Common Tragedies

Thoughts on Environmental Economics

You keep on using that word. I do not think it means what you think it means.

Posted by Daniel Hall on November 6, 2007

Presidential candidate Hillary Clinton has released her energy and climate plan. I expect one of my co-bloggers will be along at some point with a more comprehensive analysis that will serve as an update of his previous analysis of the leading candidates’ energy plans. I want to deal in this post with reaction in the blogosphere to her promise to auction of 100% of the emissions allowances in a cap-and-trade program. Over at Gristmill David Roberts says:

I was just on a conference call with the Clinton campaign’s energy advisors, who were answering questions from the press. …

[The advisors said,] “the cap-and-trade program would produce assistance for energy-intensive industries.”

Now, as you know, the criticism of giving away permits under a cap-and-trade system is that it would produce windfall profits for polluters. By auctioning all permits, Clinton has seemingly avoided this criticism. But if she takes the auction revenue and then … gives it to polluters, well, she’s just hidden the windfall profits, not eliminated them.

Let me state first off that in general the idea of auctioning allowances rather than giving them away is a very good one. Auctions generate government revenues which can (hopefully) be put to good use, and by auctioning allowances rather than giving them away you diminish the opportunities for rent-seeking.

BUT… this term “windfall profits” has gotten thrown around a lot since the EU gave away most of the allowances in its Emission Trading Scheme (ETS) and the electric power companies subsequently all made a lot of money, and there seems to be a lot of fuzzy thinking about what windfall profits are, who might get them, and what the implications are for allowance allocation. The upshot is that while using an allowance auction is generally a very good idea, it will likely be helpful to freely allocate some allowances to a few industries which face strong international competition.

Once a cap-and-trade system is set up, emission allowances should be considered as just another input to production, like labor or capital. As such, the more valuable allowances are, the more the costs of production rise. (This is true whether allowances must be bought at auction or are given away — remember opportunity costs.) With higher production costs, what will firms do? Raise prices, right? Well, not exactly. They’ll continue to try to maximize profits.

How will they do that? Let’s consider this simple thought experiment: Suppose a firm faces perfectly inelastic demand for its product. Once a cap-and-trade system is implemented, it can then raise prices by the input cost of the allowances, and continue selling the same amount of product as before. If it had to pay for those allowances in the first place, it has no change in profits, and if it got all the allowances for free, its profits increase by the value of the allowances received.

Now suppose another firm faces perfectly elastic demand for its product — if it raises product prices at all, it will sell nothing. In this case if it receives the allowances for free it can continue production, sell the same amount as before, and experience no net change in profits. If it must pay for allowances, however, it will shut down production, because it will be losing money on each unit of production.*

More worringly for those who care about emissions, this firm will likely cease production in the regulated country, and move its production to an unregulated area where it can go back to producing without incurring the cost of emissions allowances.

Now those are clearly two extremes — firms don’t often face perfectly elastic or inelastic demand in the real world. But the thought experiment usefully illustrates which types of industries should generally not receive free allowances — and which perhaps should, if we don’t want them packing up and moving their production and emissions elsewhere.

Firms that face relatively inelastic demand and are shielded from international competition — the electricity sector comes immediately to mind — do not “need” free allowances because they can pass most cost increases onto consumers. Firms that face strong international competition and which use significant amounts of energy — primary metals producers, particularly aluminum but also iron or steel, are classic examples — are most likely to be driven overseas if energy prices rise and they are forced to purchase allowances. Since emissions “leakage” to unregulated regions of the world will nullify the environmental benefits of regulating these types of firms, it may be better to subsidize the higher energy costs these firms will face by using some free allocation — particularly in the near term until there is something closer to a global effort to reduce GHG emissions.

I also want to make one further point about “windfall profits” in the electricity sector. The EU ETS initially gave away almost all allowances, expecting that by doing so they would prevent electricity prices from going up. (There was clearly not an economist in the room when this decision was taken.) What happened? Firms got free allowances, factored the opportunity cost of allowances into the price of electricity, raised electricity rates, and reaped a nice profit.**

But what was the source of this profit? Some of it came from the fact that allowances were handed out freely. But some of it would have arisen even if 100% of allowances were auctioned. This is because of the heterogeneous nature of the generation mix and the fact that the marginal generation technology sets the market rate for wholesale electricity.

If the marginal generation technology is fossil-fuel-based — and it frequently is, since it is often natural gas — then a carbon cap-and-trade system will increase the market rate for electricity, and those generation technologies which are less carbon intensive than the marginal technology will become more profitable than before (think nuclear, hydro, or wind) and the generation technologies which are more carbon intensive (coal) will be less profitable.

Since electric power companies have a heterogeneous blend of generation resources, the increased electricity prices caused by a cap-and-trade system will benefit some firms — those with less carbon-intensive portfolios — and will cost others. To an untrained eye this may look like “windfall profits” — the power company got to raise rates and make more money because of regulation! — but this is part of the power of a market-based system of regulation: it will incentivize firms to shift their generation portfolios away from carbon-intensive generation and towards lower-emitting technologies.

This is complicated issue, and for those are interested in learning more I’ll recommend the following documents:

Allowance allocation: A report from the National Commission on Energy Policy and a paper by Ray Kopp of Resources for the Future (RFF) both discuss options for allocating allowances.

Competitiveness concerns: Two recent papers by Dick Morgenstern at RFF talk about the impacts of carbon emissions regulation on various industries, and policy options for addressing these impacts.

Electricity sector: Dallas Burtraw and Karen Palmer at RFF have a working paper that examines the cost incidence of emissions regulation in the electricity sector.

*I am assuming that both firms are in perfectly competitive markets where their supply curve is the marginal production cost curve, i.e., there are no long-run profits.

**Note that there has been a lot going on in the EU electricity market in the last few years, and the ETS is just one reason — and probably not the major one — for rising prices; the natural gas market, on which much of the EU depends for generation, is a major factor.

7 Responses to “You keep on using that word. I do not think it means what you think it means.”

  1. Chris said

    I don’t have to take you seriously – I heard you were a right wing nutjob.

  2. Daniel Hall said

    Oh I am. Have you heard that I hate poor people too?

  3. Mathias said

    Good summary Daniel.

    One thing I can’t understand is how over the past several months environmental groups have latched onto the idea that any decent cap-and-trade legislation MUST have 100% auctions or its a corporate handout bonanza.

    Where did this idea get started?

  4. Mathias said

    I should have typed “many environmental groups”.

    Environmental Defense has been vilified recently for saying otherwise.

  5. Daniel Hall said

    My sense is it arose largely in reaction to the example of the EU ETS, which made a very large and elementary mistake when assuming that if allowances were given out freely then electricity prices would not rise. Since the EU ETS covered mainly the electric power sector* the end result was higher electricity prices and big profits for power companies.

    Don’t get me wrong — in general I think auctions are a great idea. If you are going to have a system that only covers the electric power sector — say, for example, RGGI — go ahead and auction everything. But the wider your coverage ranges the more you may want a little nuance in your thinking about how to allocate.

    *The EU ETS did also cover emissions in a few large industries.

  6. One thing I can’t understand is how over the past several months environmental groups have latched onto the idea that any decent cap-and-trade legislation MUST have 100% auctions or its a corporate handout bonanza.

    I agree with Daniel in blaming the EU-ETS for this phenomenon. However, I think it was compounded by the tendency of people (and the organizations they comprise) to view things in black and white. A no-auction policy was a disaster in Europe. So what’s better than no auctions? 100% auctions! Maybe even 110% auctions, if we can pull it off somehow!

  7. retro said

    As much as I’d like to see a woman president, I don’t trust Hillary as far as I can throw her.

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