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Auctioned Price Floors: Changing How We Invest in Climate

Here’s the challenge: you work for a government agency or philanthropy that wants to encourage climate mitigation projects such as solar energy installations or building efficiency upgrades, and you have a grant budget of $50 million to invest anywhere in the world. You want to invest in projects that reduce the most greenhouse gas emissions and you want to invest now. 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 grant 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 actually deliver results.

In response to these constraints, a recent article coauthored by Rocky Mountain Institute and 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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
Figure 1: Model of the Pilot Auction Facility (PAF)

As demonstrated by the World Bank’s Pilot Auction Facility as well as the UK’s Contracts for Difference program, auctioned price floors are good not only for public funders, but also for the private sector. Whereas climate investments sometimes present poor risk-return profiles, price floors offer a guaranteed price for emissions reductions—a contract that can be used to raise additional commercial finance. These price floors also offer the option of selling directly to the market, as opposed to public grants or loans, which perpetually rely on public support.

Real-world experiments with auctioned price floors suggest 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.

In short, auctioned price floors offer one answer—and we think a pretty good one—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 here.