Carbon allowance allocation methods are the key market design choice in global compliant carbon markets (CCMs). The allocation of allowances affects the creation of carbon prices, emissions costs for covered entities, and market efficiency. The decision to allocate allowances independently or through an auction mechanism is an important design feature that impacts all stakeholders in the carbon market ecosystem, including covered emitters, market operators, financial intermediaries, and investment firms. In recent years, global CCMs have shifted from free allocation to auction-based allowance distribution. Calibration of the auction mechanism is a policy choice that plays an important role in determining market outcomes.
This report reviews global CCM auction mechanisms and evaluates their effectiveness as measured by various indicators of market quality. This research is designed to inform the investment industry about different auction mechanisms and provide practical guidance on participating in auction markets. By reading this report, financial intermediaries and investment firms will be better informed to guide their decisions to participate in the primary market, while policy makers and market operators will be able to determine how to best calibrate allowance allocations in their respective markets.
This report is the latest addition to the CFA Institute Research and Policy Center’s carbon market research portfolio. Given the global expansion of carbon markets, An Effective Tool for Net Zero and Enhancing Voluntary Carbon Markets: Gaps and Solutions provided a detailed overview of global compliance and voluntary carbon markets, respectively, to help investment industry participants better understand their mechanisms. In light of the rapid growth of carbon-related trading products in secondary markets, Global Compliance Carbon Markets: Structure Explained provides an in-depth analysis of the market structure of global CCM secondary markets, providing practical guidance for the investment industry when engaging with CCMs.
Given the significant increase in participation in the carbon auction market by financial intermediaries and investment firms, as well as the broader global impact of carbon pricing on firms arising from the EU’s Carbon Border Adjustment Mechanism (CBAM), this report complements previous studies by focusing on the primary markets of global CCMs. The report has three main parts:
- The “Auction Mechanisms” section reviews the auction mechanisms of the major CCMs that have adopted auctions. It explains the auction rules, frequency, procedures, auction share allowances and market developments. It covers CCM in the European Union, New Zealand, California, Quebec, Washington State, and the United Kingdom, analyzing the similarities and unique characteristics of each system.
- Next, the “Auction Effectiveness” section evaluates the effectiveness of the CCM auction mechanism. It applies three indicators from different dimensions – auction-market price stability (the difference between the auction price and the current secondary market price, relative to the market price), demand depth (bid-to-cover ratio), and reserve price binding (auction clearing price premium) – to assess CCM in the European Union, California, and the United Kingdom. The analysis links these indicators to the specific characteristics of each system.
- The section “Auction Effectiveness Determinants” explores the key factors that can influence the effectiveness of a CCM auction.
key findings:
- The share of auctioned allowances in global CCM has steadily increased over time. In CCMs that use auctions, the primary auction structure is a single-round, sealed-bid, equal-price auction. To conduct auctions, CCMs use dedicated platforms – the European Energy Exchange (EEX) for the EU, the Western Climate Initiative, Inc. for California. (WCI, Inc.), and Intercontinental Exchange (ICE) Futures Europe for the United Kingdom. Beyond these similarities, each CCM exhibits distinctive characteristics. The EU Emissions Trading System (EU ETS) has the longest auction history, largest auction volume and highest frequency (three days per week), making it the most mature auction market. The California Cap-and-Invest Program, formerly the Cap-and-Trade Program, conducts quarterly auctions and uses a relatively strict, annually increasing auction reserve price mechanism that can directly influence auction price levels. The UK Emissions Trading Scheme (UK ETS) conducts biweekly auctions. As a new and small CCM, UK ETS auction supply is tight.
- Investment professionals participating in primary auction markets should be mindful of differences in auction effectiveness across CCMs.
- As the most mature CCM, the EU ETS has auction clearing prices that broadly correspond to prevailing secondary market prices. Its auction mechanism exhibits strong resilience to external shocks and the ability to self-adjust after shocks. In the long run, the auction mechanism maintains stable, moderate demand depth and stable auction supply.
- As a developing CCM, UK ETS auctions end at a slight discount relative to secondary market prices. The alignment between the auction and the secondary market improves over time. The auction system also exhibits stable, moderate depth of demand and stable auction supply. Auction clearing prices are consistently above the auction reserve price.
- As a CCM with a strictly annually rising auction reserve price and relatively low auction frequency, California auction clearing prices generally align with secondary market prices, although there are sometimes large deviations due to the strict reserve price policy and frequency mismatch between auction and secondary market trading. The depth of demand is more volatile, driven by fluctuations on both the demand and supply sides, and may lead to oversupply. In most cases, the reserve price is binding; Clearing prices are close to this. Auction outcomes are therefore constrained more by reserve prices than by market forces.
- Policy makers and CCM market operators who want to strengthen the effectiveness of allowance auctions can focus on the efficacy of holding more frequent auctions and increasing the share of auctioned allowances compared to free allocation, thereby promoting broader participation in the primary market and increasing trading volume and liquidity of allowances in the secondary market. The market design options discussed in this report can strengthen market functioning by improving transparency, reducing price dispersion and volatility, and stimulating demand.
Investment professionals can use this report to guide their participation in global carbon auctions, such as determining which CCMs to participate in and whether it is profitable to join primary markets. Policymakers can leverage the findings of this report to make targeted reforms to the auction system.
