Cap-and-Trade and Allowance Allocations

Perspectives from an Environmental Economist

Analysis Group affiliate Robert Stavins, a prominent environmental economist and the Albert Pratt Professor of Business and Government at Harvard University, is a recent appointee to the Energy and Environmental Markets Advisory Committee of the US Commodity Futures Trading Commission.

Below, Professor Stavins talks about the effectiveness of proposed environmental legislation and its potential impact on the economy.

Q: You’ve called for a cap-and-trade system to reduce greenhouse gas emissions. How would that affect the costs of goods and services throughout the economy?

Dr. Stavins: To address climate change seriously and cost-effectively, it is essential to have a single carbon price that affects all fossil fuels used throughout the economy, in all industrial, commercial, and residential sectors. This is precisely what cap-and-trade does. An upstream, economy-wide cap-and-trade system will increase the prices of fuels (including gasoline), electricity, and all goods and services to reflect their carbon contents and carbon intensities in production. But prices would increase in the right proportions for each fuel, energy source, and product, ensuring that the overall cap is achieved at the least possible cost. The bottom line: cap-and-trade is the cheapest and best approach – and the only politically feasible one – that can achieve the significant reductions in CO₂ emissions that will be necessary to meet the administration’s climate goals.

Q: If a cap-and-trade system is implemented, how should emissions allowances be allocated?

Dr. Stavins: It’s important to understand that the way allowances are allocated really makes no difference – for the most part – in terms of the environmental effectiveness or cost-effectiveness of a cap-and-trade system. Firms face the same emission costs at the margin regardless of whether allowances are auctioned or allocated freely. The method has no impact on which firms end up holding allowances (after trading), and, therefore, has no impact on the distribution of emissions, the magnitude of emissions, or the aggregate social costs of the program. So while political debate and pressure may lead to different initial allocations of allowances, those differences will not affect the achievement of environmental goals or the social costs of the program. Rather, they affect the distribution of costs among different groups in the economy. That’s why there are lively discussions in Congress on how allowances will be distributed in the beginning.

Q: How would a cap-and-trade system differ from a carbon tax?

Dr. Stavins: With a carbon tax, you don’t get a hard cap on total emissions. And political pressure would likely be exerted to enable exemptions for certain sectors and companies, which would not only reduce the environmental effectiveness of the climate policy, but also drive up costs, as some low-cost emission reduction opportunities would be left out of the plan.

Q: There's been a lot of discussion in the press about the free allocation of emissions allowances under climate change legislation. Who will benefit most from the allocation?

Dr. Stavins: When we look closely at proposed legislation – the Waxman-Markey bill, for example – we see that many of the benefits of freely allocated allowances accrue to consumers and to public purposes rather than to private industry. An examination of Waxman-Markey’s allocation of allowances from 2012–2050 reveals that 80% of the value of allowances goes to consumers and public purposes, while only 20% of the value of allowances goes to private industry. The press coverage of this issue has largely missed this crucial point.

Q: What is the economic policy lesson here?

Dr. Stavins: While some find the arguments over allowance allocations to be unproductive, the political process in which interested parties – states, districts, companies, interest groups, individuals – fight for their piece of the pie helps to create a political constituency in support of the cap-and-trade system, without detrimental effects to the system’s environmental or economic performance. And that is a good thing. ■