Kate Mackenzie Another view on cap-and-trade giveaways

The revised Waxman-Markey bill now plans to give away about 85 per cent of initial carbon allowances for free – despite President Obama’s first budget back in February planning for all allowances to be auctioned; with no freebies.  Many commentators, including the FT, have been critical of the giveaways.

Robert Stavins at Harvard has written a defence of giving away allowances; in principle, he says, they are not as bad as they sound.

In short he argues the political pressures of the day do not affect the cost-effectiveness or the environmental effectiveness of the scheme itself.

Generally speaking, the choice between auctioning and freely allocating allowances does not influence firms’ production and emission reduction decisions.  Firms face the same emissions cost regardless of the allocation method.  When using an allowance, whether it was received for free or purchased, a firm loses the opportunity to sell that allowance, and thereby recognizes this “opportunity cost” in deciding whether to use the allowance.  Consequently, the allocation choice will not influence a cap’s overall costs.

While political pressures affect the initial allocations of allowances, they do not affect the environmental effectiveness or even the cost effectiveness, he says.

Contrast this with what would happen when political pressures are brought to bear on a carbon tax proposal, for example.

Stavins also says the fighting over allocations can actually help support the cap-and-trade scheme, by creating a political constituency in support of the system.

But there are a few problems.

First, the foregone revenues from auctions could be spent on social measures (or, perhaps, other measures to reduce emissions).

Second, allocations given to utilities could be used to lower electricity costs, thereby affect the amount by which electricity demand could otherwise fall. (Stavins notes Waxman-Markey seeks to address this by insisting utilities pass on credit to customers in lump sum payments).

Third, if free allowances are allocated according to an ‘updating’ view of the recipient’s emissions, rather than a snapshot of past use, this can provide “perverse incentives”. In otherwords:

If allowances are freely allocated, the allocation should be on the basis of some historical measures, such as output or emissions in a (previous) base year, not on the basis of measures which firms can affect, such as output or emissions in the current year.  Updating allocations, which involve periodically adjusting allocations over time to reflect changes in firms’ operations, contrast with this.

An output-based updating allocation ties the quantity of allowances that a firm receives to its output (production).  Such an allocation is essentially a production subsidy.  This distorts firms’ pricing and production decisions in ways that can introduce unintended consequences and may significantly increase the cost of meeting an emissions target.  Updating therefore has the potential to create perverse, undesirable incentives.

And Waxman-Markey DOES use updating allocations for some sectors – as an attempt to prevent the scheme from giving an advantage to imports, without upsetting international trade relations.

Stavin also points out that most of the free allowances go towards consumers and public purposes, and only 17 per cent goes directly to private industry – not quite the ‘massive corporate giveaway’ that it is often characterised as, then.

Calculation of free allocations should be scrutinised closely, he says, especially those such as the updating mechanism which provide perverse incentives. But the horse-trading over allocations actually underlines an advantage of cap-and-trade: it provides a way to get political support for a system that does ultimately reduce greenhouse gas emissions.

Related stories:

The wonderful politics of cap and trade: a closer look at Waxman-Markey (Harvard, 27/05/09)
Editorial: Cap and trade or coach and horses
(FT, 18/05/09)
The case for a carbon tax over a cap-and-trade system (FT, 03/05/09)