The single most important market design issue facing this committee is how to allocate carbon allowances/permits. Getting it right will have a huge influence not only on the success of the market, but also on the success of the entire effort to limit carbon emissions. Conversely, getting it wrong will send the wrong message and make a market either far less useful or, even, a hindrance to limiting carbon emissions.
A simple request: a fully-developed, intellectually and empirically rigorous public discussion and debate on the best way to allocate carbon allowances must become a major part of your process, between now and the time your report is due in June. That debate must not be limited by politics or special interest pleading. And it should be held in an open manner, with information and materials from all parties forming an extensive record of debate and discussion.
Second, for your consideration as part of that debate, we believe that the result of informed discussion will inevitably be to auction permits, not give them away. We submit the following as part of that discussion.
Auctioning vs. giving away permits: a thought experiment
Assume that this committee is empowered to set policy when it makes a recommendation in its final report in July 2007. Your recommendation is for a cap and trade market to begin in 2010 or earlier to the extent feasible.
Your reason for using a market mechanism is to send the right signals for cost-effective carbon reduction with a minimum of regulatory control. The regulatory framework sets a broad and declining cap on emissions, but market signals are intended to enhance the process of adjustment by market participants—virtually all of us–to the limited stock of allowances, without cumbersome bureaucratic oversight and technology dictates.
Issue 1: Incentives and regulatory requirements
Scenario 1: Permits to emit carbon will be auctioned when the market begins in 2010.
Immediately, this approach sends the signal that carbon emissions will be costly at some time in the future. The immediate incentive of market participants is to minimize that cost by choosing the most cost-effective reductions in carbon emissions. While they must make decisions under uncertainty about the future cost of permits, they can assume that the price will increase as the cap is lowered and therefore will take the most cost-effective actions in the context of expected carbon market costs (at least, the “low-hanging fruit”.)
In this scenario, early-adopters know that they will be rewarded by not having to buy, at a given time in the future, as many permits as they would otherwise have to buy in the absence of reductions. There is no need for an administrative process to determine “credit” for early adoption, since the reward stems directly from not having to buy as many permits. That is, the market is self-executing and allows decentralized action, which is, of course, precisely the advantage of creating a market.
Scenario 2: In 2010, carbon emitters will be given permits at no charge based on their historical emission of carbon.
Immediately, market participants are sent the signal that, in order to maximize their credits (that is, the property allotted to them), they should continue to emit carbon, and perhaps increase their carbon emissions so they can be given more free allowances, from which they will presumably be able to earn revenue in a trading system.
To do so, the regulatory bureaucracy will have to determine not only the global level of allowances up for auction but facility or company-based allowances. They will have to determine if participants have “gamed” the system in order to receive more credits. And, the early adopters will have to engage in a cumbersome administrative process, lobbying the air board to receive credits for investments they have already made and pollution they have already avoided. In effect, since the market sends the wrong signal (don’t lower emissions so you can store up your allowances), a bureaucratic process has to be set up to counteract the (incorrect) market signal for those who do the right thing.
In short, the selection of auction does what a market should do: send the right signal to avoid pollution, and generate the most cost-effective cuts in emissions based on decentralized decision-making of market participants.
Giving away permits does the opposite: polluters would be given the signal that to maximize potential revenue they should continue to emit. And, a cumbersome regulatory process would be needed to correct the mistaken incentives in the market, for those who already lower emissions.
Issue 2: the allocation of benefits from a market system
There is no question that adaptation to a lower carbon economy will have costs. The major questions are: how will those costs be borne, how can the burden of costs be mitigated, and how can a successful transition take place?
Scenario 1: Under auction, the public ownership of the commons (i.e. the atmosphere) returns revenue to the public. Under California law, such revenues are the result of fees, not general taxes, and therefore must be used for purposes for which there is nexus for the exaction of such fees.
While those decisions will be up to the Legislature, one can contemplate the many options for expenditure as a result of revenues for auction. Some have argued for low-income tax relief or business tax relief, to mitigate the effects of increased prices. An argument could be made, with sound economics behind it, to subsidize a range of carbon-saving activities or technologies because the positive externality of doing so is not reflected in the market, such as increased transit, additional energy efficiency or renewable investments, or plug-in hybrid cars. Or, investments in promising technologies could make the transition smoother and more rapid.
In any case, it is easy to imagine a mix of uses of public revenues which can greatly ease the inevitable difficulties of economic transition. Having roughly $2-3 billion, as estimated by Redefining Progress, can provide enormous benefits to the economy and to the transition to lower carbon emissions.
Scenario 2. What if carbon credits are given away? The beneficiaries clearly are those to whom the credits are given, both because, initially at least, their incentive is not to change their emissions, but also, to the extent that they later change behavior, they reap the benefits from selling the credits.
Even if carbon allowances are given away, there will be societal costs resulting from the limitations on fossil fuels under a carbon reduction regime. Prices will rise, and the benefits of those increases will accrue to shareholders of corporations selling or using fossil fuel. The result is that there are no public revenues for any kind of mitigation, whether tax relief or investments in consumption reduction.
Presumably there will be market incentives to conserve, but there will be no revenue to assist in mitigation of costs or subsidies for conserving technologies. Since a functional market should reward positive externalities and penalize negative externalities, there will be no way to effectuate such a transfer.
In summary, auctioning provides a “double dividend”, sending not only the right incentives, but revenues to mitigate costs, promote change, and subsidize positive actions not accounted for by the market. The most cost-effective and equitable use of that dividend will be a major part of a global warming program.
By contrast, giving away permits generates revenue for shareholders of major emitters, many of whom will be out-of-state, and leaves the state turning to taxpayers for any mitigation costs, subsidies, or investments in new technology.
We recognize that there are a large number of additional regulatory and economic issues to be explored, such as the historical experience in similar markets, the kinds of activities which would be credited in a market-based system, the relationship between the system in California to other trading systems, including RGGI in eastern states and international carbon trading systems, and how to best structure an auction.
But as part of that broader discussion, the issue of first order discussion and debate must be the basis on which carbon allowances are allocated. We look forward to the debate.