As climate legislation once again gains prominence in the US Congress, so does the question of auctioning versus allocating emission allowances. President Obama’s budget proposal calls for 100-percent auctioning while proposals by USCAP and others call for mostly allocation. The current Waxman-Markey draft bill is silent on the issue.

Outside a very narrow range of circumstances, free allocation of allowances, especially to electric power generators and utilities, would lower the efficiency of cap-and-trade and likely produce windfall profits for some companies at the expense of consumers.

Free allocation to regulated electric utilities would dilute the consumer price signal needed to stimulate not only direct reductions in energy use, but also investment and innovation in end-use efficiency improvement. This runs counter to the widespread agreement that energy efficiency improvements will need to play a major role in combating climate change risk. Full auctioning of allowances may increase the cost of capital of regulated utilities. But that is more a feature of cap-and-trade induced volatility than of auction versus allocation, and it is likely less important than the demand effect.

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