1

Distribution of Emissions Allowances

and the Use of Auction Revenues in
the European Union Emissions
Trading System
Åsa Löfgren,* Dallas Burtraw,† Markus Wråke,‡ and
Anna Malinovskaya¶

Introduction
The European Union (EU) Emissions Trading System (ETS) introduced emissions allow-
ances as a new asset that is worth tens of billions of euros, making the distribution of these
allowances (and their value) an issue of great interest. This article examines how this asset
value has entered the economy and discusses three key features of the EU ETS.
First, we provide insights concerning the allocation of allowances and the evolution of
trading within the EU ETS. The introduction of a cap in an emissions trading program creates
a scarcity value for the right to emit, thus creating an asset in the form of emissions allow-
ances. These allowances (and their implied value) must be distributed among stakeholders
and for various purposes and ultimately acquired by firms that have a compliance obligation
under the trading program. The allocation of allowances determines the financial flows and
distributional consequences of the EU ETS among firms, energy consumers, and govern-
mental authorities (and thus ultimately among citizens). In general, the initial allocation can
be either free or auctioned. Over time, the role of auctions has expanded in most trading
programs, including the EU ETS. In fact, by 2017–2020, more than half of all allowances are
intended for auction. This intent is affected by recent reforms that delay and in some cases
cancel the issuance of some auctioned allowances.

*University of Gothenburg, Department of Economics, Box 640 SE-405 30 Gothenburg, Sweden; e-mail:
asa.lofgren@economics.gu.se.
†
Resources for the Future, 1616 P Street NW, Washington DC 20036; e-mail: burtraw@rff.org.
‡
Energiforsk AB (Swedish Energy Research Centre) 101 53 Stockholm, Sweden; e-mail: markus.wrake@
energiforsk.se.
¶
College of Human Ecology, Cornell University, Martha Van Rensselaer Hall, Ithaca, NY 14853; e-mail:
malin22a@mtholyoke.edu.
The authors appreciate financial support from the Mistra Carbon Exit research program. Comments from
Elizabeth Zelljadt, and research assistance from Oskar Falk, Diana Ivanova, Amelia Keyes, Nicklas Nordfors,
and Haben Tekie are greatly appreciated.

Review of Environmental Economics and Policy, pp. 1–21

doi: 10.1093/reep/rey012
C The Author(s) 2018. Published by Oxford University Press on behalf of the Association of Environmental and Resource
V
Economists. All rights reserved. For permissions, please email: journals.permissions@oup.com

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 2 A. Löfgren et al.

Second, we consider how auction revenues are distributed and used. In the 2016 symposium
on the EU ETS published in this journal, Ellerman et al. (2016) describe how the EU ETS has
evolved to provide an expanded role to auctions, which replace free allocation for the elec-
tricity sector. Ellerman et al. (2016) give little attention to the distribution and use of auction
revenue except to indicate that this is the prerogative of the member states. To date, member
states have directed well over half of their auction revenue to energy- and climate-related
activities. However, the amount of allowance revenue that is available for energy and climate
programs depends on the quantity of allowances to be auctioned and the allowance price path,
which has been lower than anticipated by researchers and supporters of the market. The price
path has deviated from what economic theory would predict to be an efficient path to long-
term emissions reduction goals. The recent reforms have caused an uptick in allowance prices,
but a reduction in the allowances to be auctioned, thus making auction revenues uncertain.
Finally, we discuss the challenge of member state coordination and options for resolving
their differing climate policy ambitions without causing 100 percent carbon leakage (com-
monly referred to as the waterbed effect). That is, if a country reduces its own emissions, its
demand for allowances falls. This enables other member states to abate less, which causes the
allowance price to fall, thus weakening the economic signal to industry.
We organize our discussion as follows. The next section provides background on the
evolution of allocation and trading. We also highlight the reforms that are most relevant
for the allocation of allowances and describe the basics of EU ETS auction design. In the
subsequent section we examine the financial value of allowances auctioned under the EU ETS
and their distribution across member states. We then turn attention to how member states
have used auction revenues. In the penultimate section we focus on the challenge of coordi-
nating among member states and discuss lessons the EU ETS offers for future trading pro-
grams that cover more than one jurisdiction. This is especially relevant if more trading
programs are linked in the future. The final section presents concluding remarks and iden-
tifies priorities for future research.

The Allocation of Allowances and the Evolution of Trading

The allocation of allowances—and the implicit distribution of their asset value—has efficiency
and distributional consequences that affect program outcomes. In this section we review how
these considerations have affected the evolution of allocation and trading in the EU ETS.

Background on the Allocation of Allowances

A fundamental decision in any emissions trading program is whether firms should receive
allowances for free, and according to what formula, or if they should be distributed through
an auction. Basic economic theory states that the emissions outcome, that is, where and when
emissions occur, should be independent of this decision (Hahn and Stavins 2011) and that
this decision should not affect cost-effectiveness (Montgomery 1972), the “independence
property.” Thus, although different approaches to allocation are expected to lead to different
distributions of wealth, allowance trading is expected to identify a unique market equilibrium
that minimizes the overall cost of the program. This means that the emissions outcome is

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 Distribution of Emissions Allowances and the Use of Auction Revenues in the EU ETS 3

independent of the initial allocation. Thus the distribution of allowances has often been used
as a way to compensate interest groups that may be adversely affected or to achieve political
support to enable the allowance market to develop.
Over the last couple of decades, the decision concerning the allocation of allowances has
received renewed attention from economists, from various theoretical and empirical per-
spectives that address the distributional outcomes and the policy setting for emissions trad-
ing. This increased attention has coincided with an evolution in the program’s design.

Potential for windfall profits

One perspective that has captured the attention of the public as well as economists is the
potential for free allocation to yield windfall profits—that is, excess compensation for af-
fected firms. Windfall profits arise when the regulation causes changes in firms’ revenues to
exceed changes in their costs. The change in revenue occurs in a competitive market because
even if firms receive allowances for free, the value of the allowances is reflected in consumer
prices, thus yielding additional revenue to firms. Firms charge consumers for the use of freely
allocated allowances because they (the firms) face an opportunity cost from using the allow-
ances for production rather than selling them in the market. In effect, the market for emis-
sions allowances translates a firm’s use of allowances (which are associated with its emissions)
into a variable cost of production that resembles other factor inputs, such as labor and other
resources, which are reflected in product prices. However, if one of those factors, such as
emissions allowances, is received for free, the change in product price might be greater than
the cost of compliance, thereby constituting a windfall profit. In the EU ETS, the total value of
emissions allowances is significantly greater than the expected total cost of reducing emis-
sions to achieve the total cap for the system. Thus when allowances are distributed for free, the
change in firms’ revenues can result in higher-than-normal profits, which come at the ex-
pense of consumers.
Several empirical, theoretical, and simulation studies find that free allocation can be
expected to lead to windfall profits, especially in the electricity sector (Bovenberg,
Goulder, and Gurney 2005; Sijm, Neuhoff, and Chen 2006; Burtraw and Palmer 2008;
Veith, Werner, and Zimmermann 2009; Woerdman, Couwenberg, and Nentjes 2009;
Laing et al. 2013; Nicolai and Zamorano 2014; Fabra and Reguant 2014; Hintermann
2016). Indeed, reports by banks and EU member states document that free allocation did
produce windfall profits and imposed significant costs on consumers in the electricity and
industry sectors in the early years of the EU ETS (CE Delft 2016). This finding does not violate
the independence property with respect to the emissions outcomes or the cost-effectiveness of
allowance trading, it simply indicates that free allocation may lead to excess compensation to
firms. Nevertheless, this distributional outcome was an important consideration in the EU
decision to move away from free allocation (Ellerman, Convery, and Perthuis 2010, p. 64).

Emissions trading in second-best settings

Another perspective in the literature considers the policy context for emissions markets. In
practice, policies are always implemented in a second-best setting, which means that con-
ditions for economic efficiency prior to enacting the policy are not satisfied (e.g., the presence
of market power, other externalities, unemployment) and thus efficiency might be enhanced

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 4 A. Löfgren et al.

by introducing a policy that differs from the general advice suggested by economic theory,
which ignores these considerations. For example, although the standard economic advice
would be to set the carbon price equal to marginal damages, if there are preexisting taxes or
regulations that distort the economy away from economic efficiency, then efficiency might be
improved by setting the carbon price at a different level (Parry, Williams, and Goulder 1999).
Research has shown that one way to improve efficiency is to raise revenue through an
auction—as an alternative to free allocation—and to then use the revenue to reduce
preexisting taxes, achieving the so-called double dividend (Goulder 1995).
Another second-best setting arises when policy is inconsistent across jurisdictions, which
could provide incentives for firms to move economic activity (and emissions) to a jurisdic-
tion that has less stringent policy, resulting in what is known as emissions leakage (Böhringer,
Balistreri, and Rutherford 2012; Lanzi et al. 2013). One way to address leakage is to provide a
production incentive to firms to maintain their level of production under a regulation, but
how these incentives are designed has efficiency consequences (Åhman et al. 2007). In phase 3
of the EU ETS (2013–2020), firms that face international competition receive free allocation
that is calibrated to efficient operation of facilities (benchmarking) and contingent on the
firms maintaining economic activity (European Commission 2011). This variant of free
allocation is explicitly intended to violate the independence property in order to affect the
cost-effectiveness among regulated firms, the distribution of emissions in the market, and the
emissions outcome outside the market.
Second-best issues are also a consequence of practical aspects of firm, market, and public
behavior. For example, firms may not properly recognize the opportunity costs associated
with freely allocated emissions allowances (Martin, Mu^ uls, and Wagner 2015). This is espe-
cially an issue for small firms without a background in allowance markets, in new markets, or
when the market experiences disruptions in supply or demand and the market value of
allowances is uncertain. This means firms may not behave in a way that minimizes their costs
and consequently the marginal costs of emissions reductions may not be well identified by the
market price. Free allocation may also affect perceptions among stakeholders or various
individual firms about the distribution of costs and revenues and affect public support for
the program. Just as these issues arose from the free allocation of the airwave spectrum for
telecom (Binmore and Klemperer 2002), they arose from the free allocation of emissions
allowances and have also affected the movement away from free allocation in the EU ETS
(Ellerman, Buchner, and Carraro 2007).

Evolution of Allowance Allocations in the EU ETS

In phase 1 (2005–2007) and phase 2 (2008–2012), allowances were initially distributed almost
entirely for free to incumbent firms based on their historical emissions, an approach known as
grandfathering, which helped build a coalition of support for the introduction of carbon
pricing. Moreover, in phase 1, member states were prohibited from auctioning more than 5
percent of their allowances, and in phase 2, the limit was 10 percent. The actual share of
allowances auctioned was less than 1 percent in phase 1 and varied between 2.6 percent and
5.8 percent during phase 2 (European Environment Agency 2018).
Phase 3 (2013–2020) marked an important transition in the EU ETS because it shifted a
major share of the distribution of emissions allowances away from free allocation, as

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 Distribution of Emissions Allowances and the Use of Auction Revenues in the EU ETS 5

2,500 100%

Emissions allowances (millions)

2,000 80%

1,500 60%

1,000 40%

500 20%

0 0%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
| Phase 1 | Phase 2 | Phase 3 |
Total volume of emissions allowances Share of total volume of allowances that are auctioned

Figure 1 Auctioned allowances as a share of the total volume of allowances.

Source: Based on data from table 1.

illustrated in figure 1. This transition was launched in 2012, when the European Commission1
held “early auctions” for 90 million allowances—taken from the annual allowance budgets
for 2013 and 2014—to enable entities in the power sector that were facing the new auction
regime to hedge their costs (European Commission 2011). In phase 3, most allowances are
apportioned to member state governments, which use auctions to sell these allowances into
the market (European Parliament and Council 2003, Article 10(1)).

Free allowances to address emissions leakage

The exception to the trend toward auctions is motivated by concerns about emissions leakage.
Most of the allowances that are still freely allocated flow to industry to address emissions
leakage, with the exception that some electricity-generating plants in new member states also
receive free allowances, an outcome determined primarily by political factors. Concern about
the risk of leakage spurred an evolution in the way that free allowances are distributed, with
sectors judged to be at a significant risk of leakage receiving a more generous allocation of free
allowances than those deemed at lesser risk (European Commission 2015a; Wråke et al.
2012). The criteria used to determine vulnerability to leakage are based on the additional
direct costs (e.g., their direct compliance responsibility) and indirect costs (e.g., higher costs
for electricity purchases) and the trade intensity of the sector (European Commission 2010b,
2015a). These criteria are contentious, with some research suggesting that while carbon
intensity is strongly correlated with the risk of leakage, trade exposure is not (Martin et al.
2014), which means that firms in this situation may not face a severe leakage risk.
Another controversial issue surrounding the use of free allocation to address leakage is the
use of product-specific benchmarks (i.e., emissions per unit of output). These benchmarks
reflect the most efficient techniques, substitutes, and alternative production processes
1
The European Commission is the executive arm of the EU. It is the sole EU institution that proposes laws for
adoption. The European Parliament (elected by citizens) and the Council of the European Union (con-
sisting of government ministers from each EU country) must agree on the legislative text for it to become EU
law and as part of that process both institutions review proposals from the commission and propose
amendments.

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 6 A. Löfgren et al.

available for reducing greenhouse gas emissions, are calculated for products rather than for
inputs (European Parliament and Council 2009, Article 10a(1)), and do not differentiate by
firm size or geographic location (European Commission 2015c). Although this uniform
treatment of firms across locations may be important for ensuring political support, it
appears to contradict the rationale for free allocation as a way to prevent leakage because
the threat of leakage is likely to vary across locations, thus making some facilities—say, a
cement producer in the interior of Europe—less vulnerable to international competition and
less deserving of free allocation than a facility closer to international transportation networks.
The benchmarks (e.g., tons of emissions per unit of output) are based on the average
performance of the 10 percent most efficient installations in the EU in 2007 and 2008
(European Parliament and Council 2009, Article 10a(2)). The allocation (tons) is the product
of the benchmark multiplied by historic output levels. With the allocation firmly determined,
these facilities retain an incentive to reduce the emissions intensity of their production ac-
tivities. Moreover, because the award of allowances does not vary with changes in the level of
production, there is also an incentive to reduce total emissions. However, because the allo-
cation is adjusted only if a facility curtails production more than 50 percent, the marginal
incentive to maintain production is undermined because a facility retains its allocation even if
it reduces its production substantially, that is, even if substantial leakage occurs.

The cross-sectoral correction factor

The requested allocations for all installations in the EU (based on the benchmark calculations)
would have exceeded the total amount available for free allocation. To address this issue, the
allocation is reduced for all installations by a cross-sectoral correction factor that adjusts the
total number of allowances that can be handed out for free to industry. The correction factor
reduced the actual free allocation by 5.7 percent relative to the requested, preliminary alloca-
tion in 2013 and will rise to 17.6 percent in 2020 (European Commission 2013).

Backloading
As shown in figure 1, auctioned allowances accounted for 52.1 percent of the total volume of
emissions allowances in 2013 but fell to 40.2 percent in 2014 because of the “backloading” of
allowances. Backloading refers to the EU’s 2014 decision to auction fewer allowances in the
early years of phase 3 to reduce the volume of unused allowances in circulation and to boost
the allowance price (European Commission 2017). The original intent was to reintroduce
these “backloaded” allowances in an auction during the 2019–2020 period (Ellerman et al.
2016), but the plan was changed because the number of allowances in circulation and the level
of allowance prices did not respond to the delayed allocation. Instead, the backloaded allow-
ances will be put in the Market Stability Reserve (MSR), a new mechanism that is intended to
address these issues.

The MSR
Starting in 2019, the MSR will be used to adjust auction volumes depending on the “total
number of allowances in circulation,” that is, the privately held allowance bank. If more than
833 million allowances are in circulation in any given calendar year, then an amount equal to

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 Distribution of Emissions Allowances and the Use of Auction Revenues in the EU ETS 7

24 percent of the allowances in circulation (12 percent after 2023) will be withheld from
auctions starting in September of the following year and placed in the MSR (European
Parliament 2018). Conversely, if the total number of allowances in circulation is less than
400 million, then 100 million allowances will be released from the reserve and added to the
auction. The MSR will also include backloaded allowances and allowances not allocated to
new entrants or to installations that ceased or reduced the scope of their operations
(European Commission 2015b).
Importantly, from 2023 onward, the total number of allowances in the MSR cannot be
greater than the quantity of allowances auctioned during the previous year. If this occurs, then
the reserve will be adjusted by permanently invalidating the corresponding amount of allow-
ances, thus reducing the cumulative allowance supply. Regulators hope that this will also
strengthen the allowance price. We discuss this fundamental reform in more detail later.

EU ETS Auction Design Basics

We next turn to the fundamental characteristics of the auctions. Each member state has the
right to a set number of allowances to auction.2 The auctions occur on two authorized trading
platforms that are bound by EU financial market legislation: the European Energy Exchange
(EEX) in Leipzig, which is the common auction platform used by most member states,3 and
the Intercontinental Exchange (ICE) Futures Europe in London, which is used by the United
Kingdom.
The minimum volume that can be exchanged in an auction is one “lot,” equivalent to 500
allowances. Although subnational North American programs—the Regional Greenhouse
Gas Initiative, California, and Quebec—hold auctions on a quarterly basis, the EU ETS
auctions are held at least weekly (European Commission 2010a).4
Bids are accepted within a specified time window (i.e., a single round), the bids offered by
other bidders are unknown (i.e., a sealed bid), and successful bidders pay the same price for
each allowance regardless of the price bid (i.e., a uniform price)—the same design used in
emissions allowance auctions in North America. All submitted bids are ordered by descend-
ing price (i.e., willingness to pay) and bids are fulfilled starting with the highest bid. The
auction clearing price is determined by the minimum bid at which the demand for allowances
exhausts supply. Bids with the same price are ordered through random selection.

The Value of EU ETS Allowances and the Use of

Auction Revenues
We next turn to the value of the EU ETS allowances and the EU member states spending of
their auction revenues. There are various ways to estimate the value of emissions allowances,

2
The number is based on the member state’s share of verified emissions from EU ETS installations in 2005 or
the average of the 2005-2007 period, whichever is higher.
3
Germany and Poland opted out of the common auction platform but have contracted with the EEX to run
their auctions.
4
In addition, bidding windows of auction platforms may not overlap, and there must be a minimum 2-hour
hiatus between consecutive bidding windows. The volume of allowances to be auctioned on a common
platform is spread evenly over the year except in August, when the amount is half that of any other month.

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 8 A. Löfgren et al.

Table 1 Volume and financial value of total and auctioned EU ETS emissions allowances, 2005–2020

Average Volume of Value of Volume of Value of Ratio of

price emissions emissions auctioned auctioned auctioned
(nominal e allowances allowances allowances allowances allowances
per tonne) (million (billion e) (million (billion e) to total
tonnes) tonnes) allowances
(percent)
(1) (2) (3) (4) (5) (6)

2005 21.6 2,096 45.3 0 <1 <1

2006 17.6 2,078 36.7 7 <1 <1
2007 1.4 2,195 3.0 2 <1 <1
2008 22.4 2,011 45.0 53 1.2 3
2009 13.4 2,049 27.4 79 1.1 4
2010 14.5 2,081 30.1 92 1.3 4
2011 13.3 2,101 27.9 93 1.2 4
2012 7.5 2,169 16.2 125 0.9 6
2013 4.5 2,115 9.6 1,103 5.0 52
2014 6.0 1,569 9.4 631 3.8 40
2015 7.7 1,496 11.6 625 4.8 42
2016 5.4 1,550 8.3 719 3.9 46
2017 5.8 1,702 9.9 951 5.6 56
2018 11.7 1,843 21.6 837 9.8 45
2019 12 1,506 18.1 530 6.4 35
2020 14 1,566 21.9 640 9.0 41

Notes: Prices are based on the annual average of the daily observed futures price for December of the year in which the futures
mature through 2017 and projections starting in 2018. The December futures price is a time series spanning all three EU ETS
phases. Volumes include Iceland and Norway plus the 28 EU countries. Projected volumes for 2018–2020 are updated following
the methodology described in Löfgren et al. (2015, Appendix 2). Projected auction volumes for 2019 and 2020 account for the 900
million backloaded allowances that will be placed in the MSR and an estimation of the additional number of allowances that will be
withheld from auction and placed in the MSR.
Sources: Thomson Reuters Point Carbon for historical prices and price projections; CDC Climat Research (2013) for historical
volumes and projections; Löfgren et al. (2015); Burtraw, Keyes, and Zetterberg (2018) for estimates of the volume of allow-
ances withheld from auction and placed in the MSR; European Commission (2018a, 2018b, 2018c), European Environment
Agency (2018).

depending on whether allowances are valued at the current market price when they are issued
or are adjusted continuously to the market. We assess the value of EU ETS allowances based
on annual average market prices. Auction revenues are then calculated using the market price
in addition to the number of allowances allocated to each member state for auctioning.

The Financial Value of EU ETS Allowances

Table 1 presents the financial value of total allowances based on historical data on volumes of
allowances through 2017 and projections thereafter, as well as the value and volume of
auctioned allowances. The share of auctioned allowances ranges from 40 percent to 56 per-
cent during the 2013–2020 period (column 6). The total value of allowances in 2020 is
projected to be around e22 billion (column 3).
It is interesting to note that the Commission’s Impact Assessment (European Parliament
and Council 2018) specifies that the share of allowances to be auctioned over the 2013–2020
period is 57 percent, which is significantly higher than indicated by table 1. The assessment

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accounts for unallocated allowances to new entrants and backloaded allowances in the auc-
tion share and considers a large portion of allowances distributed free to power generators in
eligible member states to be equivalent to an auction with revenues directed (“earmarked”) to
modernization of the electricity sector. However, our projections in table 1 do not include
unallocated allowances to new entrants and backloaded allowances and further adjust the
auction volume before 2020 based on the rules for the MSR. We estimate that the auction
share of total asset value of allowances peaks at 56 percent in 2017 before declining to 41
percent in 2020. Based on a number of assumptions, but not explicitly including the recent
MSR reform and cancellation provisions, Dorsch, Flachsland, and Kornek (2017) project the
total value of allowances to peak in 2039 at about e70 billion.

Member States’ Revenues from Auctioning

Next, we examine EU member states’ shares of the total allowance value as determined by the
allocation of allowances to be auctioned. Table 2 shows member states’ total revenues from
the auctioning of allowances for the 2012–2016 period (phase 3, including the early auctions
in 2012; column 1). The share of revenues for each member state is ranked by the total value of
auctioned allowances (columns 2 and 3) and the member states’ gross domestic product
(GDP) (columns 4 and 5).

Member States’ Spending of Auction Revenues

Although EU member states have sovereignty over how to use the revenues generated from
allowance auctions, they are expected to direct at least 50 percent to help achieve energy- and
climate-related purposes (see European Parliament and Council 2003).5 These purposes may
include research and development projects for mitigation and adaptation, clean energy and
energy efficiency, forestry sequestration, carbon capture, low-emissions transport, and di-
rected expenditures for low-income households (European Parliament and Council 2003,
Article 10a(3)).
This institutional encouragement for member states to earmark auction revenues for
specific uses is particularly notable considering the efficiency argument for auctions discussed
earlier. Earmarking of auction revenues might reduce the efficiency of auctioning relative to
using auction revenues to lower preexisting distortionary taxes. Interestingly, the final
amended text of the directive evolved from what was initially proposed (European
Commission 2008), that is, 20 percent of the revenues should be earmarked for energy and
climate. In expanding the share to 50 percent, the final language acknowledged the legal and
institutional reality that the EU cannot dictate how member states spend their revenue.6
Moreover, the amended directive indicates that the goal of 50 percent may be achieved with

5
This guideline is applicable to only 88 percent of total allowance revenues. The remaining 12 percent (of
revenues) is distributed among the least wealthy member states for the purpose of solidarity and to enhance
their prospects for economic growth (10 percent) and the nine member states that in 2005 had reduced their
emissions of greenhouse gases by at least 20 percent relative to their respective base years under the Kyoto
Protocol (2 percent, known as the “Kyoto bonus”). Hence, in practice, only 44 percent of total auction
revenue is encouraged to go to energy- and climate-related purposes.
6
We are grateful to A. Denny Ellerman for providing information concerning the evolution of the commis-
sion’s directive.

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 10 A. Löfgren et al.

Table 2 Auction revenues by country, 2012–2016

Auction revenues Country shares of Auction revenues as a

in phase 3 (November total auction revenues percentage of country’s
2012–December 2016), in phase 3 (November GDP in 2016
euros 2012–December 2016)

Country rank Percentage Country rank Percentage

(1) (2) (3) (4) (5)

Germany 3,646,458,340 1 23.2 17 0.03

United Kingdom 1,820,105,040 2 11.6 23 0.02
Italy 1,739,175,575 3 11.1 19 0.03
Spain 1,558,597,685 4 9.9 15 0.04
France 988,022,425 5 6.3 25 0.01
Romania 637,798,500 6 4.1 2 0.13
Greece 622,137,495 7 4.0 4 0.09
The Netherlands 603,802,085 8 3.8 20 0.02
Poland 587,438,565 9 3.7 16 0.04
Belgium 450,847,100 10 2.9 18 0.03
Czech Republic 358,194,130 11 2.3 6 0.07
Portugal 316,303,870 12 2.0 13 0.04
Bulgaria 312,794,915 13 2.0 1 0.19
Finland 301,713,560 14 1.9 14 0.04
Slovak Republic 277,525,855 15 1.8 5 0.09
Austria 251,150,255 16 1.6 22 0.02
Hungary 237,418,060 17 1.5 7 0.06
Denmark 223,113,330 18 1.4 21 0.02
Ireland 165,673,755 19 1.1 24 0.02
Sweden 160,564,170 20 1.0 27 0.01
Croatia 105,505,090 21 0.7 11 0.05
Lithuania 88,423,355 22 0.6 8 0.06
Slovenia 79,853,570 23 0.5 9 0.05
Estonia 69,021,995 24 0.4 3 0.12
Latvia 48,512,275 25 0.3 10 0.05
Luxembourg 21,631,635 26 0.1 26 0.01
Malta 18,211,570 27 0.1 12 0.05
Cyprus 2,359,150 28 0.0 28 0.00
Total 15,692,353,350 100

Notes: Revenue values do not include revenues from the auctioning of aviation allowances.
Sources: European Commission (2016) for revenue data; International Monetary Fund (2018) for GDP data.
Four countries—Germany, the United Kingdom, Italy, and Spain—account for more than 50 percent of the total auction revenues
since November 2012 (column 3). However, if we examine auction revenues in terms of member states’ GDP (column 5), Bulgaria,
Romania, and Estonia had the highest ranking in 2016, while the five countries with the highest auction revenue are in the bottom
half. Clearly, auction revenues appear to be relatively more important in member states that have smaller economies.

equivalent financial value (e.g., from other taxes) and thus need not rely directly on auction
revenues. Before describing in more detail how member states spend their auction revenues,
we briefly discuss the arguments for and against earmarked taxes.

Rationale for earmarking

The use of earmarked taxes is common in many countries and such earmarking can have a
broad or a specific end use. For example, road and fuel taxes often finance road infrastructure,

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 Distribution of Emissions Allowances and the Use of Auction Revenues in the EU ETS 11

lottery proceeds and “sin” (alcohol and tobacco) taxes finance social-sector programs, and
park fees finance the management of national parks.
The literature offers some explanation and justification for earmarked taxation. Beginning
with Buchanan (1963), several researchers have argued that countries’ use of earmarked taxes
can be explained by political processes. Under specific circumstances, such taxes could even
increase efficiency—for example, by making possible political agreements that increase both
revenues and expenditures, when each would have been impossible separately (McCleary
1991). In addition, Brett and Keen (2000) see a role for earmarking in exchanging informa-
tion between politicians and voters and also as a way to constrain politicians from breaking
their promises. Seen from this perspective, countries that have weak institutions or where
voters do not trust politicians can use earmarked taxes to more credibly signal intentions to
voters or, as suggested by Brett and Keen (2000), to restrict the actions of a new government
taking office. Finally, some environmental interest groups advocate for using earmarking to a
larger extent (and even to make it mandatory) within the EU ETS (Velten et al. 2016) or to
embed strategic incentives in transfers of allowance value among member states (Dorsch,
Flachsland, and Kornek 2017).

Reported use of revenues

Each member state is required to submit a yearly report7 on the use of auction revenues.
However, a complete review of the total spending of revenues is not possible for several
reasons. First, Directive 2003/87/EC8 mandates that countries report only how they use 50
percent of the auction revenues. Second, the level of detail of member states’ reporting of
spending on energy- and climate-related activities varies greatly. For example, in their 2016
reports, France described its investment in energy- and climate-related activities by assigning
the entire amount to one project, while Poland described investing in more than 300 projects.
Third, countries that do not practice explicit earmarking (Austria, Denmark, Finland,
Ireland, Luxembourg, Malta, Netherlands, Poland, Sweden, and the United Kingdom) add
another layer of uncertainty concerning how revenues are being spent because their expen-
ditures are not directly traceable (European Commission 2017). Finally, regarding the impact
of the spending, it is difficult to judge whether or not the auction revenues have added value,
that is, if the spending on energy- and climate-related activities are additional or if they have
crowded out funding of projects that would have been implemented without the revenues.
With these caveats in mind, we present a summary of the spending of auction revenues by
member states in table 3. Approximately 65 percent of climate and energy spending by
member states in 2016 was related to energy efficiency improvements and investments in
renewable energy sources, an increase from previous years. This aligns with the findings of
Carl and Fedor (2016), who provide an overview of carbon-pricing revenues in 2013 and 2014

7
This is then published in the European Environment Information and Observation Network Reporting
Obligations Database. The report is compulsory under Regulation (EU) No 525/2013 of the European
Parliament and of the Council on a mechanism for monitoring and reporting greenhouse gas emissions and
for reporting other information at national and Union level relevant to climate change and repealing
Decision No 280/2004/EC (specifically Articles 7, 8, 12, 13, 14, and 17 of Regulation (EU) No 525/2013).
8
See Article 10(3) Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003
establishing a scheme for greenhouse gas emission allowance trading within the Community and amending
Council Directive 96/61/EC.

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Table 3 Countries’ reported use of auction revenues for climate and energy (C&E) activities and purposes in 2016 (millions of euros) 12

Research Forestry Energy Renewable Transport International Other Total Total Total C&E

by Durham University user

efficiency energy aid C&E C&E revenues* spending
as a share of
total auction
revenues

Austria 16.5 25.1 8.5 9.8 59.9 59.5 101%

Belgium 17.5 20.0 37.5 107.9 35%
Bulgaria2 71.2 32.3 103.5 121.8 85%
Croatia 0.1 40.5 2.4 2.9 0.3 46.1 20.3 228%
Cyprus 0.3 0.3 0.4 88%
Czech Republic 65.3 58.7 124.0 118.0 105%
Denmark 20.8 32.8 53.7 53.7 100%
Estonia 0.1 12.1 12.2 23.6 51%
Finland† 71.2 71.2 100%
France 234.7 234.7 234.7 100%
Germany 95.2 10.6 955.3 273.1 271.3 1605.5 850.4 189%
Greece 19.2 128.8 148.1 148.1 100%
Hungary 13.8 25.8 11.0 5.0 1.3 56.9 63.7 89%
Ireland 25.7 13.3 1.2 40.1 40.1 100%
Italy 5.3 69.7 40.5 2.5 118.1 411.7 29%
Latvia 7.2 0.2 7.4 11.5 65%
Lithuania 48.2 18.5 0.8 67.5 20.8 324%
Luxembourg† 2.6 5.1 51%
Malta 0.1 9.5 0.1 9.7 4.5 218%
Netherlands† 142.6 142.6 100%
Poland 52.5 0.1 15.5 0.0 68.1 136.1 50%

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Portugal 10.0 0.0 59.4 0.7 1.6 1.0 72.8 75.1 97%
Romania 52.0 52.0 194.0 27%
Slovakia 25.0 10.6 35.6 65.0 55%
(continued)
A. Löfgren et al.
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Table 3 Countries’ reported use of auction revenues for climate and energy (C&E) activities and purposes in 2016 (millions of euros)(continued)
Research Forestry Energy Renewable Transport International Other Total Total Total C&E

by Durham University user

efficiency energy aid C&E C&E revenues* spending
as a share of
total auction
revenues

Slovenia 8.0 16.0 2.8 0.0 0.0 26.8 18.7 143%

Spain 362.6 28.2 390.8 369.5 106%
Sweden 21.7 21.7 38.6 56%
United Kingdom 59.8 307.1 35.5 22.0 424.3 424.3 100%
Total 243.7 36.7 1509.7 1120.0 391.5 124.1 391.7 4033.7 3830.8 105%

Notes: *Includes revenues from aviation allowances. †Finland, Luxembourg, and The Netherlands do not provide breakdowns, just the total spent on C&E. ‡Bulgaria data are for 2015 because 2016 data are
not publicly available. “Other C&E” comprises other climate and energy uses, including technology and adaptation. Table 3 does not include the financial value of targeted free allocation to electricity in eight
eligible member states.
Sources: European Environment Information and Observation Network (2018, Article 17) reports by member states on the use of auctioning revenue and project credits.

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Distribution of Emissions Allowances and the Use of Auction Revenues in the EU ETS
13
 14 A. Löfgren et al.

for all major carbon tax and cap-and-trade schemes. The authors argue that “system design
makes a difference in how revenue is spent” (p. 52), and they find significant differences
between the spending of revenues from carbon tax schemes and the spending of revenues
from auctioning in trading programs. They find that revenues from cap-and-trade programs
are used to a greater extent for “green spending,” such as subsidies for energy efficiency
measures and renewable energy investments. However, we find that the distribution of
spending also varies significantly by country. For example, from 2013 to 2016, France allo-
cated 100 percent of its revenues toward energy efficiency, while Spain allocated most of its
revenues to renewable energy investments.
Most countries report spending on climate- and energy-related activities that is greater
than 50 percent of auction revenues. Only Italy and Romania reported investing less than 50
percent of their auction revenues in climate- and energy-related programs in 2016 (29 and 27
percent, respectively). Estonia, Hungary, and Slovakia spent less than 50 percent in 2015, but
they spent more than 50 percent in 2016. Except for Italy, these are relatively low-income
countries whose auction revenue is a relatively large share of GDP (see table 2). It is difficult to
anticipate how these countries would spend their auction revenues without the explicit en-
couragement by the EU to earmark 50 percent of the revenues to energy- and climate-related
activities. However, based on the literature on earmarking (discussed earlier), we would
expect that the share might have been even lower.

The Challenge of Coordinating Member States

A central challenge for the EU ETS is the variation in ambition for carbon emissions miti-
gation among member states. As discussed earlier, the allowance price is lower than theory
and analyses suggest is necessary to trigger the innovation and investment required to achieve
future-year climate policy goals (Löfgren et al. 2014). The low price and implied modest
collective ambition has led many advocates to encourage the use of national-level technology
policies to promote renewables and energy efficiency. The most visible of these efforts is
Germany’s Energiewende (“energy transition”), but there are many other examples. The
overlap of the EU ETS and national technology policies poses a dilemma: to the extent
that technology policies affect emissions sources that are covered by the EU ETS, they do
not yield additional emissions reductions, because the emissions cap also serves as an emis-
sions floor and specifies not only the maximum but also the actual amount of emissions that
will occur (Burtraw and Shobe 2009). Goulder and Stavins (2011) describe the consequence
of such overlapping policies to be 100 percent emissions leakage, because unless the cap is
adjusted, there will be no effect on total emissions. So, for example, when Germany reduces its
own emissions through the Energiewende, it leads to the waterbed effect, that is, emissions
reductions in one place leading to increases in emissions somewhere else, introducing costs
with no change in total emissions.9 However, such overlapping policies do push down al-
lowance demand and allowance prices, which affects the value of auction revenue that flows
back to member states.

9
Whitmore (2016) argues that subsequent administrative adjustments to the cap can largely overcome this
effect.

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 Distribution of Emissions Allowances and the Use of Auction Revenues in the EU ETS 15

As overlapping policies push down auction revenue, they erode the ability of member states
to invest in climate and energy activities and programs, which can, in turn, trigger even more
support for overlapping technology mandates. Moreover, several researchers argue that di-
rect technology policies are essential to create the political coalitions, such as industry groups,
that are necessary to support a technological transformation (Keohane and Victor 2013, 2011;
Meckling et al. 2015). Low prices bring these views that favor greater ambition by some
member states and the use of direct technology policies into conflict with an efficient emis-
sions market.
It was partially in response to this dilemma that in 2015 the EU introduced the MSR, that is,
in order to limit the number of allowances in circulation in the hope that it would boost
allowance prices. The economic perspective on the initial version of the MSR tended to be
critical, because allowances that were withheld from circulation in the short run were
expected to eventually return to the market, leaving the cumulative supply of allowances
unchanged (Hepburn et al. 2016). Indeed, the allowance market exhibited little price re-
sponse after the initial adoption of the MSR.
But, as noted earlier, additional reforms in 2018 appear to have affected allowance prices.
The price rose from e7 per ton in November 2017 (when the outcome became apparent) to
e14 in May 2018. One of the recent reforms was an increase in the “linear reduction factor”
(which describes the annual percent reduction in the emissions cap) from 1.74 percent to 2.2
percent. In addition, the EU allowed for cancellation of some allowances that are contained in
the MSR, beginning in 2023. Almost 2 billion tons are expected to be canceled in 2023 (Perino
2018), an amount that is greater than a single-year allocation (about 1.6 billion tons) under
the current emissions cap. Thus the 2018 reforms appear to have reduced the “waterbed
effect.”
A more direct approach to promote robust prices might be a price floor enforced as a
minimum acceptable price (“reserve price”) in the auction (Burtraw, Palmer, and Kahn 2010;
Wood and Jotzo 2011), an approach that is used in the North American carbon programs
(i.e., the Regional Greenhouse Gas Initiative and the Western Climate Initiative).10 In these
programs, if demand is not sufficient to sell the available allowances at a price at or above this
minimum level, then some of the allowances will not sell, thereby constricting supply and
supporting the price in the market.11 As in the EU ETS, the North American programs include
substantial overlapping policies (e.g., renewable energy and energy efficiency programs, mo-
bile source standards) that push down the demand for allowances. The minimum auction
price has been triggered in both of the North American markets and the price has risen above
that level in subsequent auctions. The Regional Greenhouse Gas Initiative has also added a
price step that provides a higher minimum auction price to about 10 percent of the allow-
ances, while the lower price floor applies to all other allowances, thereby increasing the price
responsiveness of allowance supply. Although some critics have argued that this approach is
not achievable for the EU ETS because, under EU rules, unanimous political acceptance is
required, this argument has been contradicted in recent analysis (Fischer et al. 2018). A
minimum price may also be helpful for linking across emissions markets because there is

10
A minimum auction price is also a common feature on platforms such as eBay.
11
A minimum auction price has been implemented even when emissions allowances are given away for free,
through the use of a consignment auction (Burtraw and McCormack 2016).

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 16 A. Löfgren et al.

currently no single comprehensive metric for measuring emissions reduction contributions

(Aldy and Pizer 2016), and the price floor could serve as a useful partial measure of effort in a
market. For example, Canada has identified a minimum price as a necessary feature for
provincial-level climate policies to conform sufficiently to national climate objectives
(Government of Canada 2016).
Although a minimum auction price may have advantages over the MSR, including greater
transparency and predictability (Perino 2018), both approaches introduce price responsive-
ness to the supply schedule. Without a design such as a minimum auction price or the MSR,
EU member states would lose their ability to increase ambition, because of the waterbed
effect, which might threaten the future of the ETS. Thus it appears that adjustments to
allowance supply in response to the price play an important role in ensuring the durability
of emissions markets.

Concluding Remarks and Directions for Future Research

The EU ETS ensures that a specific emissions reduction target is achieved for the set of
emissions sources covered by the program, and it is designed to deliver cost-effective emis-
sions mitigation while also alleviating concerns over emissions leakage and firms’ compet-
itiveness. The program clearly continues to evolve and interacts with other, overlapping
climate and energy policies. In establishing a price on carbon, the EU ETS created an asset
value in the form of tradable emissions allowances worth billions of euros annually. During
the first 8 years of the program (2005–2012), nearly all the emissions allowances and their
associated value were distributed for free to incumbent emitters. One concern about free
allocation was evidence of windfall profits. In addition, the allocation was generous compared
with emissions, resulting in low allowance prices. The introduction of revenue-raising auc-
tions in 2013 signaled a sweeping and important change in the EU ETS approach to allocation
of allowances, and by 2017–2020, nearly half of all allowances will be distributed via auction.
The persistence of unexpectedly low allowance prices has partly been caused by, and has
itself partly been the cause of, overlapping direct technology support policies aimed at build-
ing low-emissions infrastructure. Auctions provide a source of revenue that can be earmarked
to fund such efforts. Indeed, we find that member states have been using the majority of
auction revenues in this way. However, this finding comes with a caveat: it is unclear whether
all reported spending on climate and energy represents additional spending compared with
what would have been spent without the earmarked auction revenues. Further research is
needed to identify whether revenues raised through auctions provide truly additional funding
for climate action, whether the second-best setting in which the EU ETS operates justifies
directing allowance value to specific purposes (“earmarking”) rather than using carbon
revenues to offset preexisting distortionary taxes, and whether recent market reforms due
to begin in 2019 will function as intended, thus further improving the EU ETS.
Future research should also continue to focus on the determinants of the allowance price,
because the price dynamics have changed several times over the years and have proved many
forecasts wrong.12 For example, a 2015 version of this paper assumed a 2016 price of e11, but the
12
See Hintermann, Peterson, and Rickels (2016) for a review of the literature on allowance price dynamics in
the EU ETS.

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 Distribution of Emissions Allowances and the Use of Auction Revenues in the EU ETS 17

actual price in 2016 was about half that, and at the time of this writing (May 2018), prices are
above e14 (Löfgren et al. 2015). Thus revenue uncertainty remains a challenge for member states.
Nevertheless, the EU ETS distribution of allowances and, implicitly, the value of allowances
across member states is itself an important achievement that we would argue could be viewed
as a successful example of what is often referred to as a “climate club,” with negotiated trade-
offs both within and outside the realm of climate policy (Nordhaus 2015). However, the
experience of the EU ETS also suggests that countries are likely to insist on determining the
distribution within their borders of both the cost and the value that is created by introducing a
price on carbon.
Overall, we conclude that the dramatic change in the design of the EU ETS—from free
allocation of allowances to auctions and the use of auction revenue for public policy pur-
poses—represents a major development in the evolution of emissions trading programs and
sets the EU ETS on a stronger course for the future. Although uncertainties remain, the proven
ability of the EU ETS to evolve and improve over time makes us optimistic about its future.

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 Distribution of Emissions Allowances and the Use of Auction Revenues in the EU ETS 21

A bst ra c t
The European Union (EU) Emissions Trading System (ETS) introduced emis-
sions allowances as a new asset worth tens of billions of euros. This article examines
how this asset value has entered the economy and been distributed among stake-
holders and for various purposes. We show that the system design has evolved
significantly with the broader use of auctioning, although there continues to be
free allocation of allowances to industry to address emissions leakage. By 2017–
2020, more than half of all allowances are intended for auction, but recent reforms
will reduce allowances in circulation by delaying, and to some extent canceling, the
issuance of some allowances slated for auction. To date, the low price path deviates
from what economic theory would prescribe as an efficient path to long-term
emissions reduction goals, posing an important challenge for the ETS and coordi-
nation of member states’ ambitions. Allowance prices are expected to rise due to
recent reforms; however, technology support policies promoting renewable energy
and energy efficiency tend to reduce allowance prices. Thus both auctioned quan-
tities and prices remain uncertain. The use of auction revenue is left to EU member
states, who have directed more than half of auction revenue to energy- and climate-
related activities. (JEL: H23, P48)

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