Editor’s Note: Please bear in mind that this is a “first read” of a very large piece of legislation. It was researched and written within 24 hours of the bill’s publication. I’ve since made a handful of minor revisions. I’ve also written a follow-up post on allowance allocations.

The Kerry-Lieberman climate bill emerged yesterday mid-morning, weighing in at 987 pages. (Hey, changing the entire energy economy ain’t easy.) Like the Waxman-Markey bill that passed the US House of Representatives last summer, the American Power Act is a comprehensive energy and climate bill. That means it touches a wide range of issues, from nuclear energy development to electric vehicles to offshore oil drilling. To find the full text of the bill, as well as several summaries, go to Senator Kerry’s website.

As I examine the nuts and bolts of the bill, I’ll post updates for readers. I am not, however, going to weigh in on every element in the bill. Instead, I’m going to focus mainly on the bill’s climate centerpiece: its cap-and-trade program. And I’m not going to focus on the politics—you can find armchair pundits all over the blogosphere—but rather on the policy itself.

If it’s political commentary you’re looking for, here are my recommendations:

Oh, one more thing: this blog post is not going to be Cap and Trade 101. If you’re looking for an explanation of how Cap and Trade works, and how to do it right, please see Sightline’s Cap and Trade 101: A Climate Policy Primer.

Please do send comments or questions.

The basic architecture

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    • The structural elements of the cap-and-trade program are fairly straightforward. The bill sets out a declining cap on carbon emissions that aims to achieve a 4.75 percent reduction below 2005 levels by 2013; a 17 percent reduction by 2020; 42 percent by 2030; and finally 83 percent by 2050. (Nota bene: Although these targets are consistent with other major pieces of legislation, they are not terribly ambitious. US domestic emissions are 10 percent below 2005 levels right now. An additional 7 percent reduction should be easy, even factoring in an economic recovery that will stoke demand for carbon.) The reduction goals for the overall economy are the same as the targets in the capped sectors.

    The program’s cap starts in 2013 for the electricity and transportation sectors, which together constitute an estimated 66 percent of total domestic emissions. The industrial sector joins in 2016, bringing the total up to almost 85 percent. The remaining 15 percent of US emissions are treated separately from the cap-and-trade program with a range of targeted policies and regulations, most of which seem appropriate, and most of which I will not describe here.

    The cap is implemented reasonably far “upstream”—at the electrical generator, refinery gate, and industrial smokestack—meaning that only about 7,500 entities are regulated under the bill. This design will radically simplify the program’s administration.

    What’s the deal with transportation fuels?

    The pre-release rumor mill produced a number of criticisms that were, frankly, off base. It’s true that the bill’s treatment of transportation fuels is something new under the sun, but it turns out to be a benign alteration.

    Here’s how it works. The first-sellers of refined petroleum products (generally, refiners and importers) must purchase carbon permits that are withdrawn from the total supply available under the cap. Yet these permits are somewhat different in two important respects: 1) they are purchased at a fixed priced, which is the “market price” established in the cap-and-trade program for the other sectors; and 2) the permits cannot be sold or traded, banked or borrowed; they can only be used for compliance. (As a practical matter, the program administrators simply forecast the quantity of permits needed for the transportation sector and set aside that amount from each quarter’s distribution. If the administrators over- or under-estimate, adjustments are made to the next quarter’s distribution.)

    In other words, for the transportation fuels sector, we have a program that is, essentially, cap-and-no-trade with full auctioning. In some ways, it’s similar to the managed-price cap-and-trade program floated last year by Congressman Jim McDermott of Washington. (See another post on this topic.)

    My take on the treatment of transportation fuels? It’s pretty good. All of the allowances are sold, not given away. Transportation fuels are (almost) all under the cap, meaning the petroleum industry doesn’t get a free ride. Yes, making oil companies buy permits at prices set in an auction in which mostly electric utilities participate will have a few unwanted consequences. The nation may not always get the very cheapest emissions reductions first, for example. But I submit that these distortions will be minor and mostly affect the sequence in which emissions-reduction actions are taken.

    Oh, there is one other feature for the transportation fuels sector worth mentioning. For some reason, the program exempts the carbon used in international commercial aviation, pending future international agreements on the matter. (Technically speaking, the program provides “compensatory allowances” for these fuel users.) I don’t know any practical or principled reason for this exemption. This provision is an irritant, but it’s hardly a deal-breaker.

    How does the carbon market work?

    The American Power Act gets carbon market oversight right. Appropriately enough, the bill borrows from Senator Cantwell’s CLEAR Act, as well as the Carbon Market Oversight Act of 2009.

    Carbon permit auctions are conducted quarterly and they are limited only to the carbon emitters who are required by law to hold permits, as well as a small number of designated brokers who can provide liquidity for smaller firms. The secondary market for allowances is open, meaning that firms can trade permits with one another or with brokers or other entities.

    An open secondary market also means that charities and voluntary offset sellers can purchase permits and toss them in the trash (or, rather, the recycling bin) in order to reduce total emissions below the cap. Want to genuinely offset the emissions from your flight to Hawaii? Just tally your trip’s carbon emissions and purchase the corresponding number of permits. By allowing real carbon permits to be sold on a secondary
    market, the program would allow for take-’em-to-the-bank offsets for nonprofits, or Pearl Jam tours, or Super Bowls, or what have you, thus alleviating at least one worry from folks like Jim Hansen who are very concerned with personal action.

    Under the bill, emitters are free to “bank” permits (aka, save them) indefinitely (a good thing for both the atmosphere and for firms’ financial security). Firms also get a two-year rolling compliance period. This means that they have up to two years to acquire, and then turn in, permits for their emissions. This policy will help stabilize carbon prices. They can also borrow a portion of their permits from future years, up to 5 years out—another protection against carbon price spikes. When they borrow future permits, they must pay an 8 percent annual “interest rate” in permits to do so. Kerry-Lieberman’s banking and borrowing provisions are nicely balanced: they will provide energy companies with stability and predictability without compromising the law’s climate and clean-energy benefits.

    The bill provides a tightly-regulated derivatives market on a regulated exchange in which carbon futures will be treated just as agricultural derivatives are. In fact, the bill hands market management to the same agency, the Commodity Futures Trading Commission (CFTC), under the same authorizing legislation. While this tight regulation does not, strictly speaking, completely eliminate the possibility of market manipulation, it will make the carbon market about as risky as the markets for hog bellies and soybeans.

    What’s this “price collar” I keep hearing about?

    The bill sets boundaries on the prices of the carbon permits that are sold at auction, which is a very important feature for businesses, though of dubious worth for the program’s environmental aims. Still, all things considered, I’d say the Kerry-Lieberman bill gets the price collar about right. Here’s the skinny.

    A price collar consists of two parts: a price floor (or reserve price) and a price ceiling. In this bill, the price floor will be set at $12 per ton of carbon-dioxide in 2013. (The price floor rises at the rate of inflation plus 3 percent annually until 2050.) That means that authorities will not sell any permits for less than $12. This implies that not all of the permits available for sale under the cap will necessarily be used—good news for the climate and clean-energy jobs.

    [Update 5/14/10: Edits made in the following two paragraphs.]

    On the other hand, the price ceiling will be set at $25 per ton of carbon-dioxide in 2013. (The price ceiling rises at the rate of inflation plus 5 percent annually until 2050.) That means that authorities will sell as many permits for $25 as anyone wants to buy. This means that when there are willing buyers at the price ceiling, more carbon permits may be sold than are allowed under the annual cap’s schedule, which is bad for the atmosphere. However, the bill provides for a “strategic reserve” of carbon permits. This stockpile of permits is assembled with a percentage of permits that appear to be taken largely from beneath the cap. (This section of the bill is very difficult to parse.) If any are sold, they are replenished by unsold permits (in the event that the price floor kicks in during any auction), by international offsets (at a discount of 5 offsets per 4 carbon permits added to the reserve), and then by domestic offsets, in that order.

    The design of the price ceiling and strategic reserve leave something to be desired. There’s a potential for busting the cap, if carbon demand is strong enough. A better design would establish the strategic reserve with permits that are shaved off the annual cap. But I am only a little worried. For one thing, the strategic reserve preserves some of the overall integrity of cap. For another, I don’t expect that permits in 2013 will sell for much more than $12, and a carbon price of $25 seems highly unlikely. Efficiency, renewables, and other emissions reductions opportunities are just too abundant.

    What’s the deal with EPA authority?

    A lot of folks are worried—and some are apoplectic—about the bill’s treatment of the EPA’s authority to regulate greenhouse gas emissions. I guess you could say I’m concerned.

    As Senator Kerry pointed out in his blog post at Grist, the program is actually administered by the EPA. So in that sense, the agency maintains, and perhaps even gains, considerable power. Yet the bill does prevent the EPA from regulating greenhouse gas emissions as air pollutants under its Clean Air Act authority. (Possible hair-splitting aside: the bill doesn’t provide carte blanche exemption for greenhouse gas emissions from the Clean Air Act. It says only that EPA can’t regulate them as a hazard to human health owing to their contribution to climate change or ocean acidification. Presumably, if they were shown to be unhealthful for some other reason, EPA may be able to regulate them directly as air pollutants.)

    Restricting EPA’s authority is a deal-breaker for some greens. It’s not for me, though. Direct EPA regulation is not my first choice for dealing with carbon. It’s not even my second choice. That’s because it’s likely to be expensive, cumbersome, politically fraught, and possibly ineffective. Don’t get me wrong, I’d very much like to retain EPA’s authority in case we run out of options, but it is something I’d trade away for a decent comprehensive energy and climate bill that puts a legal limit on carbon emissions. And that’s precisely what we’re getting with the American Power Act.

    Consumer protection

    The cap-and-trade program is remarkably oriented toward consumer protection—that is, it provides strong built-in protections for working families. (Much more so, I’d say, than the House-passed Waxman-Markey bill.) For reasons that I presume have to do with political influence, the bill takes a rather winding path between point A (the program) and point B (consumer protection), yet it does manage to arrive at its destination.

    In the early years of the program, a significant chunk, around 60 percent, of the carbon permit value is returned indirectly to consumers. Rather than simply auctioning the permits and returning the money to families, the bill provides free allocation of permits to local utilities and energy providers. But the free allocation comes with strings attached. The strings require the local firms to pass along the financial benefits to their ratepayers on a per-capita basis. (It’s actually somewhat more complicated than I’ve described here, but I think the topic deserves its own post, later.)

    Got that? Good. Now forget it.

    Those free permits I just told you about, the ones earmarked for consumer protection, shrink in number more or less at the same rate as the overall cap is shrinking, phasing out completely by 2030. Meanwhile, starting in 2026, a new program comes online called the Universal Trust Fund, which is essentially a cap-and-dividend style rebate program. In other words, a small but growing share of permits are auctioned with the revenue directed to the Trust Fund, and then returned directly to households, adjusted for size and without income limits. (It’s up to the Treasury Department to determine exactly how the rebate mechanism will work.) The upshot is that by 2035, nearly 78 percent of all permits will be auctioned with the money set aside for what amounts to per capita dividends for American households. This is about as close to genuine cap-and-dividend as we’ve seen, and it’s evidence that Senator Cantwell’s climate bill has had a positive influenc
    e on Senate thinking about consumer protection.

    Plus, in addition to all that stuff, the bill contains extra provisions for low-income households. They get direct cash refunds if they are below 150 percent of the poverty threshold. Households below 250 percent of the threshold are eligible for refundable tax credits.

    I am pleased with these provisions. Sightline has always argued that those who have done the least to cause—and stand to lose the most from—climate change should be held harmless. Climate policy should help to right the egregious injustice of climate change itself.

    What about offsets?

    The bill devotes more than 120 pages to offsets, so my treatment of this potentially heartburn-inducing subject will be necessarily abbreviated. Why do I say heartburn-inducing? Because if done wrong an offsets program could prove to be the Trojan Horse of comprehensive climate policy. And there are reasons to worry about Kerry-Lieberman’s provisions, which I’ll get to in a moment.

    Like most other flagship climate bills, it will use both domestic and international offsets. Domestic offsets are considered as good as emissions reductions; for example, a coal-burning power plant could substitute a certified ton of offset carbon (say, from planting trees on farmland) for a one-ton emission permit in its periodic compliance report to federal authorities. In other words, domestic offsets count, one to one, same as emissions reductions. International offsets, on the other hand, are subject to a discount rate such that five tons of international offsets must be supplied for every four tons of offset allowances actually awarded in the program. The discount rate helps cushion uncertainty about international offsets’ actual impacts.

    The bill takes a “project type” approach to offsets, which means that it requires the program administrators to identify categories of projects—landfill methane capture or forest planting, just for example—and then develop carbon measurement techniques that can be applied to all the projects in the category. It’s  a good idea. And to its credit, much of the reason the bill’s offset section is so long is that it goes to great length to provide rigorous oversight and quality assurance. I take this as reason for cautious optimism.

    Why am I worried?

    First, the bill includes a ton of offsets. Or, more precisely, 2 billion tons of offsets. In each year of the program. As a practical matter, that means that roughly 43 percent of the total capped emissions can be met with offsets, rather than permits, in 2013 when the program starts. By 2043, all capped emissions can be met with offsets. Now, assuming that the offsets are real, permanent, additional, verifiable, yadda yadda, there’s nothing wrong with this. But I’m a worrier, and this bill gives me 2 billion reasons a year to worry that we won’t be reducing carbon with the certainty and verifiability of, say, replacing coal-fired power plants with wind mills. Or replacing Hummers with plug-in hybrids. Or doing energy-saving retrofits on millions of homes and businesses. Or building compact communities in which walking, cycling, and riding transit can meet most of our mobility needs. It says, in short, “if it’s cheaper to plant trees than to convert to a super-efficient, clean-energy economy, it’s OK to plant trees.” Some observers think the supply of certifiable domestic or international offsets will simply be too expensive for most of the allowed 2 billion to ever see the light of day. But I worry.

    Second, the bill assigns a large portion of the responsibility for the domestic offsets program not to the EPA, which will administer the bulk of the cap-and-trade program, but to the Department of Agriculture. Folks in the know tend to worry about this because the USDA has sometimes been the victim of “regulatory capture,” putting the interests of the farm and forestry lobbies ahead of the public interest.

    I’ll think I’ll leave it at that. For my money, the expansive offset provisions are the most worrisome feature of the bill. Yet we haven’t seen any bill (no, not even the CLEAR Act) that doesn’t contain very large offset, or offset-like provisions. Offsets can be made to work, but I’m going to need some Pepcid if I keep thinking about them. My guess is that, once the United States passes a comprehensive climate and energy law, people like me will spend an awful lot of our time monitoring the workings of offset programs.

    Miscellaneous annoying stuff

    A few items rise to the top of the heap, some directly related to cap and trade and some not.

    State and regional cap-and-trade programs are suspended. That means no Western Climate Initiative, as well as no RGGI, no AB32 in California, and no Midwest program. The bill does provide compensation for states that have functional cap-and-trade programs, which at this point only applies to the Northeast states in RGGI.

    A truckload of giveaways and subsidies. In particular, nuclear power gets a federal loan guarantee of $54 billion; “regulatory risk insurance” for up to 12 reactors; and up to $500 million of cost recovery for each reactor. Additionally, it dedicates money for research and development on spent fuel recycling and other nuclear technologies, while it reduces some regulations and extends tax benefits, such as tax credits and a more advantageous depreciation schedule. The bill also provides some subsidies for carbon capture and sequestration at coal plants, a technology that has so far proved to be enormously expensive. I support federal funding for research on nuclear and CCS technologies, but such massive subsidies to implement them are bad policy. Which doesn’t make them bad politics. I’m willing to pay this price for other things in the bill.

    The bill tries to thread the needle on offshore oil drilling. The principled thing to do would be to just stop it: No more drilling for oil off US shores. But apparently the politically expedient thing is to provide both (1) a revenue-sharing carrot to states that allow drilling and (2) a veto to states where their own coastal waters, and those of their neighbors, are concerned. The bill includes some provisions for sorting out the sticky politics of oil spills which can, of course, cross state marine boundaries.

    Energy efficiency language perhaps doesn’t go far enough. I haven’t evaluated the efficiency components of the bill myself, but that’s the word from the American Council for an Energy Efficient Economy (ACEEE), which is among the first places you should turn for insight on these issues. That said, and with all due respect to ACEEE, I’m not sure this problem is worth stressing out about, for two reasons:

    • Much of ACEEE’s criticism is based on the fact that Kerry-Lieberman awards more of the value of the carbon credits to consumer protection and less to energy efficiency programs. And while I’m a huge believer in efficiency investments, I think consumer protection is arguably even more important.
    • It’s fixable. Wriggling out of the python-like grasp of subsidies to coal and nukes may prove next to impossible, but finding additional resources and regulation for energy efficiency should prove to be a do-able task for progressives.

    Speeding up the cap?

    Here’s something that usually gets overlooked. Despite all its flaws, there is some real reason for optimism that Kerry-Lieberman might actually reduce emissions faster than the cap requires.

    That seems counter to the basic principles of cap and trade, but it’s not. No one can possibly know how hard or easy, how expensive or cheap, it will be to get off the fossil-fuel roller coaster. But there are lots of reasons to hope it may be easier and cheaper than we expect. For example, new
    natural-gas extraction techniques could drive coal out of the electric market more quickly than we anticipate. Energy efficiency programs such as Clean Energy Works in Portland could prove terrifically effective and spread widely, once everyone knows that carbon is going to cost steadily more over time. Huge public investments in energy R&D, already underway, could bring breakthroughs in thin-film solar, or battery performance, or advanced biofuels, or smart-grid technology—or any number of other things. A price on carbon could unleash unprecedented private investment in other breakthroughs.

    Now, consider the price floor in Kerry-Lieberman. If squeezing carbon out of the economy proves easier than we expect, the market value of carbon permits would likely fall below the floor —$12 in 2013, or $20 (adjusted for inflation) in 2030, and so on. As a result, not all the permits will get distributed. There won’t be enough buyers. Emissions will decline more than required by the cap.

    Plus, the secondary market for carbon permits allows people and businesses to buy down the cap on their own. You or I or anyone else can buy and retire permits. We might even see a surge in the voluntary offsets market, currently hampered by the uncertainty surrounding offsets.

    Plus, if fewer than one in five international offsets goes bad, we’ll be seeing more genuine carbon offsets deployed than there are emissions to cover.

    Closing thoughts

    Kerry-Lieberman in its current draft form gives us plenty of causes for heartburn, from the minor (international aviation exemption) to the major (the abundance of offsets). But it’s actually better than I had allowed myself to hope for. Remember, we’re talking about the US Senate here, an institution that gives disproportionate influence to small-population states and then requires a supermajority. I had expected a bill that was substantially weaker and more-compromised than the House’s Waxman-Markey. Kerry-Lieberman is not. Aside from the massive handouts it pays to the nuclear power industry, my initial read tells me that it’s mostly better than Waxman-Markey: better market regulation, better consumer protection, and better offset rules.

    A comprehensive energy and climate bill like this one is a game-changer. It marks a fundamental, and I think irrevocable shift, in our way of doing business. It puts a bounty on carbon, and it marks out a clear path to a world where carbon emissions are a curiosity.

    Other resources

    In case you haven’t got your fill yet, here are some other good places to turn: 

    Update 5/14/10:

    Update 6/9/10: