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Parsing the Waxman-Markey Cap-and-Trade Bill

Co-authored with Devin Helfrich, Environmental Legislative Advocate, Friends (Quaker) Committee on National Legislation.

The American Clean Energy and Security Act of 2009 (ACESA) prepared by Representatives Henry Waxman (D-CA) and Ed Markey (D-MA) is the subject of four days of hearings before Waxman’s Energy and Commerce Committee this week. Here, we compare its cap-and-trade provisions with the leading alternative, a carbon tax embodied in Rep. John Larson’s America’s Energy Security Trust Fund Act of 2009 (AESTFA).

paperwork-_-chris-of-the-hunt1ACESA’s cap-and-trade provisions comprise one of four “titles” of the 648-page draft. ACESA would also impose renewable energy requirements on electric utilities; fund R&D and demonstration projects of carbon capture and sequestration for coal-fired power plants; set energy-efficiency standards for autos, appliances, homes and commercial buildings; and regulate other greenhouse gases (“black carbon” and CFCs).

Many of these regulations and programs appear positive, but they can only go so far in the absence of clear price signals on CO2 emissions. As Yale economist William Nordhaus noted recently:

Economic participants-thousands of governments, millions of firms, billions of people, all making trillions of decisions each year – need to face realistic prices for the use of carbon if their decisions about consumption, investment, and innovation are to be appropriate… without a strong price signal, there is simply no hope for making the vast number of decisions in a remotely efficient manner…  Raising the price of carbon is [thus] a necessary condition for implementing carbon policies in a way that will reach the multitude of decisions and decision makers over space, time, nations, and sectors.

We compare Waxman-Markey with Larson on six criteria that experts consider central to effective and equitable carbon pricing:

1) Auction all carbon pollution permits. Under a cap, polluters must hold permits to emit each ton of carbon pollution. Under ACESA, the government would issue tradeable permits declining in number by about 3% a year. The ACESA draft doesn’t say whether the government would give permits to polluters, auction them or some of each. Either way, permit prices would rise as the cap tightens and permits become scarce. Free permits are a windfall to polluters and have been criticized by the Congressional Budget Office, Friends of the Earth and candidate Barack Obama who promised to auction 100% of pollution permits.

Free permits were built into the EU cap-and-trade system and are still being touted by cap-and-trade proponents as a way to induce energy suppliers not to raise prices. It didn’t work in the EU. If your grandmother left you her house would you let strangers live in it rent-free? Uh-uh. No well-run business would either. Permit prices rise and fall to reflect the balance of supply and demand in the market. As the EU found out, free permits are free money to polluters; they don’t help consumers.

[G]iving away allowances would be significantly regressive, making higher-income households better off as a result of the cap-and-trade policy while making lower-income households worse off. Further, giving away the allowances would preclude the government from dedicating the value of the allowances to reducing the overall economic impact of the policy.

– Peter Orszag, then director of CBO and currently OMB director, testimony before the Senate Energy and Natural Resources Committee, May 20, 2008.

[T]he experience of a cap-and-trade system thus far is that if you’re giving away carbon permits for free, then basically you’re not really pricing the thing and it doesn’t work, or people can game the system in so many ways that it’s not creating the incentive structures that we’re looking for.

– President Obama, Business Roundtable, March 12, 2009.

ACESA: The draft doesn’t specify whether permits will be auctioned or given away to polluters. Recent news reports suggest Congress and the Administration are considering giving away some permits, at least initially.

AESTFA: Under a carbon tax such as Rep. Larson’s bill, there’s no need for permits. Carbon-based fuels would simply be taxed upstream. Just as with free permits under cap-and-trade, it would be absurd and unfair to give carbon tax revenue to polluters while increasing consumer energy prices.

2) Recycle revenues back to the people. Cap-and-trade is a regressive tax. Increasingly scarce permits would raise fossil fuel energy prices which generally will be passed through to consumers. Low- and moderate-income households spend greater fractions of income on necessities and are least able to absorb price increases.

Returning pollution permit revenue to consumers by reducing other, more regressive taxes or by direct, equal distribution would mitigate the income effects of rising costs of fossil fuel energy. Revenue “recycling” would consolidate public support and ensure long-term program viability.


Under a cap-and-trade program, firms would not ultimately bear most of the costs of the allowances but instead would pass them along to their customers in the form of higher prices…Those increases, however, would impose a larger burden, relative to their income, on low-income households than on high-income households.

Terry Dinan, Senior Advisor, CBO, testimony before the House Ways and Means Subcommittee on Income Security and Family Support, March 12, 2009.

[R]ebates protect households against the loss of purchasing power from higher energy-related prices without blunting consumers’ incentives to respond to those higher prices by conserving energy and investing in energy efficiency improvements. Because energy-related products will cost more, households with the flexibility to conserve energy or invest more in energy efficiency will get more value for their budget dollar by taking these steps than by using their rebate to maintain their old ways of consumption. At the same time, rebates help households that cannot easily reduce their energy consumption to avoid a reduction in their standard of living.

Chad Stone, Chief Economist, Center on Budget and Policy Priorities, testimony before the House Ways and Means Subcommittee on Income Security and Family Support, March 12, 2008.

ACESA: The discussion draft doesn’t specify use of revenue. To the extent that permits are given away, less revenue would be available for recycling. Waxman-Markey would fund “utility-operated retrofit programs with repayments over time through utility rates,” providing some assistance to business and residential energy consumers.

AESTFA: Rep. Larson’s bill would use 85% of revenue to reduce payroll taxes by eliminating the payroll tax on the first $3,800 of earnings. Payroll tax relief would boost employment, especially for low-wage earners.


3) Limit and verify (or prohibit) offsets. The purpose of a cap is to reduce GHG emissions. But offsets offer a way out, allowing polluters to pay others to make reductions and get credit for those reductions. Offsets delay and dilute the transition to a low-carbon economy. The intended targets of offsets, protection of carbon sinks like forests and soils, should be incentivized separately.

[O]ffsets could compromise the environmental certainty of a regulatory program if offsets used for compliance lack credibility. [T]heir use in mandatory programs may be, at best, a temporary solution to achieving emissions reductions, and …may not be a cost-effective model for achieving emission reductions.

– John Stephenson, Director Natural Resources & Environment, GAO, testimony before the House Energy and Commerce Subcommittee on Energy and Environment, March 5, 2009.

The financial crisis was sparked by bad mortgages, and U.S. carbon markets could pose similar problems through the creation of “bad carbon” or “subprime carbon.” Subprime carbon — … contracts to deliver carbon that carry a relatively high risk of not being fulfilled and may collapse in value … would most likely come from shoddy carbon offset credits, which could trade alongside emission allowances in carbon markets … It could be as difficult, if not more, to analyze the quality of the numerous underlying carbon offset projects as it is to analyze U.S. mortgages.

Michelle Chan, Director of Green Investments Program, Friends of the Earth, testimony before the House Ways and Means Committee, March 26, 2009, and “Subprime Carbon” Report, March 2009.

ACESA: Polluters could use offsets to comply with up to 30% of their permit obligations under the cap in the early years, and an even greater fraction later (e.g., 36% in 2030). Offsets are split equally between domestic and international and discounted by 20%. Though ACESA provides authority to verify and police offsets, the scale of such efforts would be daunting, rivaling the most complex securities monitoring that failed to prevent the current financial crisis. Verification of offset activities worldwide would pose new and unsolved problems of international law and create vast opportunities for fraud and gaming.

AESTFA: The Larson bill doesn’t include offsets. No polluter would have a lesser incentive to reduce emissions, and the price of emissions would be immune to gaming or “sub-prime carbon.”

4) Cap upstream. Pricing emissions at the first point of sale or other practical “chokepoint” will greatly reduce the number of sources to regulate making the system less burdensome, reduce administrative costs and cover more of the economy.

[I]f the European experience is followed and a downstream cap-and-trade program put in place, administrative complexity would rise considerably. In fact, the ETS exempts emitters of less than 10,000 tons of CO2 per year and thereby only covers about 50% of the EU’s emissions.

– Gilbert Metcalf, et al., Analysis of U.S. Greenhouse Gas Tax Proposals, a report by the MIT Joint Program on the Science and Policy of Global Change, April 2008.

Compared with a “downstream” design, which would tax or regulate users of fossil fuels, an upstream approach would have two administrative advantages. It would involve regulating a limited number of entities, and it would not require firms to monitor actual emissions…On the basis of information from the Energy Information Administration, such a system would entail regulating roughly 150 oil refineries, 1,460 coal mines, and 530 natural gas processing plants.

– Peter Orszag, former director of CBO and current director of OMB, Policy Options for Reducing CO2 Emissions – A CBO Study, February 2008.

ACESA: Emissions from coal and natural gas would be regulated downstream at or near the point of combustion. Emissions from petroleum would be regulated upstream where the product is first supplied to the market.

AESTFA: The Larson bill taxes at the first, simplest and most efficient, point of sale.


5a) Price floor. Low or fluctuating carbon prices discourage and delay investment in efficiency upgrades and alternative energy, requiring much higher average carbon prices to achieve specific emissions reductions. Reduced economic activity is now crashing prices in EU’s Emissions Trading Scheme and triggering disinvestment from emissions reductions and alternative energy.

A “reserve” or minimum auction price for permits would retain at least some price incentive for low-carbon investments and assure a return on investment in efficiency and clean energy technologies. Government buyback of permits at pre-determined floor prices may also be needed to limit price declines.

[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.

– Jonathan Ramseur, Congressional Research Service, Emission Allowance Allocation in a Cap-and-Trade Program: Options and Considerations, CRS Report, June 2, 2008.

A floor to protect investors could be achieved by the government buying back allowances if the price collapsed below a level that was deemed necessary, on average, to attract the next wave of mitigating technology and to provide some degree of revenue stability for deployments of long-lived, low-CO2 technologies.

The Brattle Group, CO2 Price Volatility: Consequences and Cures, January 2009.

ACESA: Unlimited banking and borrowing included to limit price crashes.

AESTFA: In Larson’s bill, the carbon price is pre-determined and rises gradually. The approach in Rep. Doggett’s (D-TX) “Safe Markets” bill is to set up an agency to actively manage carbon prices by buying and selling allowances as the Federal Reserve does with currency. Rep. McDermott’s (D-WA) “Stable Energy Market” approach would have Treasury set the carbon price and raise it as needed to meet an EPA-certified emissions trajectory.


6a) Price Ceiling: A pool of additional permits would function as a price ceiling to limit price spikes that could cause economic disruption and a political backlash against the system. The government would sell additional pollution permits into the market when the permit price reached a pre-determined threshold. Any additional permits released from the reserve pool into the market would be offset by reductions in the number of regularly-issued emissions permits allocated for future years to maintain the long-term cumulative emissions cap. Permits released from the reserve pool must have banking limits to keep firms from stockpiling cheaper permits for use in more expensive future compliance years. Banking of reserve permits could push current prices above the reserve pool ceiling, effectively enabling the price volatility that the pool is created to prevent. Finally, price spikes would jeopardize the political viability of the program as occurred in 2000 in the Los Angeles basin region RECLAIM cap and trade program.

[P]ermitting firms to purchase allowances from a public “reserve pool” – composed of allowances that were borrowed from future years or that supplemented the initial supply – could partially substitute for allowing borrowing by individual firms. The reserve pool could help reduce costs by giving firms the opportunity to exceed annual caps in years when the cost of complying was temporarily high. Its effectiveness in realizing cost savings would depend on the size of the pool and the threshold price at which firms could purchase the reserve allowances.

– Douglas Elmendorf, Director, CBO, testimony before the House Ways and Means Committee, March 26, 2009.

How climate policy legislation is designed can have a significant impact on price volatility. From an economic perspective, a smooth price signal that increases over time is the most efficient way to provide incentives for investors and to minimize disruptions in the economy…Moreover, the reduced price volatility resulting from the introduction of a ceiling and a floor enhances the investment climate for new investment beyond that which results from unbridled price volatility.

– Dallas Burtraw, Senior Fellow, Resources for the Future, testimony before the House Ways and Means Committee, March 26, 2009.


ACESA: Quarterly strategic reserve auction of additional permits (at price levels of twice the rolling three year average). The strategic reserve would represent approximately 2% of the total permits.

AESTFA: Under the Larson bill the price starts at $15 per ton of carbon dioxide and rises at a known (hence, predictable) $10/year. The price rises would be ratcheted up to $15/T if emissions targets weren’t being met.

5b) Raise the Floor and 6b) Lower the Ceiling to Dampen Volatility and Speculation:  Speculation and secondary markets are also grave concerns about a trading system. Narrowing the “spread” between the price floor and a ceiling would leave less room for speculation and derivatives.

Volatility like the kind experienced in the ETS [European Trading Scheme] would translate into much more volatile energy prices, unsettling everyone’s markets and undermining investment. And the volatile prices for the permits themselves, traded on financial markets, would attract speculation and new financial derivatives, putting us at risk for another crisis.

Robert J. Shapiro, former undersecretary of Commerce (1997-2000), “The Real Choice Between Cap-and-Trade and Carbon-Based Taxes,” Roll Call Jan. 15, 2009.

Ideally, to eliminate the risk and cost of speculative transactions, the floor and ceiling would be the same price, which is (of course) a carbon tax.

Conclusion: ACESA’s cap-and-trade provisions could be improved in six crucial ways to nudge it step-by-step closer to the effectiveness, fairness and price certainty of the “gold standard” — a revenue-neutral carbon tax. Rep. Van Hollen’s “Cap-and-Dividend” approach takes the first four steps but stops short, failing to limit price volatility that destroyed the RECLAIM (smog trading) program and has severely compromised the EU’s carbon cap-and-trade system.


ACESA’s current cap-and-trade proposal is a flawed, complex and costly system that seems unlikely to achieve significant emissions reductions in the time needed. Auctioning all allowances and recycling the revenues would make it more equitable, and eliminating or limiting offsets would improve its efficacy at reducing U.S. emissions while preventing fraud and gaming. The bill’s provisions to limit volatility seem modest and may be inadequate; the 2% reserve pool might be quickly exhausted under conditions of high energy demand.

The Larson carbon tax bill is the hands-down winner, meeting the “gold standard” in every category.

Photo: Flickr: “Paperwork” by Chris of the Hunt


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