Breaking Collusion in Auctions Through Speculation: an Experiment on Co2 Emission Permit Markets

BREAKING COLLUSION IN AUCTIONS THROUGH SPECULATION: AN EXPERIMENT ON CO2 EMISSION PERMIT MARKETS

MICHEL MOUGEOT CRESE University of Franche-Comte

FLORENCE NAEGELEN CRESE University of Franche-Comte

BENJAMIN PELLOUX GATE, CNRS, University of Lyon, and CREED, University of Amsterdam

JEAN-LOUIS RULLIERE` GATE, CNRS, University of Lyon

Abstract The European Emission Trading Scheme (EU-ETS) has chosen to adopt an auctioning procedure to initially allocate CO2 emission permits. Free allocation of permits will become an exception for the third phase (2013–2020) and most ﬁrms will have to buy all their permits on the market or via auctions. The ability of bidders to collude is a key concern about the design of the auction format. To counter collusion, the auction can be open to bidders without compliance obligations (speculators). This paper aims at studying experimentally speculation as a collusion-breaking

Michel Mougeot and Florence Naegelen, CRESE University of Franche-Comte, Av- enue de l’Observatoire Besançon 25030 cedex, France ([email protected], fl[email protected]). Benjamin Pelloux and Jean-Louis Rulliere,` GATE, CNRS and University of Lyon, 93 chemin des Mouilles, 69130 Ecully, France (pel- [email protected], [email protected]). Benjamin Pelloux, CREED, University of Ams- terdam, Roetersstraat 11, 1018 WB Amsterdam, The Netherlands ([email protected]). This research has been made possible by a financial support from the Mission Cli- mat, Caisse des Dep´ ots,ˆ Paris, France. Any opinions, findings, and conclusions or recom- mendations in this material are those of the authors and do not necessarily reflect the views of the Mission Climat, Caisse des Dep´ ots.ˆ The authors are grateful to Ana¨ıs Delbosc, Sylvain Boschetto, Sylvain Ferriol for the software and the technical assistance. They thank Jacob Goeree and Charles Holt, participants of the ESA 2009 American meeting in Tuc- son, two anonymous referees, and the editor of this review for their helpful comments. The remaining errors are the authors’ sole responsibility. Received December 17, 2009; Accepted February 28, 2011.

C 2011 Wiley Periodicals, Inc. Journal of Public Economic Theory, 13 (5), 2011, pp. 829–856. 829 830 Journal of Public Economic Theory

device in two different auction mechanisms: the uniform- price sealed-bid auction and the ascending clock auction. Our results suggest that a uniform sealed-bid auction open to speculators should be chosen from a revenue maximization point of view. In this mechanism, compliance agents adopt an aggressive strategy toward speculators. This strategy signiﬁcantly increases the seller’s revenue, compared to the more collusive clock auction. In the latter, on the contrary, bidders accommodate speculators, letting them buy permits in the auction and buying their necessary permits on the secondary market. However, as opening the auction to speculators deteriorates efﬁciency, the regulator faces a trade-off between these two objectives.

1. Introduction In 2005, the European Union initiated the implementation of the first CO2 emission trading scheme. This European Emission Trading Scheme (EU-ETS) was designed to cap emissions from power generation and much of heavy industry. It forms the central piece of the European policy on climate change and is the main instrument to enable European countries to comply with their objectives of the Tokyo protocol. Based on a cap-and- trade principle, the EU-ETS is the world’s largest carbon-trading market. It accounts for over 80% of the global carbon market transactions (about 90 billions euros in 2008). Its liquidity has improved continuously from 260 mil- lion tons during the first year (12% of the total allocation of allowances) to 2.75 billion tons in 2008 (130% of the allowances).1 The aim of such a mechanism is to achieve emissions reduction at the lowest overall abatement cost. The cap corresponds to the overall emission reduction objective and is set individually on the emissions of each of the installations covered by the scheme. The permits allocated to firms can be freely traded on the market. Hence, the EU-ETS puts a price on carbon and creates incentives for the reduction of CO2 emissions. A crucial issue for a cap-and-trade policy such as EU-ETS is the initial allocation of allowances. Whereas firms favor an allocation at no cost in a way related to historical outputs (i.e., to past emissions levels), economists recommend the introduction of a costly auctioning mechanism.2 In the first phase (2005–2008), permits were mainly allocated to firms according to the

1 See Charpin (2009). 2 See for instance Cramton and Kerr (2002) or Hepburn et al. (2006). According to Cramton and Kerr, powerful vested interests in the energy sector are lobbying for the permits to be allocated on a grandfathering basis. Breaking Collusion in Auctions through Speculation 831 grandfathering process. But European countries could use auctions for at most 5% of the overall allocation. In phase II (2008–2012), at most 10% of the permits could be auctioned. As the price effects of a cap-and-trade mechanism are unaffected by whether permits are grandfathered or auctioned, this free allocation has re- sulted in substantial windfall profits for the firms covered by the scheme.3 The opportunity cost of a permit (i.e., the price on the market) being the same under grandfathering or auctioning, firms transfer a proportion of the marginal production cost increase to consumers regardless of the form of the initial allocation but depending on the market structure. Thus, the two mechanisms of initial allocation are identical from an efficiency point of view. However, when marginal excess burden of raising government revenue is taken into account, rent extraction matters. Although rent accrues to shareholders of the compliance firms (i.e., the producers that must sur- render each year a number of permits corresponding to their emissions to their government) under grandfathering, it can be obtained by taxpay- ers when permits are auctioned under the condition that auction revenues are oriented toward the reduction of distortionary taxes. When the trans- fers from consumers to the government have positive social value, that is, when there is a loss incurred by the society in raising additional revenues to finance government spending, social welfare is greater when permits are auctioned. Based on these rent distribution arguments, the European Union has limited4 free allocation of permits to an exception for the third phase of the EU-ETS (2013–2020). Firms from the electricity sector will have to buy all their permits on the market or via auctions. The share of permits freely allocated to firms in the other industrial sectors will have to de- crease from 80% in 2013 to 30% in 2020. In a similar way, 10 Northeastern American States have opted for a cap-and-trade system that took effect in January 2009. The first auction preceded the adoption of the Regional Green Gas Initiative (RGGI) program and was held in September 2008. The European Commission mentions efficiency as the main objective of the auctioning of permits.5 This implies that allowances must be allocated to the

3 Hence, though they received free of charge permits, firms in the power sector have increased electricity prices. For instance, in Germany, RWE got a windfall profit of $6.4 billions in phase I of EU-ETS. See Fell (2010) for an empirical analysis of these price effects in the Nordic electricity market. In their experimental analysis, Wrake¨ et al. (2010) show that the agents learn to consider the opportunity cost of permits and that overall behavior moves towards the economic theory prediction. 4 See amended directive 2003/87/EC. 5 Maximizing the revenue is the second objective of the government when designing an auction procedure. In general, an efficient auction is also a revenue-maximizing auction. 832 Journal of Public Economic Theory

firms that attach the greatest value to them, which means that CO2 emission reductions are made at the lowest cost to society. From this point of view, how should carbon permit auctions be designed? The setting is char- acterized by a fixed supply of identical permits and by multiunit demands. Whereas economic theory provides important results on the comparison of the common auctions formats in the case of the sale of a single indivisible object or of unit demands in the case of multiunit auctions, there is no general game-theoretical solutions for the sale of multiple units when bidders demand more than a single one. In particular, the revenue equivalence theorem (Vickrey 1961) fails to hold in this case. Many important consid- erations are relevant to the design of the procedure. First, there are a va- riety of auction formats. The seller can decide to sell the permits by using a sealed-bid, a descending bid, an ascending bid or an ascending clock auction. Second, the pricing rule can be uniform, discriminatory or based on the Ausubel–Vickrey principle. Moreover, the auction access can be either re- stricted to the “compliance” agents, or be open to all current participants on the secondary market, including “compliance” and “noncompliance” agents, that is, banks and financial institutions.6 Many criteria can be used to guide the design of pollution permit auctions. Among these criteria, the ability of bidders to collude appears to be a key concern as it affects both the efficiency and the revenue of the auction. Collusion results generally in a lower revenue and in a lower efficiency. However, the impact of collusion depends on the format of the auction. For instance, in the case of a single unit, second-price auctions are more suscep- tible to collusive practices than first-price auctions because the former has a built-in enforcement mechanism whereas the cartel agreement is not self- enforcing in the latter.7 In the same way, an ascending multiround auction is more conducive to collusion than a sealed-bid format because bidders can have opportunities for signaling and detecting deviations from the collusive agreement.8 In other respects, the collusive agreement, that is, a bidding ring, depends on the type of the agents participating in the auction. Open- ing the auction to agents without compliance obligations can reduce the ability of the compliance bidders to collude.

For instance, Cramton and Kerr (2002) consider that these goals are closely aligned. How- ever, there are exceptions. For instance, a first price auction can be more profitable but less efficient than a second price auction when the bidders’ values are drawn from different distributions. In the same way, a reserve price raises the revenue of the seller but may have a detrimental effect on efficiency. In our context, one could imagine a perfect collusion in which every bidder reduces her bid by one unit. As permits would go to their highest valued use, an efficient allocation would occur but the revenue would be lower than without collusion. 6 This is discussed by Charpin (2009) on Section 5. 7 See Krishna (2002). 8 See the conclusions of Holt et al. (2007). Breaking Collusion in Auctions through Speculation 833

To illuminate the EU-ETS pollution permits auction design, we have conducted experiments to analyze the performances of both the ascending clock and the uniform sealed-bid auctions and to show how the presence of noncompliance bidders can be used as a collusion breaking device in these two auction formats, which are differently sensitive to collusion. Bidders who are nonemitters and have no use value for the allowances will be called “speculators” because they can only make profit through speculation, that is, by reselling permits on the secondary market. Of course, compliance agents also speculate but they are not pure speculators because they have to comply with their obligations. As in Burtraw et al. (2009), we find that the sealed-bid uniform auction gives higher revenue. Furthermore, our analysis shows the interest of introducing speculators in the auction, which constitutes the main point in the paper. Especially, we show how the presence of no use value bidders affects the industrial agents’ strategies in the two auction formats. In both cases, the presence of speculators weakens collusion and increases the average auction price. Moreover, it enhances the advantage of the sealed-bid auction in terms of revenue. Although it increases only slightly the prices in the clock auction, it has a more important impact on the uniform auction prices. This is the consequence of different patterns of strategies of the bidders in the two mechanisms. On the contrary, opening the auction to speculators deteriorates efficiency in the final use of allowances in both types of auctions. The effect is greater in the uniform-price sealed-bid auction. Thus, from an optimal allocation point of view, the regulator should restrict the access to compliance bidders. As the ranking of the procedures differs according to the criteria of revenue and efficiency, there is a conflict for the regulator. If its first objective is efficiency, it should not open the auction whereas it should open it if maximizing the revenue is its first goal. The paper is organized as follows. Section 2 reviews briefly both the theoretical and experimental literature on auction and speculation. In Sec- tion 3, we present the experimental design and the basic theoretical predic- tions. The main statistical and econometric results are discussed in Section 4. Some conclusions are drawn in Section 5.

2. Previous Literature Auctioning many identical permits when the supply is fixed is a relatively well-understood situation (see Cramton and Kerr 2002). However, according to Klemperer (1999), it is hard to achieve efficient outcomes in multiunit auctions. Let us first consider the most common mechanisms. Then, we will present the main results obtained in the experimental literature. Finally, we will discuss the influence of the participation of no use value agents in the auction. 834 Journal of Public Economic Theory

2.1. Different Ways to Auction Pollution Permits Several multiunit auction formats can be used to allocate permits. In private values contexts, the Vickrey sealed-bid auction and the Ausubel9 ascending auction are efficient. In both mechanisms, each bidder has to pay for each permit an amount equal to the externality she exerts on other bidders, and it is a weakly dominant strategy to bid according to her true demand. The drawbacks of these mechanisms are well known. On the one hand, imple- menting these auction formats does not result in a unique price signal for the carbon. As the externality may vary with each permit bought by each bidder, there is a multiplicity of prices. Then the market does not convey good information on the marginal cost of reducing CO2 emissions. On the other hand, these mechanisms can be considered as unfair because high-value bidders are often required to pay less than low-value bidders. In sealed-bid auctions, there is a single round in which buyers can submit multiple bids at different prices. Beside the Vickrey auction, two formats are of particular interest for practical reasons. They differ in terms of pricing rules. With pay-your-bid pricing, the n highest bidders for the auctioned permits obtain allowances at their own bid price. As the Vickrey auction, this discriminatory auction does not result in a unique price. With uniform pricing, the bidders with the n highest bids obtain allowances at a unique price equal to the highest rejected price. Whatever the pricing rule, strategic behavior leads to inefficiency in these auctions. With discriminatory pricing, each bidder attempts to guess the clearing price and bids slightly above. Then, in this procedure, bidders tend to bid well below true values. With uniform pricing, buyers have an incentive to shade their bids for all units except for the first one to pay less for their winnings.10 This demand reduction strategy11 results in an inefficient outcome for both auction formats. Moreover, there is no clear ranking between pay-your-bid and uniform-price auctions from the revenue point of view. However, the latter has the advantage that each winner pays the same price. These mechanisms have corresponding multiround open formats. As- cending auctions can be conducted with demand schedule or with an electronic clock. As for the sealed-bid format, these procedures are not efficient because bidders shade their bids to lower the price12. The most popular is the English clock auction in which the bidders submit the quantity they are willing to buy at the price specified by the clock in each round. This price is increased if the total quantity bid exceeds the supply of permits. The increase continues until there is no excess demand and permits are allocated at the prior price (and rationed for bidders who reduce their demand in the last

9 See Krishna (2002) for a description. 10 See Krishna (2002). 11 See Ausubel and Cramton (1996). 12 See Cramton and Kerr (2002). Breaking Collusion in Auctions through Speculation 835 round). Because bidders reduce their bids, this mechanism is not efﬁcient when there is market power. As the strategy spaces are complex and as multiple equilibria exist in multiunit auctions, economic theory does not provide a clear evaluation of these different formats in terms of efﬁciency, revenue or sensitivity to collusion. As a consequence, the design of permit auctions has been often based on experiments.

2.2. Experimental Results Auction theory has been tested in many laboratory experiments. Alsemgeest, Noussair, and Olson (1998) has shown that the sealed-bid auction with lowest accepted-bid pricing generates more revenue than the English clock auction due to strategic demand reduction on the part of bidders. In the case of pollution permits, Porter et al. (2009) have tested three mechanisms to max- imize revenue and efficiency in the sale of nitrous oxide emission allowances by the Commonwealth of Virginia. Since September 2008, the RGGI orga- nizes quarterly permits auctions in a uniform-price, single round sealed-bid format. This mechanism has been chosen on the basis of a report of Holt et al. (2007).13 This report uses experimental methods to identify the auction mechanism that performs best along an expanded set of performances measures: efficiency, price discovery, guard against collusion, and/or market manipulation, government revenue. Experiments were conducted with participants recruited from the undergraduate population at the University of Virginia. The main result from the experiments was that all auction formats are “reasonably” efficient. Moreover, the revenues for the two single-round, sealed-bid formats (discriminatory and uniform-price) were at least as high as those for the multiround formats. Then, the main recommendation of this research is that the RGGI should use a uniform-price sealed-bid auction because this design performs very well as a price discovery mechanism. As the price of a permit is a signal of the economic cost of reduction in emissions, it is important that the auction provides accurate price signals. Furthermore, Holt et al. (2007) show that the clock auction performs worse in terms of promoting price discovery and facilitating collusion. These proposals have been criticized by Cramton (2007), who recom- mends an ascending clock auction instead of the uniform-price sealed-bid auction. According to Cramton, the main advantage of the clock auction is price discovery. Bidders can learn about the other bidders’ demand from the dynamic process and condition their bids on this information. Cramton con- siders that the experiments of Holt et al. (2007) used a nonstandard clock format that did not include the price discovery features essential to obtain the benefits of a clock auction, that is, at each round the excess demand

13 See also Burtraw et al. (2009). 836 Journal of Public Economic Theory should be made public. However, the authors have repeated their experiment in Shobe et al. (2010) and report that the standard clock format made no difference. On the other hand, whereas Holt et al. (2007) conclude that the clock auction facilitates collusion, Cramton thinks that collusion is un- likely because the market is only moderately concentrated and because collusion is illegal. However, according to Krishna (2002), while bidding rings are illegal, they are widely prevalent. Hence, the ability of bidders to collude constitutes a major issue for the design of pollution permit auctions. Collusive bidding generally results in in- efﬁcient outcomes and seller’s low revenue.14 Moreover, a collusive auction outcome generates biased price signals for carbon. It is well known that collusive agreements are easier to sustain in ascending auctions than in sealed-bid auctions.15 Burtraw et al. (2009) have tested the ability of bidders to explicitly or tacitly collude in three auction formats. Using laboratory experiments, they conclude that the clock auction facilitates collusion, both because of its sequential structure and of the focus on only one dimension of cooperation (quantity) rather than two (price and quantity)

2.3. Opening the Auction to No Use Value Agents To counter the bidding ring, the seller can set a reserve price. But a more efficient tool could be to open the auction to agents without a use value. As financial institutions are not subject to greenhouse gas emission regulation, they only buy permits to make money when selling these permits on the secondary market. An evident advantage is given by an increasing size of the market to get closer to the competitive state and to increase liquidity. But more crucially, it gives rise to speculation, that is, buying units in the auction to resell them to bidders with high values on the spot market. The presence of speculators16 may affect other bidders’ strategies, either by inducing them to bid more aggressively to obtain units (which enhances revenue) or by affecting incentives to reduce demand to obtain a lower price. Few papers have explicitly considered the role of speculators in standard auctions. In the case of two bidders (a single bidder with a private use value for the good and a speculator with no use value), Garratt and Troger¨ (2006) have shown that an efficient equilibrium coexists with a continuum

14 Goswani, Noe, and Rebello (1996) have shown that clearing price and seller revenue in uniform-price auctions fall below those observed in discriminatory auctions when communication between bidders is introduced. In contrast, Holt et al. (2008) found that collusion is equally prevalent in the uniform-price and discriminatory-price auction formats. 15 See Sherstyuk (2008) or Sherstyuk and Dulattre (2008) for analyses based on experiments. Brown, Plott, and Sullivan (2009) show that changing from the ascending auction to the descending auction can destroy the tacit collusion. 16 That is, bidders commonly known to have no use value for the good on sale (Garratt and Troger¨ 2006). Breaking Collusion in Auctions through Speculation 837 of inefficient equilibria in second-price and English auctions whereas first- price auctions have an unique equilibrium such that the final allocation is inefficient with a positive probability. In this case, the resale opportunity can be detrimental to efficiency. In a complete information theoretical setting, Pagnozzi (2010) shows that the presence of speculators in the auction has two effects on bidders: a demand reduction effect and a competition effect. On the one hand, when resale is allowed, the presence of speculators affects bidders’ incentive to reduce demand. On the other hand, speculators increase the number of bidders in the auction. The first effect induces the bidders with high value to “accommodate” speculators, that is to bid less aggressively, because they can always buy in the secondary market the units lost during the auction. Bidding aggressively (i.e., outbidding speculators) would have the sole effect of increasing the price of the units won in the auction. In the same way, this reduction demand effect may also induce other bidders to bid less aggressively, to pay a low auction price. Hence, this effect involves some tacit collusion between bidders. The competition effect works in opposite direction. Bidders who have not the highest value may be induced to bid more aggressively to outbid speculators because they are directly competing with speculators for the possibility to resell to the highest value bidder. Hence, Pagnozzi (2010) provides evidence of three effects resulting from the possibility of resale. Two effects make demand reduction more profitable for bidders. First, resale can correct inefficient allocations and makes demand reduction less costly for the higher value bidders, as they can buy in the resale market the units lost to a speculator. Second, it is more costly to outbid lower-value competitors who bid more aggressively when they can resell. The third effect of increasing competition, that is, having to share the units with speculators, makes demand reduction less profitable for some bidders. Thus, the presence of speculators may not increase the seller’s revenue, depending on whether high value bidders accommodate speculators or not. In a context of uniform-price auction with constant marginal valuations and common knowledge valuations, Pagnozzi (2010) shows that the seller should attract speculators only when bidders are relatively symmetric. When bidders’ valuations are dispersed, the tacit collusion effect dominates because the possibility of resale induces accommodating strategies by high value bidders. Then, when there is a secondary market, the presence of speculators increases the seller’s revenue only if the competition effect is stronger than the demand reduction effect. The existence of bidders without compliance obligation may also have an effect on the ability of industrial bidders to explicitly collude. Indeed, it is more difficult to engage in bidding ring with agents belonging to another sector. Moreover, the speculators’ objectives differ from those of firms with compliance obligations. As a consequence, the seller may try to break collusion by opening the auction to financial actors. To analyze the impact of speculators in the different bidding formats, we have introduced them in the experimental protocol of Burtraw et al. (2009) 838 Journal of Public Economic Theory that we have adapted. Contrarily to Pagnozzi’s theoretical analysis, this protocol allows us to consider the dynamic aspect of the game due to the bankability of permits and assumes private information about permit valuations.

3. Experimental Procedures In the experiment, we have focused on two auctions mechanisms: a uniform- price sealed-bid auction and an ascending clock auction. To investigate these two auction formats with and without speculators, we ran a set of four different experimental treatments using 144 undergraduate students (inexperi- enced; with no specific knowledge in auction experiments and auction theory) recruited in groups of 18 from ITECH (Institut Textile Chimique) and Engineering School of Lyon (Ecole Centrale de Lyon). All the experimental sessions were performed at GATE17 in September 2009. Participants were paid 5.00 euros for showing up and engaged in an experiment lasting about 1.5 hours including instruction time. They were paid according to their performance over the whole experiment and their average final payoff was about 18.00–19.00 euros, which seemed more than sufficient to motivate them.18 During the experiment, the payoffs were given in the fictitious “Experimen- tal Currency Unit” (ECU) which was changed into Euro after the experiment by an exchange rate of two ECU for 1 euro. Payment was anonymous. Each subject participated only once. A neutral language was used in the instructions, avoiding words such as carbon permits, coal and gas industries, bankers, or speculators. The experiment consisted of four treatments with 36 participants each. One session used 18 participants who were randomly assigned to one of the three groups (six subjects by group). These groupings held for the whole experiment.

3.1. The Design Our design is based on Burtraw et al. (2009). The main modiﬁcation is the introduction of speculators as described later. Our experiments con- tain three types of players: high emitters (e.g., coal industry—type C), who need two permits for each unit produced, low emitters (e. g., gas industry— type G) who are required 1 permit for each unit produced and nonemitters (speculators—type S19) who do not produce and therefore have no use value for a permit. Each industrial player (either type G or C) was endowed with ﬁve units of production and could as a consequence produce a maximum of

17 Groupe d’Analyse et de Theorie´ Economique, University of Lyon, France. 18 The instructions and the whole set of experimental data are available from the authors upon request. 19 As indicated in the Introduction, the word speculator will be used by convenience throughout the paper to refer to noncompliance agents. Breaking Collusion in Auctions through Speculation 839

Table 1: Experimental design Treatments CI UI CS US Sessions (total number of 2 (36) 2 (36) 2 (36) 2 (36) subjects) Players 3G/3C 3G/3C 2G/2C/2S 2G/2C/2S Auction format Clock Uniform Clock Uniform Permits needed for 45 45 30 30 maximal production Permits being sold during 30 30 20 20 the auction

five units of product per period. Then, to reach their full production level, low and high emitters need 5 and 10 permits, respectively. We assume that the environmental policy is based on a cap on the number of permits fixed at two-third of the total number of permits needed for a maximal production (Table 1). For each producer, five production costs were randomly determined at the beginning of the experiment and stayed the same for the whole session. These costs were drawn from a uniform distribution within the interval [2, 6] for high emitters and the interval [5, 10] for low emitters. Production units were used in a coherent way so that the lowest cost was used to produce the first unit, the second lowest to produce the second unit, and so on. As in Burtraw et al., each unit produced is sold at a fixed and known price of 12 ECU. Speculators can only make profit by buying permits either during the auction or on the spot market and reselling them on the spot market. Each session consists of a total of 12 periods, which was known by the subjects. As in Burtraw et al. (2009), the structure of the game for one period starts with a pre-play communication using an electronic chat room. The type of the players was labeled in front of each message by a single letter that did not refer to anything real to them (e.g., we did not tell them that S stands for speculators) to avoid mistrust linked to prejudices about these words. However, the types of players present on the market (e.g., the presence or absence of speculators) were common knowledge to all the subjects. Whatever the treatment, this chat room lasted one minute prior to the auction. However, departing from Burtraw et al. (2009), we did not allow for communication between rounds in our treatments using the multiround ascending price English clock auction. Communication was anonymous but labeled so that the type of the sender was indicated by a single letter (C, G, or S) in front of each message. After the minute of communication, the auction started. Depending on our treatments, we considered two types of auction designs: the sealed- bid auction with uniform-price and the multiround ascending price English clock auction. In the uniform-price auction, types C and G bidders had to indicate the maximal value they wanted to pay for a permit for each production 840 Journal of Public Economic Theory unit. On the other hand, speculators had to indicate the quantity of permits they wanted to buy and at which price. All bids were then ranked according to their price and the auction price was determined by the price asked for the first unit above the cap, either the 31st or the 21st depending on treatments (Table 1). The ascending clock auction started at the reserve price of 2 and the price was increased by an increment of 0.15 as long as the total demand for the current price exceeded the cap. Bidders could not increase their demand of permits between auction rounds. As soon as total demand became lower than the cap, the auction stopped and permits in excess were distributed to the bidders who reduced their demand by the greatest amount during the last round.20 We run four treatments by crossing the type of the auction and the presence or absence of speculators. As a consequence, we have the CI treatment with the clock auction and only industrial players I (of types C and G) and the CS treatment with the same auction in which speculators (type S) are also present. In the same way, for the uniform auction format, we have both the UI and US treatments. Permits that do not enter the market when the reserve price is binding are withdrawn. They are not considered in the revenue and efficiency comparisons. Once the auction was over, people were authorized to trade on a spot market. Then each participant could send a buy and/or a sell order, indicating in each case, a price and a quantity. The intersection of the demand and supply curves formed by the bid and ask prices, determined the spot price. After transactions took place, types C and G players had to decide how many production units they wanted to activate. They knew they would receive 12 ECU for each active unit. Once again, subjects were not constrained in their decisions and could incur deficits with respect to compliance standards. As in Burtraw et al. (2009), compliance periods spanned multiple periods. Every three periods, we confronted the number of permits required for the produced units summed over the three periods with the number of permits held by a producer at this particular moment. So producers could incur temporary permit deficits in non-compliance periods without being penalized or save permits for future periods. At the end of period 3, 6, 9, and 12, any deficit in permits was penalized at a rate of 9 ECU for each missing permit. At the end of the last period (period 12), permits that were not use for production had no value and participants knew it beforehand.21 At the end of each period, we provided feedback to the participants. They saw a screen indicating their buying and selling activities (quantities and prices) for the current period, both during the auction and on the spot market. They could also see their current stock of permits and the current number of permits required according to their type and production

20 Obviously, this is not the case if the auction stops after the ﬁrst round, that is, if the total demand is below the cap at the reserve price. We will see that this happened several times in our experiments. The permits that were not sold at the auction were lost. 21 Recall that permits were bankable and valid for the whole duration of the experiment. Breaking Collusion in Auctions through Speculation 841

decisions during the on-going compliance periods. In the case of periods 3, 6, 9, and 12, the possible penalties were indicated. Their cumulated payoff for the experiment was also shown. Throughout the whole experiment, a reserve price of two ECU was imposed for a permit, so that at no point in time it was possible to buy or sell a permit below this price. Table 1 shows the basic features of our four treatments. The number of players is ﬁxed (e.g., six players whatever the treatment) but the types of players vary according to the treatment. We opted for a 2×2designwhere we crossed the auction format (either clock or uniform) with the presence or absence of speculators. This allows us not only to study the impact of the auction format on collusion but also to analyze the impact of the presence of speculators on the outcome of the auction according to the format.

3.2. Theoretical Benchmark Before analyzing the experimental results, we can determine the theoretical Walrasian equilibrium price p of permits in a continuous static model as a benchmark. Let us first consider that speculators are not present and assume that firms act as price takers. According to our assumptions22, we have three firms of type G, three firms of type C, and a cap equal to 30 permits. A low emitter’s profit is equal to g = 12 − p − cg ,wherecg denotes the production cost of this producer. It is positive if 12− p > cg . Then, the expected supply of a low emitter depends on the permit price and is given by ⎧ ⎪ − < . . > , ⎨⎪ 0if12 p 5 i e p 7 12−p = / = − < − < . . < ≤ , Sg (p ) ⎪ 5 1 5dcg 7 p if 5 12 p 10 i e 2 p 7 ⎩⎪ 5 5if12− p ≥ 10 (i.e. p ≤ 2) .

In the same way, a high emitter’s proﬁt is equal to c = 12 − 2p − cc,wherecc denotes the production cost of the high emitter. It is positive if 12 − 2p > cc,. Then, the expected supply of a high emitter is ⎧ − < . . > , ⎪ 0if12 2p 2(ie p 5) ⎨ 12−2p = / = / − ≤ − < . . < ≤ , Sc (p ) ⎪ 5 1 4dcc 5 2(5 p )if2 12 2p 6(ie 3 p 5) ⎩⎪ 2 5if12− 2p ≥ 6(i.e. p ≤ 3).

If we denote Dg (p)andDc(p) the demand of permits from low and high emitters, we have Dg (p) = Sg (p)andDc(p) = 2Sc(p). When the number of

22 See Goeree et al. (2009) for a model with similar assumptions in a different setting (auctions without speculators) 842 Journal of Public Economic Theory permits is capped at 30, the permit price is such that

30 = 3Dg (p ) + 3Dc (p ) =D(p ) with

⎧ ⎪ 45 if p ≤ 2, ⎪ ⎨ 51 − 3p if 2 < p ≤ 3, = − < ≤ , D(p ) ⎪ 96 18p if 3 p 5 ⎪ − < ≤ , ⎩⎪ 21 3p if 5 p 7 0ifp > 7. If we consider that the individual demand of permits can be only ex- pressed as an integer, and then if we substitute the corresponding demand function with jumps to D(p), the competitive price of a permit is equal to 3.6. At this price, a low emitter demands three permits, and produces three units; whereas a high emitter demands seven permits, and produces 3.5 units. Then the whole production is equal to 19.5 units and requires 30 permits. In an auction, if bidders reveal their true demand, a low emitter is then assumed to acquire three permits whereas a high emitter is assumed to acquire seven permits at a price pa equal to 3.6. The auction revenue is equal to 108. If the auction allocates permits optimally, there is no activity on the spot market. Let us now introduce speculators and assume that there are two firms of type G, two firms of type C and two speculators. If the cap is equal to two third of the permits needed for a maximal production, only 20 permits are sold. If we assume as previously that type G and type C firms act as price takers and that speculators have a positive demand for each level of price, the price of the permits is higher. Indeed, in the absence of speculators, when the individual demand of permits is an integer, the sale price is 3.6, solving 20 = 2Dg (p) + 2Dc(p). However, introducing speculators may induce firms to reduce their demand in the auction to obtain permits on the spot market. Then, if speculators obtain permits in the auction, we can expect activity on the spot market. In this Walrasian equilibrium benchmark model, we assume that all the agents act as price takers. In an auction context with private information on production costs, bidders may act strategically to obtain rent when there are few bidders. This can be strengthened by collusive agreements. Then we can expect that the equilibrium price will be lower than the Walrasian equilibrium price in the auction.

4. Results In their study, Burtraw et al. (2009) justify the restriction of their data analysis to the second-half of the experiment by the presence of learning in experimental auctions. Indeed, such games are unfamiliar to subjects, quite complex to understand, especially in our case where the auction is followed Breaking Collusion in Auctions through Speculation 843 by a spot market and by production decisions. Then, it might take some time to determine the best strategy. As a consequence, Burtraw et al. (2009) do not take into account the first periods of their experiment to focus solely on the more stable part (once learning has taken place). Thus, before going on in our data analysis, we consider the learning effect and its con- sequences on the auctions results. To show the existence of learning effects, we look for a time trend for the revenue (normalized according to the number of permits auctioned, either 20 or 30 depending on treatments). We exhibit negative correlations between revenues and periods. These correlations are only significant for the two treatments including speculators. The strongest effect appears in the US treatment (Spearman =−0.474; p < 0.001)23 but the effect is still important in the CS treatment (Spearman =−0.261; p = 0.027). In the two treatments including only producing agents (CI and UI), the correlations never reach significance (for CI and UI, respectively, Spearman =−0.0097 and −0.193; p = 0.936 and 0.104). Then we can conclude that subjects needed more time to discover their optimal strategy in the treatments including speculators. This seems intuitive because the presence of speculators induces a greater heterogeneity in incentives and probably a bigger conflict of interests between players of different types. The negative correlation suggests that subjects learned to coordinate themselves to obtain permits at a lower price during the auction. This time trend survives in the US treatment if we study the last nine periods (Spearman =−0.429; p = 0.001) but disappears in all treatments if we consider only the last six periods. As a consequence, we focus our econometric analysis of revenue only on these last six periods, as in Burtraw et al. (2009). However, econometric results over the whole experiment will also be mentioned and briefly commented (see Tables A1, A2, and A3 in the Ap- pendix). The data analysis will be done to study the differences in prices, revenue and efficiency between treatments and the impact of the presence of speculators on these criteria, as well as on the permit holding patterns, the activity on the spot market and the production decisions.

23 Spearman’s rank correlations are using all available observations (144 for 12 periods, 108 for 9 periods). All subsequent Wilcoxon rank sum tests run in this paper are two- sided (except when explicitly noticed otherwise, all the z statistics in this paper refer to the Wilcoxon rank sum test). To keep our observations independent, we used a single data point per group of participants, which was the mean of the considered variable from this group for the last six periods. We thus have six data points per treatment. This lack of observations and the lower sensitivity of this test may explain some lack of signiﬁcance compared to parametric analyses. 844 Journal of Public Economic Theory

Figure 1: Distribution of auction prices.

4.1. Prices and Revenues Concerning the auction performances with respect to prices and revenue, we observe different patterns. The distribution of auction prices for each treatment is shown in Figure 1. The two top panels correspond to the two clock auction treatments, without (CI) and with speculators (CS). On average, 70% of the auctions end at the reserve price equal to 2 (80.6% and 69.4% for CI and CS, respectively), which could be consistent with a very high level of collusion facilitated by the chat room. Even more striking is the fact that in the CI treatment, the price reached 2.3 only once after the second round of the clock auction. This result is consistent with the theoretical literature and with the study of Burtraw et al. (2009) who also found the clock auction more collusive. The introduction of speculators alters this result only slightly. A Wilcoxon rank sum test does not reject the equality of medians between the CI and CS treatments (z =−0.905; p = 0.366). Then, the presence of bidders with no use value did not impact signiﬁcantly the prices in the clock auction. The results are rather different when we consider the uniform auction. Even if the treatment including only compliance agents yields a majority of auctions ending at the reserve price (52.8%), the presence of speculators shifts the distribution to the right with only 8.3% of the auction price equal to the reserve price. This difference appears marginally signiﬁcant (z = –1.858; p = 0.063). The auction prices are shown in Table 2, which contains the average auction and spot prices per treatment. It must be noticed that the average Breaking Collusion in Auctions through Speculation 845

Table 2: Average auction and spot market prices Treatments Avg. Auction Price Avg. Spot Price CS 2.163 2.950 CI 2.033 2.279 US 2.571 2.697 UI 2.258 2.284

Table 3: Econometric analysis of auction revenue (periods 7–12) Normalized Revenue Coefﬁcient P > |z| Speculators −8.802 0.000 Uniform 11.735 0.010 Speculators × Uniform 14.033 0.008 Period −0.616 0.195 Walrasian normalized revenue −0.554 0.067 Constant 108.34 0.000 N 144 Wald χ 2 185.55

auction prices reached in our four treatments are far below the theoretical prediction of 3.6 in the benchmark model. The maximum price, equal to 3.2, is obtained twice in the US treatment. Moreover, the average price is always greater in the sealed-bid uniform auction than in the clock auction, with or without speculators. These prices are informative on the ability of the auction to raise revenue for the seller. This is an important question when designing the CO2 permits auctions. As the auction revenue reduces the need for distortionary taxation, maximizing the revenue is an objective of the public authority besides goals such as efficiency or minimization of price volatility. We use a random effects generalized least squares model with an AR1 error term and regressed revenues (normalized according to the number of permits auctioned, either 20 or 30 depending on treatments) on dummies reflecting the presence of speculators, the format of the auction, an interaction term between the two, on the current period, on the normalized Walrasian revenues and on a constant. Data are clustered at the group level and the (panel specific) au- tocorrelated error term allows us to take into account correlations between periods within the same group of bidders. The results of this estimation are shown in Table 3. First, we can notice that the three dummies appear to be statistically significant. As expected, the auction format matters: the fact that the auction is sealed-bid uniform-price has a positive and very significant impact on revenue. Then, collusion seems more effective in clock auctions than in sealed- bid uniform-price auctions. More surprisingly, we see a negative and again 846 Journal of Public Economic Theory very significant coefficient for the speculators dummy. This comes from the fact that in the CS treatment, prices are low and a limited number of permits are bought in some rounds of the auction. This last observation is explained by the fact that producers considerably reduce their demand and accommodate the quite aggressive strategy of the speculators. This leads to miscoordi- nation on the total quantity demanded at the first round of the auction so that, in some cases, less than 20 permits were sold at the reserve price. Fi- nally, the coefficient of the interaction term is positive and significant. This reflects the fact that our US treatment yields the highest revenue. As expected, the time trend is not significant.24 The introduction of speculators in the sealed-bid uniform-price auction seems to be the best solution as far as government’s revenue is concerned. All the discussions between participants in the chat room show that they try to engage in a bidding ring. However, whereas this strategy is well understood in both treatments, its implementation appears to be more difficult in the sealed-bid uniform-price auction.25 The less collusive the auction environ- ment is, the more positive the impact of the presence of speculators is on the revenue. This result is similar to the result obtained by Pagnozzi (2010) under complete information when the bidders do not accommodate speculators: the presence of speculators increases revenue. To assess the significance of differences in revenue between treatments, we perform both Wald χ 2 tests based on the previous regression and

24 We also run the same regressions over the 12 periods. The time trend is very significant (p < 0.01), confirming the presence of learning. The main difference concerning the treatment effects is that the “speculators” dummy is not significant anymore (p > 0.1). As a consequence, the Wald test of the difference between the revenue raised by the CI and CS treatments is not significant (p > 0.1). Indeed, the negative effect of the presence of speculators in the clock auction is emerging only after some time. Moreover, the interaction term stays very significant (p = 0.012) and the uniform dummy only marginally (p = 0.067). All other comparisons between treatments using Wald tests yield the same results as in Table 4 (Appendix A). 25 To illustrate these findings, we can briefly quote some extracts from the discussions between participants in the chat room. They show how the differences between the CS and US treatments suggested by the data analysis were taking place during the experiment. The accommodation strategy was understood and very often suggested right away. For example, in the CS treatment, a subject wrote at the very first round of the session: “The best strategy is that the S buy everything at a price of 2, so 10 permits each, and resell it at a price of 2.5. This way, everyone wins.” Next, at round 3, we can read: “It worked this time.” “We do the SAME this time again.” If this strategy was also understood by subjects in the US treatment, its implementation was more difficult. In round 1, we can read “the S buy everything at 2” showing that the accommodation strategy has been proposed. However, at round 5, it had not been implemented yet: “C and G do not buy during the auction”; “there are fools not letting S buying in the auction.” In round 7, a S player in financial difficulty wrote “stop C and G, otherwise I am buying all the permits and you are going to beg me” followed in round 8 by “Since C and G are acting stupid, auctions are going to change, I have a 10000 points loss, I have nothing to lose.” If these examples are surely not representative of all the sessions of each treatment, they are still informative about how agreements or tensions might happen. Breaking Collusion in Auctions through Speculation 847

Table 4: Pairwise revenue comparisons Wilcoxon Rank Results Wald χ 2 Sum Revenue US > Revenue UI 13.25∗∗∗ 3.636∗∗∗ (0.001) (0.000) Revenue US > Revenue CS 108.95∗∗∗ −5.156∗∗∗ (0.000) (0.000) Revenue UI > Revenue CI 6.70∗∗∗ −3.796∗∗∗ (0.009) (0.000) Revenue CS < Revenue CI 12.27∗∗∗ −1.494 (0.001) (0.135) Note: p values appear in parentheses, where ∗∗∗ indicates signiﬁcance at the 0.01 level.

Wilcoxon rank sum tests. Table 4 shows the results of these tests, which are almost all significant. These tests confirm the results of the regression analysis. Opening the auction to speculators has a more positive impact on revenue in the uniform auction setting, as shown in the second row of the table. Moreover, as suggested by the positive and significant coefficient of the interaction term in our regression, the auction revenue in the US treatment is also significantly higher than in the UI treatment. Finally, the last row con- firms that including non-compliance agents in the clock auction mechanism deteriorates revenue because of a quantity effect. The average auction price is higher in the CS than in the CI treatment, but a lower number of permits is sold in presence of speculators. From a government revenue point of view, these experimental results recommend the design of a sealed-bid uniform auction open to no use value agents, that is speculators, for several reasons. The first one is the same as in Burtraw et al. (2009). We find that when only producers participate in the auction, the sealed-bid auction with uniform price gives higher revenues. The second one is specific to our experiment. The introduction of speculators in the uniform auction weakens collusion, in line with the idea that in general, the more competitive an auction is, the higher the outcome is for the auctioneer. These first tests suggest that the presence of agents with no use value does not prevent collusion during the clock auction but has a significant impact on the outcome of the uniform auction.

4.2. Who gets the permits The inﬂuence of speculators can be considered through the distribution of permits among agents. Figure 2 shows the average number of permits bought during each auction by the different types of agents. We can observe an important change in the type of permits holders following the introduction 848 Journal of Public Economic Theory

8 Speculators High Emitters Low Emitters 6 4 2 0 CI CS UI US

Figure 2: Permit holding. of speculators in the clock auction. Indeed, one speculator bought on average 5.35 permits in our CS treatment, meaning that these agents held more than half of the emitted allowances after the auction. This strong position is obtained mainly at the expense of high emitting producers whose average number of permits bought during the auction is divided by more than three, when moving from the CI to the CS treatment. However, both types of producers get a lower number of permits when switching from CI to CS (for high and low emitters, respectively: z = 2.908 and 2.892; p = 0.004 for both types). Together with our first results, this can indicate that speculators easily outbid compliance agents during the clock auction and obtain a lot of permits at a low price. The sealed-bid uniform-price auction exhibits a different pattern. Even if speculators get a quite large share of the auctioned permits, their impact is less important than in the clock auction. They obtained on average 2.60 allowances in the US treatment, which is less than half of the permits bought in the CS treatment (this difference is (marginally) significant; z = 1.922; p = 0.0547). It also appears that low and high emitters share quite evenly this “burden.” Their average permit holding decreases to a similar extent but both decreases are only marginally significant (for high and low emitters, respectively: z = 1.524 and 1.761; p = 0.127 and 0.078). The previous results concerning the prices and the allocation of permits in the auction lead to the conclusion that compliance agents adopt two different strategies when agents with no use values are introduced in the Breaking Collusion in Auctions through Speculation 849 ascending clock and the sealed-bid uniform auctions. In the former, they accommodate speculators. On the one hand, no use value bidders get more than half of the permits in the clock auction. On the other hand, the average price in this auction is lower than the average price in the US treatment and only slightly greater than in the CI treatment. This implies that producers reduce notably their demand during the clock auction when it is open to speculators. Because of this demand reduction strategy, producers seem to let speculators do their job, that is, to buy permits at a low price during the auction to resell them at a higher price on the spot market. Producers reduced demand so much that in 50% of the auctions of the CS treatment, total demand at the reserve price did not reach the cap of 20 permits, so that all allowances were not sold.26 It seems that producers accept to let the permits in the hand of speculators voluntarily and that this tacit coordination is facilitated by the intrinsic collusive nature of the clock auction, where bidders focus on only one dimension, the quantity. Coordination is less easy to sustain in the uniform auction, where bidders have to coordinate on both the price and quantity dimensions, as shown by higher price levels and a more equal distribution of permits among the three types of agents. In this auction, producers do not accommodate speculators whose outbidding strategy is more costly. Instead, they buy a significant share of the permits during the auction.

4.3. Spot Market These different patterns of permit holding between treatments should be reflected on the spot market, that we consider now, both through the volume of transactions and the prices. Figure 3 exhibits the average volume of exchange for the last six periods of each treatment. Because speculators capture a large share of the permits sold during the auction in the CS treatment, we expect a high volume of exchanges in this treatment, conditional on the fact that compliance agents are still willing to produce. This is indeed the case with on average 13 permits being traded, mostly from speculators to producers. In line with the permit holding findings, we observe a significant difference in the number of exchanged allowances on the spot market between our two treatments including speculators (z = 2.082; p < 0.037). Because of the stronger position of producers after a uniform auction than after a clock auction, less trade is necessary on the spot market in the US treatment than in the CS treatment. Even without speculators, the spot market could have worked as a coordination device, so that collusion could have been maintained over time in the auction phase. But the sessions without speculators exhibit very low volumes of exchange on the spot market. Remarkably, no trade occurs in

26 See also the econometric analysis of revenue above. 850 Journal of Public Economic Theory 15 10 5 0 CI CS UI US

Figure 3: Mean exchanged quantities on the spot market.

41.7% (respectively 47.2%) of the rounds in the CI treatment (respectively in the UI treatment). The underlying explanation may be that an efficient allocation has already been achieved during the auction so that little reallo- cation of allowances was needed afterward. Speculators seem to exploit efficiently their quasi-monopolistic position on the spot market in the CS treatment (Table 2). The average spot price is equal to 2.95, far above the mean auction price of 2.16 (this difference is significant according to a Wilcoxon signed-rank test: z =−1.992; p = 0.046). This is however not the case for the US treatment in which the auction and the spot prices are closer and the difference between them is not significant (Wilcoxon signed-rank test: z = 1.363; p = 0.173). According to our previous results, the scenario is close to perfection for the speculators in the CS treatment. As the more collusive nature of the clock auction does not make their outbidding strategy too costly, they buy a lot of permits at a low price during the auction, which generates high prospective profits on the spot market. On this secondary market, speculators can ask for high prices that compliance agents must accept if they want to produce and to comply with their obligations. The collusive agreements in the auction are costly to the producers and benefit only to the speculators. The story is different in the US treatment. Because coordination is harder in the uniform auction, permits are more expensive in the auction. Speculators cannot obtain a quasi- monopolistic position on the spot market and, as a consequence, get a lower price than in the CS treatment (Table 2). Breaking Collusion in Auctions through Speculation 851

5 High Emitters Low Emitters 4 3 2 1

CI CS UI US

Figure 4: Production.

4.4. Production and Efficiency Finally, we can consider the impact of the auction format and of the presence of speculators on the decision of production and more precisely on the relative levels of production of low and high emitters. According to the theoretical model, when the number of permits is capped at 20, each low and high emitter should produce respectively 3 and 3.5 units in the absence of speculators. Considering the experimental results, we must first notice that producers are producing more than the theoretical level, but less in the presence of speculators than without them. They produce on average 3.52 in the S treatments versus 3.79 in the I treatments. This difference is significant according to a Wilcoxon rank sum test (z =−3.985; p < 0.001). The mean production level per low and high emitter for each treatment is shown in Figure 4. High emitters are producing on average half a unit less in the CS treatment than in the US treatment (3.06 vs. 3.57), owing to the difficulties they encounter to buy permits in the clock auction with speculators. This difference is marginally significant (z =−1.687; p = 0.092). The difference is in the opposite direction for the low emitters (4.01 in CS vs. 3.46 in US) who are producing less in the uniform case but the difference is not significant (z = 0.964; p = 0.335). Let us consider now the impact of the auction format on the efficiency of the ultimate allocation and use of the permits. If the auction is efficient, permits must be allocated to the producers with the highest permit values and 852 Journal of Public Economic Theory

Table 5: Average efficiency Treatments Avg. Efficiency Over the 12 Periods CS 0.858 CI 1.037 US 0.867 UI 0.991 production decisions made accordingly. However, the experiment induces a dynamic game in which producers could incur temporary permit deficits in noncompliance periods without being penalized or save permits for future periods. Therefore, production decisions are based on the permits obtained in the auction and/or in the spot. Moreover, they depend on previous and future decisions. Comparing the value of the permits used at each period for production with the theoretical value (obtained by summing the 30 or 20 highest values of the permits for the producers) gives only an indication of a temporary possible misallocation. Efficiency calculations have to be ap- plied to the ultimate disposition of the permits when they are surrounded for compliance after secondary transaction or banking. The overall allocation has to be considered on the whole game, that is, the 12 periods. An average allocative efficiency ratio can be obtained by dividing for each period the value of the permits used for production by the theoretical value and by taking the mean value of these ratios over the 12 periods. A ratio close to 1 on the whole game indicates that the producers with the highest values get the permits and produce. Table 5 shows the average allocative efficiency in the use of permits over the 12 periods.27 It is very close to 1 for the treatments without speculators and lower than one for the treatment with speculators, whatever the auction format. Then, allocative efficiency is greater in the absence of speculators. Hence, from an efficiency point of view, the ranking of the mechanism is CI UIUSCS. All these differences appeared to be significant, except between US and CS (see Table A3 in Appendix). In both types of auction, the presence of no use agents deteriorates efficiency. This conclusion is consistent with the result of Garratt and Troger¨ (2006) that show that inefficiency may arise in second-price auctions with a resale opportunity. Moreover, the ranking of the clock and sealed-bid auctions is reversed with respect to the auction price criterion (where CSCI and USUI). Thus, the conclusions according to the objectives of revenue and efficiency are opposed. Whereas opening the auction to speculators has to be recommended when government revenue maximization is considered, the regulator should restrict the access to compliance bidders if its choice is based on efficiency in the use of permits.

27 It differs from the efﬁciency of the auctions to allocate permits to the producers with the highest values right after the auction. Breaking Collusion in Auctions through Speculation 853

5. Conclusion The laboratory experiment we conducted shows that introducing speculators in auctions matters and that speculation may play a significant role in the pollution permit auctions as a means to increase the auction price and the seller’s revenue. In the terms of Pagnozzi (2010), speculators are welcome in this market. However, the impact of speculators on the revenue, efficiency and allocation of permits depends heavily on the auction format, as well as on the activity on the spot market. According to the average auction price, we have shown that the ranking of the mechanisms is USUICSCI. The revenue analysis shows that USUI, USCS, and UICI whereas CIUIUSCS from an efficiency point of view. In the sealed-bid auction with uniform price, opening the auction to non-compliance agents leads to higher prices. Is it because speculators weaken collusion? A priori, in this mechanism, collusion is less likely to appear according to theoretical arguments. This is also what is shown by Bur- traw et al. (2009) and by our experimental results in the absence of no-use value agents. When speculators participate in the auction, our experiment shows that compliance agents adopt outbidding strategies. Consequently, as competition increases, their demand reduction strategy is weaker. This behavior leads to higher revenue for the seller. In the ascending clock auction, opening the auction to financial institutions results also in higher prices but the effect is less important. With or without speculators, a great number of permits are sold at the reserve price. In this a priori more collusive auction, the price is significantly lower than in the sealed-bid format whatever the participating agents. Compliance agents seem to accommodate noncompliance bidders. They reduce their demand, let speculators buy permits in the auction and buy their necessary permits on the spot market. This behavior leads to a lower auction price and to a lower seller’s revenue than in the sealed-bid auction. In other respects, we show that the presence of speculators has an impact on production levels. More importantly, we show that opening the auction to no use value bidders deteriorates allocative efficiency in both auction formats. As the ranking of the procedures is not the same according to the objectives, there is a trade-off for the public authority. On the one hand, from a revenue point of view, these experimental results recommend the design of a sealed-bid uniform auction open to agents having no use value for permits, that is speculators.28 On the other hand, the efficiency of the auction, that is, its ability to allocate permits to the producers with the highest values is greater when the auction is not open to speculators. In a sealed-bid uniform auction as well as in a clock auction, the participation of the speculators

28 This is also the conclusion of the Charpin (2009) Report for the EU-ETS. It recom- mends the total openness of the auctioning process to all current participants on the secondary market, including industrial and energy producers covered by the scheme, banks and investment funds. 854 Journal of Public Economic Theory works in opposite directions in terms of revenue maximization and of allocative efficiency. Hence, the choice of the auction format and the introduction of agents with no use value in the auction depend on the objective function of the public authority. Our results must however be considered cautiously because the experiment does not explore all the complexity of the market. For example, the question of different vintages is not considered here. The allowances of different vintages can be sold in separate auctions or in simultaneous ascending auctions. In our model, the product market price is fixed. However, depending on the activity sector of the firms, the cost of the permits could be trans- ferred differently to the downstream product prices. Then bidders could adopt different strategies in the auction according to the market structure. Furthermore, we do not introduce forward markets in our analysis. Further research will consider these issues.

Appendix: Estimates for 12 Periods

Table A1: Econometric analysis of auction revenue (periods 1–12) Normalized Revenue Coefﬁcient P > |z| Speculators −4.027 0.250 Uniform 9.501 0.067 Speculators × Uniform 15.562 0.012 Period −1.648 0.000 Walrasian normalized revenue −1.052 0.001 Constant 153.16 0.000 N 144 Wald χ 2 122.49

Table A2: Wald tests for revenue comparisons (periods 1–12) Results Wald χ 2 Revenue US > Revenue UI 6.40∗∗ (0.041) Revenue US > Revenue CS 63.23∗∗∗ (0.000) Revenue UI > Revenue CI 3.35∗ (0.067) Revenue CS = Revenue CI 1.32 (0.250) Note: p values appear in parentheses, where ∗∗∗, ∗∗,and∗ indicate signiﬁcance at the 0.01, 0.05, and 0.1 level, respectively. Breaking Collusion in Auctions through Speculation 855

Table A3: Wilcoxon rank sum tests for efficiency comparisons (periods 1–12) Results Wilcoxon Rank Sum Efficiency CI > Efficiency UI 2.082∗∗ (0.037) Efficiency UI > Efficiency US 2.562∗∗ (0.010) Efficiency US = Efficiency CS −0.480 (0.631) Note: p values appear in parentheses, where ∗∗∗, ∗∗,and∗ indicate significance at the 0.01, 0.05, and 0.1 level, respectively.

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