Timing Flexibility Under a Cap-and-Trade Program

March 26, 2009

This morning I testified before the House Ways and Means Committee about the ways to reduce the economic cost of a cap-and-trade program for greenhouse-gas emissions by increasing firms flexibility in the timing of their emission reductions. Accumulating evidence about the pace and potential extent of global warming has heightened the interest of policymakersin cost-effectiveways to achieve substantial reductions in emissions. Many analysts agree that that putting a price on carbon emissionsrather than dictating specific technologies or changes in behaviorwould lead households and firms to reduce emissions where and how it was least costly to do so.

Allowing flexibility about when emissionswere reduced would further lower costs, because changes in weather and fuel markets lead the cost of emissions reduction to vary from year-to-year. This flexibility in timing can be achieved without lowering the benefits of emissions reductions because climate change depends not on the amount of greenhouse gases released in a given year but on their buildup in the atmosphere over decades. Analysts have developed a number of options for increasing timing flexibility;this morning I made five key points about these options:

  • First, permitting firms to bank allowancesto save allowances for use in the futurehas helped lower compliance costs in existing cap-and-trade programs. However, existing cap-and-trade programs that use banking have still experiencedsubstantialvolatility in allowance prices.
  • Second, permitting firms to borrow future allowances as well as to bank them could further lower compliance costs. Existing cap-and-trade programs typically preclude borrowing, in part because of concerns that firms that borrow allowances might be unable to pay them back later.
  • Third, permitting firms to purchase allowances from a public reserve pool"-- composed of allowances that were borrowed from future years or that supplemented the initial supplycould partially substitute forborrowing by individual firms. Theeffectivenessof the reserve pool inrealizing cost savings would depend on the size of the pool and the threshold price at which firms could purchase the reserve allowances.
  • Fourth, setting a floor and ceiling for the price of allowances would also lower firms compliance costs, but it would not ensure a particular level of emissions in the end.
  • Finally,a managed-price approach would allow for substantial cost savings by eliminating short-term volatility in the price of allowances while accommodating longer-term shifts in prices that would be necessary to keep emissions within a long-term cap. In a managed-price arrangement, firms could purchase allowances from the government each year at a price specified by regulators; in this respect,the policy would be similar to a tax.However, the policy is like a cap-and-trade program in other key respects: Policymakers could choose to distribute some allowances to firms for free; they could allow firms to comply by purchasing offsets, or credits for emission reductions made in sectors not covered by the cap; and cumulative emissions over a period of several decades would be capped. To implement this approach, regulators would establish a path of rising prices for allowances with thegoal of complying with the cumulative cap that legislators had set; that path would be adjusted periodically based onnew information about emissions and future compliance costs.

In short: timing flexibility can be a useful tool in meetingemissions targets as efficiently as possible. The more flexibility that is granted regarding the timing of emissions reductions, the less short-term volatility in the price of emissions and the lower the cost of meeting any given emissions target.