Overheated by clean energy

As the debate over the Waxman-Markey climate bill rages on, Harvard's top environmental economist sheds some light

Topics: Environment, U.S. Economy, Global Warming, Economics, Science

The groundbreaking American Clean Energy and Security bill, better known as the Waxman-Markey bill, seeks to fight global warming by implementing a “cap-and-trade system” to limit greenhouse gas emissions. But the bill, which was recently passed by the House, can seem like a riddle wrapped in a mystery inside an enigma.

While the legislation has yet to be passed by the Senate, much less signed into law by President Obama, it represents the first significant climate bill to advance politically in the United States, which has been a notorious laggard on the international stage when it comes to climate change. Even so, environmentalists and political analysts of all stripes have taken issue with the bill, often for diametrically opposed reasons.

Some charge it doesn’t go far enough to reduce greenhouse gas emissions quickly enough. Others contend it amounts to a vast giveaway to corporate polluters. Others claim it will unduly pinch consumers in the pocketbook, or curb American competitiveness. We turned to economist Robert Stavins, who is a professor of business and government at Harvard’s Kennedy School, for his perspective.

Stavins is uniquely positioned to explain the ins and outs of a cap and trade scheme. In the 1980s, he directed Project 88, which proposed the use of a cap-and-trade system to mitigate acid rain. The concept was written into the Clean Air Act of 1990 and has become a model for other emissions-trading schemes internationally.

Today Stavins directs the Harvard Environmental Economics Program and the Harvard Project on International Climate Agreements. He also serves on the Energy and Environmental Markets Advisory Committee at the U.S. Commodity and Futures Trading Commission. Plus, he’s written extensively on his blog about the Waxman-Markey legislation.

Could you describe how the cap-and-trade system within the Waxman-Markey bill will work?

In order to reduce the emissions of carbon dioxide and other greenhouse gases, a cap is placed on overall emissions. That cap is reduced over time — about 80 percent by the year 2050 relative to 2005. For each year in which the cap and trade program is in operation — it begins in 2012 and becomes seriously binding in 2016 — there are a set number of allowances [which represent the quantity of greenhouse gases that can be emitted]. The allowances are allocated in a variety of ways to the sources, which are required under the legislation to hold allowances.

And the sources, like electric utilities, are not required to pay for the allowances?

That’s not quite correct. The way that they’re initially allocated is that 15 percent of the allowances are sold at auction, and 85 percent of the allowances are allocated, either to private entities, or to government agencies.

That’s the way it is at the beginning. The free allocation phases out of over time, and eventually it goes to 100 percent auction. However, even in the short-term, when you look at that 85 percent compared to 15 percent, that in itself can be very misleading. There has been a huge amount of confusion about this among a lot of discussions in the blogosphere, as well as in the conventional press, and among pundits of all stripes.

They’re saying that this amounts to a big corporate giveaway.

They say it’s a corporate giveaway that 85 percent of the allowances are being given away. And in fact, what matters is the value of the allowances. To whom does the value of the allowances, that financial value, actually accrue?

When you do the analysis, as I did in a post on my blog, what you find is that approximately 20 percent of the allowance value is given to private entities that have to comply, and 80 percent of that value of the allowances accrues to consumers, to small businesses and then for various public purposes.

How does that happen?

In a variety of ways. There’s a sizable portion of the allowances dedicated for specific public purposes. Those are given to government agencies. For example, some percentage of the allowances, I think it starts at about 5 percent or so, are for retarding deforestation in developing countries. The allowances go to a U.S. government agency that then raises money, with the allowances, to finance the deforestation retardation. What does the government agency do? It sells the allowances. So, a lot of the allowances, which are categorized as being given away, are actually being given to government agencies, who then auction them to the private industry entities who need them for compliance purposes.

Another example: Approximately 35 percent of the allowances are given to local distribution companies of electricity. You’d look at that and think, “Oh, wow, there’s 35 percent, that’s part of the corporate giveaway.” But the legislation requires that the local distribution companies pass on those allowances, in terms of their value, to electricity consumers.

But some consumer groups, like Public Citizen, have said, Oh, yes, it does require it, but it’s written in this vague way, and it will be interpreted by 50 state utility commissions differently. So they’re skeptical that it will go to ratepayers.

They may be skeptical about it. But I can tell you that in 50 states, whether a state is a regulated state or has a restructured electricity market, the local distribution companies are regulated by the state public utility commission. And so any benefits that go to a local distribution company get written into the rate base, and therefore it gets passed on to consumers.

What is the value of giving away allowances vs. auctioning them?

That’s a good question. For the most part, with some key exceptions, how the allowances are allocated has no effect on the environmental performance of the system. Nor does it have an effect on the overall social cost of the system, the aggregate cost of the system. That’s an extremely important property.

Indeed, it’s for that reason that we have used cap-and-trade systems. It means that the government can essentially set up the overall cap, and then leave it up to the Congress to do what it does well, and that is fight over shares of the pie, and essentially allocate those shares of the pie in a way that builds the political constituency to enact the program.

But unlike a lot of public policies in many domains, when they go through this process of the horse trading, of building a political constituency with a cap-and-trade system, it does not degrade the efficacy of the system. It doesn’t degrade the impact of the policy, nor does it drive up its cost. And that’s a remarkable property.

Some critics have argued that all the allowances should be auctioned, and the money raised from that should be invested in clean technology. What do you think of that scenario?

We are on the threshold in the United States of successfully putting in place a cap-and-trade system. We’ve got a bill successfully out of the House, there is an uphill and a significant battle in the Senate. But the reason that we’ve gone even as far as we have is the fact that the allowances were not 100 percent auction. If the allowances were 100 percent auction, this system is no different than a tax. It looks exactly the same as a tax. A 100 percent auction and a carbon tax are symmetric policy instruments.

So, the allocation is what makes it politically feasible?

Exactly. And the beauty of it is that the mechanism that makes it politically feasible does not degrade its environmental performance, or drive up its cost. Otherwise I wouldn’t support it. I’m an environmental economist. I care about environmental performance, and I care about the cost of achieving it. That’s the remarkable property of a cap-and-trade system.

Do you think that if this bill becomes a law it will result in utility customers’ bills going up?

The problem is that to keep costs down for consumers, they’ve allocated the allowances to the local distribution companies, who will then pass on these cost savings to consumers. It makes a lot of sense to compensate consumers, particularly low-income consumers, for electricity price increases. It does not make sense to insulate consumers from electricity price increases.

Because you want there to be an incentive for consumers to use less electricity?

That’s exactly right. What is important is that electricity rates go up. Now, the way that this is addressed within Waxman-Markey is that they recommend to the local distribution companies that when they pass this money on to ratepayers, they don’t do it by reducing their electricity rates. Rather, they do it by reducing the fixed charge in their electricity bills. There’s a part of your monthly electricity bill that is a fixed charge. It doesn’t matter how much electricity you use. Even if you go to zero, you’re still going to pay that. That’s often referred to as a connection charge.

That makes a lot of sense, and will work perfectly well for businesses. Businesses are very rational about this, they will take appropriate action in terms of energy conservation, because they’re paying attention to what they should pay attention to, which is the electricity rate per kilowatt hour.

But you and me, we tend not to open up our bills and look at them so carefully. We open up the bill, and we look at the dollar amount of the bill, and we write a check. So, the way in which that increased electricity price will inspire energy conservation in residences is in terms of the bottom line of the bill. So separating it out into the fixed charge doesn’t help.

That’s what needs to happen in the Senate. If they stick with the allowances going to local distribution companies, they need to direct local distribution companies to pay the consumers. I don’t want to go into the fixed charge, and certainly it shouldn’t go into reducing the electricity rate per kilowatt hour. People should just get a check in the mail.

Some critics of the bill have charged that it doesn’t go far enough, that it doesn’t require enough cuts of CO2 emissions, quickly enough. What is your take on that?

Global climate change is an environmental problem in which we are concerned with the accumulation of greenhouse gases in the atmosphere, the stock not the flow. That’s what causes global climate change. We’re concerned with the amount of water in the bathtub, not with the amount that’s coming out of the faucet at any moment in time. It’s a long-term environmental problem.

That means when we’re thinking about how to achieve some given degree of stabilization of greenhouse gases in the atmosphere that the thing to focus on is how do we get there cost-effectively. The trajectory of cuts in greenhouse gases that is most cost-effective, minimizing the sacrifice for all the other things we care about, like reasonably priced electricity and food supply, is a trajectory in which we ramp up slowly.

That’s simply because one wants to avoid rendering large parts of the capital stock prematurely obsolete. In other words, rather than sending you a letter and telling you that your car can no longer be driven as of tomorrow morning, and you have to go buy a new car, it’s more cost-effective for me to provide price signals so that the next time you buy a car you buy a more fuel-efficient car.

Likewise in the private sector. It’s not cost-effective to insist that coal-fired power plants close down tomorrow morning. It’s cost-effective to stop building coal-fired power plants.

That means what is most important is the 2050 target of 80 percent below 2005 levels. That’s the key one. For 2050, this legislation is very aggressive. It’s more aggressive than anything the European Union has committed to. I think that it’s a very ambitious piece of legislation.

What kind of investments does the bill put into clean-energy technology, and do you think they’re appropriate?

The best thing that can be done for clean-energy technology is to get the prices of coal, petroleum and natural gas relative to renewables. Nothing else we can do is going to spur the R&D, the invention and the innovation of more climate-friendly technologies. That’s the primary thing that the bill does [by capping emissions].

In addition to that, the bill also uses some of the revenue that is raised to focus on specific technologies. The most important example in the bill is public funding of private-sector research and development of carbon-capture storage and technologies.

Since global warming is obviously a worldwide problem, do you think that it makes sense for the U.S. to adopt this kind of climate policy now, before a post-Kyoto international treaty is hammered out and ratified?

If you had asked me this question four years ago, my answer would have been: The United States should not put in place, should not even move to put in place, a domestic climate policy, until there is an international agreement that is scientifically sound, economically rational, politically pragmatic that will be ratified by the U.S. Senate, and approved by China and other key developing countries.

Much has happened in the meantime. And we’re now at a point in terms of international developments, where the only way that the U.S. can establish its credibility to participate — indeed to lead in the development of a good post-Kyoto climate agreement — is to be on track simultaneously with a meaningful domestic climate policy.

My view is that the two have to move in parallel. It will be impossible for a meaningful international accord unless and until the U.S. makes significant progress of putting in place a domestic climate policy. That’s the unfortunate political reality in which we find ourselves.

Do you think that if this bill passed into law as it is written it would result in overall emissions reductions?

I don’t think that there is any question of that, as long as it is enforced. I have no reason to think that it won’t be enforced. The reason I say that is that if it is not enforced, there are environmental advocacy groups across this country who will sue the government to make sure that it is enforced. That’s the history of environmental regulation in the United States.

If it is enforced, the cap on emissions will come in place in 2012. It will begin to really bind in 2016, and that puts it on a trajectory for an extremely serious emissions reduction. And that is very significant.

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