will 

result in a variety of environmental changes over time, 

including a gradual warming of the global climate, extensive changes in regional weather patterns, and significant 

shifts in the chemistry of the oceans.1

 Emissions of carbon dioxide—the result mainly of fossil fuel consumption and deforestation—are a particularly large source of 

greenhouse gases; in the United States, carbon dioxide 

accounts for roughly 80 percent of all greenhouse gases 

emitted annually.2

In the light of growing concern about the prospect of 

global climate change, lawmakers have considered policies to reduce greenhouse gases and thus limit the extent 

of such change and the harm that could result from it. 

Because reductions in emissions would impose costs on 

the U.S. economy, policymakers have sought approaches 

that would curb emissions in the most cost-effective way 

possible.3

 The range of available options includes conventional command-and-control approaches (such as setting 

standards for vehicles, buildings, machinery, equipment, 

and appliances) and market-based approaches (such as 

imposing taxes on emissions or establishing cap-andtrade programs).4

 Market-based approaches give firms 

and households much more latitude to determine the 

most cost-effective means of reducing emissions to a specified level. As a result, experts generally conclude that 

market-based approaches would accomplish that goal 

at a significantly lower cost than would conventional 

standards-based methods.

This Congressional Budget Office (CBO) study focuses 

on one of those market-based approaches that has been 

considered by the Congress—cap-and-trade programs. 

Under such programs, the government would set annual 

limits on emissions—the “cap” part of the program—that 

would gradually tighten over several decades. It would 

then distribute allowances, which are essentially rights to 

emit specific amounts of greenhouse gases, to privatesector firms and other entities. The number of allowances 

issued would reflect the emissions permitted by the 

annual caps, measured in metric tons of carbon dioxide 

equivalent.5

 Firms that were subject to the caps—for 

example, firms that emitted large quantities of greenhouse gases or that produced or imported fossil fuels that 

generate emissions when burned—would have to submit 

one allowance for each ton of emissions they generated to 

the agency charged with implementing the program, 

1. See Congressional Budget Office, Potential Impacts of Climate 

Change in the United States (May 2009). 

2. Other greenhouse gases are methane, nitrous oxide, and several 

man-made gases containing fluorine and chlorine. 

3. For additional information, see Congressional Budget Office, 

The Costs of Reducing Greenhouse-Gas Emissions, Issue Brief 

(November 23, 2009), and Policy Options for Reducing CO2

Emissions (February 2008). 

4. Some proposed programs would combine those approaches. For 

additional discussion, see Congressional Budget Office, How 

Regulatory Standards Can Affect a Cap-and Trade Program for 

Greenhouse Gases, Issue Brief (September 16, 2009).

5. Greenhouse gas emissions differ in the amount of global warming 

that they cause. Carbon dioxide equivalent indicates the amount 

of carbon dioxide that would have the same global warming 

potential as a particular greenhouse gas when measured over a 

specified period (generally 100 years). 
2 MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM

CBO

such as the Environmental Protection Agency.6 The government would distribute the allowances by selling them, 

giving them away, or using some combination of the two 

approaches. 

Once the allowances were distributed, firms would be 

able to “trade” them, buying and selling them in a secondary market in which firms that required fewer allowances—because they could reduce their emissions relatively inexpensively—could sell their allowances to firms 

that had greater difficulty and costs in reducing theirs. In 

addition, under most proposed programs, firms could 

shift their use of allowances from one year to another by 

“banking” unused allowances for the future or, to a more 

limited degree, by “borrowing” allowances from future 

allocations. That trading and flexibility over time would 

allow firms to undertake emissions reductions where, 

how, and to some extent when it was least costly for them 

to do so. The firms that would need either to submit 

allowances or reduce their emissions to comply with the 

program would generally pass those compliance costs on 

to their customers. Thus, the prices of goods and services 

throughout the economy would eventually increase on 

the basis of the emissions associated with their production and consumption. 

The price of allowances would reflect the “marginal” cost 

of the reductions made at any point in time to comply 

with the program—that is, the cost of the last metric ton 

of emissions to be reduced after all lower-cost options had 

been exhausted. Under a program that did not permit 

allowances to be shifted over time, firms’ emissionsreducing efforts at any given point would depend on the 

cap for that particular year. Under a program that allowed 

for such shifting, firms’ efforts would depend on the 

cumulative cap implied by the sum of the annual caps 

and on the relative cost of reducing emissions at different 

times. The price of allowances would be higher or lower 

depending on the chosen level of the cumulative cap; on 

the amount of emissions that would have occurred in the 

absence of the program, referred to as “baseline emissions”; and on the technologies available for reducing 

emissions. Baseline emissions, in turn, would depend on 

such factors as the level of economic activity, fluctuations 

in energy markets, and the weather—for example, an 

exceptionally hot summer would increase the demand for 

energy and make meeting a cap more expensive. 

Factors such as baseline emissions and future technologies, which would help determine the price of allowances 

and thus firms’ compliance costs, cannot be known with 

certainty when a cap-and-trade program is being 

designed. Consequently, the actual prices that would 

prevail once the program was in place might be quite different from projections of allowance prices provided by 

analysts before the program had begun. That intrinsic 

uncertainty about the price of allowances and the corresponding uncertainty about the cost of the program 

to businesses and, ultimately, consumers have led some 

policymakers to express interest in including features in a 

program’s design to manage allowance prices—in particular, by altering the supply of allowances available to firms 

at various prices.

This study examines the effect that three such features—

price ceilings, allowance reserves, and price floors—

would be likely to have on long-term trends in emissions, 

the price of allowances, and firms’ incentives to invest in 

emissions-reducing technologies. The study also 

addresses some of the unintended consequences that 

efforts to limit prices could entail. Features that set upper 

or lower limits on allowance prices could affect the degree 

of price fluctuation that occurred within those limits; 

however, an examination of that fluctuation is beyond the 

scope of this analysis. 

An Overview of Cap-and-Trade 

Programs and Allowance Prices

Policymakers have used cap-and-trade programs to 

reduce several pollutants in the United States. Since 

1995, for example, a federal cap-and-trade program 

has been operating to reduce sulfur dioxide emissions 

from coal-fired power plants (sulfur dioxide is a major 

6. For example, many programs that have been proposed would 

impose a cap on large “downstream” emitters of greenhouse gases 

involved in the generation of electricity (such as electric utilities 

and large industrial emissions generators) and on “upstream” suppliers of petroleum and natural gas not used in generating electricity. (Those suppliers would be required to submit allowances on 

the basis of the emissions that would ultimately be released when 

their product was burned.) Such a system would cover more than 

80 percent of all greenhouse gas emissions from the burning of 

fossil fuels while limiting the number of entities that would need 

to comply with the cap. 
MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM 3

CBO

contributor to acid rain).7

 And since January 2009, a 

state-level cap-and-trade program has been reducing 

emissions of carbon dioxide from large power plants in 

10 states in the Northeast and in the mid-Atlantic 

region.8

 In addition, the European Union has implemented a cap-and-trade program for greenhouse gases, 

the Emissions Trading System (formerly known as the 

Emissions Trading Scheme).

Flexibility in Reducing Emissions

In a cap-and-trade program, flexibility about where and 

how reductions in emissions could occur comes through 

the trading of allowances. Many cap-and-trade proposals 

would increase that flexibility by allowing regulated firms 

to submit “offset credits” in lieu of allowances for some of 

their emissions. Those credits would be created when 

entities (within the United States or in other countries) 

whose emissions would not otherwise be subject to the 

caps reduced those emissions in approved ways. For 

example, regulators might issue domestic offset credits for 

the carbon dioxide that would remain sequestered in the 

soil—rather than be released into the atmosphere—if 

farmers in the United States tilled the soil less when 

planting their crops. Similarly, they might issue international offset credits for the carbon dioxide that would 

remain sequestered in trees if countries agreed to limit the 

deforestation taking place within their borders.

Banking and borrowing provisions in a cap-and-trade 

program could offer firms flexibility in timing the emissions reductions they must undertake, freeing them from 

the obligation to reduce their emissions by just the 

amount necessary to meet each year’s annual cap. Typically, under such provisions, a firm could bank unused 

allowances from a year when its compliance costs were 

relatively low and then use them in a relatively high-cost 

future year.9

 Similarly, firms could borrow allowances 

from future years to use when the prices of allowances 

were unusually high. Most cap-and-trade proposals 

would allow firms to bank an unlimited number of 

allowances but would restrict the amount of firms’ 

borrowing.10

Allowing firms to bank and borrow allowances would 

enable them to reduce their emissions at the most costeffective time. The costs that a firm would incur in 

complying with a program’s specific annual caps could 

vary from year to year for a number of reasons—for 

example, severe weather in winter could increase the use 

of fossil fuels, and thus the amount of greenhouse gas 

emissions, to provide heating or cooling for households 

and businesses; the level of economic activity could be 

higher or lower than average, affecting energy use from 

year to year; or new technologies for reducing emissions 

could either become available or their commercial use 

could be delayed. 

Permitting businesses to decide where, how, and when to 

reduce emissions would probably not lessen the benefits 

of limiting emissions of greenhouse gases. Such gases are 

global pollutants: A ton of emissions from any point on 

the globe has the same effect on the atmospheric concentration of the gases and thus causes the same amount of 

damage. Therefore, shifting efforts to reduce emissions 

from one firm to another to minimize the costs would 

result in the same benefits. In addition, climate change 

depends on the gases’ buildup in the atmosphere over 

decades, not on the amounts emitted in a given year. So 

shifting efforts to reduce emissions from one year to 

another would probably not alter the policy’s benefits, 

7. Acid rain is precipitation containing harmful amounts of sulfuric 

and nitric acids formed primarily from sulfur dioxide and nitrogen oxides released into the atmosphere when fossil fuels are 

burned. It can be wet precipitation (rain, snow, or fog) or dry 

precipitation (absorbed gaseous and particulate matter, aerosol 

particles, or dust). For more information, see the discussion at 

www.epa.gov/acidrain. 

8. Cap-and-trade programs were also used in the United States to 

phase out the use of leaded gasoline in the 1980s and the use of 

ozone-depleting chemicals (such as chlorofluorocarbons) under 

the Montreal Protocol (see www.epa.gov/ozone/intpol), and 

to reduce sulfur dioxide and nitrogen oxide emissions from 

sources in the Los Angeles area via the RECLAIM program 

(see www.aqmd.gov/reclaim/reclaim.html).

9. For a detailed description of various options for providing flexibility in timing, see Congressional Budget Office, Policy Options for 

Reducing CO2 Emissions.

10. For example, under the American Clean Energy and Security Act 

of 2009 (H.R. 2454), which was passed by the House of Representatives, a firm could meet no more than 15 percent of its compliance obligation in any given year by submitting borrowed 

allowances. In addition, firms would not be able to borrow allowances from their allotment more than five years ahead. Under 

H.R. 2454, borrowed allowances would permit a firm to emit 

only a fraction of the greenhouse gases that would have been permitted had the allowances been used in the year for which they 

were issued: For example, an allowance permitting 1 ton of emissions in 2017 would permit only 0.84 tons of emissions if it was 

submitted to comply with the cap in 2015.
4 MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM

CBO

provided that the reduction in cumulative emissions was 

the same over the duration of the policy. 

Allowance Prices

The price of allowances under a cap-and-trade program 

would be determined by many factors whose values 

would be revealed over time. As a result, the actual prices 

that prevailed once the program was in place could be 

quite different from projections of allowance prices made 

by analysts prior to the start of a program.

Factors Affecting Allowance Prices. The annual caps, 

baseline emissions, and technologies that firms had available for staying within the caps would all play an important role in determining the price of allowances. All else 

being equal, more-stringent caps would lead firms to 

deploy more-expensive emissions-reducing technologies: 

Businesses would use the lowest-cost methods first and 

move on to higher-cost approaches as needed for compliance. Consequently, more-stringent caps would lead to 

higher prices for allowances. 

Typically, cap-and-trade programs set looser annual caps 

in the initial years of a program and tighter caps in later 

years. But if a program also included provisions that 

allowed firms to bank their current-year allowances for 

use later as well as borrow allowances from a future year’s 

allotment, the price of an allowance at any point in time 

would depend less on the cap in place that year than 

on the cumulative limit on emissions over the entire policy period—that is, the sum of the annual caps. When 

firms are allowed to transfer allowances over time, they 

seek to minimize their total compliance costs over the 

duration of the policy by reducing emissions more when 

the cost of doing so is relatively low and less when the 

cost is high. Under such conditions, the price of an allowance at a certain time—in economic terms, the marginal 

cost of reductions made at that time—reflects not only 

the current cost of cutting emissions but also what firms 

expect future compliance costs to be. 

Because allowances in a cap-and-trade program could be 

bought and sold, they would be financial assets. Entities 

(including firms that were subject to the caps as well as 

other firms that might want to trade allowances) would 

wish to buy or sell them depending on whether future 

allowance prices were expected to be higher or lower than 

today’s prices. For example, the price of an allowance 

would be lower today and the effort that firms put into 

reducing emissions less if businesses and investors 

expected emissions-free nuclear energy to be cheap and 

widely accepted in the future. In that case, the current 

holders of allowances would expect future prices to be relatively low, and firms would tend to defer reducing their 

emissions. If, however, new information indicated that 

nuclear power was unlikely to be widely available—for 

example, if an accident occurred at an existing nuclear 

plant—the price of allowances could take a sharp jump 

because firms would no longer expect to minimize their 

compliance costs by waiting to reduce their emissions. In 

those circumstances, firms that held allowances could 

expect to sell them at a higher price in the future—

reflecting the higher future compliance costs—so they 

would demand a higher price for them today. As a result, 

the allowances’ anticipated price path would shift 

upward; that is, both the current price of allowances and 

expectations about prices in the future would rise. 

Moreover, active trading would result in the constant 

updating of those expectations. In some cases, new information could lead to large shifts in prices, which could 

produce sizable changes in firms’ compliance costs. However, those shifts could also motivate firms to undertake 

actions that would minimize their total costs for complying with the cumulative cap over the life of the program. 

For example, an increase in the current price of allowances, reflecting expectations of higher prices in the 

future, would motivate firms to invest more in developing new lower-cost technologies for reducing emissions 

and to spend more on emissions-reducing capital equipment in the near term in order to cut their compliance 

costs in the future. 

Although information about current and future conditions affecting the cost of meeting a cap would help 

determine the level of allowance prices at a given time, 

other market conditions would determine the rate at 

which prices rose over time.11 Because allowances are 

financial assets, firms would bank and borrow them up to 

the point at which the return they expected to receive on 

them from increases in their price equaled the return they 

11. Estimates of the growth in allowance prices over time are strongly 

affected by different assumptions about how firms that are subject 

to a cap would take advantage of banking opportunities. See 

Congressional Budget Office, The Costs of Reducing GreenhouseGas Emissions; and Congressional Research Service, Climate 

Change: Costs and Benefits of the Cap-and-Trade Provisions of 

H.R. 2454, CRS Report for Congress R40809 (September 14, 

2009).
MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM 5

CBO

Figure 1.

The Daily Price of Selected Allowances Under the European Union’s 

Emissions Trading System

(Nominal dollars)

Sources: Congressional Budget Office based on data from IHS Cambridge Energy Research Associates.

Note: Data are plotted daily from April 19, 2005, through August 2, 2010. They reflect the average daily closing price of December futures 

contracts for allowances that are eligible for compliance in phase II (covering 2008 to 2012) of the European Union’s Emissions

Trading System, a multinational cap-and-trade program to reduce carbon dioxide emissions from large businesses. (A December 

futures contract for allowances is an agreement to exchange a fixed number of allowances in December of the specified year at an 

agreed-upon price.) 

could receive on a comparable investment—that is, one 

carrying a similar risk of loss. For example, if a firm 

judged that the price of an allowance would rise faster 

than the rate of return on that comparable investment, it 

would want to bank more rather than fewer allowances. 

That tendency would slow the rate at which allowance 

prices rose: It would increase the demand for and thus the 

price of allowances in the current year and then increase 

their supply and decrease their price in the future, when 

the banked allowances were sold or used. Consequently, 

the price of allowances would be expected to increase at 

roughly the same pace as the rate of return on comparable 

investments. 

Allowance prices in a U.S. cap-and-trade program would 

also be affected by events outside the United States. For 

example, if other countries implemented cap-and-trade 

programs and allowed their firms to comply with a cap by 

purchasing international offset credits, fewer credits 

would be available to U.S. companies, and their price 

would go up. Constraints on the ability of U.S. firms to 

comply with emissions limits by using low-cost offset 

credits would result in higher allowance prices in a 

domestic cap-and-trade program.

The Variability of Allowance Prices. Prices would 

undoubtedly fluctuate as conditions changed and as new 

information about factors affecting compliance costs—

such as technological developments—became available. It 

is difficult to extrapolate from the allowance price paths 

of existing domestic and international cap-and-trade programs to an economywide program for greenhouse gas 

emissions in the United States. Nevertheless, it is revealing that existing programs, such as the European Union’s 

Emissions Trading System, have experienced continually 

changing prices (see Figure 1).

Ups and downs in allowance prices may stem from transitory factors as well as from changing expectations about 

factors affecting long-run costs, including the possibility 

of alterations in the stringency of a program’s caps. (For 

example, in the case of the U.S. Acid Rain Program, a 

spike in allowance prices in 2005 was due at least in part 

to the fact that policymakers were considering tightening 

the caps.) A U.S. cap-and-trade program for greenhouse 

gases could see substantial fluctuations in the price of 

allowances, particularly in the program’s early years, 

because firms would be uncertain about the operation of 

the allowance market and would not as yet have had a 

2006 2007 2008 2009 2010

0

10

20

30

40

50

60
6 MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM

CBO

chance to build up a bank of allowances (if the program 

allowed it). 

Rationales for Managing Allowance Prices

The price of allowances under a cap-and-trade program 

could be much higher or lower than policymakers had 

anticipated when they decided how stringent to make 

the caps. As a result, the costs that firms would face in 

complying with the caps could exceed those that policymakers had considered acceptable when they chose those 

limits—a decision that entailed trade-offs between anticipated costs and benefits. 

Prices that were higher than anticipated would impose 

larger costs on firms that had to comply with the policy as 

well as on U.S. households, which would pay higher 

prices for the goods and services they purchased. In 

addition, higher allowance prices could lead to greaterthan-expected reductions in profits and employment in 

emissions-intensive industries whose products faced foreign competition—especially competition from firms in 

countries without limits on emissions. If the policy’s substantially larger costs in those circumstances exceeded 

what policymakers had originally considered acceptable, 

given their view of the benefits of reducing emissions, the 

caps would end up being more stringent than lawmakers 

would have chosen if more accurate cost information had 

been available.

In contrast, allowance prices that were lower than anticipated, particularly in the early years of a program, could 

fail to motivate firms in the near term to invest in equipment or new lower-cost technologies for reducing emissions. That lack of investment would in turn increase 

firms’ costs for complying with limits on emissions in the 

future. Moreover, if the costs of complying with the policy were substantially less than policymakers had anticipated when they designed the policy, those unexpectedly 

low costs might make them wish they had chosen tighter 

caps, which would be more expensive to meet but might 

be justified by their benefits. 

Managing Allowance Prices with a 

Price Ceiling, an Allowance Reserve, or 

a Price Floor 

Most of the recent legislative proposals for cap-and-trade 

programs have included features to manage allowance 

prices (see Box 1). CBO examined the effects of three of 

those mechanisms on prices and emissions: a price ceiling,

which would be implemented by adding an unlimited 

number of allowances at a given price to the initial supply; an allowance reserve, in which a limited number of 

additional allowances would be offered for sale to firms at 

or above a given price; and a price floor, which would be 

implemented by decreasing the number of available 

allowances at a given time to maintain a lower bound on 

prices. In part, those features are attempts to manage 

allowance prices—and in turn firms’ compliance costs—

when actual prices vary from the projections made prior 

to a program’s start.

In its analysis, CBO used a simplified cap-and-trade 

system as a basis for assessing the effects of alternative 

price management features. That illustrative program is 

similar to some proposed systems but does not reflect the 

full details of any of them. Specifically, the hypothetical 

program used for this analysis would: 

B Cap cumulative greenhouse gases from large emitters 

throughout the United States over the 2012–2050 

period, reducing their emissions from a baseline level 

of 245 billion metric tons to 130 billion metric tons,

B Allocate allowances to firms through an auction or at 

no charge,

B Permit firms to borrow a limited number of allowances for current use and bank an unlimited number 

for future use, and 

B Allow firms to purchase up to 1.5 billion domestic or 

international offset credits annually instead of reducing their emissions or using allowances for that part of 

their compliance obligation. 

Under a program with those features and using available 

information and current estimates about the many factors 

that would affect allowance prices, CBO estimated that 

the nominal price of allowances in 2012 would be $17. It 

also estimated that prices would increase through 2050 at 

a real (inflation-adjusted) annual rate of 5.6 percent, the 

rate of return firms might expect to receive on an investment with a similar risk of loss. 

Taking that simplified cap-and-trade program as a starting point, CBO examined the effects that various designs 

of a price ceiling or an allowance reserve might have if the 

price of the allowances necessary to comply with the 
MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM 7

CBO

program’s cap was twice as high as had been initially 

projected.12 In that high-price example, the price of 

allowances would begin at $34 rather than at $17 and rise 

at a real annual rate of 5.6 percent. In addition, CBO 

considered the effects that a price floor might have if 

allowance prices were lower than anticipated. 

A Price Ceiling

A price ceiling would set an upper limit on the price of 

allowances in a cap-and-trade program. Policymakers 

could establish a ceiling by requiring the government to 

offer to sell an unlimited number of additional allowances at a predetermined price that would typically 

increase each year. Because firms would always have the 

option of purchasing allowances at that price, the ceiling 

Box 1.

Recent Legislative Approaches to Managing Allowance Prices

Several recent proposals have included features that 

would help manage allowance prices in a cap-andtrade program by altering the supply of allowances 

available at various prices.

B The Low Carbon Economy Act of 2007 (S. 1766) 

and the Carbon Limits and Energy for America’s 

Renewal, or CLEAR, Act of 2009 (S. 2877) would 

allow firms to purchase an unlimited number of 

additional allowances at a predetermined price 

(called a “Technology Accelerator Payment” under 

the Low Carbon Economy Act and a “safety valve” 

price under the CLEAR Act) that would rise over 

time and serve as a ceiling on prices. In addition, 

the CLEAR Act would establish a price floor to 

prevent allowances from being purchased below a 

given price in the auctions held by the government to sell the allowances. Further, those allowances that consequently were withheld from the 

overall supply available under the cap would not 

be offered to firms in subsequent auctions. The 

Low Carbon Economy Act did not include a price 

floor.

B America’s Climate Security Act of 2007 (S. 2191) 

would have established a “Carbon Market Efficiency Board” that could, among other things, 

have increased the total number of allowances 

available in a particular year by reallocating allowances from future years to the present. However, 

the board would not have been permitted to 

increase the number of allowances available over 

the entire policy period. S. 2191 did not include a 

price floor.

B The American Clean Energy and Security Act of 

2009 (H.R. 2454), the Clean Energy Jobs and 

American Power Act (S. 1733), and the American 

Power Act of 2010 (APA) would each create, at 

the onset of the policy, a reserve of allowances 

taken from future allocations. H.R. 2454 and 

S. 1733 would permit firms to purchase allowances from the reserve at or above a specified minimum price. In contrast, APA would permit firms 

to purchase a limited number of allowances from 

the reserve each year at a fixed price; the number 

they could purchase would depend on their emissions. Under all three bills, allowances that were 

not purchased from the reserve while the policy 

was in effect would go unused, and regulators 

could replenish the reserve by purchasing offset 

credits (issued for reductions in greenhouse gases 

made outside sectors of the economy that were 

covered by the cap). H.R. 2454 and S. 1733 

would require regulators to replenish the reserve 

with international offset credits; APA would allow 

them to use domestic offset credits if international 

credits were not available. All three bills would 

establish a price floor by withholding allowances 

that the government would have auctioned had 

their price not fallen below a given amount. Those 

allowances would then be placed in the reserve. 

12. Specifically, for its high-price example, CBO assumed that emissions would be 20 percent higher than in the base case, that only 

1.25 billion offset credits would ultimately be available to firms, 

and that the reduction in emissions caused by a 10 percent 

increase in the price of allowances would be 20 percent less than 

in the base case. 
8 MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM

CBO

would set an upper bound on the cost per metric ton of 

reducing emissions and on the price at which allowances 

would trade. If firms could cut their emissions at a cost 

that was less than the ceiling price, they would choose to 

do so; if the cost for cutting their emissions was greater 

than the ceiling price, firms would choose to purchase 

additional allowances from the government at the ceiling 

price. 

In choosing the ceiling price, policymakers would have to 

balance the goals of not exceeding the cap on emissions 

and limiting firms’ costs for complying with the cap. A 

lower ceiling price would offer firms greater protection 

from higher-than-anticipated costs, which in turn would 

lower the program’s overall cost to the economy. But the 

lower price would also increase the likelihood that emissions would exceed the cap, because policymakers could 

not know at the time they designed the policy how many 

additional emissions the ceiling would allow. 

Policymakers could reduce the likelihood that the price 

ceiling provision would be triggered (causing firms to buy 

additional allowances and emissions to exceed the cap) by 

setting the ceiling price well above the annual prices projected for allowances when the program was established.13

For example, if the actual price of allowances in 2012 was 

$34—and not $17, as initially projected for CBO’s hypothetical program—and policymakers had set the ceiling 

price for that year at $40, firms would generally choose 

not to purchase any additional allowances (see the farright column in Figure 2). In that case, the price of allowances and the number of emissions would be the same as 

they would have been under a program with the same cap 

but no price ceiling (see the far-left column in Figure 2). 

Alternatively, if policymakers had set the initial ceiling 

price at $20 or $30, firms would probably purchase additional allowances from the government at the ceiling 

price. All else being equal, firms would wish to purchase 

more additional allowances at a ceiling price of $20 than 

at a ceiling price of $30 (see the middle two columns in 

Figure 2). CBO estimated that under the parameters of 

its high-price example, a ceiling price of $20 (rising in 

subsequent years at a real annual rate of 5.6 percent) 

would result in the issuance of 32 billion additional 

allowances and therefore 32 billion additional tons of 

emissions—25 percent more than would have been emitted in the absence of the price ceiling—over the lifetime 

of the program. In contrast, an initial ceiling price of 

$30 would lead to the issuance of 6 billion additional 

allowances, for a 5 percent increase in emissions.

By curbing increases but not decreases in the future price 

of allowances, a price ceiling could also dampen current 

prices even if it was not currently binding. In general, the 

value that firms attached to an allowance—that is, its 

market price—would depend on the price at which they 

expected to be able to sell it in the future: The higher 

firms expected future prices to be, the more they would 

pay for an allowance today. Thus, firms would be willing 

to pay less for an allowance today if they knew that the 

price ceiling would curb any increase in the future price 

that could result from, say, an extraordinarily hot summer 

but not any decrease in price that could result from an 

extraordinarily mild one. That price dampening would 

be most likely when the market price of allowances was 

near the ceiling price.14

Any lowering of allowance prices would be likely to 

weaken firms’ incentives, relative to a cap-and-trade program with the same cap and no price ceiling, to develop 

new technologies for reducing emissions. Prices could be 

lower than would otherwise be the case either because the 

ceiling became binding or because the ceiling dampened 

prices as the market price approached the ceiling. The 

expectation of lower allowance prices stemming from the 

price ceiling would reduce the profits anticipated from 

developing such technologies, which in turn would tend 

to curtail investment in them.

However, firms’ incentives to develop new technologies 

could also be weakened by uncertainty about the future 

of the policy, which could be affected by the presence or 

absence of a price ceiling. With no limit in place, the 

price of allowances might rise so high that pressures 

would build to loosen the cap on emissions or repeal the 

policy, which would lead to a subsequent drop in prices. 

13. For example, Robert Stavins (“A Meaningful U.S. Cap-and-Trade 

System to Address Climate Change,” Harvard Environmental Law 

Review, vol. 32, no. 2, 2008, pp. 293–371) suggests that the ceiling should be set at the highest amount that society is willing to 

bear to achieve reductions. Such a ceiling would prevent reductions in emissions that were unexpectedly—and unacceptably—

costly to achieve.

14. For a related discussion, see Dallas Burtraw, Karen Palmer, 

and Danny Kahn, A Symmetric Safety Valve, RFF DP 09-06 

(Washington, D.C.: Resources for the Future, February 2009). 
MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM 9

CBO

Figure 2.

Greenhouse Gas Emissions and Allowance Prices Under Various 

Price Ceilings in a Cap-and-Trade Program

(Billions of metric tons of emissions) (2012 dollars)

Source: Congressional Budget Office.

Note: Each bar in the chart except the one farthest to the left corresponds to a different price ceiling in 2012; for this analysis, ceiling prices 

were assumed to grow at a real (inflation-adjusted) annual rate of 5.6 percent. The height of a bar shows the amount of emissions over 

the 2012–2050 period under that price ceiling, and the box within each bar shows CBO’s estimate of the market price of allowances in 

2012. That price was also assumed to grow at a real annual rate of 5.6 percent. 

The existence of a ceiling, by contrast, could make firms 

more certain that the cap would be sustained, which 

would maintain their expectations about prices as well 

as their incentives to invest in low-carbon and energyefficient technologies. 

An Allowance Reserve

Policymakers could curb rather than eliminate increases 

(beyond a given level) in the price of allowances by 

providing a “reserve” of additional allowances that firms 

could draw on. The reserve would contain a set number 

of allowances; thus, unlike a program with a price ceiling, 

a program with a reserve would impose a fixed limit on 

emissions over the life of the program. Potential methods 

for distributing the allowances held in a reserve would 

include auctioning them at or above a specified minimum price or giving each firm required to comply with 

the program the option of purchasing a limited number 

of allowances at a fixed price.

Establishing the Reserve. A cap-and-trade program with 

a reserve would establish a limit on emissions, but that 

No Price Ceiling $20 $30 $40

0

20

40

60

80

100

120

140

160

180

0

5

10

15

20

25

30

35

40

45

50

162

136

7

Ceiling Price in 2012

$34

Emissions Resulting from Allowances Purchased at the Ceiling Price

Emissions Allowed Under the Cap

$20

$30

$34

130 130
10 MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM

CBO

Table 1.

Allowance Prices and Emissions Under a Cap-and-Trade Program with an 

Allowance Reserve Relative to a Program with the Same Cap but No Reserve

Source: Congressional Budget Office.

limit could exceed the program’s cumulative cap. The 

manner in which the reserve was stocked—either by 

boosting the number of available allowances above the 

number specified by the cap or by setting aside, or “withholding,” a portion of the allowances that the cap already 

included—would determine whether the use of the 

allowances would cause emissions to exceed the cap. 

B Using allowances purchased from a reserve that added 

to those already counted under a cap—called here a 

supplemental-allowance reserve—would permit emissions to exceed the cap, thus allowing greater environmental damage; that approach would also lower 

allowance prices compared with the prices that would 

result with the same cap in place but no reserve (see 

Table 1). 

B Using allowances purchased from what is referred to 

here as a withheld-allowance reserve would not cause 

emissions to exceed the cap. If firms did not purchase 

allowances from such a reserve—for example, because 

the market price for allowances remained below the 

minimum price at which firms could bid on the 

reserve’s allowances—the establishment of the reserve 

would increase firms’ compliance costs and the price 

of allowances because it would effectively remove 

allowances from the system. However, relative to a 

program with the same cap but no reserve, a policy 

that included a withheld-allowance reserve would tend 

to reduce emissions, further lessening damage to the 

environment. 

Despite the two approaches’ differing implications for 

allowance prices and emissions relative to programs with 

no reserve, policymakers could design a program so that 

either approach would result in the same allowance prices 

and the same emissions. For example: 

B Policymakers could set the cap on cumulative emissions over the policy’s duration at 130 billion metric 

tons and allow regulators to issue 15 billion additional 

(supplemental) allowances. If firms used all of those 

additional allowances, emissions would rise to 145 billion metric tons and exceed the cap, but the costs of 

complying with the program would be lower than 

would otherwise be the case—because the additional 

allowances would help lower allowance prices. Using 

none of the reserve allowances would result in 130 billion metric tons of emissions.

B Alternatively, policymakers could limit cumulative 

emissions over the course of the policy to 145 billion 

metric tons and withhold 15 billion allowances—

place them in a reserve at the outset of the program. 

Using the full reserve would result in 145 billion metric tons of emissions, but the cap would not be 

exceeded. Using none of the reserve allowances would 

result in 130 billion metric tons of emissions, an 

amount well below the cap; however, that reduction 

would be more costly to achieve than if all of the 

allowances—representing the full 145 billion tons of 

emissions—had been distributed.

The final outcomes of both approaches for the environment and the economy would be the same, even though 

the implications for meeting the cap would be different: 

The first approach would have a lower initial cap that 

could be exceeded, whereas the second approach would 

involve a higher initial cap that could not be exceeded.15

Source of Reserve

Allowances Reserve Is Used Reserve Is Not Used Reserve Is Used Reserve Is Not Used

Supplemental to the Cap Lower Same Higher Same

Withheld from the Cap Same Higher Same Lower

Prices Emissions

15. Among the legislative proposals described in Box 1 on page 7, 

those that feature a reserve—H.R. 2454, S. 1733, and the American Power Act of 2010—define the cap as including the allowances that are placed in the reserve. 
MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM 11

CBO

Distributing Reserve Allowances. Of the two potential 

methods that CBO examined for distributing the allowances—auctioning them at or above a specified minimum price (referred to here as the reserve “access” price) 

or giving each firm required to comply with the cap-andtrade program the option of purchasing a limited number 

of allowances at a fixed price—neither would set an upper 

limit on the market price of allowances. Depending on 

conditions in the market, the price of allowances could be 

either higher or lower than the access price at which firms 

could bid on the reserve allowances or the fixed price at 

which they could purchase a limited number of them. 

The market price of allowances and the broad economic 

costs of the program would generally be the same regardless of the method chosen for distributing the reserve 

allowances: Those price and cost outcomes would reflect 

the total supply of allowances available over the course of 

the policy, including those in the reserve. (As discussed 

later, that conclusion would not hold if the reserve allowances were distributed in a manner that weakened firms’ 

incentives to reduce their emissions.) However, in contrast to the method’s effect on prices and economic costs, 

the way policymakers chose to distribute the reserve 

allowances would determine which entities—the government or various private firms—could garner the reserve 

allowances’ value. Selling them in an auction or giving 

firms the option to purchase them at a fixed price would 

lead to different outcomes.

Selling the reserve allowances in an auction would allow 

the federal government to reap their full market value. 

Lawmakers could specify a minimum price that firms had 

to pay for the allowances—for example, firms could purchase allowances only at or above a price of $30. That 

minimum price would not necessarily be the price that 

firms would actually pay for the allowances when they 

first got them from the government or the price at which 

the allowances would trade in the secondary market. If 

the number of allowances that firms wanted to purchase 

at the access price exceeded the number of allowances 

available from the reserve, the auction price of the reserve 

allowances would increase until the number of allowances 

that firms wanted to buy at the auction price was equal to 

the number of available reserve allowances. 

In contrast, distributing reserve allowances by offering 

firms options to purchase them at a fixed price would 

mean that the government and firms would share the 

allowances’ value. Under that distribution method, firms 

that received the options could profit from them by selling the allowances in the secondary market at a higher 

price. Policymakers would determine which firms could 

receive those profits when they decided how to distribute 

the options. 

Yet another consideration in choosing a distribution 

method is how it might distort firms’ decisions about 

how much to reduce their emissions. Firms would have 

less of an incentive to reduce emissions if the reductions 

decreased the number of allowance-purchasing options 

they received. To keep that from happening, policymakers would have to use a strategy that was not tied to 

firms’ emissions under the program. For example, lawmakers could base the number of options that each firm 

received on the firm’s emissions during a year well before

the time of the program’s design. Under that kind of policy, firms would not have an incentive to increase their 

emissions in order to receive more allowances. 

Restocking the Reserve. Policymakers could expand the 

reserve by directing regulators to replenish it over time, 

which would allow more allowances to be sold from the 

reserve than the number initially placed in it. For example, policymakers could specify that 2 billion allowances 

be placed in the reserve. But provided that the reserve 

could be replenished, regulators could eventually sell substantially more than 2 billion allowances from it over the 

course of the policy. 

To date, cap-and-trade proposals that allow restocking 

would direct the government to replenish the reserve as 

follows: Regulators would purchase offset credits with the 

revenue raised by selling the reserve allowances, increase 

the number of allowances in the reserve according to the 

number of credits purchased, and then retire the credits.16

Restocking the reserve in that manner would make the 

reserve’s ultimate size uncertain because the amount of 

restocking that occurred would depend on the availability 

of the credits. If credits proved scarce, regulators might be 

unable to sell the full number of allowances from the 

reserve that legislators had authorized them to sell. 

16. That approach was included in the provisions of H.R. 2454, 

S. 1733, and the American Power Act of 2010 (APA). Under 

H.R. 2454, the number of allowances that regulators could sell 

over the course of the program would exceed the number originally placed in the reserve by 12 billion, or roughly 9 percent of 

the total cap. Under S. 1733, that excess would be 30 billion, or 

roughly 23 percent of the total cap; under APA, it would be 

17 billion, or roughly 12 percent of the cap.
12 MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM

CBO

Directing regulators to purchase offset credits for restocking would be most likely to lower firms’ compliance costs 

and, as a result, reduce the price of allowances (because 

more would be available) if one of the following conditions applied: 

B A large supply of low-cost offset credits was available, 

but firms purchased only some of them because of 

constraints on the number they could submit to comply with the cap; or

B Regulators could purchase offset credits from a pool 

that individual firms did not have access to—for 

example, a pool of credits that did not meet the standards applied to credits purchased by firms for compliance purposes. 

Under other conditions, the use of offset credits for 

restocking a reserve would probably not lower firms’ 

compliance costs and the price of allowances. For example, if offset credits were costly for both firms and regulators to obtain, regulators might be able to purchase only a 

few credits with the revenue from selling the reserve 

allowances.17 Further, if regulators were trying to purchase offset credits from the same limited supply that 

private firms were attempting to access, then regulators’ 

purchases could drive up the prices of the credits for 

those firms. 

If regulators could restock the reserve by purchasing offset credits that would not otherwise be purchased by 

firms needing to comply with the cap, the fraction of the 

cap that represented the use of offsets would increase. 

That would then boost the extent to which compliance 

with the cap relied on reductions in emissions that were 

made outside the capped sector of the economy and that 

might be more difficult to verify than reductions from 

sources whose emissions were subject to the cap.18 Some 

observers are concerned that such increased reliance on 

offsets could undermine the program’s environmental 

goals and lessen the credibility of the cap.19 

Illustrative Example of the Effects of a Reserve. CBO 

used its high-cost scenario to estimate the effects that 

reserves of varying sizes and differing access prices would 

have on emissions and allowance prices. Under that scenario, the initial price of allowances (with no reserve) 

would be $34 rather than $17, the projected price in 

CBO’s base-case program, and the cost of complying 

with an emissions cap of 130 billion metric tons over a 

four-decade period would be roughly twice as great as 

policymakers had anticipated at the time they established 

the cap. 

All else being equal, the higher the access price that 

would permit firms to purchase the reserve allowances, 

the smaller would be the likelihood that they would make 

such purchases. For example, if the access price for a 

supplemental-allowance reserve was $40 in 2012 (rising 

in subsequent years at a real annual rate of 5.6 percent), 

firms would not demand any reserve allowances because 

the price at which they could buy them would exceed the 

$34 market price (see Figure 3). In contrast, if the initial 

access price was either $20 or $30, firms would bid at the 

reserve auction and purchase enough allowances to clear 

the market—that is, they would bid the price up to the 

point where the demand for allowances at that price was 

equal to their supply. If a supplemental-allowance reserve 

held 5 billion allowances and they were all made available, the expected price of allowances in 2012 would 

drop to $31—but the added reserve allowances would 

also allow total emissions of 135 billion metric tons over 

the 2012–2050 period (versus 130 billion tons under a 

program with no reserve). The access price would be neither a price ceiling nor a price floor: The market price of 

allowances could be higher than the access price, as would 

be the case for the reserve with a $20 or $30 access price, 

or the market price could be lower, which would be the 

17. See Harrison Fell and others, Soft and Hard Price Collars in a 

Cap-and-Trade System: A Comparative Analysis, RFF DP 10-27 

(Washington, D.C.: Resources for the Future, April 2010).

18. For example, under H.R. 2454, if firms submitted the maximum 

number of offset credits allowed and if restocking enabled firms to 

purchase the full number of reserve allowances that regulators 

were permitted to sell each year, up to 74 percent of the reductions in emissions that the act would require could be achieved, in 

CBO’s estimation, through reductions made by sources not covered by the cap-and-trade program.

19. For a discussion of the potential cost savings and challenges 

associated with using offset credits, see Congressional Budget 

Office, The Use of Offsets to Reduce Greenhouse Gases, Issue Brief 

(August 3, 2009).
MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM 13

CBO

Figure 3.

Greenhouse Gas Emissions and Allowance Prices Under Various Designs of a 

Supplemental-Allowance Reserve in a Cap-and-Trade Program

(Billions of metric tons of emissions) (2012 dollars)

Source: Congressional Budget Office.

Notes: A supplemental-allowance reserve would increase the number of allowances available under the cap. Firms would have the option of 

purchasing the reserve allowances at or above a specified minimum price—referred to here as the reserve “access” price—that would 

be determined by law.

Each bar in the chart except the one farthest to the left corresponds to a unique combination of allowance reserve size and access 

price in 2012; for this analysis, access prices were assumed to grow at a real (inflation-adjusted) annual rate of 5.6 percent. The height 

of a bar shows the amount of emissions over the 2012–2050 period under that combination, and the box within each bar shows CBO’s 

estimate of the market price of allowances in 2012. That price was also assumed to grow at a real annual rate of 5.6 percent.

Emissions Resulting from Allowances Purchased from the Reserve

Emissions If the Reserve Is Not Used

No Reserve $20 $30 $40 $20 $30 $40

0

20

40

60

80

100

120

140

160

180

0

10

20

30

40

50

60

70

135 135

145

136

4 4 7

Reserve of 5 Billion

Supplemental Allowances

Reserve of 15 Billion

Supplemental Allowances

$34

$31 $31

$34

$26

$30

$34

130 130

Access Price in 2012

130

145

136
14 MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM

CBO

case with the same sized reserve but an access price of 

$40. 

Increasing the size of the reserve, all else being equal, 

would lessen the likelihood that the market price would 

exceed the access price, but it would also permit more 

emissions. For example, if the supplemental-allowance 

reserve was increased from 5 billion to 15 billion allowances and firms could purchase reserve allowances at or 

above an initial access price of $20, they would find it 

cost-effective to purchase all of those allowances.20 The 

additional 10 billion allowances from the larger reserve 

would further dampen the price of allowances—in 2012, 

it would be $5 lower ($26 rather than $31, as under a 

5billion-allowance reserve)—but emissions over the life 

of the policy would increase by 10 billion metric tons. 

Total emissions from 2012 through 2050 would be 

145 billion metric tons if that larger reserve was in place, 

compared with 135 billion metric tons with the smaller 

reserve. 

By adding to the supply of allowances, a supplementalallowance reserve would tend to push down prices even 

when the market price was below the access price. Like a 

price ceiling, the reserve would dampen increases but not 

decreases in allowance prices, and that asymmetry would 

result in a downward adjustment in expected prices. 

Once the reserve was (or was expected to be) depleted, 

actual prices would be somewhat lower than they would 

have been in the absence of the reserve; however, no further price dampening would occur because firms would 

have incorporated the entire supply of reserve allowances 

into their expectations about prices and no additional 

reserve allowances would be available. 

Creating a reserve by withholding allowances from the 

supply already designated under the cap would yield a 

different outcome: It would tend to increase the 

allowances’ expected prices and lower expected emissions 

relative to a policy with the same cap but no reserve. In 

CBO’s high-cost scenario, for example, creating a reserve 

of 5 billion allowances by withholding those allowances 

(rather than adding 5 billion to the number of allowances 

corresponding to the cap) would increase the price of 

allowances in 2012 from $34 to $38 and reduce emissions under the program from 130 billion to 125 billion 

metric tons if the access price was set at $40 (rising in 

subsequent years at a real annual rate of 5.6 percent; see 

Figure 4). In that instance, firms would not find it costeffective to purchase any of the reserve allowances. Alternatively, if the initial access price was $20 or $30 and the 

allowance price in 2012 was $34, firms would consider it 

cost-effective to purchase all of the reserve allowances. 

Under those lower access prices, allowance prices and 

emissions would be the same as they would have been if 

none of the 130 billion allowances created with the cap 

had been withheld for a reserve. 

All else being equal, if policymakers increased the size of a 

reserve composed of withheld allowances, the allowances’ 

expected price would tend to increase, because firms 

would have fewer allowances available to them below the 

access price. For example, if the cap was 130 billion metric tons and the size of the reserve increased to 15 billion 

allowances, firms would have access to only 115 billion 

allowances at less than the access price; consequently, they 

would be willing to pay a higher price to acquire the 

reserve allowances. In the example here, firms would purchase 7 billion of the 15 billion reserve allowances if the 

initial access price was set at $40, CBO estimates.

A Price Floor

If policymakers were concerned that allowance prices 

might turn out to be lower than anticipated, thus diminishing firms’ incentives to reduce emissions, they might 

choose to establish a floor—that is, a lower bound—on 

allowance prices. A floor, which could be implemented 

on its own or in conjunction with a price ceiling or an 

allowance reserve, could take two possible forms. Policymakers could establish a hard price floor for the market 

price of allowances by agreeing to purchase them from 

firms at a predetermined price. Those purchased allowances would then be effectively removed from the supply 

represented by the cap. Alternatively, the government 

could attempt to establish a lower bound on prices by 

selling some or all of the allowances created by the cap in 

an auction and withholding allowances from that auction 

20. Firms that expected the reserve to be exhausted would have an 

incentive to purchase allowances at the access price and either use 

them in the current period or bank them for future use. Firms 

would also have an incentive to purchase as many of the reserve 

allowances as were available if they expected the price of allowances to rise above the access price in the future and the reserve to 

be rapidly depleted. Such purchases would be a natural consequence of the limited number of allowances in the reserve, the 

initial supply of allowances, and the expected demand for allowances in the future. See Stephen Salant, “The Vulnerability of 

Price Stabilization Schemes to Speculative Attack,” Journal of 

Political Economy, vol. 91, no. 1 (February 1983), pp. 1–38.
MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM 15

CBO

Figure 4.

Greenhouse Gas Emissions and Allowance Prices Under Various Designs of a 

Withheld-Allowance Reserve in a Cap-and-Trade Program

(Billions of metric tons of emissions) (2012 dollars)

Source: Congressional Budget Office.

Notes: A withheld-allowance reserve would decrease the number of allowances available under the program if the reserve was not used. 

Firms would have the option of purchasing the reserve allowances at or above a specified minimum price—referred to here as the 

reserve “access” price—that would be determined by law.

Each bar in the chart except the one farthest to the left corresponds to a unique combination of allowance reserve size and access 

price in 2012; for this analysis, access prices were assumed to grow at a real (inflation-adjusted) annual rate of 5.6 percent. The height 

of a bar shows the amount of emissions over the 2012–2050 period under that combination, and the box within each bar shows CBO’s 

estimate of the market price of allowances in 2012. That price was also assumed to grow at a real annual rate of 5.6 percent.

if the price fell below a certain amount—that is, below a 

minimum bid price. 

When allowance prices under a cap-and-trade program 

were lower than policymakers had anticipated in establishing the program, the presence or absence of a price 

floor could affect the incentives firms would have to 

reduce emissions and the actions they would undertake. 

If a binding price floor was in effect, it would boost 

allowance prices, causing firms to reduce emissions more 

than would otherwise be the case and providing a greater 

incentive for firms to invest in emissions-reducing capital 

equipment. But if the program permitted banking, a 

binding price floor in one period would probably not 

lead to greater reductions in emissions over the duration 

of the policy: The floor would tend to just shift those 

reductions forward in time. Whether the price floor came 

Emissions Resulting from Allowances Purchased from the Reserve

Emissions If the Reserve Is Not Used

No Reserve $20 $30 $40 $20 $30 $40

0

20

40

60

80

100

120

140

160

180

0

10

20

30

40

50

60

70

130 130 130 130

122

4 4

13 7

Reserve of 5 Billion

Withheld Allowances

Reserve of 15 Billion

Withheld Allowances

$34 $34 $34

$38

$34 $34

$40

130

125

Access Price in 2012
16 MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM

CBO

into play would depend on the costs firms faced in 

complying with the cap and the floor price itself. The 

more costly that reductions in emissions were—that is, 

the higher the market price of allowances—and the lower 

the floor price, the less likely it would be that conditions 

would warrant the floor’s taking effect.

Unless otherwise noted, the discussion that follows uses 

the term “price floor” to cover a hard price floor and a 

minimum bid price, both of which CBO assumed would 

rise over time. A further assumption is that the minimum 

bid price would effectively establish a lower bound on the 

price of allowances. (Circumstances in which a minimum 

bid price would not serve as an effective lower bound on 

the price of allowances sold in the market are discussed at 

the end of this section.) The effects of both limits are 

assessed relative to the outcomes of a program with the 

same cap but no floor. 

Effects on Prices. If a price floor took effect, the price of 

allowances would be higher than would otherwise be the 

case during the time that the floor was binding. Moreover, even when the market price of allowances was 

higher than the floor price, a floor would tend to increase 

the market price and slow the pace at which that price 

rose over time.

Both of those effects stem from a price floor’s tendency to 

strengthen the incentives firms have to bank allowances. 

CBO assumed that under a program with no price 

floor—that is, one in which the price of an allowance 

could fall to zero—firms would be willing to bank allowances only if they expected to receive a return on them of 

at least 5.6 percent. Thus, without a price floor, a firm 

would be willing to purchase an allowance, say, at $10, 

bank it, and sell it the next year only if the firm expected 

the price of allowances in that next year to be at least 

$10.56, or 5.6 percent more. But the price of allowances 

would be uncertain, so the presence of the price floor 

would generally reduce the risk of loss associated with 

banking allowances by guaranteeing firms a certain minimum return from selling what they had banked. For 

example, if a firm bought an allowance at a floor price of 

$10 and the floor price was scheduled to increase at an 

annual rate of 3 percent, the firm would not run the risk 

of having to sell it for less than $10.30 the next year.

Because the price floor would reduce the risk of banking 

allowances, it would in turn increase the demand for 

allowances and thus their price. Moreover, a floor would 

lead firms to require a lower rate of return on banked 

allowances (because of less risk), which would slow the 

pace of increases in allowance prices. The faster the pace 

at which the price floor rose, the more that it would boost 

the demand for allowances in the current period—

because firms could bank them and sell them at a higher 

guaranteed minimum price in a future period—and thus 

the more it would drive up the current price of allowances. The tendency of a floor to boost near-term prices 

would be lessened if the government made the allowances 

that were removed from the market (in establishing the 

price floor) available to firms in the future.21

In the near term, a price floor would increase firms’ costs 

for complying with the cap because it would lead to 

higher allowance prices. However, those higher prices 

would also increase firms’ incentives to install emissionsreducing capital equipment and develop new technologies for reducing emissions, both of which would tend to 

lower compliance costs in the future. A floor would have 

the opposite effect of a price ceiling or an allowance 

reserve in that regard: Whereas a ceiling or reserve would 

tend to lower near-term prices and reduce incentives to 

invest in new technologies, a floor would tend to raise 

near-term prices and boost incentives. 

Effects on Emissions. If a program permitted firms to 

bank allowances, the triggering of a price floor would 

probably not reduce the number of allowances that 

firms purchased—and the amount of greenhouse gases 

they emitted—over the course of the policy. A floor 

would cause firms to undertake more emissions reductions (compared with the results from the same policy 

with no price floor) in a year in which the floor was binding. However, because a floor would decrease the risk 

associated with banking, it would increase firms’ incentives to bank allowances for future use or sale. If firms 

chose to acquire allowances at the floor price and bank 

them, the additional reductions in emissions when the 

floor was in effect would be offset by a corresponding 

increase in emissions when firms submitted the banked 

allowances for compliance in future years.

21. H.R. 2454, S. 1733, and the American Power Act of 2010—but 

not the Carbon Limits and Energy for America’s Renewal, or 

CLEAR, Act of 2009—would make allowances that were not sold 

in the government-run auctions available to firms in future periods by adding them to the reserve that each of those proposals 

includes.
MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM 17

CBO

The likelihood that firms would engage in such behavior 

would be substantial because allowances purchased at the 

floor price would be relatively safe investments: Firms 

would know that they could sell them in the future at 

tomorrow’s floor price (which generally would rise over 

time), but they would also know that if the market price 

rose above the floor price, they could sell them at an even 

higher price. Firms would have an incentive to bank any 

allowances they purchased at the floor price unless they 

did not expect the government to maintain the price floor 

in the future (see the discussion below) or unless the market price was below the floor price during the program’s 

final compliance period. In the latter case, firms would 

sell allowances to the government at the floor price if a 

hard price floor was in effect or decline to purchase 

allowances below the floor price in any government-run 

auctions held in that final period. 

In contrast, if firms did not have the option of banking 

allowances, the triggering of a price floor would lead to 

fewer emissions over the duration of the policy. The floor 

would boost the price of allowances, which would cause 

firms to undertake more emissions reductions—more, 

that is, up to the point at which the marginal cost of 

achieving them was equal to the floor price. However, the 

additional reductions undertaken when the floor was in 

effect could not then be used to permit more emissions in 

future compliance periods. 

Implementing an Effective Price Floor. The government 

would be more certain of setting an effective floor for the 

market price of allowances if it agreed to buy them at a 

given price—establishing a hard price floor—than if it 

withheld allowances from the government-run auction 

when bids fell below that price. In particular, the latter 

approach would be ineffective if conditions in the allowance market caused firms to choose not to purchase any 

allowances from the government when the auction’s 

minimum bid price was in effect.22 For example, the government could not maintain a price floor if it sold only 

10 percent of the supply of allowances in its auctions and 

the market price for the remaining 90 percent was less 

than the minimum bid price in those auctions. 

The credibility and effectiveness of a hard price floor 

would depend on the strength of the government’s 

commitment to purchase allowances—those that firms 

had banked, for example—at the floor price. The government could face a substantial financial obligation if market conditions caused firms to decide to sell large quantities of banked allowances to the government at the floor 

price. Moreover, if firms anticipated that the government 

at some point would be unable or unwilling to support 

the price floor, they would tend to sell their allowances 

sooner than they otherwise would. 

The Potential for Unintended 

Consequences from Managing 

Allowance Prices

Setting upper or lower limits on allowance prices would 

reduce some of the uncertainties associated with a capand-trade program but could also have unintended 

consequences. Existing cap-and-trade programs in the 

United States and the European Union do not include 

price ceilings or allowance reserves, so they can provide 

no evidence about how those approaches might work in 

practice. One program, the Regional Greenhouse Gas 

Initiative (RGGI), has a price floor but only a brief history from which to extrapolate: The initiative began capping greenhouse gas emissions from large electricity generators in January 2009. The program features a 

minimum bid price of $1.86 on allowances auctioned on 

behalf of RGGI; however, none of the allowances that 

firms can use for complying with the program’s cap in the 

current year have sold at the minimum bid price in any of 

the eight quarterly auctions for which data are available. 

(In one auction, though, they sold for just 2 cents above 

the minimum bid price.) Future-vintage allowances, 

which can be bought now but used for compliance only 

in future years, sold at the minimum bid price in three of 

the eight auctions. 

Some efforts by governments to control prices in other 

areas of their economies have failed or led to unintended 

results. One example was an attempt in 1992 by the 

United Kingdom to control prices of another sort—

namely, to prevent the value of the pound from falling 

below a targeted level. That undertaking failed because 

the government ultimately found it too costly to do what 

was needed to succeed—buy up pounds to decrease the 

supply. That experience could be relevant to setting a 

price floor for allowances, depending on the method that 

was used to establish the floor. If the government implemented such a limit by agreeing to purchase allowances at 

22. The minimum-bid approach is used in H.R. 2454, S. 1733, the 

American Power Act of 2010, and the Carbon Limits and Energy 

for America’s Renewal, or CLEAR, Act of 2009.
18 MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM

CBO

a given price, market conditions might cause many firms 

to take up that offer, at a substantial cost to the government, which might conclude that maintaining the floor 

price was too costly.23 In contrast, if the government 

attempted to establish a floor for the price of allowances 

in the secondary market by setting a minimum bid price 

on the allowances it auctioned, no federal expenditures 

would be required to maintain the floor. However, that 

price would serve as a floor in the market only if demand 

for allowances was sufficiently strong that firms wanted 

to buy at least some of those that the government was 

selling in its auctions. 

In addition to potential difficulties in maintaining an 

allowance price floor, other unintended effects of 

attempts to manage prices could include the following: 

B If expectations about future compliance costs caused 

the price of allowances to increase—and caused additional allowances to be introduced into the program 

via the price ceiling or allowance reserve—the additional allowances (and the additional emissions they 

represented) would become a permanent part of the 

program, even if those expectations were not borne 

out. 

B In some circumstances, a small number of firms could 

seek to use a price ceiling or an allowance reserve to 

manipulate the price of allowances. For example, the 

firms might purchase large quantities of the additional 

allowances available at a ceiling price (if the program 

had a price ceiling) or an access price (if it had a 

reserve), even when the market price of allowances—

and thus the marginal cost of complying with the program—were below those levels. The availability of 

those additional allowances would then loosen the cap 

and cause allowance prices to fall. That small group of 

firms could profit from such a strategy under a limited 

set of circumstances—in particular, if they had very 

large compliance obligations and if, in general, firms 

used relatively short planning horizons in deciding 

whether to bank or borrow allowances.24 Under those 

circumstances, additional allowances would be 

released through the price ceiling or the allowance 

reserve—even though the marginal cost of complying 

with the program had remained below the level that 

policymakers had designated as justifying a loosening 

of the cap.

B The presence of an allowance price ceiling or price 

floor could cause market prices to gravitate toward 

those bounds. For example, experiments using simulated markets found evidence that when price floors 

and ceilings were present, the responses of study 

participants tended to migrate toward them as if those 

boundaries provided significant information about the 

market value of products.25

B The method by which policymakers chose to add 

allowances to or subtract them from the cap could create uncertainty about the future supply of allowances, 

which in turn could affect prices and the degree to 

which they fluctuated. Those outcomes would be 

most likely if the rules for altering the supply of allowances were not clearly established at the onset of the 

program but were instead left to the discretion of regulators. By creating considerable uncertainty, that 

kind of approach could decrease the allowances’ value 

and cause their prices to fluctuate on the basis of speculation about regulators’ decisions. 

Some analysts have focused on another consideration—

that a price ceiling could complicate possible efforts to 

tighten the annual caps in the later years of a policy.26

Firms that considered more stringent caps a possibility 

would have an incentive to purchase large numbers of 

allowances at the ceiling price, bank them, and use them 

once the caps were tightened and compliance costs were 

23. If the floor’s credibility came into question, firms might then seek 

to sell large quantities of allowances to the government at the floor 

price. See Salant, “The Vulnerability of Price Stabilization 

Schemes to Speculative Attack.”

24. See Andrew Stocking, Unanticipated Consequences of Price Controls: An Application to Allowance Markets, Congressional Budget 

Office Working Paper 2010-06 (September 2010).

25. See Mark Isaac and Charles Plott, “Price Controls and the Behavior of Auction Markets: An Experimental Examination,” American 

Economic Review, vol. 71, no. 3 (June 1981); and Vernon Smith 

and Arlington Williams, “On Nonbinding Price Controls in a 

Competitive Market,” American Economic Review, vol. 71, no. 3 

(June 1981).

26. See Brian C. Murray, Richard G. Newell, and William A. Pizer, 

“Balancing Cost and Emissions Certainty: An Allowance Reserve 

for Cap-and-Trade,” Review of Environmental Economics and Policy, vol. 3, no. 1 (2009), pp. 84–103. 
MANAGING ALLOWANCE PRICES IN A CAP-AND-TRADE PROGRAM 19

CBO

higher. That strategy would undercut the objective of 

such tightening and enable firms to produce emissions in 

excess of any newly tightened caps. Policymakers could 

attempt to adjust for that behavior by taking the additional banked allowances into account in their changes to 

the caps; however, those adjustments could in turn 

prompt even more banking.

Preventing firms from banking the allowances they purchased at the ceiling price might seem to be a logical solution to that problem. But firms could use those allowances to comply in the current year and bank other 

allowances for use in the future. Policymakers might be 

able to tighten the caps in a way that would compensate 

for that kind of behavior, although they could find it 

difficult to estimate how many allowances firms might 

purchase in those circumstances.27

Restricting the number of additional allowances firms 

could purchase, as an allowance reserve would do, would 

make it harder for firms to purchase additional allowances to avoid making higher-cost reductions in emissions once caps were tightened. And smaller reserves—or 

annual limits on the number of allowances that firms 

could purchase from a reserve in any given year—would 

provide more protection against such behavior than 

would larger reserves or reserves with no limits on 

purchases. However, those measures would also do less to 

reduce uncertainty about prices. 

Because the operation of a cap-and-trade program would 

depend on many future decisions about its design, the 

possible unintended consequences discussed here are by 

no means an exhaustive list of those that might result 

from a price ceiling, an allowance reserve, or a price floor. 

At the same time, those mechanisms could help prevent 

the costs of a cap-and-trade program from being much 

higher or lower than policymakers had envisioned. The 

potential for unintended consequences would also 

accompany other approaches to curbing emissions or 

other ways of implementing a cap-and-trade program. 

27. In contrast, a tax on greenhouse gas emissions would provide an 

upper limit on the marginal cost of emissions reductions; provide 

firms with a stable, predictable price on emissions; and allow 

policymakers to increase the stringency of the program whenever 

it was desirable (by increasing the tax). Such a policy would not, 

however, guarantee a given level of emissions: Lawmakers would 

need to adjust the tax rate to motivate fewer (or allow more) emissions. For a discussion of a proposal for a tax that would be 

adjusted on the basis of a legislative formula, see Gilbert Metcalf, 

“Cost Containment in Climate Change Policy: Alternative 

Approaches to Mitigating Price Volatility,” University of Virginia 

Tax Review, vol. 29, no. 2 (2009).