{"id":582736,"date":"2010-05-28T09:49:43","date_gmt":"2010-05-28T13:49:43","guid":{"rendered":"http:\/\/climateprogress.org\/?p=25453"},"modified":"2010-05-28T09:49:43","modified_gmt":"2010-05-28T13:49:43","slug":"stavins-on-senate-climate-bill-%e2%80%9c82-of-the-value-of-allowances-accrue-to-consumers-and-public-purposes-and-some-18-accrue-to-covered-private-industry-%e2%80%9d","status":"publish","type":"post","link":"https:\/\/mereja.media\/index\/582736","title":{"rendered":"Stavins on Senate climate bill: \u201c82% of the value of allowances accrue to consumers and public purposes, and some 18% accrue to covered, private industry.\u201d"},"content":{"rendered":"

Harvard economist\u00a0Robert Stavins analyzes the <\/em>American Power Act’s <\/em>allowance distribution in this repost<\/a><\/em>.\u00a0 Here are his main conclusions:
\n<\/em><\/p>\n

<\/span><\/p>\n

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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.\u00a0 There\u2019s nothing wrong with that.<\/p>\n

But let\u2019s 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.<\/strong><\/p>\n

Second, we should recognize that the legislation is by no means a corporate give-away.\u00a0 On the contrary, 82% of the value of allowances accrue to consumers and public purposes, and some 18% accrue to covered, private industry.\u00a0 This split is roughly consistent with the recommendations of independent economic research.<\/strong><\/p>\n

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<\/a>Lieberman<\/a> 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\u2019s effectiveness or driving up its cost<\/strong><\/p>\n<\/blockquote>\n

[JR:\u00a0 What follows is Stavins’ full analysis<\/a> <\/em>from Harvard\u2019s Belfer Center for Science and International Relations Blog<\/em>.]<\/em><\/p>\n

As with the Waxman-Markey bill<\/a> (H.R. 2454<\/a>), 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 \u2014 the American Power Act of 2010<\/a> \u2014 sponsored by Senator John Kerry<\/a>, Democrat of Massachusetts, and Senator Joseph Lieberman<\/a>, Independent of Connecticut.\u00a0 As before, the mistake is being made of confusing the share<\/em> of allowances that are freely allocated versus auctioned with (the appropriate analysis of) the actual incidence<\/em> of the allowance value<\/em>,<\/a> that is, who ultimately benefits from the allocation and auction revenue.<\/p>\n

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<\/a>.\u00a0 I find (as with Waxman-Markey) that the lion\u2019s share of the allowance value \u2014 some 82% \u2014 goes to consumers and public purposes, and only 18% accrues to covered, private industry. \u00a0 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 \u2014 and do not have \u2014 in cap-and-trade systems.<\/p>\n

The American Power Act of 2010<\/strong><\/p>\n

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 \u2014 Republican of South Carolina \u2014 from the former triplet of Senate sponsors).\u00a0 Two reasons.\u00a0 First, conventional wisdoms often turn out to be wrong<\/a> (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).\u00a0 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 \u2014 which it inevitably will in the future\u00a0 \u2014 among the key starting points for Congressional thinking will be the Waxman-Markey and Kerry-Lieberman proposals.\u00a0 Hence, the design issues do matter.<\/p>\n

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 \u201ccap-and-trade\u201d \u2014 but rather \u201creduction and investment\u201d), and many elements that go well beyond the cap-and-trade system (sorry, I meant to say the \u201creduce-and-invest\u201d system).\u00a0 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.<\/p>\n

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.<\/p>\n

The Role of Allowance Allocations in Cap-and-Trade Systems<\/h4>\n

It is exceptionally important to keep in mind what is probably the key attribute of cap-and-trade systems:\u00a0 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.\u00a0 (There are some caveats<\/a>, about which more below.)\u00a0 By the way, this independence of a cap-and-trade system\u2019s performance from the initial allowance allocation was established as far back as 1972 by David Montgomery<\/a> in a path-breaking article<\/a> in the Journal of Economic Theory<\/a> <\/em>(based upon his 1971 Harvard economics<\/a> Ph.D. dissertation). <\/em>It has been validated with empirical evidence<\/a> repeatedly over the years.<\/p>\n

Generally speaking, the choice between auctioning and freely allocating allowances does not influence firms\u2019 production and emission reduction decisions (although it\u2019s 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).\u00a0 Firms face the same emissions cost regardless of the allocation method.\u00a0 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 \u201copportunity cost\u201d in deciding whether to use the allowance.\u00a0 Consequently, the allocation choice will not \u2014 for the most part \u2014 influence a cap\u2019s overall costs.<\/p>\n

Manifest political pressures lead to different initial allocations of allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.\u00a0 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.\u00a0\u00a0 With other policy instruments \u2014 both in the environmental realm and in other policy domains \u2014 political pressures often reduce the effectiveness and\/or increase the cost of well-intentioned public policies.\u00a0 Cap-and-trade provides natural protection from this.\u00a0 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.<\/p>\n

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<\/a>, but without detrimental effects to the system\u2019s environmental or economic performance.\u00a0 That\u2019s the good news, and it should never be forgotten.<\/p>\n

But, depending upon the specific allocation mechanisms employed, there are several ways that the choice to freely distribute allowances can affect a system\u2019s cost.\u00a0 Here\u2019s where the caveats come in.<\/p>\n

Some Important Caveats<\/h4>\n

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<\/a>.\u00a0 Free allocations forego such opportunities.<\/p>\n

Second, some proposals to freely allocate allowances to electric utilities may affect electricity prices, and thereby affect the extent to which reduced electricity demand<\/a> contributes to limiting emissions cost-effectively.\u00a0 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.\u00a0 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.\u00a0 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<\/em>, the effect can be<\/em> to compensate consumers for increased electricity prices without reducing incentives for energy conservation.\u00a0 (There are some legitimate behavioral questions here about how consumers will respond to such rebates; these questions are best left to ongoing economic research.)<\/p>\n

Third, \u201coutput-based updating allocations\u201d<\/a> can be useful for addressing competitiveness impacts of a climate policy on particularly energy-intensive and trade-sensitive sectors<\/a>, but these allocations can provide perverse incentives and drive up the costs of achieving a cap if they are poorly designed.\u00a0 This merits some explanation.<\/p>\n

An output-based updating allocation ties the quantity of allowances that a firm receives to its output (production).\u00a0 Such an allocation is essentially a production subsidy.\u00a0 While this affects firms\u2019 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.<\/p>\n

This approach is probably superior to an import allowance requirement<\/a>, whereby imports of a small set of specific commodities must carry with them CO2<\/sub> allowances, because import allowance requirements can damage international trade relations.\u00a0 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.\u00a0 (On this, please see the work of the Harvard Project on International Climate Agreements<\/a>.)<\/p>\n

Is the Kerry-Lieberman Allowance Allocation a Corporate Give-Away?<\/h4>\n

Perhaps unintentionally, there has been some potentially misleading coverage on this issue.\u00a0 At first glance, about half of the allowances would be auctioned and about half freely allocated over the life of the program, 2012-2050.\u00a0 (In the early years, the auction share is smaller, reflecting various transitional allocations that phase out over time.)\u00a0 But looking at the shares that are auctioned and freely allocated can be very misleading.<\/p>\n

Instead, the best way to assess the real implications is not as \u201cfree allocation\u201d versus \u201cauction,\u201d but rather in terms of who is the ultimate beneficiary of each element of the allocation and auction, that is, how the value<\/em> of the allowances and auction revenue are allocated.\u00a0 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.\u00a0 Indeed, my conclusion is that over the period 2012-2050, less than 18% of the allowance value accrues to industry.<\/p>\n

First, let\u2019s looks at the elements which will accrue to consumers and public purposes<\/span><\/strong>.\u00a0 Next to each allocation element is the respective share of allowances over the period 2012-2050:<\/p>\n

\n

I.\u00a0 Cost Containment<\/strong><\/p>\n

a.\u00a0 Auction from cost containment reserve, 3.1%<\/p>\n

II.\u00a0 Indirect Assistance to Mitigate Impacts on Energy Consumers<\/strong><\/p>\n

b.\u00a0 Electricity local distribution companies, 18.6%<\/p>\n

c.\u00a0 Natural gas local distribution companies, 4.1%<\/p>\n

d.\u00a0 State programs for home heating oil, propane, and kerosene consumers, 0.9%<\/p>\n

III.\u00a0 Direct Assistance to Households and Taxpayers<\/strong><\/p>\n

e.\u00a0 Allowances auctioned to provide tax and energy refunds for low-income households, 11.7%<\/p>\n

f.\u00a0 Allowances auctioned for universal tax refunds, 22.3%<\/p>\n

IV.\u00a0 Other Domestic Priorities<\/strong><\/p>\n

g.\u00a0 State renewable and energy efficiency programs, 0.6%<\/p>\n

h.\u00a0 State and local agency programs to reduce emissions through transportation projects, 1.9%<\/p>\n

i.\u00a0 Grants for national surface transportation system, 1.9%<\/p>\n

j.\u00a0 Auctioned allowances for Highway Trust Fund, 1.9%<\/p>\n

k.\u00a0 Domestic adaptation, 1.0%<\/p>\n

l.\u00a0 Rural energy savings (consumer loans to implement energy efficiency measures), 0.1%<\/p>\n

V.\u00a0 International Funding<\/strong><\/p>\n

m.\u00a0 International adaptation, 1.0%<\/p>\n

VI.\u00a0 Deficit Reduction<\/strong><\/p>\n

n.\u00a0 Allowances auctioned for deficit reduction, 7.4%<\/p>\n

o.\u00a0 Remaining allowances auctioned to offset bill\u2019s impact on deficit, 6.1%<\/p>\n

Next, the following elements will accrue to private industry<\/strong><\/span>, again with average (2012-2050) shares of allowances:<\/p>\n

I.\u00a0 Allocations to Covered Entities<\/strong><\/p>\n

a.\u00a0 Energy-intensive, trade-exposed industries, 7.0%<\/p>\n

b.\u00a0 Petroleum refiners, 2.2%<\/p>\n

c.\u00a0 Merchant coal-fired electricity generators, 2.2%<\/p>\n

d.\u00a0 Generators under long-term contracts without cost recovery, 0.9%<\/p>\n

II.\u00a0 Technology Funding<\/strong><\/p>\n

e.\u00a0 Carbon capture and sequestration incentives, 3.8%<\/p>\n

f.\u00a0 Clean energy technology R&D, 0.7%<\/p>\n

g.\u00a0 Low-carbon manufacturing R&D, 0.3%<\/p>\n

h.\u00a0 Clean vehicle technology incentives, 0.3%<\/p>\n

III.\u00a0 Other Domestic Priorities<\/strong><\/p>\n

i.\u00a0 Manufacturing plant energy efficiency retrofits, 0.1%<\/p>\n

j.\u00a0 Compensation for early action emissions reductions prior to cap\u2019s implementation, 0.1%<\/p>\n<\/blockquote>\n

The bottom line?\u00a0 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<\/strong>. Rounding error brings the total to 100.2%, so to be conservative, I\u2019ll call this an 82%\/18% split.<\/span>
\n<\/span><\/p>\n

Moreover, because some of the allocations to private industry are \u2013 for better or for worse \u2013 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.<\/p>\n

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.\u00a0 The fundamental reality remains:\u00a0 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<\/em>.<\/p>\n

Comparing the Kerry-Lieberman 82\/18 Split with Recommendations from Economic Analyses<\/h4>\n

The 82-18 split is roughly consistent with empirical economic analyses of the share that would be required \u2013 on average \u2014 to fully compensate (but no more) private industry for equity losses due to the policy\u2019s implementation.\u00a0 In a series of analyses that considered the share of allowances that would be required in perpetuity<\/em> 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.<\/p>\n

In my work for the Hamilton Project in 2007<\/a>, 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.\u00a0 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.<\/p>\n

So, the Kerry-Lieberman 82\/18 allowance split (like the 80\/20 Waxman-Markey allowance split<\/a>) turns out to be consistent\u00a0 \u2014 on average, i.e. economy-wide \u2014 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.<\/p>\n

The Path Ahead<\/h4>\n

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.\u00a0 There\u2019s nothing wrong with that.<\/p>\n

But let\u2019s 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.<\/strong><\/p>\n

Second, we should recognize that the legislation is by no means a corporate give-away.\u00a0 On the contrary, 82% of the value of allowances accrue to consumers and public purposes, and some 18% accrue to covered, private industry.\u00a0 This split is roughly consistent with the recommendations of independent economic research.<\/strong><\/p>\n

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<\/a>Lieberman<\/a> 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\u2019s effectiveness or driving up its cost.<\/strong><\/p>\n

–<\/em> <\/em><\/em>Robert N. Stavins<\/a> is the Albert Pratt Professor of Business and Government, Director of the Harvard Environmental Economics Program, and Chairman of the Environment and Natural Resources Faculty Group.<\/em><\/p>\n

Related posts:<\/p>\n