This is a follow-up to the recent discussion between Brad DeLong and Greg Mankiw on the effects of giving away rather than auctioning carbon permits under a cap and trade system (see, e.g., here, here, here, and here). Mankiw begins with the premise that:
Rather than auctioning the carbon allowances, the bill that recently passed the House would give most of them away to powerful special interests.
But is it correct to classify the program as "giving most of them away to powerful special interests"? Here's Harvard's Robert Stavins who knows a thing or two about this topic. He notes that "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." He also says that "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, 80% of the value of allowances accrue to consumers and public purposes":
The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey, by Robert Stavins: ...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%), minus share (6%) that benefits industry as consumers of electricity (note: there is a consequent 3% reduction in the allocation to energy-intensive trade-exposed industries, below, which is then dedicated to broad-based consumer rebates, below), 22.2 - 6 = 16.2%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 (minus reduction in allocation due to EITE benefits from LDC allocation above) 8.0% - 3% = 5%k. Carbon-capture and storage incentives, 4.1%l. Clean vehicle technology standards, 1.0%m. Oil refiners, 1.0%n. Net benefits to industry as consumers of lower-priced electricity from allocation to LDCs, 6.0%
The split over the entire period from 2012 to 2050 is 53.4% for consumers and public purposes, and 20.1% for private industry. This 20% 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 (n), above - sum to 73.5% of the total quantity of allowances over the period 2012-2050. The remaining allowances — 26.5% 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 79.9% for consumers and public purposes versus 20.1% 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 20% 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 80% of the value of allowances go to consumers and public purposes, and 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, 80% of the value of allowances accrue to consumers and public purposes, and some 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.