The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey

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The headline of this post is not meant to be ironic.   Despite all the hand-wringing in the press and the blogosphere about a political “give-away” of allowances for the cap-and-trade system in the Waxman-Markey bill voted out of committee last week, the politics of cap-and-trade systems are truly quite wonderful, which is why these systems have been used, and used successfully.

The Waxman-Markey allocation of allowances has its problems, which I will get to, but before noting those problems it is exceptionally important to keep in mind what is probably the key attribute of cap-and-trade systems:  the allocation of allowances – whether the allowances are auctioned or given out freely, and how they are freely allocated – has no impact on the equilibrium distribution of allowances (after trading), and therefore no impact on the allocation of emissions (or emissions abatement), the total magnitude of emissions, or the aggregate social costs.  (Well, there are some relatively minor, but significant caveats – those “problems” I mentioned — about which more below.)  By the way, this independence of a cap-and-trade system’s performance from the initial allowance allocation was established as far back as 1972 by David Montgomery in a path-breaking article in the Journal of Economic Theory (based upon his 1971 Harvard economics Ph.D. dissertation). It has been validated with empirical evidence repeatedly over the years.

Generally speaking, the choice between auctioning and freely allocating allowances does not influence firms’ production and emission reduction decisions.  Firms face the same emissions cost regardless of the allocation method.  When using an allowance, whether it was received for free or purchased, a firm loses the opportunity to sell that allowance, and thereby recognizes this “opportunity cost” in deciding whether to use the allowance.  Consequently, the allocation choice will not influence a cap’s overall costs.

Manifest political pressures lead to different initial allocations of allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.  This means that ordinary political pressures need not get in the way of developing and implementing a scientifically sound, economically rational, and politically pragmatic policy.  Contrast this with what would happen when political pressures are brought to bear on a carbon tax proposal, for example.  Here the result will most likely be exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs (as some low-cost emission reduction opportunities are left off the table).  Furthermore, the hypothetical carbon tax example is the norm, not the exception.  Across the board, political pressures often reduce the effectiveness and increase the cost of well-intentioned public policies.  Cap-and-trade provides natural protection from this.  Distributional battles over the allowance allocation in a cap-and-trade system do not raise the overall cost of the program nor affect its environmental impacts.

In fact, the political process of states, districts, sectors, firms, and interest groups fighting for their share of the pie (free allowance allocations) serves as the mechanism whereby a political constituency in support of the system is developed, but without detrimental effects to the system’s environmental or economic performance.  That’s the good news, and it should never be forgotten.

But, depending upon the specific allocation mechanisms employed, there are several ways that the choice to freely distribute allowances can affect a system’s cost.  Here’s where the “caveats” and “problems” come in.

First, auction revenue may be used in ways that reduce the costs of the existing tax system or fund other socially beneficial policies.  Free allocations to the private sector forego such opportunities.  Below I will estimate the actual share of allowance value that accrues to the private sector.

Second, some proposals to freely allocate allowances to electric utilities may affect electricity prices, and thereby affect the extent to which reduced electricity demand contributes to limiting emissions cost-effectively.  Waxman-Markey allocates allowances to local distribution companies, which are subject to cost-of-service regulation even in regions with restructured wholesale electricity markets.  So, electricity prices would likely be affected by these allocations under existing state regulatory regimes.  The Waxman-Markey legislation seeks to address this problem by specifying that the economic value of the allowances given to electricity and natural gas local distribution companies should be passed on to consumers through lump-sum rebates, not through a reduction in electricity rates, thereby compensating consumers for increases in electricity prices, but without reducing incentives for energy conservation.

Third, and of most concern in the context of the Waxman-Markey legislation, “output-based updating allocations” provide perverse incentives and drive up costs of achieving a cap.  This merits some explanation.  If allowances are freely allocated, the allocation should be on the basis of some historical measures, such as output or emissions in a (previous) base year, not on the basis of measures which firms can affect, such as output or emissions in the current year.  Updating allocations, which involve periodically adjusting allocations over time to reflect changes in firms’ operations, contrast with this.

An output-based updating allocation ties the quantity of allowances that a firm receives to its output (production).  Such an allocation is essentially a production subsidy.  This distorts firms’ pricing and production decisions in ways that can introduce unintended consequences and may significantly increase the cost of meeting an emissions target.  Updating therefore has the potential to create perverse, undesirable incentives.

In Waxman-Markey, updating allocations are used for specific sectors with high CO2 emissions intensity and unusual sensitivity to international competition, in an effort to preserve international competitiveness and reduce emissions leakage.  It’s an open question whether this approach is superior to an import allowance requirement, whereby imports of a small set of specific commodities must carry with them CO2 allowances.  The problem with import allowance requirements is that they can damage international trade relations.  The only real solution to the competitiveness issue is to bring non-participating countries within an international climate regime in meaningful ways.  (On this, please see the work of the Harvard Project on International Climate Agreements.)

Also, output-based allocations are used in Waxman-Markey for merchant coal generators, thereby discouraging reductions in coal-fired electricity generation, another significant and costly distortion.

Now, let’s go back to the hand-wringing in the press and blogosphere about the so-called massive political “give-away” of allowances.  Perhaps unintentionally, there has been some misleading press coverage, suggesting that up to 75% or 80% of the allowances are given away to private industry as a windfall over the life of the program, 2012-2050 (in contrast with the 100% auction originally favored by President Obama).

Given the nature of the allowance allocation in the Waxman-Markey legislation, the best way to assess its implications is not as “free allocation” versus “auction,” but rather in terms of who is the ultimate beneficiary of each element of the allocation and auction, that is, how the value of the allowances is allocated.  On closer inspection, it turns out that many of the elements of the apparently free allocation accrue to consumers and public purposes, not private industry.

First of all, let’s looks at the elements which will accrue to consumers and public purposes.  Next to each allocation element is the respective share of allowances over the period 2012-2050 (measured as share of the cap, after the removal – sale — of allowances to private industry from a “strategic reserve,” which functions as a cost-containment measure.):

a.  Electricity and natural gas local distribution companies (22.2%), minus share (6%) that benefits industry as consumers of electricity (note:  there is a consequent 3% reduction in the allocation to energy-intensive trade-exposed industries, below, which is then dedicated to broad-based consumer rebates, below), 22.2 – 6 = 16.2%

b.  Home heating oil/propane, 0.9%

c.  Protection for low- and moderate-income households, 15.0%

d.  Worker assistance and job training, 0.8%

e.  States for renewable energy, efficiency, and building codes, 5.8%

f.   Clean energy innovation centers, 1.0%

g.  International deforestation, clean technology, and adaptation, 8.7%

h.  Domestic adaptation, 5.0%

The following elements will accrue to private industry, again with average (2012-2050) shares of allowances:

i.   Merchant coal generators, 3.0%

j.   Energy-intensive, trade-exposed industries (minus reduction in allocation due to EITE benefits from LDC allocation above) 8.0% – 3% = 5%

k.  Carbon-capture and storage incentives, 4.1%

l.   Clean vehicle technology standards, 1.0%

m. Oil refiners, 1.0%

n.  Net benefits to industry as consumers of lower-priced electricity from allocation to LDCs, 6.0%

The split over the entire period from 2012 to 2050 is 53.4% for consumers and public purposes, and 20.1% for private industry.  This 20% is drastically different from the suggestions that 70%, 80%, or more of the allowances will be given freely to private industry in a “massive corporate give-away.”

All categories – (a) through (n), above – sum to 73.5% of the total quantity of allowances over the period 2012-2050.  The remaining allowances — 26.5% over 2012 to 2050 — are scheduled in Waxman-Markey to be used almost entirely for consumer rebates, with the share of available allowances for this purpose rising from approximately 10% in 2025 to more than 50% by 2050.  Thus, the totals become 79.9% for consumers and public purposes versus 20.1% for private industry, or approximately 80% versus 20% — the opposite of the “80% free allowance corporate give-away” featured in many press and blogosphere accounts.  Moreover, because some of the allocations to private industry are – for better or for worse – conditional on recipients undertaking specific costly investments, such as investments in carbon capture and storage, part of the 20% free allocation to private industry should not be viewed as a windfall.

Speaking of the conditional allocations, I should also note that some observers (who are skeptical about government programs) may reasonably question some of the dedicated public purposes of the allowance distribution, but such questioning is equivalent to questioning dedicated uses of auction revenues.  The fundamental reality remains:  the appropriate characterization of the Waxman-Markey allocation is that 80% of the value of allowances go to consumers and public purposes, and 20% to private industry.

Finally, it should be noted that this 80-20 split is roughly consistent with empirical economic analyses of the share that would be required – on average — to fully compensate (but no more) private industry for equity losses due to the policy’s implementation.  In a series of analyses that considered the share of allowances that would be required in perpetuity for full compensation, Bovenberg and Goulder (2003) found that 13 percent would be sufficient for compensation of the fossil fuel extraction sectors, and Smith, Ross, and Montgomery (2002) found that 21 percent would be needed to compensate primary energy producers and electricity generators.

In my work for the Hamilton Project in 2007, I recommended beginning with a 50-50 auction-free-allocation split, moving to 100% auction over 25 years, because that time-path of numerical division between the share of allowances that is freely allocated to regulated firms and the share that is auctioned is equivalent (in terms of present discounted value) to perpetual allocations of 15 percent, 19 percent, and 22 percent, at real interest rates of 3, 4, and 5 percent, respectively.  My recommended allocation was designed to be consistent with the principal of targeting free allocations to burdened sectors in proportion to their relative burdens, while being politically pragmatic with more generous allocations in the early years of the program.

So, the Waxman-Markey 80/20 allowance split turns out to be consistent  — on average, i.e. economy-wide — with independent economic analysis of the share that would be required to fully compensate (but no more) the private sector for equity losses due to the imposition of the cap, and consistent with my Hamilton Project recommendation of a 50/50 split phased out to 100% auction over 25 years.

Going forward, many observers and participants in the policy process may continue to question the wisdom of some elements of the Waxman-Markey allowance allocation.  There’s nothing wrong with that.

But let’s be clear that, first, for the most part, the allocation of allowances affects neither the environmental performance of the cap-and-trade system nor its aggregate social cost.

Second, questioning should continue about the output-based allocation elements, because of the perverse incentives they put in place.

Third, we should be honest that the legislation, for all its flaws, is by no means the “massive corporate give-away” that it has been labeled.  On the contrary, 80% of the value of allowances accrue to consumers and public purposes, and some 20% accrue to covered, private industry.  This split is roughly consistent with the recommendations of independent economic research.

Fourth and finally, it should not be forgotten that the much-lamented deal-making that took place in the House committee last week for shares of the allowances for various purposes was a good example of the useful, important, and fundamentally benign mechanism through which a cap-and-trade system provides the means for a political constituency of support and action to be assembled (without reducing the policy’s effectiveness or driving up its cost).

Although there has surely been some insightful press coverage and intelligent public debate (including in the blogosphere) about the pros and cons of cap-and-trade, the Waxman-Markey legislation, and many of its design elements, it is remarkable (and unfortunate) how misleading so much of the coverage has been of the issues and the numbers surrounding the proposed allowance allocation.

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45 Responses to The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey

  1. rich sweeney says:

    Rob,

    Quick question about “lump sum” rebates to electricity consumers. Roughly 2/3 of US electricity is consumed by the industrial and commercial classes. I totally agree that if allowance value was distributed through the fixed portion of their utility bills, these customers would still internalize the cost of carbon in their electricity consumption. That means that their decision to use electricity, and therefore the electricity costs that they factor into their product prices, will be independent of the lump sum transfer they received. If you believe this, doesn’t that mean that the lump sum transfers industrial and commercial consumers receive (equal to roughly 2/3 of the allowance allocation to electricity distribution companies) will really just end up being a transfer to the shareholders of these companies?

  2. Rich,
    You make a good point. Here’s a back-of-the-envelope calculation. First, you’re right that a portion of the LDC allowances ultimately benefit industry as consumers of electricity. The simplest calculation would move 6% of the allowances from my consumers & public purpose (CPP) category to the private industry category. But, there are some complexities. In short, given the way the Waxman-Markey allocation is structured, the 6% will be offset by half this amount because of a consequent reduction in the allocation to the Energy-Intensive, Trade-Exposed Industries. As soon as I have a chance, I will revise my numbers in the post to reflect 3% more to industry and 3% less to CPP, bring the split to almost exactly 20% covered industry and 80% to consumers and public purposes. Thanks for raising this issue.
    RS

  3. Rich, et al.,
    I have made the indicated corrections in the post. Before, the split was approximately 20/80; now it is exactly 20/80.
    RS

  4. Pingback: Robert Stavins: “The appropriate characterization of the Waxman-Markey allocation is that more than 80% of the value of allowances go to consumers and public purposes, and less than 20% to private industry.” | Climate Vine

  5. Climate Vine,
    Although I would personally question whether I’m “not anyone’s idea of a progressive economist,” I’m pleased to maintain communication with concerned individuals — whether or not they happen to agree with me.
    RS

  6. David Stearns says:

    I’d really like it if you could weigh in on the bigger picture behind this bill. In the work of yours with which I’m familiar (passingly), you really stress the importance of having a *global* approach to carbon reduction, lest carbon intensive economic activity just leak out to countries w/o restrictive regimes. Here, it looks like Waxman-Markey doesn’t really have that much to offer, though I confess that I don’t really have the time to look at the bill too carefully. I’m curious: assuming this bill will impose non-trivial costs (please let me know if you think that assumption is incorrect) and that the goal of such a bill is ostensibly to mitigate climate change, what are your thoughts on the merits of this kind of unilateral action? I remember that you thought the US shouldn’t have joined Kyoto for cost/benefit reasons. How important are the abatements that will come from the types of carbon-intensive activities that can’t leak to other countries (e.g. transportation and electrical generation)? The arguments that if we take this first step, China will be so impressed by our example that they’ll follow suit seem really naive to me.

    Tyler Cowen (at Marginal Revolution) seems to have reservations about what the benefits of this bill are when evaluated with climate change as the goal, though he does seem to think there’s at least a case to be made for the bill as a way to keep more options open down the road. Is this a compelling reason? I’d love to hear your thoughts.

  7. Pingback: FT.com | FT Energy Source | Another view on cap-and-trade giveaways

  8. David,
    Thanks for your thoughtful comment. I will be brief in responding, at least partly because many of your questions are topics I intend to address thoroughly in future posts. Now, to respond briefly, first, I certainly believe that a post-Kyoto international regime which includes the key rapidly-growing developing countries in increasingly meaningful ways over time is essential to addressing climate change in a way which is ultimately scientifically sound, economically rational, and politically pragmatic. This is why so much of my time nowadays is devoted to the Harvard Project on International Climate Agreements, which I direct. Google it, or go to the link in the post above. Second, the Waxman-Markey bill has several provisions which tie into this, including the generous allowance allocation on an updating basis to the energy-intensive trade-sensitive sectors (see the post), and Presidential authority to put in place an import allowance requirement if determined to be necessary. Third, there is clearly a “game of chicken” between the United States and China. I used to be of the opinion that the U.S. should wait for the “ideal” international agreement to take domestic action, but my views have evolved over the past few years to recognize that the best process going forward will most likely involve moving domestic and international processes in parallel, which is what I see happening. The outcome of current bilateral discussions between the U.S. and China will, I suspect, surprise you, but of course I could be wrong. We’ll have to wait and see. Finally, I haven’t read Tyler Cowen’s analysis, and so I’ll hold off on commenting on that.
    Thanks again for your comment,
    RS

  9. David Stearns says:

    Robert,

    Thanks a lot for your reply. I’m interested in what has made your thinking evolve in recent years. I might be misremembering your answer to a talk you gave at my college a couple years back, but I think you said, in part, that what made you more sympathetic to not-so-economically-rational policies like Kyoto was that they are an important signal to the rest of the world that we’re actually serious about confronting climate change. So should we look at Waxman-Markey more as a solution to the game of chicken rather than a solution to the climate problem? That might still be a great reason to favor it, but I think we should be clear that’s what we’re hoping to accomplish. (Or maybe we shouldn’t be so clear, depending on how Straussian we want to get.)

    I get that answering this might be more doable in a full post or a series of posts, so am more than willing to be patient.

    Here are Tyler’s posts, in case the google breaks:

    http://www.marginalrevolution.com/marginalrevolution/2009/05/my-markeywaxman-query-what-are-the-climate-benefits.html

    http://www.marginalrevolution.com/marginalrevolution/2009/05/waxmanmarket-costbenefit-calculations.html

    I’d say he’s more raising issues to consider rather than analyzing per se.

    D

  10. David,
    As you will notice from other correspondence following (other) posts on my blog, when we get to the second or third stage of a correspondence, I simply have to bow out, both because I am overwhelmed with professional obligations, and to invite others to join the conversation. Thank you again for your thoughtful comments.
    RS

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  13. Dallas Burtraw says:

    Rob,
    Your posting is getting useful attention and clarifies a lot of issues. There are a few fine points that you might elaborate.
    One is that the economics literature (Bovenberg and Goulder, 2003; Smith, Ross, and Montgomery, 2002) identify that harm to owners of capital could be of this magnitude. However, the information does not provide justification for compensation to shareholders. This is a public policy question, and one should anticipate the moral hazard associated with compensating these shareholders. It undermines the assumption of risk associated with these investments, as well as the incentives for others to take risks as climate leaders. It is analogous to bail outs for other companies; as I say a public policy question.
    Second, you appropriately identify the nuance of the output subsidy associated with output based allocation (more specifically, with updating the basis for any free allocation). However, I think this is a tool. Used properly it can do good, used broadly it can do harm. The reward of rebates to indutries facing unfair trade exposure relieves them of their allowance cost burden as long as they keep production on shore. The output subsidy serves a specific purpose, and recent work by Carolyn Fischer and others indicates it may be advantageous relative to border tax adjustments, and clearly more cost effective than the grandfathering approach used in the EU.
    Third, the suggestion of advocates of free allocation to local distribution companies that it can be dedicated to offsetting the fixed part of the bill (the lines charge) and thereby preserve the price signal at the margin and the incentive to conserve has some plausibility for industrial class customers, but it is not admissable for residential class customers. Households respond to the bill, not the price. If the compensation comes in the same envelope as the electricity bill then it is a subsidy to electricity consumption from the household perspective. I think the advocates recognize that fact; it will maintain relatively high levels of electricity demand, drive up the cost of emission reductions, and drive up the cost of the program for people who drive, or other sectors of the economy.
    Finally, these forms of compensation to consumers are idiosyncratic, at best. It is an open question whether households are better off or worse off for the fact that we decide to subsidize their electricity consumption, thereby raising the cost of energy in other aspects of their lives. Our research indicates this may help the top income decile, and help one region of the country generally, but the majority of households would prefer a per capita dividend. Since we are talking about differences that add up to billions of dollars, every year, it is worth the trouble of constructive criticism.
    Nonetheless, I agree with you that what we have in Waxman-Markey is of historic importance because of the start on climate policy and equally importantly with respect to the allocation issue, it is a huge step away from wholesale grandfathering, which was the accepted wisdom just five years ago.
    Keep up the great work. Dallas

  14. Dallas,
    I agree wholeheartedly that these points merit “elaboration,” and you’ve provided it, for everyone to read! Thank you.
    Rob

  15. Rob,
    Thanks for the informative post on Waxman-Markey. As you say, the beauty of cap and trade is that it leaves the division between free allowances and auctioned allowances up to the political system. In light of this, how could the President, with all his smart economic advisers, have failed to understand that a 100% auction was politically a non-starter?
    Dallas Burtraw asserts that “households respond to the bill, not the price.” That may be true for most consumers. The trick is to make the bill sufficiently transparent so that more consumers respond rationally. Compare block-pricing explained in the fine print with something that tells consumers how much they paid for the last block of electricity. Imagine a light bulb at the bottom of the bill telling them that if they cut 10% off their consumption that they could cut 20% from the bill and save the planet in the bargain!
    Aloha,
    Jim

  16. Charlie Donovan says:

    Dear Rob,

    while you make some very helpful corrections to the (mis)information going around about how the legislation would work, I feel that you did not address one of the primary sources of the “corporate giveaway” argument. as we can see very clearly from the experience in the EU ETS, there are severe complications associated with an economy-wide cap and trade that have not been explored in the economic literature. First among them in my mind is the wealth transfer that occurs from power users to power generators when there is free allocation. In theory, and in practice, it is clear that power generators will pass through the market cost of carbon regardless of allocation method – as they should. the problem is that when they have acquired those allowances for free, the firm is increasing prices by its opportunity cost, although it has no real expenditure. This issue, which is most obvious in the power sector, is the same for any “upstream” firm in the energy chain; they (correctly) pass through a carbon cost to consumers, but that cost has already been paid for them by the government.

    The total wealth transfer in the EU from power users to power generators (due to free allocation in that system) will be tens of billions of dollars – and the same could play out again at an even larger scale in the US. Do you believe that a trading system can maintain popular political support in the face of these distributional impacts from free allocation?

    with thanks,

    Charlie Donovan

  17. Charlie,

    Thanks for your input, but the comparison with the EU ETS is a misleading distraction due to the fundamental differences in the allocation mechanisms between the two systems. I describe this briefly in the post: Waxman-Markey allocates allowances to local distribution companies, which are subject to cost-of-service regulation even in regions with restructured wholesale electricity markets. So, existing state regulatory regimes will require that the allowance benefits are passed on to consumers.

    That addresses your issue, but there’s a further issue, which is that one would not want this to be passed on with lower electricity prices, because that would reduce or destroy appropriate incentives, so the Waxman-Markey legislation seeks to address this problem by specifying that the economic value of the allowances given to electricity and natural gas local distribution companies should be passed on to consumers through lump-sum rebates, not through a reduction in electricity rates, thereby compensating consumers for increases in electricity prices, but without reducing incentives for energy conservation.

    So, please try to get your mind off the EU ETS, and focus on the system I’m talking about, which is the Waxman-Markey bill.

    If you want to read a more detailed analysis on this point, go to the following recent entry at Climate Progress: http://climateprogress.org/2009/05/27/exclusive-report-foxpenner-chupka-waxman-markey-utility-allowances/

    Thanks again for your comment,

    RS

  18. Pingback: A Few Bits and Bobs - End of May ‘09 Edition | Climate Change

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  20. Gib Metcalf says:

    Rob,
    This is a useful calculation you’ve carried out. I’d suggest that you also calculate the consumer-industry split over the 2012-2020 period. It is hard to believe that government allocations more than (roughly) ten years out will not be subject to change of some form or another. This is not to say that we should not focus on the allowance allocation over the entire control period but we should probably pay more attention to near-term allocations.

    Note too that adding up allowances over a long time period as you’ve done only makes sense if the permit price rises at the same rate as the relevant discount rate for groups that receive the value of the permits. The allowance allocation is not so much the point as the value of the allowances being allocated.

  21. Gib,

    Thanks for your comment.

    It would be interesting to see the 2012-2020 numbers as well, which I could do if I had time, but I’m about to leave for Bonn (climate meetings), and so that will have to be left to someone else. It’s certainly possible to calculate, since the bill provides the time-path for each allocation. If I can find time to go back to the documents, and do this, I’ll do it.

    As for your second comment, I agree completely with your premise, and my thinking (and that of some very good economists in the government with whom I discussed this point) is that with the bill’s banking provisions, the best guess is that the allowance prices will indeed rise at the rate of interest, and that therefore the best way to add up the allowance VALUE share is simply to add up the shares for each year (i.e., the correct present discounted value in this case is the same as addition of allowance numbers or shares). I did not mention that or many other underlying issues in the blog post, and so I’m pleased that this one, as well as others (see Dallas Burtraw’s comment above) are coming out in this comment thread.

    Thanks again for the excellent comment.

    Rob

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  24. Roman Kramarchuk says:

    I tend to be more hesitant to stay with the general academic economist party line that the specific choices of allocation of free allowances have no impact on aggregate social costs. In practical experience, who (which specific industries and which specific companies) end up getting free allowances, their levels of market participation and their forward hedging strategies have a clear and strong bearing on market carbon prices and therefore on social costs.

    The entire Phase I EU ETS price trajectory (high initial prices, followed by a slow decline after the overall oversupply became obvious) is a testament to that – as prices were very dependent upon WHO was long and WHO was short and WHO was participating in the market on a regular basis. Current EUA prices are also very dependent upon the hedging patterns of the short power generators.

    I am certain that the RGGI prices would be different (and lower) if allocations had been handed out for free rather than being auctioned – which has little to do with the general efficiency arguments typically discussed in the auction vs. free allocation debate. I also think that giving not-trivial amounts of allocations (rather than auction revenue) to entities with little institutional trading capabilities has potential to create market inefficiencies.

    Just some thoughts from regularly tracking and advising clients on these markets, and seeing them as far less than perfect markets….

  25. Roman,
    Thanks for your comment. A healthy dose of reality is always welcome to any discussion, and so I really do appreciate your interesting observations from your experience. However, to be honest, I would find it more compelling if you (or perhaps others who are reading this) can cite some rigorous analysis to support the general point you’re making, i.e., the fact that the initial allocation of allowances in a cap-and-trade system has affected environmental performance and/or aggregate social cost. The evidence of which I’m aware (from the performance of the U.S. SO2 allowance trading program) would not support your proposition. Again, thanks for the comment.
    RS

  26. Ian Parry says:

    Rob
    Your commentary provides an excellent discussion of the allowance allocation provisions in Waxman-Markey. Nonetheless it behooves economists to remind policymakers just how much more costly this allocation mechanism is, relative to the cost of the same cap-and-trade program with full allowance auctions and recycling of that revenue in personal income tax reductions.
    According to my reading of the public finance literature, using $1 of revenue to reduce marginal income tax rates seems to yield an economic efficiency gain of roughly $0.4 (relative to returning revenue lump-sum), when account is taken of the distortions in factor markets created by the income tax system, and the bias towards tax-preferred spending (like home ownership and fringe benefits). So if the value of the allowances in a given year is $100 billion, the potential efficiency gains from recycling that revenue in income tax reductions might be around $40 billion. In other words, a policy that does not exploit this revenue-recycling benefit, either because allowances are given out free or allowance auction revenues are not used productively, imposes an enormous annual deadweight loss burden of $40 billion (relative to the lowest-cost policy). In fact, it is difficult to think of another environmental or energy policy reform that would yield social welfare gains of this magnitude.
    Of course the revenue-neutral/full allowance auction approach seems to have no political traction in the US at present—but that is not my point.

  27. Ian,
    Thanks for your comment. Needless to say, I agree with your general point, and I’ll accept your approximation of a potential 40% economic gain if all allowances were auctioned AND all of the revenue from the auction were used to cut the most distortionary taxes. There’s no dispute among economists — including me — on that point. What is key and often overlooked in casual discussion and debates is that this is NOT a distinction between “free allocation versus auctioning,” but between “free allocation versus auctioning PLUS use of 100% of the auction revenue exclusively for cutting the most distortionary taxes.” And, as you well know, that second distinction is not even a matter of debate in Washington. So, I accept your point about “policy heaven,” but in the real world of Washington, D.C., the real choices are what matters. It’s ironic that a Harvard academic should be saying this to a Washington think-tank guy, but so be it. By the way, you might also note that a substantial part of the so-called free allocation in the Waxman-Markey bill consists of allocations to government agencies who will sell the allowances to industry. Hence, these are revenue-raising instruments. Of course, just like the auction revenue, this revenue will be ear-marked for expenditure for particular purposes.
    Thanks again for your comment.
    RS

  28. Michael L. Wagner says:

    Here Read: The Case Against Carbon Trading / Transnational Institute:
    ”…Citigroup’s Peter Atherton confessed that the European Union’s Emission Trading Scheme had ‘done nothing to curb emissions.’ He admitted,‘Prices up, emissions up, profits up …’ Who wins and loses? Coal and nuclear-based generators–biggest winners. Hedge funds and energy traders–even bigger winners. Losers … Consumers!”
    Of course, here the argument is that the European Cap-and-Trade Scheme needed a little work…
    Yet with regard to the Energy Industry–certainly there’s nothing to stop “them” from simply passing along any extra cost to the consumer–without ever lowering their emissions!!!
    Much better to set GHG Caps, then require companies to lower emissions to meet the Cap Level. If necessary, the Govt. could provide a 0-interest loan.
    Here Read: + New climate change legislation overlooks a major GHG source: industrial ag / Grist Magazine:
    –”The bill fails to address greenhouse gas emission reductions from agriculture, factory farms, and animal manure whatsoever–and even goes the extra mile to specifically exempt the entire sector from any type of regulation.”
    “Enteric fermentation is literally the largest source of methane emissions in the entire country.”
    + EPA’s Landfill Methane Outreach Program / EPA:
    –”Municipal solid waste landfills are the second largest source of human-related methane emissions in the United States.”
    “At the same time, methane emissions from landfills represent a lost opportunity to capture and use a significant energy source.”
    + Beware emissions trading, airlines stand to make billions / Mother Jones,
    + The Carbon Folly / BusinessWeek,

  29. Michael,
    Thanks for your comment. From the sound of your text, I doubt that I can persuade you of the efficacy of the Waxman-Markey legislation, but let me try to place some of your selective press quotes into context.

    It’s certainly true that you can find critiques of the European Union’s Emission Trading Scheme in the press, and you’ve cited those selectively, but there has also been some solid analysis of the system. I would draw your attention, for example, to the work of Denny Ellerman of MIT, published in the Review of Environmental Economics and Policy, Winter 2007 issue. In a nutshell, the problems that were observed with the EU ETS — during its pilot phase, not its current Kyoto phase, by the way — took place because of particular design flaws with the system, which fortunately have not been replicated in Waxman-Markey.

    In terms of methane emissions from agriculture, the important thing to recognize — from a pragmatic and practical policy perspective — is that Waxman-Markey would achieve close to 98% coverage of CO2 emissions by approximately 2016. That is a remarkable accomplishment. Further, it would do so cost-effectively. As you may know, agricultural emissions would be brought in through offsets.

    I’m afraid I have no more time for this reply, but if you wish to get a balanced picture of the promise (and the problems) of the Waxman-Markey approach, I urge you to read the numerous analyses which have been published and are forthcoming from the academic community, some of which I will try to cite in future posts.

    RS

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  31. Michael Wara says:

    Hi Rob,

    I think that your posting is helpful in clarifying what is actually going on in the allocation but misrepresents a key aspect of the political economy of cap and trade legislation. My view – and I think this is supported by the evidence – is that at the heart of any agreement to implement cap-and-trade legislation are three interlocking components – the stringency of the cap, the level of cost-control provided (offsets), and the allowance allocation. Looking at the allowance allocation in isolation misses key components of the political negotiation and ultimate compromise that DO impact the environmental effectiveness of the outcome as well as its costs to society.

    Best,
    Michael

  32. Michael, my post is about one aspect of the legislation and one aspect of the press coverage. If you find that misleading, so be it, but I will stand by what I’ve written.
    RS

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  44. Dallas says:

    Michael said… “Looking at the allowance allocation in isolation misses key components of the political negotiation and ultimate compromise that DO impact the environmental effectiveness of the outcome as well as its costs to society.”

    That’s exactly what was in my head as I read this. Not sure if I could explain it as well. Interesting stuff on both sides.

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