Auctioning Carbon Permits—a Primer for the U.S.A.

In a previous post I laid out a primer for U.S. carbon pricing. One key element was the auctioning of carbon permits. There are a lot of ways to conduct an auction, but one—of the “ascending clock” variety—stands out as ideal for allocating carbon permits. To my surprise, I have found no concise explanation on the Internet of how this type of auction can be applied to carbon permits. So that’s what this post is for.

An auction is a way to allocate goods to multiple buyers based on a simultaneous expression of preferences. The kind that most of us are most familiar with is a simple “ascending clock” auction for a single item (sometimes called an “English auction”). The auctioneer states a low price. The first person to raise their hand has dibs at that price. The auctioneer continues to state progressively higher prices, and bidders continue to indicate their willingness to pay, until a price is reached that no one is willing to pay. The item belongs to the person who was the first to raise their hand at the second-highest named price, the highest price with a willing buyer. Auctions can be run in other ways too. They can go from high price to low instead of from low to high. Bidders can bid on stated quantities rather than stated prices. And bidders could be asked to submit an entire schedule of price/quantity preferences rather than revealing their preferences step by step over multiple rounds.

General principles of good auction design include:

• Make it easy to participate. The rules should be simple. They should not favor big players with expensive consultants.

• Make it difficult to cheat. The auction should reveal actual price and/or quantity preferences. There should be as little opportunity as possible for one bidder or a group of bidders to get the goods at a lower prices than they would actually be willing to pay, or to otherwise make the auction system itself a source of profit or competitive advantage.

The simple “ascending clock” model is good in both of these respects. But for carbon permits we need to adapt it slightly. We need to sell not one item at a time, but multiple identical items all at once. Here is how the adapted ascending clock model will work:

1. As with a regular English auction, the bidding proceeds in multiple rounds, starting with a low price and proceeding incrementally to higher prices until the bidding ends.

2. In each round, each participant privately informs the auctioneer how many carbon permits they would be willing to purchase at the current bidding price, and the auctioneer totals up all the bids.

3. If the total number of permits that all participants are willing to buy at the current price is higher than the number of permits available to be sold, the bidding proceeds to another round at a higher price.

4. From round to round, each participant is allowed to bid the same quantity of permits as they bid in the previous round, or a lower number, but not a higher number. (This is to prevent gaming.)

5. When a price is reached where the total number of permits that all participants are willing to buy is less than or equal to the number of permits available to be sold, the bidding stops. The quantities requested in that final round are locked in at the agreed-upon price. If any permits were not claimed at the final price, they may be sold at the second-highest price to bidders who had offered to purchase additional permits at that lower price. (Or they may be held back for the next auction, or held back and retired.)

An auction like this does not need to be conducted in person. It could be conducted on a secure web platform.

One question that arises is: who should be allowed to participate in the bidding? From an auction design point of view, there should be a sufficiently large number of bidders to ensure that a handful of powerful players can’t secretly collude to fix prices. And while there is no upper limit on the optimal number of bidders, it is important that all participants be sophisticated enough to bid intelligently in their own interest. As discussed in the previous post, a sound carbon pricing system will take an “upstream” approach, regulating energy companies that introduce carbon into the economy (as opposed to the end-use consumers who release it into the atmosphere). These energy companies probably number in the thousands. With several thousand bidders participating, the auction is likely to be free from concerns about price-fixing. And the energy companies are likely to be sophisticated enough to intelligently forecast demand for their own product at multiple price points.

Should others besides the “first sellers” of carbon fuels (the businesses that will need to redeem the permits) be allowed to bid on the permits? Some carbon cap-and-permit programs allow “non-covered entities” like investment banks to participate in permit auctions and to buy and sell the permits in secondary markets. As explained in the previous post, making a business out of owning and buying and selling permits will just create addition costs (brokers’ fees, consultants’ fees, speculative profits) that will ultimately be passed on to the consumer. The only valid reason to allow buying and selling of permits is to ensure efficient allocation, and a well-designed auction already provides an efficient allocation. There is no valid reason whatsoever for non-covered entities to hold and buy and sell carbon permits. Bidding should be limited to bona fide “first seller” energy companies. They should be required to register in advance of participating in the auction.

But: can we really be fully confident that auctions will ensure efficient allocation of permits? What if market conditions change rapidly, leading to (say) a sudden increase in demand for petroleum and decrease in demand for natural gas? What if something mundane goes predictably wrong, like a bidder having an Internet outage that prevents it from participating in the auction, or making a typo and accidentally purchasing 50 permits rather than 500? Here are some features of the auction system (and the cap-and-permit system as a whole) that could provide the necessary flexibility:

• Auctions should be held on a fairly brisk schedule (say: quarterly, or even bimonthly or monthly), so permit-holding can keep up reasonably well with market conditions.

• Participants should be allowed to bank permits, holding them over from one redemption period to the next, at least for a certain length of time (they could expire, say, after two or three years). That should ease concerns about possibly buying too many permits and being unable to use them.

• As a backstop, there needs to be a penalty in place for sale of carbon fuels without the required permits. The penalty should be onerous enough to provide a real disincentive. Proposed legislation in the U.S. has included penalty provisions ranging from twice the price of the missing permits to five times the price of the missing permits. To keep the nation’s carbon budget on track, the offender should also be required to acquire the missing permits after the fact at the next auction.

• Nevertheless, there could be a cushion of flexibility before penalties kick in. Like: participants could be allowed, without penalty, to run a small (say, under 10% of permit purchases over the past year) short-term deficit of permits, to be made up at the next auction. The advantage of a provision like this (sometimes called borrowing and seen as complementary to banking) is that it frees participants from needing to hold on to a large number of permits as a cushion in case of spikes in demand.

• In principle, banking and borrowing should provide all the flexibility that permit holders need. But if regulators decide they want to provide additional flexibility, they could allow limited trading between covered entities: e.g., on a case-by-case basis with the regulator’s explicit approval and in the regulators’ own ledgers, or more freely in a regulator-managed marketplace. In that case, to discourage gaming (e.g., speculative purchases at auction with an intent to resell at a profit) the trading price of a permit should be fixed at the original sale price.

Some carbon cap-and-dividend systems include a “collar” on the auction price: i.e., a minimum price and a maximum price. In an ascending clock auction, the minimum price is also known as the reserve price: the price at which the bidding starts. Setting a reasonably aggressive schedule for a rising minimum price can help mitigate some short-term price volatility and can also provide businesses with the assurance they need, for planning purposes, that carbon prices will rise in the long term.

Businesses planning their budgets might also prefer regulators to set a maximum carbon price. But setting a maximum price can cause problems.

Enforcing a maximum price will require regulators to either (a) increase the number of permits available for sale, or (b) allocate scarce permits among willing buyers using some non-market criterion. The first option will compromise the carbon cap; the second will create economic inefficiency and open up regulators to accusations of unfairness. Studies have shown that when a carbon cap-and-permit system has a price collar, the price usually perches at either the minimum or maximum price; it rarely balances in between. As long as it perches at the minimum, the pricing system is equivalent to a carbon tax, which is fine—provided that the minimum price is set to rise on a robust schedule. When it perches at the maximum, it converts the efficient auction system into something else entirely, an inefficient system where regulators pick winners and losers. Better to let the price rise freely and let the market do its job of incentivizing decarbonization.

Rising and possibly volatile carbon prices will be an inconvenience to businesses during the decarbonization transition. Since the costs will ultimately be passed on to consumers, it is worth reiterating that rising carbon prices will be more than an inconvenience to households: they are equivalent to a regressive tax and they will break the budget of many households if some mitigating measure is not put in place, and the most obvious candidate mitigating measure is carbon dividends. Net revenue from the carbon permit auction should be redistributed among households. The higher the price of carbon rises, the more revenue households will receive to help them ride out the storm. On the other side of the storm will be a low-carbon economy, and those who decarbonized fastest and most thoroughly will reap the most rewards from the recycling of auction revenue.

As with the previous post: This was written with the 2021 U.S. policy context in mind, but the principles apply generally. Feasta has long advocated for GlobalCapCarbon as an equitable way to manage decarbonization globally. National programs could be linked and federated to achieve that goal.

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