A Guide to Cap and Trade Legislation

When I first heard of the concept of a Cap and Trade system for reducing pollution, I thought it was one of the most elegant ideas that I’d ever heard. A Cap puts a hard limit on the amount of pollution that will be allowed in a given time period, and permits for that amount of pollution are distributed and traded among the polluters. Polluters that are ahead of the goals can sell their excess permits, and those that are behind have to buy extras. If lots of people fall behind the goal then the demand and price for permits go up, raising the incentive to stay on target.

Having seen a number of proposed and implemented cap and trade systems over the last decade, I’ve come to understand that there are many of different ways to design such a system, and some of the choices more appealing than others. So given the expected release of the Kerrey-Lieberman Bill on Wednesday, I thought it might be useful to outline some of the possible features of a Cap and Trade system so that more people will be able to dissect the new bill and decide for themselves whether they like it.

Notes: 1) the new bill has been rumored to use a straight tax for gasoline, so some of the following may not apply to that part. 2) the new bill may not use the phrase “cap and trade” for a process that sounds like a cap and trade system. If they use different words, then the rest of us will have to decide if its really something different or not.

Cap and Trade is a Market-Based Solution….Sort Of

People often refer to Cap and Trade as “market-based”, but for most implementations that’s only true if you thought that the economy of the USSR was “market-based”. Sure people buy and sell things, but the government can have a very heavy hand in the process, with controls on supply, demand and prices, and the ability to put certain people or organizations in a very advantaged position in the market.

The situation is aided by the fact that there is no true “cost of goods” for a pollution permit, aside from the damage to society, which no one pays for directly. As a result, if the government wants to give someone a free permit, it bears no cost, so doesn’t require a budget line item or pay-go exception. If it wants to manipulate the price, it doesn’t have to worry about net margins or the like. Basically a cap and trade system is free of a key constraint of most markets, removing many of the downsides for market manipulation.

This isn’t, in and of itself, good or bad, but it just means that you need to look closely at the government’s role in the game, and you may see some mechanisms proposed (such as offsets), that are unfamiliar, and require some extra thought.

What is Covered

The very first feature to look at in a Cap and Trade bill is what is covered. While the obvious big hitters are electricity generation and transportation based on fossil fuels, many industrial processes also generate CO2 or other GHGs. The truth is that many activities at home, including breathing and some baking activities also release CO2. So just from a practical perspective, any GHG Cap and Trade system will have to draw the line on what is covered under the system and what is not.

This is an area where nothing really silly has happened in any of the proposals (though regulating methane from cattle does come up every once in awhile), but there may be fairness issues here. For example, if industrial output above 25K tons of CO2 require permits and below 25K don’t, that could make a big difference in particular industries and is worthy of some study.

Summary: look who is covered under the legislation and who is not, and understand what impacts that will have on energy and non-energy industries

Who is Required to Get Permits

Just because you emit GHG from your vehicle doesn’t mean you’re going to be required to get permits. In most cases it will be a large company upstream, the electricity producer in the case of electricity, and someone in the chain of refiners and distributors in the case of transportation fuels (any industrial emissions are typically paid directly by the emitter).

While every day logic would dictate that you don’t want to be the one who has to obtain the permits, there are two reasons why large energy companies might be happy to take on that burden: 1) if you believe that you can pass the full cost of the permits on to your customers (as most do), then the main reason not to do it goes away. But the reality may be even better – if your actual costs for permits are invisible to the market, you can actually pass on a higher cost to your customers than you pay, thus making money on the deal! 2) if you feel like you have good influence in Washington, then being the permit purchaser puts you in a position to bargain with the federal government over free permits, offsets, etc (more on these below).

These are important elements of the case for large energy companies to publicly support some Cap and Trade legislation.

Summary: look at the bills supporters and understand if they are required to get permits. If so, look for advantages they will get from it.

Where Does the Money Go

Most Cap and Trade systems will auction off at least some, and possibly all, of the permits every year. The government will get the revenues, which raises the question of where the money will go. In general there will be tendency to want to give some of it back to the citizens in order to offset the burden of energy price increases, and it is important to fund energy R&D and other GHG reducing programs (more on this in the next post). But this revenue is a windfall for legislators, and can be used for anything.

Summary: look at where the money goes and make sure it is either lowering the impact on energy users or supporting the reduction of GHG emissions through R&D and incentives.

Freebies

Since permits have no cost, its tempting to give some of them away in order to gain support for the legislation. And, as you’d expect, the most likely candidates to receive those will be the largest energy companies (who are, ironically, also the largest polluters).

The danger here is that if the amount of freebies is large, its possible to create a major barrier to smaller, innovative companies without the same political clout as the big entrenched ones. For example, if I’m a small energy company with a lower-emissions solution, I have to buy permits for my emissions and compete against the big old companies with lots of free permits. As a result, its important to look at the free permits and who is getting them, and to consider the effect on the competitive dynamics of the market.

Summary: understand who is getting free permits, and what the competitive implications may be, especially for small companies entering the market.

Offsets

Offsets are an interesting invention. The idea is that if you do something that will reduce GHG emissions, and that is not covered under the typical system, you can turn your emissions savings into an offset permit, and can be granted the right to sell that to a company as a real emissions permit. For example, if I plant a large new forest that will capture CO2 (and hopefully hold onto it), then I may can work through the offsetting process and turn those emissions savings into permits, which I can sell and get the money for.

The rationale behind offsets is that the CO2 savings are equivalent, and that this clever mechanism funnels money to organizations which are helping out, but are outside the Cap and Trade system. Furthermore, some strongly advocate for the use of international offsets, which can be cheaper than domestic ones, and which help funnel money to developing countries who will need financial assistance for their own GHG initiatives, whether reductions or adaptation.

In addition to the organizations that sell the offset permits, the other group that likes this mechanism are the big emitters, since offsets have historically been cheaper than auctioned permits, and foreign offsets have even been cheaper. However, I believe there are three reasons to take a hard look at how offsets are implemented in a cap and trade system. First, offsets systems have, to date, been rife with fraud (here’s one recent example). Second, international offsets can result in large flows of money out of the US economy (see my analysis of foreign offsets in Waxman-Markey). Finally, if there is a limit on offsets per year (and there usually is), then the question is who gets priority to buy these cheap alternatives to auctioned permits.

Summary: offsets will have some champions, but they also have the potential to introduce complexity and risk to the system. As a result, any proposed use of them deserves extra scrutiny.

Market Distortions

One of the little discussed features of GHG Cap and Trade is that it doesn’t affect all energy consumers or technologies the same. Its important to understand this in the context of any given bill so that the resulting market distortions can be accounted for.

The varied impact on energy consumers results from the fact that the carbon content of electricity varies from location to location by over 3 times. For example, using EPA’s eGRID numbers, the amount of GHG per kWH of electricity varies from state to state as follows: CA - 0.54, CT - 0.80, AZ - 1.1, GA - 1.4, MO - 1.8, Utah - 2.1 and DC - 2.4. This is the result of the sources used - hydro, renewables, nuclear and natural gas make the numbers lower, coal and gas make them higher. As a result, someone in Missouri will be paying three times as much of a premium for their gas than someone from California.

On the technology front, the results are either from underlying price and carbon density differences, or from deliberate policy decisions. For example, a $10/ton price on GHG applied evenly to gas and electricity will raise the average price of residential electricity in the US by 8.7%, while it would raise the average price of gas by only 3.0%. Raise the price for GHG to $20 and both numbers double. A policy decision could have the same effect - we could decide to leave gasoline out of the Cap and trade altogether (an option which has been rumored for Kerrey-Lieberman), in which case we’d disadvantage electricity even further.

This isn’t to say whether these decisions are right or wrong, but its important to measure these impacts and consider what effect they have on the broader strategy. For example, the federal government has clearly made electric vehicles a priority, but either of the situations above appear to push in the opposite direction by increasing the cost advantage of gas-powered vehicles.

Summary: pricing of GHG emissions may not affect all locations or technologies the same. It is important to understand potential market distortions that may result from inequitable carbon prices.

Opaque Prices

Finally, many people argue that we need to get a visible price on carbon in order to cause people to make smarter decisions. Unfortunately, many Cap and Trade implementations offer so many ways for companies to get permits that the price reported by carbon markets doesn’t really reflect what the energy companies paid for them (for a more detailed explanation see my earlier post on this subject).

As a result, it is important to look at how companies get their permits, whether the bill contains reporting requirements, and whether you or other consumers of energy (including companies) will have any idea how much you’re really paying for your emissions.

Summary: since energy users don’t buy permits directly, in a complex Cap and Trade system it may be difficult, or even impossible to know the cost of carbon for a given amount of energy. It is important that a Cap and Trade system force this information to be transparent and available.

Conclusion

As you can see, there are many features of Cap and Trade legislation that can be complex, and can have interesting side effects on the overall market. That said, it is also possible to design a simpler system that is more transparent, less prone to fraud and abuse, and less likely to have unpredictable side effects.

When we see new climate legislation it is important to look at each of these features and understand why they are there, who might benefit, and what the consequences of it might be.

(Note: At this point an astute reader may say that I’ve talked a lot about side effects, but not about whether the bill will actually be able to drive down emissions without putting the overall economy at risk. I’ll cover that in a blog post later this week.)