Climate change issues have generated interest and debate over the past two decades. In 1992, the United States ratified the United Nations Framework Convention on Climate Change (UNFCCC). Arguably, in recent years the primary issues under debate have shifted from science—such as the role of greenhouse gas (GHG) emissions from human activities —to policy. For instance, a 2005 Sense of the Senate Resolution on climate change stated: It is the sense of the Senate that Congress should enact a comprehensive and effective national program of mandatory, market-based limits and incentives on emissions of greenhouse gases that slow, stop, and reverse the growth of such emissions at a rate and in a manner that, No. 1, will not significantly harm the U.S. economy and, No. 2, will encourage other action and key contributors to global emissions. In the 110 th Congress, Members have introduced several bills that would establish a market-based, mandatory GHG emission reduction program. Most of these proposals would establish some type of cap-and-trade system to regulate GHG emissions. For a brief primer on cap-and-trade systems, see Appendix A . In designing a cap-and-trade program, one of the more controversial and challenging questions for policymakers is how, to whom, and for what purpose to distribute the emission allowances. Concerning the question of how to distribute allowances, policymakers could (1) sell the allowances through an auction process (2) allocate the allowances at no cost to covered sources, (3) provide allowances to non-covered sources, who would, in turn, sell them to covered sources via the emissions trading market, or (4) use some combination of these methods. Regardless of the method of distribution, emission allowances would have monetary value in a carbon-constrained regime, such as a cap-and-trade program. If an auction is used, policymakers could distribute auction revenues to a wide range of parties to support various policy objectives. Likewise, policymakers could allot allowances at no cost to non-covered entities—for example, federal or state agencies, among others—to promote the same (or different) objectives. By addressing the question of how, to whom, and for what purpose to distribute the emission allowances, policymakers would craft an allocation strategy. The strategy would not affect the environmental integrity of the emissions cap. In addition, covered entities would generally face the same emission reduction decisions under either allocation strategy. A "common misconception" is that if covered sources receive allowances at no cost, the sources would behave differently from sources who purchased allowances through an auction. Economists point out "free allowances" have value, and when covered entities submit an allowance for compliance purposes, the entities forgo the opportunity to sell the unused allowance in the emissions trading market. The first two sections of this report discuss the primary emission allowance distribution methods : auctions and no-cost distribution to covered sources. These sections examine the potential benefits and concerns of these allocation mechanisms. The final section identifies different options and policy considerations for Congress when determining to whom and for what purpose to distribute the value of the emission allowances. The allocation strategy would have substantial consequences for the cost of the cap-and-trade program and how the costs are apportioned. In recent years, the use of auctions to allocate emission allowances has generated considerable interest. Several of the cap-and-trade proposals from the 110 th Congress—including S. 2191 , which was reported from the Senate Environment and Public Works Committee on May 20, 2008—would use auctions to allocate an increasing percentage of the cap's emission allowances. This section describes the potential benefits that auctions may provide, if used to distribute allowances to covered sources in a cap-and-trade program. In addition, this section discusses auction design issues and considerations for policymakers. In general, the concept of an auction is relatively simple to understand. Auctions would allow the market to determine which entities receive emission allowances and at what price: parties placing the highest value on the allowances would receive them. With this allocation method, policymakers would be relieved of the responsibility to make distribution decisions, a process that might be described as picking winners and losers. For this reason, auctions are generally considered to be the most transparent mechanism for distributing allowances. In addition, in a free allocation format parties would have strong incentives to seek increasing shares of the overall allowance allotment. Parties with resources available for such efforts may have an advantage. An auction system would eliminate this behavior. Requiring emission sources to purchase emission allowances would support the "polluter pays" principle. In a general environmental policy context, the polluter pays principle holds that pollution costs should be borne by the polluting facility or industry, not society at large. To accomplish this objective, pollution costs should be included in the overall price of a good. Proponents of the polluter pays notion would likely argue that if products are priced to reflect environmental costs—air pollution, land use, GHG emissions—demand for these products may decline. Advocates of polluter pays maintain that the environment and the services it provides are a shared public good. Under this framework, facilities should have to pay for the right to pollute (i.e., emit GHGs). If allowances are provided at no cost to emission sources, the polluter pays principle would be violated. If Congress decides to use an auction to distribute emission allowances to covered sources—as opposed to providing allowances to covered sources at no cost—the auction revenues could be used to substantially minimize the overall costs on society of the cap-and-trade program. Economic studies have found that, if revenues are used in the most economically efficient manner , the overall costs imposed by a cap-and-trade program could be reduced by approximately 50%. Economists maintain that the most economically efficient application of revenues would be to offset reductions in taxes on desirable activities, such as employment or personal income. The opportunity to use allowance value in this manner and thus minimize overall costs to this extent is unique to the auction mechanism. However, many observers argue that applying auction revenues in this fashion is politically unlikely. Other potential uses of the auction revenues may or may not generate overall economic cost savings. These options are discussed later in this report. Auctions would avoid several of the undesired economic effects that are likely to occur if allowances are provided to covered sources at no cost. These concerns are discussed in greater detail later in the no-cost distribution section. In brief, they include: Inefficient and inequitable price signals in the electricity sector; Potential overcompensation to covered sources; and Challenges with allotting allowances to new and retiring sources. Although many of the cap-and-trade proposals in the 110 th Congress would employ an auction to some degree, none of the bills specifies the design of the auction. A recent study that examined auction design issues for the Regional Greenhouse Gas Initiative (RGGI) found that "careful attention to auction design can be critical to an auction's success in achieving the goals specified for the auction." The success of an auction is typically measured by both its efficiency and revenue generation. In an emission auction context, efficiency is achieved when the parties that receive the allowances are the parties that place the most value on the allowances. Other attributes of an auction that may be used to measure its success include: In a cost-effective emissions trading program, the allowance price should mirror (or closely follow) the marginal cost of emission reduction—that is, the cost of reducing the last, most expensive ton. An effective auction should help identify the allowance price that is near to the marginal cost of reduction. Auctions should discourage or prohibit bidding behavior that would create inefficient outcomes in the market. For example, collusion among bidders may artificially lower the allowance price. Another concern is hoarding, in which one party makes speculative bids above the competitive price, in order to capture a disproportionately large percentage of the allowances. Substantial administrative or transaction costs could reduce the cost-effectiveness of using an auction. Moreover, high transaction costs could place smaller firms at a disadvantage. The rules should be readily available to all parties and should not favor certain participants. Certain auction designs may provide advantages or disadvantages, depending on the auction's primary objective. For example, some auction designs in certain contexts may favor revenue generation; others may be more efficient in terms of matching the market price. Policymakers may undertake further study before specifying the particular auction logistics. Although economic studies have examined the performances of different auction formats in other contexts, "relatively few papers have examined the relative merits of each of these auction forms in multi-unit [e.g., emission allowances] auctions." One option for Congress would be to direct an implementing agency to devise the most appropriate auction format, based on the ranking of objectives provided by Congress. Policymakers may consider various auction designs . In general, auction designs are distinguished by (1) the number of rounds for bidding—generally one round (often called "sealed bid") versus multiple rounds; and (2) whether there is a uniform price or individual price ("discriminatory" price) for each buyer. Examples of auction designs with different combinations of these two characteristics include the following: This type of auction is used in EPA's SO 2 emission trading program. In this system, parties submit a sealed bid, containing multiple offers to purchase a set number of allowances at certain prices. The implementing agency opens the bids and distributes allowances, starting with the highest offer, until the supply is exhausted.