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Robert Stavins: “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.”

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"Robert Stavins: “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.”"

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… let’s be clear that, first, for the most part, the allocation of allowances affects neither the environmental performance of the cap-and-trade system nor its aggregate social cost….

Third, we should be honest that the legislation, for all its flaws, is by no means the “massive corporate give-away” that it has been labeled.  On the contrary, more than 80% of the value of allowances accrue to consumers and public purposes, and less than 20% accrue to covered, private industry.  This split is roughly consistent with the recommendations of independent economic research.

Some commenters here and elsewhere have described the Waxman-Markey clean energy and climate bill as a big giveaway to polluters.  The most credible progressive experts I know on energy economics dispute that description (see “Preventing windfalls for polluters but preserving prices “” Waxman-Markey gets it right“).  Now a more detailed analysis from an unlikely source makes the overall case stronger.

Weighing into the whole debate is Harvard University’s Robert Stavins — who is certainly not anyone’s idea of a progressive economist (see here and here), although he is obviously one of the country’s leading economic experts on cap-and-trade.  I am excerpting most of his long analysis, first posted here:

Despite all the hand-wringing in the press and the blogosphere about a political “give-away” of allowances for the cap-and-trade system in the Waxman-Markey bill voted out of committee last week, the politics of cap-and-trade systems are truly quite wonderful, which is why these systems have been used, and used successfully.

The Waxman-Markey allocation of allowances has its problems, which I will get to, but before noting those problems it is exceptionally important to keep in mind what is probably the key attribute of cap-and-trade systems:  the allocation of allowances — whether the allowances are auctioned or given out freely, and how they are freely allocated — has no impact on the equilibrium distribution of allowances (after trading), and therefore no impact on the allocation of emissions (or emissions abatement), the total magnitude of emissions, or the aggregate social costs.  (Well, there are some relatively minor, but significant caveats – those “problems” I mentioned “” about which more below.)  By the way, this independence of a cap-and-trade system’s performance from the initial allowance allocation was established as far back as 1972 by David Montgomery in a path-breaking article in the Journal of Economic Theory (based upon his 1971 Harvard economics Ph.D. dissertation). It has been validated with empirical evidence repeatedly over the years.

Generally speaking, the choice between auctioning and freely allocating allowances does not influence firms’ production and emission reduction decisions.  Firms face the same emissions cost regardless of the allocation method.  When using an allowance, whether it was received for free or purchased, a firm loses the opportunity to sell that allowance, and thereby recognizes this “opportunity cost” in deciding whether to use the allowance.  Consequently, the allocation choice will not influence a cap’s overall costs.

Manifest political pressures lead to different initial allocations of allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.  This means that ordinary political pressures need not get in the way of developing and implementing a scientifically sound, economically rational, and politically pragmatic policy.  Contrast this with what would happen when political pressures are brought to bear on a carbon tax proposal, for example.  Here the result will most likely be exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs (as some low-cost emission reduction opportunities are left off the table).  Furthermore, the hypothetical carbon tax example is the norm, not the exception.  Across the board, political pressures often reduce the effectiveness and increase the cost of well-intentioned public policies.  Cap-and-trade provides natural protection from this.  Distributional battles over the allowance allocation in a cap-and-trade system do not raise the overall cost of the program nor affect its environmental impacts.

In fact, the political process of states, districts, sectors, firms, and interest groups fighting for their share of the pie (free allowance allocations) serves as the mechanism whereby a political constituency in support of the system is developed, but without detrimental effects to the system’s environmental or economic performance.  That’s the good news, and it should never be forgotten.

But, depending upon the specific allocation mechanisms employed, there are several ways that the choice to freely distribute allowances can affect a system’s cost.  Here’s where the “caveats” and “problems” come in.

First, auction revenue may be used in ways that reduce the costs of the existing tax system or fund other socially beneficial policies.  Free allocations to the private sector forego such opportunities.  Below I will estimate the actual share of allowance value that accrues to the private sector.

Second, some proposals to freely allocate allowances to electric utilities may affect electricity prices, and thereby affect the extent to which reduced electricity demand contributes to limiting emissions cost-effectively.  Waxman-Markey allocates allowances to local distribution companies, which are subject to cost-of-service regulation even in regions with restructured wholesale electricity markets.  So, electricity prices would likely be affected by these allocations under existing state regulatory regimes.  The Waxman-Markey legislation seeks to address this problem by specifying that the economic value of the allowances given to electricity and natural gas local distribution companies should be passed on to consumers through lump-sum rebates, not through a reduction in electricity rates, thereby compensating consumers for increases in electricity prices, but without reducing incentives for energy conservation.

Third, and of most concern in the context of the Waxman-Markey legislation, “output-based updating allocations” provide perverse incentives and drive up costs of achieving a cap.  This merits some explanation.  If allowances are freely allocated, the allocation should be on the basis of some historical measures, such as output or emissions in a (previous) base year, not on the basis of measures which firms can affect, such as output or emissions in the current year.  Updating allocations, which involve periodically adjusting allocations over time to reflect changes in firms’ operations, contrast with this.

An output-based updating allocation ties the quantity of allowances that a firm receives to its output (production).  Such an allocation is essentially a production subsidy.  This distorts firms’ pricing and production decisions in ways that can introduce unintended consequences and may significantly increase the cost of meeting an emissions target.  Updating therefore has the potential to create perverse, undesirable incentives.

In Waxman-Markey, updating allocations are used for specific sectors with high CO2 emissions intensity and unusual sensitivity to international competition, in an effort to preserve international competitiveness and reduce emissions leakage.  It’s an open question whether this approach is superior to an import allowance requirement, whereby imports of a small set of specific commodities must carry with them CO2 allowances.  The problem with import allowance requirements is that they can damage international trade relations.  The only real solution to the competitiveness issue is to bring non-participating countries within an international climate regime in meaningful ways.  (On this, please see the work of the Harvard Project on International Climate Agreements.)

Also, output-based allocations are used in Waxman-Markey for merchant coal generators, thereby discouraging reductions in coal-fired electricity generation, another significant and costly distortion.

Now, let’s go back to the hand-wringing in the press and blogosphere about the so-called massive political “give-away” of allowances.  Perhaps unintentionally, there has been some misleading press coverage, suggesting that up to 75% or 80% of the allowances are given away to private industry as a windfall over the life of the program, 2012-2050 (in contrast with the 100% auction originally favored by President Obama).

Given the nature of the allowance allocation in the Waxman-Markey legislation, the best way to assess its implications is not as “free allocation” versus “auction,” but rather in terms of who is the ultimate beneficiary of each element of the allocation and auction, that is, how the value of the allowances is allocated.  On closer inspection, it turns out that many of the elements of the apparently free allocation accrue to consumers and public purposes, not private industry.

First of all, let’s looks at the elements which will accrue to consumers and public purposes.  Next to each allocation element is the respective share of allowances over the period 2012-2050 (measured as share of the cap, after the removal – sale “” of allowances to private industry from a “strategic reserve,” which functions as a cost-containment measure.):

a.  Electricity and natural gas local distribution companies, 22.2%

b.  Home heating oil/propane, 0.9%

c.  Protection for low- and moderate-income households, 15.0%

d.  Worker assistance and job training, 0.8%

e.  States for renewable energy, efficiency, and building codes, 5.8%

f.   Clean energy innovation centers, 1.0%

g.  International deforestation, clean technology, and adaptation, 8.7%

h.  Domestic adaptation, 5.0%

The following elements will accrue to private industry, again with average (2012-2050) shares of allowances:

i.   Merchant coal generators, 3.0%

j.   Energy-intensive, trade-exposed industries, 8.0%

k.  Carbon-capture and storage incentives, 4.1%

l.   Clean vehicle technology standards, 1.0%

m. Oil refiners, 1.0%

The split over the entire period from 2012 to 2050 is 59.4% for consumers and public purposes, and 17.1% for private industry.  This 17% is drastically different from the suggestions that 70%, 80%, or more of the allowances will be given freely to private industry in a “massive corporate give-away.”

All categories – (a) through (m), above – sum to 76.5% of the total quantity of allowances over the period 2012-2050.  The unallocated allowances “” 23.5% over 2012 to 2050 “” are scheduled in Waxman-Markey to be used almost entirely for consumer rebates, with the share of available allowances for this purpose rising from approximately 10% in 2025 to more than 50% by 2050.  Thus, the totals become 82.9% for consumers and public purposes versus 17.1% for private industry, or approximately 80% versus 20% “” the opposite of the “80% free allowance corporate give-away” featured in many press and blogosphere accounts.  Moreover, because some of the allocations to private industry are – for better or for worse – conditional on recipients undertaking specific costly investments, such as investments in carbon capture and storage, part of the 17.1% free allocation to private industry should not be viewed as a windfall.

Speaking of the conditional allocations, I should also note that some observers (who are skeptical about government programs) may reasonably question some of the dedicated public purposes of the allowance distribution, but such questioning is equivalent to questioning dedicated uses of auction revenues.  The fundamental reality remains:  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.

Finally, it should be noted that this 80-20 split is roughly consistent with empirical economic analyses of the share that would be required – on average “” to fully compensate (but no more) private industry for equity losses due to the policy’s implementation.  In a series of analyses that considered the share of allowances that would be required in perpetuity for full compensation, Bovenberg and Goulder (2003) found that 13 percent would be sufficient for compensation of the fossil fuel extraction sectors, and Smith, Ross, and Montgomery (2002) found that 21 percent would be needed to compensate primary energy producers and electricity generators.

In my work for the Hamilton Project in 2007, I recommended beginning with a 50-50 auction-free-allocation split, moving to 100% auction over 25 years, because that time-path of numerical division between the share of allowances that is freely allocated to regulated firms and the share that is auctioned is equivalent (in terms of present discounted value) to perpetual allocations of 15 percent, 19 percent, and 22 percent, at real interest rates of 3, 4, and 5 percent, respectively.  My recommended allocation was designed to be consistent with the principal of targeting free allocations to burdened sectors in proportion to their relative burdens, while being politically pragmatic with more generous allocations in the early years of the program.

So, the Waxman-Markey 80/20 allowance split turns out to be consistent  “” on average, i.e. economy-wide “” with independent economic analysis of the share that would be required to fully compensate (but no more) the private sector for equity losses due to the imposition of the cap, and consistent with my Hamilton Project recommendation of a 50/50 split phased out to 100% auction over 25 years.

Going forward, many observers and participants in the policy process may continue to question the wisdom of some elements of the Waxman-Markey allowance allocation.  There’s nothing wrong with that.

But let’s be clear that, first, for the most part, the allocation of allowances affects neither the environmental performance of the cap-and-trade system nor its aggregate social cost.

Second, questioning should continue about the output-based allocation elements, because of the perverse incentives they put in place.

Third, we should be honest that the legislation, for all its flaws, is by no means the “massive corporate give-away” that it has been labeled.  On the contrary, more than 80% of the value of allowances accrue to consumers and public purposes, and less than 20% accrue to covered, private industry.  This split is roughly consistent with the recommendations of independent economic research.

Fourth and finally, it should not be forgotten that the much-lamented deal-making that took place in the House committee last week for shares of the allowances for various purposes was a good example of the useful, important, and fundamentally benign mechanism through which a cap-and-trade system provides the means for a political constituency of support and action to be assembled (without reducing the policy’s effectiveness or driving up its cost).

Although there has surely been some insightful press coverage and intelligent public debate (including in the blogosphere) about the pros and cons of cap-and-trade, the Waxman-Markey legislation, and many of its design elements, it is remarkable (and unfortunate) how misleading so much of the coverage has been of the issues and the numbers surrounding the proposed allowance allocation.

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12 Responses to Robert Stavins: “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.”

  1. paulm says:

    Looks like the US will be following China…

    China Is Said to Plan Strict Gas Mileage Rules
    http://www.nytimes.com/2009/05/28/business/energy-environment/28fuel.html?_r=1

  2. Dan says:

    Very enlightening, thank you for sharing this. Perhaps now we can focus on strengthening the weakest aspects of the bill. I must say I had my doubts too, coming from an economic background where I learned that auctioning is better than giving away, but as always, caveats are important.

  3. Tim R. says:

    Mr. Romm,

    Your analysis certainly makes sense and is a great counterweight to unreasoned criticism that is far more prevalent. In my mind, the big corporate giveaway is not accomplished through the allocation scheme. I believe that what really has the polluters smiling is something that no one is discussing. Waxman-Markey shreds EPA’s ability to use the Clean Air Act to regulate greenhouse gases as pollutants. Sections 831-833 gut the Act and prevent EPA from declaring GHGs as criteria air pollutants, as hazardous air pollutants or as subject to New Source Review.

    These sections give credence to arguments that Waxman-Markey, at least the Global Warming Title, is worse than nothing at all. I am very curious about your thoughts.

  4. A Siegel says:

    Hold it … what is the majority of the money going to consumers? It seems accurate to describe it as an ‘indirect subsidy to fossil fuels’ because the money will be used to mask any actual carbon price from users.

    Let us say that you’re 100% on coal-electricity and the bill has an impact of 1 cent per kWh on your electricity prices. According to claimed paths of how the allocations will work, the ‘consumer’ will end up getting back 90 percent of that. Thus, at the end of the month, my “bill” might show a (for the average electricity user, roughly) $10.00 increase in the bill, but there will a check for $9 in the same envelope. Or, even more directly, a $9 deduction from the bill. Will a $1 increase in monthly electricity costs (if it even arrives) provide any incentive for changed behavior or purchasing?

    [JR: No and no. The misconception you are pushing is sufficiently common that I will do a separate post on it. Always remember, energy efficiency is already cost-effective. The barrier to it ain't that people's utility bills are too low. This bill addresses many of the barriers.]

  5. Ken says:

    This ivory-tower stuff is just so detached from the real world.

    “… ordinary political pressures need not get in the way of developing and implementing a scientifically sound, economically rational, and politically pragmatic policy …” In what sense is W-M “scientifically sound”?

    “… the share of allowances that would be required in perpetuity for full compensation … 13 percent would be sufficient for compensation of the fossil fuel extraction sectors …” How is “full compensation” of fossil fuel extractors “in perpetuity” reconciled with the objective of reducing fossil fuel emissions by 83% in 2050?

    “… the allocation of allowances affects neither the environmental performance of the cap-and-trade system nor its aggregate social cost.” Are the cap targets handed down from God on stone tablets? Is there no relationship between allocation and politically viable emission targets (or price ceilings)? Is it not possible to use allowance value to incentivize additional emission reductions?

    “… questioning should continue about the output-based allocation elements, because of the perverse incentives they put in place.” With pure output-based allocation in the electricity sector, renewable and fossil-fuel sources would get the same dollar-per-MWh subsidy, so their relative competitiveness would not be affected. But net regulatory costs to fossil fuels would be greatly diminished and renewables would get a large net subsidy. The regulatory incentives would shift from demand reduction to more low-carbon generation, which is the easier way to get 83% emission reduction. Complementary incentive policies for energy efficiency could also induce significant demand reduction without forcing austerity and economic contraction.

  6. Jason` says:

    Suppose that 20% is correct. Its still hundreds of billions of dollars.

    Why is it acceptable for the US, which may already be burdened with more debt than it can handle, to give away hundreds of billions of dollars in the name of political expediency?

    [JR: Far less, I think. But in any case, that is the way laws get written, although again I'm sure the producers would say that you are just returning to them the economic cost to them created by this bill in the first place.]

  7. Modesty says:

    On this, Stavins is very clear:

    “Given the nature of the allowance allocation in the Waxman-Markey legislation, the best way to assess its implications is not as “free allocation” versus “auction,” but rather in terms of who is the ultimate beneficiary of each element of the allocation and auction, that is, how the value of the allowances is allocated. On closer inspection, it turns out that many of the elements of the apparently free allocation accrue to consumers and public purposes, not private industry.”

    This is certainly part of what I meant when I wrote:

    “Distributing a certain amount of allowances to ELDCs in the specific manner specified in W-M is simply one use of allowance value, not really “free allocation.”

    Additionally, as I’ve also tried to make clear previously, because LDCs are not covered entities, the whole concept of free allocation is a misnomer in their case, since this term suggests the “free allocation vs auction framework.” But it’s not as if these LDCs otherwise* would have had to purchase allowances at auctions.

    So, that framework is wrong for purposes of assessing both implications and implicatures.

    *(SOMEONE would have had to purchase them at auction–and will now have to purchase these allowances from the LDC instead; often, for sure, the entity buying will be another part of the company of which the LDC is a part–and the proceeds could have gone to consumers and the public good, in, for instance, the way the allowances (value) now does. If the distribution of this allowance value had been specified to take place in this way (through a process including an auction), presumably media coverage would have been more on point.)

    Stavins is also very clear when he says:

    “the allocation of allowances — whether the allowances are auctioned or given out freely, and how they are freely allocated — has no impact on the equilibrium distribution of allowances (after trading), and therefore no impact on the allocation of emissions (or emissions abatement), the total magnitude of emissions, or the aggregate social costs. (Well, there are some relatively minor, but significant caveats – those “problems” I mentioned — about which more below.)”

    There are indeed significant caveats in the real world, and Stavins goes on to list some of them. Allocation schemes can, for instance, give rise to perverse incentives that lead to it costing more to meet targets. In the real world, this threatens the political viability of the targets, and hence the “total magnitude of emissions.”

    On the other hand, allowing for allocation schemes with such perverse incentives may, politically, allow for tighter (original) targets, relatively speaking, in the first place. Hence: “Everything affects the cap.”

  8. hapa says:

    i was going to bemoan the lack of best-case-scenario analyses of this package — even though no one knows what actual bill might pass, or survive legal challenges afterward — because what we need to know to judge this is what cap it places on the speed of change.

    but i think the minimum cap is the line to watch. that’s our fate. a measure of the relationship between the challenges and our willingness to face them honorably. if we refuse to exchange power and glory for safety and health, trying to take the shortest possible route to job security and esteem, this line of minimum public obligation will creep along the edges of the whirlpool, all engines full against the irresistable downforce.

  9. hapa says:

    i was going to bemoan the lack of best-case-scenario analyses of this package — even though no one knows what actual bill might pass, or survive legal challenges afterward — because what we need to know to judge this is what cap it places on the speed of change.

    but i think the minimum cap is the line to watch. that’s our fate. a measure of the relationship between the challenges and our willingness to face them honorably. if we refuse to exchange power and glory for safety and health, trying to take the shortest possible route to job security and esteem, this line of minimum public obligation will creep along the edges of the whirlpool, all engines full against the irresistable downforce.

    people will do anything not to lose face.

  10. hapa says:

    oops sorry!

  11. Thank you, Tim R. Bottom line J.R., can you give us a table or a graph of how fast coal is replaced by other sources of energy under Waxman-Markey? Can anybody at this time provide the same graph without Waxman-Markey? How about graphs of CO2 in the atmosphere for both with and without Waxman-Markey? Isn’t CO2 the real subject here?

  12. Rob Stavins is no doubt right about the allocation of allowances. However, he addresses only a part of the issue and ignores another part of almost equal magnitude.

    Only about 15% of the increase in consumer costs from pricing carbon would pay for the actual costs of reducing CO2 emissions. The rest (85%) would be wealth transfers. About half of the wealth transfers would pay for allowances, which payments could be returned to consumers as Rob describes. But the other half of the wealth transfers would go from consumers to the generators that emit no CO2, such as wind, hydro, and nuclear. These wealth transfers result from the increased market price of electricity, due to the cost of allowances. Generators that emit no CO2 benefit from a higher market price without any increase in costs. They simply make more money. Since nuclear generation is much greater than the other generation with no CO2 emissions, nuclear generators would get the largest share by far. The equity of these wealth transfers has not yet been widely discussed.

    My comments are based on a recent paper: “The Adverse Consequences of Pricing Carbon” which can be found at http://www.wingrg.com.