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Why Cap-and-Trade Is Politically Failing: Cost, Cost, Cost (The Chamberlin study and his response to Michael Levi, Council on Foreign Relations)

[Editor note: The summary and analysis below is reprinted with the permission of the Institute for Energy Research. The sections past the summary are authored by Dr. Andrew Chamberlin. Cap-and-trade remains alive unless the U.S. Senate fails to pass legislation to go to conference with HR 2454, The American Clean Energy and Security Act of 2009.)

To better understand the broad consequences of the proposed Kerry-Lieberman American Power Act on the U.S. economy, the Institute for Energy Research commissioned Chamberlain Economics, L.L.C to perform an economic and distributional analysis of cap-and-trade portion of the proposal.

The report examines the impacts that the American Power Act would have on the U.S. economy, the method by which emission allowances are distributed to corporations and the distributional cost of the bill on households by income, age group, region and family type.

The study’s key findings of the American Power Act follow:

  •   U.S. employment would be reduced by roughly 522,000 in 2015, rising to over 5.1 million jobs by 2050.
  • Households would face a gross annual burden of $125.9 billion per year or $1,042 per household, with costs disproportionately borne by low-income households.
  • On a net basis, the top income quintile will benefit financially, redistributing to these households roughly $12.3 billion per year from the bottom 80 percent of earners.
  • Households over age 75 bear the largest burden at 2.3 percent of income, followed by households aged 65-74 and under age 25 at 2.1 percent. By contrast, the nation’s highest-earning households between age 45 and 54 years would bear the smallest percentage burden of just 1.5 percent.
  • Contrary to the legislation’s stated goal of reducing price volatility by excluding petroleum refiners from quarterly auctions, the Kerry-Lieberman bill is likely to significantly increase allowance price volatility from quarter to quarter, compared to an ordinary auction in which all covered industries bid for allowances.

The authors also explored two specific propositions: the first, the potential for shareholders, and not consumers, to benefit from the distribution of free emission allowances; and, second, the expected consequences of the bill’s creation of a separate pool of allowances for petroleum refiners, thus adding to the price volatility of those allowances.  Both conclusions are contrary to Kerry and Lieberman’s stated intent of the legislation.

Michael Levi Challenge

Michael Levi at the Council on Foreign Relations challenges the study with a naive view of state and local utility regulation. He argues for a world in which municipal regulators have the ability to force utility managers to act against their own economic interests, passing forward the full benefit of free emission allowances to consumers rather than their own shareholders.

Levi argues,

The regulator knows the value of the free allowances: it is equal to the number of allowances given out for free multiplied by the value of the allowances at auction. If the LDCs cannot account for having spent that money on public purposes, the regulator will know… [I]t’s actually pretty simple.

If only regulating public utilities were simple! Even in the absence of climate policy, there exists today a vast and complex network of utility regulatory boards, governed by millions of pages of regulatory guidelines, all designed to simply govern the ordinary business of utilities. The American Power Act would overlay a complex federal climate policy atop this arrangement. Saying anything about the behavior of regulated firms under climate policy is “simple” belies the complex reality of public utility regulation in the U.S.

Rebuttal to Levi

There are several problems with Levi’s criticism. The most obvious is, why not distribute allowance values directly to electricity and natural gas consumers, rather than first granting them to utilities? As we have seen in recent financial and environmental disasters, regulators can, and often do, fail to fulfill their role as industry watchdogs. Other provisions of the bill, such as the “consumer relief” program, auction allowances and distribute cash payments directly to households. This could easily be done for electricity and natural gas consumers.

Using a simple database of addresses for existing ratepayers, IRS administrators could distribute rebate checks to households, piggybacking on the infrastructure of the Earned Income Tax Credit with no danger of moral hazard, and no need for additional costly, complex regulations on LDCs. Why not make the system as simple as possible, rather than leaving it open to the possibility of regulatory failure? As we make clear in our study, lawmakers did not follow this approach. That suggests there exists instead a political dynamic at work that has more to do with compensating industries for losses from cap-and-trade than actually compensating consumers, as claimed by advocates of the bill.

Levi’s argument that shareholders will not economically benefit from free allowances is simply inconsistent with the fact that LDCs and their parent companies themselves have lobbied heavily for these provisions. U.S. Senate records show electricity LDCs have spent millions lobbying for provisions in cap-and-trade bills in recent years. Atlanta-based Southern Company, which covers 4.4 million residential customers with local utilities in four states, spent $9.8 million alone in 2008 on climate change lobbying.

American Electric Power, which operates electricity LDCs in 11 states serving more than 5 million customers, spent $8.4 million. Other large electricity firms such as Duke Energy, FPL Group and Ameren spent similar amounts lobbying during the period in which both the Waxman-Markey and Kerry-Lieberman bills were being crafted on Capitol Hill. If shareholders are expected to receive zero benefit from free allowances, what explains these tremendous lobbying expenditures? Such behavior is simply not consistent with a naive view the American Power Act that simply assumes, with no microeconomic foundation, that utility consumers stand to benefit from free LDC allowances.

In fact, distributing funds directly to households rather than indirectly through free allowances to LDCs would have been a much more efficient way to provide consumer relief. If households are given cash rebates, these may be used for other purposes than electricity and natural gas, such as home weatherization, more efficient vehicles or other household expenditures. Instead, the American Power Act leaves open the possibility that utilities could simply be forced to offer households a credit on a utility bill. That is, rather than allowing consumers to choose how best to spend these benefits, LDCs would have the ability to restrict it for use on utility bills only—guaranteeing LDCs additional revenue they wouldn’t otherwise enjoy. Thus, even in the unrealistic scenario in which regulators are able to perfectly force LDCs to pass benefits on to consumers, the bill does this in a highly inefficient way that favors utilities over consumers.

Chamberlin argues that lawmakers cannot control the economic incidence of regulatory policy any more than revenue officials can control the economic incidence of business taxes. Levi argues this analogy is inaccurate since “those firms aren’t regulated.” But from the standpoint of revenue officials, they are very much regulated. Revenue officials are charged explicitly with enforcing the legal incidence of business taxes specified by lawmakers.

This is a different form of regulation than cost-of-service price regulation, but it remains an explicit legal control over the behavior of firms backed by the force of law. The fact that this regulatory regime is unable to control tax incidence is highly relevant to understanding the behavior of regulated utilities under cap-and-trade.

Levi argues that since regulators will know the dollar value of the subsidy granted to each LDC, they can simply verify that an identical amount has been spent on “public purposes.” But this view is highly unrealistic. Anyone who has worked in a municipal regulatory rate-setting environment—which I have at the Seattle Department of Transportation—will tell you that accounting costs are not unique. Labor comprises the vast majority of costs within regulated utilities. Accounting costs for projects within LDCs are built from time-card data on employees’ allocated of time, along with various indirect and other allocated costs—all of which are subject to wide discretion by both employees and utility managers, little of which is observable by outside regulatory bodies.

Consider a simple example. Suppose that an electric utility receiving $12 million of free allowances is required by regulators to increase expenditures on “public purposes” by $12 million, as Levi argues. Suppose further that prior to cap-and-trade, this utility operated a $15 million energy conservation program, distributing energy-efficient light bulbs to households and conducting public education campaigns.

What in the language of the American Power Act prevents utility managers from simply shifting funds internally, scaling back the energy conservation program to $3 million, freeing up $12 million of existing budget authority for “public purposes?” Because internal funds are fungible, managers can easily reduce ancillary services to households—effectively increasing electricity rates to consumers on a quality-adjusted basis—while leaving shareholders unaffected, thus shifting the full burden of climate policy onto consumers. Such behavior is common in the regulatory literature in economics, which is vast and brimming with examples of regulatory failure of exactly this type assumed away by Levi and the authors of the Kerry-Lieberman bill.

Levi argues utilities can be forced to spend the value of free allowances for “public purposes.” But what qualifies as a “public purpose”? The text of the American Power Act provides only vague guidelines, and does not require that utilities actually provide rebates to consumers as has been widely assumed by advocates of the bill. Does investing in clean energy sources qualify as a “public” purpose? What if doing so leads to somewhat higher profit margins for utilities?

What if the value of free allowances is instead used to establish a “rate stabilization fund” to shield consumers from rate volatility? What if consumers are granted only a partial rebate check, with the remainder used to upgrade capital equipment that lowers costs and thus increases profits for the firm?

Levi assumes a clear distinction between “public” and “private” purposes for utility expenditures. In reality, the language of the American Power Act leaves the concept of “for the benefit of” ratepayers open to wide discretion—something utilities themselves are surely aware of, judging from their extensive lobbying efforts to secure those provisions.

Criticism of Employment Effects Estimates

Another criticism made by Levi is that the estimated employment impacts in our study are invalid because more capital-intensive industries will be more heavily affected than labor-intensive industries by climate policy.

As made clear in the Chamberlin study, estimated potential job losses are only order-of-magnitude estimates designed to give a general idea of the size of the employment effects we can expect from a policy that reduces GDP by the amounts predicted by EPA in various years. We don’t model the entire American Power Act bill. Instead, we show about how many jobs can reasonably be expected to disappear if GDP falls by a given amount, holding all else constant.

The study assumes that the overall GDP reductions will be felt by industries in proportion to the fossil-fuel carbon intensity of their products. Levi is right that if industries are affected in different proportions than what we assumed, the pattern of employment losses — and potentially the overall total job losses — will differ from our estimates. But it’s easy to see that they won’t differ by much. In fact, it turns out our estimates are robust across a wide variety of assumptions about the distribution of GDP impacts among industries.

To see why, suppose Levi is correct that capital-intensive industries will be most heavily affected by Kerry-Lieberman. Rather than dividing the overall GDP impacts among industries by carbon intensity as we’ve done, we can instead divide it by an estimate of capital intensity by industry. A back-of-the-envelope way of doing this is to use data on the relative share of labor income as a percentage of value added for industries. In capital-intensive industries, labor income will be small relative to total value added. We can then weight these “capital intensity factors” by total industry output to arrive at a reasonable proxy for capital intensity by industry. These figures can then be used to distribute overall GDP impacts to industries, consistent with Levi’s argument above.

Are Estimated Job Losses Too Conservative?

Re-running the Chamberlin model using this method, the employment effects of Kerry-Lieberman would be significantly larger than our estimates—not smaller as Levi assumes. Here are the figures for total job losses in various years under the assumption that capital-intensive firms are more heavily affected:

2015 : -653,783

2020 : -895,924

2030 : -3,511,055

2040 : -4,915,477

2050 : -6,440,970

Overall, these figures are broadly comparable to our original estimates. However, they are higher by roughly 25 percent. It is simply not the case that our study has over-stated employment effects from the bill as Levi claims. To the contrary, if Levi’s argument above is correct, our estimates may in fact may err on the conservative side. This should not come as a surprise—our estimates of job losses should be considered order-of-magnitude estimates, which are unlikely to vary dramatically to changes in the assumption of how overall GDP declines are distributed among industries.

3 comments

1 Ed Reid { 07.28.10 at 11:01 am }

Carbon emitters today effectively have unlimited free carbon emissions allowances. That must be the starting point of any analysis. Therefore, assuming the initial quantity of emissions allowances available is equal to the current annual emissions, there is no immediate economic benefit to anyone from creating the emissions allowances.

In an expanding economy, increases in emissions, either by new market entrants or existing market participants, would create a demand for emissions allowances in excess of the supply of allowances and a corresponding requirement for existing emitters to reduce emissions, thus creating a progressively increasing value for the available emissions allowances. A declining cap would also create a progressively increasing value for the available emissions allowances.

Existing market participants would be able to adapt to the progressive reductions in emissions allowance availability by: investing in low/no emissions facilities and equipment; reducing business activity, with a corresponding reduction in emissions; or, purchasing emissions allowances from other market participants who have reduced their emissions.

My estimate of the annual investment required in new low/no emissions facilities and equipment to comply with the W/M or K/L emissions reductions requirements is ~$700 billion per year; or, ~$30 trillion through 2050. Those investments would not be made unless there is an acceptable return on the investments. Assuming a 10% annual return, the ROI would add ~$70 billion per year each year, less depreciation, over the period through 2050, to the costs of the products and/or services provided by those installing the low/no emissions facilities and equipment.

Any requirement to pay for emissions allowances, no matter how the resulting revenues are used, would further add to the costs of the products and/or services provided by those purchasing the allowances.

The ability to trade emissions allowances is a market-based mechanism which could provide flexibility to emitters for whom emissions reductions: are more investment intensive; require long lead times; or, require the commercialization of new technology, such as CCS.

I suggest that anyone who believes that the US government would sell emissions allowances and return 100% of the revenue from the sales to those who would ultimately pay for the allowances (a perfect zero-sum game, with no winners or losers) is likely to believe in the Great Pumpkin as well. My innocent belief in such things has long since dissipated.

2 Mark Krebs { 07.29.10 at 2:01 pm }

You call it a “free market approach.” I call it (370.000.000 tons/year) times ($25/ton) times 51% = $4,717,500,000 per year.

Call it $4.7 billion for simplicity.

3 Ed Reid { 08.02.10 at 4:33 pm }

Mark,

The basis for your calculation is a bit cryptic. Regardless, the trade component of cap & trade, in and of itself, consists of transactions between willing buyers and willing sellers at a mutually agreeable price. It could certainly be a very large market, depending on the schedule of reductions in the cap and the rate of commercialization of new technology to reduce carbon emissions from various sources.

The “cap” portion of cap & trade is certainly command and control. However, a NAAQS with a 10 year compliance time frame would make cap & trade appear like a new scalpel by comparison.

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