Economics and Politics in California: Cap-and-Trade Allowance Allocation and Trade Exposure

In my previous essay at this blog – The Importance of Getting it Right in California – I wrote about the precedents and lessons that  California’s Global Warming Solutions Act (AB 32) and its greenhouse gas (GHG) cap-and-trade system will have for other jurisdictions around the world, including other states, provinces, countries, and regions.  This is particularly important, given the failure of the U.S. Senate in 2009 to pass companion legislation to the Waxman-Markey bill, passed by the U.S. House of Representatives, highlighting the absence of a national, economy-wide carbon pricing policy.

In my previous essay, I focused on three pending design issues in the emerging rules for the AB-32 cap-and-trade system:  (1) the GHG allowance reserve; (2) the role of offsets; and (3) proposals for allowance holding limits.  I drew upon a presentation I made on “Offsets, Holding Limits, and Market Liquidity (and Other Factors Affecting Market Performance)” at the 2013 Summer Issues Seminar of the California Council for Environmental and Economic Balance.

At the same conference, I made another presentation, which was on “Allowance Value Distribution and Trade Exposure,” a topic that is of great importance both economically and politically, not only in the context of the design of California’s AB-32 cap-and-trade system, but for the design of any cap-and-trade instrument in any jurisdiction.  It is to that topic that I turn today.  (For a much more detailed discussion, please see a white paper I wrote with Dr. Todd Schatzki of Analysis Group, “Using the Value of Allowances from California’s GHG Cap-and-Trade System,” August, 2012).

Why Does Anyone Care About the Allowance Value Distribution?

A cap-and-trade policy creates a valuable new commodity – emissions allowances.  In a well-functioning emissions trading market, the financial value of these allowances (per ton of emissions, for example) is approximately equivalent to their opportunity cost, which is the marginal cost of emissions reductions.  This is because of the existence of the overall cap, which – if binding – fosters scarcity of available allowances, and hence generates their economic value.

It should not be surprising, then, that the initial allocation of these allowances can have important consequences both for environmental and for economic outcomes.

Environmental Consequences of the Initial Allowance Allocation

No matter how many times I meet with policy makers around the world to talk about alternative policy instruments (for climate change and other environmental problems), I never cease to be struck by the confusion that abounds regarding the environmental (and the economic) consequences of the initial allocation of allowances in a cap-and-trade system.  As I have written many times in the past at this blog, the initial allocation does not directly affect environmental outcomes.  Regardless of the allocation method used, aggregate emissions are limited by the emissions cap.  This is true whether the allowances are sold (auctioned) or distributed without charge.  Furthermore, which firms or sources receive the initial allocation of allowances has no effect on either aggregate emissions or the ultimate distribution of emissions reductions among sources.

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.  (More below about the initial allocation’s potential effects on economic performance.)

However, it is also true that the initial allocation method can indirectly affect emissions.  In particular, emissions leakage can arise if economic activity shifts to unregulated sources – this risk is greatest with auctions or free fixed allocations.  In contrast, an updating, output-based allocation (used in AB 32 for “industry assistance”) can reduce leakage risk by making the free allocation of allowances marginal, rather than infra-marginal (as is the case with a simple free allocation).

Economic Consequences of the Initial Allowance Allocation

A favorite topic of academic economists is that the allowance allocation method in a cap-and-trade system can affect the overall social cost of the policy if the allowances are auctioned (sold by government to compliance entities), and if the revenues are then used to reduce distortionary taxes (such as taxes on labor and investment), thereby eliminating some deadweight loss and cutting overall social cost.  I discuss this a bit more below, but for now let’s recognize that the combination of two California propositions and subsequent court rulings means that the State is not permitted to use the auction proceeds to cut taxes (rather, any auction proceeds must be used to achieve the purposes of AB 32, that is, reducing GHG emissions).

So, within the set of feasible options, the initial allowance allocation will not directly affect the cost-effectiveness of actions taken by emission sources to reduce emissions.  In other words, aggregate abatement costs will not be directly affected by the nature of the initial allocation.

I was careful to use the word, “directly,” because the initial allowance allocation can indirectly affect economic outcomes.  In particular, the use of updating, output-based allocations can:  (1) lower the costs seen by consumers, which can reduce incentives to conserve; (2) avoid reductions in economic activity within California, with associated distributional impacts; and (3) avoid potential shifts of production to less efficient, more distant producers.

Auction Revenue Use

Decisions about how auction revenues are used can have profound consequences for the potential benefits of auctioning.  There are three basic options.

First, as I emphasized above, in theory, reducing distortionary taxes provides the greatest net economic benefit (by reducing the social cost of the policy).  But California’s unique legal context takes this option off the table.

Second, funding programs to address other market failures that are not addressed by the price signals provided by the cap-and-trade system can be meritorious.   For example, information spillovers can be addressed through financing of research and development activities, and the principal-agent problems that infect energy-efficiency adoption decisions in rental properties can be addressed — to some degree — through zoning and other local policies.

The third and final option, however, is highly problematic, if not completely without merit, and yet, ironically, there are strong incentives in place for policy makers to go this third route.  This third option is to use auction revenues to fund programs to subsidize emission reductions.  There is a strong incentive to do this, because of California’s legal constraint to employ any auction revenues in pursuit of the objectives of the statute, that is, reducing GHG emissions.

What’s the problem?  The AB-32 cap-and-trade system will cover approximately 85% of the economy.  In other words, the vast majority of sources are under the cap.  As I have explained in detail in several previous essays at this blog, under the umbrella of a cap-and-trade mechanism, (successful) efforts to further reduce emissions of capped sources will have three consequences:  (1) allowance prices will be supressed (take a look at the hand-wringing in Europe over allowance prices in its CO2 Emissions Trading System); (2) aggregate compliance costs will be increased (cost-effectiveness is reduced because marginal abatement costs are no longer equated among all sources); and (3) nothing is accomplished for the environment, in the sense that there are no additional CO2 emissions reductions (rather, the CO2 emissions reductions are simply relocated among sources under the cap).

Economics, Policy, and Politics

As I concluded in my previous essay, the California Air Resources Board has done an impressive job in its initial design of the rules for its GHG cap-and-trade system.  Of course, there are flaws, and therefore there are areas for improvement. A major issue continues to be the mechanisms used for the initial allocation of allowances.  Because of the economics and politics of this issue, it will not go away.  But, going forward, it would be helpful if those debating this issue could demonstrate better understanding of the allowance allocation’s real – as opposed to fictitious – environmental and economic consequences.


The Real Options for U.S. Climate Policy

The time has not yet come to throw in the towel regarding the possible enactment in 2010 of meaningful economy-wide climate change policy (such as that found in the Waxman-Markey legislation passed by the U.S. House of Representatives in June, 2009, or the more recent Kerry-Lieberman proposal in the Senate).  Meaningful action of some kind is still possible, or at least conceivable.  But with debates regarding national climate change policy becoming more acrimonious in Washington as midterm elections approach, it is important to ask, what are the real options for climate policy in the United States – not only in 2010, but in 2011 and beyond.  That’s the purpose of this essay.

Federal Policy Options

Let’s begin my considering Federal policy options under two distinct categories:  pricing instruments and other approaches.  Carbon-pricing instruments could take the form of caps on the quantity of emissions (cap-and-trade, cap-and-dividend, or baseline-and-credit), or approaches that directly put carbon prices in place (carbon taxes or subsidies).  Beyond pricing instruments, the other approaches include regulation under the Clean Air Act, energy policies not targeted exclusively at climate change, public nuisance litigation, and NIMBY and other public interventions to block permits for new fossil-fuel related investments.  I will discuss each of these in turn.

Quantity-Based Carbon Pricing

I’ve frequently written about cap-and-trade in the past (See, for example:  Here We Go Again: A Closer Look at the Kerry-Lieberman Cap-and-Trade Proposal; Eyes on the Prize:  Federal Climate Policy Should Preempt State and Regional Initiatives; Any Hope for Meaningful U.S. Climate Policy? You be the Judge; Confusion in the Senate Regarding Allowance Allocation?; Cap-and-Trade versus the Alternatives for U.S. Climate Policy; Can Countries Cut Carbon Emissions Without Hurting Economic Growth?; Cap-and-Trade: A Fly in the Ointment? Not Really; National Climate Change Policy: A Quick Look Back at Waxman-Markey and the Road Ahead; Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal; The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey; The Making of a Conventional Wisdom), and so I will be very brief on this instrument in this essay.

A Quick Reminder about Cap-and-Trade

In brief, there are four principal merits of the cap-and-trade approach to achieving significant reductions of carbon dioxide (CO2) emissions.  First, this approach achieves overall targets at minimum aggregate cost, that is, it is cost-effective, both in the short term by allocating responsibility among sources, and in the long term, by providing price signals that will drive technological innovation and diffusion of carbon-friendly technologies.  Second, the allowance allocation under a cap-and-trade system can be used to build a constituency of political support across sectors and geographic areas without driving up the cost of the program or reducing its environmental performance.  Third, we have significant experience in the United States with the use of this approach, including during the 1980s to phase out leaded gasoline from the marketplace, and since the 1990s to cut acid rain by 50 percent.  Fourth, and of great importance, a domestic cap-and-trade system can be linked directly and cost-effectively with cap-and-trade systems and emission-reduction-credit systems in other parts of the world to keep costs down domestically.

Three principal concerns have been voiced about cap-and-trade systems in U.S. debates.  First, while a cap-and-trade system constrains the quantity of emissions, the costs of control are left uncertain (although such cost uncertainty can be limited — if not eliminated — through the use of safety valves, price collars, or related mechanisms).  Second, in the wake of concerns regarding the roll that financial markets played in the global recession, there have been many fears about the possibilities of market manipulation in a cap-and-trade system.  A third concern – in a political context – is that this cost-effective approach to environmental protection, pioneered by the Republican administration of President George H. W. Bush, has – ironically — been demonized by conservatives in current debates.

That said, a variety of pending design issues will need to be addressed in the development of any cap-and-trade system, including:  ambition, scope (suddenly important because of a renewed focus in Washington on the possibility of a utility-only cap), point of regulation in the economy, allowance allocation, the role of offsets, cost-containment mechanisms, international competition protection, and regulatory oversight.  (I’ve written about all of these design issues in previous essays at this blog and elsewhere.)

A Design-Change for Cap-and-Trade?

Does the current political climate call for a design change — or at least a name change — for cap-and-trade?   Both stepwise and sectoral approaches are being considered.  A stepwise approach of beginning with one or a few sectors of the economy and subsequently expanding gradually to an economy-wide program was embodied in both the Waxman-Markey legislation and in the Kerry-Lieberman proposal.  Under a sectoral approach, cap-and-trade would be used for some sectors, but other approaches would be used for other parts of the economy.  To some degree, the Kerry-Lieberman proposal embodies this approach.  The current focus in Washington is on the possibility of using cap-and-trade for the electricity sector only.

Although the politics may argue for a stepwise or sectoral approach, it should be recognized that neither is likely to be cost-effective, because it is highly unlikely that marginal abatement costs will be equated across all sectors of the economy without the use of a single (implicit) price on carbon.

So the potential approach now receiving much attention in Washington of employing a cap-and-trade system in the electricity sector only would — in all likelihood — achieve less in terms of overall emissions reductions, and would not be cost-effective (due to the exclusion of other sectors).  However, it is at least conceivable that will prove to be the best among politically-feasible paths to a better future policy.  That is, of course, a political — not an economic — question.

A Populist Approach?

Populism has emerged as a major theme in recent electoral politics in the United States, both from the left and from the right.  What might be characterized as a populist approach would be a cap-and-trade system with 100% of the allowances auctioned and the auction revenue returned directly “to the people.”  Although this is a standard variant of cap-and-trade design, contemporary politics — with its demonization of the phrase “cap-and-trade” — might well argue for a name change:  how about “cap-and-dividend?”

This approach is embodied in the CLEAR Act of Senators Maria Cantwell (D-Washington) and Susan Collins (R-Maine).  The merits of this approach include its simplicity, appearance of fairness, and related appeal to the populist mood.  Concerns, however, include the proposal’s relatively modest environmental achievements (according to an analysis by the World Resources Institute), its overall cost due to restrictions on trading, and its apparent political infeasibility, given its lack of visible support in the Congress.

Other Trading Mechanisms

In addition to cap-and-trade, the other major type of tradable permit system is an emission-reduction-credit system, or baseline-and-credit system.  Because such approaches lack caps, they raise some well-known concerns, in particular the necessity of comparing actual emissions with what emissions would have been in the absence of the policy.  In such a system, the latter is fundamentally unobserved and unobservable.  This is the problem of “additionality,” which comes up in spades in the case of the Clean Development Mechanism (CDM), but also in the context of most other offset programs.

A related trading mechanism is found in the Clean Energy Standards approach, embodied in Senator Richard Lugar’s (R-Indiana) legislative proposal.  This mechanism is similar to a Renewable Portfolio Standard (RPS), but allows for a broader set of qualified sources;  not only renewables, but also nuclear power, fossil fuel power with carbon capture and storage (CCS), and – in principle — efficient natural gas.  If the clean energy credits are denominated in units of carbon free megawatt hours and are tradable, then the merits of this approach include the flexibility that is provided through trading.  The concerns include the lack of an emissions cap, and the difficulty of expanding this approach to other sectors or linking it with a cap-and-trade system.  However, if the clean energy credits are denominated in emissions per megawatt hour, then the program can more easily be converted to or linked with a cap-and-trade system.

Direct Carbon Pricing

A carbon tax system would be similar in design to an upstream cap-and-trade approach.  There is some real interest in this approach, mainly from academics, and there is also what I would characterize as “strategic interest,” principally from those who recognize that once the focus is on carbon taxes rather than other instruments, political debates will inevitably result in less ambitious targets or, in fact, no policy at all.

Carbon Taxes in Brief

Having said this, the merits of a carbon tax approach compared with cap-and-trade include the fact that cost uncertainty is eliminated with the tax approach (although, of course, there is quantity uncertainty, that is, no emissions cap).  And, I mentioned earlier, the cost uncertainty inherent in a cap-and-trade system can be reduced, if not eliminated, with cost-containment mechanisms such as a price collar.

Another merit of the carbon tax approach is that it would generate substantial revenues (as would a cap-and-trade system in which the allowances are auctioned).  These revenues can be used – in principle – for a variety of worthwhile public purposes, including reducing distortionary taxes, which would serve to lower the overall social cost of the policy.  Third, the tax approach is (at least perceived to be) much simpler than the allowance market that would be generated by a cap-and-trade scheme.

Major concerns regarding carbon taxes are fourfold.  First, despite their social cost-effectiveness, pollution taxes can be more costly to the regulated sector than even a non-cost-effective command-and-control instrument.  Second, unlike cap-and-trade, the tax approach lacks a benign mechanism for building political constituency, and is likely to lead to requests for tax exemptions, and hence a less ambitious policy and possibly a more costly one.  Third, although it is not impossible to link such as system internationally (for purposes of cost containment), it is more challenging to do so than with the quantity based cap-and-trade alternative.  A fourth and final concern is the apparent political infeasibility of this approach, at least currently in the United States.

In this regard, it is important to note that what has frequently been interpreted as hostility to cap-and-trade in the U.S. Senate is actually – on closer inspection — broader hostility to the very notion of carbon pricing (or any climate change policy).  Surely, the political reception to a carbon tax would be even less enthusiastic than the reception that has greeted recent cap-and-trade proposals.

Subsidies:  The Good, the Bad, and the Ugly

If it’s so politically difficult to tax “bad behavior,” how about subsidizing “good behavior?”  The mirror image of a tax is indeed a subsidy, and two potential price-based approaches to achieving greenhouse gas emission reductions are the use of climate-friendly subsidies and the elimination of problematic subsidies that exacerbate the climate problem.

In thinking about climate-friendly subsidies, we should first keep in mind that the Obama economic stimulus package enacted by the Congress includes significant subsidies (and tax credits) for renewables and efficiency upgrades — to the tune of about $80 billion.  A major problem has been that the administration (in particular, the Department of Energy) has been finding it difficult to spend the money fast enough.  Also, some would consider subsidies for biofuels, such as ethanol, as falling within this category of climate-friendly subsidies, but clearly that is a matter of considerable controversy.

Principal among the problematic subsidies – and hence major candidates for reduction or elimination – are subsidies for the development and use of fossil fuels.  According to the Environmental Law Institute, U.S. fossil-fuel subsidies and tax breaks currently amount to $8-$10 billon per year.  At the global level, the International Energy Agency has estimated that such fossil-fuel subsidies now amount to $550 billion annually!  President Obama proposed at the G20 meeting in Pittsburgh in November, 2009, that such subsidies be phased out around the world, and there seemed at the time to be broad-based support for this proposal.  However, it should not be surprising that less than a year later, it now appears that the commitment may be watered down somewhat at the G20 meeting in Toronto this June.

The merit of trying to use climate-friendly subsidies is based on the fact that subsidies affect relative prices, much like taxes do, but are much more politically attractive, since politicians prefer to give out benefits rather than costs to their constituents.  And eliminating problematic subsidies can be economically efficient.

But a major concern of using climate-friendly subsidies is that the funds go not only to marginal units that otherwise would not be taking specific actions, but also to infra-marginal units that are pleased to accept the funds, but whose behavior is unaffected by them.  This means that this approach is relatively costly to the government (and to society at large) for what is accomplished.  And a concern of removing fossil fuel subsidies – particularly in the current political climate of worries about oil imports – is that this can work against so-called “energy security” (some have therefore suggested the addition of an “oil import fee”).

Climate Change Regulation under the Clean Air Act

Regulations of various kinds may soon be forthcoming – and in some cases, will definitely be forthcoming – as a result of the U.S. Supreme Court decision in Massachusetts v. EPA and the Obama administration’s subsequent “endangerment finding” that emissions of carbon dioxide and other greenhouse gases endanger public health and welfare.  This triggered mobile source standards earlier this year, the promulgation of which identified carbon dioxide as a pollutant under the Clean Air Act, thereby initiating a process of using the Clean Air Act for stationary sources as well.

Those new standards are scheduled to begin on January 1, 2011, with or without the so-called “tailoring rule” that would exempt smaller sources.  Among the possible types of regulation that could be forthcoming for stationary sources under the Clean Air Act include:  new source performance standards; performance standards for existing sources (Section 111(d)); and New Source Review with Best Available Control Technology standards under Section 165.

The merits that have been suggested of such regulatory action are that it would be effective in some sectors, and that the threat of such regulation will spur Congress to take action with a more sensible approach, namely, an economy wide cap-and-trade system.

However, regulatory action on carbon dioxide under the Clean Air Act will accomplish relatively little and do so at relatively high cost, compared with carbon pricing.  Also, it is not clear that this threat will force the hand of Congress.  Indeed it is reasonable to ask whether this is a credible threat, or will instead turn out to be counter-productive (when stories about the implementation of inflexible, high-cost regulatory approaches lend ammunition to the staunchest opponents of climate policy).

Furthermore, there is the question of possible preemption.  Although Senator Lisa Murkowski’s (R-Alaska) resolution was defeated in the Senate, Senator Jay Rockefeller’s (D-West Virginia) proposal of a two-year delay of Clean Air Act regulatory action is still pending; and depending upon the outcome of the November elections, there may be a series of further Congressional actions to tie the hands of EPA in this regard.

Regulation of Conventional Pollutants under the Clean Air Act

It’s also possible that air pollution policies for non-greenhouse gas pollutants, the emissions of some of which are highly correlated with CO2 emissions, may play an important role.  For example, the three-pollutant legislation co-sponsored by Senator Thomas Carper (D-Delaware) and Senator Lamar Alexander (R-Tennessee), focused on SOx, NOx, and mercury, could have profound impacts on the construction and operation of coal-fired electricity plants, without any direct CO2 requirements.  Beyond this, there are also possibilities of policies for the non-CO2 greenhouse gases.

Important, Unanswered Questions

An important pending question regarding EPA’s use of the Clean Air Act is whether EPA may legally create CO2 cap-and-trade or offset markets under existing Clean Air Act authority.  The answer appears to be “probably yes.”  There is positive precedent from EPA’s emissions trading program of the 1970s, and it’s a leaded gasoline phase-down of the 1980s, although recent court decisions regarding the Bush administration’s Clean Air Interstate Rule may cause concern in this regard.

The more important question, however, may turn out to be whether EPA can politically create significant CO2 markets in the face of Congressional opposition.  The answer to this is considerably less clear.

Energy Policies Not Targeted Exclusively at Climate Change

The “positive politics” generated by the Gulf oil spill, combined with the “negative politics” of addressing climate change explicitly, may well increase the likelihood of so-called “energy-only” legislation being enacted this year.  Senator Jeff Bingaman’s (D-New Mexico) bill from the Environment and Natural Resources Committee and perhaps Senator Richard Lugar’s bill will feature centrally in any bipartisan initiative.

The possible components of such an approach which would be relevant in the context of climate change include:  a national renewable electricity standard; Federal financing for clean energy projects: energy efficiency measures (building, appliance, and industrial efficiency standards; home retrofit subsidies; and smart grid standards, subsidies, and dynamic pricing policies); and new Federal electricity-transmission siting authority.

Other Legal Mechanisms

Even without action by the Congress or by the Administration, legal action on climate policy is likely to take place within the judicial realmPublic nuisance litigation will no doubt continue, with a diverse set of lawsuits being filed across the country in pursuit of injunctive relief and/or damages.  Due to recent court decisions, the pace, the promise, and the problems of this approach remain uncertain.

Beyond the well-defined area of public nuisance litigation, other interventions which are intended to block permits for new fossil energy investments, including both power plants and transmission lines will continue.  Some of these interventions will be of the conventional NIMBY character, but others will no doubt be more strategic.

Does the Road to National Climate Policy Need to Go through Washington?

With political stalemate in Washington, attention may increasingly turn to regional, state, and even local policies intended to address climate change.  The Regional Greenhouse Gas Initiative (RGGI) in the Northeast has created a cap-and-trade system among electricity generators.  More striking, California’s Global Warming Solutions Act (Assembly Bill 32, or AB 32) will likely lead to the creation of a very ambitious set of climate initiatives, including a statewide cap-and-trade system (unless it’s stopped by ballot initiative or a new Governor, depending on the outcome of the November 2010 elections).  The California system is likely to be linked with systems in other states and Canadian provinces under the Western Climate Initiative.

These sub-national policies will interact in a variety of ways – some good, some bad — with Federal policy when and if Federal policy is enacted.  As Professor Lawrence Goulder (Stanford University) and I have written in a new paper for the National Bureau of Economic Research (NBER), some of these interactions could be problematic, such as the interaction between a Federal cap-and-trade system and a more ambitious cap-and-trade system in California under AB 32, while other interactions would be benign, such as RGGI becoming somewhat irrelevant in the face of a Federal cap-and-trade system that was both more stringent and broader in scope.

An important question is whether there can be sensible sub-national policies even in the presence of an economy-wide Federal carbon-pricing regime?  The answer is surely yes, partly because other market failures will continue to exist that are not addressed by carbon pricing.  A prime example is the principal-agent problem of insufficient energy-efficiency investments in renter-occupied properties, even in the face of high energy prices.  This is a problem that is best addressed at the state or even local level, such as through building codes and zoning.

In the meantime, in the absence of meaningful Federal action, sub-national climate policies could well become the core of national action.  Problems will no doubt arise, including legal obstacles such as possible Federal preemption or litigation associated with the so-called Dormant Commerce Clause.  Also, even a large portfolio of state and regional policies will not be comprehensive of the entire nation, that is, not truly national in scope.  And even if they are nationally comprehensive, with different policies of different stringency in different parts of the country, carbon shadow-prices will by no means be equivalent, and so overall policy objectives will be achieved at excessive social cost.

Is there a solution, if only a partial one?  Yes, state and regional carbon markets can be linked.  Such linkage occurs as a result of bilateral recognition of allowances, which results in reduced costs, price volatility, leakage, and market power.  Such bottom-up linkage of state and regional cap-and-trade systems may be an important part or perhaps the core of future of U.S. climate policy, at least until there is meaningful action at the Federal level.  In the meantime, it is at least conceivable that linkage of state-level cap-and-trade systems across the United States will become the de facto post-2012 national climate policy architecture.

The Path Ahead

Conventional politics clearly disfavors market-based (pricing) environmental policy approaches that render costs obvious or at least somewhat transparent, despite the fact that the costs of these same policies are actually less than those of alternative approaches.  Instead, conventional politics favors approaches to environmental protection that render costs less obvious (or better yet invisible), such as renewable portfolio standards, and — for that matter — all sorts of command-and-control performance and technology standards.

But carbon pricing will be necessary to address the diverse economy-wide sources of CO2 emissions effectively and at sensible cost, whether the carbon pricing comes about through an economy-wide Federal cap-and-trade system or through a Federal carbon tax.  It is inconceivable that truly meaningful reductions in CO2 emissions could be achieved through purely regulatory approaches, and it remains true that whatever would be achieved, would be accomplished at excessively high cost.

So, although it is true – as I have sought to explain in this essay – that there are a diverse set of options for future climate policy in the United States, the best available alternative to an economy-wide cap-and-trade system enacted in 2010 may be an economy-wide cap-and-trade system enacted in 2011.  But ultimately, the question of what is the best alternative this year to an economy-wide cap-and-trade system is a political, not an economic question.


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.