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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.

Any Hope for Meaningful U.S. Climate Policy? You be the Judge.

The current conventional wisdom – broadly echoed by the news media and the blogosphere – is that comprehensive, economy-wide CO₂ cap-and-trade legislation is dead in the current U.S. Congress, and perhaps for the next several years.

Watch out for conventional wisdoms! They inevitably appear to be the collective judgment of numerous well-informed observers and sources, but frequently they are little more than the massive repetition of a few sample points of opinion across the echo-chamber of the professional news media and the blogosphere.

Keep in mind that the conventional wisdom as recently as June of 2009 had it that – with the Waxman-Markey bill having been passed triumphantly by the House of Representatives – Senate action would follow; the only question raised by many commentators was whether the final legislation could be sent to the President for his signature by the time of the Copenhagen climate talks in December. My, how the conventional wisdom has changed!

But over the past nine months, the politics have not fundamentally changed. In June of 2009, passage of meaningful climate legislation in the Senate was already unlikely, because of the terrible economic recession in which the country found itself, and – of even greater political salience – lingering high rates of unemployment. And with the lack of Republican support for the stimulus bill, the relatively small (partisan) margin by which the House passed Waxman-Markey, the then-upcoming challenges of health care and financial regulatory reform dominating the legislative calendar, and concerns voiced about climate legislation by moderate Senate Democrats, success in the Senate was always a long-shot.

What is the Likely Legislative Outcome?

In addition to ongoing consideration of an economy-wide cap-and-trade system, another possibility now receiving attention is a utility-only cap-and-trade system, which some members of the Congress inexplicably find more attractive than an economy-wide approach. The result of such a system would be much less accomplished (forget about the President’s “conditional commitment” under the Copenhagen Accord), and at much greater cost. This would be equivalent to taking the Northeast’s Regional Greenhouse Gas Initiative (RGGI) as a model for national action. Not a good idea.

Even more likely is that the Congress would develop a so-called energy-only bill, which would – to a large degree – consist of killing the one part of Waxman-Markey worth saving (the comprehensive CO₂ cap-and-trade system), and moving forward with the worst parts of that legislation – the smorgasbord of regulatory initiatives. As I’ve written previously, those additional elements of the legislation are highly problematic. When implemented under the cap-and-trade umbrella, many of those conventional standards and subsidies would have no net greenhouse-gas-reducing benefits, would limit flexibility, and would thereby have the unintended consequence of driving up compliance costs. That’s the soft under‑belly of the House legislation.

Without the cap-and-trade umbrella, that same set of standards and subsidies will accomplish very little, and do so at exceedingly high cost. Take just one example that seems to be popular among politicians – “renewable portfolio standards” (RPS), requirements that all states or all electricity utilities derive some fixed share of their power, say 20%, from renewable sources. Note, for example, that such an approach does not distinguish between coal and natural gas, despite the dramatically different impacts these fuels have on CO₂ emissions (and a host of other environmental outcomes). Furthermore, although an RPS may displace some new coal-fired generation with other types of generation, there is little, if any, effect on the operation of existing coal-fired power plants.

If those other, regulatory parts of the climate legislation are so ineffective and so costly, why are they so popular with politicians? The reason is simple. The costs are hidden. The government simply mandates that electric utilities or manufacturers take particular actions, employing the best technology available. Where’s the cost? Unlike a cap-and-trade system, there’s no analysis and debate about the cost of allowances (and the marginal abatement costs they represent); and unlike a carbon tax, there’s no analysis and no focus on the dollar amount of the tax and the aggregate cost. That is the unfortunate but fundamental political economy behind much of U.S. environmental policy since the first Earth Day in 1970.

What about Court-Ordered Regulation?

Whether “best-available-control technology standards” are crafted by the Congress or put in place by the Environmental Protection Agency (EPA) under the court-ordered mandate stemming from the Supreme Court decision in Massachusetts v. EPA and the Obama administration’s subsequent “endangerment finding,” such an approach will be relatively ineffective and terribly costly for what is accomplished. The EPA route would essentially apply the mechanisms of the Clean Air Act, intended for localized, “criteria air pollutants,” to CO₂, resulting in ineffective and costly regulations.

The White House (and most member of Congress) recognize that this is an inappropriate way to address climate change, but they seem determined to go forward, claiming that this threat will force the hand of Congress to do something more sensible instead. Unfortunately, this is akin to my telling you that if you don’t do what I want, I will shoot myself in the foot – not a very credible or intelligent threat. What I am referring to is that costly Clean Air Act regulation of CO₂ will play into the hands of right-wing opponents of climate action, creating a poster-child of excessive regulatory intervention that will bring about a backlash against sensible climate policies. EPA claims that there will be no such excessive regulatory actions, because it will exempt small sources through a so-called “tailoring rule.” But legal scholars have noted that the tailoring rule stands on questionable legal grounds and could be invalidated by the courts. In this regard, note that the first lawsuits to stop EPA from exempting small sources are coming from groups on the right, not the left.

Perhaps Senator Murkowski’s proposed joint resolution (H.J. Res. 66), introduced on January 21, 2010, disapproving (stopping) EPA’s regulatory action under the endangerment finding could save the Administration. The conventional wisdom is that Senator Murkowski’s resolution has no political future, but with a bi-partisan list of 40 co-sponsors, that’s a total of 41 votes (more than the current total of 40 “Yes” and “Probably Yes” votes in the Senate for serious climate legislation, according to Environment and Energy Daily). And remember that the disapproval resolution requires only 51, not 60 votes in the Senate, under the rules of the enabling statute, the Congressional Review Act of 1996 (signed by President Clinton, and part of the Republican “Contract with America”). Of course, House action, not to mention signature by President Obama, would also be required for the resolution to take effect. But a positive vote in the Senate will send a strong political message.

So Is There No Hope for Good Climate Policy?

Here is where it gets interesting, because as much as the current political environment in Washington may seem increasingly unreceptive to an economy-wide cap-and-trade system or some other meaningful and sensible climate policy, there is one promising approach that could actually benefit from the national political climate.

In these pages, I have expressed support for cap-and-trade mechanisms to address climate change, including the system embodied in the Waxman-Markey legislation that emerged from the House in June of last year. Although that approach is scientifically sound, economically sensible, and may still turn out to be politically acceptable, there’s a modified version of cap-and-trade that could be much more attractive in this era of rampant expressions of populism, coming both from the right (“no new taxes”) and the left (“bash the corporations”). Neither of those views, of course, is consistent with sound economic thinking on the environment, but it’s nevertheless possible to recognize their national appeal and build upon them.

This could be done with a simple upstream cap-and-trade system in which all of the needed allowances are sold (auctioned) – not given freely – to fossil-fuel producers and importers, and a very large share – say 75% – of the revenue is rebated directly to American households through monthly checks in a progressive scheme through which all individuals receive identical payments.

Such an approach could appeal to the populist sentiments that are increasingly dominating political discourse and judgments in this mid-term election year. Such a system – which would have direct and visible positive financial consequences (i.e., rebate checks larger than energy price increases) for 80% of American households – might not only not be difficult for politicians to support, but it might actually be difficult for politicians to oppose!

Importantly, even though this is a specific type of cap-and-trade design (which has been known, studied, and proposed for decades), for better political optics, it should be called something else. How about “cap-and-dividend?”

A CLEAR Answer?

What I’ve described bears a close resemblance to the “Carbon Limits and Energy for America’s Renewal (CLEAR) Act,” sponsored by Senators Maria Cantwell (D-Washington) and Susan Collins (R-Maine). So, the politics of their proposal looks appealing, and the substance of it looks promising – a simple upstream cap-and-trade system (called something else), with 100% of the allowances auctioned (with a “price collar” on allowance prices to reduce cost uncertainty), 75% of the revenue refunded to all legal U.S. residents, each month, on an equal per capita basis as non-taxable income, the other 25% of the revenue dedicated to specified purposes, including “transition assistance,” and some built-in measures of protection for particularly energy-intensive, trade-sensitive sectors (not unlike Waxman-Markey).

That’s the good news. The bad news, however, is that the proposal needs to be changed before it can promise to be not only politically attractive, but economically and environmentally sensible. In particular, as it is currently structured, only producers and importers of fossil fuels can buy the carbon allowances. In an up-stream system – an approach I have endorsed for years – it is producers and importers that are subject to compliance, that is, must eventually hold the allowances. That’s fine. But there is no sound reason to exclude other entities from participating in the auction markets; and doing so will greatly reduce market liquidity.

Furthermore, the Senators’ proposal says that holders of carbon allowances are actually prohibited from creating, selling, purchasing, or trading carbon derivatives, thereby tremendously reducing the efficiency of the market and needlessly driving up costs. While no doubt borne out of a well-intentioned desire to protect consumers (remembering the recent impacts of mortgage-backed securities on financial markets), the Senators’ approach is akin to responding to a tragic airplane crash by concluding that the best way to protect consumers from air disasters in the future is simply to ban flying.

Less important structurally, but most important environmentally, an analysis by the World Resources Institute (which I have not validated) indicates that the caps – as currently set – would not bring about emissions reductions by 2020 that would even come close to the President’s announced goal of 17% reductions (equivalent to the Waxman-Markey targets), as submitted by the United States under the Copenhagen Accord.

But these and other problems with the CLEAR proposal can – in principle – be addressed while maintaining its basic structure and political attraction.

An Economic Perspective

It is interesting to note that many – perhaps most – economists have long favored the variant of cap-and-trade whereby allowances are auctioned and the auction revenue is used to cut distortionary taxes (on capital and/or labor), thereby reducing the net social cost of the policy. Cap-and-Dividend moves in another direction. This system (which was introduced several years ago in the “Sky Trust” proposal) has some merits compared with the economist’s favorite approach of tax cuts, namely that the Cap-and-Dividend scheme addresses some of the distributional issues that would be raised by using the auction revenue to fund tax cuts (which could favor higher income households). On the other hand, it eliminates the efficiency (cost-effectiveness) gains associated with the tax-cut approach. In fact, Stanford’s Larry Goulder has estimated that the tax-and-dividend approach would cost 40% more than an approach of combining an auction of allowances with ideal income tax rate cuts. (By “ideal,” I mean focusing on tax cuts that would lead to the lowest net cost.)

In general, there are sound reasons to seek to compensate consumers for the energy price increases that will be brought about by a cap-and-trade system, or any meaningful climate change policy. But it is important not to insulate consumers from those price increases, as diluting the price signal reduces the effectiveness and drives up the cost of the overall policy. Thus, “compensation” as in Cap-and-Dividend is fine, but “insulation” is not.

The most politically salient question with the Waxman-Markey approach of freely allocating a significant portion of the allowances to the private sector is how to distribute (that is, who gets) those allowances which are freely allocated. In this regard, contrary to much of the hand-wringing in the press, the deal-making that took place in the House and may still take place in the Senate for shares of free allowances is an example of the useful and important 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.

The ultimate political question seems to be whether there is greater (geographic and sectoral) political support for the Waxman-Markey (H.R. 2454) approach of substantial free allocations and targeted use of auction revenue, or if there is greater (populist) political support for the full auction combined with lump-sum rebate which characterizes the “cap-and-dividend” approach. Alas, the textbook economics preference — full auction combined with cuts of distortionary taxes — appears to be a political, if not academic, orphan.

The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey

The headline of this post is not meant to be ironic. Despite all the hand-wringing in the press and the blogosphere about a political “give-away” of allowances for the cap-and-trade system in the Waxman-Markey bill voted out of committee last week, the politics of cap-and-trade systems are truly quite wonderful, which is why these systems have been used, and used successfully.

The Waxman-Markey allocation of allowances has its problems, which I will get to, but before noting those problems it is exceptionally important to keep in mind what is probably the key attribute of cap-and-trade systems: the allocation of allowances – whether the allowances are auctioned or given out freely, and how they are freely allocated – 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. (Well, there are some relatively minor, but significant caveats – those “problems” I mentioned — 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. 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 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. Contrast this with what would happen when political pressures are brought to bear on a carbon tax proposal, for example. Here the result will most likely be exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs (as some low-cost emission reduction opportunities are left off the table). Furthermore, the hypothetical carbon tax example is the norm, not the exception. Across the board, political pressures often reduce the effectiveness and 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” and “problems” come in.

First, auction revenue may be used in ways that reduce the costs of the existing tax system or fund other socially beneficial policies. Free allocations to the private sector forego such opportunities. Below I will estimate the actual share of allowance value that accrues to the private sector.

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 allocates allowances to local distribution companies, which are subject to cost-of-service regulation even in regions with restructured wholesale electricity markets. So, electricity prices would likely be affected by these allocations under existing state regulatory regimes. The Waxman-Markey legislation seeks to address this problem by specifying that the economic value of the allowances given to electricity and natural gas local distribution companies should be passed on to consumers through lump-sum rebates, not through a reduction in electricity rates, thereby compensating consumers for increases in electricity prices, but without reducing incentives for energy conservation.

Third, and of most concern in the context of the Waxman-Markey legislation, “output-based updating allocations” provide perverse incentives and drive up costs of achieving a cap. This merits some explanation. If allowances are freely allocated, the allocation should be on the basis of some historical measures, such as output or emissions in a (previous) base year, not on the basis of measures which firms can affect, such as output or emissions in the current year. Updating allocations, which involve periodically adjusting allocations over time to reflect changes in firms’ operations, contrast with this.

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. This distorts firms’ pricing and production decisions in ways that can introduce unintended consequences and may significantly increase the cost of meeting an emissions target. Updating therefore has the potential to create perverse, undesirable incentives.

In Waxman-Markey, updating allocations are used for specific sectors with high CO₂ emissions intensity and unusual sensitivity to international competition, in an effort to preserve international competitiveness and reduce emissions leakage. It’s an open question whether this approach is superior to an import allowance requirement, whereby imports of a small set of specific commodities must carry with them CO₂ allowances. The problem with import allowance requirements is that they can damage international trade relations. The only real solution to the competitiveness issue is to bring non-participating countries within an international climate regime in meaningful ways. (On this, please see the work of the Harvard Project on International Climate Agreements.)

Also, output-based allocations are used in Waxman-Markey for merchant coal generators, thereby discouraging reductions in coal-fired electricity generation, another significant and costly distortion.

Now, let’s go back to the hand-wringing in the press and blogosphere about the so-called massive political “give-away” of allowances. Perhaps unintentionally, there has been some misleading press coverage, suggesting that up to 75% or 80% of the allowances are given away to private industry as a windfall over the life of the program, 2012-2050 (in contrast with the 100% auction originally favored by President Obama).

Given the nature of the allowance allocation in the Waxman-Markey legislation, the best way to assess its 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 is 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.

First of all, 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 (measured as share of the cap, after the removal – sale — of allowances to private industry from a “strategic reserve,” which functions as a cost-containment measure.):

a. Electricity and natural gas local distribution companies (22.2%), minus share (6%) that benefits industry as consumers of electricity (note: there is a consequent 3% reduction in the allocation to energy-intensive trade-exposed industries, below, which is then dedicated to broad-based consumer rebates, below), 22.2 – 6 = 16.2%

b. Home heating oil/propane, 0.9%

c. Protection for low- and moderate-income households, 15.0%

d. Worker assistance and job training, 0.8%

e. States for renewable energy, efficiency, and building codes, 5.8%

f. Clean energy innovation centers, 1.0%

g. International deforestation, clean technology, and adaptation, 8.7%

h. Domestic adaptation, 5.0%

The following elements will accrue to private industry, again with average (2012-2050) shares of allowances:

i. Merchant coal generators, 3.0%

j. Energy-intensive, trade-exposed industries (minus reduction in allocation due to EITE benefits from LDC allocation above) 8.0% – 3% = 5%

k. Carbon-capture and storage incentives, 4.1%

l. Clean vehicle technology standards, 1.0%

m. Oil refiners, 1.0%

n. Net benefits to industry as consumers of lower-priced electricity from allocation to LDCs, 6.0%

The split over the entire period from 2012 to 2050 is 53.4% for consumers and public purposes, and 20.1% for private industry. This 20% is drastically different from the suggestions that 70%, 80%, or more of the allowances will be given freely to private industry in a “massive corporate give-away.”

All categories – (a) through (n), above – sum to 73.5% of the total quantity of allowances over the period 2012-2050. The remaining allowances — 26.5% over 2012 to 2050 — are scheduled in Waxman-Markey to be used almost entirely for consumer rebates, with the share of available allowances for this purpose rising from approximately 10% in 2025 to more than 50% by 2050. Thus, the totals become 79.9% for consumers and public purposes versus 20.1% for private industry, or approximately 80% versus 20% — the opposite of the “80% free allowance corporate give-away” featured in many press and blogosphere accounts. 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 20% free allocation to private industry should not be viewed as a windfall.

Speaking of the conditional allocations, 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 Waxman-Markey allocation is that 80% of the value of allowances go to consumers and public purposes, and 20% to private industry.

Finally, it should be noted that this 80-20 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 Waxman-Markey 80/20 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.

Going forward, many observers and participants in the policy process may continue to question the wisdom of some elements of the Waxman-Markey allowance allocation. There’s nothing wrong with that.

But let’s be clear that, first, for the most part, the allocation of allowances affects neither the environmental performance of the cap-and-trade system nor its aggregate social cost.

Second, questioning should continue about the output-based allocation elements, because of the perverse incentives they put in place.

Third, we should be honest that the legislation, for all its flaws, is by no means the “massive corporate give-away” that it has been labeled. On the contrary, 80% of the value of allowances accrue to consumers and public purposes, and some 20% accrue to covered, private industry. This split is roughly consistent with the recommendations of independent economic research.

Fourth and finally, it should not be forgotten that the much-lamented deal-making that took place in the House committee last week for shares of the allowances for various purposes 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).

Although there has surely been some insightful press coverage and intelligent public debate (including in the blogosphere) about the pros and cons of cap-and-trade, the Waxman-Markey legislation, and many of its design elements, it is remarkable (and unfortunate) how misleading so much of the coverage has been of the issues and the numbers surrounding the proposed allowance allocation.