Emissions trading: auctioning vs grandfathering permits

Emissions trading programs are increasingly used as market based climate policy instruments to reduce greenhouse gas emissions cost-effectively. Under these programs, a national or regional limit (cap) is placed on the total amount of emissions across a given industry, or the whole economy. The total amount is split into allowances, each permitting a company to emit one ton of emissions. The permits are distributed either free (grandfathering) or through an auction, and participating companies that cut their emissions faster can sell (trade) allowances to companies with higher emissions or “bank” them for future use. This market approach gives companies flexibility in how they pursue emissions reduction measures, encouraging faster reductions and rewarding innovation. A fundamental challenge confronting policy-makers in designing effective tradable permit markets is the incentives it creates for firms to invest in the research and development (R&D) of advanced emissions control technologies. A new study by Professor Timothy Cason (Economics) and Frans de Vries (University of Stirling, Scotland) explored how the allocation mechanism (grandfathering vs auctioning) affects companies’ incentives to invest in R&D. Their laboratory experiment found that overall higher levels of R&D investments are observed under auctioning allocation mechanisms.

Cason, T.N. and F.P. de Vries (2019). Dynamic Efficiency in Experimental Emissions Trading Markets with Investment Uncertainty. Environ Resource Econ 2019 73: 1 1-13.