The GHG cap-and-trade system is a key element of the policies designed to achieve California's ambitious goal of reducing GHG emissions to 1990 levels by the year 2020. The cap-and-trade program creates allowances necessary for regulatory compliance that become valuable because of their limited supply. Decisions about how to initially allocate these allowances have important consequences for the cap-and-trade program's environmental effectiveness, economic performance, and distributional

more »

... Regulators have three basic options for allocating allowances initially: allocating pre-determined fixed quantities for free ("fixed allocations"), allocating each year's allowances in proportion to recent actual production output ("updating output-based allocations"), and auctions. The choice among these alternatives does not directly affect environmental performance. Regardless of the choice of allocation method, aggregate emissions are limited by the emissions cap. However, allocation choices may indirectly affect emissions through emissions leakage if economic activity shifts to unregulated sources due to cap-and-trade costs. In the context of California's GHG cap-and-trade program, leakage is most likely to occur if all allowances are distributed through some combination of auctions and fixed allocations. Appropriately designed output-based allocations can reduce leakage and thus increase emission reductions achieved by AB 32 policies. The choice among allowance allocation options does not directly affect the cost-effectiveness of actions taken by emission sources to reduce emissions. Under most circumstances, allowance trading provides incentives for the most cost-effective actions to be taken to meet the emissions cap regardless of whether allowances are auctioned or distributed through fixed or updating output-based allocations. However, allowance allocation can indirectly affect costs in important ways. Leakage can raise costs if production shifts from California to otherwise less efficient or more-distant producers (with higher transportation costs) simply to avoid carbon costs. While updating output-based allocations may lower costs by mitigating leakage, they can also dampen consumer's incentives to shift to less-GHG intensive goods and services; consequently, costs may increase by leading to over-reliance on reductions