Common Tragedies

Thoughts on Environmental Economics

Why carbon permit allocation matters more than you think

Posted by Rich Sweeney on June 6, 2008

A lot has been written about cap-and-trade in the econoblogosphere during the past week. Everything I’ve read though (which, to be honest, hasn’t been everything) takes as a starting point the Coasean notion that ownership doesn’t effect equilibrium price. The point being that firms care about opportunity costs, which are set by the market’s marginal willingness to pay, not accounting costs. Thus the market price for carbon permits should be the same regardless of how the permits are initially distributed. I’ve actually made this point several times before.

Yet, in practice, this isn’t entirely true. That’s because in half the country the electricity sector, where most expect the bulk of CO2 reductions to come from, isn’t a competitive market. Utilities are publically owned and prices are set at cost of service, as opposed to marginal cost. This means that they don’t make any profit, and customers see a price that is equal to the average cost of producing the electricity they consumed.

In regulated regions, free allocation to utilities would work as follows: Utilities would still consider the opportunity cost of these permits, and would gladly sell them to the market if the price was higher than their own marginal cost. However, unlike in competitive regions, where this money is pocketed and distributed to shareholders, regulated utilities would take this revenue and distribute it to customers, effectively lowering the average cost of electricity.

Thus, giving away permits to the electricity sector in regulated regions would effectively soften the blow for customers in those regions. Price wouldn’t go up by as much as if all the permits were auctioned off. Which brings me to the rub: since price doesn’t increase as much, demand doesn’t decrease as much either. This means that for a given permit price, we get a smaller emission reduction under free allocation – i.e. the efficiency of the whole program goes down. Since the electricity sector in regulated regions does less work when permits are given away for free, other sectors have to pick up the slack, driving up the cost for the economy as a whole. Preliminary modeling results done here at RFF have confirmed this relationship, and my boss, Dallas Burtraw, actually testified before the House on this relationship earlier this year.

Finally, I should note that this is more than just an academic debate, as I think Lieberman-Warner had about 9% of permits going to load serving entities for free as of last week (I’m sure Daniel knows the correct figure). I should also note that, despite the efficiency costs, I’m not necessarily opposed to softening the blow for electricity consumers. Electricity consumption makes up a higher percentage of poor households’ carbon footprint than rich households’, which means that allocating to load could have some nice distributional effects. Again, preliminary results here at RFF appear to confirm this. We’re hoping to have a discussion paper out on this soon.

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3 Responses to “Why carbon permit allocation matters more than you think”

  1. F Chow said

    huh? How do we get “a smaller emission reduction under free allocation”? The point of cap and trade is that the maximum level of emissions per year, or any other period of time, is fixed.

  2. Rich Sweeney said

    F,

    with free allocation, we get a smaller reduction in emissions from the electricity sector in regulated regions. the total cap economy wide is fixed, but the emissions in each sector are obviously variable. my point is that under free allocation the price signal sent by a cap or tax is somewhat muted in regulated regions. thus, for a given tax or permit price, these regions see less of an electricity price increase when permits are given away for free, and thus the demand response is not as great. since, as you point out, the national cap is fixed, the permit price must rise to achieve the emissions reduction target. this, in some sense, can be seen as inefficient.

  3. Rich Sweeney said

    ok, rereading that comment i’m still not even sure i’ve cleared things up. in terms of tons abated per dollar tax/ permit price, the cheapest emissions reductions are in the electricity sector. by giving away permits, electricity abatement becomes a little more expensive for the reason i mentioned above. you could imagine excluding the electricity sector entirely, still keeping the cap fixed, and forcing abatement to come from transport or the commercial sector. the economy wide emissions reduction would be the same, but permits would cost $1000/ton. economic efficiency hinges on there only being one price for a given good. by effectively cushioning the price signal in the electricity sector, we depart from this, making the whole program less efficient.

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