August 1, 2001

Commentary

How Much Is the Right
To Pollute Worth?

By Susan Lee, a member of the Journal's editorial board

Cap-and-trade programs for controlling pollution are suddenly hot.

The U.S. started experimenting with these market-based regulatory programs in the 1970s, but the concept remained the concern of a small set of economists, policy swamis in government agencies and the affected industries for almost three decades. Now, however, with an agreement on the Kyoto Protocol, the concept of cap-and-trade has become part of the larger debate over pollution control.

In a perfectly sensible world, nobody would have to interest herself in cap-and-trade programs for carbon emissions before science has answered the question of how harmful (if at all) those emissions are. But, as the Kyoto Protocol demonstrates, this world isn't even remotely sensible. So, read on.

The idea of cap-and-trade is deceptively simple. Government mandates a cap on pollution at an "acceptable" level and issues a bunch of pollution allowances reflecting that level. Firms that produce less pollution than their allowances can then sell their excess allowances to firms that produce more than their allowances. This approach creates financial incentives for firms to come up with pollution-reducing strategies or innovations because they will directly benefit through lower abatement costs, lower payments for pollution allowances and/or selling unneeded allowances.

That's good, but it gets better. Market-based trading results in a more efficient allocation of allowances. Firms that can reduce pollution at relatively lower costs will reduce more and sell their allowances, and firms that have higher costs will reduce less and buy allowances. The net is the same amount of overall reduction in pollution, but achieved at a lower overall cost than under a traditional, inflexible regulatory regime.

This happy result can be seen in the cap-and-trade program the U.S. started in 1995 as part of the effort to reduce acid rain by controlling sulfur-dioxide emissions. Although the program is not yet fully implemented, it has successfully cut emissions at one-half the cost initially estimated.

Sounds straightforward enough, but the decision to use a cap-and-trade program is not that simple; the design of the program is crucial. Mercifully, the Congressional Budget Office has already put its collective mind to analyzing several designs as they might apply to carbon emissions. The results are presented in two papers -- published this June and last. Unlike most government reports, these discussions are really worth a look. Here's a tiny summary.

A key element for designing a cap-and-trade program concerns the issue of who, exactly, will reap the value of the emissions allowances. After all, these allowances create value from thin air, so to speak, by transforming something that had been free -- the right to emit -- into a financial asset. Who gets the initial value of this asset depends on how government distributes the allowances to carbon-emission producers. If government sells the allowances in an auction, then 100% of the initial value goes to government in the form of sale revenue. If government gives away the allowances, then 55% of the value goes to the recipients of the allowances -- firms and their shareholders -- in the form of higher profits (created by the increased price of fossil fuels without the need to buy the initial allowances). But the remaining 45% of the value goes to government in the form of increased tax revenues paid by those firms and shareholders on their higher profits. Either way, government pockets a nice chunk of change.

At the same time, something that had been free -- the right to emit -- now has a cost attached to it. Who pays? We all do. The cost of the allowances becomes a cost of doing business and thus, in the long run, is passed on to consumers in the form of higher prices for anything that uses fossil fuels. The largest increases will show up in the prices of electricity, natural gas, fuel oil and coal, and gasoline. The CBO estimates that an allowance price of $100 per metric ton of carbon would cause a 2.8% increase in the general price level.

The increase in the prices will be felt in two ways: as a cost to the economy as a whole (as consumers cut their consumption of stuff with a high carbon content) and as a transfer of income from those who consume to those who receive the value of the allowances. Moreover, since consumers with a higher consumption-to-income ratio will pay a larger share, and since these consumers tend to be lower-income, any program will be regressive. Oops, big political problem.

And now the plot thickens. Government could use its revenue from the distribution of allowances either to offset the cost to the economy or to offset the transfer of income. The first goal can be achieved by reducing current taxes on capital by, for example, cutting marginal tax rates on corporate income. The second goal can be achieved by giving a lump-sum rebate to each citizen.

The CBO takes a close look at four designs for carbon-trading and finds that the most regressive design requires government to give away the allowances and use its 45% share of the revenue to reduce corporate taxes. The least regressive design requires government to auction the allowances and use its 100% share of the revenue for a lump-sum rebate.

Hmmm, you are probably saying, since we all pay for emissions reduction, why not implement the least regressive design? Well, the CBO suggests that the least regressive design might not be optimal -- especially if policy makers want to reduce the cost of a cap-and-trade program. In this case, the best design would require government to auction allowances and use the revenue to cut corporate income taxes. This approach, or one that includes a reduction in marginal tax rates on labor, would increase incentives to work and invest, and could generate efficiency gains, boosting growth. A lump-sum rebate, on the other hand, would not increase incentives to work and invest and, thus, precludes any possibility for efficiency gains.

This all sounds complicated (and it is). But if we want to reduce carbon emissions, then we must find some reasonable way to deal with the inevitable price increases. Although cap-and-trade programs represent a huge improvement over command-and-control regulation -- offering the same amount of emissions reduction at lower cost -- as the CBO analysis demonstrates, design matters and it matters a lot.

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