Tuesday, October 06, 2009

Emissions trading: Auctioning permits vs giving them away

As I've talked about before (The great permit give-away), one of the big debates in emissions trading is whether to auction most of the permits or give them away free to industry. Under the Australian CPRS it looks like more and more will be given away, to industries that are particularly affected and/or have to compete with overseas industries that do not face carbon costs.

There's a few myths going around about the different results from allocating and giving away permits.

One myth that I hear from the green side is that if you give permits to companies for free, they have no incentive to reduce their emissions.

A myth I hear from the industry side is that if they're given free permits, they won't have to raise their prices to recover the additional costs of permits.

But in theory, you get the same carbon price and the same impact on, for example, electricity prices, whichever allocation method you use.

The reason is trade and opportunity cost. Even if a firm gets permits for free, the permits still have a value. They can be sold. Other firms will need to buy them if they want to expand production and the firm with free permits can choose to sell or use the permits. If it can reduce its emissions more cheaply than the permit price then it has an incentive to reduce its emissions and sell the permits - even if it got the permits for free.

And if a firm gets permits for free, will it pass the savings on to its customers? Well maybe. But its competitors will still have to buy permits at market price. And the firm (and any other firms in the industry) will have to buy more permits if it wants to expand. So, at the margin, firms will need to take the permit price into account. Now the firm with the free permits could undercut its competitors. Its market share would then increase and it would have to buy more permits - at the market price. Or it could just charge the market price for electricity and pocket the difference as pure profit.

That was the experience under the EU's emissions trading scheme, where German electricity generator RWE passed the "cost" of permits onto its customers, even though it had received most of those permits for free. The result was a windfall profit of about $6.4 billion for RWE in the first 3 years of the scheme, and electricity prices that rose by 5% a year.

A new experimental study (PDF) also casts some light on the theory.

Experimental economics is a fairly recent and fascinating field where the predictions of economic theory are put to test in the lab. Testing economic theory in the real world is fraught because it's almost impossible to isolate the parameter you're testing from the thousands of other factors that could be affecting the outcome. What's the effect of the stimulus package on retail spending? No-one really knows because there are so many other factors affecting retail spending: unemployment, interest rates, exchange rates, etc etc. You can't control for them all. In the lab, you can control the environment. (The trade-off is whether you can translate behaviour in the lab to behaviour in real life.)

In this study, participants were randomly assigned roles as high emitting or low emitting firms in a simplified industry. In one treatment, high emitting firms were given free permits, while in the second treatment, permits were auctioned. Trading of permits was then allowed freely in both treatments and firms also then decided on how much they would produce and the prices they would charge for their products, taking into account the need for permits and the decisions of their competitors.

The results are interesting and accord roughly, but not exactly, with the theory:
  • Under free allocation, most permits remain with the high emitters who received them for free, apparently because the high emitters are able to use their market power to keep the permit price high and reduce trade.

  • Firms pass the cost of permits through to their customers under both treatments (even if they got them for free). Surprisingly, product prices are even higher under free allocation (not sure why this is the case).

  • With free allocation of permits, the high emitters walk away with large windfall profits. These disappear with auctioning, with the surplus instead going to the government as auction revenue and to consumers in the form of lower product prices.

This study adds further support to the idea that permits should be overwhelmingly auctioned, not given away. Permit giveaways benefit no-one other than the companies who get the free permits, at the expense of their competitors, consumers and taxpayers.

Goeree, J., C. Holt, K.L. Palmer, W. Shobe and D. Burtraw (2009). "An Experimental Study of Auctions versus Grandfathering to Assign Pollution Permits." RFF Discussion Paper 09-39, Sept 2009.

(HT: Climate Changes)


Ashley said...

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