Revenue and efficiency in pollution permit allocation mechanisms

The most contentious design issue within pollution markets is the choice of initial allocation mechanism. Within this debate, auctions have become the predominant method of initial permit allocation. Although auctions provide potential gains—such as revenue generation, allocative efficiency and clear price discovery—these benefits are rarely fully realized due to firms submitting non-truthful bids. We propose a mechanism that can improve on existing auctions. In our design the regulator determines the supply (up to an upper bound) once all bids have been submitted. This simple and applicable design incites truthful revelation of firms’ private abatement costs, maximizes revenue, and allocates the permits efficiently. This design is relevant to all existing permit auctions including those in the European Union Emissions Trading Scheme (EU-ETS), Regional Greenhouse Gas Initiative (RGGI), and the California Cap-and-Trade Program.