Existing cap-and-trade programs that regulate greenhouse gases, such as the EU ETS, have experience in the sale of allowances. As we reported in November 2008, the ETS began the first of its trading periods, or “phases,” in 2005. In Phase I, which ran from 2005 to 2007, member states were allowed to auction up to 5 percent of their allowances, with the remainder distributed to covered entities free of charge. The auctioning limit increased to 10 percent in Phase II, which is to run from 2008 to 2012. The EU’s decentralized approach gives member states the authority to design and execute their own sales. While some member states chose to sell or auction a portion of their allowances in Phases I and II, the quantity sold has been a relatively small percentage of the overall quantity of allowances distributed (see appendix III for more information). For Phase III, which begins in 2013, the EU decided to increase the amount of auctioning significantly, and as a result approximately half of all the allowances will be auctioned. The EU is currently assessing various auction design options for Phase III and beyond—including holding centralized, EU-wide auctions—and plans to adopt an official auctioning regulation by June 2010. U.S. programs also offer experience in emissions allowance auctions. The federal government has auctioned allowances for the emission of sulfur dioxide under its Acid Rain Program since 1993, and the Commonwealth of Virginia auctioned allowances for nitrogen oxide emissions—a pollutant that contributes to the formation of smog—in 2004. More recently, in 2005, RGGI was created to regulate the carbon dioxide emissions of large fossil fuel-fired generators in participating states. RGGI has auctioned nearly 87 percent of emissions allowances issued under the program for 2009, and each of the six centralized auctions held since September 2008 has raised between $38 million and $117 million for programs to promote energy efficiency and renewable energy projects, among other uses. In addition to auctions for emissions allowances, the U.S. government has experience conducting other types of auctions, such as for government securities, surplus property, oil leases, timber harvests, and electromagnetic spectrum licenses. The Treasury Department’s Bureau of Public Debt, for example, conducts more than 250 public auctions per year involving over $5 trillion in marketable securities. In a cap-and-trade program for greenhouse gas emissions, covered entities and other interested parties will be able to buy allowances not only from the government, but also from participants in the secondary trading market. In the ETS, for example, allowances can be purchased through over-the-counter markets or on exchanges such as the European Climate Exchange in London or BlueNext in Paris. Secondary market trading can involve a range of intermediaries—including banks and brokers—and several types of allowance transactions can occur. “Spot” sales involve the immediate payment and delivery of allowances between two parties. Market participants may also trade “forward” or “futures” contracts, both of which allow for delivery of allowances at a later date. Futures contracts may be attractive to covered entities that wish to secure an allowance price in advance and reduce uncertainty about future compliance costs. Because the value of futures contracts fluctuates based on the current market price of allowances, parties that do not have a compliance obligation under the program may also wish to purchase them as an investment. The literature and programs that we reviewed present many options for the design of a mechanism to sell allowances under a cap-and-trade program. We drew two major observations from the literature and the cap- and-trade programs we reviewed. First, because elements of the mechanism’s design may affect outcomes—such as the price of allowances obtained at auctions and the cost of the program—it is important that design choices align with an emissions trading program’s goals. Second, once a goal is chosen, policymakers have numerous choices regarding the sale of allowances, including whether to sell them on an exchange or use auctions. If policymakers choose auctions—as did the majority of countries participating in the ETS and the RGGI states— they must also make important design choices in the areas of format, participation requirements, frequency and timing, price controls, and rules for reporting and monitoring. Program officials and economists suggested establishing clear goals to help guide the design and implementation of government allowance sales in a cap-and-trade program. Identifying priorities early is critical to developing an effective sales approach, as certain designs may better serve certain goals. Goals commonly cited by researchers and program officials include: Simplicity and transparency. Many economists and program officials recommended that allowance sales be simple and transparent for all participants. Sales should be guided by rules that are clear and understandable—both to participants and to the general public—to encourage participation, prevent discrimination, and ensure easy access to allowances. To that end, several economists and program officials recommended selecting an auction format that is easy to use and does not involve complicated bidding procedures. Reporting sales results in a public and timely manner can also help to create a transparent market. Maximizing participation. Ensuring sufficient levels of participation in allowance sales is critical, according to available information and program officials we interviewed. Participation fosters competition and limits opportunities for collusion. Economists and program officials also advised that sales should not discriminate against any one group of participants, whether by excluding them directly or indirectly, such as through high transaction costs. Participation can also be encouraged with a simple and transparent auction design. Economic efficiency. Economic literature suggests that efficiency is a key goal for allowance sales. In the case of allowance auctions, economic efficiency can be achieved if allowances are purchased by those who value them the most. A general measure of the efficiency of an auction, therefore, is its ability to generate bids that accurately reflect how much value a bidder places on the allowance. If efficiency is achieved, the resource—in this case, the right to emit greenhouse gases—is allocated to its highest-valued use. Efficiency may be affected by strategic bidding behavior or collusion if these activities artificially depress the price of allowances. Facilitating price discovery. Allowance sales may help facilitate price discovery—the process of determining a commodity’s price based on supply and demand. Sales that successfully facilitate price discovery will generate an allowance price that accurately reflects the marginal cost of reducing emissions. That is, the price would reflect decisions by covered entities either to reduce their emissions or to purchase allowances to cover them, whichever is more cost-effective. Economists expect that this process of price discovery will prompt emissions reductions by those covered entities that can undertake them most cost-effectively. Without effective price discovery, the overall efficiency of the allowance market may be diminished, increasing the program’s costs to the economy. According to several program officials involved in the ETS, the need for price discovery depends on the volume of allowances sold under the program. If only a small percentage is sold, and the rest freely allocated, price discovery will be accomplished in the secondary market. Avoiding market manipulation. According to economic literature, allowance sales should limit opportunities for participants to collude or engage in other forms of market manipulation. Collusion to depress allowance prices, if successful, could distort price signals, reduce revenues collected by the government from the sale of allowances, and cause participants and observers to question the fairness and transparency of the program. In addition, if allowance ownership were to become concentrated among a small group of participants in the secondary market, these participants could then withhold allowances from the market, driving up prices and impeding efficiency. However, several program officials and economists said it would be difficult to pursue such a strategy in the presence of a liquid market, since participants would have to acquire large shares of allowances both at individual auctions and in the secondary market. In addition, literature and economists we interviewed suggest that a U.S. cap-and-trade program for carbon dioxide allowances would likely attract a large number of participants. According to them, broad participation would prevent any single participant from gaining undue influence within the market, limiting opportunities for collusion and market manipulation. Revenue generation. Available literature suggests that policymakers could also aim to maximize the level of revenues collected from the sale of allowances. For example, policymakers could design a sale so that it is more likely to achieve high allowance prices. However, while maximizing revenue is a common goal in other government auctions of public assets, high allowance prices could increase the burden of a cap-and-trade program on covered entities or consumers of their products, which could erode political support for the program. Furthermore, some program officials noted that it would be much easier to accomplish this goal by increasing the stringency of the emissions cap. Minimizing administrative and transaction costs. Several economists and program officials recommended minimizing the administrative and transaction costs associated with allowance sales. Administrative costs are the time and resources governments spend designing and implementing allowance sales; available information suggests that most of these costs are incurred in the design phase of the program. Transaction costs, on the other hand, refer to costs incurred by participants in obtaining allowances—for example, costs associated with registering for an auction, developing a bidding strategy, and any bidding fees. According to available information, high transaction costs could discourage participation, and smaller entities in particular may face disproportionately high costs relative to the value of allowances they purchase. According to economic literature, the design of an allowance sale can have a significant impact on both administrative and transaction costs. For instance, weekly auctions may result in higher administrative and transaction costs than those held less frequently, although using existing infrastructure may help to minimize these costs. While several economists noted that any costs incurred by governments and participants would likely be minor compared to the value of the allowances, program officials said that keeping these costs low would help ensure ongoing support for the program.