Confusion in the Senate Regarding Allowance Allocation?

According to an October 22nd  story in Environment & Energy Daily (“Climate:  GOP Fence Sitters Voice Concerns Over Allocations” by Darren Samuelson), several key swing-vote Senate Republicans — including Senator Lisa Murkowski, ranking member of the Energy and Natural Resources Committee — are voicing skepticism about the Senate’s Boxer-Kerry climate bill’s cap-and-trade system because of the free allocation of some of the allowances to various recipients in the private (and public) sector.  Although the testimony by a group of very knowledgeable economists (see below) made some important points about the implications of alternative allocation mechanisms in a cap-and-trade system, the questions and comments from some members of the Senate Committee suggest that there is lingering confusion on some points that are absolutely central to the debate.  This is important because debate is now advancing on “The Clean Energy Jobs and American Power Act” (Boxer-Kerry), S. 1733, an important (but not sole) element of which is the carbon cap-and-trade system.

First, I want to acknowledge that there are sound reasons for considering allocation mechanisms other than free allocation — for example, auctioning allowances (more about this below) — but the distribution of those allowances that are freely allocated need not be a great source of concern.  In some respects, the new debate is repeating the confusion which was prevalent in the press and the blogosphere about the allowance allocation in the Waxman-Markey legislation in the House of Representatives (H.R. 2454).

It is important to distinguish the above question of whether to employ free allocation or auction, from the question how to allocate the total number of freely allocated allowances among various potential recipients.  As Denny Ellerman of MIT pointed out at the Senate Energy and Natural Resources Committee hearings, “it is not enough to simply say that allowances should be auctioned or allocated freely.  The real issue is the use to which the newly created value will be directed and the households that will thereby ultimately receive the benefit of the allowance value.”   This is a point which I carefully explained and quantified in a post on May 27th (“The Wonderful Politics of Cap-and-Trade:  A Closer Look at Waxman-Markey.”)

Rather than being a “massive corporate give-away” of 80% of the allowances to private industry — as it was frequently characterized — the H.R. 2454 allowance allocation would result in precisely the opposite, namely, about 80% of the value of allowances accruing to consumers, small business, and public purposes, and some 20% accruing to covered, private industry, a split which is roughly consistent with the recommendations from independent economic research.  (I want to acknowledge that estimates by Lawrence Goulder (Stanford) and his colleagues suggest that H.R. 2454 would convey more than 20% of the allowance value to industry.  Perhaps in some future blog post, I can look at these alternative estimates, particularly in the context of analysis of the emerging Senate legislation, S. 1733.)

Directly to Senator Murkowski’s and others’ concern — how the total number of freely allocated allowances is divided up among various potential recipients — does not with some relatively minor exceptions (see list below) — affect either the environmental performance or the overall social cost of the system.

The division of the free allowances among recipients largely affects the distribution of costs, rather than aggregate social cost or the degree of environmental performance.  To this point, the independence of the equilibrium allowance allocation from the initial allocation in a cap-and-trade system was demonstrated by David Montgomery in a path-breaking article in 1972 in the Journal of Economic Theory, and is a more or less direct consequence of principles established by Nobel laureate Ronald Coase in 1960 in “The Problem of Social Cost.”  This independence does not, however, hold in all situations, a topic which Robert Hahn and I are currently analyzing for a conference to be held at the University of Chicago in December.   Examples of such specific conditions include particular types of transaction costs, market power, conditional allowance allocations, non-cost minimizing behavior by firms, and differential regulatory treatment of firms.   We are investigating this topic both theoretically, and empirically, assessing the impacts of initial allowance allocations on the performance of actual and planned cap-and-trade systems in the United States, Europe, Australia, and elsewhere.

Let me emphasize again that I am not talking about the decision regarding whether to freely allocate or auction the allowances.  That decision certainly can affect aggregate social costs, because if some of the allowances are auctioned and if the revenue thereby generated is used to cut distortionary taxes, then the social cost of the overall policy (cap-and-trade plus tax cut) can be less than it would be if the allowances were freely allocated.  This is a well-known distinction both from theory and empirical analysis, with much of the relevant academic work having been done by Stanford University Professor Lawrence Goulder.

So, many economists have long favored a system whereby allowances are auctioned and the auction revenue is used to cut distortionary taxes (on capital and/or labor), thereby reducing the net social cost of the policy.  But recent interest by Senate Energy and Natural Resources Committee Chairman Jeff Bingaman (D-NM) and others seems to be moving in the direction of a so-called “cap-and-dividend” approach.   In such a system (which was originally raised several years ago in the “Sky Trust” proposal), all allowances would be auctioned to complying firms, and the auction revenue distributed to U.S. households on a per capita basis.  This can address some of the distributional issues that would be raised by using the auction revenue to fund tax cuts (which could favor higher income households), but it would eliminate the efficiency (cost-effectiveness) gains associated with the tax cut approach.  In fact, Stanford’s Goulder has estimated that the tax-and-dividend approach would cost 40% more than an approach of combining an auction of allowances with ideal income tax rate cuts.  By “ideal,” I mean cutting those distortionary taxes which would lead to the lowest net cost.

In general, there are sound reasons to seek to compensate consumers for the energy price increases that will be brought about by a cap-and-trade system for climate change, but it is important not to insulate consumers from those price increases (which — as Professor Gilbert Metcalf of Tufts University pointed out at the Senate hearings — dilutes the price signal and thereby reduces the effectiveness and drives up the cost of the overall policy).  So, in my language, “compensation” is fine, but “insulation” is not.

Distinct from that issue, however, is the politically salient question of how to distribute (that is, who gets) those allowances which are freely allocated.  This is the issue on which I have focused.  In this regard, the deal-making that took place in the House and will take place in the Senate for shares of the free allowances is an 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).

Beyond this, the ultimate political question associated with the allocation mechanism may be whether there is greater (geographically and sectoraly based) political support for the partially free allocation and targeted use of auction revenue, which characterizes the Waxman-Markey (H.R. 2454) approach, or greater (“populist”) political support for the full auction combined with lump-sum rebate which characterizes the “cap-and-dividend” approach.  Alas, the textbook economics preference — full auction combined with cuts of distortionary taxes — may be a political, if not, academic orphan..

Author: Robert Stavins

Robert N. Stavins is the Albert Pratt Professor of Business and Government, John F. Kennedy School of Government, Harvard University, Director of the Harvard Environmental Economics Program, Director of Graduate Studies for the Doctoral Program in Public Policy and the Doctoral Program in Political Economy and Government, Co-Chair of the Harvard Business School-Kennedy School Joint Degree Programs, and Director of the Harvard Project on Climate Agreements.

16 thoughts on “Confusion in the Senate Regarding Allowance Allocation?”

  1. I’m not familiar with the details of the free allocation, but I would assume that those 80% going to entities that are not regulated (consumers, small biz etc) are structured like lump sum transfers, i.e. such that they don’t create any new incentive to change behaviour? If that is the case (and I’m happy to be corrected there, I just don’t know!), then I don’t really understand how you come to the conclusion that this free allocation does not affect the overal social cost of the program. I have to get back to the Bovenberg Goulder stuff, that literature finds that the social cost could be dramatically higher for free allocation vs cuts of e.g. marginal income tax rates. Not sure whether you referred to that work with the “relatively minor exceptions”, but do you think these authors would agree that this question of free allocation does not influence social cost in a significant way? I’d be very interested in your opinion on this, maybe a topic for a seperate blog post? 🙂

  2. Bard, thanks for comment. I hope readers will follow the link to your paper.

    David, thanks for your comment. We’re talking about two different issues. You are referring to the decision between auctioning and freely allocating allowances. I am talking about the decision regarding who gets any freely allocated allowances. I will revise the post to make this clear.

  3. Rob,

    I listened to the hearing and while it was unclear what exactly Murkowski was talking about when she made her comment regarding environmental integrity. She did express concern about the allocation picking technology winners. Also, it seemed as if her concern was more that the allowance allocation was a giant opaque corporate giveaway/earmark. At the end however, she did say that no matter how the permits are distributed, households will ultimately bear the costs. That statement would seem to demonstrate a lack of understanding of the distinction between the environmental performance versus distributional issues.


  4. As a journalist who has covered climate change for 20 years, I would note that the allocation system in Waxman-Markey has a serious design flaw. Utilities, through their local distribution companies (LDC), would get about 30 percent of the total allowance pool, and the bill anticipates the value of these allowances will be passed through to utility customers to absorb some of the higher rates resulting from the carbon price. However, nationwide, residential customers account for roughly one-third of electricity demand, while industrial and commercial (I&C) customers account for the remaining two-thirds. The Congressional Budget Office has said that I&C customers will keep the value of their allocations as profit, rather than passing that value on to their own customers. So, if my math is right, nearly 20 percent of the total allowance pool will go to shareholders of these I&C ompanies rather than used for the public good. This provision, first spotted by Chad Stone at the Center for Budget and Policy Priorities, needs to be fixed.

  5. Hi, Robert,

    I’ve tried unsuccessfuly to explain Cap and Trad several times to people who just don’t get it at a blog I write for (cleantechnica) (with your help, thanks Robert).

    But I just found this new way to popularize Cap and Trade. Let individual PEOPLE buy emissions permits and hold them, so polluters can’t buy them.

    I think making that possible in the USA with CEJAPA would help people learn hands on how they work and reduce that mindless cynicism and distrust.

    Sandbag currently prices one tonne of carbon emissions at around $40, making this an affordable way for an individual to make a real contribution.

  6. Susan,

    I’ve always thought that one of the truly remarkable aspects of a cap-and-trade program is that ordinary citizens can intervene in a simple way to change (make more stringent) the overall cap on pollution in a statute that was approved by both houses of Congress and signed by the President, simply by — as you note — purchasing and retiring a permit. I can’t think of any other environmental policy instrument — or policy instrument in some other area of public policy — that provides this scope for citizen involvement on an INDIVIDUAL basis. This is precisely what has happened with the SO2 allowance trading program under the Clean Air Act amendments, as many individuals and quite a number of environmental student groups at law schools have purchased a retired allowances.

    Thanks for this reminder.


  7. A great set of comments. I do have one issue. Your write:

    “Distinct from that issue, however, is the politically salient question of how to distribute (that is, who gets) those allowances which are freely allocated.”

    –Although you are trying to work out something here, I still think that comments like these can mislead people. Free allocation doesn’t mean that the allowance will not have value that drives up costs. This value will accrue to whomever receives the free allocation. I know you get this, I just want to make it clear to folks that:

    A) This is a pollutant;
    B) Then, should the value of the pollutant accrue to businesses who pollute? Or, should it accrue to the public/government?
    C) This is a tax (not a bad thing in that) – who should collect taxes? Private businesses, or government?

    Just because we create a market mechanism to more efficiently fix a pollution problem does not mean that the cost is magically a new type of creature. This is either a tax, or a fee of some sort, and I’m perfectly fine with that. It is a government-mandated pricing-in of an externality, and I think it’s great. I just don’t think, when understood as such, that we should allow its revenue to accrue to private businesses; That’s just weird.

  8. Joshua,
    In terms of economics, you’re saying that the free allocation has distributional implications, but not impacts on efficiency or cost effectiveness, with which I agree. Various people, from different perspectives, can and will make arguments about what is equitable or fair, as do you. Some would say that industry ought to be compensated for equity losses due to the regulation; others, such as you, would say that the value ought to go to compensate consumers for energy price increases.

  9. Thanks, Dr. Stavins. I would add that my question is more fundamental than how you capture it. Of course, we can reimburse however we choose; but, who should do the tax collecting? Should it be the companies (through free allocation of a government-created value)? Or, should it be the government? I think that cutting out the middleman in this system hides the reality of the situation to a strange degree.

    You are correct that I see it as more equitable to redistribute to Americans, but I also see it as economically preferable. Redistribution of equal dollars to Americans, regardless of income, is the reverse of a regressive tax – it’s a regressive rebate, and as such, adds MU to recirculating money.

    I don’t see it as going to “compensate consumers” for prices, I see it as going to Americans as a transfer equal to the external costs we have all borne from the pollution. This has economic impact, and is even economically preferable to free allocation, but it is an ex-economic purpose. Even the CEO’s of major polluters should be cut a check for the value of the externalities, just as they have had to suffer the effects of those externalities (in that carbon is a global pollutant with no noticeable local effects).

  10. Dr. Stavins, regarding your suggestion that citizens and students have made the SO2 cap more stringent under the Clean Air Act’s acid rain program by purchasing and retiring allowances: is there any evidence that SO2 emissions have fallen by more than they otherwise would have due to this phenomenon? How would you account for the confounding effect of other or more recent SO2 regulatory requirements, since the phase II cap is by no means the only driver for SO2 reductions? Moreover, SO2 allowance prices are down and have been for some time, reportedly leading some power plants owners to defer planned scrubber installations or cease operation of installed scrubbers. There are enough SO2 allowances in the bank to allow actual emissions above the phase II cap for years. Meanwhile, only 28% of electric generating units in the U.S. even have scrubbers, according to EPA. And last but not least, tens of thousands of Americans are dying each year due to power plant emissions of SO2 (PM2.5). We must do better than the acid rain program has done.

  11. I really understand what Lisa Murkowski was talking about when she made her comment about the Global climate change. I heard she did express concern about the allocation picking technology winners. I totaly agree, especcialy what she said at the end. No matter how the permits are distributes, households will ultimately bear the costs. This is someting i don’t want to see. However i think that statement would seem to demostrate a lack of understanding of the distinction between environmental performance versus distributional issues.

  12. Joshua,
    In terms of economics, you’re saying that the free allocation has distributional implications, but not impacts on efficiency or cost effectiveness, with which I agree. Various people, from different perspectives, can and will make arguments about what is equitable or fair, as do you. Some would say that industry ought to be compensated for equity losses due to the regulation; others, such as you, would say that the value ought to go to compensate consumers for energy price increases.

  13. In terms of economics, you’re saying that the free allocation has distributional implications, but not impacts on efficiency or cost effectiveness, with which I agree. Various people, from different perspectives.

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