Climate Finance 2.0: Introducing Auctioned Price Floors
The Climate Finance Challenge
Imagine you work for a government agency or philanthropy that wants to support climate mitigation projects (e.g., solar energy installations, building efficiency upgrades). You have a grant budget of $50 million to invest anywhere in the world, and you want to invest in projects that reduce the most greenhouse gas emissions. Where do you put your money, and how do you know that you’re getting the best bang for your buck?
To answer this question, you might look to the carbon markets for the price of emissions reductions from various technologies and pick the cheapest ones. But this data is spotty and the markets are volatile. You might then ask project developers or governments to submit proposals for how to best use the $50 million. But this process is time-intensive and political. Further, you have no way of knowing that these projects will deliver results, meaning you risk wasting already limited taxpayer dollars or private grants.
Introducing Auctioned Price Floors
In response to this challenge, a recent article coauthored by Rocky Mountaint Institute (RMI) published in Climate Policy offers a new solution: auctioned price floors for emissions reductions. Piloted by the World Bank, these price floors, which are allocated through auctions, provide a guaranteed price for emissions reductions generated from clean technologies. Price floors give auction winners the right but not the obligation to sell emissions reductions at a fixed price (the strike price). If carbon market prices for emissions reductions rise above this price, option holders sell emissions reductions to the market. If market prices remain below the fixed price, option holders sell emissions reductions to the funder.
By awarding price floors only to the projects that reduce emissions at the lowest cost, auctions eliminate the challenge of picking winners. The price floors are also results-based, meaning that funds are disbursed only once the projects deliver emissions reductions. This is the first truly market-based, transparent approach to allocating subsidies and could prompt a revolution in the way climate finance is allocated.
Here’s how auctioned price floors work:
- Public funders such as development agencies, multilateral climate funds, or philanthropies commit to funding emissions reductions, denominated in tons of carbon dioxide equivalent (tCO2e). Funders agree to pay a fixed price per tCO2e upon verification of emissions reductions.
- Private firms bid in an online auction to receive a share of this funding. The auctions reveal the firms that can deliver emissions reductions at the lowest cost to the funder.
- Auction winners purchase price floors, which are technically put options. The strike price is the price at which auction winners have the right but not the obligation to sell emissions reductions.
- If auction winners cannot reduce emissions as planned, they can seek to recoup their investment by selling the options to other projects, thus maximizing the likelihood of achieving emissions reductions.
The Track Record
Between 2015 and 2017, the World Bank’s Pilot Auction Facility (PAF) conducted three pilot auctions, the first two targeting methane emissions reductions and the third targeting nitrous oxide emissions reductions. Over the three auctions, the PAF allocated over $50 million in auctioned price floor contracts to project developers and aggregators operating in developing countries. To receive payment, contract holders must present emissions reductions that have been verified under an approved carbon standard.
The auctions--which occurred online and attracted bidders from around the world--demonstrated the potential for this approach to not only attract private investment, but also drive down the price of emissions reductions. Winners of the first auction paid $0.30 per ton of carbon dioxide equivalent (tCO2e) for contracts that guarantee a future payment of $2.10/tCO2e. In the second auction, winners paid $1.41/tCO2e for contracts guaranteeing a future payment of $3.50/tCO2e. Finally, winners in the nitrous oxide auction paid $0.30/tCO2e for contracts guaranteeing a future price of $2.10/tCO2e.
Figure 1: The Pilot Auction Facility Model
In addition to the PAF, the UK government’s UK’s Contracts for Difference program (CfD) has experimented with a similar approach in an effort to increase the security of its power supply. Just as the PAF offers a guaranteed price for future emission reductions, CfD reduces market risk by offering low-carbon energy generators a “top-up” between the market electricity price and a price determined through an auction. Unlike the PAF, which focused on sustaining existing projects, CfD demonstrates the ability of auctioned price floors to incentivize investment in emerging technologies.
The experiences of the PAF and CfD offer several lessons for policymakers. First and foremost, both programs highlight the importance of strategic auction design. Key principles for successful auctions include 1) setting the budget based on the market size (number of participants) and estimated technology costs, 2) maximizing participation to ensure competitive auctions, 3) avoiding collusion and gaming, again by maximizing participation and/or contract design.
The CfD program also offers several lessons on how to use auctioned price floors to enable emerging and capital-intensive projects. Unlike existing projects seeking operating expenditure support, new projects and technologies with capital expenditure needs may require larger auction budgets, long timelines for project and bid development, and contracts with longer payback periods.
The experiences of the PAF and CfD point to a number of opportunities for replication. For example, the Green Climate Fund, currently facing the challenge of efficiently allocating its $10 billion resource base, could save drastically on administrative costs by running a series of auctions tailored to key technologies, sectors, and countries. Auctioned price floors could also be used within a single country to support state or national-level initiatives, for example in California, where auctioned price floors are being considered to stimulate the production of low-carbon fuels. Finally, auctioned price floors could be used in combination with carbon pricing, offering a near-term subsidy to ease the transition to a carbon tax or cap-and-trade system.
In short, auctioned price floors offer one answer to the challenge of bringing climate finance tools into the 21st century. The next step: figuring out how to invest the funding that you save, and even raise, using this innovative approach.
You can download the Climate Policy article, "Underwriting 1.5°C: competitive approaches to financing accelerated climate change mitigation," here.
The opinions expressed herein are solely those of the authors and do not necessarily reflect the official views of the GGKP or its Partners.