At a Glance
- Using an auction to allocate put options ensures the maximum impact for each dollar provided by facility donors.
- The PAF intends to test different auction approaches, such as ascending and descending clock auctions.
- The PAF will conduct a series of auctions to maximize learning.
- An important objective of the PAF is to provide lessons for future scaled up climate finance mechanisms.
Benefit of using an auction to allocate the options
The Pilot Auction Facility (PAF) will use auctions to sell its put options. As a resource allocation method, auctions have seldom been used in international climate or development finance. Auctions will ensure that the facility’s resources achieve the maximum impact by selecting winners with the lowest expected costs per ton of reduced CO2 equivalent.
For each auction, the PAF will decide on a budget, i.e., a share of its funds needed to pay the strike price when put options are exercised in the future. The PAF will also specify the types of carbon credits that will be eligible to exercise with the put options (“eligibility criteria.”)
Different auction approaches
The PAF will test different auction approaches in different auction rounds. Its first auction will be a descending clock auction, where the guarantee price, or strike price, is being auctioned, and it is bid down from a pre-set starting price.
At each increment bidders announce how many put options they would want to buy at that strike price. The strike price goes down in each successive round, causing some bidders to drop out (because the strike price would be too low to cover their project costs), until finally the demand for the put options is equal to or lower than the supply (supply being the amount of PAF funds allocated to the auction round). At that point the strike price is set.
The put option premium – what the winning bidders must pay to buy put options from the PAF – is announced ahead of the auction. This premium cost will be set by the World Bank Group so that it is significant enough to make sure that the bidder has a genuine commitment to take part and a financial incentive to deliver the carbon credits, but at the same time is not so high that it becomes a barrier to participation.
In a future auction, the PAF will consider an ascending clock auction where the premium is bid up and the strike price, or guarantee price, is fixed in advance. The mechanisms is similar to the previous case, with bidders dropping out as the premium becomes too expensive for them (the difference between the premium and the strike price is the net benefit of the put option for the bidder, and has to be greater or equal to the cost of the project). The strike price would be set by the World Bank Group close to the actual abatement cost of the technologies or sectors targeted by the auction round in order to ensure maximum participation and efficiency of the auction process.
In both cases, the auctions will set limits on the total number of put options a single bidder can purchase, to ensure that there are multiple winners. At the conclusion of the auction (i) a list of the winning firms and (ii) the universal price terms by which all the winners are sold a put option by the World Bank Group, are made known. The World Bank Group will then sell the put options to the winners.
Learning, replication and Scaling-up
The PAF is expected to perform a series of auctions, each one potentially using a different format in order to maximize learning.
The proposed innovative approach to financing methane reductions aims to combine piloting in results-based climate finance with immediate impact and maximum cost-effectiveness. It will provide powerful lessons for future climate finance flows. The facility has the potential to provide a major impact through replication and scaling-up, including through the Green Climate Fund or other public funders. Scaled-up versions could target projects that reduce carbon dioxide or other climate pollutants, or projects for which results can be measured and verified independently using a different metric.