A Wind Tunnel Test of Alternative Emissions Trading Schemes

With a unique opportunity of recruiting hundreds of emissions trading system (ETS) participants in a series of lab-in-the-field experiments, we compare a revenue-neutral consignment auction (CA) with free allocation (grandfathering, GF hereafter) and a uniform price auction (UPA) as alternative permit allocation designs. In our setup, firms first receive their permits for free. Then, under the two auction mechanisms, they need to buy back a share of the permits, either with auction revenues returned to the firms in the primary market (CA) or not returned (UPA), followed by a spot (secondary) market for all mechanisms with the continuous double auction. We find that enforced permit transactions in the primary market induce a higher price, facilitating price discovery with lower volatility and more effective trading in the spot market. Both auctions reduce non-compliance compared with GF, because the auctions reduce both permit hoarding and risky over-selling in the spot market. Both CA and UPA help smaller polluting firms lower their profit risks. CA also helps large, cleaner firms increase profits. Our results provide insights on permit allocation designs when introducing an ETS, especially for developing countries that are pondering the balance between market efficiency and firms’ cost burden.