Cap-and-Trade: The Good, the Bad, the Ugly

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Friday, the Congressional Budget Office (CBO) released its analysis of the Waxman-Markey cap-and-trade bill. The analysis estimates the bill will raise more than $850 billion in 10 years; yet incredibly, barely any of the money will be used to cut taxes or reduce the deficit.
 
The Basics: As with any cap-and-trade program, the bill sets limits on economy-wide carbon emissions, which are accounted for through tradable permits or “allowances.” Over time, the government will decrease the number of allowances it issues, thus forcing changes to reduce overall pollution. The Waxman-Markey bill, specifically, gives away most of its permits freely – many to electricity and gas providers, and other industries affected by the costs of the cap-and-trade program; about a quarter of allowances will be auctioned off by the government.
 
The Good: The most important feature of the Waxman-Markey bill is that it reduces overall carbon emission – a key cause of global warming. By 2020, domestic emissions are expected be 17 percent lower than in 2005, and 80 percent lower by 2050. For those of us who worry about the long-term effects of climate change, this is a big plus. Moreover, the negative economic effects of this bill will be far less severe than “command-and-control” regulations or caps on individual firms, since it will allow energy producers (and indirectly, consumers) to allocate the reduction of carbon emissions in  economically efficient ways – with those who can most easily and cost-effectively reduce their carbon footprint doing so the most.
 
The Bad: Although the bill would reduce global warming, the decision to freely allocate permits is concerning. Most economists believe the government should auction 100 percent of the allowances it issues, after which the prices of activities and products which contribute most to global warming will increase. Consumers will respond by demanding less of those goods, resulting in more conservation and a market shift toward cleaner and more efficient energy use. Revenue raised from auctions can then be cycled back to consumers, one way or another. Unfortunately, the bill gives away many of the permits to polluters instead. Generally, this won’t result in prices being any lower, but instead will give a windfall to energy producers. Some regulations requiring public electric providers keep prices low would partially offset this effect, but this would result in serious market inefficiency and unfairness, while driving up allowance prices.
 
The Ugly: In my opinion, revenue from selling allowances should be used to offset some of the negative effects of a cap-and-trade. That means countering the negative effects on economic growth – by cutting taxes on labor or capital, reducing the long-term budget deficit, or increasing investment – and mitigating the effects of higher energy prices, especially for lower-income individuals. I would do this by auctioning all permits, and using them mainly on flat refundable tax rebates and some tax rate cuts (payroll, corporate, or income), as well as to pay down a small part of the deficit.
 
But this bill not only gives away 75 percent of permits for free, it uses the revenue from auctioned permits on all sorts of goodies: promoting hybrid cars, funding alternative energy, preventing tropical deforestation, subsidizing carbon sequestration technologies, etc. Rather than trying to lower the price of every little environmentally-friendly activity, a cap-and-trade system should just raise the price of activities which contribute to climate change, and let the market decide how to deal with it. Rather than having interest groups fight out how much of a subsidy should go to wind versus solar versus nuclear, the government should eliminate all of these little tax credits. But this cap-and-trade bill would complicate things so much, so as to significantly distort market activities in a number of costly and undesirable ways.
 
The Concession: An argument could be made that, because prices are somewhat sticky, polluters do deserve some early assistance to help them transition into this new system. And this bill does phase-out a lot of the freely distributed allowances by 2030, using additional revenues to compensate consumers. Still, I worry about a bill which drastically increases energy prices (an indirect tax) without significantly cutting direct taxes; and I worry about a bill which has the capability to raise $100 billion a year, and yet cannot use any of that money to reduce our humungous and unsustainable budget deficits. Although also far from ideal, I wonder if a plan to institute a carbon tax and use the revenue to cut payroll taxes might be more economically-efficient and less subject to political interference. In any case, this cap-and-trade bill needs a lot of work before it's ready for prime time.