Over at Washington Policy Center, Todd Myers had a post a couple of weeks ago that gets something importantly right. Free allocation of carbon permits in a cap and trade system is a bad idea. Take it away, Todd:
This system was used in Europe and led to some companies being given large excesses of carbon credits which they then sold on the market. In short, government gave something of value (carbon credits) to companies who then profited from them. Worse, a recent report by the Government Accounting Office found that politicians handed out presents, choosing winners and losers when it came to handing out allocations, leaving some industries short and others long.
That’s a good point. Not only is it free allocation inefficient, but it’s ripe for abuse and favortism. Forget about fairness for consumers for a moment — a subject we’ve written a lot about — free allocation is not even fair for the firms that will be regulated under cap and trade. It’s very difficult, and perhaps impossible, to develop a principled, rational, and fair way to hand out permits for free.
The most popular scheme for free allocation gives out permits based on historical emissions. This is sometimes called “grandfathering”. The European cap and trade program took this approach (albeit in some peculiar ways) and it’s possible that Washington may head down the same path. Unfortunately, grandfathering can cause some very problematic inequities.
Consider how this might work in practice.
Imagine that there are two steel firms in your state: Green Steel and Brown Steel. Let’s say that in 2005, Green Steel decided to radically upgrade its efficiency. Maybe Green Steel was getting hassled by air quality regulators, or maybe its existing equipment was nearing the end of its lifespan, or maybe it saw change coming and wanted to get ahead of its competitors. The reason doesn’t much matter, just the result: that Green Steel spent a lot of its own money (or, more likely, borrowed money) to upgrade its equipment and operations. After making the investments, by 2006 Green Steel became the cleanest and most efficient steel operation in the region.
By contrast, Brown Steel has done nothing. They operate a heavily polluting plant and they’re happy just they way they are.
Now fast-forward to 2012 when carbon permits are given away on the basis of historical pollution. Assuming that the historical reference period is sometime after 2006, Brown Steel will get a truckload of free permits (enough to cover, or nearly cover, its large emissions profile) while Green Steel will get a comparative pittance (because its emissions are smaller). And remember: these permits are worth something. They can be sold for cash.
Brown Steel can cash in. They can sell a portion of their permits and then use the proceeds to upgrade their equipment. (More precisely, they’ll use some financing arrangement.) The result is that by 2013 or so, Brown Steel will be just as clean and efficient as Green Steel. That’s good news for the environment, but it’s hardly fair. Green Steel had to pay out of its own pocket to act responsibly (and Green Steel’s early action was a particular benefit to the climate), while Brown Steel did nothing and essentially used public funds to become just as competitive.
How do we fix the problem? By auctioning. If we sell the permits at a public auction, Green Steel will reap the rewards of its responsible action because they’ll have to spend less to purchase permits than will their main competitor. In fact, all across the economy, cleaner firms will have a leg up on dirtier ones. Then, Brown Steel will want to do what Green Steel did years ago: upgrade their systems and get clean. The result for the environment is just the same in either scenario, but the fairness implications are much different.
Plus, if we’ve auctioned the permits, we may even choose to use a portion of the revenue to help Brown Steel do the right thing. With a transparent strings-attached loan, for example, we might give Brown Steel a helping hand in a way that would be much harder to accomplish with a big grant of free tradeable permits.
Auctioning is just better. So it should come as no surprise that the European system is transitioning toward an auction. And that most federal cap and trade proposals have intended to auction a large share of their permits. And that the RGGI system in the northeast is auctioning almost all permits. And that Governor Schwarzenegger has said that he intends for California to eventually auction all of its permits.
So Todd Myers is right. Sort of.
Unfortunately, Todd’s solution to the problem of free allocation isn’t the obvious one—auctioning — but rather to toss out cap and trade entirely. That’s a bummer because the fix is really pretty do-able. It’s got big benefits. And it’s a fix that progressives are working hard to make a reality.
Update, 2:30: In an email, Todd says:
I toss out cap-and-trade but offer another alternative and one you even like. You make it sound like I have contrived a complaint about cap-and-trade to do nothing, which is not my position as you know. At least give me some love for that.
Sure, sure. I was trying to limit the topic to cap and trade, but Todd does deserve a little love here. He’s proposed a revenue-nuetral carbon tax for Washington state. (We even wrote a favorable blog post about it.) The proposal is similar, in fact, to British Columbia’s carbon tax, about which we’re on record as big supporters.
For too many reasons to include in this post, we prefer cap and trade to taxes. Not that we’re opposed to taxes, mind you—we like them quite a bit actually—just that we believe cap and trade to be the better tool for addressing climate emissions. So I hate to see cap and trade rejected over something that can be so easily fixed.
Stacey W-H
I fully support auctioning in general, but Washington’s unique situation may mean it’s sensible to give free allocations to Washington utilities, such as the WCI is now proposing. The public utilities in Washington either own their own hydro or are customers of Bonneville. A few of them own natural gas generators but none own coal. They may buy coal from others but that’s a behavior that can change. The investor-owned utilities (IOUs) do not have the same access to the hydro system and have had to build their own generation to serve Washington customers. All of the coal owned by Washington utilities is owned by IOUs (and all of the coal plants owned by these IOUs are out of state). With 100% auction, most, if not all, of the costs for meeting our climate goals would fall on the customers and shareholders of IOUs. PSE is an IOU, their costs would jump. Meanwhile, the owners of hydro stand to make a lot of money from their higher-valued surplus. Is it politically acceptable to see rates in one utility jurisdiction be orders of magnitude higher than it’s neighbor, just because of luck of geography and organizational structure? I think we should stay focused on changing the future rather than penalizing the past: take actions which ensure the shift away from fossil fuels, rather than creating massive rate distortions because of historical actions, many of which made perfect sense at the time those decisions were made many decades ago. All of the IOUs are regulated by the state’s utility commission, and the proceeds from sale of the credits are strictly dedicated for use in energy efficiency, renewable energy and low-income assistance programs. The PUDs who may have free allocations will be subject to the state auditors to ensure they use the proceeds properly as well.So, my jaw dropped when I first saw they were planning on free allocation—I was angry after all we had heard about lessons learned from the EU – but it just so happens, at least in Washington, that it does make some sense. There are still very clear signals to shift off of coal as quickly as possible and that is the main point. I think it’s important that the utilities remain whole while making that shift – forward progress is the key.-Stacey
ray benish
Cap and trade is a bad idea all around and in many respects it resembles the noxious notion of “deregulation of the energy market” that was sold to a number of state public utility commissions. In the real world cap and trade has been a failure in both achieving its goals and delivering change at an acceptable economic and social cost. I think we can defeat it in the Washington State Legislature. The idea of Ecology selling the snake oil of 49% offsets is indeed remarkable as even a cursory web search leads to the conclusion that offsets are major scam CDM and JI under the Kyoto Protocol- the rampart degree of fraud is openly acknowledged. Come on Ecology – get smart! Do not claim that you have consulted the “stakeholders” that is other than the industry groups who feel comfortable sitting at the table because they all envision buckets of cash. The ordinary folks will end up picking up this tab. We will be paying for a lot and getting a little. Why would a legislator vote to turn the most critical piece of our infrastructure – electic power generation- over to the Bernie Madoffs of Wall Street? Crazy, crazy.
Eric de Place
Couple of things. 1. Cap and trade has been highly successful in a air quality programs, particularly for addressing acid rain-causing pollutants.2. The 49% offset figure refers specifically to the emissions reductions in a given compliance period, not to the total number of carbon credits that a polluter would need to hold (i.e. not to the “compliance obligation” as it’s called). 3. Ecology (and WCI) are aware of the serious problems with CDM. We can expect a more rigorous approach.All that said, it’s true that there are, indeed, ways to make cap and trade ineffective and unfair. (Though that’s true of pretty much any public policy I can think of.) It’s paramount that we get the details right.