What is an Allowance?
Carbon allowances are issued by a government under an emissions cap-and-trade regulatory program. Each allowance (or emissions permit) typically allows its owner to emit one tonne of a pollutant such as CO2e.
Under a cap-and-trade system, the supply of GHG allowances is limited by the mandated ‘cap’. Allowances can be allocated freely by the governing program, be purchased when auctions are held, or be purchased from other entities that have excess.
The location of the emission sources covered by a cap-and-trade program depends on its scope set out in regulation or legislation. There are programs in the European Union, United States (California and RGGI), Canada (Alberta and Quebec), and emerging systems all over the world, including China, Korea, and South America.
The EU Emissions Trading System (EU-ETS) is the largest cap-and-trade program covering over 40% of the EU’s GHG emissions (as of 2020). The cap is set at minus 20% by 2020 and minus 43% by 2030 below 2005 emissions.
In the USA, there are two emission trading systems (ETSs) as of 2020:
- The Regional Greenhouse Gas Initiative (RGGI) began in 2009. RGGI is the first mandatory GHG cap-and-trade system in the United States. It includes eleven Northeastern and Mid-Atlantic states. Each state establishes its own cap and trade program that sets limits on in-state CO2 emissions from electric power plants. These programs link to a multi-state allowance market.
- The cap and trade program established by California’s Global Warming Solutions Act AB 32 started in 2013 (CA ETS). It covers 85% of California’s GHG emissions, including the transportation sector. The California and Quebec cap-and-trade programs are linked.
Cost and Management Burden
Cost per tonne of CO2e (2019 data):
- RGGI: US$5-6
- California: US$14-18
- EU ETS: around €20-30
Most RGGI member states allow non-capped voluntary buyers to purchase and cancel RGGI allowances. The purchase of CA or EU-ETS allowances is also possible. The purchase of such allowances to make a voluntary emission reduction claim would not require a major management burden, and ongoing-management costs would be minimal. Numerous environmental commodity brokers exist that can facilitate the purchasing and retirement of allowances.
You can find updated allowance price information and more details on program price floors and other aspects of these and other cap-and-trade programs here.
Buying and canceling allowances from a cap-and-trade system offers an alternative to carbon offset credits for claiming emission reductions. This approach has the potential to avoid offset quality issues, such as non-additionality. The purchase and voluntary cancellation of allowances reduce the availability of allowances in a cap-and-trade system, effectively “tightening the cap” and, in principle, reducing emissions that can be produced by sources covered under the cap (e.g., power plants, large industry, and fuel suppliers). By this logic, purchasing and canceling allowances compels cap-covered sources to achieve additional emission reductions. However, a concern with this approach is that cap-and-trade programs can have oversupplied allowance markets.
Cancelling in an oversupplied market has a negligible effect. Canceling allowances will only result in additional emission reductions to the extent that allowance markets are not over-supplied. Oversupply can build up if the emissions cap is unambitious (i.e., higher than the projected business-as-usual (BAU) emissions). In such a case, a cap-and-trade policy in a country or region actually has no significant effect on emissions from covered sources. There will be too many allowances issued by the governing regulatory authority and result in an accumulation of surplus allowances in the market. More allowances mean covered sources can emit as much as they choose.
Oversupply of allowances can also be created if the covered entities engage in more mitigation activities than required by the cap. If a cap is ambitious, over-achievement will be transient and will not lead to a build-up of surplus allowances.
In a cap-and-trade system with a long-term oversupply problem, canceling surplus allowances is one option to remove the built-up surplus but this action will not cause emission reductions. Canceling allowances from an oversupplied market may lead to additional emission reductions later in time, assuming the oversupply was temporary and that there is a scarcity of allowances in the future. However, such emission reductions would be subject to uncertainty, as reductions would depend on the continuation of the ETS and increased stringency in the ETS’s cap.
Historically, most cap-and-trade systems have been oversupplied with allowances. Many have also incorporated minimum price floors for new emission allowance sold at auction. One clear signal that a market is oversupplied is that auction prices are at or near the program’s price floor.
- The EU-ETS was oversupplied for many years, but changes to the program were instituted to neutralize that surplus (e.g., Market Stability Provisions 2019). Prices reflect these EU-ETS oversupply adjustments improving the efficacy of the program to reduce emissions. If this trend continues the oversupply problem for the EU ETS may have been resolved.
- The CA-ETS has a price ceiling and price floor. To date allowance prices have traded at or slightly above the floor price, indicating that there is no scarcity of allowances.
- RGGI was severely oversupplied in the past because of a switch to natural gas from coal by many utilities and a weak economy over the baseline setting period. RGGI has a low price floor and allowance prices have traded at or slightly above this floor, indicating that there is no scarcity of allowances.
Concerns related to the environmental integrity of allowances due to oversupply presents a significant risk – if used as an instrument to make voluntary emission reduction claims. Buyers should not make such claims based on the voluntary retirement of allowances from oversupplied cap-and-trade programs.
Social and Environmental Co-Benefits
Unlike offsets, the purchase of allowances would not allow the purchaser to select activities with sustainable development benefits.
Outlook and Considerations
Buying and canceling allowances from a cap-and-trade system offers an alternative to offsets but environmental integrity can only be ensured if allowances come from a system that is not oversupplied over the long-term.
The cancellation of EU-ETS allowances has become a viable option as the EU-ETS no longer appears oversupplied. RGGI and the CA-ETS, however, are clearly oversupplied and should not be considered for voluntary allowance retirement. Any buyer considering this option should follow developments under both systems to track prices, allowance supply, and changes to programmatic rules.
 We use the terms canceling and retiring interchangeably. In some systems canceling refers to deleting the units without using them for compliance and retiring as using them for compliance and then deleting them.