How Much Will ‘Cap and Trade’ Cost?

Copyright, The New York Times Company

As part of a public strategy to offset global warming, the president and Congress are considering possible “cap and trade” laws to limit the United States’ carbon dioxide emissions. One question raised in this debate is the amount that such limits would cost United States taxpayers and consumers.

Many scientists argue that carbon dioxide emissions are a significant contributor to global warming, and that humanity would benefit if the government did something to stop, or partly offset, global warming.

One proposal for limiting the United States’ carbon dioxide emissions is to set an emission limit for each business, and allow businesses to trade their emissions “allowances” with each other. The “trades” would involve a business that uses less than its permitted limit and that then sells the remainder to another business that wants to produce over its limit.

If we suppose that limiting the United States’ emissions through a cap-and-trade system would generate an environmental benefit, that still leaves the question of how much taxpayers and consumers would pay.

One component is the cost of reducing United States energy production, and then reallocating energy production toward nuclear power and other means that emit less carbon dioxide per unit of energy produced.

Those “reallocation” costs are hard to know because, among other things, we do not yet know the degree to which restrictions on the building of new nuclear plants will be relaxed to help attain the goal of reducing carbon dioxide emissions. One study puts these costs at about $300 per family per year, although from experience I have seen reallocation costs overestimated because the capacity for our economy to adjust to new circumstances is not adequately appreciated.

On the other hand, one reason why the reallocation costs might be underestimated is that the worldwide pattern of production can adjust so that some carbon-intensive production occurs outside the United States. To the degree that carbon-intensive production leaves the United States, the (financial) costs of cap and trade will be less, although so will be the benefits in terms of reducing global carbon emissions.

A second issue is the distribution of the emission allowances. Will emission allowances be auctioned by the government, as President Obama promised during his campaign? Or will they be given away to existing energy producers?

To a rough approximation, the distribution of the allowances does not affect the total amount of the costs of reducing aggregate emissions, just the allocation of those costs across different sectors (i.e., which industries pay what). To the extent that allowances are auctioned and the revenues go to the United States Treasury, the stockholders and consumers of existing energy companies would pay more and taxpayers would pay less. Some estimates suggest that the amount at stake for the taxpayers is over $3,000 per family.

To the extent that allowances are given away to energy companies, shareholders and consumers pay less and taxpayers pay more.

But the allowances would be valuable. That means existing business would strategically adjust their behavior (and probably already are doing so) to be eligible for a larger emission permit. The costs of jockeying for permits are costs in addition to the cost of reducing and reallocating energy production.

For example, a grandfathering system would give businesses emission allowances in proportion to how much they had emitted in the past. Given the monetary value of emission permits, a grandfathering system gives producers a large incentive to, in anticipation of the grandfather awarding of permits, emit more prior to the creation of the cap-and-trade system.

Reducing carbon is a goal shared by the Obama administration and a number of members of Congress. But, as with the promotion of hybrid vehicles,cleaning banks of their toxic assets, and other government ambitions, it takes more than a lofty goal to create good policy. Cap and trade is yet another example of how the details of regulation matter not only for the costs to taxpayers and consumers, but also for whether the policy actually pushes the economy in the intended direction.