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Tuesday, April 14, 2009

The conventional wisdom is wrong: cap-and-trade will affect all consumers nationwide with little to distinguish the burden across regions.

Several media outlets, blogs, and political commentators recently announced the unofficial death of the cap-and-trade bill designed to regulate greenhouse gas emissions—and breathed a sigh of relief. In an April 1 Senate vote, 26 Democrats joined 41 Republicans to raise the bar for passage of the bill. Those senators included liberals from Wisconsin, Michigan, and West Virginia—all states with more than 60 percent of their electricity produced from coal. The Wall Street Journal interpreted this as a signal that “California and East Coast Democrats won’t be able to sock it to coal and manufacturing–heavy Midwestern states without a fight.”

But even coastal Democrats would be in for a rude shock if cap-and-trade legislation does come to pass. Their viewing the politics of cap-and-trade as a regional issue that will not affect prices in their states is based on shortsightedness and ignorance of both the nation’s regulatory regime and the program’s true costs.

A cap-and-trade program would essentially set a “cap” on the total emissions allowed by all companies in the economy, and then allow firms to “trade” permits that grant them the right to emit a certain amount of carbon emissions. In other words, it creates a new market for the emission of carbon and, like any other market, allows the market participants to determine a price for this good (or “bad”).

These permits can be either auctioned, in which emitters bid on them, or freely allocated, where the government gives emitters permits based on their emission history. The extensive debate on the method of permit distribution would have you believe that the impact on prices would be different under the two cases, but this is not true. Cap-and-trade systems increase energy and product prices because of the scarcity they introduce. Someone must reduce emissions at some cost. That scarcity is what drives the price increases, not the method of permit distribution.

In a recent paper written with my coauthors Kevin Hassett of the American Enterprise Institute and Gilbert E. Metcalf of Tufts University, we estimate the impact on energy and other product prices of a $15 permit price of carbon. The first thing to note is that while the focus of all discussion of environmental taxation is on energy prices, this is only part of the story. Virtually every product that the American consumer buys uses carbon-intensive fuels in production (such as coal and oil). Cap-and-trade would therefore result in increased prices of all goods—from food, clothing, and shoes to housing, transportation, and recreational amusement. This is the “indirect burden” of cap-and-trade—non-energy goods whose prices rise only as a result of the use of energy in their production.

Before discussing the regional distribution of the cap-and-trade burden, there is one critical element that we need to consider. A lot of attention has been given to states with coal-intensive electricity production and how they would be hurt the most from such a policy. However, missing from this discussion is the fact that most of these coal-dependent states are heavily regulated, which affects the regional burden of cap-and-trade. If permits are auctioned, electricity regulators may allow utilities to pass on the costs of the permits to consumers in the form of higher prices. However, if permits are freely allocated, regulators would prevent any cost increases from being transferred to the consumer in the form of higher prices.

The first graph below shows the regional distribution of the burden (the regions are as defined by the Census Bureau) if the permits are auctioned. Surprisingly, variation in the average burden across regions is quite modest—only about one-half of a percentage point. It is remarkable how small the differences are, given the variation in weather conditions and driving patterns. In other words, all parts of the country, not just the coal-dependent states, are likely to bear the consequences of cap-and-trade.

Burden with 100% Auctioning

Having said that, it is interesting to explore why certain regions such as the East South Central and the West South Central have marginally higher burdens. Since it is clear that these differences are mainly driven by the direct burden of cap-and-trade, we focus on that for an explanation.

The second graph shows that these regions have high electricity consumption expenditures. By itself, this would have lead to relatively much larger burdens of the energy costs on consumers in this region.

Energy Burden of Cap-and-Trade

However, the other direct energy consumption items such as natural gas, gasoline, and home heating oil even out the variation in the burden across regions. For instance, gas consumption is highest in East North Central, gasoline in the Mountain regions, and home heating oil in New England. Therefore, the East Coast Democrats and their constituents would be as likely to feel the pinch of cap-and-trade as the Midwestern states.

The following graph shows the total burden assuming permits are freely allocated to energy providers. It assumes that permit costs are passed forward into higher electricity prices only in states with deregulated electricity (such states include California, Connecticut, Delaware, Massachusetts, New York, and Washington, D.C.). In all other states, the assumption is that state electricity regulators do not allow utilities to pass on the cost of using freely allocated permits to residential consumers.

Burden with Freely Allocated Permits

The impact of freely allocated permits and regulators who do not pass forward the price of permits is to shift the regional burden from coal-intensive states to those states that have moved ahead with electricity deregulation. We can see this by looking at the difference in the total burden with and without free allocation. The burden falls by much more in regions such as the South Atlantic, East North Central, East South Central, and West North Central and much less in the Mid-Atlantic and Pacific regions. Hence, ironically, free allocation may make the coal-intensive regions better off than others. However, the total burden will still be fairly high and fairly evenly distributed across regions.

Setting conventional wisdom aside, cap-and-trade as it will apply in practice will affect all regions and all consumers nationwide with little to distinguish the burden across regions. That is the only change you can believe in.

Aparna Mathur is a research fellow at the American Enterprise Institute.

FURTHER READING: Kenneth P. Green wrote about cap-and-trade in “That First Step is a Doozy.” Green, Steven Hayward, and Kevin Hassett recently weighed the merits of carbon taxes versus a cap-and-trade program (taxes won).


Image by Darren Wamboldt/The Bergman Group.



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