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.


Cap-and-Trade versus the Alternatives for U.S. Climate Policy

Let’s credit Senator Lisa Murkowski (R-Alaska) for raising questions in the National Journal about the viability of cap-and-trade versus other approaches for the United States to employ in addressing CO2 and other greenhouse gas emissions linked with global climate change.

Senator Murkowski says that only one approach – cap-and-trade – has received significant attention in the Congress.  Let’s put aside for the moment the fact that most of the 1,428 pages of H.R. 2454 – the American Clean Energy and Security Act of 2009 (otherwise known as the Waxman-Markey bill) – are not about cap-and-trade at all, but about a host of other regulatory approaches (several of which are highly problematic, as I’ve discussed in a previous post).  We can also put aside the fact that both conventional regulatory approaches and carbon taxes have been discussed repeatedly in numerous House and Senate committees over the past decade, and received detailed attention from a succession of U.S. administrations.

So, let’s not quibble about the Senator’s claim that cap-and-trade is the only approach that has received serious attention.  Instead, let’s address the key substantive questions which Senator Murkowski raises, because they are important questions:  Is cap-and-trade the most effective way of addressing climate change?  And are there other approaches capable of achieving the same results at lower cost?  From my perspective, as a card-carrying environmental economist, these are indeed the key questions.

While political leaders in the European Union, Canada, Australia, New Zealand, Japan, and the United States (Congress) move toward cap-and-trade systems as their preferred approach for achieving meaningful reductions in emissions of CO2 and other greenhouse gases, many people – including some of my fellow economists — have been critical of the cap-and-trade approach in the climate context and have endorsed the use of carbon taxes.  The Senator is correct that we should reflect on the merits of that alternative approach.

But, first, what about conventional regulatory approaches, that is, performance standards and technology standards?

Conventional Regulatory Standards

In short, experience has shown that such standards cannot ensure achievement of emissions targets, create problematic unintended consequences, and are very costly for what they achieve.

Why can conventional standard not ensure achievement of reasonable emissions targets?  First, standards typically focus on new emissions sources, and do not address emissions from existing sources.  Think about greenhouse gas standards for new cars and new power plants, for example.  Second, standards cannot possibly address all types of new sources, given the ubiquity of energy generation and use (and hence CO2 emissions) in a modern economy.  Third, emissions depend upon many factors that cannot be addressed by standards, such as:  emissions from existing sources and unregulated new sources; how quickly the existing capital stock is replaced; the growth in the number of new emissions sources; and how intensively emissions-generating plants and equipment are utilized.

Next, what about those unintended consequences?  First, by reducing operating costs, energy-efficiency standards – for example — can cause more intensive use of regulated equipment (for example, air conditioners are run more often), leading to offsetting increases in emissions — the “rebound effect.”  Second, firms and households may delay replacing existing equipment if standards make new equipment more costly.  This is the well-known problem with vintage-differentiated regulations or “New Source Review.”  Third, standards may encourage counterproductive, unintended shifts among regulated activities (for example, from purchasing cars to purchasing SUVs under the CAFE program).  All of these unintended consequences result from the problematic incentives that standards can create, compared with the efficient incentives created by a cap-and-trade system (or a carbon-tax, for that matter).

If you favor a regulatory approach, then you may welcome what’s coming from EPA as a result of the Supreme Court ruling of a few years ago combined with the Administration’s endangerment finding.  For my part, I don’t welcome it; I worry about it, because the set of regulatory approaches that could be forthcoming will accomplish relatively little, do so at an unnecessarily high cost, and hence play into the hands of opponents of progressive climate policy.  (More about that in some other, future post.)

Putting a Price on Carbon

To virtually all participants in the policy world, it has become increasingly clear that the only approach that can do the job and do it cost-effectively is one which involves at its core putting a price on carbon.  That leaves cap-and-trade and carbon taxes.  Let me take these in turn.


Let’s step back from the debate regarding the details of the Waxman-Markey House bill or the new Senate proposal by Senators Boxer and Kerry, and think about the essence of the cap-and-trade approach.  (For some of those details, however, please see my previous posts, where I have commented on various aspects of Waxman-Markey and described a proposal I developed for The Hamilton Project of an up-stream, economy-wide CO2 cap-and-trade system to cost-effectively achieve meaningful greenhouse gas emissions reductions.)

Here are the basics.  First, aggregate emissions from regulated sources are capped, and the cap is enforced through a requirement for affected firms to hold emissions allowances.  Importantly, allowance trading minimizes costs of meeting the cap.  It does this because allowances migrate to the highest-valued uses, covering emissions that are the most costly to reduce.  So, the emission reductions undertaken are those that are least costly to achieve.  In essence, the uniform market price of allowances creates incentives for all covered sources to reduce all emissions, and do so cost-effectively.

A cap-and-trade system can be more environmentally-effective and more cost-effective than standards.  First, in terms of environmental-effectiveness, a cap-and-trade system can ensure achievement of emissions targets.  Cap-and-trade allows policymakers to set specific overall emissions targets.  And a well-enforced system guarantees achievement of those targets, because emissions will not exceed available allowances.  An economy-wide, upstream cap-and-trade system on the carbon content of fossil fuels can cover all fossil-fuel-related CO2 emissions without needing to regulate each emissions source individually.

In terms of cost-effectiveness, a well-designed cap-and-trade system minimizes emission reduction costs.  Unlike NOx, SO2, and other pollutants, GHG emission reductions have the same effect no matter how, where, or when they are achieved.  This makes the climate change problem unique in the degree to which compliance flexibility can be used to lower costs without compromising environmental integrity.  Hence, a cap-and-trade system can minimize costs while still meeting environmental objectives by offering three forms of flexibility: what flexibility; where flexibility; and when flexibility.

In regard to “what flexibility,” many types of actions offer low-cost emission reductions, and a cap-and-trade system allows emission reductions through whatever measures are least costly.  By contrast, standards can target only certain identified emission reduction measures, leaving other cost-effective opportunities untapped.  Furthermore, predictions of what measures are cost-effective may be wrong.

In regard to “where flexibility,” the costs of emission reductions vary widely across industries, across facilities, and even across users of the same equipment.  A cap-and-trade system exploits this variation in costs by achieving reductions wherever they are least costly.  By contrast, standards would only be cost-effective if they accounted for all of the variation in costs across sectors, technologies, and regulated entities — but it is completely infeasible for standards to do this.  Emission reduction costs across sectors and technologies change over time, making the flexibility offered by a cap-and-trade system even more valuable.  Also, lower-cost opportunities to reduce emissions may exist in other countries.  Importantly, a cap-and-trade system creates a common currency (emissions allowances) that makes it possible to link with other systems.

A cap-and-trade system also minimizes costs through “when flexibility.”  Costs can be reduced through flexibility in the timing of emission reductions by avoiding:  premature retirement of capital stock or lock-in of existing technologies; and unnecessarily costly reductions in one year due to unusual circumstances when less-costly offsetting reductions can be achieved in other years.  A cap-and-trade can incorporate “when flexibility”
without compromising cumulative emissions targets through: allowance banking and borrowing; and multi-year compliance periods.

Beyond such “static cost-effectiveness,” cap-and-trade creates incentives for technology innovation, and thereby lowers long-run costs.  By rewarding any means of reducing emissions, a cap-and-trade system provides broad incentives for any innovations that lower the cost of achieving emissions targets.  Although standards may encourage development of lower cost means of meeting the standards’ specific requirements, they do not encourage efforts to exceed those standards.

Several cap-and-trade systems have been successful at achieving environmental goals and cost savings:  the phase-out of leaded gasoline in the 1980s; the phase-out of ozone depleting substances; and the Clean Air Act amendments of 1990 SO2 allowance trading program to cut acid rain by 50%.  Perceived shortcomings in other cap-and-trade systems reflect design choices, not problems with the policy instrument itself.  This applies both to California’s RECLAIM program, and the pilot phase of the EU Emissions Trading Scheme (which is operating successfully in its real, Kyoto phase).

In summary, compared with conventional standards, a cap-and-trade system can be more environmentally-effective and more cost-effective.  As with any policy instrument, however, careful design is important.

Taxing Carbon

As I mentioned, it is clear that the only approach that can do the job and do it cost-effectively is one that involves putting a price on carbon.  So, what about the other carbon-pricing approach — a carbon tax?

I am by no means opposed to the notion of a carbon tax, having written about such approaches for more than twenty years.  Indeed, both cap-and-trade and carbon taxes are good approaches to the problem; they have many similarities, some tradeoffs, and a few key differences.   I am opposed, however, to the confused and misleading straw-man arguments that have sometimes been used against cap-and-trade by carbon-tax proponents.

While there are tradeoffs between these two principal market-based instruments targeting CO2 emissions — a cap-and-trade system and a carbon tax – the best (and most likely) approach for the short to medium term in the United States is a cap-and-trade system.  I say this based on three criteria:  environmental effectiveness, cost effectiveness, and distributional equity.  So, my position is not capitulation to politics.  On the other hand, sound assessments of environmental effectiveness, cost effectiveness, and distributional equity should surely be made in the real-world political context.

The key merits of the cap-and-trade approach I have described above are, first, the program can provide cost-effectiveness, while achieving meaningful reductions in greenhouse gas emissions levels.  Second, it offers an easy means of compensating for the inevitably unequal burdens imposed by a climate policy.  Third, it provides a straightforward means to harmonize with other countries’ climate policies.  Fourth, it avoids the current political aversion in the United States to taxes.  Fifth, it is unlikely to be degraded – in terms of its environmental performance and cost effectiveness – by political forces. And sixth, this approach has a history of successful adoption and implementation in this country over the past two decades.

Having said this, there are some real differences between taxes and cap-and-trade that need to be recognized.  First, environmental effectiveness:  a tax does not guarantee achievement of an emissions target, but it does provides greater certainty regarding costs.  This is a fundamental tradeoff.  Taxes provide automatic temporal flexibility, which needs to be built into a cap-and-trade system through provision for banking, borrowing, and possibly a cost-containment mechanism.  On the other hand, political economy forces strongly point to less severe targets if carbon taxes are used, rather than cap-and-trade – this is not a tradeoff, and this is why environmental NGOs are opposed to the carbon-tax approach.

In principle, both carbon taxes and cap-and-trade can achieve cost-effective reductions, and – depending upon design — the distributional consequences of the two approaches can be the same.  But the key difference is that political pressures on a carbon tax system will most likely lead to 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.  But political pressures on a cap-and-trade system lead to different allocations of allowances, which affect distribution, but not environmental effectives, and not cost-effectiveness.

Proponents of carbon taxes worry about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax is sensitive to the same political pressures, and may be expected to succumb in ways that are ultimately more harmful:  reducing environmental achievement and driving up costs.

The Bottom Line

The Hamilton Project staff concluded in an overview paper (which I highly recommend) that a well-designed carbon tax and a well-designed cap-and-trade system would have similar economic effects.  Hence, they said, the two primary questions to use in deciding between them should be:  which is more politically feasible; and which is more likely to be well-designed?

The answer to the first question is obvious; and I have argued here that given real-world political forces, the answer to the second question also favors cap-and-trade.  In other words, it is important to identify and design policy that will be “optimal in Washington,” not just from the perspective of Cambridge, New Haven, or Berkeley.

In “policy heaven,” the optimal instrument to address climate-change emissions may well be a carbon tax (largely because of its simplicity), but in the real world in which policy is developed and implemented, cap-and-trade is the best approach if one is serious about addressing the threat of climate change with meaningful, effective, and cost-effective policies.


Cap-and-Trade: A Fly in the Ointment? Not Really

For more than two decades, environmental law and regulation was dominated by command-and-control approaches — typically either mandated pollution control technologies or inflexible discharge standards on a smokestack-by-smokestack basis.  But in the 1980s, policy makers increasingly explored market-based environmental policy instruments, mechanisms that provide economic incentives for firms and individuals to carry out cost-effective pollution control.  Cap-and-trade systems, in which emission permits or allowances can be traded among potential polluters, continue today to be at the center of this action.

Most recently, this has been in the context of deliberations regarding possible U.S. actions to reduced carbon dioxide and other greenhouse gas emissions linked with global climate change, as in HR 2454, the Waxman-Markey bill approved by the U.S. House of Representatives, as well as in proposals developing in the Senate.  (I have written a number of blog posts on this topic.  If you’re interested, please see:  “Opportunity for a Defining Moment” (February 6, 2009); “The Wonderful Politics of Cap-and-Trade:  A Closer Look at Waxman-Markey” (May 27, 2009); “Worried About International Competitiveness?  Another Look at the Waxman-Markey Cap-and-Trade Proposal” (June 18, 2009); “National Climate Change Policy:  A Quick Look Back at Waxman-Markey and the Road Ahead” (June 29, 2009).  For a more detailed account, see my Hamilton Project paper, A U.S. Cap-and-Trade System to Address Global Climate Change.)

But the transition from command-and-control regulation to market-based policy instruments has not always been easy.  Sometimes policy can outrun basic understanding, and the claims made for the cost-effectiveness of cap-and-trade systems can exceed what can be reasonably anticipated.  Among the factors that can adversely affect the performance of such systems are transaction costs.

In general, transaction costs — those costs that arise from the exchange, not the production, of goods and services — are ubiquitous in market economies.  They can arise from any exchange:  after all, parties to transactions must find one another, communicate, and exchange information.  It may be necessary to inspect and sometimes even measure goods to be transferred, draw up contracts, consult with lawyers or other experts, and transfer title.

In cap-and-trade markets, there are three potential sources of transaction costs. The first source, searching and information-collection, arises because it can take time for a potential buyer of a discharge permit to find a seller, though — for a fee — brokers can facilitate the process.  Although less obvious, a second source of transaction costs — bargaining and deciding — is potentially as important.  A firm entering into negotiations incurs real resource costs, including time and/or fees for brokerage, legal, and insurance services.  Likewise, the third source — monitoring and enforcing — can be significant, although these costs are typically borne by the responsible governmental authority and not by trading partners.

The cost savings that may be realized through cap-and-trade systems depend upon active trading.  But transaction costs are an impediment to trading, and such impediments thereby can limit savings.  So, transaction costs reduce the overall economic benefits of allowance trading, partly by absorbing resources directly and partly by suppressing exchanges that otherwise would have been mutually (indeed socially) beneficial.  But when transaction costs can be kept to a minimum, high levels of trading — and significant cost savings – are the result.

Since David Montgomery’s path-breaking work in 1972, economists have asserted that the post-trading allocation of control responsibility among sources and hence the aggregate costs of control are independent from the initial permit allocation.  This is an extremely important political property, but does this still hold in the presence of transaction costs?  This is a question I investigated in an article titled, “Transaction Costs and Tradable Permits,” which was published in the Journal of Environmental Economics and Management in 1995 (and which the publisher lists as one of the ten most cited articles in the journal’s history, going back to 1974).

The answer to this question is: “it depends.”  If incremental transaction costs are independent of the size of individual transactions, the initial allocation of permits has no effect on the post-trading allocation of control responsibility and aggregate control costs.  But if incremental transaction costs decrease with the size of individual trades, then the initial allocation will affect the post-trading outcome.

This is of great political importance, because it means that in the presence of transaction costs, the initial distribution of permits can matter not only in terms of distributional equity, but in terms of cost-effectiveness or efficiency.  This can reduce the discretion of the Congress (or other legislature or agency) to distribute allowances as they please (in order to generate a constituency of support for the program), and may thereby reduce the political attractiveness and feasibility of a cap-and-trade system.

Empirical evidence, however, indicates that transaction costs have been minimal, indeed trivial, in enacted and implemented cap-and-trade systems, including the U.S. EPA’s leaded-gasoline phasedown in the 1980s, and the well-known SO2 allowance trading system, enacted as part of the Clean Air Act amendments of 1990.

That’s good news, surely.  But nevertheless, going forward, choices between conventional, command-and-control environmental policies and market-based instruments should reflect the imperfect world in which these instruments are applied.  Such choices are not simple, because no policy panacea exists.

On the one hand, even if transaction costs prevent significant levels of trade from occurring, aggregate costs of control will most likely be less than those of a conventional command-and-control approach.  A trading system with no trading taking place will likely be less costly than a technology standard (because the trading system provides flexibility to firms regarding their chosen means of control) and no more costly than a uniform performance standard.

But the existence of transaction costs may make the choice between conventional approaches and cap-and-trade more difficult because of the ambiguities that are introduced.  With transaction costs — as with other departures from frictionless markets — greater attention is required to the details of designing specific systems.  This is the way to lessen the risk of over-selling such policy ideas and ultimately creating systems that stand the best chance of being implemented successfully.