Managing Allowance Prices in a Cap-and-Trade Program

November 5, 2010

The accumulation of greenhouse gases in the atmosphere could cause costly changes in regional climates throughout the world and has led policymakers and analysts to consider policies to restrict emissions of those gases. One option for reducing emissions in a cost-effective manner would be to establish a cap-and-trade program for those gases. Such a program would limit the number of tons of greenhouse gases emitted by setting gradually tightening annual caps, which, when added together, would set a cumulative cap over the duration of the policy. The government could distribute allowances, which would be rights to emit those gases, by selling them, possibly through an auction, or giving them away. Then firms could trade allowances, “bank” unused allowances for future use, or “borrow” allowances allocated for future years in order to reduce the cumulative cost of complying with the caps.

The price of allowances would vary on the basis of current conditions, such as the weather and the economy, and firms’ expectations about factors affecting their compliance costs over the duration of the policy. Unexpectedly high (or low) allowance prices would make the cost of meeting the caps much higher (or lower) than policymakers had expected, which could alter the tradeoff between costs and benefits that policymakers had anticipated when they selected the caps. Because they cannot know in advance how high or low allowance prices would be in any given year, policymakers might consider including mechanisms in a cap-and-trade program that would help limit the range of potential allowance prices.

Today CBO released a study—prepared at the request of the Chairman of the Senate Committee on Energy and Natural Resources—that examines the potential effects of certain mechanisms that would help manage allowance prices, and thus the cost of complying with a cap-and-trade program, by altering the number of allowances available to firms at various prices. CBO examined the effects of three such mechanisms: a price ceiling, an allowance reserve, and a price floor. Actual experience in managing allowance prices through the approaches that CBO examined is quite limited, and they could have effects other than those identified here.

A Price Ceiling

Policymakers could set an upper limit, or ceiling, on allowance prices by allowing firms to buy an unlimited number of allowances, in addition to those permitted under the cumulative cap, at a specified “ceiling price.” Such a policy would have the following consequences:

  • It would provide an upper limit on allowance prices but not on emissions, meaning emissions could exceed the cap.
  • The higher the ceiling price was set above the projected path of allowance prices, the less likely it would be that firms would buy additional allowances, and if they did buy them, the fewer they would buy. As a result, a higher ceiling would generally lead to fewer additional emissions than would arise under a lower ceiling.
  • Provided that firms were able to shift allowances from one year to another—that is, bank and borrow allowances—a ceiling could dampen the price of allowances, even when their market price was below the ceiling price.
  • If the ceiling lowered allowance prices, it would diminish firms’ incentives to invest in equipment that reduced emissions and in efforts to develop new lower-cost technologies for reducing emissions. That decrease in investment would lower firms’ spending for emissions reductions in the near term but could increase it in the future, when their compliance costs rose.

An Allowance Reserve

Alternatively, policymakers could offer to sell firms a limited number of allowances at or above a given price. Such an “allowance reserve” would have the following effects:

  • It would impose an upper limit on emissions—which might be different from the cumulative cap—but would not set an upper limit on the price of allowances.
  • A reserve created by adding to the number of allowances supplied under the cap would allow a limited loosening of the cap when costs were high. Such a reserve would tend to increase emissions and lower allowance prices relative to a policy with the same cap but no reserve.
  • A reserve created by withholding allowances that would otherwise be distributed under the cap could increase firms’ compliance costs but allow fewer emissions than those under a program with the same cap but no reserve.
  • The effect of a reserve on emissions and allowance prices might be greater but would be less certain if regulators could restock the reserve by using offset credits, which reflect reductions in domestic or overseas emissions that would not otherwise be subject to the cap.
  • If the federal government used auctions to sell the reserve allowances it created, it would capture their full value. Alternatively, if the reserve allowances were distributed by offering firms options to purchase them at a fixed price, the government and firms would share the allowances’ value.

A Price Floor

Another approach, a price floor, would set a lower limit on the price of all traded allowances. With a “hard” price floor, the simplest form of such an approach, the government would be required to purchase an unlimited number of allowances at a predetermined price. Broadly speaking, including a price floor in a cap-and-trade program would tend to boost allowance prices in the near term but would probably not result in fewer emissions over the duration of the policy if firms were permitted to bank allowances. CBO’s analysis also indicates the following:

  • The further below the projected path of allowance prices that the floor price was set, the less likely it would be that the floor would become binding—that is, prevent any further decline in prices.
  • At a time when it was binding, a price floor would increase firms’ compliance costs, relative to a policy with the same cap and no price floor, because it would require firms to reduce emissions more than they otherwise would.
  • To the extent that a price floor increased the price of allowances, it would strengthen firms’ incentives to invest in emissions-reducing equipment and to develop new lower-cost technologies for reducing emissions. Those investments would boost firms’ spending in the near term but decrease their compliance costs (and lower allowance prices) in the future.
  • If firms could shift allowances from one period to another (by banking and borrowing allowances), a price floor would probably not result in cumulative emissions over the life of the policy (typically several decades) that were less than the amount permitted under the policy’s cap. Instead, it would shift reductions forward in time.
  • Policymakers could try to set a lower limit on the price of allowances by establishing a minimum bid price for the allowances sold in a government-run auction. But that bid price would establish a floor for prices in the secondary market only if the demand for allowances was great enough that firms would want to buy at least some of the allowances being auctioned.

This study was prepared by Terry Dinan of CBO’s Microeconomic Studies Division.