Which allocation rule generates true price signals for the CO2 allowance market?

Panel: Panel 1: The foundations of a future energy policy. Longer term strategies

Authors:
Eva Benz, Bonn Graduate School of Economics, University of Bonn, Germany
Karl-Martin Ehrhart, Institute of Economic Theory and Operations Research, University of Karlsruhe, Germany

Abstract

The Kyoto Protocol sets national quotas on the global pollutant CO2 and allows for international emissions trading as a way to obtain air quality standards at least costs. The economic efficiency of the system depends on firms being able to deal with permits at competitive prices and to decide on the “best” emissions reducing investment. Here, early and reliable price signals constitute the basis, particularly for energy efficient investment decisions which are of increasing interest for companies under emissions trading. Based on our experimental study (Benz and Ehrhart, 2006), we exclusively investigate the reliability of market price signals generated by different policy-relevant allocation rules for CO2 allowances under the EU emissions trading system (EU-ETS). We consider gratis allocation (grandfathering), auctions, and their combination in so-called hybrid systems. Regarding the auctions, we also inquire for the “appropriate design” for carbon auctions.

Based on a theoretical approach, where agents bid according to their marginal abatement costs, we show that the hybrid system of grandfathering and a one-sided auction (which is taken into account in the EU-ETS) does not generate reliable price signals, which should reflect the actual market scarcity of the allowances. This requirement, however, is met, if in the hybrid system the one-sided auction is replaced by a double auction or if a one-sided auction is used exclusively. The results of a laboratory experiment persuasively support our theoretical findings with respect to correct price signals.