Posted by: Steven M. Taber | August 5, 2009

GAO Issues “Observations” on Cap-and-Trade Proposals

On August 4, 2009, the Government Accountability Office issued the statement of John Stephenson, Director Natural Resources & Environment, that he presented to the U.S. Senate’s Committee on Finance.  The statement, entitled “Preliminary Observations on Options for Distributing Emissions Allowances and Revenue under a Cap-and-Trade Program,” provides the GAO’s preliminary results assessing the potential effects of allowance allocation methods and options for distributing program revenues or economic value of allowances.

Mr. Stephenson’s testimony indicated that the GAO looked at three methods for allocating allowances in a cap-and-trade program.  First, the government could auction all of the allowances.  The GAO pointed out that this would result in a significant amount of revenue flowing into the federal government, which then could be used to offset the cost incurred by household as a result of the program.  Second, the government could give away the allowances to the affected entities, effectively transferring the value of the allowances to those entities.  Mr. Stephenson warned that while this would increase the appeal of the program to the affected entities, it would greatly impact the program’s overall cost to the economy.  Third,  the government could give away some allowances and auction the rest.  This, of course, is what the GAO believes to be the best option.  The GAO states that “studies have suggested that freely allocating 6 to 21 percent of the allowances created by a cap-and-trade program would be sufficient to compensate entities in energy intensive industries for any profit losses incurred as a result of the cap-and-trade program.”  This led the GAO to the following conclusion:

According to the economic literature and economists we interviewed, regardless of the mechanism for distributing allowances, consumers will bear most of the costs of a cap-and-trade system because most regulated entities will pass along their increased costs in the form of increased prices; however, these costs could be largely offset depending on how revenues are used.

Next, the GAO looked at “available literature” and interviewed economists to arrive at five “main” options for distributing a program’s allowance revenues.  First, by reducing the taxes on income, labor and/or investment, the overall cost of the cap-and-trade program could be lowered.  Second, lump-sum payments could be made to households from the auction revenues to offset the higher consumer prices and mitigate any disproportionate impacts on low-income households.  Third, the Earned Income Tax Credit could be expanded to further reduce the impact on low-income working families.  Fourth, regulated entities and their shareholders could be compensated directly for their lost profits by allocating free allowances to them.  Fifth, auction revenues could be used to fund climate-related programs, such as research on low-carbon technologies, or used to support climate change mitigation activities in developing nations.

Ultimately, each potential use of auction revenue has trade-offs.  Decreasing tax rates could lower the overall economic costs of the program, but do little in lessening the impact on low-income consumers.  Likewise, assisting affected entities in keeping their energy prices stable may benefit ratepayers, but it would reduce incentives to conserve energy, which, in turn, would potentially increase the program’s overall cost.

And so, the debate continues.

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