Carbon allowance allocation methods in global compliance carbon markets (CCMs) are key market design choices. The allocation of allowances influences the formation of carbon prices, the emission costs for covered entities, and market efficiency. The decision to allocate allowances freely or via auction mechanisms is a critical design feature that affects 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 toward auction-based allowance distribution. The calibration of auction mechanisms is a policy choice that plays a critical role in determining market outcomes.
This report reviews the auction mechanisms of global CCMs and evaluates their effectiveness, measured by various indicators of market quality. The research is designed to inform the investment industry about various auction mechanisms and to 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 policymakers and market operators will be able to determine how best to calibrate allowance allocation in their respective markets.
This report is the latest addition to 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 the Voluntary Carbon Market: Gaps and Solutions provided detailed overviews 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 provided an in-depth analysis of the market structure of global CCMs’ secondary markets, offering practical guidance for the investment industry on engaging with CCMs.
Given the significant increase in carbon auction market participation by financial intermediaries and investment firms, as well as the broadened 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 consists of three main sections:
The “Auction Mechanisms” section reviews the auction mechanisms of major CCMs that adopt auctioning. It explains the auction rules, frequency, processes, auction share of allowances, and market development. It covers CCMs in the European Union, New Zealand, California, Quebec, Washington state, and the United Kingdom, analyzing the similarities and unique features of each system.
Next, the “Auction Effectiveness” section evaluates the effectiveness of CCM auction mechanisms. It applies three indicators from different dimensions — auction-market price stability (difference between the auction price and prevailing secondary market price, relative to the market price), demand depth (bid-to-cover ratio), and reserve price bindingness (auction clearing price premium) — to assess CCMs in the EU, 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 may influence the effectiveness of CCM auctions.
Key Findings:
The share of allowances auctioned in global CCMs has steadily increased over time. Among CCMs that use auctioning, the primary auction structure is a single-round, sealed-bid, uniform-price auction. To conduct auctions, CCMs use dedicated platforms — the European Energy Exchange (EEX) for the EU, the Western Climate Initiative, Inc. (WCI, Inc.) for California, and the Intercontinental Exchange (ICE) Futures Europe for the United Kingdom. Beyond these similarities, each CCM displays distinct characteristics. The EU Emissions Trading System (EU ETS) has the longest auction history, the largest auction volumes, and the 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) holds biweekly auctions. As a newer and smaller CCM, the UK ETS has a tighter auction supply.
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 are broadly aligned with prevailing secondary market prices. Its auction mechanism demonstrates strong resilience to external shocks and capacity for post-shock self-adjustment. In the long run, the auction mechanism maintains stable, moderate demand depth and a steady auction supply.
As a developing CCM, the UK ETS auction tends to clear at a small discount relative to secondary market prices. The alignment between auctions and the secondary market improves over time. The auction mechanism also exhibits stable, moderate demand depth and a steady auction supply. Auction clearing prices are consistently above the constant auction reserve price.
As a CCM with a strictly annually increasing auction reserve price and relatively low auction frequency, California’s auction clearing prices are generally aligned with secondary market prices, although occasional large deviations occur because of the strict reserve price policy and the frequency mismatch between auctions and secondary market trading. Demand depth is more volatile, driven by fluctuations on both the demand and supply sides, and oversupply can occur. In most cases, the reserve price is binding; clearing prices are close to it. Auction outcomes are therefore more constrained by reserve prices than driven by market forces.
Policymakers and CCM market operators that wish to strengthen the effectiveness of allowance auctions may focus on the efficacy of holding more frequent auctions and increasing the share of allowances auctioned versus free allocation, thereby promoting broader participation in the primary market and enhancing the trading volume and liquidity of allowances in the secondary market. The market design choices 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 by determining which CCMs to participate in and whether it is profitable to engage in the primary markets. Policymakers can draw on this report’s findings to make targeted improvements to auction mechanisms.
