One of the problems of allocating emissions allowances for free is that they "distort the carbon price signal for efficient investment, operation and consumption choices, delay market opportunities and create uncertainties for low-carbon alternatives," argue the researchers.
Neuhoff and Matthes reject the argument that free allocations of emissions allowances are needed to avoid 'carbon leakage'. "Existing indications show that serious leakage problems could only occur for a narrow range of sectors and products," they argue, while "only certain types of free allowance allocation can address this leakage concern and these must be tailored to the specific requirements of the sector".
The paper claims that free allocations of emissions allowances are likely to raise equity issues, and favours auctioning because it would create public funds "which can be used to compensate poor households for short-term increases of energy and commodity prices associated with climate policy".
The researchers argue that any attempt to address leakage concerns through allocation must be conditional on firms' investment, operational and closure decisions. For this reason, they believe that using free allowances to address this problem is unsatisfactory because it will create "perverse incentives for and undermine the efficiency of investment, operational, closure and consumption decisions".
To put auctioning into practice and ensure the transparency and reliability of the market, the authors believe the "frequency of auctions should be high (at least monthly) and the distribution of allowances to be auctioned over time should be clearly defined and announced in advance by the relevant authorities".
The paper concludes that "auctioning will contribute to better market performance by increasing liquidity of trading and hedging activities, and by reducing the ability of market participants to exercise market power in order to alter the value of grandfathered allowances in spot markets".
