Welcome to the RFF Weekly Policy Commentary, which is meant to provide an easy way to learn about important policy issues related to environmental, natural resource, energy, urban, and public health problems.
It looks as though the United States may be on the verge of passing legislation to establish a nationwide cap-and-trade program to control greenhouse gases. However, beyond the stringency of emissions caps at different future dates, there are many additional, and very important, policy specifics that need to be decided. This week, Daniel Hall, provides an overview of the main policy design issues. Given the topic is both timely and involved, this commentary is considerably longer than our usual contributions.Climate change is a top priority for both congressional leaders and the new administration, and there is a good chance that the United States will soon adopt limits on emissions of greenhouse gases (GHGs), particularly carbon dioxide (CO2). What form will such limits take? It is widely accepted that putting a price on emissions or on the carbon content of fuels, either directly through an emissions tax or indirectly through marketable emissions allowances, is a far more cost-effective approach than traditional forms of regulation, like mandated emissions-reduction technologies. The current political momentum is behind market approaches like cap and trade.
Designing Cap and Trade
Here are six issues that will be debated as American politicians design a cap-and-trade program.
How aggressively and how rapidly should the United States reduce its emissions?
Most policymakers think in terms of an intermediate target that’s broadly consistent with a long-term global strategy to stabilize atmospheric GHGs concentrations (or the amount of projected future warming) at some “safe” level. Many proposals from the last Congress were quite aggressive, intended to reduce 2050 emissions by anywhere from 50 to 80 percent below current levels. Energy models suggest that near-term emissions prices need to be about $5 to $50 per ton of CO2 (rising at about five percent a year) to be consistent with these emissions control targets.
In contrast, economists typically think in terms of balancing the cost of additional emissions mitigation with the benefits of avoided future damage from climate change. This requires putting a price on emissions equal to an estimate of marginal benefits. Most estimates suggest that the “right” price is somewhere between $5 and $30 per ton of CO2 in the near term, although there are disputes about whether these studies give sufficient weight to distant future benefits and adequately account for extreme risks.
To fully exploit low-cost opportunities for emissions reduction, a program should cover CO2, which accounts for more than 80 percent of U.S. GHG emissions, and its sources. The program should also address other GHGs, such as methane from landfills, nitrous oxide from agricultural operations, and fluorinated gases from industrial processes. For administrative simplicity, most proposals involve regulating upstream, at the point where fuels enter the economy. Alternatively, downstream programs, which would regulate emissions from power generators and large industrial facilities, can be combined with midstream regulations on refined fuels for transportation and home heating. To a large extent, non-CO2 GHGs can be either regulated directly or incorporated through offset credits for verifiable reductions.
How allowances are allocated, and how the revenues generated by an emissions pricing program are used, will have equity implications. Under a cap-and-trade program, allowances will be a scarce input to production and therefore represent a large source of value. Given the enormous wealth at stake—analyses of the Lieberman-Warner bill from the last Congress suggested that the value of all allowances would be around $100 billion a year initially and rising over time—it would be preferable for the government to auction all allowances and then make explicit and transparent decisions about how to use revenues, rather than giving allowances away.
Allocating allowances for free to regulated entities represents a large transfer of wealth to firms, a point Europe demonstrated in the initial phase of its Emission Trading Scheme, in which regulated firms enjoyed windfall profits when they received allowances for free but passed most of the market value (that is—in simplified terms—the costs) of these allowances onto consumers. Ongoing work by Richard Morgenstern and colleagues suggests that around 15 percent of allowance revenues would be sufficient to compensate energy-intensive industries for their abatement costs. Whether such compensation can be targeted appropriately is more questionable: work by Dallas Burtraw and Karen Palmer suggests that delivering allowances to the shareholders of incumbent firms that actually are harmed—rather than having the allowance value accrue to undeserving parties—is problematic. And if the goal is not simply to compensate shareholders but also to prevent emissions leakage, allowances would need to distributed based on firms continuing domestic production (discussed in “Competitiveness” below).
Although several proposals from earlier Congresses gave most allowances away for free, recent proposals move toward auctioning a larger portion of allowances. But whether auction revenues will be used judiciously is another question. The most recent version of the Lieberman-Warner bill included a host of new regulatory programs funded through cap-and-trade revenues. Though often well-intentioned, such programs are unlikely to be the highest-value use for scarce revenues, which are subject to special-interest lobbying or pork-barrel pressures. Some members of Congress have voiced support for simply auctioning all allowances and returning revenues to consumers through per capita rebates, an approach sometimes called “cap-and-dividend.” Some other work by Dallas Burtraw and colleagues suggests that this approach would make climate policy more equitable because the dividend, relative to income, would be higher for lower-income households. Alternatively, using revenues to cut taxes on labor and capital income, and thereby reduce the distortions in the economy created by these taxes, could substantially lower the overall costs of a cap-and-trade policy. A typical estimate is that recycling $100 billion of revenue in income tax cuts would generate economic efficiency gains of around $25 billion or more The work by Burtraw also suggests that investments in energy efficiency might improve both the efficiency and the equity of a cap-and-trade program.
Cost containment is the central issue, the fulcrum on which legislators hope to balance the ambition of an emissions reduction program with its economic impact. It therefore intersects with the emissions target, the revenues that will be raised, and the impacts on domestic industries and households. Cost containment itself, however, is not well defined. In practice, it conflates two different (though related) issues. The first is how to manage short-term volatility in the price of emissions allowances. The second is how—or whether—to manage the long-term trajectory of allowance prices. Several policy mechanisms, outlined below, have been proposed to accomplish one or both of these goals.
Mechanisms to address short-term volatility:
- Banking and borrowing provide intertemporal flexibility and prevent allowance prices from being driven by year-to-year fluctuations in unrelated factors (such as weather and economic growth). Banking of allowances is uncontroversial and will certainly be included in legislation. Borrowing is likely to be allowed but limited in both volume and duration because of concerns about default by heavily indebted firms.
- Allowance reserves are essentially institutionalized long-term borrowing by the government. The government brings some allowances forward from far-future caps and distributes them in the present.
Mechanisms to address long-term prices:
- Escalators and off-ramps kick in if allowance prices move outside a defined range. For example, if prices are low, the emissions cap declines more quickly, but if prices are high, the cap stops declining or actually increases.
Mechanisms to address both:
- Price floors and ceilings allow legislators to select a range within which allowance prices will remain. Price floors can be implemented easily by incorporating a reserve price in allowance auctions. Price ceilings—often called a safety valve—are controversial, particularly among environmentalists. The government’s willingness to sell an unlimited number of additional allowances at a prespecified price undermines the objective of capping emissions.
- Independent oversight bodies have been proposed to oversee and intervene in allowance markets (modeled in some ways on the Federal Reserve for monetary policy). This proposal is not so much a mechanism as an institutional structure through which various policy mechanisms could be applied.
Which policies will likely be employed, and which should be? Banking and borrowing are both helpful (see Fell et al. 2008) and are likely to be incorporated. Triggered mechanisms have not been popular; this is for the best, given their potential for abruptly cycling on and off or for creating odd incentives. Price floors—in the form of minimum auction prices—should certainly be used, and recent proposals include them. A price ceiling could increase the efficiency of a cap-and-trade program but may not be politically viable. This makes the idea of a reserve pool of allowances potentially attractive. Even though it may not alter long-term expectations, in the short run it indicates a commitment to climate policy that may make a program more credible and robust. To function well, independent oversight bodies need a clearly legislated objective combined with instrumental independence, but the proposals to date have been fuzzy on the objectives while constraining the range of policy instruments.
Congress may find it useful to focus the discussion of cost containment on the question of short-term volatility. Choices about long-term price trajectories are implicitly choices about long-term emissions levels, and these will have to be adjusted over time in response to new information. Focusing on short-term volatility will help separate the question of good policy design from the broader scientific, economic, and political debate about emissions targets.
Climate policy will raise the price of GHG-intensive (energy-intensive) goods. The concern is that this will unfairly disadvantage domestic producers and ultimately shift production and emissions overseas to unregulated regions. Fundamentally, policy to address competitiveness must either lower the costs of domestic goods and exports or raise the cost of imported goods.
The most visible proposals—supported by many domestic industries—would raise the cost of imports, essentially through border taxes on the “embedded emissions” in manufactured goods. Some argue