Implications of a cap-and-trade program

April 24, 2008

I am testifying this morning before the Senate Finance Committee on the implications of a cap-and-trade program for carbon dioxide emissions. The testimony is posted here.

Global climate change is one of the nations most significant long-term policy challenges. Human activities are producing increasingly large quantities of greenhouse gases, particularly CO2. The accumulation of those gases in the atmosphere is expected to have potentially serious and costly effects on regional climates throughout the world. The magnitude of such damage remains highly uncertain, but there is growing recognition of the risk that the damage may be extensive and perhaps even catastrophic.

The risk of potentially catastrophic damage associated with climate change can justify actions to reduce that possible harm in much the same way that the hazards we all face as individuals motivate us to buy insurance. Reducing greenhouse-gas emissions would help limit the degree of damage associated with climate change, especially the risk of significant damage. However, decreasing those emissions would also impose costs on the economyin the case of CO2, because much economic activity is based on fossil fuels, which release carbon in the form of carbon dioxide when they are burned. Most analyses suggest that a carefully designed program to begin lowering CO2 emissions would produce greater benefits than costs.

One option for reducing emissions is to establish a cap-and-trade program. Under such a program, policymakers would set a limit on emissions and allow entities to buy and sell rights (referred to as allowances) to emit CO2. In designing a cap-and-trade program to achieve emission reductions, policymakers would face a number of critical decisions, including whether to limit fluctuations in the price of allowances and whether to sell the allowances or give them away. If the government chose to sell them, decisions would also have to be made about whether to use the resulting revenue to offset other taxes, to assist workers or low-income households that might be adversely affected by the emission cap, to support other legislative priorities, or to reduce the deficit. My testimony makes the following key points about those issues:

  • Market-oriented approaches to reducing carbon emissions (such as a cap-and-trade program or a carbon tax) are much more efficient than command-and-control approaches (such as regulations that require across-the-board reductions by all firms). The reason is that the market-oriented approaches create incentives and flexibility for emissions reductions to occur where and how they are least expensive to accomplish.
  • Within the relatively efficient category of approaches that rely on the power of markets, a tax on emissions is generally more efficient than a cap-and-trade system. The reason is that although both a tax and a cap-and-trade system encourage firms to find the lowest-cost reductions at a particular point in time, a tax provides greater flexibility over time, allowing firms to achieve reductions when they are least expensive. In particular, a tax encourages firms to make greater reductions in emissions at times when the cost of doing so is low and allows them leeway to lessen their efforts when the cost is high. A cap-and-trade program can be designed to capture many of those time-related efficiencies by incorporating design features that prevent large fluctuations in the price of allowances (for example, a floor and a ceiling on allowance prices).
  • A cap-and-trade program, like a tax on CO2 emissions, could raise a significant amount of revenue because the value of the allowances created under such a program would probably be substantial. For example, in 2012, the value of the emission allowances that would be issued under S. 2191 would be roughly $145 billion, CBO estimates. As the cap that is included in that legislation became more stringent over time, the value of the allowances would grow. A key decision for policymakers is whether to sell emission allowances, thereby capturing their value in the form of federal revenue, or give them away.
  • Under a cap-and-trade program, firms would not ultimately bear most of the costs of the allowances but instead would pass them along to their customers in the form of higher prices. Such price increases would stem from the restriction on emissions and would occur regardless of whether the government sold emission allowances or gave them away. Indeed, the price increases would be essential to the success of a cap-and-trade program because they would be the most important mechanism through which businesses and households would be encouraged to make investments and behavioral changes that reduced CO2 emissions.
  • Policymakers decisions about whether to sell or give away the allowances could significantly affect the overall economic cost of capping CO2 emissions and the way gains and losses from such a program were distributed among U.S. households. A policy of giving away rather than selling a large share of the allowances could be more costly to the economy and impose disproportionately large burdens on low-income households.
    • Evidence suggests that the cost to the economy of a 15 percent cut in U.S. emissions (not counting any benefits from mitigating climate change) might be more than twice as large if policymakers gave allowances away than if they sold them and used the revenue to lower current taxes on capital that discourage economic activity.
    • In addition, providing allowances free of charge to energy producers and energy-intensive firms could create windfall profits for relatively high income shareholders of those companies, even though the emission cap would be likely to cause price increases that would disproportionately affect people at the lower end of the income scale. Further, allocating allowances without charge would not prevent the loss of jobs in affected industries because such firms would probably reduce their output in response to higher prices for carbon-intensive goods and services. Those job losses, in turn, would impose concentrated income losses in some households and communities. In contrast, if the government chose to sell emission allowances, it could use some of the revenue from those sales to offset the disproportionate economic burden that higher prices would impose on low-income households and to provide transitional assistance to dislocated workers.
  • CBO has concluded that the federal budget should record the value of allowances that are given away by the government if the recipients of the allowances could readily convert them into cash. In particular, the budget should record the value of those allowances, when they are distributed, as both revenues and outlays. That procedure, which CBO has already applied in its estimates for S. 2191, underscores that giving away allowances is economically equivalent to auctioning the allowances and then dedicating the proceeds to the recipients.