by Robert Stavins
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 Sens. John Kerry (D-Mass.) and Joseph Lieberman (I-Conn.). 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 percent—goes to consumers and public purposes, and only 18 percent 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
Sen. Lindsay Graham (R-S.C.) 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 PhD 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 percent 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 percent
II. Indirect Assistance to Mitigate Impacts on Energy
Consumers
b. Electricity local distribution companies, 18.6 percent
c. Natural gas local distribution companies, 4.1 percent
d. State programs for home heating oil, propane, and kerosene
consumers, 0.9 percent
III. Direct Assistance to Households and Taxpayers
e. Allowances auctioned to provide tax and energy refunds for
low-income households, 11.7 percent
f. Allowances auctioned for universal tax refunds, 22.3 percent
IV. Other Domestic Priorities
g. State renewable and energy efficiency programs, 0.6 percent
h. State and local agency programs to reduce emissions through
transportation projects, 1.9 percent
i. Grants for national surface transportation system, 1.9 percent
j. Auctioned allowances for Highway Trust Fund, 1.9 percent
k. Domestic adaptation, 1.0 percent
l. Rural energy savings (consumer loans to implement energy
efficiency measures), 0.1 percent
V. International Funding
m. International adaptation, 1.0 percent
VI. Deficit Reduction
n. Allowances auctioned for deficit reduction, 7.4 percent
o. Remaining allowances auctioned to offset bill’s impact on
deficit, 6.1 percent
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 percent
b. Petroleum refiners, 2.2 percent
c. Merchant coal-fired electricity generators, 2.2 percent
d. Generators under long-term contracts without cost recovery, 0.9 percent
II. Technology Funding
e. Carbon capture and sequestration incentives, 3.8 percent
f. Clean energy technology R&D, 0.7 percent
g. Low-carbon manufacturing R&D, 0.3 percent
h. Clean vehicle technology incentives, 0.3 percent
III. Other Domestic Priorities
i. Manufacturing plant energy efficiency retrofits, 0.1 percent
j. Compensation for early action emissions reductions prior to cap’s
implementation, 0.1 percent
The bottom line? Over the entire period from 2012 to 2050, 82.6 percent of the allowance value goes
to consumers and public purposes, and 17.6 percent to private industry. Rounding error brings the total to
100.2 percent, so to be conservative, I’ll call this an 82/18 percent 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 percent 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 percent of the value of
allowances go to consumers and public purposes, and 18 percent 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 percent 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 percent 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.
Related Links:
The American Power Act and California’s AB 32
Battle of the Carbon Titans
Big Green and little green clash over the American Power Act
A source at 
