Cap and Trade Part 6: Emission Allowances

This is the sixth and final part in a series on cap and trade.

Arguably the most contentious aspect of cap and trade is what to do with the emission allowances or permits. Do you auction them or do you give them away?

In cap and trade the cap part is pretty obvious: it sets the total amount of emissions across all economic sectors that fall inside the cap. The trade part is also fairly apparent: it allows emitters under the cap to buy and sell emissions (including offsets) to meet the cap. But there is another critical aspect that falls between the cap and the trade: how the allowances (or permits) to emit a given amount of the pollutant are distributed.

Two Basic Approaches for Distributing Allowances

• Auction. In this approach the government holds an auction and sells emission allowances to the highest bidders. For an analogy, think back to when the government auctioned off new portions of the radio spectrum.
  
• Giveaway. Here, the allowances are given to emitters at no cost. This is what was done in the Acid Rain Program in which Congress set up a cap and trade in the Clean Air Act Amendments of 1990 to reduce emissions of sulfur dioxide (SO₂) and nitrogen oxides (NO_x): emissions allowances were given to power plants on a pro-rata basis in proportion to their historical emissions. Plants that were historically large emitters got proportionately more allowances than smaller plants. There are other ways of distributing free allowances; for example they could be provided based on the financial difficulties different emitters will have to meet the cap.
  

A third approach is a hybrid of two above: a compromise where some allowances are auctioned and some are given away. That is what the Waxman-Markey climate bill does, but more about that later.

Arguments For or Against Tend to Fall Along Ideological Lines

There's not a lot of meeting of the minds so far on this subject. Arguments fall largely along ideological lines and can be quite heated.

The business community, not surprisingly, usually does not favor auctions. Companies tend to argue that forcing emitters to purchase allowances will place an unacceptable financial burden on them, which will in turn cause prices to rise, which will thus burden consumers. Giving allowances to emitters that decline over time (along with the overall cap), on the other hand, gives companies time to retool and meet the cap without major financial shocks –- or at least that's the argument.

Left-Leaning Folks: Don't Reward Polluters for Polluting

Many environmentalists and folks on the left side of the political spectrum strongly object to the notion that emitters (aka polluters) be given allowances free of charge. Such opponents point out that in a cap and trade, emission allowances are worth money and giving them away is essentially the same as giving money away.

That’s bad enough, they reason, but to give them away to polluters is nothing short of rewarding them for having been polluters. And, if the cap is set too high (as was the case in the early years of the European Trading System for greenhouse gases), some polluters may end up with windfall profits – excess allowances they can sell. The argument on this side of the debate is that allowances should be auctioned so that companies pay for their pollution.

Right-Leaning Folks: Stop the Big Government Money Grab

To counter all that, here come the folks from the right side of the political spectrum. A government auction, they argue, is nothing more than a money grab by “big government” out to expand and fund new expensive programs. The Wall Street Journal called it a ”cap and tax.” And, as it turned out, President Obama’s initial outlines for a climate bill had the allowances all auctioned and a good part of the proceeds going to subsidize alternate energy – for some, I guess that’s a big government program while to others it’s an enlightened energy policy. 

To counter the cap and tax argument, many pro-auctioneers propose that the entire program be “revenue neutral” (as in so-called cap and dividend plans) so that all the proceeds from the auctions are returned directly to the citizens. No money grab by big government there.

But a revenue-neutral cap and trade also presents choices that lead to more ideological arguments. Suppose you return the money as a pro-rated tax rebate or a reduction in payroll taxes. Liberal-minded people might object because then the richest get the largest payments, less goes to the less affluent, and none goes to the folks who don’t pay taxes — the very ones who are disproportionately stressed by any rise in prices from the cap and trade.

On the other hand you could provide equal payments to everyone regardless of tax status or even provide larger dividends to the poor. You are then likely to hear accusations of big-government social engineering and wealth redistribution.

And so the arguments go…

Waxman-Markey: A Little This and a Little That

The Waxman-Markey American Clean Energy and Security Act of 2009 bill reflects the quintessential American legislative process. The way it was crafted in the House to garner broad support led to big compromises. How it treats allowances is no exception. It includes allowance giveaways to industries that have political clout and/or were able to make a cogent argument for financial relief. Chalk one up for business.

But it also includes auctions, with the percentage of allowances auctioned increasing over time, and with some of the proceeds returned to lower income consumers. (See here and here.) Chalk one up for  progressives. Some of the proceeds also go to fund renewable energy development. Is that a victory for the environmental community or the business community? For more details see here [PDF].

Not surprisingly, lots of folks are unhappy with Waxman-Markey. A number of environmental groups have withdrawn support in part because they find the allowance giveaways excessive. Some conservatives have criticized the allowance distributions as Congress playing favorites with corporate America. Ironic, don’t you think? In the meantime, other business and corporate interests maintain the allowance giveaways don’t go far enough.

Round 1 in the House is over — it’s a split decision, although I give the environment the edge. Stay tuned for round 2 in the Senate.