RGGI Auction Design Research: Phase 1 Results RGGI Stakeholder Meeting, New York City May 31, 2007 Dallas Burtraw, Karen Palmer; RFF Charlie Holt, Bill Shobe; Univ. of Virginia Jacob Goeree; CalTech

Purpose  To provide the states participating in the Regional Greenhouse Gas Initiative (RGGI) with information that they will need to implement a successful auction of carbon allowances.

Key approach  Use economics laboratory experiments to test auction designs:  Networked computers with student subjects  Carefully structured financial incentives  Used in many auction design applications 2  FCC spectrum sales, U.S. treasury notes, SO 2, NOx, irrigation reductions, timber, and others  Helpful in setting auction design details

Proposal  Phase 1:  Literature Review  Assessment of auction types  Phase 2:  Specific performance and design analysis

Phase 1 Experiments  Auction types:  Sealed bid - pay as bid (‘discriminatory’)  Sealed bid - uniform price for all winners  Multi-round clock auctions  English (increasing)  Dutch (decreasing)  English clock with ‘ shootout ’ round  Interaction with spot market

Stylized setting for experiments  Designed to capture key aspects of market  Simple enough to implement in the lab

Setup  Experimental sessions  12 participants per ‘lab session’  Univ. of Virginia student subjects  Subjects earn money by buying, trading, and using allowances  Each subject acts as a firm with a capacity to produce a product  Production requires that the firm use allowances  ‘Low’ users need 1 allowance per capacity unit  ‘High’ users need 2 allowances but have lower production costs

Setup (cont.)  Production costs randomly distributed across ‘firms’  Wide cost range (15 sessions), narrow (11 sess.)  Initial sessions run without secondary (spot) market and no banking  Price of product fixed and known  Earnings equal price of product sold minus production costs minus allowance costs

Measures of performance  Efficiency is high if allowances are purchased by firms with the highest value for allowances (results in lowest cost carbon abatement)  Revenue is high if the auction is competitive; firms are not able to collude to pay less than the market price

Session data

Results table

Phase 1 Considerations  Revenues and efficiency  Accurate price discovery  Liquidity and price volatility  Fairness and transparency  Administrative costs  Setting reservation price  Handling unsold allowances

Preliminary Recommendations  Format and Frequency  Reservation Prices  Futures Market  Miscellaneous

Format and Frequency  Auction format  Mixed auction format  First auction for a vintage: English clock with shootout sealed-bid round  Subsequent auctions sealed-bid  English clock enhances price discovery  Sealed-bid: low cost, resistant to collusion, commonly used

Format and Frequency  Define ‘vintage’ to coincide with the enforcement period  Minimize irrelevant differences  Reduce transaction costs  Maximize number of identical assets

Format and Frequency  Auction frequency  Quarterly throughout the vintage  Enhances liquidity  Less likely to disrupt spot market  Reduced ability for ‘surprise hoarding’

Reserve Prices  Set firm reserve price  Very important element of auction design  Protects against collusion  May help reduce volatility  Must be willing to have unsold allowances  Option: put unsold allowances in a ‘contingency bank’

Facilitating Futures Markets  Sell some allowances before vintage year  May not be used before vintage year  Develop price signals about future scarcity  Help reduce risk on long-term investments

Miscellaneous  Allow broad participation in auction  Anyone who can financially qualify  This enhances price discovery and efficiency  Efforts to limit participation may be difficult to enforce

Miscellaneous  Auctions should include binding financial assurance  Escrow, letters of credit, bond rating  No bids for more than posted assurance  Bidders held responsible for bid amounts

Questions?

Phase 2 Research  Impact of “non-compliance” entities in auction  Appropriate levels of information revelation  Financial assurance and escrow requirements  Bidding rules that deter collusion  Establishing a credible reserve price  Rules for selling reserve allowances  Discriminatory or uniform price sealed-bid auctions  Guidance on selling future allowances