Reconsidering Carbon Permits Auction Mechanism: An Efficient Dynamic Model

• Author: Mingrong Wang,Lihua Lang,Mingxi Wang
• Date: 01 August 2017
• Published date: 01 August 2017
• DOI: http://doi.org/10.1111/twec.12436

Reconsidering Carbon Permits Auction

Mechanism: An Efficient Dynamic Model

Mingrong Wang

1

, Mingxi Wang

2

and Lihua Lang

1

1

School of Economics, Capital University of Economics and Business, Beijing, China and

2

School of

International Trade and Economics, University of International Business and Economics, Beijing, China

1. INTRODUCTION

THE study on carbon emission rights allocation is significant, as many countries promised

that they would set tough specific targets for cutting carbon emissions after 2020 at the

UN Climate Summit 2014. However, an important question faced by these countries is how

to implement the targets efficiently. To answer the question, designing efficient allocation

mechanism for carbon emission rights can provide a theoretical foundation. Since China is

discussing the issue about whether it will join such a global carbon emission rights market,

exploration on the theoretical mechanism design of efficient allocation for carbon emission

rights is becoming the necessary part in China’s scheme.

Since the Kyoto Protocol was enacted in 1997, the carbon trading market has been of key

environmental focus (Zhang, 2010),

1

and negotiation on this issue has boomed in post-Kyoto

Protocol era. In 2013, 60 per cent of the allowances was auctioned off in the EU emission-

and-trade scheme (ETS). In 2014, about 5 per cent of carbon emission rights was auctioned

in China’s carbon trading pilots. Typically, from 2013 the power plant of EU ETS Member

States obtains emission quota only through the auction. Capoor and Ambrosi (2009) estimated

that about 80 per cent of the total cap would be auctioned in the ETS by 2020. Much atten-

tion is fixated on such auctions by many observers and economists; the main reason is that

they allow market, rather than administrative fiat, to determine who will use the rights

resource.

2

However, when multiple objects are sold, like carbon emission rights, agents may

have combinatorial valuation functions. Due to possibility of synergies and substitutability

among objects, it is not clear how to allocate the objects efficiently. Dynamic auctions facili-

tate a price discovery and terminate at efficient allocations under various conditions on valua-

tion functions (See, for example Vulcano et al., 2002; Goeree et al., 2 006; Said, 2011; Sun

The research was supported by National Natural Science Foundation of China under grant no. 71471039,

National Social Science Foundation of China under grant no. 12CJY078 and Program for Academic

Innovative Research Team in Beijing under grant no. IDHT20130522. We are grateful for the excellent

research assistance by Professor Xiaopeng Yin, as well as the helpful comments provided by the two

anonymous referees and the associate editor.

1

In fact, the emission right market has long been a major issue of economic research. In the 1960s,

Coase (1960), Crocker (1966) and Dales (1968) introduced its seminal idea; in the 1980s, Baunol and

Oates (1988) and Misoilek and Elder (1989) explored its implementation and the associated major

parameters; until the 1990s, Bohi and Burtraw (1992), Rubin (1996) and Kling and Rubin (1997) exam-

ined the emitting entities’ decision behaviour by introducing investment factor into the emission right

market.

2

Realising the inadequacy and cost-inefficiency of heavy reliance on administrative and political mea-

sures, some countries, such as China and Korea, have a strong motivation to rely much more on emis-

sion trading markets to reduce carbon emissions.

©2016 John Wiley & Sons Ltd

1624

The World Economy (2017)

doi: 10.1111/twec.12436

The World Economy

and Yang, 2014). In consideration of some unique features of carbon emission rights, the auc-

tion mechanism design for them may be different from those for other multiple items.

In the ETS, the government consigns the auction house to sell emission rights to emitting

entities, and the entities can trade their rights won in auction in the environmental exchange.

Thus, the ETS is constituted by the auction (the primary) market and the trade (the sec-

ondary) market. Due to the secondary market’s existence, it is important to consider whether

the final assignment is efficient. Assuming that the allocation in the primary market does not

matter, Montgomery (1972) and Rubin (1996) show there is a cost minimum equilibrium for

the given environmental target. However, in Montgomery’s framework, the equilibrium does

not coincide with that maximising the social welfare (Benz and Truck, 2006), and the initial

allocation determines whether the final allocation is efficient. In a single item setting , Krishna

(2002) demonstrates that the final assignment closely depends on the auction mechanism

design and the resale after the auction sometimes fails to attain the efficient outcome. In

spectrum licences auctions, Milgrom (2000) mentions that an inefficient initial assignment

cannot, in general, be quickly corrected by trading in licences after the auction is complete.

With the existence of secondary markets for the goods being sold, the optimal reserve price

of the auctioneer and the bidder’s valuation are endogenously determined in part by the bid-

der’s information after the auction (Haile, 2000, 2001, 2003). In standard auctions, post-

auction resale not only creates a role for a speculator –a bidder who is commonly known to

have no use value for the good on sale (Garratt and Troger, 2006), but also affects the sell-

er’s preference to some auction formats (Board, 2007; Hafalir and Krishna, 2008). Conse-

quently, designing an appropriate auction mechanism is a necessary prerequisite for an

efficient assignment of carbon emission rights. In this paper, we develop a dynamic auction

mechanism in which the seller’s utility gradually increases, while the bidders’ utility gradu-

ally decreases as the auction continues. In the auction, the straightforward bidding strategy

makes bidders avoid the risk of loss.

Unlike most ordinary goods auctions, in the carbon emission rights auction the winning

bidders pay at the delivery price to the seller, whereas the losing bidders must increase their

emission reduction investment to meet given emission budget. Thus, relatively to the busi-

ness-as-usual case, the seller obtains the environmental benefit from the auction, and the win-

ners’ payment as well. The modification this paper brings with respect to the existing

literature is that the utility function of the seller is more general. Earlier literature generally

assumed that the utility of the seller is sum of prices of goods, while the seller’s utility func-

tion in this paper involves environmental benefit from carbon emissions reduction, except for

auction prices of rights. Gross substitutes valuations and dynamic auctions have been earlier

studied by the earlier literature, such as Bikhchandani (1999), Gul and Stacchetti (1999,

2000), Holzman et al. (2004) and De Vries et al. (2007). The current paper under a more uni-

versal utility function of the seller is a contribution to the dynamic auction literature.

A number of other papers have considered a similar dynamic auction problem. Bikhchan-

dani and Ostroy (2002) and Milgrom and Strulovici (2009) identify a Walrasian equilibrium

under gross substitutes valuations similar to the one considered here. This paper complements

their results by focusing on how to achieve the Walrasian equilibrium via a dynamic adjust-

ment auction mechanism. Typically, the usual definition of a Walrasian equilibrium has

anonymous prices; that is, each agent faces the same price. However, the current paper dis-

cusses Walrasian equilibrium prices as non-anonymous. With gross substitute valuations, the

existence of Walrasian equilibrium is guaranteed if the seller has the ‘sum of prices’ utility

function. This result, surprisingly, still holds in our model with anonymous prices. As a result,

©2016 John Wiley & Sons Ltd

CARBON PERMITS AUCTION MECHANISM 1625