The Role of Auctions and Forward Markets in the EU ETS: Counterbalancing the Cost-Inefficiencies of Combining Generous Allocation with a Ban on Banking

From an analysis of the available National Allocation Plans for the first period (2005–2007)
of the EU emissions trading scheme (EU ETS), it can be inferred (i) that the total allocation to
installations covered under the EU ETS is rather generous and (ii) that most, if not all EU
Member States ban the transfer of allowances (banking) into the second period (2008–2012).
In this paper, we explore the cost efficiency issues associated with such a generous allocation
of allowances to the trading sectors in combination with the ban on banking. It is argued that
allocation to the trading sectors is higher than implied by a cost-minimization approach.
Moreover, due to the reduced level of flexibility, a ban on banking increases overall
compliance costs. In addition, the results of a simulation game conducted with real company
participants and with a student control group suggest that a generous primary allocation in the
first phase combined with a ban on banking also leads to a cost-inefficient choice of
abatement measures within periods. The results of the simulations are also consistent with the
conjecture that forward markets and auctioning off a part of the total quantity of allowances
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result in more reliable price signals and more cost-efficient outcomes.