Cap-and-Trade: Hold Off on Any Auctions

Within the next few months, either the Environmental Protection Administration (EPA) or the United States Congress will likely be in the business of regulating greenhouse gases--in particular carbon dioxide (CO2).

The EPA has just declared carbon dioxide a danger to public health, which could trigger regulation of CO2 emissions under the Clean Air Act. At the same time, climate czar Carol Browner is urging Congress to establish a broad U.S. greenhouse gas policy before global climate change talks begin near the end of the year. To this end, Congressmen Henry Waxman of California and Edward Markey of Massachusetts have drafted a bill titled “The American Clean Energy and Security Act of 2009.” Though the bill includes titles promoting clean energy and energy efficiency, the most significant provisions are those mandating reductions in CO2 emissions.

The proposed mechanism for getting from here to there is “cap-and-trade.” This involves first setting a limit on the total volume of emissions that can be produced across the U.S. in a given year and then granting tradable federal permits, called “allowances,” to covered entities for each ton of CO2 emitted. The intention is to encourage firms that find it cheap to cut emissions to do so while allowing those with no easy means to reduce pollution to buy permits instead. The Waxman-Markey bill would reduce the number of available allowances each year in order to achieve an 83 percent reduction in CO2 emissions by 2050.

Waxman-Markey does not address how allowances would be initially distributed or what percentage might be auctioned or simply allocated to polluters. Some observers argue that with many industries currently suffering from the economic downturn, the auctioning of permits would be ill-advised. The U.S. Chamber of Commerce has warned that many companies could face additional fiscal burdens that might threaten their survival if forced to “bid” for CO2 emission rights in today’s recessionary economy because it would be difficult to pass these costs on to consumers. By contrast, some environment groups are relishing the prospect of billions of dollars from permit auctions that could be spent on research into, and subsidies for, alternative energy sources.

The issue of allocation versus auction is of particular concern to America’s electric utilities. According to the Edison Electric Institute, power generation from all sources accounts for roughly 40 percent of U.S. carbon dioxide emissions. If the industry were required to bid for 40 percent of the CO2 allowances, this would result in a sizeable spike in the cost of delivered power. What’s more, the huge demand for permits from this one economic sector would push up the price of permits for every other industry.

A better approach would be to initially allocate allowances to the power sector proportional to its level of CO2 emissions while gradually shifting to an auction process. This would help ease the transition to a carbon-constrained economy as all technology options--including renewables, advanced nuclear generation and carbon sequestration--become available and as compliance costs are stabilized. It would also cushion the impacts on electricity customers, particularly low-income families and energy-intensive businesses. Permit allocations have been used successfully for many years under the federal Acid Rain Program, a cap-and-trade program that has significantly reduced sulfur dioxide emissions, and at a much lower cost than had been initially projected.

Numerous organizations have expressed support for CO2 allowance allocations, instead of auctions, during the early stages of cap-and-trade. For example, the U.S. Climate Action Partnership--an alliance of major businesses and leading climate and environmental groups--argues that an allowance value distribution structure can cushion the costs to both consumers and businesses during the transition to a full auction system. Support for allocations has also come from the Pew Center on Global Climate Change, major labor organizations, and the National Association of Regulatory Utility Commissioners.

Without question, reducing greenhouse gas emissions is the most serious environmental challenge America has ever faced. Cap-and-trade can produce tremendous benefits over time, but it comes with a substantial price tag. By initially allocating allowances, and not auctioning them off to the highest bidders, we can lessen the burden on consumers while still achieving the goal of substantially reduced CO2 emissions in the years ahead.

Bernard L. Weinstein is a professor of applied economics at the University of North Texas and director of the Center for Economic Development and Research. His email address is bernard.weinstein@unt.edu.