Letting Cap-and-Trade Work

By Max Epstein
Friday, May 30, 2008

The Climate Security Act to be debated in the Senate next week would establish a cap-and-trade system for greenhouse gases from the manufacturing, transportation and electric power sectors. It would reduce overall carbon emissions by about 66 percent by 2050, a target many say is inadequate. But of more concern now than the ultimate level of reductions should be how efficiently those reductions are pursued: Excessive costs will drain support for the program, while a relatively smooth transition could motivate bigger reductions in the future. Action now on any significant target would also strengthen efforts to secure foreign commitments.

The bill, sponsored by Sens. Barbara Boxer, Joe Lieberman and John Warner, would create a set number of credits, to decline annually, that polluters could purchase to cover emissions. But tens of billions of dollars' worth of these credits also would be given free every year (though declining steadily) through 2030 to covered industries. Eighteen percent of all credits would be given to fossil-fuel electrical plants in 2012, for example, and 15 percent in 2020, with these allowances allocated to the highest historical emitters. During committee debate of the bill, Lieberman defended the free allocations, saying that "if they don't have these transitional allowances . . . power plants are going to charge their customers a lot more money."

Yet this is misleading; in a free market, the allocations would instead result in windfall profits for the companies. A free credit would not be used to produce a product that creates emissions (such as electricity from coal) unless a company could recoup, through higher prices, the money it otherwise could have made by selling the credit. Either way, the additional cost to consumers would be the going market price for a credit. Europe has experienced this with its cap-and-trade program and recently announced plans to end free allocations to electricity generators starting in 2012.

Supporters of the allocations argue that since most power companies must set rates based on cost-of-service regulations, state public utility commissions would ensure that the savings from allocated permits are passed on to consumers through lower rate increases. This reasoning doesn't address the allocations for manufacturers and oil companies, which are not subject to such regulation, or for electricity consumers in deregulated markets. More important, even where such an approach is successful, it would do more harm than good.

The fundamental way a cap-and-trade system achieves emissions reductions is by increasing the price of emissions-intensive goods, thereby curtailing their use. Artificially depressing prices reduces the incentive to conserve, forcing the economy to make more-costly reductions (with concomitant price increases) elsewhere.

Softening the effect of the new regulations on consumers and workers is important, but giving emissions allocations to regulated industries would not help them. In fact, it would hurt them, because the free allocations would reduce the money available for the sensible programs that would be funded by the government's sale of allowances. Such measures include help for workers affected by the legislation (e.g., laid-off coal miners), assistance to states whose economies are reliant on coal or emissions-intensive manufacturing, money for mass transit, and a fund for a future, progressive tax cut or credit to help consumers deal with rising energy prices (a significant but underfunded addition by Sen. Boxer to the legislation). Advanced energy research, ultimately the best way to mitigate price increases over the long term, gets only one-quarter of 1 percent of the funding from the allowances.

The legislation also falls into the trap of attempting to aid consumers by mitigating price increases with another allocation program. Around 10 percent of all credits from 2012 to 2050 would be given to local electricity distribution companies (and about 3 percent to natural gas distribution companies) to ease rate increases, provide rebates and promote energy efficiency. The bill prohibits any rebates "based solely on the quantity of electricity or natural gas used," because that would reduce the incentive to conserve. Yet it also suggests mitigating price increases, which is just such a saving per quantity used and thus also would reduce the incentive to conserve. This could be remedied simply by changing the language in the bill to prescribe lump-sum rebates, which would help cut energy bills but preserve the incentive to turn off the computer at night.

Lawmakers should focus more on lessening the effects of price increases instead of trying to mitigate the price increases themselves, since such increases are an inevitable, even necessary, part of cap-and-trade.

If more allowances were sold, they would create revenue to fund progressive cuts in personal income taxes that would help consumers afford higher prices, as well as cuts in corporate income taxes to help producers free up funds to invest as the new market demands.

But these funds are squandered when credits are given away to the industries subject to the cap. Depending on the criteria for their allocation, these allowances become perverse incentives or, at best, pure waste.

The writer is a student at the University of Maryland. His e-mail address ismepstein@umd.edu.

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