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Cap and…Invest or Dividend?

Dan Lashof

Posted March 3, 2009

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Last week President Obama galvanized the debate about how to ensure an economic recovery with clean energy investments by calling on this Congress to deliver global warming legislation for him to sign. The administration followed this up by releasing a budget that assumes revenues from a cap-and-trade program starting in 2012. This would build on the economic stimulus bill by immediately giving clean energy investors long term certainty and additional technology deployment incentives. In 2012-hopefully well after the economy has recovered-carbon caps would go into effect, giving the government sustained revenue from the sale of pollution allowances to pay back the Treasury (see Investing in Our Recovery).

The budget provides a brief outline of the administration's approach: cap global warming pollution; auction all the emission allowances; invest $15 billion per year in clean energy; and return the rest of the revenues to consumers. This is (surprise, surprise for those of us who have watched previous presidents ignore their campaign promises) totally consistent with what then-Senator Obama said during the campaign. The budget goes slightly further than the campaign platform by indicating that about $65 billion of revenue from allowance auctions will be returned as a dividend to consumers in the form of the "making work pay" tax credit. If allowance prices start at $20 per ton total revenue would be about $120 billion per year. A footnote in the budget indicates that additional revenue beyond the $80 billion specifically allocated would be used to help vulnerable communities, businesses, and families transition to a clean energy economy.

Putting these details in the budget shines a spotlight on the $6.4 trillion question: How should the value of emission allowances be used?

There are three basic approaches:

1) Give emission allowances away to polluters for free ("grandfathering");

2) Auction emission allowances and return the money to consumers as a tax reduction or rebate ("dividending");

3) Use the value of emission allowances to promote the goals of climate legislation, including promoting clean energy deployment and adaptation to unavoidable consequences of global warming ("investing")

Before discussing the merits of these approaches, it's important to emphasize something that often gets lost in the debate: The most important environmental driver in all this is the cap itself. No cap, no emission reductions and no allowance value to divide up. This doesn't mean environmentalists have no stake in how allowance value is allocated-it does mean that we need to be nimble in response to the evolving allocation debate and not lose sight of the original objective of cutting global warming pollution.

Just a few years ago most policymakers assumed that all emission allowances would be grandfathered. After all, that's what Congress did in the sulfur dioxide cap-and-trade program established by the 1990 amendments to the Clean Air Act and it seemed to work fine. There are, however, two big differences: (1) At the time the sulfur dioxide cap was established, the covered electricity generators were all regulated monopolies. This meant that state Public Utility Commissions could ensure that electricity rates reflected only actual compliance costs, which were relatively low due to the free allocation of allowances. (2) Carbon dioxide allowances are worth about 100 times as much as sulfur dioxide allowances. These arguments by themselves may not have been enough to shake the presumption for grandfathering, but the European Union did us a big favor by going first and establishing a carbon trading program (the EU ETS) that grandfathered allowances in its initial "learning" phase. The result was that power producers reaped windfall profits because they received free allowances and then raised power prices to reflect their potential resale value. In order to prevent thse windfalls in the future, the EU is moving toward auctioning its emission allowances and most politicians have abandoned the idea of grandfathering most allowances.

As a counterpoint to grandfathering, a growing chorus of voices is advocating "cap and dividend." The great appeal of this idea is its simplicity: Auction emission allowances and return the revenue to the public through a tax rebate - or dividend from granting private firms permissions to use a public resource (the atmosphere) to dispose of their carbon dioxide waste. The theory is solid, but in practice the idea becomes much more complicated when advocates are confronted with the need to address disproportionate impacts on low income consumers who are too poor to pay taxes and on coal-dependent parts of the country. Moreover, there are important climate protection goals that dividending simply doesn't address.

Another approach to using the allowance value for public good is "cap and invest." Investing some of the allowance value to kick start the transition to a clean energy economy will allow emissions to be reduced faster and more cheaply than under a cap alone. The cap provides the backbone for the effort required to cut U.S. emissions at least 20% by 2020 and 80% by 2050, but by itself the cap won't achieve these emission reductions at the lowest possible cost because the cap does not address two key barriers to repowering our economy with clean energy.

On one side (the left hand side of the abatement cost curve shown here) there is a large menu of energy efficiency measures that are already cost effective but are blocked from widespread use by market barriers (Why upgrade the efficiency of a commercial office building or rental home if the tenant pays the utility bills? How can a consumer demand a more fuel efficient version of a vehicle if the manufacturer does not offer that option? How can more efficient industrial motors compete when firms routinely demand 2 year paybacks during capital budgeting?)

On the other side (the right hand side of the abatement cost curve shown here), strong innovation policies are needed to ensure a continuous flow of new cost-reducing technologies to help us finish the job of driving down emissions over coming decades. Many advanced low-carbon energy supply technologies have the potential to be cost effective if they were deployed at scale, but private firms systematically under invest in bringing technologies across the "valley of death" between government-funded basic research and development and full commercial maturity (Why invest billions to build the first full-scale carbon capture and storage facilities if other firms will be able to benefit from your experience with technology integration at scale, educating the public regarding carbon sequestration, and developing a workable interface with regulators?)

Finally, resources are needed to achieve emission reductions from sources that are not covered by the cap and to facilitate adaptation to the consequences of global warming that can no longer be avoided. This includes vulnerable communities at home and abroad, as well as the natural resources on which they depend.

The appropriate mix of investments, dividends, and adaptation support will change over time. Directing allowance value to clean energy investments is most important in the early years of the program when it is essential to break down long-standing barriers to energy efficiency and begin learning-by-doing in supplying renewable energy. This support should be phased out as the clean energy market matures and the rising price of carbon takes over as the main driver of further emission reductions. As directed clean energy investments decline the allowance value dividend to consumers should increase. At the same time, adaptation needs will grow as the global warming already in the pipeline manifests itself and the most severe impacts become clear. It is impossible to anticipate the most important uses of allowance revenue over the very long term, so by default all allowance revenue should be returned directly to consumers after, say, 15 years, unless specific programs are reauthorized by Congress.

Finding the right mix between "invest," "adapt," and "dividend" is one of the key economic and political issue in the design of climate policy. NRDC is working hard to shed light on the implications of different approaches through our Cap 2.0 project, but in the end this is a decision that Congress must make. As environmental advocates we need to recognize that the mechanism is secondary to the objective: solving global warming.


I gratefully acknowledge the contribution of my NRDC colleague Rick Duke to this post.


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ErinMar 3 2009 12:19 PM

>The [cap and dividend] theory is solid, but in practice the idea becomes much more complicated when advocates are confronted with the need to address disproportionate impacts on low income consumers who are too poor to pay taxes.

Hmmmmm... has it been decided that a dividend would be administered via a tax credit? I understood that Peter Barnes' advocacy of cap and dividend included issuing rebate debit cards to Americans, not via a tax credit. This would allow Americans whose income is so low that they do not pay taxes (or even have a bank account) to still receive their dividend. What am I missing...?

Dan LashofMar 3 2009 02:34 PM

Good point Erin. Electronic benefits cards can and should be used to address the needs of the poor. This does make the policy more complex but is necessary. Regional differences would still need to be addressed through a different mechanism.

William PentlandMar 3 2009 04:08 PM

This is spot on. Global warming is a systemic problem and demands systemic responses. A portfolio approach should guide both policy and investments in clean technology because of the profound uncertainty that surrounds the challenges that we will face ahead. One issue that the post fails to address is the degree to which global warming policy goals should be pursued through regulatory and legislative mechanisms primarily designed for other social policies. For example, is it wise to bundle social security and carbon-emissions revenues? The administration has clearly used the stimulus to pursue climate technology R&D. Will it leverage future problems to pursue other dimensions of climate policy? Perhaps we should abandon the entire concept of "climate policy" as separate from other policy problems. Sooner or later, the jurisdictional fiction will collapse anyway. In any event, great post.

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