Auctioning vs. Grandfathering in Cap-and-Trade Systems with Market Power and Incomplete Information

We compare auctioning and grandfathering as allocation mechanisms of emission permits when there is a secondary market with market power and the firms have private information. Based on real-life cases such as the EU ETS, we consider a multi-unit, multi-bid uniform auction, modelled as a Bayesian game of incomplete information. At the auction each firm anticipates his role in the secondary market, which affects the firms' valuation of the permits (that are not common across firms) as well as their bidding strategies and it precludes the auction from generating a cost-effective allocation of permits, as it would occur in simpler auction models. Auctioning tends to be more cost-effective than grandfathering when the firms' costs are asymmetric enough, especially if the follower has lower abatement costs than the leader and uncertainty about the marginal costs is large enough. If market power spills over the auction, the latter is always less cost-effective than grandfathering. One central policy implication is that the specific design of the auction turns out to be crucial for cost-effectiveness. The chances of the auction to outperform grandfathering require that the former is capable of diluting the market power that is present in the secondary market