\nlast June, there is now some confusing commentary in the press and
\nblogosphere about the allocation of allowances in the new Senate
\nproposal—the American Power Act of 2010<\/a>—sponsored by Sens. John Kerry<\/a> (D-Mass.) and Joseph Lieberman<\/a> (I-Conn.). As before, the mistake is being made of confusing the share of allowances<\/a> that are
\nfreely allocated versus auctioned with (the appropriate analysis of) the
\n actual incidence of the allowance value, that is,
\n who ultimately benefits from the allocation and auction revenue.<\/p>\n
<\/p>\n
In this essay, I assess quantitatively the actual incidence of the <\/p>\n The American Power Act of 2010<\/strong><\/p>\n <\/p>\n You may be wondering why I am bothering to write about the <\/p>\n The American Power Act, like its House counter-part, is a long and <\/p>\n Before turning to an empirical examination of the Kerry-Lieberman <\/p>\n The role of allowance allocations in cap-and-trade systems<\/strong><\/p>\n <\/p>\n It is exceptionally important to keep in mind what is probably the <\/p>\n Generally speaking, the choice between auctioning and freely <\/p>\n Manifest political pressures lead to different initial allocations of <\/p>\n In fact, the political process of states, districts, sectors, firms, <\/p>\n But, depending upon the specific allocation mechanisms employed, <\/p>\n Some important caveats<\/strong><\/p>\n <\/p>\n First, as I said above, auction revenue may be used in ways that reduce the costs of the existing tax system or fund <\/p>\n Second, some proposals to freely allocate allowances to electric <\/p>\n Third, “output-based updating allocations”<\/a> can be useful <\/p>\n An output-based updating allocation ties the quantity of allowances <\/p>\n This approach is probably superior to an import allowance requirement<\/a>, whereby imports of a <\/p>\n Is the Kerry-Lieberman allowance allocation a corporate give-away?<\/strong><\/p>\n <\/p>\n Perhaps unintentionally, there has been some potentially misleading <\/p>\n Instead, the best way to assess the real implications is not as “free <\/p>\n First, let’s looks at the elements which will accrue to consumers and public purposes<\/strong>. Next to each allocation element is the respective share of allowances I. Cost Containment<\/strong><\/p>\n <\/p>\n a. Auction from cost containment reserve, 3.1 percent<\/p>\n <\/p>\n II. Indirect Assistance to Mitigate Impacts on Energy <\/p>\n b. Electricity local distribution companies, 18.6 percent<\/p>\n <\/p>\n c. Natural gas local distribution companies, 4.1 percent<\/p>\n <\/p>\n d. State programs for home heating oil, propane, and kerosene <\/p>\n III. Direct Assistance to Households and Taxpayers<\/strong><\/p>\n <\/p>\n e. Allowances auctioned to provide tax and energy refunds for <\/p>\n f. Allowances auctioned for universal tax refunds, 22.3 percent<\/p>\n <\/p>\n IV. Other Domestic Priorities<\/strong><\/p>\n <\/p>\n g. State renewable and energy efficiency programs, 0.6 percent<\/p>\n <\/p>\n h. State and local agency programs to reduce emissions through <\/p>\n i. Grants for national surface transportation system, 1.9 percent<\/p>\n <\/p>\n j. Auctioned allowances for Highway Trust Fund, 1.9 percent<\/p>\n <\/p>\n k. Domestic adaptation, 1.0 percent<\/p>\n <\/p>\n l. Rural energy savings (consumer loans to implement energy <\/p>\n V. International Funding<\/strong><\/p>\n <\/p>\n m. International adaptation, 1.0 percent<\/p>\n <\/p>\n VI. Deficit Reduction<\/strong><\/p>\n <\/p>\n n. Allowances auctioned for deficit reduction, 7.4 percent<\/p>\n <\/p>\n o. Remaining allowances auctioned to offset bill’s impact on Next, the following I. Allocations to Covered Entities<\/strong><\/p>\n <\/p>\n a. Energy-intensive, trade-exposed industries, 7.0 percent<\/p>\n <\/p>\n b. Petroleum refiners, 2.2 percent<\/p>\n <\/p>\n c. Merchant coal-fired electricity generators, 2.2 percent<\/p>\n <\/p>\n d. Generators under long-term contracts without cost recovery, 0.9 percent<\/p>\n <\/p>\n II. Technology Funding<\/strong><\/p>\n <\/p>\n e. Carbon capture and sequestration incentives, 3.8 percent<\/p>\n <\/p>\n f. Clean energy technology R&D, 0.7 percent<\/p>\n <\/p>\n g. Low-carbon manufacturing R&D, 0.3 percent<\/p>\n <\/p>\n h. Clean vehicle technology incentives, 0.3 percent<\/p>\n <\/p>\n III. Other Domestic Priorities<\/strong><\/p>\n <\/p>\n i. Manufacturing plant energy efficiency retrofits, 0.1 percent<\/p>\n <\/p>\n j. Compensation for early action emissions reductions prior to cap’s The bottom line? Over the entire period from 2012 to 2050, 82.6 percent of the allowance value goes <\/p>\n Moreover, because some of the allocations to private industry are— <\/p>\n I should also note that some observers (who are skeptical about <\/p>\n Comparing the Kerry-Lieberman 82\/18 split with recommendations from economic analyses<\/strong><\/p>\n <\/p>\n The 82-18 split is roughly consistent with empirical economic <\/p>\n In my work for the Hamilton Project in 2007<\/a>, I <\/p>\n So, the Kerry-Lieberman 82\/18 allowance split (like the 80\/20 Waxman-Markey allowance split<\/a>) turns <\/p>\n The path ahead<\/strong><\/p>\n <\/p>\n Going forward, many observers and participants in the policy process <\/p>\n But let’s be clear that, first, for the most part, the specific <\/p>\n Second, we should recognize that the legislation is by no means a <\/p>\n Finally, it should not be forgotten that the much-lamented Related Links:<\/strong><\/p>\n The American Power Act and California’s AB 32<\/a><\/p>\n Battle of the Carbon Titans<\/a><\/p>\n Big Green and little green clash over the American Power Act<\/a><\/p>\n
\nallowance value in the new Senate proposal, much as I did last year with the House legislation<\/a>. I find
\n(as with Waxman-Markey) that the lion’s share of the allowance value—
\nsome 82 percent—goes to consumers and public purposes, and only 18 percent accrues
\nto covered, private industry. First, however, I place this in context
\nby commenting briefly on the overall Senate proposal, and by examining
\nin generic terms the effects that allowance allocations have—and do
\nnot have—in cap-and-trade systems.<\/p>\n
\nKerry-Lieberman proposal at all, given the conventional wisdom that the
\nlikelihood is very small of achieving the 60 votes necessary in the
\nSenate to pass the legislation (particularly with the withdrawal of
\nSen. Lindsay Graham (R-S.C.) from the former
\n triplet of Senate sponsors). Two reasons. First, conventional wisdoms often turn out to be wrong<\/a> (although I must say that the vote count on Kerry-Lieberman does not
\nlook good, with the current tally according to Environment & Energy
\nDaily being 26 Yes, 11 Probably Yes, 31 Fence Sitters, 10 Probably No,
\nand 22 No). Second, if the conventional wisdom turns out to be correct,
\n and the 60-vote margin proves insurmountable in the current Congress,
\nthen when the Congress returns to this issue—which it inevitably will
\nin the future—among the key starting points for Congressional
\nthinking will be the Waxman-Markey and Kerry-Lieberman proposals.
\nHence, the design issues do matter.<\/p>\n
\ncomplex piece of legislation with many design elements in its
\ncap-and-trade system (which, of course, is not called “cap-and-trade”—but rather “reduction and investment”), and many elements that go well
\nbeyond the cap-and-trade system (sorry, I meant to say the
\n“reduce-and-invest” system). Perhaps in a future essay, I will examine
\nsome of those other elements (wherein there is naturally both good news
\nand bad news), but for today, I am focusing exclusively on the allowance
\n allocation issue, which is of central political importance.<\/p>\n
\nallowance allocation, it may be helpful to recall some generic facts
\nabout the role that allowance allocations play in cap-and-trade systems.<\/p>\n
\nkey attribute of cap-and-trade systems: the particular allocation of
\nthose allowances which are freely distributed has no impact on the
\nequilibrium distribution of allowances (after trading), and therefore no
\n impact on the allocation of emissions (or emissions abatement), the
\ntotal magnitude of emissions, or the aggregate social costs. (There are some caveats<\/a>, about which more below.) By the way, this independence of a cap-and-trade system’s performance
\nfrom the initial allowance allocation was established as far back as
\n1972 by David Montgomery<\/a> in a path-breaking article<\/a> in the Journal of
\nEconomic Theory<\/a> (based upon his 1971 Harvard
\neconomics<\/a> PhD dissertation). It has been validated with empirical evidence<\/a> repeatedly over the years.<\/p>\n
\nallocating allowances does not influence firms’ production and emission
\nreduction decisions (although it’s true that the revenue from auctioned
\nallowances can be used for a variety of public purposes, including
\ncutting distortionary taxes, which can thereby reduce the net cost of
\nthe program). Firms face the same emissions cost regardless of the
\nallocation method. When using an allowance, whether it was received for
\n free or purchased, a firm loses the opportunity to sell that allowance,
\n and thereby recognizes this “opportunity cost” in deciding whether to
\nuse the allowance. Consequently, the allocation choice will not—for
\nthe most part—influence a cap’s overall costs.<\/p>\n
\n allowances, which affect distribution, but not environmental
\neffectiveness, and not cost-effectiveness. This means that ordinary
\npolitical pressures need not get in the way of developing and
\nimplementing a scientifically sound, economically rational, and
\npolitically pragmatic policy. With other policy instruments—both in
\nthe environmental realm and in other policy domains—political
\npressures often reduce the effectiveness and\/or increase the cost of
\nwell-intentioned public policies. Cap-and-trade provides natural
\nprotection from this. Distributional battles over the allowance
\nallocation in a cap-and-trade system do not raise the overall cost of
\nthe program nor affect its environmental impacts.<\/p>\n
\nand interest groups fighting for their share of the pie (free allowance
\nallocations) serves as the mechanism whereby a political constituency in support of
\n the system is developed<\/a>, but without detrimental effects to the
\nsystem’s environmental or economic performance. That’s the good news,
\nand it should never be forgotten.<\/p>\n
\nthere are several ways that the choice to freely distribute allowances
\ncan affect a system’s cost. Here’s where the caveats come in.<\/p>\n
\nother socially beneficial policies<\/a>. Free allocations forego such
\nopportunities.<\/p>\n
\nutilities may affect electricity prices, and thereby affect the extent
\nto which reduced electricity demand<\/a> contributes to limiting
\nemissions cost-effectively. Waxman-Markey and Kerry-Lieberman both
\nallocate a significant number of allowances to local (electricity)
\ndistribution companies, which are subject to cost-of-service regulation
\neven in regions with restructured wholesale electricity markets.
\nBecause the distribution companies are subject to cost-of-service
\nregulation, the benefit of the allocation will ultimately accrue to
\nelectricity consumers, not the companies themselves. While these
\nallocations could increase the overall cost of the program if the
\neconomic value of the allowances is passed on to consumers in the form
\nof reduced electricity prices, if that value is instead passed on to
\nconsumers through lump-sum rebates, the effect can be to compensate consumers for increased electricity prices without
\nreducing incentives for energy conservation. (There are some legitimate
\n behavioral questions here about how consumers will respond to such
\nrebates; these questions are best left to ongoing economic research.)<\/p>\n
\nfor addressing competitiveness impacts<\/a> of a climate policy
\non particularly energy-intensive and trade-sensitive sectors, but
\nthese allocations can provide perverse incentives and drive up the costs
\n of achieving a cap if they are poorly designed. This merits some
\nexplanation.<\/p>\n
\nthat a firm receives to its output (production). Such an allocation is
\nessentially a production subsidy. While this affects firms’ pricing and
\n production decisions in ways that can, in some cases, introduce
\nunintended consequences and increase the cost of meeting an emissions
\ntarget, when applied to energy-intensive trade-exposed industries, the
\nincentives created by such allocations can contribute to the goal of
\nreducing emission leakage abroad.<\/p>\n
\nsmall set of specific commodities must carry with them CO2 allowances, because import allowance requirements can damage
\ninternational trade relations. The only real solution to the
\ncompetitiveness issue is to bring key non-participating countries within
\n an international climate regime in meaningful ways, an obviously
\ndifficult objective to achieve. (On this, please see the work of the Harvard Project on International Climate Agreements<\/a>.)<\/p>\n
\ncoverage on this issue. At first glance, about half of the allowances
\nwould be auctioned and about half freely allocated over the life of the
\nprogram, 2012-2050. (In the early years, the auction share is smaller,
\nreflecting various transitional allocations that phase out over time.) But looking at the shares that are auctioned and freely allocated can be
\n very misleading.<\/p>\n
\n allocation” versus “auction,” but rather in terms of who is the
\nultimate beneficiary of each element of the allocation and auction, that
\n is, how the value of the allowances and auction revenue are
\nallocated. On closer inspection, it turns out that many of the elements
\n of the apparently free allocation accrue to consumers and public
\npurposes, not private industry. Indeed, my conclusion is that over the
\nperiod 2012-2050, less than 18 percent of the allowance value accrues to
\nindustry.<\/p>\n
\nover the period 2012-2050:<\/p>\n
\nConsumers<\/strong><\/p>\n
\nconsumers, 0.9 percent<\/p>\n
\nlow-income households, 11.7 percent<\/p>\n
\ntransportation projects, 1.9 percent<\/p>\n
\nefficiency measures), 0.1 percent<\/p>\n
\ndeficit, 6.1 percent<\/p>\n
\nelements will accrue to private industry<\/strong>, again with
\naverage (2012-2050) shares of allowances:<\/p>\n
\n implementation, 0.1 percent<\/p>\n
\n to consumers and public purposes, and 17.6 percent to private industry<\/strong>. Rounding error brings the total to
\n100.2 percent, so to be conservative, I’ll call this an 82\/18 percent split.<\/p>\n
\nfor better or for worse—conditional on recipients undertaking specific
\n costly investments, such as investments in carbon capture and storage,
\npart of the 18 percent free allocation to private industry should not be viewed
\n as a windfall.<\/p>\n
\ngovernment programs) may reasonably question some of the dedicated
\npublic purposes of the allowance distribution, but such questioning is
\nequivalent to questioning dedicated uses of auction revenues. The
\nfundamental reality remains: The appropriate characterization of the
\nKerry-Lieberman allocation is that about 82 percent of the value of
\nallowances go to consumers and public purposes, and 18 percent to private
\nindustry.<\/p>\n
\nanalyses of the share that would be required—on average—to fully
\ncompensate (but no more) private industry for equity losses due to the
\npolicy’s implementation. In a series of analyses that considered the
\nshare of allowances that would be required in perpetuity for
\nfull compensation, Bovenberg and Goulder (2003) found that 13 percent
\nwould be sufficient for compensation of the fossil fuel extraction
\nsectors, and Smith, Ross, and Montgomery (2002) found that 21 percent
\nwould be needed to compensate primary energy producers and electricity
\ngenerators.<\/p>\n
\nrecommended beginning with a 50-50 auction-free-allocation split, moving
\n to 100 percent auction over 25 years, because that time-path of numerical
\ndivision between the share of allowances that is freely allocated to
\nregulated firms and the share that is auctioned is equivalent (in terms
\nof present discounted value) to perpetual allocations of 15 percent, 19
\npercent, and 22 percent, at real interest rates of 3, 4, and 5 percent,
\nrespectively. My recommended allocation was designed to be consistent
\nwith the principal of targeting free allocations to burdened sectors in
\nproportion to their relative burdens, while being politically pragmatic
\nwith more generous allocations in the early years of the program.<\/p>\n
\nout to be consistent—on average, i.e. economy-wide—with independent
\n economic analysis of the share that would be required to fully
\ncompensate (but no more) the private sector for equity losses due to the
\n imposition of the cap, and consistent with my Hamilton Project
\nrecommendation of a 50\/50 split phased out to 100 percent auction over 25
\nyears.<\/p>\n
\nmay continue to question the wisdom of some elements of the
\nKerry-Lieberman proposal, including its allowance allocation. There’s
\nnothing wrong with that.<\/p>\n
\nallocation of free allowances affects neither the environmental
\nperformance of the cap-and-trade system nor its aggregate social cost.<\/p>\n
\ncorporate give-away. On the contrary, 82% of the value of allowances
\naccrue to consumers and public purposes, and some 18% accrue to covered,
\n private industry. This split is roughly consistent with the
\nrecommendations of independent economic research.<\/p>\n
\ndeal-making for shares of the allowances for various purposes that took
\nplace in the deliberations leading up the announcement by Senators Kerry<\/a> and Lieberman<\/a> was a
\ngood example of the useful, important, and fundamentally benign
\nmechanism through which a cap-and-trade system provides the means for a
\npolitical constituency of support and action to be assembled, without
\nreducing the policy’s effectiveness or driving up its cost.<\/p>\n
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