How does cap-and-trade work?

There are no paddles or speed-talking auctioneers, and bidding in an auction takes only about 20 minutes.

from the June 27, 2009 edition

The idea behind cap-and-trade is relatively simple: A governing body caps the amount of pollutants that can be released into the atmosphere, then mandates that companies emitting those pollutants must hold permits to cover the amount of pollutants they expel. To reduce pollution, the governing body slowly reduces the number of allowances available over time.

So how do auctions for emissions allowances work?

It's not quite Sotheby's.

And with the Regional Greenhouse Gas Initiative – a coalition of 10 Northeastern states that has agreed to limit its carbon-dioxide emissions – the winner isn't simply the highest bidder.

Rather, when participants place a bid, they name the amount they're willing to pay per allowance and the number of allowances they'd like to purchase.

Absent are the auctioneers, the paddles, the excitement of bid and counter-bid more typically associated with auctions. Participants simply place their bids on an online interface, not unlike eBay.

The bids are then collected and ordered according to price. Starting at the top of the list, with the highest bids, the auction overseer works his way down, adding the number of allowances requested until he reaches the total number of allowances offered in that auction. When he reaches that point, he draws a line; everyone above the line receives the number of allowances they requested at the lowest winning bid – the price closest to, but still above, the line. This is known as the clearing price, the price that every winning bidder will pay for their allowances, no matter what price they originally bid.

While bidders will likely have extensive conversations with their company's compliance team in the days before the auction, the bidding process usually takes only a few minutes.

For two days after the auction, results are calculated and affirmed by an auction overseer to ensure that there hasn't been collusion between bidders or other prohibited behavior. Then, participants log back onto the auction interface to find out if their bids were successful.

In RGGI's most recent auction on June 17, the 10 participating states put 33,060,160 allowances – each representing 1 ton of carbon-dioxide emissions. There were 54 different bidding entities which bid on allowances that eventually each sold for $3.23, for the compliance period ending in 2009, and $2.06, for the 2012 period.