Tag: cost-effectiveness

Here We Go Again: A Closer Look at the Kerry-Lieberman Cap-and-Trade Proposal

As with the Waxman-Markey bill (H.R. 2454), passed by the House of Representatives last June, there is now some confusing commentary in the press and blogosphere about the allocation of allowances in the new Senate proposal — the American Power Act of 2010 — sponsored by Senator John Kerry, Democrat of Massachusetts, and Senator Joseph Lieberman, Independent of Connecticut.  As before, the mistake is being made of confusing the share of allowances that are freely allocated versus auctioned with (the appropriate analysis of) the actual incidence of the allowance value, that is, who ultimately benefits from the allocation and auction revenue.

In this essay, I assess quantitatively the actual incidence of the allowance value in the new Senate proposal, much as I did last year with the House legislation.  I find (as with Waxman-Markey) that the lion’s share of the allowance value — some 82% — goes to consumers and public purposes, and only 18% accrues to covered, private industry.   First, however, I place this in context by commenting briefly on the overall Senate proposal, and by examining in generic terms the effects that allowance allocations have — and do not have — in cap-and-trade systems.

The American Power Act of 2010

You may be wondering why I am bothering to write about the Kerry-Lieberman proposal at all, given the conventional wisdom that the likelihood is very small of achieving the 60 votes necessary in the Senate to pass the legislation (particularly with the withdrawal of Senator Lindsay Graham — Republican of South Carolina — from the former triplet of Senate sponsors).  Two reasons.  First, conventional wisdoms often turn out to be wrong (although I must say that the vote count on Kerry-Lieberman does not look good, with the current tally according to Environment & Energy Daily being 26 Yes, 11 Probably Yes, 31 Fence Sitters, 10 Probably No, and 22 No).  Second, if the conventional wisdom turns out to be correct, and the 60-vote margin proves insurmountable in the current Congress, then when the Congress returns to this issue — which it inevitably will in the future  — among the key starting points for Congressional thinking will be the Waxman-Markey and Kerry-Lieberman proposals.  Hence, the design issues do matter.

The American Power Act, like its House counter-part, is a long and complex piece of legislation with many design elements in its cap-and-trade system (which, of course, is not called “cap-and-trade” — but rather “reduction and investment”), and many elements that go well beyond the cap-and-trade system (sorry, I meant to say the “reduce-and-invest” system).  Perhaps in a future essay, I will examine some of those other elements (wherein there is naturally both good news and bad news), but for today, I am focusing exclusively on the allowance allocation issue, which is of central political importance.

Before turning to an empirical examination of the Kerry-Lieberman allowance allocation, it may be helpful to recall some generic facts about the role that allowance allocations play in cap-and-trade systems.

The Role of Allowance Allocations in Cap-and-Trade Systems

It is exceptionally important to keep in mind what is probably the key attribute of cap-and-trade systems:  the particular allocation of those allowances which are freely distributed 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.  (There are some caveats, 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 (although it’s true that the revenue from auctioned allowances can be used for a variety of public purposes, including cutting distortionary taxes, which can thereby reduce the net cost of the program).  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 — for the most part — 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.   With other policy instruments — both in the environmental realm and in other policy domains — political pressures often reduce the effectiveness and/or 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 come in.

Some Important Caveats

First, as I said above, auction revenue may be used in ways that reduce the costs of the existing tax system or fund other socially beneficial policies.  Free allocations forego such opportunities.

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 and Kerry-Lieberman both allocate a significant number of allowances to local (electricity) distribution companies, which are subject to cost-of-service regulation even in regions with restructured wholesale electricity markets.  Because the distribution companies are subject to cost-of-service regulation, the benefit of the allocation will ultimately accrue to electricity consumers, not the companies themselves.  While these allocations could increase the overall cost of the program if the economic value of the allowances is passed on to consumers in the form of reduced electricity prices, if that value is instead passed on to consumers through lump-sum rebates, the effect can be to compensate consumers for increased electricity prices without reducing incentives for energy conservation.  (There are some legitimate behavioral questions here about how consumers will respond to such rebates; these questions are best left to ongoing economic research.)

Third, “output-based updating allocations” can be useful for addressing competitiveness impacts of a climate policy on particularly energy-intensive and trade-sensitive sectors, but these allocations can provide perverse incentives and drive up the costs of achieving a cap if they are poorly designed.  This merits some explanation.

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.  While this affects firms’ pricing and production decisions in ways that can, in some cases, introduce unintended consequences and increase the cost of meeting an emissions target, when applied to energy-intensive trade-exposed industries, the incentives created by such allocations can contribute to the goal of reducing emission leakage abroad.

This approach is probably superior to an import allowance requirement, whereby imports of a small set of specific commodities must carry with them CO2 allowances, because import allowance requirements can damage international trade relations.  The only real solution to the competitiveness issue is to bring key non-participating countries within an international climate regime in meaningful ways, an obviously difficult objective to achieve.  (On this, please see the work of the Harvard Project on International Climate Agreements.)

Is the Kerry-Lieberman Allowance Allocation a Corporate Give-Away?

Perhaps unintentionally, there has been some potentially misleading coverage on this issue.  At first glance, about half of the allowances would be auctioned and about half freely allocated over the life of the program, 2012-2050.  (In the early years, the auction share is smaller, reflecting various transitional allocations that phase out over time.)  But looking at the shares that are auctioned and freely allocated can be very misleading.

Instead, the best way to assess the real 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 and auction revenue are 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.  Indeed, my conclusion is that over the period 2012-2050, less than 18% of the allowance value accrues to industry.

First, 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:

I.  Cost Containment

a.  Auction from cost containment reserve, 3.1%

II.  Indirect Assistance to Mitigate Impacts on Energy Consumers

b.  Electricity local distribution companies, 18.6%

c.  Natural gas local distribution companies, 4.1%

d.  State programs for home heating oil, propane, and kerosene consumers, 0.9%

III.  Direct Assistance to Households and Taxpayers

e.  Allowances auctioned to provide tax and energy refunds for low-income households, 11.7%

f.  Allowances auctioned for universal tax refunds, 22.3%

IV.  Other Domestic Priorities

g.  State renewable and energy efficiency programs, 0.6%

h.  State and local agency programs to reduce emissions through transportation projects, 1.9%

i.  Grants for national surface transportation system, 1.9%

j.  Auctioned allowances for Highway Trust Fund, 1.9%

k.  Domestic adaptation, 1.0%

l.  Rural energy savings (consumer loans to implement energy efficiency measures), 0.1%

V.  International Funding

m.  International adaptation, 1.0%

VI.  Deficit Reduction

n.  Allowances auctioned for deficit reduction, 7.4%

o.  Remaining allowances auctioned to offset bill’s impact on deficit, 6.1%

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

I.  Allocations to Covered Entities

a.  Energy-intensive, trade-exposed industries, 7.0%

b.  Petroleum refiners, 2.2%

c.  Merchant coal-fired electricity generators, 2.2%

d.  Generators under long-term contracts without cost recovery, 0.9%

II.  Technology Funding

e.  Carbon capture and sequestration incentives, 3.8%

f.  Clean energy technology R&D, 0.7%

g.  Low-carbon manufacturing R&D, 0.3%

h.  Clean vehicle technology incentives, 0.3%

III.  Other Domestic Priorities

i.  Manufacturing plant energy efficiency retrofits, 0.1%

j.  Compensation for early action emissions reductions prior to cap’s implementation, 0.1%

The bottom line?  Over the entire period from 2012 to 2050, 82.6% of the allowance value goes to consumers and public purposes, and 17.6% to private industry. Rounding error brings the total to 100.2%, so to be conservative, I’ll call this an 82%/18% split.

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 18% free allocation to private industry should not be viewed as a windfall.

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 Kerry-Lieberman allocation is that about 82% of the value of allowances go to consumers and public purposes, and 18% to private industry.

Comparing the Kerry-Lieberman 82/18 Split with Recommendations from Economic Analyses

The 82-18 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 Kerry-Lieberman 82/18 allowance split (like the 80/20 Waxman-Markey 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.

The Path Ahead

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

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

Second, we should recognize that the legislation is by no means a corporate give-away.  On the contrary, 82% of the value of allowances accrue to consumers and public purposes, and some 18% accrue to covered, private industry.  This split is roughly consistent with the recommendations of independent economic research.

Finally, it should not be forgotten that the much-lamented deal-making for shares of the allowances for various purposes that took place in the deliberations leading up the announcement by Senators Kerry and Lieberman 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.

Share

Eyes on the Prize: Federal Climate Policy Should Preempt State and Regional Initiatives

In just a few days, Senators John Kerry, Lindsey Graham, and Joe Lieberman will release their much-anticipated proposal for comprehensive climate and energy legislation – the best remaining shot at forging a bipartisan consensus on this issue in 2010.  Their proposal has many strengths, but there’s an issue brewing that could undermine its effectiveness and drive up its costs.  I wrote about this in a Boston Globe op-ed on Earth Day, April 22nd (the original version of which can be downloaded here).

Government officials from California, New England, New York, and other northeastern states are vociferously lobbying in Washington to retain their existing state and regional systems for reducing greenhouse gas emissions, even after a new federal system comes into force. That would be a mistake – and a potentially expensive one for residents of those states, who could wind up subsidizing the rest of the country.  The Senate should do as the House did in its climate legislation:  preempt state and regional climate policies.  There’s no risk, because if Federal legislation is not enacted, preemption will not take effect.

The regional systems – including the Regional Greenhouse Gas Initiative (RGGI) in the Northeast and Assembly Bill 32 in California – seek to limit carbon dioxide emissions from power plants and other sources, mainly by making emissions more costly for firms and individuals.  These systems were explicitly developed because the federal government was not moving fast enough.

But times have changed.  Like the House climate legislation passed last June, the new Senate bill will feature at its heart an economy-wide carbon-pricing scheme to reduce carbon dioxide emissions, including a cap-and-trade system (under a different name) for the electricity and industrial sectors.  (In a departure from the House version, it may have a carbon fee for transportation fuels.)

Though the Congress has a history of allowing states to act more aggressively on environmental protection, this tradition makes no sense when it comes to climate change policy.  For other, localized environmental problems, California or Massachusetts may wish to incur the costs of achieving cleaner air or water within their borders than required by a national threshold.  But with climate change, it is impossible for regions, states, or localities to achieve greater protection for their jurisdictions through more ambitious actions.

This is because of the nature of the climate change problem. Greenhouse gases, including carbon dioxide, uniformly mix in the atmosphere – a unit of carbon dioxide emitted in California contributes just as much to the problem as carbon dioxide emitted in Tennessee.  The overall magnitude of damages – and their location – are completely unaffected by the location of emissions.  This means that for any individual jurisdiction, the benefits of action will inevitably be less than the costs. (This is the same reason why U.S. federal action on climate change should occur at the same time as other countries take actions to reduce their emissions).

If federal climate policy comes into force, the more stringent California policy will accomplish no additional reductions in greenhouse gases, but simply increase the state’s costs and subsidize other parts of the country. This is because under a nationwide cap-and-trade system, any additional emission reductions achieved in California will be offset by fewer reductions in other states.

A national cap-and-trade system – which is needed to address emissions meaningfully and cost-effectively – will undo the effects of a more stringent cap within any state or group of states.  RGGI, which covers only electricity generation and which will be less stringent than the Federal policy, will be irrelevant once the federal system comes into force.

In principle, a new federal policy could allow states to opt out if they implement a program at least as stringent.  But why should states want to opt out?  High-cost states will be better off joining the national system to lower their costs. And states that can reduce emissions more cheaply will be net sellers of Federal allowances.

Is there any possible role for state and local policies?  Yes.  Price signals provided by a national cap-and-trade system are necessary to meaningfully address climate change at sensible cost, but such price signals are not sufficient.  Other market failures call for supplementary policies.  Take, for example, the principal-agent problem through which despite higher energy prices, both landlords and tenants lack incentives to make economically-efficient energy-conservation investments, such as installing thermal insulation.  This problem can be handled by state and local authorities through regionally-differentiated building codes and zoning.

But for the core of climate policy – which is carbon pricing – the simplest, cleanest, and best way to avoid unnecessary costs and unnecessary actions is for existing state systems to become part of the federal system.  Political leaders from across the country – including the Northeast and California – would do well to follow the progressive lead of Massachusetts Governor Deval Patrick and Secretary of Energy and Environmental Affairs Ian Bowles, who have played key roles in the design and implementation of RGGI, and yet have also publicly supported its preemption by a meaningful national program.

California’s leaders and those in the Northeast may take great pride in their state and regional climate policies, but if they accomplish their frequently-stated goal – helping to bring about the enactment of a meaningful national climate policy – they will better serve their states and the country by declaring victory and getting out of the way.

Share

Who Killed Cap-and-Trade?

In a recent article in the New York Times, John Broder asks “Why did cap-and-trade die?” and responds that “it was done in by the weak economy, the Wall Street meltdown, determined industry opposition and its own complexity.”  Mr. Broder’s analysis is concise and insightful, and I recommend it to readers.  But I think there’s one factor that is more important than all those mentioned above in causing cap-and-trade to have changed from politically correct to politically anathema in just nine months.  Before turning to that, however, I would like to question the premise of my own essay.

Is Cap-and-Trade Really Dead?

Although cap-and-trade has fallen dramatically in political favor in Washington as the U.S. answer to climate change, this approach to reducing carbon dioxide (CO2) emissions is by no means “dead.”

The evolving Kerry-Graham-Lieberman legislation has a cap-and-trade system at its heart for the electricity-generation sector, with other sectors to be phased in later (and it employs another market-based approach, a series of fuel taxes for the transportation sector linked to the market price for allowances).  Of course, due to the evolving political climate, the three Senators will probably not call their system “cap-and-trade,” but will give it some other creative label.

The competitor proposal from Senators Cantwell and Collins — the CLEAR Act — has been labeled by those Senators as a “cap-and-dividend” approach, but it is nothing more nor less than a cap-and-trade system with a particular allocation mechanism (100% auction) and a particular use of revenues (75% directly rebated to households) — and, it should be mentioned, some unfortunate and unnecessary restrictions on allowance trading.

And we should not forget that cap-and-trade continues to emerge as the preferred policy instrument to address climate change emissions throughout the industrialized world — in Europe, Australia, New Zealand, and Japan (as I wrote about in a recent post).

But back to the main story — the dramatic change in the political reception given in Washington to this cost-effective approach to environmental protection.

A Rapid Descent From Politically Correct to Politically Anathema

Among factors causing this change were:  the economic recession; the financial crisis (linked, in part, with real and perceived abuses in financial markets) which thereby caused great suspicion about markets in general and in particular about trading in intangible assets such as emission allowances; and the complex nature of the Waxman-Markey legislation (which is mainly not about cap-and-trade, but various regulatory approaches).

But the most important factor — by far — which led to the change from politically correct to politically anathema was the simple fact that cap-and-trade was the approach that was receiving the most serious consideration, indeed the approach that had been passed by one of the houses of Congress.  This brought not only great scrutiny of the approach, but — more important — it meant that all of the hostility to action on climate change, mainly but not exclusively from Republicans and coal-state Democrats, was targeted at the policy du jour — cap-and-trade.

The same fate would have befallen any front-running climate policy.

Does anyone really believe that if a carbon tax had been the major policy being considered in the House and Senate that it would have received a more favorable rating from climate-action skeptics on the right?  If there’s any doubt about that, take note that Republicans in the Congress were unified and successful in demonizing cap-and-trade as “cap-and-tax.”

Likewise, if a multi-faceted regulatory approach (that would have been vastly more costly for what would be achieved) had been the policy under consideration, would it have garnered greater political support?  Of course not.  If there is doubt about that, just observe the solid Republican Congressional hostility (and some announced Democratic opposition) to the CO2 regulatory pathway that EPA has announced under its endangerment finding in response to the U.S. Supreme Court decision in Massachusetts vs. EPA.

(There’s a minor caveat, namely, that environmental policy approaches that hide their costs frequently are politically favored over policies that make their costs visible, even if the former policy is actually more costly.  A prime example is the broad political support for Corporate Average Fuel Economy (CAFE) standards, relative to the more effective and less costly option of gasoline taxes.  Of course, cap-and-trade can be said to obscure its costs relative to a carbon tax, but that hardly made much difference once opponents succeeded in labeling it “cap-and-tax.”)

In general, any climate policy approach — if it was meaningful in its objectives and had any chance of being enacted — would have become the prime target of political skepticism and scorn.  This has been the fate of cap-and-trade over the past nine months.

Why is Political Support for Climate Policy Action So Low in the United States?

If much of the political hostility directed at cap-and-trade proposals in Washington has largely been due to hostility towards climate policy in general, this raises a further question, namely, why has there been so little political support in Washington for climate policy in general.  Several reasons can be identified.

For one thing, U.S. public support on this issue has decreased significantly, as has been validated by a number of reliable polls, including from the Gallup Organization.  Indeed, in January of this year, a Pew Research Center poll found that “dealing with global warming” was ranked 21st among 21 possible priorities for the President and Congress.  (It should be noted some polls are not consistent with these.)  This drop in public support is itself at least partly due to the state of the national economy, as public enthusiasm about environmental action has — for many decades — been found to be inversely correlated with various measures of national economic well-being.

Although the lagging economy (and consequent unemployment) is likely the major factor explaining the fall in public support for climate policy action, other contributing factors have been the so-called Climategate episode of leaked e-mails from the University of East Anglia and the damaged credibility of the Intergovernmental Panel on Climate Change (IPCC) due to several errors in recent reports.

Furthermore, the nature of the climate change problem itself helps to explain the relative apathy among the U.S. public.  Nearly all of our major environmental laws have been passed in the wake of highly-publicized environmental events or “disasters,” ranging from Love Canal to the Cuyahoga River.

But the day after Cleveland’s Cuyahoga River caught on fire in 1969, no article in The Cleveland Plain Dealer commented that “the cause was uncertain, because rivers periodically catch on fire from natural causes.”  On the contrary, it was immediately apparent that the cause was waste dumped into the river by adjacent industries.  A direct consequence of the “disaster” was, of course, the Clean Water Act of 1972.

But climate change is distinctly different.  Unlike the environmental threats addressed successfully in past legislation, climate change is essentially unobservable.  You and I observe the weather, not the climate (note the dramatic difference of opinion about the reality of climate change between climatologists and television weathercasters).  Until there is an obvious and sudden event — such as a loss of part of the Antarctic ice sheet leading to a disastrous sea-level rise — it’s unlikely that public opinion in the United States will provide the bottom-up demand for action that has inspired previous Congressional action on the environment over the past forty years.

Finally, it should be acknowledged that the fiercely partisan political climate in Washington has completed the gradual erosion of the bi-partisan coalitions that had enacted key environmental laws over four decades.  Add to this the commitment by the opposition party to deny the President any (more) political victories in this year of mid-term Congressional elections, and the possibility of progressive climate policy action appears unlikely in the short term.

An Open-Ended Question

There are probably other factors that help explain the fall in public and political support for climate policy action, as well as the changed politics of cap-and-trade.  I suspect that readers will tell me about these.

Share