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Chapter
2Implementation Considerations for Different Policy Designs
In addition to the efficiency trade-offs highlighted in the previous chapter, policymakers may wish to weigh other aspects of alternative policies, including the likelihood that the policy could be easily implemented. The following discussion examines the relative ease of implementing a carbon dioxide tax, an inflexible cap, and the flexible cap designs discussed in the previous chapter. It is not meant to provide a comprehensive examination of the challenges associated with implementing individual policies but rather to highlight implementation considerations that would vary across policies.
A Carbon Dioxide Tax Versus an Inflexible Carbon Dioxide Cap
Successfully implementing either a CO2 tax or an inflexible cap would entail several similar requirements. Under an upstream design, suppliers of fossil fuels (such as coal producers, petroleum refiners, and natural gas processors) would be required to pay a tax—or hold an allowance—for each ton of carbon that was contained in the fuel they sold (and, thus, would be emitted in the form of CO2 when the fuel was burned). In that case, firms would need to report their sales data and the carbon content of the fuels they sold so that regulators could determine each firm’s tax or allowance requirement. Regulators would need to have methods of verifying the accuracy of the reported data. In that way, they could detect underpayments of taxes or excessive emissions and impose adequate, consistent, and predictable penalties.
Further, regulators would need to have a method of ensuring that all fuels that should be subject to the regulatory requirements were covered by the policy. That would entail accounting for fossil fuels that did not pass through a domestic mine mouth (less than 0.5 percent of all coal consumed in the United States), a domestic petroleum refinery (approximately 1 percent of the petroleum produced or imported into the United States), or a natural gas processing plant (approximately 22 percent of the natural gas consumed in the United States).1 Finally, regulators would need to be able to accurately identify fossil fuels that were not combusted and, therefore, should be exempt from the tax or allowance requirement, such as petroleum that was used in producing plastics or tires. On the basis of information from the Energy Information Administration, such a system would entail regulating roughly 150 oil refineries, 1,460 coal mines, and 530 natural gas processing plants.2
Moving the point of regulation downstream—to users of fossil fuels—could be more difficult to implement in some sectors. For the power sector, such a change would be relatively simple to make because large power producers subject to the Acid Rain Program are required under the Clean Air Act to have equipment in place that continuously monitors CO2 emissions. (See the appendix for a description of the Acid Rain Program.) Outside the power sector, however, a downstream system could impose significant implementation challenges. The number of entities that would need to be regulated would grow, and identifying their emissions would initially be difficult. In fact, inaccurate data about the baseline emissions of downstream industries (such as cement, iron, and steel plants) in the European Union’s trading program for CO2 emissions caused regulators to issue more allowances to those industries than they intended to under the first phase of the program. That overallocation contributed to large price swings at the end of the first year of reporting.3
Similar data problems occurred with the start-up of the Acid Rain Program. It took the Environmental Protection Agency two rounds of data review with industry (through public notice and comment) over the course of two years to sort out anomalies in the data used for determining generating units’ initial allocations (based on energy data reported to the Department of Energy). For example, EPA made adjustments for electricity generating units that had significant outages during the period that was used to determine the initial allocations. Because EPA had a much longer time to implement the Acid Rain Program than the EU had to implement the initial phase of its program for carbon dioxide, EPA was able to review and revise the data before allocating the allowances. And because the anomalies were discovered before the initial allocations were made and the trading program was operational, the revisions did not lead to price swings in the allowance market.4
Another implementation consideration is whether allowances should be grandfathered, or given away for free, on the basis of previously existing circumstances. A cap-and-trade program in which allowances were not grand-fathered could have substantially lower start-up costs (because it would avoid the lengthy process of determining the basis for grandfathering) than a cap-and-trade program in which allowances were grandfathered. A tax would have significantly lower start-up costs than a cap-and-trade program with grandfathering provided that policymakers did not decide to grant exemptions based on historical production or emissions data. Further, implementing a tax would not require the government to set up a process for auctioning allowances.
The cost of implementing an upstream carbon tax is likely to be less than that of a cap-and-trade program (regardless of how allowances were initially allocated) because the tax could build upon an existing infrastructure. For example, coal producers already pay an excise tax (which is used to fund the Black Lung Trust Fund) as do producers and importers of petroleum (to fund the Oil Spill Trust Fund). A CO2 tax based on the sales of coal or petroleum would be an additional excise tax and could, presumably, be implemented at a relatively modest incremental cost. While natural gas is not subject to a federal excise tax, many natural gas processors are subject to a corporate income tax.
In contrast, implementing an upstream cap-and-trade program would probably require a new administrative infrastructure. However, based on EPA’s experience with the Acid Rain Program, the cost of administering such a program could be relatively modest. Regulators would need to take the following steps:
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Set up an allowance account for each regulated unit and for other nonregulated entities that might wish to trade allowances (such as brokers),
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Record information on allowance allocations for each regulated unit,
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Review submitted allowance transfers to make sure that they have all necessary information and meet the regulatory requirements,
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Record transfers into and out of each account, and
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Notify both participants in a transfer when the transfer was recorded.5
EPA estimates that it spends approximately $1.5 million annually to operate its Allowance Tracking and Allowance Transfer Systems for the Acid Rain Program.6 That program maintains accounts for regulated power generators (who must comply with the cap-and-trade program) as well as for other traders. On the basis of the most recent data, a little more than half of the accounts (roughly 1,200) are held by regulated generators, and the remainder (915) are general accounts.7 In 2005, nearly 5,700 private allowance transfers (moving roughly 20 million allowances) were recorded in EPA’s Allowance Tracking System.8
Flexible Cap Designs
As discussed in the previous chapter, including features in a cap-and-trade program that would make it more responsive to annual variations in the cost of reducing emissions could improve its efficiency. In some cases, those features could be relatively easy to incorporate:
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Implementing a safety valve (a ceiling on the price of emission allowances) could be relatively straight-forward. The government could offer an unlimited amount of allowances at the safety-valve price.
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Implementing banking provisions (in which firms could save allowances from one period to use in a future period) could also be straightforward. Banking has already been successfully implemented in several existing cap-and-trade systems. For example, emitters in the Acid Rain Program may bank allowances for an unlimited amount of time, and some countries participating in the European Union’s Emission Trading Scheme allowed banking in the first phase of the program (2005 to 2007). For implementation purposes, borrowing (in which firms use allowances designated for a future period in the current period) would be similar to banking.
Other features of a cap-and-trade program could be more difficult to implement. A circuit breaker, which would freeze an otherwise declining cap once the price of allowances rose to a predetermined circuit-breaker price (and would keep the cap at that level until the allowance price fell back below the circuit-breaker price) could pose more significant implementation challenges. In order to determine when to trigger the circuit breaker, policymakers would need accurate information on allowance prices. They would also need to decide how sensitive the trigger would be. For example, would the circuit breaker be triggered if any single allowance was traded at a price above the circuit-breaker price? Or would it be based on a price index? If so, would the chosen price indicator have to remain above the circuit-breaker price for a given amount of time? Making such determinations could be difficult, for several reasons:
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Allowances for CO2 could be traded in "over the counter" transactions between an individual buyer and seller (possibly through a broker)—as is the case for the sulfur dioxide (SO2) allowances that are traded under the Acid Rain Program. In such transactions, the parties involved are not required to report the price at which the commodity is traded. In the case of SO2, most brokers voluntarily report prices, and several publications report prices or publish indexes—but those prices are not verified.9
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Traders could have an incentive to provide inaccurate information about prices. For example, sellers of allowances could inflate their price information to convince buyers that they need to pay more for their allowances. Likewise, regulated entities might wish to have the price of allowances appear high enough to trigger the circuit breaker so as to prevent the CO2 cap from becoming more stringent.
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Prices could fluctuate widely over time. Determining whether a change in price represented a temporary spike or a more permanent shift in underlying market conditions would be difficult.
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There could be several different prices for allowances at any given point, and those prices would vary during a year. As a result, determining when the circuit breaker should be triggered could be difficult: Policymakers would need to decide which allowance price the circuit breaker would be based on and how long that price would have to be above the specified level to cause the cap to stop declining. Policymakers would need to make similar decisions in order to determine when the circuit breaker should no longer be in effect—and the cap should once again begin to decline.
Based on information provided to the Congressional Budget Office by the Environmental Protection Agency’s Clean Air Markets Division (July 5, 2007).
See Department of Energy, Energy Information Administration, "EIA-820, Annual Refinery Report" as of January 1, 2006, and "EIA-816, Monthly Natural Gas Liquids Report," both available at www.eia.doe.gov/oss/forms.html, and EIA’s 2005 Coal Production Data Files, available at www.eia.doe.gov/cneaf/coal/page/database.html.
Once this fact was revealed, prices of allowances fell by more than 75 percent. See the statement of Jill Duggan, Head of International Emissions Trading, U.K. Department for Environment, Food, and Rural Affairs, EU Cap-and-Trade Programme, before the House Committee on Energy and Commerce (March 29, 2007), p. 3.
Based on information provided to the Congressional Budget Office by the Environmental Protection Agency’s Clean Air Markets Division (July 5, 2007) as well as Joseph Kruger and William A. Pizer, The EU Emissions Trading Directive: Opportunities and Potential Pitfalls (Washington, D.C.: Resources for the Future, April 2004), pp. 14–15.
Those steps are based on EPA’s responsibilities for operating both the Allowance Tracking System and the Allowance Transfer System for sulfur dioxide trading under the Acid Rain Program. See Environmental Protection Agency, Information Collection Request Renewal for the Acid Rain Program Under the Clean Air Act Amendments Title IV (July 26, 2006), pp. 31–32.
Ibid., p. 32.
Based on information provided to the Congressional Budget Office by the Environmental Protection Agency’s Clean Air Markets Division (July 5, 2007).
See Environmental Protection Agency, Acid Rain 2005 Progress Report, EPA-430-R-06-15 (October 2006), p. 9.
Based on information provided to the Congressional Budget Office by the Environmental Protection Agency’s Clean Air Markets Division (July 5, 2007).
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