CO2 emission allowance allocation mechanisms, Allocative efficiency and the environment: A Static and dynamic perspective

The object of this paper is to place allocation mechanisms into a framework of emission trading systems and thereby to establish a typology. It analyses how various assignment mechanisms deal with issues such as price determination, allocative efficiency and environmental considerations in a static and dynamic economy model. It analyses how allocation mechanisms are to be ranked and whether they serve the attainment of the general equilibrium. First the paper examines how market-based allocation mechanisms (auctions) perform in light of the above issues. Second the paper distinguishes between the two types of administrative allocation mechanisms: (1) financial administrative allocation mechanisms, combining payment schemes with bureaucratic expertise, and (2) free administrative allocation mechanisms, based inter alia on industrial policy considerations and on passed emission records (grandfathering). In particular, the value added of relative performance standards, which are for example included in the “performance standard rate” (psr) emission trading system, are examined as a means to provide allowances. The overall finding is that in a closed static economy and in the presence of an efficient trading market, different allocation methods produce equally efficient outcomes in allocative and environmental respects. With regard to an open dynamic economy, the impact of initial allocation mechanisms resembles those of a static closed economy. In such an economy the upper limit to the internalisation of negative externalities is given by operator’s costs of environmentally harmful relocation and hence the cost burden placed upon operators is crucial. Auctions and financial administrative allocation mechanisms perform less well than free administrative mechanisms. Relative standard base mechanisms, constituting an important element of the psr emission trading system, perform better than grandfathering schemes because they take into account abatement possibilities of industries, minimise stranded costs and do not give rise to time shifting of abatement projects. It is therefore concluded that allocation mechanisms merit more attention than the discussion relating to capped trade and trade without a cap.