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An important feature in the design of an emissions trading program is how emissions allowances are initially distributed into the market. In a competitive market the choice between an auction and free allocation should, according to economic theory, not have any influence on firms’ production choices nor on consumer prices. However, many observers expect the method of allocation to affect product prices. This paper reports on the use of experimental methods to investigate behavior with respect to how prices will be determined under a cap-and-trade program. Participants initially display a variety of pricing strategies. However, given a simple economic setting in which earnings depend on this behavior, we findthat subjects learn to consider the value of allowances and overall behavior moves toward that predicted by economic theory.

As cap-and-trade emerges as the leading approach to regulating greenhouse gases, attention is turning to not just theory, but to how such programs work in practice.  RFF researchers recently went into the laboratory to test whether people’s actions conform to the predictions of economic theory.
One of the most important decisions in the design of an emissions trading program is whether or not allowances should be given away to firms as opposed to being auctioned by the government.  Because a U.S. cap-and trade  program to control greenhouse gases will introduce into the economy property rights ranging from $100 billion to $370 billion every year, the potential wealth transfers associated with this decision are enormous.

A widely held belief working in favor of free allocation is that it will lead to lower prices for consumers. The presence of this intuition explains the uproar in Europe over alleged “windfall profits” captured by firms in the European Trading System that received gratis allowances that did not result in lower consumer prices.

In fact, economic theory is settled on this question.  In theory at least, the method of distribution should have no impact at all on the price in a competitive market.  A profit-maximizing firm will recognize its allowances have an opportunity cost (i.e., they could be sold in the market) and reflect the value of that input in the final price of goods and services. On the other hand, there are numerous examples of the real world failing to conform to economic theory.  RFF researchers recently tested how actual behavior matches up with theoretical predictions. Senior Fellow Dallas Burtraw and Research Assistant Erica Myers partnered with colleagues at other institutions to develop a laboratory setting that allowed real people to make decisions earning real money under conditions similar to those in an actual cap and trade system.

In the first rounds of the experiments, participants displayed a range of behaviors. While many failed to incorporate the value of free allowances in their pricing strategies, the others who did earned substantially higher profits. Over the course of repeated experiments, individuals learned from each others’ success and the long-term outcome evolved toward that predicted by economic theory: the method of allocation had a diminishing effect on the final price. The results show that while passing through the cost of freely allocated allowances is theoretically superior, recognizing opportunity costs is not intuitive, which may explain why policymakers have opted for free allocation in the past.

The details and results of the study are presented in the RFF Discussion Paper “Pricing Strategies Under Emissions Trading: an Experimental Analysis,” by Myers and Burtraw with Markus Wråke of the Swedish research institute IVL, Svante Mandell of Stockholm University, and  Charles Holt of the University of Virginia.