23 May 2009

Winners and Losers in the Waxman-Markey Stealth Tax

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I was the lead author in this IER blog post. The main thing in this one was to explain (to a first approximation) why handing free allowances to emitters will not lower energy prices, but instead represents a simple transfer of wealth from the general public to the emitters. Here’s the meat of it:

It’s difficult for some non-economists to understand why handing back allowances to producers wouldn’t significantly alter energy price increases, but the point is crucial so we’ll walk through it: Suppose the government auctioned off 100 percent of the carbon allowances, and the resulting market price for a ton of emissions was (say) $25. If the government spent all of the auction receipts to pay for universal health care, leaving the burden of the cap and trade system to fall entirely on the energy sector, it is clear that prices for consumers would rise. Ultimately, it wouldn’t be the utilities, but rather their customers, who would foot the bill. Because of the cap on emissions, the costs of producing energy rise, and so the price of electricity for consumers rises as well.

Now suppose instead of spending all of the auction revenues on health care, the government chose to give, say, $10 million to every major electricity producer. Would that push down electricity prices? In general the answer is probably “no.” In order to push down prices, more electricity would need to be produced (because consumers would try to buy more after the price cut). But that means firms would have to use some of their $10 million handout to enter the carbon allowance market and buy the rights to emit more CO2, or to invest in a larger capacity for carbon-free generation, in order to ramp up their operations and sell more electricity (at a lower unit price).

But why would firms use their $10 million handouts in this way? If it made sense to buy more carbon permits (at the going price of $25 each), or to invest in a larger carbon-free capacity, the producers could have relied on private sources of capital to make these changes. But the firms chose not to, because on the margin the $25 price for each ton of carbon emissions made it sensible to scale back their operations. This logic doesn’t change just because the government writes them a check for $10 million (unless the subsidy is somehow tied to market share).

Even though it is counterintuitive, the important point is that even if the allowances are handed out for free to utilities, they still see their costs of production go up because of cap and trade. A coal-fired power plant still “loses” $25 per ton of emissions, because it could choose to scale back operations and sell its allowances into the market at $25 each. The logic is inescapable: the consumers will ultimately pay for cap and trade through higher energy (and other) prices. By giving some of the potential auction revenues to individual firms in the form of free allowances, the government doesn’t thereby prevent price hikes, all it does is lay subsidies to these beneficiaries on top of the other effects of Waxman-Markey.

If you want to divorce yourself from the carbon context, just imagine that you run a grocery store that’s been losing money for years. No matter how you advertise or try to cut costs, you check the books and realize that you lose money with every item you sell. So you decide to go out of business and stop the bleeding.

Ah, but that very same day you get notified that your rich uncle died, and left you $100,000. Does that mean you now decide to keep the store open?

Of course not, the logic of your decision is still the same. On the margin, you are poorer by staying in business. Obviously the new information makes you richer–$100,000 richer to be precise–but becoming richer doesn’t make you more willing to sell grocery items at a loss.

So it’s similar with handing out free allowances to emitters. Unless there are strings attached–e.g. if the number of allowances is based on last year’s market share of the electricity market or something like that–then generally speaking handing the allowances to producers will just mean a transfer of wealth to them.

Some producers, such as owners of coal-fired power plants, might still be worse off than under the status quo, but the point is that very few of these free allowances are devoted to protecting the general public. This just shows how naive those people were–and I truly am not implicating any of the readers of the this blog–who agitated for either a cap and trade or a carbon tax with dollar-for-dollar cuts in other taxes.

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