The initial allocation of allowances is widely regarded as among the most important design features of a cap-and-trade program to control greenhouse gas (GHG) emissions, both because emissions allowances are valuable assets—the amounts at stake for a greenhouse gas program in Europe or the US are estimated in the billions of euros or dollars per year—and because the method of allocation could affect the performance of the cap-and-trade program. Setting the initial allocation has been a major issue in all GHG cap-and-trade programs and proposals, including the European Union Emissions Trading Scheme (EU ETS), the Regional Greenhouse Gas Initiative (RGGI) for Northeast states and the various federal proposals in the US, and the states/territories and federal proposals in Australia.

In this report for the International Emissions Trading Association (IETA), a NERA team led by NERA Senior Vice President and Environment Group Head Dr. David Harrison and Associate Director Daniel Radov seeks to clarify the major complexities involved in the initial allocation of allowances and to consider the implications of these complexities for government determination of an appropriate allocation approach.

The report concentrates on three types of complexities that have emerged as particularly important in the context of a cap-and-trade program for GHGs:

• Multiple policy and allocation aims. Allocations can be designed to achieve or support “traditional” aims, such as program cost-effectiveness and compensation to covered sources, as well as to achieve other aims, such as preventing “leakage” of emissions or production outside the program boundaries. The possibility of “leakage”—emissions increases outside the program cap due to less stringent regulations elsewhere—clearly undermines the overall environmental objective of a GHG control program. Furthermore, there are a host of other aims that are not equally served by all allocations under real-world conditions, leading to tradeoffs that only become apparent when these complexities in aims are acknowledged.
• Cost burdens and other empirical uncertainties. This area focuses on complexities related to the difficulty of determining the extent to which different groups bear costs under a major GHG trading program, and thus the complexities in determining a “fair" allocation of allowances to compensate for burdens. Although this report focuses on cost burdens, the authors also consider the more general problem of quantifying the impacts of alternative approaches on the various aims, including cost-effectiveness, emissions leakage, and competitiveness.
• Timing. This area considers the additional complications that arise when one considers the long time horizon over which a GHG emissions trading program would operate.

Consideration of these complexities leads the authors to conclude that superficially simple approaches tend to disguise the tradeoffs that are involved in choosing among alternatives. Indeed, decision makers face a fundamental dilemma in reconciling the implications of these various conceptual and empirical complexities with the understandable desire for a simple and transparent approach to initial allocation. The authors suggest an approach for policy-makers and other decision makers to help resolve some of the complexities and select from the various allocation alternatives.