Cantwell's Cap-and-Trade Bill: Almost Genius

To borrow Dave Eggers’ book title, the novel approach to cap and trade proposed by Senator Maria Cantwell is a heartbreaking work of staggering genius. Genius, because it is an innovative plan to create a best-case version of cap and trade. And heartbreaking, because by design and by omission it undermines the most important feature of cap and trade: a legally binding limit on carbon emissions.

It’s true that Cantwell’s CLEAR Act sets out ambitious reduction targets. Yet at present, it lacks detailed guidance for achieving them, especially in the near term.

Sightline Institute wants to love this bill—and, in fact, we are head-over-heels for the majority of it—but we believe that its small number of flaws are so serious that, at best, it’s a diamond in the rough. (At worst, it’s a lump of coal that could jeopardize the best chance Americans have for comprehensive carbon pricing, ACES and its companion Senate bill, the Clean Energy Jobs Act.) In short, an “A” for intention, a “C” for execution. (We gave “B’s” to ACES and CEJ.) Fortunately, Senator Cantwell has time to revise her bill—or use it as a model for improving CEJ—in the weeks ahead.

Below is a detailed look at how CLEAR would work—and where it doesn’t get the job done. First, though, a synopsis:

• A solid reduction target: 20 percent below 2005 levels by 2020 and 83 percent below by 2050. Yet the targets are disconnected from CLEAR’s cap-and-trade program, which has a more modest trajectory and a narrower scope than other bills.
• Full auctioning — an excellent principle—but the auction format is less than ideal and the bill lacks detail about market oversight.
• Individuals are directly rebated with  three-quarters of the auction proceeds — a wonderful idea for promoting fairness—but, again, the bill lacks a detailed plan for actually distributing the funds.
• Details are in short supply when it comes to enacting a border-adjustment tariff (to prevent industrial “leakage”) and for spending money on reductions outside the cap, as well as for adapation, international assistance, worker transition, energy efficiency, and other programs.
• A price ceiling, which could bust the cap in certain circumstances. The bill does include provisions to offset permits that are issued beyond those allowed by the cap, but the details are sketchy.

One selling point of CLEAR is its brevity: it’s well under 50 pages. One might assume its concision brings clarity and transparency, especially when compared with 1,428-page ACES or 821-page CEJ. But we ended up wishing CLEAR were much longer. ACES and CEJ are thick because they are completed overhaul plans for the US energy economy. CLEAR, on the other hand, is more of an outline.

Let’s dig into the details.

The cap, the targets, and some confusion

While the bill aims to reduce total US greenhouse gas emissions, the cap-and-trade program, and hence the binding cap, is restricted to fossil fuel-based carbon-dioxide emissions. In other words, it caps a smaller share of the economy than the Clean Energy Jobs Act (CEJ), which directly covers some 86 percent of emissions under its cap and considerably more through regulatory and offset programs. But a fossil-only carbon cap isn’t nuts because the emissions account for an estimated 82 percent of US greenhouse gas emissions; and if the cap is implemented upstream, as CLEAR does, then regulatory compliance is limited to only about 3,000 firms, a number small enough to reduce administrative complexities.

The CLEAR cap would start up in 2012 at the level of actual emissions in that year, and the cap would remain at a constant level until 2015 when the program would make its first reduction. Thereafter, the rate of reduction would accelerate each year so that by 2050 total emissions under the cap were approximately 82 percent below 2012 levels.

Although the bill has just been released, there’s already much confusion about CLEAR’s reduction targets, which are actually different from the reductions in its cap-and-trade program. CLEAR sets out a target of a 20 percent reduction below 2005 levels by 2020. Yet the act’s cap-and-trade program achieves only about a 5 percent reduction below 2012 levels by 2020. Because the act’s overall targets and its cap-and-trade program use different baseline years, and because no one knows what emissions will be in 2012, it is impossible to determine the extent to which CLEAR’s cap-and-trade mechanism falls short of the act’s overall goals. But it is clear that there will be some shortfall.

If we assume that emissions in 2012 are the same as they were in 2005—a somewhat optimistic assumption in our view—then by 2020 CLEAR’s cap would still be “missing” an additional 15 percent reduction. (There’s a similar shortfall in 2025 and 2030 for which CLEAR also sets forth overall reduction goals that fail to jibe with the cap-and-trade program’s trajectory.) However, CLEAR has a plan for making up the difference.

These missing reductions are to be achieved by use of the Act’s CERT fund (about which, more later) to enact complementary policies and perhaps purchase offsets. But the CERT fund is essentially a laundry list of funding areas, only some of which would reduce emissions. There’s little guidance—and no guarantee — provided by CLEAR’s current language about how CERT would actually achieve emissions reductions on a set schedule.

In other words, more than three-quarters of CLEAR’s reductions by 2020 are left to a roughed-in fund that lacks adequate explanation, oversight, and direction. Not only would CERT have to make up the shortfall in the cap-and-trade program’s targets, but it would have to achieve an additional 20 percent reduction in the emissions that are outside the cap-and-trade program. Short on specifics as CERT is now, it’s not clear at all whether the bill contains the legislative mechanisms to accomplish its goals.

Auction & markets

CLEAR proposes to auction 100 percent of the permits, a decision Sightline wholeheartedly endorses. We also like that CLEAR’s auctions will be conducted using a “uniform price” method, a good method for minimizing the risks of manipulation by bidders. We do wish, however, that the bill contained a bit more specificity about the auction format. We tend to favor sealed bid, uniform price, single round auctions, but granting authority to the auction administrator to alter the format as best-practices advance also makes good sense to us. In particular, altering the format can prevent auction participants from devising gaming strategies. This is not a major consideration, however, given that gaming a carbon auction would be exceedingly difficult and bring little reward.

Yet other provisions for conducting the auction are not as canny. Bidding is restricted to the big polluters who are regulated by the program, and these regulated entities are allowed to trade the permits with one another.

Unfortunately, limiting participation in the auctions and trading to regulated entities may have the opposite effect of what is intended: it may increase the slim chances for collusion in the auction. The fewer bidders or traders, the easier it is for them to organize themselves. Sightline sees many reasons to regulate closely the carbon market, but we do not see a reason to limit entrance to the regulated entities. Brokers, for example, could play a valuable role in smoothing the market and maintaining a daily secondary market to help firms adjust to their changing needs.

Furthermore, we doubt that limiting participation—as opposed to other regulations on the market—does anything to prevent market manipulation. For example, prohibiting trading of carbon permits cannot prevent financial firms from trading in derivative products based on the underlying dynamics of the carbon permit market. (CLEAR does allow for derivatives trading, though regulated entities are not allowed to participate.) What’s missing rather is specific regulatory guidance for carbon derivatives. On this question, CLEAR essentially punts market regulation to an administrative process — a process for which it provides very little direction. In fact, this is one of several areas where CLEAR is missing key details.

A more minor problem: limiting auction participation to regulated entities will prevent mission-driven organizations from buying and retiring permits without using them, to accelerate the transition to a clean-energy future.

All told, the auction and market limitations are only a small flaw in CLEAR. Any market, including CLEAR’s, will need oversight to guard against manipulation. More distinctive is CLEAR’s use of auction revenue, which Sightline enthusiastically supports.

A climate rebate

The bill returns three-quarters of the auction revenue directly to legal US residents in the form of equal per capita rebates, making it an only somewhat diluted version of “cap and dividend.” Preliminary analysis shows that CLEAR’s dividend would leave about half of all households, including all low income households, in a better financial position than without the program; and most remaining households, with the exception of some high energy users, would feel minimal financial impact on net.

Per-capita rebates of auction proceeds are smart policy, but the details can be tricky and the administration of the particular plan in this bill—electronic fund transfers to everyone—is a worrisome prospect. Providing monthly payments to each legal resident of the nation would be extremely difficult. No mechanism currently exists that can deliver funds in this manner. The United States has neither a registry of legal residents, nor an address list, nor a system for adding births and immigrants, nor for removing deaths and emigrants. The bill doesn’t specify certain important details, such as who would receive and manage the funds for children and legal dependents, such as the developmentally disabled.

Existing public mechanisms such as Social Security, income taxes, Medicare, and the electronic benefit transfer (EBT) systems of most states can reach large swaths of the public. But none of them can reach everyone. The Alaska Permanent Fund does pay dividends to legal residents of the state, but it does not pay dividends to minors. It pays dividends only once a year. It requires residents to register to receive payment—a prospect that civil liberties advocates would likely bitterly oppose at the national level. And Alaska is a state with fewer than 1 million residents.

The Center on Budget and Policy Priorities (CBPP) has done excellent work to identify practical means of distributing auction rebates through existing mechanisms. (ACES adopted CBPP’s recommendations in its plan for rebates to low-income families.) Our recommendation for CLEAR would be to use a mix of CBPP’s plan for low-income families, an expanded earned-income tax credit, and a refundable income tax credit for all tax filers. President Obama’s 2009 budget proposal, to use auction proceeds to fund his working families tax reduction, is another good option that’s easy to administer. Annual rather than monthly payments make the most sense to us.

The Clean Energy Reinvestment Trust (CERT)

So while three-quarters of the auction revenue goes to rebates, the remaining quarter goes into a special fund, called CERT, that is dedicated to a variety of climate-related purposes such as research and development into new technology, low-income weatherization, and climate adaptation programs. Many of these purposes seem smart to us, but the bill is very short on specifics. It would be easier for us to endorse these investments if the bill provided a clearer picture of what, precisely, they might be—or at at least what guidelines would be used for making spending decisions with these funds.

The absence of details about CERT is problematic for several reasons. First, CLEAR relies on CERT to achieve about three-quarters of its reductions by 2020 (and about half its reductions by 2025 and one-third of its reductions by 2030). Second, CLEAR relies on CERT to offset any emissions in excess of the cap, in the event that the so-called “safety valve” price ceiling is reached at auction. (More on this, later.) And third, CLEAR relies on CERT to achieve reductions in greenhouse gas emissions outside of the capped sectors, about 18 percent of total emissions. That’s a lot—too much—riding on a section of the bill that at present contains hardly any specifics about oversight, spending, and accountability.

Border adjustment

As an aside, CERT and market regulation are not the only areas where CLEAR seems short on details. The bill sets out a border adjustment provision that is admirable in its simplicity. (Basically, a border adjustment attempts to prevent carbon-intense industries from departing for countries that do not price carbon. It levies a tariff on imported carbon-intense goods that originate in countries without rigorous carbon policy while it provides a payment for goods that are exported to such countries.) CLEAR would be stronger if it gave more guidance on which commodities are energy intensive enough to merit border adjustments. How to calculate border adjustments is also a tricky analytical job with huge implications for trade policy. Ascertaining the carbon footprint of a commodity in international trade is an extraordinarily difficult task. The US Trade Representative will have his or her hands full!

Price controls—and a leaky cap

Where CLEAR gets really interesting, however, is in its auction pricing: the carbon permit auction in CLEAR includes both a price floor and a price ceiling, collectively refered to as a “price collar.” (The construction of the price collar is similar to that in the Senate’s Clean Energy Jobs Act.) At the outset, the floor is set at $7 and the ceiling at $21 and starting in 2015 they begin climbing annually at the rate of inflation plus 6.5 percent.

In case you need a refresher, a price floor prevents the government from selling carbon permits to firms that are unwilling to pay the floor price, even when not all the carbon permits allowed under the cap have been exhausted. So when a price floor kicks in, it is effectively a tightening of the cap—a good thing from a climate protection perspective. By contrast, a price ceiling means that the government must provide unlimited carbon permits to firms that are willing to pay the ceiling price, even when the number of carbon permits being sold exceeds the number allowed under the cap. So when a price ceiling kicks in, it is effectively a removal of the cap—a bad thing for the climate.

Of course, when the auction price of permits is between the floor and the ceiling then the government will supply exactly the number of permits that are allowed under the cap. Demand
from bidders for the limited supply of permits will determine the auction price.

Carbon permit prices can oscillate between the floor and ceiling prices, so CLEAR’s price limits provide bidding firms with more certainty about price than they would have in an open market. But by putting an upward boundary on prices CLEAR erodes certainty about overall emissions. Emissions may exceed the cap, if the ceiling is reached. In other words, CLEAR fails to establish a firm limit on carbon emissions because it puts price certainty ahead of emissions certainty.

Plugging the leaks?

In fairness, CLEAR has one more trick up its sleeve. In the event that auction prices exceed the ceiling—when the government must supply more permits than are provided for by the cap—the revenue from sales in excess of the cap would be set aside for a special purpose. CLEAR would use these revenues to either purchase offsets or pursue emissions reductions from non-fossil fuel sources. In either case, the money earned from the cap-busting permits would be directed to the CERT fund where it would be used to obtain emission reductions outside the cap, thereby neutralizing the damage of exceeding the cap, at least in theory.

CLEAR’s approach is intriguing to be sure: if the revenue from the carbon permits sold above and beyond the cap is used to obtain genuine emissions reductions from outside the cap, the program appears to have its price ceiling and its cap too. It’s almost a stroke of genius, but unfortunately the bill provides exceedingly little guidance on how to use these funds. Unlike ACES or CEJ, CLEAR does virtually nothing to define how its offsets program might work or how the program would really guarantee that the excess revenue was actually achieving genuine and permanent carbon reductions. This is more than a nitpick: as we mentioned earlier, the sketchy language that defines CERT is a rather substantial weakness of CLEAR — albeit one that could be fixed by a more attentive and robust approach to address reductions outside the cap.

Yet even if CLEAR were to enhance its treatment of reductions beyond its cap, we see few compelling arguments for a price ceiling. Rather, we believe ACES’s “strategic reserve” approach is superior, in which sudden price increases can trigger the release of permits from a special reserve of permits. But ACES can guarantee that its cap is protected because the strategic reserve is mostly stocked with actual permits under the cap that are set aside in prior years. In other words, it tightens the cap slightly in the early years, while the reserve is being stocked with permits; and it effectively prevents body-shocks to the economy from carbon price spikes. (CEJ includes both a price ceiling and a strategic reserve; it stocks its strategic reserve largely with offsets.)

Furthermore, ACES’s strategic reserve is activated by relative price increases, not absolute ones—making it more responsive to actual market conditions and a better economic shock absorber. If carbon prices hovered around the price floor for three years, then jumped 60 percent in a month, the reserve would activate. In the same circumstances, CLEAR’s price celing would not activate until prices had jumped 300 percent! On the other hand, if carbon prices hover for a long spell at levels close to CLEAR’s price ceiling, even a modest increase would trigger the release of new permits. ACES, meanwhile, would not release any new permits unless prices rose rapidly by 60 percent.

The politics

We believe that the relative price approach is better because the economic risk is not in the absolute price of carbon but rather in sudden changes in its price—sudden changes for which households and businesses are unprepared. That said, we understand why a price ceiling might be politically desirable, to reassure certain legislators or interest groups. But most other aspects of CLEAR are written without pandering to political popularity, so why include a price ceiling in the bill at all?

It’s here, in the hazardous zone of politics, that we register our final complaint. Sightline is concerned that Senator Cantwell’s bill will not be used to improve Congressional climate legislation but rather to torpedo ACES, which has already cleared the House, and its companion, CEJ, which has the best chance of passing the Senate. Neither ACES nor CEJ is flawless—indeed, we’ve catalogued our grievances in some detail—but we believe that they are basically sound bills.

We very much believe that the major congressional climate bills would be improved if they were to adopt some of CLEAR’s better features, such as generous auctioning and per-capita rebates. But climate policy doesn’t need a circular firing squad, it needs to be strengthened and passed into law post-haste.

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Update 12/13/09: For more analysis of this bill, see Dave Robert’s post over at Grist: What To Make of the Cantwell/Collins CLEAR Act.

Also at Grist, a thoughtful response to our post by Michael A. Livermore: Defending the Cantwell/Collins CLEAR Act.