[Increasingly, people agree that markets for carbon permits are likely to be a major mechanism for fighting climate change. But how those permits are designed, how they're sold, and who benefits or loses from their sale -- these are all very complex-yet-pressing challenges. Here, WC allies Clark Williams-Derry and Eric de Place explain why just giving permits away both burns consumers and lets polluters rake in unearned profits. While written in the context of the U.S. Western Climate Initiative negotiations, this is the clearest explanation of the questions involved I've yet seen in any context, and is really worth a read. -- Alex]
1. Allocation Economics: A Simple Explanation
Try buying World Series tickets from a scalper. Would he charge you any less if he found the tickets on the ground? Of course he wouldn’t. Like energy, the street price of World Series tickets is based on supply and demand. The supply and demand for tickets is the same no matter how much the scalper paid for them, and so the price he charges you will also be the same no matter how he got them.
Of course, the scalper would much rather get his tickets for free - and that’s precisely the point. Polluters are financially much better off if permits are given away instead of auctioned, but the cost of cutting emissions and the resulting effect on energy prices will be the same no matter how the permits are delivered.
A permit to emit carbon is like a World Series ticket. It has a value in the marketplace; and any owner of permits will attempt to sell them to the highest bidder, rather than just giving them away. That’s true regardless of how the owner acquired the permits (whether through an auction or free allocation) and regardless of who buys them (the firm’s own customers or some other entity).
2. Allocation Economics: More Detail
Let’s take a look at how the system would work if permits were given away for free:
• Let’s say that WidgetCo is given free permits, and that the market price for permits is $10 per ton. And let’s say WidgetCo releases one ton of CO2 to make each widget.
• When WidgetCo’s managers decide whether to produce a widget, they have to ask themselves: “Should we use up a permit so we can sell yet another widget? Or is it better to simply sell the permit?”
• If WidgetCo sells the permit, it nets an easy $10 profit. So the company won’t bother to make another widget unless it can make at least as much money as it can by selling a $10 permit.
• So, to recoup the $10 profit they could have made by selling a permit, WidgetCo raises prices by just about $10 dollars per widget. (If they don’t raise prices, then they’d be better off just selling permits, rather than widgets.)
• In the end, WidgetCo’s sales may fall a bit from higher prices. And when its sales fall, its emissions fall too. But WidgetCo won’t mind losing a few sales because they will be making $10 more per widget.
• In fact, the only people who won’t be happy are widget consumers. They’ll be paying higher prices, while WidgetCo reaps the profits – all thanks to free permits.
In the real world, the dynamics depend on the specifics of WidgetCo’s markets. If the company competes with firms that aren’t operating under an emissions cap, it may not be able to pass on the full costs of unsold permits to consumers. Or if WidgetCo is operating in a tightly regulated market (such as the Western electricity market) then it may not be legally allowed to raise consumer prices to cover the opportunity costs of unsold permits.
But if WidgetCo has a captive market with high demand for its products (if widgets are gasoline, for example) then it will pass most of the opportunity cost of its unsold permits. Energy prices will go up, and any firm that was given free permits will reap the unearned profits.
Note that selling permits, rather than giving them out for free, does not change the underlying dynamic of price increases for consumers. No matter how permits are allocated—whether through auctioning, grandfathering, or some other form—firms will attempt to charge consumers for the market cost of the allowance. Consumer prices will go up exactly the same amount, regardless of how the permits are distributed initially.
A permit auction system, on the other hand, gets the system off to the right start. Financial incentives can spark innovation, speed least-cost efficiency measures, and encourage start-ups with smart ideas for clean energy sources. The revenue can cushion consumers from higher prices and fuel public efficiency and infrastructure investments [And provide more climate equity. - Ed.].
3. What Happened in Europe
Don’t take our word for it. Take a look at the one real-world case where cap and trade was used for carbon emissions -- Europe. Under the EU’s Emissions Trading Scheme (ETS), almost all of the permits were given to polluters for free. And, as it turned out, firms reaped windfall profits from consumers based on the market value of the permits they were given.
That’s what the bipartisan National Commission on Energy Policy found in a March 2007 paper:
Recent experience with the Emission Trading System (ETS) now being implemented by the European Union (EU) suggests that the potential for windfall profits, far from being purely hypothetical, is borne out by empirical evidence, with utility companies that received free allocations under the EU program having realized substantial gains. 
What was the effect for consumers? The Commission’s report continues:
...an allocation approach that gives all allowances for free to directly affected industries will have the overall effect of transferring some wealth from the broad public (in this case consumers) to those industries.
The International Energy Agency independently studied Europe’s system and came to the same conclusion. In a February 2007 report the Agency said:
If any evidence is needed of the CO2 pass-through into electricity prices, it was provided by the abrupt fall of the CO2 price in May 2006, as market players were made aware of the excess quantity of EU allowances for the year 2005. The fall by EUR 10/tCO2 was immediately followed by a drop in wholesale electricity prices of EUR 5-10/MWh. This electricity price adjustment can be directly attributable to the CO2 [permit] price fall, itself not connected to other energy market movements that could also affect electricity prices.
In other words, permit prices dictated the rise and fall of consumer prices, even when permits had been free for energy producers. And when an energy research group at the University of Cambridge looked at the European experience, they also agreed:
...in theory, power producers pass on the opportunity costs of freely allocated emission allowances to the price of electricity. For a variety of reasons, however, the increase in power prices on the market may be less than the increase in CO2 costs per MWh generated by the marginal production unit. This is confirmed by empirical and model findings, showing estimates of CO2 cost pass through rates varying between 60 and 100 percent for wholesale power markets in Germany and the Netherlands.
That is, specific market conditions may influence price outcomes, but the not method of allocation.
At first, the European Union gave away permits for free. Now the EU is rewriting their program to correct the mistake, and to ensure that new permits are auctioned. The Western Climate Initiative can do it right the first time around, saving enormous
headaches and delays.
0. In a competitive market, WidgetCo simply doesn’t make much money from selling an additional widget. Supply, demand, costs, and prices are all balanced so that WidgetCo’s barely profits, or possibly loses money, from selling an additional widget. (That’s what economic theory says, and it’s largely borne out in practice.)
1. Jos Sijm et al., “CO2 Cost Pass Through and Windfall Profits in the Power Sector,” Electricity Policy Research Group, University of Cambridge, May 2006, web link, page 2.
2. National Commission on Energy Policy, “Allocating Allowances in a Greenhouse Gas Trading Program,” March 2007, web link, page 11.
3. Julia Reinaud, “CO2 Allowance and Electricity Price Interaction,” International Energy Agency, February 2007, web link, page 5.
4. Op. cit. 1, page 26.
Respectfully, you only have part of the story correct. Your argument is totally valid for industry sectors which are able to fully pass on the costs to consumers (ie electricity). Internationally traded products from energy intensive industries are exposed to competition (either for customers or for investment internally within their company). Such industries are price takers and a requirement to buy all their emission allowances from government would represent a massive transfer of funds (in some cases rivaling existing profits) from the company to government. Such companies cannot simply raise prices or they will lose market share and contribute to the shift in production capacity to developing countries. This is known as risk of carbon leakage and the EU is currently explicitly trying to design their ETS (2012-2020) to address this risk. Reducing carbon leakage risk with free allocation based on emission benchmarks will reduce the risk for industries like cement, steel, aluminum and some chemicals. Reducing carbon leakage risk is actually a pro-environmental policy! An illustration of this is in the 'sightline' evidence base - the paper by Smale et al (06 - Cambridge) 'the aluminium industry will cease to exist' - if that isn't carbon leakage I don't know what is! Heavy industry needs to be able to exist under tight carbon caps-else what kind of message does it send to those we are trying to encourage taking on carbon policy committments/targets.
It would be worth Worldchaning doing an article on this.
There is an evidence base on this - check out the report on competitiveness impacts at http://www.climate-strategies.org
Nice try, but this argument fails at the very beginning. The scalper analogy is not an accurate analogy. Imagine if the scalper were required to use the free ticket to watch the game... then it couldn't be sold to the highest bidder and there is no windfall profit.
The reality is that most power companies and big emitters have to emit carbon to keep their business running. Think about it. They are very unlikely to just shut down their business to make a few bucks on carbon allocation sales. This is particularly true for electric power utilities, who have to serve their customers by law.
In the long run, all carbon allocations should be auctioned, but as a start, only a small percentage should be auctioned so that we figure out how auctions should work properly. The economic impact of 100% auctions right from the start are quite scary.
There are two solutions to the problems described above:
1) Cap emissions upstream where carbon enters the economy (fuel distributers)- this equalizes the economic impact amongst all industries that currently use carbon.
2) Institute border adjustment fees on imports from countries with a lower carbon cost/emissions reductions. This has the added benefit of pushing countries like China & India towards emissions reductions.