EPA Grant to U.Va. Economists Follows Emission Auction Success

September 20, 2010

September 20, 2010 — The Environmental Protection Agency's National Center for Environmental Economics has awarded a $177,000 grant to University of Virginia economists Charles A. Holt and William Shobe to further their research on pollution emission auctions.

Holt and Shobe helped design the nation's first auction of carbon dioxide emission allowances, which began in 2008 and affects more than 200 power plants in 10 Northeastern states that make up the Regional Greenhouse Gas Initiative.

Under an emissions trading system like RGGI, also known as cap and trade, pollution producers like power companies must purchase enough emissions allowances to cover their annual emissions, giving them a cost incentive to reduce emissions through alternative energy investments or improved efficiency. The allowances can be bought and sold among power plants, and saved for use in a later year. This enables free market forces to determine the cheapest and most efficient measures to produce a cumulative reduction in emissions of a given pollutant, such as nitrogen oxides (a key contributor to acid rain) or the greenhouse gas carbon dioxide.

The RGGI auctions are ongoing, roughly every three months (the latest occurred Sept. 8). To date, they have raised $729 million from the sale of more than 290 million one-ton emission credits. More than 80 percent of the revenues have been invested in programs and research to promote clean energy. 

The RGGI auction design has proven quite successful, Holt and Shobe said. It has generated strong revenue, with no signs of buyers gaming the system.

The RGGI auction has also produced relatively consistent prices over time. In contrast, the world's largest emission auction, the European Union's Emissions Trading Scheme, saw unsettling price volatility in its early years. The price of ETS carbon permits tripled in the first six months after the program began operating in 2005, then collapsed by half in a one-week period in 2006 when data showed that Phase 1 permits, which could not be "banked" for use during Phase 2, were in excess supply. Prices declined to zero later that year.

Relatively stable carbon emission prices are crucial to spur long-term investments in low-carbon technologies, Shobe noted.

With that goal in mind, the European Union recently selected the auction design for Phase 3 of the ETS. They settled on an auction system very similar to the RGGI system.

Good auction design minimizes price volatility, Shobe said, and that is one aspect of the research that will be funded by the new EPA grant.

Related research by Shobe and Holt of the College of Arts & Sciences has long been funded by U.Va.'s Bankard Fund for Political Economy, administered by the Office of the Vice President for Research.

"The technical expertise of professors Bill Shobe and Charlie Holt has been an important component in laying the foundation for the success of the RGGI carbon dioxide allowance auction program," said RGGI's executive director, Jonathan Schrag. "RGGI auctions now run like clockwork, due, in large part, to the careful and thorough analysis of the research team in analyzing auction mechanism design and market structure."

Many states and nations around the world are planning or considering adopting emission allowance auctions to control pollution and reduce greenhouse gases. President Obama has called for the creation of a national cap-and-trade system for carbon emissions, similar to RGGI, as one of the key ways to deal with global warming. Last year, the House of Representatives passed a bill that would create such a system, but a similar measure failed to clear the Senate. 

In the absence of federal action, states are stepping up. The Western Climate Initiative is a multi-state collaboration, similar to RGGI but still in the planning stages, involving a number of Western states and Canadian provinces.

Subtle variations in auction design can significantly impact the revenues generated as millions of permits are sold. "There are hundreds of millions of dollars at stake," Shobe said.

That's one reason that Holt and Shobe extensively test auction designs in U.Va.'s behavioral economics laboratory, allowing them to learn the flaws of any particular design long before it is put into action selling real permits worth millions.

U.Va.'s virtual behavioral economics laboratory, "V-econlab," built with hundreds of hours of custom programming by Holt, is also a great teaching tool. Free and open to anyone via the Internet, 8,000 to 10,000 students from around the world log in to use the lab every month. "These experiments provide a hands-on active learning experience that complements the abstract theory taught in class," Holt said.

With millions of dollars on the line, the field-tested success of the RGGI auction and related experimental studies by Shobe and Holt "will certainly influence future auction design" around the world, said Regina Betz, joint director of the Centre for Energy and Environmental Markets at the University of New South Wales in Australia, who has worked with the duo on auction design for greenhouse gas emissions allowances in Australia.

Schrag echoes Betz. "Over two years and nine auctions, RGGI has proven how well auctions work to allocate carbon dioxide allowances, and this success is now looked to as other jurisdictions design similar programs."

— By Brevy Cannon