Emission Allowance Allocation in a Cap-and-Trade Program: Options and Considerations

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Emission Allowance Allocation in a Cap-andTrade Program: Options and Considerations

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Analyst in Environmental Policy

June 2, 2008

Congressional Research Service

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RL34502

CRS Report for Congress

Prepared for Members and Committees of Congress

Emission Allowance Allocation in a Cap-and-Trade Program

Summary

When designing a cap-and-trade program, one of the more controversial and challenging

questions for policymakers is how, to whom, and for what purpose to distribute the emission

allowances. Regarding the method of distribution to covered sources, policymakers could (1) sell

the allowances through an auction process, (2) allocate the allowances at no cost to covered

sources, (3) provide allowances to non-covered sources who would, in turn, sell them to covered

sources, or (4) use some combination of these methods. Although the emission allocation method

would not affect the environmental integrity of the cap-and-trade program, the selected allocation

strategy could have considerable consequences.

Using auctions as a distribution method could avoid certain concerns that are likely to occur if

covered sources receive all (or most) of the allowances at no cost: (1) consumers in different

electricity markets may face inequitable price increases; (2) a weak price signal for electricity

may be sent in areas with the most carbon-intensive fuel portfolios; and (3) no-cost allowances

may overcompensate covered sources. In addition, auction revenues offer a unique opportunity to

reduce the overall costs of the emissions program. Several economic studies indicate that if used

in the most efficient manner, overall costs could be minimized by almost 50%.

A greenhouse gas (GHG) emission cap-and-trade program would create a valuable new

commodity: the GHG emission allowance. EPA estimates that allowance value could potentially

account—in aggregate—for tens or hundreds of billions of dollars each year. When distributing

this value, policymakers would face a choice between minimizing the costs imposed on the entire

economy, minimizing the expected burden on specific parties, or supporting a range of climate- or

non-climate-related policy objectives.

For example, Congress may consider providing transition assistance to carbon-intensive

industries. Studies have estimated profits could be maintained in the energy production and

electricity generation sectors, if approximately 20% of allowances were provided to those sectors

at no cost. Members may also consider allotting allowance value to consumers, particularly lowincome households, who are expected to bear the majority of the compliance costs via higher

energy prices. Another option would involve distributing the allowance value to support various

objectives: technology development, energy efficiency improvements, biological sequestration,

climate change adaptation efforts, or non climate-related purposes, such as deficit reduction. Of

these objectives, technology advancement is arguably the most crucial in terms of mitigation.

Moreover, deployment of new technologies could potentially lower the overall costs of the

program.

Although many of the proposals in the 110th Congress (e.g., S. 2191, S. 1766, and S. 3036) would

employ an auction to some degree, none of the bills specifies the design of the auction. Congress

may want to consider including specific design elements in legislative text, particularly auction

frequency and whether or not the auction should have a reserve price, and if so, at what level.

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Emission Allowance Allocation in a Cap-and-Trade Program

Contents

Introduction ................................................................................................................................1

Auctions .....................................................................................................................................2

Implementation Benefits .......................................................................................................3

Polluter Pays Principle ..........................................................................................................3

Potential Minimization of Costs on Society...........................................................................3

Avoidance of Economic Concerns from No-Cost Distribution ...............................................4

Auction Design Issues...........................................................................................................4

Design Considerations ....................................................................................................4

Design Options ...............................................................................................................5

Reserve Price ..................................................................................................................6

Auction Frequency..........................................................................................................7

No-Cost Distribution to Covered Sources ....................................................................................8

Potential Benefits..................................................................................................................8

Mitigation of Disproportionate Costs...............................................................................8

Political Feasibility .........................................................................................................9

Concerns...............................................................................................................................9

Undesirable Effects in the Electricity Sector ....................................................................9

Overcompensation to Covered Entities .......................................................................... 12

Treatment of New and Retiring Sources ........................................................................ 13

Distribution of Allowance Value: Options and Considerations ................................................... 14

Overview and Estimate of Allowance Value ........................................................................ 14

Compliance Costs Versus the Value of Emission Allowances ......................................... 14

Estimates of Allowance Value ....................................................................................... 16

Options for Allowance Value Distribution ........................................................................... 17

Provide Transition Assistance to Carbon-Intensive Industries ........................................ 17

Offset Reductions in Distortionary Taxes....................................................................... 18

Distribution to Non-Covered Entities ............................................................................ 19

Distribution to Support Specific Objectives ................................................................... 20

Policy Considerations ......................................................................................................... 21

Reduce Costs, Alleviate Burdens, or Promote Technology ............................................. 21

Regressive or Progressive Economic Effects ................................................................. 23

Figures

Figure 1. Change in Electricity Price by Region: Allowances Distributed to Covered

Sources with Auction ............................................................................................................. 10

Figure 2. Change in Electricity Price by Region: Allowances Distributed to Covered

Sources at No Cost................................................................................................................. 11

Figure 3. Number of Allowances vs. Number of Reductions ...................................................... 15

Figure 4. Relative Differences in Cap-and-Trade Program’s Cost to Society with

Different Emission Allocation Strategies ................................................................................ 19

Figure 5. Relative Distribution of Costs Using Upstream Auction (Without Revenue

Redistribution) ....................................................................................................................... 20

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Figure 6. Comparison of After-Tax Household Income Changes (by Quintile) Imposed by

Emissions Cap, Using Different Emission Allocation and Revenue Distribution

Strategies ............................................................................................................................... 24

Tables

Table 1. Estimates of Auction Revenue under the Framework of the Lieberman-Warner

Climate Security Act of 2008 (S. 2191) .................................................................................. 16

Table B-1. Emission Allowance Allocation under S. 2191 ......................................................... 26

Table B-2. Auction Revenue Distribution under S. 2191 ............................................................ 28

Appendixes

Appendix A. What Is a Cap-and-Trade System? ........................................................................ 25

Appendix B. Allowance Allocation Strategy under S. 2191 (as Reported) .................................. 26

Contacts

Author Contact Information ...................................................................................................... 30

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Introduction

Climate change issues have generated interest and debate over the past two decades. In 1992, the

United States ratified the United Nations Framework Convention on Climate Change (UNFCCC).

Arguably, in recent years the primary issues under debate have shifted from science—such as the

role of greenhouse gas (GHG) emissions from human activities1—to policy. For instance, a 2005

Sense of the Senate Resolution on climate change2 stated:

It is the sense of the Senate that Congress should enact a comprehensive and effective

national program of mandatory, market-based limits and incentives on emissions of

greenhouse gases that slow, stop, and reverse the growth of such emissions at a rate and in a

manner that, No. 1, will not significantly harm the U.S. economy and, No. 2, will encourage

other action and key contributors to global emissions.

In the 110th Congress, Members have introduced several bills that would establish a marketbased, 3 mandatory GHG emission reduction program.4 Most of these proposals would establish

some type of cap-and-trade system to regulate GHG emissions.5 For a brief primer on cap-andtrade systems, see Appendix A.

In designing a cap-and-trade program, one of the more controversial and challenging questions

for policymakers is how, to whom, and for what purpose to distribute the emission allowances.

Concerning the question of how to distribute allowances, policymakers could (1) sell the

allowances through an auction process (2) allocate the allowances at no cost to covered sources,

(3) provide allowances to non-covered sources, who would, in turn, sell them to covered sources

via the emissions trading market, or (4) use some combination of these methods.

Regardless of the method of distribution, emission allowances would have monetary value in a

carbon-constrained regime, such as a cap-and-trade program. If an auction is used, policymakers

could distribute auction revenues to a wide range of parties to support various policy objectives.

Likewise, policymakers could allot allowances at no cost to non-covered entities—for example,

federal or state agencies, among others—to promote the same (or different) objectives.

By addressing the question of how, to whom, and for what purpose to distribute the emission

allowances, policymakers would craft an allocation strategy. The strategy would not affect the

The Intergovernmental Panel on Climate Change (IPCC) concluded in 2007 that “most of the observed increase in

globally averaged temperatures since the mid-20th century is very likely due to the observed increase in anthropogenic

greenhouse gas concentrations” (emphasis added). IPCC Working Group I, Climate Change 2007: The Physical Basis

(Cambridge, UK: Cambridge University Press, 2007). See CRS Report RL34266, Climate Change: Science Highlights,

by (name redacted).

Senate Amendment No. 866 to H.R. 6 (109th Congress), passed by voice vote June 22, 2005. A motion to table the

amendment was rejected by a roll call vote (44 - 53).

The policy alternative to a market-based approach would likely require specific emission limits or particular

technological controls for specific emission sources.

See CRS Report RL34067, Climate Change Legislation in the 110th Congress, by (name redacted) and (name red

acted).

Another market-based approach would entail a carbon tax. Some of the cap-and-trade proposals include elements

(e.g., safety-valve) that are akin to a carbon tax. These proposals are often described as hybrid approaches. See CRS

Report RL33846, Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th Congress, by (name redacted), (name red

acted), and (name redacted).

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environmental integrity of the emissions cap.6 In addition, covered entities would generally face

the same emission reduction decisions under either allocation strategy.7 A “common

misconception” is that if covered sources receive allowances at no cost, the sources would behave

differently from sources who purchased allowances through an auction.8 Economists point out

“free allowances”9 have value, and when covered entities submit an allowance for compliance

purposes, the entities forgo the opportunity10 to sell the unused allowance in the emissions trading

market. 11

The first two sections of this report discuss the primary emission allowance distribution methods:

auctions and no-cost distribution to covered sources. These sections examine the potential

benefits and concerns of these allocation mechanisms. The final section identifies different

options and policy considerations for Congress when determining to whom and for what purpose

to distribute the value of the emission allowances. The allocation strategy would have substantial

consequences for the cost of the cap-and-trade program and how the costs are apportioned.

Auctions

In recent years, the use of auctions to allocate emission allowances has generated considerable

interest.12 Several of the cap-and-trade proposals from the 110th Congress—including S. 2191,

which was reported from the Senate Environment and Public Works Committee on May 20,

2008—would use auctions to allocate an increasing percentage of the cap’s emission

allowances.13

This section describes the potential benefits that auctions may provide, if used to distribute

allowances to covered sources in a cap-and-trade program. In addition, this section discusses

auction design issues and considerations for policymakers.

U.S. Environmental Protection Agency (EPA), Office of Air and Radiation, Tools of the Trade: A Guide To

Designing and Operating a Cap and Trade Program For Pollution Control (2003).-B-03-002.

There are two noteworthy exceptions: electric utilities operating in a price-regulated market (discussed below) and

facilities that receive allowances based on an output-based distribution system. Robert Stavins, A U.S. Cap-and-Trade

System to Address Global Climate Change (2007), The Hamilton Project, Brookings Institution.

Congressional Budget Office, Trade-Offs in Allocating Allowances for CO2 Emissions (2007), Economic and Budget

Issue Brief.

Like there is no free lunch, free allowances are not really free. However, this report uses the phrase “distribution at no

cost” and “free allowances” interchangeably.

In economics parlance, this is referred to as a firm’s “opportunity cost.”

See National Commission on Energy Policy, Allocating Allowances in a Greenhouse Gas Trading System (2007);

Congressional Budget Office, Trade-Offs in Allocating Allowances for CO2 Emissions (2007), Economic and Budget

Issue Brief; Dallas Burtraw, Cap, Auction, and Trade: Auctions Revenue Recycling under Carbon Cap and Trade

(2008), Testimony Prepared for the House Select Committee on Energy Independence and Global Warming.

The 10 states participating in the Regional Greenhouse Gas Initiative (RGGI) have agreed to auction at least 25% of

their allowances, and several of the RGGI states intend to auction almost 100% of their allotments. See CRS Report

RL33812, Climate Change: Action by States to Address Greenhouse Gas Emissions, by (name redacted).

For a comparison of the cap-and-trade bills see CRS Report RL33846, Greenhouse Gas Reduction: Cap-and-Trade

Bills in the 110th Congress, by (name redacted), (name redacted), and (name redacted).

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Implementation Benefits

In general, the concept of an auction is relatively simple to understand.14 Auctions would allow

the market to determine which entities receive emission allowances and at what price: parties

placing the highest value on the allowances would receive them. With this allocation method,

policymakers would be relieved of the responsibility to make distribution decisions, a process that

might be described as picking winners and losers.15 For this reason, auctions are generally

considered to be the most transparent mechanism for distributing allowances.

In addition, in a free allocation format parties would have strong incentives to seek increasing

shares of the overall allowance allotment.16 Parties with resources available for such efforts may

have an advantage. An auction system would eliminate this behavior.

Polluter Pays Principle

Requiring emission sources to purchase emission allowances would support the “polluter pays”

principle. In a general environmental policy context, the polluter pays principle holds that

pollution costs should be borne by the polluting facility or industry, not society at large. To

accomplish this objective, pollution costs should be included in the overall price of a good.

Proponents of the polluter pays notion would likely argue that if products are priced to reflect

environmental costs—air pollution, land use, GHG emissions—demand for these products may

decline.

Advocates of polluter pays maintain that the environment and the services it provides are a shared

public good. Under this framework, facilities should have to pay for the right to pollute (i.e., emit

GHGs). If allowances are provided at no cost to emission sources, the polluter pays principle

would be violated.

Potential Minimization of Costs on Society

If Congress decides to use an auction to distribute emission allowances to covered sources—as

opposed to providing allowances to covered sources at no cost—the auction revenues could be

used to substantially minimize the overall costs on society of the cap-and-trade program.

Economic studies have found that, if revenues are used in the most economically efficient manner,

the overall costs imposed by a cap-and-trade program could be reduced by approximately 50%.17

Economists maintain that the most economically efficient application of revenues would be to

offset reductions in taxes on desirable activities, such as employment or personal income. 18 The

The logistics of establishing and running an auction are more complicated. This issue is discussed below.

U.S. Environmental Protection Agency (EPA), Office of Air and Radiation, Tools of the Trade: A Guide To

Designing and Operating a Cap and Trade Program For Pollution Control (2003).

This behavior is described as “rent-seeking” in economic contexts. Dallas Burtraw, Prepared Testimony before the

House Select Committee on Energy Independence and Global Warming, January 23, 2008.

This cost savings estimate is based on an analysis that simulated a cap-and-trade program with a 22% emission

reduction between 2000 and 2080. Lawrence H. Goulder, Mitigating the Adverse Impacts of CO2 Abatement Policies

on Energy-Intensive Industries (2002), Resources for the Future Discussion Paper.

See, e.g., Goulder (2002); Anne E. Smith and Martin T. Ross, Allowance Allocation: Who Wins and Loses Under a

(continued...)

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opportunity to use allowance value in this manner and thus minimize overall costs to this extent is

unique to the auction mechanism. 19 However, many observers argue that applying auction

revenues in this fashion is politically unlikely.20 Other potential uses of the auction revenues may

or may not generate overall economic cost savings. These options are discussed later in this

report.

Avoidance of Economic Concerns from No-Cost Distribution

Auctions would avoid several of the undesired economic effects that are likely to occur if

allowances are provided to covered sources at no cost. These concerns are discussed in greater

detail later in the no-cost distribution section. In brief, they include:

•

Inefficient and inequitable price signals in the electricity sector;

•

Potential overcompensation to covered sources; and

•

Challenges with allotting allowances to new and retiring sources.

Auction Design Issues

Although many of the cap-and-trade proposals in the 110th Congress would employ an auction to

some degree, none of the bills specifies the design of the auction. A recent study that examined

auction design issues for the Regional Greenhouse Gas Initiative (RGGI) found that “careful

attention to auction design can be critical to an auction’s success in achieving the goals specified

for the auction.”21

Design Considerations

The success of an auction is typically measured by both its efficiency and revenue generation.22 In

an emission auction context, efficiency is achieved when the parties that receive the allowances

are the parties that place the most value on the allowances. Other attributes of an auction that may

be used to measure its success include:

(...continued)

Carbon Dioxide Control Program? (2002), Charles River Associates; Dallas Burtraw, et al., The Effect of Allowance

Allocation on the Cost of Carbon Emission Trading (2001), Resources for the Future.

A carbon tax system, which is not within the purview of this report, could achieve the same result, if carbon tax

proceeds were applied in a similar manner.

See, e.g., Robert W. Hahn, Greenhouse Gas Auctions and Taxes: Some Practical Considerations (2008), AEI Center

for Regulatory and Market Studies; Robert Stavins, A U.S. Cap-and-Trade System to Address Global Climate Change

(2007), The Hamilton Project, Brookings Institution.

Charles Holt et al., Auction Design for Selling CO2 Emission Allowances Under the Regional Greenhouse Gas

Initiative (2007), prepared for RGGI Working Group staff..

Holt et al. (2008).

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Price discovery

In a cost-effective emissions trading program, the allowance price should mirror (or closely

follow) the marginal cost of emission reduction—that is, the cost of reducing the last, most

expensive ton. An effective auction should help identify the allowance price that is near to the

marginal cost of reduction. 23

Protection against market manipulation

Auctions should discourage or prohibit bidding behavior that would create inefficient outcomes in

the market. For example, collusion among bidders may artificially lower the allowance price.

Another concern is hoarding, in which one party makes speculative bids above the competitive

price, in order to capture a disproportionately large percentage of the allowances.

Minimize transaction costs

Substantial administrative or transaction costs could reduce the cost-effectiveness of using an

auction. Moreover, high transaction costs could place smaller firms at a disadvantage.

Transparency and fairness

The rules should be readily available to all parties and should not favor certain participants.

Design Options

Certain auction designs may provide advantages or disadvantages, depending on the auction’s

primary objective. For example, some auction designs in certain contexts may favor revenue

generation; others may be more efficient in terms of matching the market price.

Policymakers may undertake further study before specifying the particular auction logistics.

Although economic studies have examined the performances of different auction formats in other

contexts, “relatively few papers have examined the relative merits of each of these auction forms

in multi-unit [e.g., emission allowances] auctions.”24 One option for Congress would be to direct

an implementing agency to devise the most appropriate auction format, based on the ranking of

objectives provided by Congress.

Policymakers may consider various auction designs . In general, auction designs are distinguished

by (1) the number of rounds for bidding—generally one round (often called “sealed bid”) versus

multiple rounds; and (2) whether there is a uniform price or individual price (“discriminatory”

price) for each buyer. Examples of auction designs with different combinations of these two

characteristics include the following:

Note that this value will fluctuate daily with changes in fuel prices and energy demands.

Holt et al. (2008).

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Discriminatory Price, Sealed-Bid Auction

This type of auction is used in EPA’s SO2 emission trading program. 25 In this system, parties

submit a sealed bid, containing multiple offers to purchase a set number of allowances at certain

prices. The implementing agency opens the bids and distributes allowances, starting with the

highest offer, until the supply is exhausted. For example, consider a hypothetical auction, in

which the supply of allowances is 20 units and the highest bidder offered $100 per allowance for

15 allowances, and the second highest bidder offered $90 per allowance for 10 allowances: the

highest bidder would receive 15 allowances for $100/allowance; the second highest bidder would

receive 5 allowances at $90/allowance.

Uniform-Price, Sealed-Bid Auction

This type of auction is similar to the above format—discriminatory price, sealed-bid—with one

major difference: the price paid by all bidders is the highest rejected bid (i.e., the second-highest

bid). Using the above scenario, the highest bidder would receive 15 allowances at $90/allowance,

and the second-highest bidder would receive 5 allowances at $90/allowance. Ireland used this

design to implement its auction for the EU ETS.26 In addition, in a study prepared for RGGI

officials, researchers recommended using this approach.27

Uniform-Price, Multi-Round (English Clock) Auction

In an emission allowance auction using this format, the auctioneer would post a allowance price

and parties would offer the quantity they are willing to buy at the posted price. The first posted

price would be set at a low level, so that demand would exceed supply. The auctioneer would

continue posting higher prices at set time intervals, until demand is less than (or equal to) the

allowance supply. The posted price that produces this outcome would become the allowance price

for all bidders. Virginia used this auction type to sell nitrogen oxide emission allowances pursuant

to the “NOx SIP Call.”28

Reserve Price

One issue that arguably transcends auction design considerations is whether or not the auction

should have a reserve price, and if so, at what level. In an auction, a reserve price is a price set by

the seller, below which the seller refuses to part with the item for sale. In a large volume, multiunit auction that is expected to have substantial participation (i.e., high demand for the items for

sale), a reserve price would all but guarantee a revenue stream. In a cap-and-trade allowance

emissions auction, a reserve price would operate much like a minimum tax or price floor.

More information on EPA’s SO2 emission trading auction is at http://www.epa.gov/airmarkets/trading/factsheetauction.html#how.

Ken Macken (Ireland Environmental Protection Agency), Presentation for RGGI Auction Workshop, March 2006, at

http://www.rggi.org/documents.htm.

Holt et al. (2008).

For more information about Virginia’s auction, see William Shobe, Presentation for RGGI Auction Workshop,

March 2006, at http://www.rggi.org/documents.htm.

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A reserve price may address certain logistical concerns, such as bidder collusion, that are often

associated with auctions. In addition, a reserve price may provide assurance to parties making

emission reductions that the reductions will have some value in the allowance market. For

example, if a covered source can expect a reserve price to be set at a certain level (e.g., $10/ton),

and the source makes multiple reductions, each at a per-ton cost below the expected reserve price,

the source can have confidence that its efforts will be cost-effective.

The authors of the RGGI auction study recommended that RGGI participants set a reserve price

when conducting allowance auctions, concluding:

A compelling justification for a reserve price can be found in the academic literature and

from previous experience with auctions, and the reserve price would help the auction achieve

the criteria [e.g., the design criteria discussed above] set out in this report.29

Because a reserve price (if established) could influence revenue flows from an auction, Congress

may consider addressing this issue specifically in legislative text, rather than leave this matter

open for interpretation to an implementing agency.

Auction Frequency

EPA’s SO2 emissions trading program holds annual auctions to distribute a small percentage of

allowances. Likewise, S. 2191 would direct the implementing agency to conduct annual auctions.

However, policymakers may consider holding more frequent auctions (e.g., every quarter).

More frequent auctions could provide several benefits, both for covered sources and to the

efficiency of the program. More auctions would give covered sources more flexibility to

incorporate unanticipated events—for example, higher electricity demand due to warmer than

expected temperatures. If auctions were held more frequently, the allowances sold would be in

smaller lots. This may help facilities, particularly smaller operations, maintain cash flow.

In terms of efficiency, smaller, more frequent auctions would likely reduce the potential for

parties to manipulate the market (e.g., from speculative hoarding). More auctions may increase

market liquidity by making allowances available for purchase in more frequent intervals.

The potential downside to having multiple auctions per year is that covered sources may face

additional transaction costs. However, the authors of the RGGI auction study stated:

past experience suggests that a significant proportion of the administrative cost of holding

auctions is related to the initial set-up ... and that incremental costs of repeating a particular

auction type will be low in comparison to these initial costs.30

After considering the “costs, risks, and benefits,” the study authors recommended that

participating RGGI states use a quarterly auction to allocate emission allowances. 31

Holt et al. (2008).

Ibid.

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No-Cost Distribution to Covered Sources

Emission trading programs, in the United States32 and abroad,33 have generally distributed the

vast majority of allowances at no cost to sources directly subject to a cap. In recent years,

however, support for auctions has gained momentum. This momentum likely reflects a better

understanding of the benefits of using auctions, as well as increased scrutiny of the effects of

distributing allowances at no cost.34 This section discusses the potential benefits and concerns of

allotting allowances to covered sources at no cost.

Potential Benefits

Mitigation of Disproportionate Costs

The primary argument in support of no-cost distribution is that carbon-intensive industries are

expected to face disproportional costs under a carbon-constrained system. These industries

maintain they should receive compensation (i.e., free allowances) for the financial losses imposed

by the cap-and-trade program. The financial losses may lead to loss of jobs in particular

industries. The compensation may be considered a form of transition assistance for industries and

industry employees most impacted by a GHG emissions cap.

This argument is perhaps stronger for industries that may have a more difficult time including the

costs of emission reduction in the price of their products. For example, certain U.S. industries

may be more vulnerable to foreign competition, especially if their competitors are located in

nations without GHG emissions caps. For these industries, increasing the price of their materials

(to reflect the cost of emissions abatement) may entail a comparative disadvantage. Moreover, if

foreign competitors in these industries increase their market share as a result of a U.S. cap-andtrade program, the foreign facilities (in uncapped economies) are likely to increase their GHG

emissions. This potential scenario is described as emissions leakage, a constant concern in

climate change policy.

In other economic sectors, particularly the electricity generation sector, that do not face foreign

competition, facilities are expected to pass along the vast majority of the emission reduction

costs. This would entail higher prices for consumers, which includes businesses and households.

Although EPA annually auctions a small percentage of the allowances in its sulfur dioxide (SO2) cap-and-trade

program (pursuant to Title IV of the 1990 Clean Air Act Amendments), most of the allowances are provided at no cost

to emission sources, based on their historical emissions. See CRS Report RL34235, Air Pollution as a Commodity:

Regulation of the Sulfur Dioxide Allowance Market, by (name redacted) and (name redacted).

The European Union’s (EU) Emissions Trading Scheme (ETS), a CO2 cap-and-trade program that applies to power

plants and certain carbon-intensive industries, allowed countries (between 2005-2008) to auction up to 5% of allowance

allocations. Only 4 of 25 countries used auctions at all, and only Denmark auctioned the full 5%. See CRS Report

RL34150, Climate Change and the EU Emissions Trading Scheme (ETS): Kyoto and Beyond, by (name redacted).

See, e.g., Cameron Hepburn, et al., “Auctioning of EU ETS phase II allowances: how and why?” (2006) Climate

Policy 6(1): 137-160.

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However, price increases would likely reduce consumer demand,35 potentially lowering the

profits of carbon-intensive industries.36

Political Feasibility

Cap-and-trade programs, both domestic and international, have usually provided allowances to

covered sources at no cost; this free allocation to covered sources is arguably a means to garner

support for an emissions reduction program. Moreover, industries may prefer to receive

allowances at no cost rather than compete for a share of auction revenues: a transfer of free

allowances may be more “politically secure than government promises of compensation from

auction revenues.”37

Concerns

Undesirable Effects in the Electricity Sector

As the electricity sector accounts for the largest percentage (34% in 2006)38 of GHG emissions in

the United States, it would play a major role in the effectiveness of a cap-and-trade program.

There is concern that if allowances are distributed to electric utilities at no cost, the electricity

consumers who purchase electricity under a price-regulated structure would receive a price signal

that is weaker than the signal received by consumers in unregulated (or competitive) markets.39 In

contrast, an auction distribution system would enable electricity generators, in both priceregulated and competitive markets, to send a comparable price signal to consumers.40

In the United States, the price consumers pay for electricity may be determined by a state

regulatory body—often described as cost-of-service regulation—or the price may be subject to

market forces—often described as deregulated or competitive. In general, the regulatory structure

varies by the type of facility and/or the state in which the electricity is generated. In 2007, the

more traditional, price-regulated electric utilities generated approximately 60% of the total net

electricity generated in the United States.41 The remaining 40% of electricity was generated by

facilities that are unregulated in terms of their ability to set a price for the electricity they

generate.

This may vary by the product sold and the level of price increase. Some products may display a relatively inelastic

price/demand relationship. This discussion is beyond the scope of this report.

For industry-specific estimates, see, e.g., U.S. EPA, EPA Analysis of the Lieberman-Warner Climate Security Act of

2008 (2008).

National Commission on Energy Policy, Allocating Allowances in a Greenhouse Gas Trading System (2007), p. 10.

U.S. EPA, Inventory of U.S. Greenhouse Gas Emissions and Sinks: 1990-2006 (2008), Table ES-7, at http://epa.gov/

climatechange/emissions/usinventoryreport.html.

See, e.g., National Commission on Energy Policy, Allocating Allowances in a Greenhouse Gas Trading System

(2007).

Dallas Burtraw, Prepared Testimony before the House Select Committee on Energy Independence and Global

Warming, January 23, 2008.

The above percentages are calculated by CRS with data from the Energy Information Administration’s 906/920

database, available at http://www.eia.doe.gov/cneaf/electricity/page/eia906_920.html.

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A comparison between Figure 1 and Figure 2 demonstrates the difference in price signals that

the two regulatory frameworks would send.42 These figures present a distribution of electricity

price changes that consumers could expect under a cap-and-trade system that included the

electricity sector.43 For example, under an auction system (Figure 1), a large percentage of

consumers would face an increase of $8/Mwh; approximately equal numbers of consumers would

face either higher or lower prices.

In Figure 1, the change in electricity price for both “regulated” and “competitive” regions is

fairly symmetrical. The (rise-and-fall) shape of the column heights, which is generally identical

for both the price-regulated and competitive regions, reflects the different electricity-generating

fuel portfolios that exist throughout the country. Regions with higher carbon content fuel

portfolios44 are expected to experience higher electricity prices under a cap-and-trade system.

Figure 1. Change in Electricity Price by Region: Allowances Distributed to Covered

Sources with Auction

Source: Dallas Burtraw (Resources for the Future), Prepared Testimony before the House Select Committee

on Energy Independence and Global Warming, January 23, 2008.

These figures are from Dallas Burtraw, Prepared Testimony before the House Select Committee on Energy

Independence and Global Warming, January 23, 2008. This testimony cites the author’s more in-depth study: Dallas

Burtraw and Karen Palmer, Compensation Rules for Climate Policy in the Electricity Sector (2007), Resources for the

Future Discussion Paper.

These figures are provided for illustrative purposes only.

For example, electricity in some states or regions may use higher percentages of coal or renewable energy than other

areas. See CRS Report RL34272, State Greenhouse Gas Emissions: Comparison and Analysis, by (name redact

ed).

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Emission Allowance Allocation in a Cap-and-Trade Program

Figure 2. Change in Electricity Price by Region: Allowances Distributed to Covered

Sources at No Cost

Source: Dallas Burtraw (Resources for the Future), Prepared Testimony before the House Select Committee

on Energy Independence and Global Warming, January 23, 2008.

However, when covered sources receive allowances at no cost (Figure 2), consumers in priceregulated and competitive regions experience dramatically different price changes. Note the

asymmetrical shape of the columns, as compared to those in the previous figure. In most of the

price-regulated regions, the electricity price would remain the same (or decrease), while the price

would increase in most of the competitive regions.

The different consumer impacts identified in Figure 1 and Figure 2 result from the dissimilar

market structures—price-regulated versus competitive—that determine the price of electricity for

U.S. consumers. The different impacts reflect the electric-generating facilities’ varied abilities to

pass through all types of costs to consumers in the form of higher electricity prices. In an auction,

the costs to utilities would include both the costs of mitigation and the costs of purchasing

allowances. Under a no-cost distribution system, utilities would have mitigation costs and

opportunity costs associated with the allowances (discussed above).

If policymakers auction allowances to electric utilities, both price-regulated and competitivemarket utilities would include the cost of purchasing emission allowances in the price of

electricity. However, if allowances are distributed at no cost to utilities, only competitive-market

utilities would be able to pass along their opportunity costs.

Because price-regulated facilities would not be able to pass through the opportunity costs

associated with free allowances, consumers in these areas would effectively receive the benefit of

the “free” allowances in the form of stable or lower electricity bills (Figure 2). Consumers in

competitive areas would not receive the benefit of “free allowances” and would thus face

disproportionate price increases. This consequence would erode the effectiveness of the cap-andtrade program, because consumers would likely not receive a price signal that is strong enough to

encourage conservation or energy efficiency improvements.

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The effects of this inefficient outcome may be magnified, because approximately 75% of coalfired electricity was generated by price-regulated utilities in 2007.45 Thus, consumers that utilize

more-carbon intensive electricity would face a weaker price signal than consumers using less

carbon-intensive electricity. 46

The price disparities that consumers with comparable fuel portfolios would experience under

different electricity regulatory structures would be both unfair and inefficient. An auction would

eliminate both of these concerns. Consumers in price-regulated and competitive regions (with

similar carbon-intensive electricity profiles) would experience more equitable impacts. Moreover,

the costs of the cap-and-trade program would be included in the price of electricity in each market

structure. This result is necessary if the carbon price is to modify consumer behavior: for

example, spur energy conservation efforts or the installation of more energy efficient

technologies.

Overcompensation to Covered Entities

If covered entities receive, at no-cost, GHG emission allowances in proportion to their emissions,

there is concern that the recipients would be overcompensated for the compliance costs imposed

by a cap-and-trade program.47 Depending on the percentage of emission allowances auctioned, an

auction could avoid overcompensation.

This potential outcome is a function of several factors. First, the aggregate value of the GHG

emission allowances is expected to be substantially greater than the aggregate costs of making

emission reductions pursuant to the emissions cap.48 (See Figure 3 and surrounding discussion

below.) Second, if covered sources receive allowances at no cost, they would retain the benefits

of these allowances, which are essentially a form of currency.49 Although it may be

counterintuitive, covered entities are expected to raise the price of their products, even if entities

receive allowances at no cost.50 Thus, covered sources would receive the financial benefit of the

allowances and the gains associated with higher prices.51 These benefits are often described as

“windfall profits.”52

Calculated by CRS with data from the Energy Information Administration’s 906/920 database, available at

http://www.eia.doe.gov/cneaf/electricity/page/eia906_920.html.

National Commission on Energy Policy, Allocating Allowances in a Greenhouse Gas Trading System (2007).

See Lawrence H. Goulder, Mitigating the Adverse Impacts of CO2 Abatement Policies on Energy-Intensive Industries

(2002), Resources for the Future Discussion Paper; Anne E. Smith and Martin T. Ross, Allowance Allocation: Who

Wins and Loses Under a Carbon Dioxide Control Program? (2002), Charles River Associates.

Compared to other emissions trading programs—namely, the U.S. SO2 emissions (acid rain) program—the ratio of

allowance value to compliance costs is expected to be much greater.

As discussed above, price-regulated electric utilities represent a critical exception.

This is due to the opportunity costs that an entity would face if it used (i.e., surrendered to the implementing agency

for compliance) its allowances. Instead of using the allowance, the entity could have sold it for its market value.

However, higher prices could reduce consumer demand and potentially lower profits (discussed below).

U.S. Congress, Senate Committee on Energy and Natural Resources, Design Elements of a Mandatory Market-Based

Greenhouse Gas Regulatory System, Chairman and Ranking Member Statement: Climate Change Conference (2006),

109th Congress.

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A windfall profit result has been observed in cap-and-trade models53 and in the largest existing

cap-and-trade program: the European Union’s (EU) Emissions Trading Scheme (ETS). The EU

ETS established a cap-and-trade program for power plants and certain carbon-intensive

industries, allocating virtually 100% of the allowances at no cost to covered entities between

2005 and 2007 (“Phase 1”). One study estimated that power plants in the United Kingdom

received windfall profits of 800 million euro (approximately $1 billion)54 per year;55 a separate

study estimated windfall profits for power plants in the Netherlands at 300 million to 600 million

euro ($378 million-$750 million)56 per year.57 However, the EU ETS Phase 1 allowance price (for

reasons beyond the scope of this report) dropped dramatically in April 2006 and never

recovered.58 Thus, the windfall profits were only generated in the first year (2005) of the program.

Nevertheless, a 2008 study estimated that European power plants are expected to continue to

receive windfall profits during the second phase (2008-2012) of the EU ETS. For example,

German plants are projected to generate the most windfall profits: between 14 billion and 22

billion euro ($21 billion-$33 billion)59 over that time period.60 In recognition of this projection,

the European Commission (EC) has proposed to address this issue, stating: “taking into account

their ability to pass through opportunity costs, full auctioning should be the rule from 2013

onwards for the power sector.” In addition, the EC has proposed that free allocation in other

sectors would gradually phase out, so that by 2020, auctions would distribute 100% of the

allowances.61

Treatment of New and Retiring Sources

An auction distribution format would address economic inefficiencies and concerns of fairness

regarding new emission sources and facilities that are near retirement. A recurrent auction creates

a level playing field for these two categories of sources. In contrast, a distribution strategy that

allots allowances at no cost based on prior year emissions (“grandfathering”) could provide a

considerable advantage to existing facilities. A free allowance effectively subsidizes currently

operating facilities, which may be using outdated, inefficient technologies.62 Moreover, if entities

receive allowances at no cost, the financial gain imparted in the allowance could serve as an

Goulder (2002) simulated a U.S. cap-and-trade program that would require a 23% emission reduction. In the model’s

scenario that distributed allowances at no cost to energy producers (coal, oil, natural gas), the coal sector profits

increased by 155% after two years of the program.

Converted using exchange rate of 1.25 (average rate in 2005), provided by http://www.oanda.com.

IPA Energy Consulting, Implications of the EU Emissions Trading Scheme for the UK Power Generation Sector

(2005), Prepared for the United Kingdom Department of Trade and Industry.

Converted using exchange rate of 1.25 (average rate in 2005), provided by http://www.oanda.com.

Jos Sijm et al., “CO2 Cost Pass-Through and Windfall Profits in the Power Sector,” Climate Policy 6 (2006): 49-72.

See CRS Report RL34150, Climate Change and the EU Emissions Trading Scheme (ETS): Kyoto and Beyond, by

(name redacted).

Using exchange rate of 1.5, provided by http://www.oanda.com.

Point Carbon Advisory Services, EU ETS Phase II—The Potential and Scale of Windfall Profits in the Power Sector

(2008), Prepared for World Wildlife Fund.

Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC so as to

improve and extend the greenhouse gas emission allowance trading system of the Community (January 23, 2008), at

http://ec.europa.eu/environment/climat/emission/ets_post2012_en.htm.

In some cases, where the firm might shift these operations to a foreign, unregulated country, such incentives might

make sense. Raymond J. Kopp, 2007, Allowance Allocation, Resources for the Future.

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incentive to extend the facility’s operation beyond a time that would otherwise be efficient to

cease operations.63

Distribution of Allowance Value: Options and

Considerations

By limiting the annual number of emission allowances available for compliance purposes, a capand-trade system creates emission allowances. Emission allowances would become a valuable

new commodity, potentially accounting—in aggregate—for tens or hundreds of billions of dollars

(Table 1 and surrounding discussion). To whom and for what purpose the value of allowances is

distributed would affect (1) the overall cost to society of a cap-and-trade program and (2) which

parties bear the costs of the program. Policymakers would face a choice between minimizing the

costs imposed on the entire economy (society’s costs) or using the allowance value for other

purposes.64 The latter choice covers a range of options. Congress could choose to provide

assistance to specific industries or groups, or choose to distribute the allowance value to support

various objectives. To provide an example, Appendix B of this report identifies the allowance

and auction revenue distribution strategies proposed by S. 2191.

The first part of this section provides an overview of some key concepts and an estimate of the

total allowance value that may be available for distribution in a cap-and-trade program. The

second part examines the range of options for distributing allowance value. This is followed by a

discussion of policy considerations.

Overview and Estimate of Allowance Value

Compliance Costs Versus the Value of Emission Allowances

A cap-and-trade program would impose costs: covered entities would comply by reducing their

own emissions, purchasing emission reductions (credits) from other covered entities, or (if

allowed) buying offsets from non-covered sources that have reduced, avoided, or sequestered

emissions.65 The combined costs of these activities are the “compliance costs” of the cap-andtrade program. 66

The compliance costs are different from the aggregate value of emission allowances. In the early

years of a cap-and-trade program, the aggregate value of allowances would likely dwarf the costs

of making (or finding) emission reductions. Figure 3 depicts this contrast: the area under the

emissions cap curve represents the number of allowances; the area between the emissions cap

Markus Ahman et al., “A Ten-Year Rule to Guide the Allocation of EU Emission Allowances,” Energy Policy 35

(2007):1718-1730.

However, some objectives, if met—namely, technology advancement—may also reduce the overall costs of the

program. This is discussed below.

See CRS Report RL34436, The Role of Offsets in a Greenhouse Gas Emissions Cap-and-Trade Program: Potential

Benefits and Concerns, by (name redacted).

These costs may be described with different terms in different publications: e.g., program costs, mitigation costs, or

economic costs.

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curve and the business-as-usual curve represents the required reductions. The former area will be

larger as long as the emission reduction target is less than 50% of the emissions baseline. 67

The compliance costs represent the sum of the costs of each ton of reduction, and the cost of each

reduced ton will vary. For example, some projects may present “low-hanging fruit” reduction

opportunities, whereas investments in extra capital (e.g., carbon capture technology) may

represent a more expensive reduction option.

Consider a simplified example:68 policymakers set a 7-ton cap on an economy that currently emits

10 tons. The 3 tons that must be reduced cost $1, $5, and $10, respectively. The cost of the last,

most expensive ton—the marginal cost—is $10. Because the marginal cost largely establishes the

market price of emission allowances in a cap-and-trade, each emission allowance has a value that

is approximate to the marginal cost.69 Therefore, in this example, the value of the allowances

would equal $70, but the compliance costs would be only $16.

GHG Emissions

Figure 3. Number of Allowances vs. Number of Reductions

Reductions

Allowances

Time

Business-as-Usual

Emissions Cap

Source: Prepared by CRS. The concept for the figure comes from National Commission on Energy Policy,

Allocating Allowances in a Greenhouse Gas Trading System (2007).

For the more stringent cap-and-trade proposals in the 110th Congress, this threshold would not be reached until

approximately 2040. See CRS Report RL33846, Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th

Congress, by (name redacted), (name redacted), and (name redacted).

Raymond J. Kopp, Allowance Allocation (2007), Resources for the Future.

The option to bank emission allowances would likely alter this calculus. In anticipation that allowance prices will

increase in subsequent years, covered sources would likely purchase more allowances than are needed for compliance

purposes in the early years of the program.

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Estimates of Allowance Value

Whether or not Congress sells the allowances through an auction (and generates revenues) or

distributes the allowances at no cost, the allowances would have monetary value.

To put the allowance value in context, consider the Lieberman-Warner Climate Security Act of

2008 (S. 2191), an “economy-wide”70 cap-and-trade proposal that was reported out of the Senate

Environment and Public Works Committee May 20, 2008. At the request of Senators Lieberman

and Warner, EPA prepared an economic analysis of provisions of S. 2191.71 One of the primary

results of the analysis is the estimated price range for emission allowances. From these price

estimates, potential auction revenues can be identified, because the legislation specifies the

percentage of allowances to be auctioned in each compliance year. Table 1 lists the estimated

annual action revenues that would be generated under provisions of S. 2191. In addition, the table

provides an estimate of revenues that would be generated if 100% of the emission allowances

were auctioned. This latter estimate represents an approximation of the aggregate value of the

emission allowances in a given year.

Table 1. Estimates of Auction Revenue under the Framework of the LiebermanWarner Climate Security Act of 2008 (S. 2191)

S. 2191 w/ 100%

Auction

S. 2191

Year

Total

Allowances

Available

(mtCO2-e)

Percentage of

Allowances

Auctioned

Estimated

Emission

Allowance Price

Range

($/mtCO2-e)

Estimated

Annual

Auction

Revenue

($ billions)

Estimated Annual

Auction Revenue

($ billions)

2015

5,456

29.5%

$29 - $40

$47 - $64

$158 - $218

2020

4,924

36.5%

$37 - $51

$67 - $92

$182 - $251

2025

4,392

48.5%

$48 - $65

$101 - $139

$211 - $285

2030

3,860

62.8%

$61 - $83

$147 - $201

$235 - $320

2035

3,328

69.5%

$77 - $106

$179 - $245

$256 - $353

2040

2,796

69.5%

$98 - $135

$191 - $263

$274 - $377

2045

2,264

69.5%

$125 - $173

$197 - $272

$283 - $392

2050

1,732

69.5%

$159 - $220

$192 - $265

$275 - $381

Source: Prepared by the Congressional Research Service with estimates of annual emission allowance prices

provided by U.S. EPA, EPA Analysis of the Lieberman-Warner Climate Security Act of 2008 (2008), p. 27.

Note: The price range represents the results of two separate models. For more information, see Appendix 1 of

EPA’s analysis of S. 2191. In addition, the figures in the “Total Allowances Available” column are from the

reported version of S. 2191 (May 20, 2008) and do not include proposed changes for deficit reduction purposes.

Typically, “economy-wide” proposals would cover the vast majority of the nation’s GHG emissions by capping

electricity generation, carbon-intensive industries, and the transportation sector. Depending on the design of the

program, some sectors (e.g., agricultural or residential) may be excluded from the cap.

U.S. EPA, EPA Analysis of the Lieberman-Warner Climate Security Act of 2008 (2008).

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To put the auction revenues/allowance value in context, consider the federal net tax revenue from

the three largest revenue sources for Fiscal Year 2007:72

•

individual income tax: $1,118 billion;

•

employment taxes: $838 billion;

•

corporate income taxes: $368 billion.

Options for Allowance Value Distribution

Provide Transition Assistance to Carbon-Intensive Industries

Several economic studies have estimated the percentage of allowances (a comparable amount of

auction revenues could also be used) that would provide compensation for projected profit losses

to specific carbon-intensive industries. The findings include the following:

•

Goulder found that 13% of the emission allowances would compensate the fossil

fuel producing industry (coal mining, oil and natural gas extraction) for lost

profits.73

•

Burtraw and Palmer concluded that the electric-generating industry’s estimated

profit losses could be offset with 6% of the emission allowances.74

•

Smith and Ross estimated that 21% of the allowances would compensate the

combined losses of primary energy producers and electric utilities (i.e., a

combination of the sectors examined in the other two studies).75

Although these studies analyzed the net effects to certain economic sectors, there are likely to be

winners and losers within the sectors, particularly in electricity generation. For instance, some

facilities, such as coal-fired plants, are expected to see greater losses, while others—hydroelectric

or renewable energy plants—may see a gain in profits.76

The above estimates consider that allowances would be provided to covered sources in perpetuity.

However, some cap-and-trade proposals in the 110th Congress (e.g., S. 2191 and S. 1766) would

generally phase-out free allocation as the percentage of allowances to be auctioned increases. As

such, the initial percentage of allowances provided at no cost in these bills is higher than

estimates that provide for indefinite distribution at a set percentage. For example, during the first

five years of the program established by S. 2191, fossil fuel-fired power plants would receive

U.S. Internal Revenue Service, Internal Revenue Service Data Book 2007, Publication 55B, issued March 2008.

Lawrence H. Goulder, Mitigating the Adverse Impacts of CO2 Abatement Policies on Energy-Intensive Industries

(2002), Resources for the Future Discussion Paper.

Dallas Burtraw and Karen Palmer, Compensation Rules for Climate Policy in the Electricity Sector (2007),

Resources for the Future Discussion Paper.

The authors found a range of 9% to 21%, but noted that the 21% was consistent with the scenario presented in

Goulder’s study. Anne Smith et al., Implications of trading Implementation Design for Equity-Efficiency Trade-Offs in

Carbon Permit Allocations (2002), Charles River Associates.

Dallas Burtraw and Karen Palmer, Compensation Rules for Climate Policy in the Electricity Sector (2007),

Resources for the Future Discussion Paper.

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19% of the emission allowances at no cost.77 This percentage would gradually decline to zero by

2031.78

Offset Reductions in Distortionary Taxes

Economic theory generally supports a tax policy that would reduce taxes on favored activities

(increased employment or personal income) and increase taxes on less desirable behavior

(increased pollution). 79 Auction revenues could be used to offset reductions in the taxes that apply

to desirable activities.

Using auction proceeds in this manner has been described as yielding a double-dividend: (1)

reduced GHG emissions and (2) reduced market distortions from the taxes on desirable behavior.

In the early 1990s, some economists suggested that the double-dividend effect would be strong

enough to keep the overall costs to society relatively small or even negative. 80 However, more

recent economic studies indicate that the costs imposed by the cap-and-trade program could act as

an additional tax,81 which would most likely (at least in the United States)82 exceed the benefits of

revenue recycling.

Several economic studies have estimated the cost savings to society that auction revenues could

provide.83 A cap-and-trade program is expected to impose an economic cost on society. 84 A

frequently cited study found that auctioning allowances could reduce the projected costs between

21% and 47%.85 The range of potential cost savings reflects different uses of the auction

revenues. If policymakers were to distribute the revenues to U.S. households in “lump-sum”

payments—for example, increase the standard tax deduction or mail payments to households—

the cost savings would be on the lower end of the spectrum. Alternatively, if Congress decided to

use the revenues to reduce taxes on labor or investment, society’s costs would be minimized.

Section 3901 (reported May 20, 2008).

In addition, note that S. 2191 would not provide allowances directly to the coal industry, although petroleum

producers/importers would receive a small percentage (2%).

The rationale for this policy is that taxes on desirable activities create market distortions, discouraging increased

levels of desirable actions. Assuming the same amount of revenue could be collected, economic policy would favor

placing the tax on activity that is generally considered undesirable. Further discussion is beyond the scope of this

report.

Ian Parry, “Fiscal Interactions and the Case for Carbon Taxes over Grandfathered Carbon Permits,” in Climate

Change Policy (Dieter Helm, editor), Oxford University Press (2005); Intergovernmental Panel on Climate Change

Working Group III, Climate Change 2001: Mitigation, (Cambridge, UK: Cambridge University Press, 2001) Chapter 8.

This is referred to as the “tax-interaction effect” in economic literature. See, e.g., Ian Parry, “Fiscal Interactions and

the Case for Carbon Taxes over Grandfathered Carbon Permits,” in Climate Change Policy (Dieter Helm, editor),

Oxford University Press (2005)

There is some evidence that the double-dividend benefits are stronger in Europe than in the United States, because

the former has a more stringent tax system. Intergovernmental Panel on Climate Change Working Group III, Climate

Change 2001: Mitigation, (Cambridge, UK: Cambridge University Press, 2001) Chapter 8, citing several studies.

See Lawrence H. Goulder, Mitigating the Adverse Impacts of C02 Abatement Policies on Energy-Intensive Industries

(2002), Resources for the Future Discussion Paper; and Anne E. Smith and Martin T. Ross, Allowance Allocation: Who

Wins and Loses Under a Carbon Dioxide Control Program? (2002), Charles River Associates; Dallas Burtraw, et al.,

The Effect of Allowance Allocation on the Cost of Carbon Emission Trading (2001), Resources for the Future.

See CRS Report RL34489, Climate Change: Costs and Benefits of S. 2191/S. 3036, by (name redacted) and (name red

acted).

Goulder (2002). This analysis simulated a cap-and-trade program with a 22% emission reduction between 2000 and

2080.

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Figure 4 shows the relative differences in society costs when different allocation strategies are

used.

R elative C o st s o f Pro g ram t o So ciety

Figure 4. Relative Differences in Cap-and-Trade Program’s Cost to Society with

Different Emission Allocation Strategies

100% Auction, Revenues Used to

Cut Marginal Tax Rates

100% Auction, Revenues

Distributed in Lump-Sum to

Households

Allocations Distributed at No

Cost to Regulated Entities

Source: Prepared by CRS with data from Lawrence H. Goulder, Mitigating the Adverse Impacts of CO2 Abatement

Policies on Energy-Intensive Industries (2002), Resources for the Future Discussion Paper.

Distribution to Non-Covered Entities

Non-covered entities may receive free allowances (sometimes referred to as “set-asides”) or a

percentage of the auction revenues. For example, Congress may decide to allot allowance value to

electricity consumers, particularly those in low-income households. The rationale for this

distribution policy is that specific subsets of society are expected to bear a disproportionate

percentage of the costs of a cap-and-trade program.

Whether covered sources receive allowances at no cost or purchase them through an auction,

economic principles predict that covered sources would pass along their opportunity costs or

purchase costs, respectively, in the same manner as an actual expense: for example, installing

more efficient technology or switching to more expensive (but less carbon-intensive) fuels.

Covered sources have demonstrated this behavior in two cap-and-trade programs, in which the

vast majority of allowances was provided at no cost: the European Union’s Emission Trading

System (EU-ETS) and the U.S. sulfur dioxide emissions trading program.86

Because of cost pass-through, consumers, particularly households, are ultimately expected to bear

the majority of the costs associated with a cap-and-trade program. Figure 5 illustrates the relative

distribution of costs to different groups in a cap-and-trade program.87 The figure is based on a

cap-and-trade scenario that would auction 100% of the emission allowances to fossil fuel

Congressional Budget Office, Trade-Offs in Allocating Allowances for CO2 Emissions (2007), Economic and Budget

Issue Brief.

This figure is based on a National Commission on Energy Policy (NCEP) proposal that would lead to a relatively

modest reduction in GHG emissions compared to those required under current proposals in the 110th Congress. Thus,

this figure is illustrative and only useful for comparing relative differences.

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producers (often referred to as “upstream” sources). Households and businesses experience the

vast majority (89%) of the costs. Moreover, the household percentage is potentially understated,

because many businesses would likely pass through some of their increased energy/electricity

costs in the form of higher prices for their goods and services. 88

Figure 5. Relative Distribution of Costs Using Upstream Auction

(Without Revenue Redistribution)

4% 7%

35%

54%

Fossil Fuel Producers

Fossil Fuel-Fired Pow er Plants

Business/Industry

Households

Source: Prepared by CRS based on the data from the National Commission on Energy Policy, Allocating

Allowances in a Greenhouse Gas Trading System (2007).

Note: The percentages above do not account for any offsetting income from allowance allocation. The figure

illustrates the relative distributions that would occur if allowances were auctioned to fossil fuel producers

(“upstream”), without recycling the revenues.

The figure is instructive for the allocation debate, because it shows a starting point for cost

distribution. However, the cost percentages depicted in Figure 5 do not account for distribution of

auction revenues. In a real cap-and-trade system that employs an auction, auction revenues would

be used to support specific objectives, or allotted to various parties.

Distribution to Support Specific Objectives

Policymakers may also consider distributing a percentage of the allowances or auction revenues

to support a range of objectives, including:

•

Technology development: Promotion of emission mitigation technology is widely

recognized as a vital step towards making substantial GHG emission

reductions.89 S. 2191 would distribute the majority of its auction revenues

(approximately 52%) to promote energy-related technologies: low-carbon energy

sources, carbon capture and storage (CCS),90 and cellulosic biofuels.

National Commission on Energy Policy, Allocating Allowances in a Greenhouse Gas Trading System (2007).

See, e.g., CBO, Evaluating the Role of Prices and R&D in Reducing Carbon Dioxide Emissions, (2006).

See CRS Report RL33801, Carbon Capture and Sequestration (CCS), by (name redacted).

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•

Energy efficiency: Improvements in energy efficiency could make considerable

contributions in achieving GHG emission reductions. Although energy efficiency

may involve technology advancements, new technologies must be used in order

to realize the efficiency gains. In some cases, parties may need incentives beyond

the efficiency gains to induce behavioral changes. For example, allowance value

could be distributed to support efficiency gains at places—residences,

commercial buildings—that are unlikely to be covered by an emissions cap.

•

Biological sequestration: Trees, plants, and soils sequester carbon, removing it

from the earth’s atmosphere. Allowance values could be allotted to provide

financial incentives for landowners to engage in activity—for example,

conservation tillage, reforestation—that would increase sequestration on their

land. Although some of these actions may qualify as offsets (if allowed in a capand-trade program), some activities may need additional incentives or be unable

to satisfy the offset approval process.91

•

Adaptation efforts: Some level of global warming (and associated effects) will

occur regardless of emission reduction efforts taken today, because previous and

current GHG emissions will have long term climate impacts. Therefore, some

contend that investment (e.g., allowance value) should focus on preparing

communities to adapt to the effects of a changing climate.

•

Deficit reduction: Another proposal for the use of allowances or auction revenue

is to address a budget deficit that may result from a cap-and-trade program. A

portion of the allowances or auction proceeds could be set aside to offset

projected revenue shortfalls. This option is sometimes described as making the

program “revenue-neutral.” In addition, Congress may consider using allowance

value to offset shortfalls beyond those that are related to the cap-and-trade

program.

Policy Considerations

The distribution of allowance value would present policymakers with a series of trade-offs. The

primary options for applying the allowance value involve (1) minimizing the overall costs of the

cap-and-trade program imposed on society; (2) alleviating the disproportionate costs borne by

subgroups in society; and (3) providing funding to support other policy objectives, such as

technological development. Intertwined among these options is a trade-off between regressive or

progressive impacts.

Reduce Costs, Alleviate Burdens, or Promote Technology

Economic studies indicate that using auction revenues (i.e., revenue recycling) to offset

reductions in distortionary taxes (labor, income) would be the most efficient use of the revenues

and yield the greatest benefit to society as a whole. These studies show that if the revenues are

See CRS Report RL34436, The Role of Offsets in a Greenhouse Gas Emissions Cap-and-Trade Program: Potential

Benefits and Concerns, by (name redacted).

Congressional Research Service

Emission Allowance Allocation in a Cap-and-Trade Program

used for other purposes, economic efficiency would suffer and the overall cost of the program

would be higher (Figure 4). 92

The opportunity to substantially lower overall costs is a unique attribute of the auction allocation

strategy. Some argue that using auction revenues to offset tax reductions is an unlikely outcome. 93

In general, when the government obtains new revenue, it tends to fund new or existing programs

rather than reduce existing taxes.94 Indeed, none of the cap-and-trade bills in the 110th Congress

has proposed to use revenues in this manner.95

Moreover, the most efficient manner of revenue recycling would generally spread the cost

reductions throughout the economy, while certain groups would be expected to bear a

disproportionate percentage of the costs of a cap-and-trade program. In particular, industries that

cannot pass along their increased costs (for competitive reasons or otherwise) would face higher

costs compared to other economic sectors. Ultimately, consumers are expected to absorb the vast

majority of the program costs. As discussed above, policymakers may consider compensating—

through free allowances or auction revenues—specific industries and/or providing assistance to

households that would face higher energy (e.g., electricity and gasoline) prices. Such

compensation would forgo the opportunity to reduce the overall cost of the emission program.

Using allowance value for other purposes—for example, technology development—would impart

a trade-off. While such allotments would limit the allowances available for the purposes

described above—reduced overall costs or relief for disproportionate impacts—new technologies,

in particular, could have a considerable impact on the costs of an emissions reduction program.

This is particularly the case if technologies can be commercialized ahead of their projected

schedules96 or if unanticipated low- or zero-carbon alternatives can be developed.

The amount of funding allotted to technology development under S. 2191 would represent a

substantial increase, compared to current federal funding for emission reduction and low-carbon

technologies. Although allocating allowance value to technological development could yield

considerable gain, the return in terms of additional investment to promote technology

improvements remains uncertain.97 In a recent study, the author found:

While academics have extensively studied how revenues from auctions can be used to make

the tax system more efficient, they have not done much research on examining the impact of

using such revenues for retiring debt or increasing government investment.

However, if additional funding for technology advancement leads to faster development of low-carbon technologies,

the cost of the program may decrease (discussed below).

Robert W. Hahn, Greenhouse Gas Auctions and Taxes: Some Practical Considerations (2008), AEI Center for

Regulatory and Market Studies; Robert Stavins, A U.S. Cap-and-Trade System to Address Global Climate Change

(2007), The Hamilton Project, Brookings Institution.

Ibid, citing Gary Becker and Casey Mulligan, “Deadweight Costs and the Size of the Government (2003),” Journal

of Law and Economics 46(2).

Another obstacle to this approach may concern Congressional committee jurisdiction issues. A cap-and-trade

proposal that would restructure elements of the tax code may overlap with multiple committee jurisdictions.

For example, the cost models for S. 2191 make assumptions about the availability of CCS. When this technology

actually goes online, it will likely have a substantial impact on the cost of a cap-and-trade program.

For more discussion of recent modeling results regarding technological development, see CRS Report RL34489,

Climate Change: Costs and Benefits of S. 2191/S. 3036, by (name redacted) and (name redacted).

Congressional Research Service

Emission Allowance Allocation in a Cap-and-Trade Program

In short, if allowance value is used to increase funding to existing programs or provide funding

for new programs, the return on investment is uncertain. For example, some programs may be

operating at full capacity, and additional funding may not provide comparable impacts. Moreover,

the marketplace already provides incentive for technological change, and a cap-and-trade

program would increase the incentive to develop low-carbon or zero-carbon energy alternatives.

Regressive or Progressive Economic Effects

Another trade-off for policymakers is whether the emission allocation strategy would produce

regressive or progressive economic results.98 The Congressional Budget Office (CBO) analyzed

the distributional effects of a cap-and-trade program under four different scenarios:

•

Allowances auctioned and auction revenues distributed to households in a lumpsum payment;

•

Allowances provided to covered sources at no cost;

•

Allowances auctioned and revenues are used to cut corporate income taxes; and

•

Allowances auctioned and revenues used to cut payroll income taxes.

The results are presented in Figure 6. As the figure indicates, an auction that distributed the

revenues to households in a lump-sum payment would yield the most progressive results. In

contrast, the most regressive result occurs when allowances are provided to covered sources at no

cost. The two other options that would cut tax rates would also produce regressive results.

However, these two strategies would substantially lower the overall cost of the cap-and-trade

program, a result not captured by Figure 6.

Analogous to a regressive tax policy, a regressive allocation strategy would disproportionately impact lower income

households. In contrast, in a progressive distribution scheme the ratio of cost to income would increase as income rises.

Congressional Research Service

Emission Allowance Allocation in a Cap-and-Trade Program

Figure 6. Comparison of After-Tax Household Income Changes (by Quintile)

Imposed by Emissions Cap, Using Different Emission Allocation and Revenue

Distribution Strategies

Percentage Change

-1

-2

-3

-4

Lowest

Second

Third

Fourth

Highest

Income Quintiles

Lump-Sum Distribution to Households

No-Cost Distribution to Covered Sources

Revenue Recycling: Cut Payroll Taxes

Revenue Recycling: Cut Corporate Taxes

Source: Prepared by CRS with data from the CBO: the no-cost distribution scenario data are from CBO, Who

Gains and Who Pays Under Carbon-Allowance Trading? The Distributional Effects of Alternative Policy Designs (2000);

the other three scenario data are from CBO, Trade-Offs in Allocating Allowances for CO2 Emissions (2007),

Economic and Budget Issue Brief.

Congressional Research Service

Emission Allowance Allocation in a Cap-and-Trade Program

Appendix A. What Is a Cap-and-Trade System?

A cap-and-trade system would create an overall limit (i.e., a cap) on GHG emissions from the

emission sources covered by the program. Cap-and-trade programs can vary by the sources

covered. The covered sources are likely to include major emitting sectors (e.g., power plants and

carbon-intensive industries), fuel producers/processors (e.g., coal mines or petroleum refineries),

or some combination of both.

The emissions cap is partitioned into emission allowances. Typically, one emission allowance

represents the authority to emit one (metric) ton of carbon dioxide-equivalent (tCO2-e). The

“equivalent” is necessary, because GHGs other than CO2—methane, nitrous oxide, sulfur

hexafluoride, hydrofluorocarbons, and perfluorocarbons—vary in their global warming potential

(GWP).99 Thus, GHG emissions are presented in a standard form of measure (CO2-e).

In general, policymakers may decide to distribute the emission allowances to covered entities at

no cost (based on, for example, previous years’ emissions), sell the allowances through an

auction, or use some combination of these strategies. This report examines issues associated with

these allocation options.

Covered entities that face relatively low emission-reduction costs would have an incentive to

make reductions beyond what is required, because these further reductions could be sold (i.e.,

traded) as emission credits to entities that face higher emission-reduction costs. Other

mechanisms, such as banking or offsets, may be included to increase the flexibility of the

program.

At the end of each established compliance period (e.g., a calendar year), covered sources would

be required to surrender emission allowances to cover the number of tons emitted. If a source did

not have enough allowances to cover its emissions, the source would be subject to penalties.

For more information, see U.S. Environmental Protection Agency (EPA), Office of Air and

Radiation, Tools of the Trade: A Guide To Designing and Operating a Cap and Trade Program

For Pollution Control (2003); CRS Report RL33799, Climate Change: Design Approaches for a

Greenhouse Gas Reduction Program, by (name redacted).

GWPs are used to compare gases to carbon dioxide, which has a GWP of 1. For example, methane’s GWP is 25, and

is thus 25 times more potent a GHG than CO2. GWPs are typically based on estimates provided by the

Intergovernmental Panel on Climate Change (IPCC).

Congressional Research Service

Appendix B. Allowance Allocation Strategy under S. 2191 (as Reported)

Table B-1. Emission Allowance Allocation under S. 2191

2012

2015

2020

2025

2030

2035

2040

2045

2050

62.8%

69.5%

Allowances Sold through an Auction

Early Auction

Auction

21.5%

29.5%

36.5%

48.5%

Allowances Distributed at No Cost

2012

2015

2020

2025

2030

2035

2040

2045

2050

Energy Savings

Building Efficiency

Programs that Exceed Fed. Targets

General Allocation - by LIHEAP Share

1.5%

Population Share

1.5%

Fossil Production CO2 Share

1.5%

States

Mass Transit

Transition Assistance

Fossil Fueled Electric Plants

19%

16%

10%

Rural Electric Cooperatives

0.2%

Energy-Intensive Manufacturing

10%

Petroleum Production/Importers

1.00%

0.25%

HFC Producers/Importers

1.00%

0.25%

Pilot Program for VA and MT

CRS-26

2012

2015

2020

2025

2030

2035

2040

2045

2050

Other Purposes or Recipients

Early Action

0.5%

Low/Middle-Income Electricity Consumers

Low/Middle-Income Natural Gas Consumers

Carbon Capture and Sequestration

Domestic Agriculture and Forestry

2.5%

Tribal Communities

International Forest Protection

Landfill and Coal Mine CH4 Reduction

Source: Prepared by CRS.

CRS-27

Table B-2. Auction Revenue Distribution under S. 2191

Off-the-Top Allocation of Auction Revenues (in $1,000s)

2012

2015

2020

2025

2030

2035

2040

2045

2050

BLM Emergency Firefighting Fund

$150

Forest Service Emergency Firefighting Fund

$430

Climate Security Act Management Fund

$1,071

$1,211

$1,393

$1,586

$1,776

$1,950

$2,086

$2,149

$2,092

Percentage Allocation of Remaining Revenues

2012

2015

2020

2025

2030

2035

2040

2045

2050

Zero- or Low-Carbon Energy Technology

16.6%

Advanced Coal and Sequestration Technology

13.0%

Fuel from Cellulosic Biomass

3.1%

Advanced Technology Vehicles Manufacturing

6.2%

Sustainable Energy Program

13.0%

TOTAL

52.0%

Technology Deployment

Energy Assistance Fund

LIHEAP

9.0%

Weatherization

4.5%

Rural Energy Assistance

4.5%

TOTAL

18.0%

Climate Change Worker Training Fund

DOE University Programs

1.3%

TOTAL

5.0%

CRS-28

Off-the-Top Allocation of Auction Revenues (in $1,000s)

Adaptation Fund

DOI - Wildlife Conservation and Restoration

6.3%

DOI - Adaptation Activities

3.4%

DOI - Cooperative Grant Programs

0.9%

DOI - Tribal Wildlife Grants

0.2%

DOI LWCF Sec. 6 Grants

0.3%

DOI LWCF Sec. 7 Acquisitions

0.6%

USDA Forest Legacy Program Sec. 7 Acquisitions

0.3%

USDA LWCF Sec. 7 Acquisitions

0.6%

SUBTOTAL

1.8%

Forest Service Adaptation Activities

0.9%

EPA Adaptation Activities

0.9%

Army Corps of Engineers Adaptation Activities

1.8%

Department of Commerce Adaptation Activities

1.8%

TOTAL

18.0%

Energy Independence Acceleration Fund

2.0%

Climate Change and National Security Fund

5.0%

Land and Water Conservation Fund

Source: Prepared by CRS.

Notes: CRS estimates of off-the-top revenues based on allowance price projections from the EPA/ADAGE-TECH scenario in U.S. EPA, EPA Analysis of the LiebermanWarner Climate Security Act of 2008 (2008). Higher allowance price estimates would lead to higher auction proceeds. CRS estimates of firefighting fund requirements based

on historic data. Estimate of administration cost (“CSA Management Fund”) based on EPA’s estimate of 1% of total allowance value.

CRS-29

Emission Allowance Allocation in a Cap-and-Trade Program

Author Contact Information

(name redacted)

Analyst in Environmental Policy

[redacted]@crs.loc.g

ov, 7-....

Congressional Research Service

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