CBO director Peter Orszag weighs in on the allocation of carbon permits under a cap-and-trade regime. Orszag argues the standard economics of the program — that only with an auction can the revenue be recycled, through lower taxes or rebates. Without the auction, polluters would be able to raise prices, and be given $100 billion+ in a new tradable commodity.
While both Sens McCain and Obama support a cap-and-trade program, only Obama supports a full immediate auction.
A second way to reduce costs under a cap-and-trade program involves the method for initially distributing emissions allowances. The key questions here are whether some or all of the allowances will be sold by the government or given away — and, if they are sold, how the revenue will be used.
Cap-and-trade programs create a new commodity: the right to emit carbon. With a constraint on total emissions, allowances would suddenly be highly valuable — likely to be worth more than $100 billion per year. Selling them would provide revenue to offset some of the costs of the program. For example, revenue could be used to lower existing taxes that dampen economic activity. Following this path, the cost to the U.S. economy of a 15 percent cut in emissions might be half as large as it would be if the allowances were given away.
Another possible use of revenue from auctioning allowances is to offset the effects that higher energy prices would have on low- and moderate-income households. Although such price increases encourage greater efficiency in reducing emissions, and are thus essential to the success of a cap-and-trade program, they would impose a disproportionate burden on low- and moderate-income households. The Congressional Budget Office has found that if the allowances were sold and the revenue used to provide equal rebates to every household, lower-income households could be financially better off because the rebate would be larger than the average increase in their spending on energy-intensive goods. Alternatively, the distributional consequences could be offset by increasing the earned-income tax credit or boosting food stamp benefits.
By contrast, granting allowances free to emitters would not be well suited to reducing either the macroeconomic costs or the distributional effects of a cap-and-trade program. Businesses would raise energy prices for their customers regardless of whether the allowances were auctioned or given away. Indeed, providing free permits to energy producers and energy-intensive firms would be equivalent to auctioning the permits and simply giving the proceeds to the firms. The result would be a lost opportunity to use the money to offset the costs of emissions reductions as well as the potential creation of regressive “windfall profits” for the relatively high-income shareholders of those companies.