Cheat Sheet for Climate Policy: Part II – What’s Important for a Good Climate Bill

By and / 4.23.2010

How to tell a good climate bill from a bad one? This series will guide you through the main issues that are likely to arise in the coming weeks as the Senate takes on climate change. In this post we highlight issues that are very important — but not quite essential — in climate policy. These ideas will likely play a key role in the eventual passage of legislation from the Senate. (To read the other posts in the series, click here.)

In our last post we identified the two absolutely critical issues for any climate policy: putting a price on carbon and targeting meaningful emissions reductions. Pricing carbon imposes costs on emitters, thereby changing behavior and encouraging innovation, but it will also generate revenues. Once they are generated, who receives them and how they are spent are important elements of climate policy.

Category II Issues: Key Elements of Climate Policy

#1: Public revenue or private giveaways?

If carbon is priced with a tax, it will generate new government revenues. If, as seems likely, carbon is priced with some form of cap-and-trade, things get a little more complicated. For cap-and-trade to work, emissions allowances must be allocated in some way. The two simplest ways to allocate allowances are to give them away for free, or to auction them to the highest bidder. Only the latter would generate any new public revenues. Allowances are assets with real value, so giving them away is no different from a government subsidy to the recipient.

Auctioning allowances is generally more efficient than giving them away — society as a whole is better off the more allowances are auctioned. Nevertheless, many groups of emitters or industries have made arguments (and will continue to do so) that they should be given free allowances. They argue the impact of climate policy on their industries will be too onerous or that they represent the interests of their consumers. Generally speaking, these claims are old-fashioned Washington handout-seeking behavior.

Fights over allowance allocation were predictably rampant when the House considered its bill, Waxman-Markey, last year. Comparatively few allowances would be auctioned under Waxman-Markey, especially before 2020, and substantial allowance handouts (35 percent of allowances) would be given to local gas and electricity distribution companies, ostensibly to protect consumers from increases in electricity prices. It is very likely that allocation will again be a central (possibly the central) political issue in the Senate debate.

A carbon price won’t affect every person, firm, or industry equally. In particular, low-income households will feel the effects of a carbon price far more than wealthy households, and an equitable climate policy should compensate the losers to offset that disparity. The best way to do so would be to compensate them with cash (through direct rebates or tax cuts) raised from auctions – yet another factor in their favor. Under a giveaway scenario, the government could hand out free allowances to utilities, hoping that they pass along savings in the form of lower energy prices. That may help consumers, but they would still be better off if they receive the savings directly out of auction or tax revenues and can make their own choices about how to spend that compensation—more on how these revenues could be spent in the next section. Besides, lower consumer energy prices can blunt the price signal a cap sends, leading to increased energy usage.

However attractive auctioning all allowances is, it’s probably not politically realistic. Handouts will probably have to be made to some industries to get votes for the bill (though there’s still hope, on both the right and left, that the general welfare can prevail over handouts to special interests ) In any case, auctions are the most desirable distribution mechanism, and should be a major component of any climate legislation.

#2: What do we do with the money?

Assuming you’ve auctioned at least some allowances (or have revenues from a carbon tax), what should the government do with the money? There is no easy answer here, but in general we have three options:

a) Reduce existing taxes

If the government receives revenues from a carbon price, one response is to cut the taxes already on the books. Reducing other taxes shifts the U.S. tax burden from those who currently bear it (primarily income earners) to carbon emitters and, indirectly, to consumers of carbon-intensive goods and services. In general, this is a good thing, for the simple reason that you are lowering taxes on something you generally want people to do (work) and raising them on something you don’t want them to do (emit carbon). In economic terms, you move from taxing something we generally think has positive externalities to something we know has negative externalities. And politically, who doesn’t like lower taxes? One drawback is on that you may end up reducing progressive income taxes in favor of carbon pricing, whose costs might be harder to bear for those who can least afford it.

b) Dividends to consumers

If you’re troubled by the possibly regressive character of tax cuts, but think returning carbon price revenues to the people ultimately affected by increased prices is a good idea, then a good alternative is direct payments to consumers. This is the “cap-and-dividend” approach taken by the Cantwell-Collins bill in the Senate that Danny wrote about recently. Under cap-and-dividend, revenues generated by an allowance auction (or a carbon tax) are used to make payments directly to consumers. In other words, every household would get a check. Because all households would get equal payments, the plan turns a somewhat regressive carbon price scheme on its head by transferring money from those with a large carbon footprint (often the wealthy) to those with a smaller one (often the poor). Politically, it’s broadly appealing—even conservatives that tend to oppose redistribution of wealth find a lot to like, in large part because dividends “cut government out of the picture.”

Instead of sending everyone the same amount, it’s also possible to try to identify specific losers from climate policy and compensate them directly. One example of such relative losers might be trade-exposed industries, who would stand to lose competitive ground against foreign firms not subject to a carbon price (more on this issue later in the series). Making payments to industries instead of households isn’t usually characterized as cap-and-dividend, but the difference is only distributional—who gets the money. One disadvantage is that direct dividends pose a bureaucratic challenge — there is no clear mechanism for distributing them.

c) Public goods

Alternatively, the government could spend the revenues from an auction. In some cases, the government can create greater benefits by spending revenues than by giving them back. Restricting ourselves to climate-related spending, good examples might be energy R&D, investments in adaptation to climate change, or efforts to reduce emissions internationally or verify international emissions offsets. Indeed, the federal government will need to spend money in some of these areas regardless because the private sector may underinvest in energy R&D, and will almost certainly underinvest in climate change adaptation and international mitigation efforts. The Waxman-Markey bill devotes auction revenues to many of these areas, and a Senate bill probably will (and, in large part, should) do the same.

Of course, carbon price revenues could also be used for any other government expenditure, from education to infrastructure or defense. Revenues could also be used to pay down the debt. Any of these might be worthwhile expenditures, but it’s important to remember that any revenues that are not returned through dividends or lowering other taxes represent a tax increase on anyone who uses carbon—that is, everyone. Opponents of action on climate often characterize it as a major tax increase. To the extent that revenues from a carbon price are dedicated to unrelated government expenditures, this criticism isn’t dirty politics, it’s a fact. Taxing and spending on a given project may or may not be a good idea, but bringing carbon into the picture doesn’t change the fact that it’s taxing and spending.

#3: Market design: banking and borrowing

A major policy and political priority for climate legislation is to reduce emissions as effectively and cheaply as possible. Whether this goal proves to be attainable or not depends greatly on how cap-and-trade markets are designed. While these issues tend to fly under the radar of the political debate — partially because they are complex and partially because they are not very sexy — they have major implications not only for how firms will behave under a cap-and-trade system, but the timing of actual emissions reductions.

There are multiple options for controlling the costs of climate legislation compliance (most of which will covered in our next post), but the key aspects are the closely related concepts of banking and borrowing of allowances. The general concept of banking isn’t terribly complicated: firms ‘bank’ allowances by overcomplying with the cap (they reduce their emissions more than is required) throughout the program, thus building a surplus of allowances that they can use at a future date. Similarly, firms may choose to ‘borrow’ allowances, by using an allowance from a future year, then repaying that allowance with future reductions (possibly with interest).

Polluting firms have two reasons why they want to be able to bank and borrow. First, the path of the lowering cap (established by legislation) will likely not be set in a way that is optimal for regulated parties. Banking and borrowing credits gives them the flexibility to take an emissions-reduction path that is most cost effective, either by filling their bank with credits through overcompliance in the early years of the market or by borrowing in later years if they expect some kind of efficiency increase to come through at a certain future time. Second, banking and borrowing can protect firms against unforeseen shocks to their compliance paths. For instance, a company may have unanticipated problems that force it to use a more carbon-intensive energy source, increasing its emissions above the number of allowances it possesses. Borrowing allows the firm to get more allowances now in exchange for stronger future reductions.

While some may claim that banking and borrowing look like a way to game the system, they are simply mechanisms to help firms control costs and reduce their emissions as efficiently as possible. A strict cap-and-trade system where firms can only trade amongst each other would be more expensive. Banking and borrowing helps reduce costs while still achieving the cumulative emissions reductions desired. A study by Resources for the Future scholars Harrison Fell and Dick Morgenstern contends that borrowing generates significant cost savings, especially when the cap is being lowered at some rate (which is the case in all serious climate proposals). If borrowing is restricted, costs go up.

Allowance banking and borrowing are key issues for climate policy because they will not only play a major role in the behavior of firms in the cap-and-trade market, but they will also have a strong influence on the actual path of emissions reduction. This gets back to the point we made in the last post, where we said that specific reduction targets don’t matter as much cumulative emissions reductions. The ability to bank means that carbon polluters may strongly overcomply, meaning that they will reduce far beyond the 17-20 percent reduction goals in 2020. Analyses from the EPA and the EIA back this up. The flipside, however, is reductions in later years may be less than the cap as companies start to cash in their banked allowances. As long as the cumulative emissions over the life of the regulation come in under the cap, it’s fine for the year-to-year levels to be ruled by how regulated parties bank and borrow.

The Bottom Line

In the last post, we presented three issues that we deemed essential to any climate bill. Here we discuss the merely important:

  1. How are emissions allowances allocated—are they auctioned, or given away?
  2. How are the public revenues from climate policy spent?
  3. Is the allowance market designed for economic efficiency—does it allow banking and borrowing?

In our next post, we will travel further down the rabbit hole and address some further issues climate policy that are still relevant and meaningful, but less important than what we’ve talked about so far.

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