Methods for allocating carbon credits in global compliance carbon markets (CCMs) are vital market design decisions. The allocation of allowances influences the formation of carbon prices, emissions costs for covered corporations and market efficiency. The decision to allocate allowances freely or through auction mechanisms is a key design feature that affects all stakeholders within the carbon market ecosystem, including covered emitters, market operators, financial intermediaries and investment firms. In recent years, global CCMs have shifted from free allocation to auction-based distribution of allowances. Calibration of auction mechanisms is a policy decision that plays a critical role in determining market outcomes.
This report examines the auction mechanisms of world CCMs and evaluates their effectiveness as measured by various indicators of market quality. The aim of the research is to tell the investment industry about various auction mechanisms and to supply practical advice on participating in auction markets. By reading this report, financial intermediaries and investment firms will likely be higher informed to make their decisions to take part in the first market, while policymakers and market operators will have the ability to find out how best to calibrate the allocation of allowances of their respective markets.
Given the numerous increase within the participation of monetary intermediaries and investment firms within the carbon auction market, in addition to the expanded global impact of carbon pricing on corporations arising from the EU’s Carbon Border Adjustment Mechanism (CBAM), this report complements previous studies by specializing in the first markets of world CCMs. The report consists of three most important sections:
- The “Auction Mechanisms” section examines the auction mechanisms of the key CCMs that use auctions. It explains the auction rules, frequency, processes, auction share of certificates and market developments. It covers CCMs within the European Union, New Zealand, California, Quebec, Washington State and the United Kingdom and analyzes the similarities and unique characteristics of every system.
- Next, the Auction Effectiveness section evaluates the effectiveness of the CCM auction mechanisms. To evaluate CCMs within the EU, California and the UK, three indicators from different dimensions are used: price stability within the auction market (difference between the auction price and the prevailing secondary market price relative to the market price), depth of demand (bid-to-cover ratio) and floor price maintenance (auction clearing price premium). The evaluation links these indicators to the precise characteristics of every system.
- The “Determinants of Auction Effectiveness” section examines the important thing aspects that may influence the effectiveness of CCM auctions.
Key findings:
- The proportion of allowances auctioned in global CCMs has increased steadily over time. For CCMs that use auctions, the first auction structure is a single-round, sealed-bid, single-price auction. To conduct auctions, CCMs use special platforms – the European Energy Exchange (EEX) for the EU, the Western Climate Initiative, Inc. (WCI, Inc.) for California and the Intercontinental Exchange (ICE) Futures Europe for the UK. Beyond these similarities, each CCM has different characteristics. The EU Emissions Trading System (EU ETS) has the longest auction history, the biggest auction volumes and the very best frequency (three days per week), making it essentially the most mature auction market. The California Cap-and-Invest Program, formerly the Cap-and-Trade Program, conducts quarterly auctions and uses a comparatively strict, annually increasing auction reserve price mechanism that may directly influence the extent of auction prices. The UK Emissions Trading Scheme (UK ETS) runs auctions every two weeks. As a more recent and smaller CCM, the UK ETS has a narrower auction offering.
- Investment professionals participating in primary auction markets should consider the differences in auction effectiveness between CCMs.
- As essentially the most sophisticated CCM, the EU ETS has auction clearing prices which are largely aligned with prevailing secondary market prices. Its auction mechanism shows strong resilience to external shocks and the flexibility to self-adjust after a shock. In the long run, the auction mechanism ensures a stable, moderate level of demand and a continuing auction supply.
- Because it’s a developing CCM, the UK ETS auction tends to shut at a small discount in comparison with secondary market prices. The coordination between auctions and the secondary market improves over time. The auction mechanism also encompasses a stable, moderate depth of demand and a gentle auction supply. The auction release prices are at all times above the constant auction reserve price.
- As a CCM with a strict annually increasing auction reserve price and a comparatively low auction frequency, California’s auction clearing prices are generally based on secondary market prices, although large deviations occasionally occur because of the strict reserve price policy and the frequency mismatch between auctions and secondary market trading. The depth of demand is more volatile because of fluctuations on each the demand and provide sides and oversupply can occur. In most cases the minimum price is binding; The clearing prices are near that. Auction results are due to this fact determined by reserve prices slightly than market forces.
- Policymakers and CCM market operators in search of to strengthen the effectiveness of allowance auctions can deal with the effectiveness of more frequent auctions and increasing the share of allowances auctioned in comparison with free allocation, thereby encouraging broader participation in the first market and improving the trading volume and liquidity of allowances within the secondary market. The market design decisions discussed on this report can strengthen market functioning by improving transparency, reducing price dispersion and volatility, and stimulating demand.
Investment professionals can use this report back to guide their participation in global carbon auctions, for instance by determining which CCMs to take part in and whether it’s profitable to interact in primary markets. Policy makers can use the outcomes of this report back to specifically improve auction mechanisms.
