Economics of cap-and-trade

A lot of people on both sides of the climate change issue are worked up about the Waxman-Markey cap-and-trade bill that seems due for a vote on the House floor next week. Purists are upset that only 15% of the allowances will be auctioned, as opposed to 100% (as Obama promised on the campaign trail). Here are two posts I find particularly helpful in unraveling the economics.

1) Harvard Kennedy School professor Robert Stavins explains why cap-and-trade is environmentally effective and economically efficient regardless of the initial allocation of permits. This is a VERY attractive property in a policy mechanism which will inevitably be subject to political horse-trading, and one not shared by a carbon tax. I tend to think that some stakeholders clamoring for a carbon tax (e.g., major oil and coal companies) do so because in practice it would be politically infeasible.

2) Geoff Styles explains why the Waxman-Markey allocation of allowances would implement a de facto gasoline tax. Basically you can do two things with cap-and-trade revenues: rebate them to consumers, or invest them in clean energy research and energy efficiency. (I suppose you could also use them for a third thing, e.g. paying for universal health care, but let's ignore that for simplicity.) 100% rebates would be required to avoid price increases, which consumers (read voters) don't like. On the other hand, some investment of proceeds will, in theory, lower the long-term cost of complying with the cap. The current allocation effectively rebates for electricity (by giving 35% of permits to the power sector) but does not for transportation fuels (they have to buy permits on the market, likely from the renewables sector, which gets more permits than they need). In case you're wondering, the quick back-of-the-envelope is it takes about 100 gallons of gas to emit 1 ton of CO2 equivalent, so an allowance price of $20/t of CO2e would equate to a "tax" of about 20 cents per gallon.

P.S. Stavins' killer synthesis: “The appropriate characterization of the Waxman-Markey allocation is that more than 80% of the value of allowances go to consumers and public purposes, and less than 20% to private industry.”

P.P.S. Stavins has a new post on Waxman-Markey taking on international competitiveness and collective global action on climate change. His conclusion: "Like any legislation, the Waxman-Markey bill has its share of flaws. But it represents a solid foundation for a domestic climate policy that can help place the United States where it ought to be -- in a position of international leadership to develop a global climate agreement that is scientifically sound, economically rational, and politically acceptable to the key nations of the world."

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