Creating the right atmosphere: How should carbon-emissions permits be allocated?

September 30, 2009

If you had an asset worth billions of dollars, would you give it away free? No? Would you hand it over if charging for it would clobber farmers with added expense, hobble businesses in similar fashion, boost unemployment and raise the cost of living for just about everyone?

To hear policy wonks and special-interest types spin it, those are the consequences lawmakers face in considering an allocation scheme for carbon-emission permits. And, right now, some 85 percent of the permits that will give utilities and other organizations the right to emit greenhouse gases into the atmosphere are going to be given away free of charge. Is that allocation scheme in the best interest of U.S. citizens? That's one of the questions legislators will consider in coming months.

Musical chairs

In economics, allocation is how we determine who gets what. "The reason we talk about allocation is because not everyone gets what they want," explains William Boyes, an economics professor at the W. P. Carey School of Business. "There is a limited supply of resources, and we have to figure out the best way to distribute those resources to the people who want them."

According to Boyes, everything is allocated in four major ways. One is first-come, first-served, which is how, for example, we gain entry onto the highway, get that kidney transplant we've been waiting for or snag a seat in a game of musical chairs.

Or, you can allocate resources by random chance, such as what happens when people buy tickets to a state lottery.

Markets are allocation engines, too. As Boyes explains, markets distribute resources according to "people's ability and willingness to pay for them."

Governments get into the allocation game, as well. They divvy out things like welfare benefits, water-tap rights and fishing permits. And, speaking of permits, under H.R. 2454, a piece of legislation passed in the U.S. House of Representatives last June, the government would grant businesses and utilities permits to emit limited amounts of greenhouse gases, such as carbon dioxide and methane. The American Clean Energy and Security Act of 2009, dubbed the Waxman-Markey Bill in honor of its sponsors, institutes a "cap-and-trade" system designed to lower greenhouse gas emissions overall.

Cap-and-trade systems offer economic incentives for lowering emissions of pollutants. Under House Bill 2454, the government will limit, or cap, the total amount of greenhouse gas emissions businesses are allowed to release into the atmosphere, then issue permits allowing businesses to emit a share of that total. Those that emit less than their allowance are free to sell the leftover amount to businesses that will exceed their permitted amount of emissions. That's the trade part of cap-and-trade legislation.

Similar legislation was put in place by the Clean Air Act Amendments of 1990, which set a goal of combating acid rain by reducing sulfur dioxide emissions to 10 million tons below 1980 levels. The landmark cap-and-trade approach was successful in achieving that goal. During 1980, U.S. industry coughed more than 17 million tons of SO2 into the air, according to the U.S. Environmental Protection Agency. By 2008, emissions were down to 7.6 million tons.

Moving from regulation to a market-based system requires three things –- a decision of how much to emit each year in total; a decision of who gets to emit how much of that total or who gets the permits; and finally how, if at all, do they pay for them. Trading among firms from that starting point is how a market system aligns incentives. Those who can control at least incremental cost will sell off their excess permits to those who cannot.

Boyes sees a market-based approach as "the efficient" means to organize those exchanges. But, in the case of pollution permits, the government starts the process by allocating the permits initially, and then deciding how much they pay for them. In general, markets are efficient at organizing the exchanges. All the other allocation approaches are "inefficient, meaning they waste resources," he says. According to him, "When the government allocates the initial set of permits, people spend resources lobbying the government. If it's first-come, first-served, they all race to grab their share."

Boyes doesn't see random lotteries as the answer, either. "Someone who doesn't need a permit will get one, and someone who really needs one won't," he predicts.

"Price-based allocation means the businesses will choose the most efficient way to use their resources. If it's less expensive for them to buy new equipment and sell their permits, they'll do that. If it's less expensive to buy permits and not improve equipment, they'll do that," he says. "As the number of permits goes down and permit prices go up, it induces people to use more efficient production technologies. The market system is what works best."

That's why he thinks that if the government is going to get into the pollution permit business, the market system is probably the best way to allocate those permits.

But, how do we get those permits into a market to begin with?

Pay to play

Should the government sell the permits and generate revenue? Or give them away, as it did with most of the SO2 permits issued to comply with the Clean Air Act?

That's a question of great interest to carbon emitters, such as electric utilities. According to government data, energy-related carbon dioxide emissions represent more than 82 percent of total U.S. human-produced greenhouse gas emissions, and electric utilities produce 40 percent of those carbon emissions.

Not surprisingly, electric utilities are hoping the government will simply give the emission allowances away. And, that's what will happen with 85 percent of the emission allowances if the allocation details of H.R. 2454 prevail in a Senate bill, notes Kerry Smith, a professor of economics at the W. P. Carey School of Business.

Analysts for the Edison Electric Institute, a trade group representing 70 percent of the power industry, have issued a number of policy statements on the allocation issue. According to them, the disbursements based on historical levels of emissions are important "consumer cost-containment measures." The EEI commentary suggests that if Congress gives the permits away, electricity costs won't be as likely to rise, or they might not rise as dramatically.

"That is nonsense. If I give away 100 new laptops to 100 incoming freshman, do you think those who receive the free laptops and already have one will simply give it away to another student? I don't think so -- they will make use of E-Bay and sell the one they don't want" says the W. P. Carey School's Smith. "There is a fiction that giving the permits away holds down costs. We regular citizens will pay for the costs of control soon after the permits are given out as we pay for gasoline and electricity."

Smith points out that the price of electricity produced in large part from coal did not remain constant after the sulfur dioxide emission permits were handed out gratis. Many firms had to wait for approved rate hikes, but they did increase prices and lobbied commissions to be allowed to sell their permits when they could control sulfur at lower costs.

"Prices for these permits tell us how difficult it is to control emissions," he said "According to data from the financial firm of Cantor Fitzgerald, the price per ton for SO2 was around $200 in January of 1993. By January of 2007, it was around $600 per ton, and it spiked to $1,600 per ton in January of 2005. The spike was due to anticipated changes in the national emission target, a proposed tightening in the sulfur dioxide cap. Permits could be banked. Firms that didn't need their permits certainly did not give up $1,600 per ton and hand them over gratis to a competitor. Utilities had to pay, and they passed the costs along to consumers."

So, according to Smith, the best approach would be to have an auction and allow utilities to buy the permits from the government. "We're trillions of dollars in debt, and we're giving these permits away?" he asks.

Smith also recognizes that "people say costs will rise, and industry will go in the tank." He has a simple solution: "Have an auction and declare a price cap for permits each year -- because we do not have experience with control costs in advance. If bids go over the price cap, we sell as many permits as needed that year at the price cap. Everyone knows what to expect and we have a clear path for the extent of cost increase" He notes that this kind of approach will reduce uncertainty among permit-buyers while ensuring that the revenue from the auctions goes to the American public.

"The question is who owns the permits," he continues. "My perspective is that the citizens of the United States own those permits. Our representatives are giving them away and telling us this is to hold down costs. That's just nonsense."

Watts the Cost?

Smith isn't the only one who thinks electricity prices will rise under H.R. 2454, even though the legislation currently calls for some 85 percent of those permits to be given away free of cost.

Ben Lieberman, a policy analyst for the Heritage Foundation, sees electricity costs rising dramatically under the bill. He said as much in testimony before the House and Senate Western Caucus this past July.

Noting that the bill's provisions go into effect in 2012, Lieberman predicted that a household of four would see energy costs rise $436 that year. "Electricity costs will go up 90 percent by 2035, gasoline by 58 percent and natural gas by 55 percent," he warned.

"Since higher energy costs raise production costs," the price of everything else will rise, too, he added. In fact, he projected the cost of Waxman-Markey to be "an average of $2,979 annually from 2012 to 2035 for a household of four."

The Congressional Budget Office (CBO) disagrees. According to its June, 2009 assessment, H.R. 2454, as now written, would incur additional economy-wide costs equal to approximately $175 per household in 2020. That's an average, the CBO notes. Households in the highest income quintile would each see a net cost of $245, while those in the lowest income quintile would see an average net benefit of about $40.

Of course the control of emissions is being considered for important reasons and that often gets lost in the wake of competing claims about costs, giveaways and so forth. Greenhouse gases accumulate in the atmosphere for decades. They appear to be changing our climate system. We can expect those changes will be with us for a long time. They will be different depending on where you live. Right now the effects of these accumulations are also very uncertain. It turns out that these considerations are what need to be assessed to measure the benefits from controlling greenhouse gases. The EPA, CBO and Energy Information Administration all crunched numbers to pinpoint the cost of complying with Waxman-Markey, but none of them factored in the benefits of climate-change abatement.

Along with costs of cap-and-trade legislation, special-interest groups are urging policymakers to think about job losses. Jay Timmons and David N. Taylor, two representatives of manufacturing trade groups, wrote a Labor Day opinion piece for The Philadelphia Inquirer. In it, they warned that Waxman-Markey could slash 97,500 jobs out of the Pennsylvania economy by 2030, "even when 'green jobs' created are accounted for." Nationally, the team predicts 2.4 million jobs will be sacrificed due to the legislation's high costs for compliance.

The legislation is sowing seeds of stress for farmers, too, mostly because it targets methane -- an animal byproduct. The W. P. Carey School's Smith reports that lawmakers considered treating the emission permits associated with agriculture differently and giving the Department of Agriculture control over the agriculture sector's share, rather than EPA which would administer the rest. He called the idea "terrible -- one market, but different agencies deciding what counts and handing out permits. That's a non-starter."

Speaking of farming, where do carbon offsets come in? That, Smith points out, will be one of the issues to consider in answering allocation questions. So, for instance, planting trees creates a "carbon sink," a reservoir that accumulates carbon and keeps it out of the atmosphere. If someone already has land that's covered with trees, should they get offset credits? "Hopefully not" would be Smith's answer. Or, would existing forests be exempt, because they're not new reductions to greenhouse-gas emissions. And, he continues, "Who decides what counts" with offsets? He says emission offsets should come under the same agency regulation as permits "to emit, and they should have the same price in annual terms when they are equivalent to a reduction in a ton of emissions."

So, we know there are clearly going to be impacts -- on everything we do, including agriculture. But we don't yet know the extent of the impact, so it's hard to assess how much we would pay to avoid it.

What's certain is grumbling. "Consumers want lower prices," says the W. P. Carey School's Boyes. "They don't want pollution, but they don't want to pay the cost of reducing it."

How will those divergent attitudes be reconciled?

"They won't," Boyes concludes.

Bottom Line:

  • Cap-and-trade legislation that is designed to curb emissions of greenhouse gases was passed in the U.S. House of Representatives last June. It will likely be considered by the Senate this fall.
  • Cap-and-trade systems limit the amount of emissions a business may release, but reward those that don't reach their permit limit by allowing excess emissions to be sold.
  • Under cap-and-trade systems, lawmakers must decide how to allocate emission permits.
  • The question of how to initially allocate permits faces lawmakers today. Should the permits be auctioned or simply given away to businesses?