Policy by Design: Virginia’s NOx Allowance Auction

1. Policy by Design: Virginia’s NOx Allowance Auction D. Porter, S. Rassenti, B. Shobe, V. Smith, and A. Winn June 20, 2005

2. Why is this interesting? • First time allowances sold for revenue • Innovative auction designs • Experimental comparisons of auctions • Implementation • Timing • Bureaucratic issues • Broker’s issues

3. NOx allowances • Nineteen state regional market • Allowances have vintages • Use on or after vintage year • ’04 and ‘05 had 1,855 allowances in the set-aside • At prevailing prices, vintages would earn about $9 million • Allowances may be banked at a risk • Subject to “progressive flow control” or discounting if total stock of banked allowances rises above 10% of total allowances

4. Criteria for successful auction • Maximize revenues for the state • Auction must be completed by June 30 • Fair, understandable, and transparent auction process

5. Results of initial design work • Initial evaluation suggests 3 auction types for evaluation: • Combinatorial sealed-bid • Combinatorial English clock auction • Sequential English clock

6. Combinatorial sealed bids • For the combinatorial sealed bid • “Any/Or” (AO) bids • Bids take the form: (p4,Q4 | p5,Q5) • Which includes any linear combination: • q4 ≤ Q4; • q5 ≤ (1-)Q 5; • 0 ≤  ≤ 1

7. Combinatorial sealed bids - 2 • For example, the bid (100, 10| 90, 20) could result in: • Q4 = 10 or Q5 = 20 or any linear combination such as • 4 units of 2004 ( =.4) and 12 units of 2005 for (1- =.6) • Revenue is maximized by solving an integer programming problem in Q4, Q5 , and ij

8. The “English clock” • Seller has many units to sell • Seller announces price, bidders announce quantity • Start at low price where demand is high • Increase price at set periods • Stop when demand equals supply • Sell all allowances at ending price

9. Advantages of the clock • Quick and easy to implement • Reduces political risk • Does not reveal WTP of high-value bidder

10. Combinatorial English clock • Bidders bid on 2 clocks simultaneously • Clock increases for any vintage in excess demand • Bidders may switch quantities between vintages subject to some limits • When both clocks stop, revenue maximizing bids are selected by algorithm

11. Sequential English clock • Sell one vintage in morning and one in afternoon • Each by standard English clock • Does the order make a difference?

12. Experimental results - revenue • Both clocks beat CSB with elas. demand • CEC does a little better than SEC • Clocks fair worse with inelastic demand • Differences in vintage prices does not affect relative performance of CEC and SEC • For SEC, order of auction does not matter • External market probably implies elasticity

13. Auction timeline • As of mid-April,time pressure appeared to rule out all but the simple sealed bid. • RFP for auction brokerage services published May 17 • Responses were due on May 27 • Contract was signed on June 8 • Auction was held on June 24 • Light-speed for a state bureaucracy!!

14. The winning brokerage bid • No mention of clock auctions in the RFP • Credible bids from five firms • All could do a sealed bid • Amerex proposed an English clock auction • This was a surprise as the ICES work had not been publicized. • Virginia chose the risky path to maximize revenue from the auction

15. Sixteen days • 5 days of intense discussion on design detail • Sequential versus joint auction of vintages • Single price or discriminatory pricing • How to select winning bids • Auction design finalized on June 14

16. Programming and paperwork • Programming the Internet application • Writing contract • Contacting potential buyers • Getting contracts approved • Arranging financial assurance • Bond ratings, escrow, or letters of credit • Bids limited to credit amounts

17. The auction - bidders • Bidders see only two things • The current price • That the auction is still open • Bidders enter only quantity bid • Bidding early is important because winning bids are filled in order received • Must bid each round to stay in • Can’t increase bid in later rounds

18. The auction - seller • Announce schedule of rounds • Time for bidding; time for posting new round • Stay in touch with bidders • When quantity bid falls below quantity to sell, auction ends • Seller chooses top price or next price down to maximize revenues

19. Price paid • Bidders at top price get goods at seller’s chosen price • Even if next to last price is chosen • If final price drops down, additional quantity is sold in time order of bids • Bidders who drop quantity in last round may get some units at their last bid price

20. Auction results: 2004 vintage • Number for sale: 1,855 • 19 bidders, 10 winners • Day before the auction: • Bid: $2,200; Ask: $2,350 • Morning of auction over-the-counter sale: $2,250 per ton • Auction clearing price: $2,325 • 3.3% over morning trade price!

21. Auction results: 2005 vintage • Number for sale: 1,855 • 17 bidders, 5 winners • Day before auction: • Bid: $3,150; Ask: $3,200 • Morning of auction over-the-counter sales: $3,200 per ton • Auction clearing price: $3,425 • 7% over the morning trade price!

22. Revenue exceeds expectations • Total auction revenue: $10,666,250 • Auction expenses: under $200,000 • Including one-time research costs • Net revenue: $10,466,250