Emission Allowance Allocation in a Cap-and-Trade Program: Options and Considerations

Emission Allowance Allocation
in a Cap-and-Trade Program:
Options and Considerations
Updated June 2, 2008
Jonathan L. Ramseur
Analyst in Environmental Policy
Resources, Science, and Industry



Emission Allowance Allocation in a
Cap-and-Trade Program: Options and Considerations
Summary
When designing a cap-and-trade program, one of the more controversial and
challenging questions for policymakers is how, to whom, and for what purpose to
distribute the emission allowances. Regarding the method of distribution to covered
sources, policymakers could (1) sell the allowances through an auction process, (2)
allocate the allowances at no cost to covered sources, (3) provide allowances to non-
covered sources who would, in turn, sell them to covered sources, or (4) use some
combination of these methods. Although the emission allocation method would not
affect the environmental integrity of the cap-and-trade program, the selected
allocation strategy could have considerable consequences.
Using auctions as a distribution method could avoid certain concerns that are
likely to occur if covered sources receive all (or most) of the allowances at no cost:
(1) consumers in different electricity markets may face inequitable price increases;
(2) a weak price signal for electricity may be sent in areas with the most carbon-
intensive fuel portfolios; and (3) no-cost allowances may overcompensate covered
sources. In addition, auction revenues offer a unique opportunity to reduce the overall
costs of the emissions program. Several economic studies indicate that if used in the
most efficient manner, overall costs could be minimized by almost 50%.
A greenhouse gas (GHG) emission cap-and-trade program would create a
valuable new commodity: the GHG emission allowance. EPA estimates that
allowance value could potentially account — in aggregate — for tens or hundreds of
billions of dollars each year. When distributing this value, policymakers would face
a choice between minimizing the costs imposed on the entire economy, minimizing
the expected burden on specific parties, or supporting a range of climate- or non-
climate-related policy objectives.
For example, Congress may consider providing transition assistance to carbon-
intensive industries. Studies have estimated profits could be maintained in the energy
production and electricity generation sectors, if approximately 20% of allowances
were provided to those sectors at no cost. Members may also consider allotting
allowance value to consumers, particularly low-income households, who are
expected to bear the majority of the compliance costs via higher energy prices.
Another option would involve distributing the allowance value to support various
objectives: technology development, energy efficiency improvements, biological
sequestration, climate change adaptation efforts, or non climate-related purposes,
such as deficit reduction. Of these objectives, technology advancement is arguably
the most crucial in terms of mitigation. Moreover, deployment of new technologies
could potentially lower the overall costs of the program.
Although many of the proposals in the 110th Congress (e.g., S. 2191, S. 1766,
and S. 3036) would employ an auction to some degree, none of the bills specifies the
design of the auction. Congress may want to consider including specific design
elements in legislative text, particularly auction frequency and whether or not the
auction should have a reserve price, and if so, at what level.



Contents
In troduction ......................................................1
Auctions .........................................................3
Implementation Benefits........................................3
Polluter Pays Principle..........................................4
Potential Minimization of Costs on Society.........................4
Avoidance of Economic Concerns from No-Cost Distribution...........5
Auction Design Issues..........................................5
Design Considerations......................................5
Design Options............................................6
Reserve Price.............................................7
Auction Frequency.........................................8
No-Cost Distribution to Covered Sources...............................9
Potential Benefits..............................................9
Mitigation of Disproportionate Costs..........................9
Political Feasibility.......................................10
Concerns ...................................................10
Undesirable Effects in the Electricity Sector....................10
Overcompensation to Covered Entities........................13
Treatment of New and Retiring Sources.......................15
Distribution of Allowance Value: Options and Considerations.............16
Overview and Estimate of Allowance Value........................16
Compliance Costs Versus the Value of Emission Allowances......16
Estimates of Allowance Value...............................18
Options for Allowance Value Distribution.........................19
Provide Transition Assistance to Carbon-Intensive Industries......19
Offset Reductions in Distortionary Taxes......................20
Distribution to Non-Covered Entities.........................21
Distribution to Support Specific Objectives....................23
Policy Considerations.........................................24
Reduce Costs, Alleviate Burdens, or Promote Technology.........24
Regressive or Progressive Economic Effects....................25
Appendix A. What Is a Cap-and-Trade System?.........................27
Appendix B. Allowance Allocation Strategy under S. 2191 (as Reported).....28
List of Figures
Figure 1. Change in Electricity Price by Region: Allowances Distributed to
Covered Sources with Auction..................................12
Figure 2. Change in Electricity Price by Region: Allowances Distributed to
Covered Sources at No Cost....................................12
Figure 3. Number of Allowances vs. Number of Reductions...............17



with Different Emission Allocation Strategies......................21
Figure 5. Relative Distribution of Costs Using Upstream Auction
(without Revenue Redistribution)................................22
Figure 6. Comparison of After-Tax Household Income Changes
(by Quintile) Imposed by Emissions Cap, Using Different Emission
Allocation and Revenue Distribution Strategies.....................26
List of Tables
Table 1. Estimates of Auction Revenue under the Framework of the
Lieberman-Warner Climate Security Act of 2008 (S. 2191) ...........18
Table 2. Emission Allowance Allocation under S. 2191...................28
Table 3. Auction Revenue Distribution under S. 2191....................29



Emission Allowance Allocation
in a Cap-and-Trade Program:
Options and Considerations
Introduction
Climate change issues have generated interest and debate over the past two
decades. In 1992, the United States ratified the United Nations Framework
Convention on Climate Change (UNFCCC). Arguably, in recent years the primary
issues under debate have shifted from science — such as the role of greenhouse gas
(GHG) emissions from human activities1 — to policy. For instance, a 2005 Sense
of the Senate Resolution on climate change2 stated:
It is the sense of the Senate that Congress should enact a comprehensive and
effective national program of mandatory, market-based limits and incentives on
emissions of greenhouse gases that slow, stop, and reverse the growth of such
emissions at a rate and in a manner that, No. 1, will not significantly harm the
U.S. economy and, No. 2, will encourage other action and key contributors to
global emissions.
In the 110th Congress, Members have introduced several bills that would
establish a market-based,3 mandatory GHG emission reduction program.4 Most of
these proposals would establish some type of cap-and-trade system to regulate GHG
emissions.5 For a brief primer on cap-and-trade systems, see Appendix A.


1 The Intergovernmental Panel on Climate Change (IPCC) concluded in 2007 that “most of
the observed increase in globally averaged temperatures since the mid-20th century is very
likely due to the observed increase in anthropogenic greenhouse gas concentrations”
(emphasis added). IPCC Working Group I, Climate Change 2007: The Physical Basis
(Cambridge, UK: Cambridge University Press, 2007). See CRS Report RL34266, Climate
Change: Science Update 2007, by Jane Leggett.
2 Senate Amendment No. 866 to H.R. 6 (109th Congress), passed by voice vote June 22,

2005. A motion to table the amendment was rejected by a roll call vote (44 - 53).


3 The policy alternative to a market-based approach would likely require specific emission
limits or particular technological controls for specific emission sources.
4 See CRS Report RL34067, Climate Change Legislation in the 110th Congress, by
Jonathan L. Ramseur and Brent Yacobucci.
5 Another market-based approach would entail a carbon tax. Some of the cap-and-trade
proposals include elements (e.g., safety-valve) that are akin to a carbon tax. These proposals
are often described as hybrid approaches. See CRS Report RL33846, Greenhouse Gas
Reduction: Cap-and-Trade Bills in the 110th Congress, by Larry Parker and Brent D.
(continued...)

In designing a cap-and-trade program, one of the more controversial and
challenging questions for policymakers is how, to whom, and for what purpose to
distribute the emission allowances. Concerning the question of how to distribute
allowances, policymakers could (1) sell the allowances through an auction process
(2) allocate the allowances at no cost to covered sources, (3) provide allowances to
non-covered sources, who would, in turn, sell them to covered sources via the
emissions trading market, or (4) use some combination of these methods.
Regardless of the method of distribution, emission allowances would have
monetary value in a carbon-constrained regime, such as a cap-and-trade program. If
an auction is used, policymakers could distribute auction revenues to a wide range
of parties to support various policy objectives. Likewise, policymakers could allot
allowances at no cost to non-covered entities — e.g., federal or state agencies, among
others — to promote the same (or different) objectives.
By addressing the question of how, to whom, and for what purpose to distribute
the emission allowances, policymakers would craft an allocation strategy. The
strategy would not affect the environmental integrity of the emissions cap.6 In
addition, covered entities would generally face the same emission reduction decisions
under either allocation strategy.7 A “common misconception” is that if covered
sources receive allowances at no cost, the sources would behave differently from
sources who purchased allowances through an auction.8 Economists point out “free
allowances”9 have value, and when covered entities submit an allowance for
compliance purposes, the entities forgo the opportunity10 to sell the unused allowance
in the emissions trading market.11
The first two sections of this report discuss the primary emission allowance
distribution methods: auctions and no-cost distribution to covered sources. These


5 (...continued)
Yacobucci.
6 U.S. Environmental Protection Agency (EPA), Office of Air and Radiation, Tools of the
Trade: A Guide To Designing and Operating a Cap and Trade Program For Pollution
Control (2003).-B-03-002.
7 There are two noteworthy exceptions: electric utilities operating in a price-regulated
market (discussed below) and facilities that receive allowances based on an output-based
distribution system. Robert Stavins, A U.S. Cap-and-Trade System to Address Global
Climate Change (2007), The Hamilton Project, Brookings Institution.
8 Congressional Budget Office, Trade-Offs in Allocating Allowances for CO2 Emissions
(2007), Economic and Budget Issue Brief.
9 Like there is no free lunch, free allowances are not really free. However, this report uses
the phrase “distribution at no cost” and “free allowances” interchangeably.
10 In economics parlance, this is referred to as a firm’s “opportunity cost.”
11 See National Commission on Energy Policy, Allocating Allowances in a Greenhouse Gas
Trading System (2007); Congressional Budget Office, Trade-Offs in Allocating Allowances
for CO2 Emissions (2007), Economic and Budget Issue Brief; Dallas Burtraw, Cap, Auction,
and Trade: Auctions Revenue Recycling under Carbon Cap and Trade (2008), Testimony
Prepared for the House Select Committee on Energy Independence and Global Warming.

sections examine the potential benefits and concerns of these allocation mechanisms.
The final section identifies different options and policy considerations for Congress
when determining to whom and for what purpose to distribute the value of the
emission allowances. The allocation strategy would have substantial consequences
for the cost of the cap-and-trade program and how the costs are apportioned.
Auctions
In recent years, the use of auctions to allocate emission allowances has
generated considerable interest.12 Several of the cap-and-trade proposals from theth
110 Congress — including S. 2191, which was reported from the Senate
Environment and Public Works Committee on May 20, 2008 — would use auctions13
to allocate an increasing percentage of the cap’s emission allowances.
This section describes the potential benefits that auctions may provide, if used
to distribute allowances to covered sources in a cap-and-trade program. In addition,
this section discusses auction design issues and considerations for policymakers.
Implementation Benefits
In general, the concept of an auction is relatively simple to understand.14
Auctions would allow the market to determine which entities receive emission
allowances and at what price: parties placing the highest value on the allowances
would receive them. With this allocation method, policymakers would be relieved
of the responsibility to make distribution decisions, a process that might be described
as picking winners and losers.15 For this reason, auctions are generally considered
to be the most transparent mechanism for distributing allowances.
In addition, in a free allocation format parties would have strong incentives to
seek increasing shares of the overall allowance allotment.16 Parties with resources


12 The 10 states participating in the Regional Greenhouse Gas Initiative (RGGI) have agreed
to auction at least 25% of their allowances, and several of the RGGI states intend to auction
almost 100% of their allotments. See CRS Report RL33812, Climate Change: Action by
States To Address Greenhouse Gas Emissions, by Jonathan L. Ramseur.
13 For a comparison of the cap-and-trade bills see CRS Report RL33846, Greenhouse Gas
Reduction: Cap-and-Trade Bills in the 110th Congress, by Larry Parker and Brent D.
Yacobucci.
14 The logistics of establishing and running an auction are more complicated. This issue is
discussed below.
15 U.S. Environmental Protection Agency (EPA), Office of Air and Radiation, Tools of the
Trade: A Guide To Designing and Operating a Cap and Trade Program For Pollution
Control (2003).
16 This behavior is described as “rent-seeking” in economic contexts. Dallas Burtraw,
Prepared Testimony before the House Select Committee on Energy Independence and
Global Warming, January 23, 2008.

available for such efforts may have an advantage. An auction system would
eliminate this behavior.
Polluter Pays Principle
Requiring emission sources to purchase emission allowances would support the
“polluter pays” principle. In a general environmental policy context, the polluter
pays principle holds that pollution costs should be borne by the polluting facility or
industry, not society at large. To accomplish this objective, pollution costs should
be included in the overall price of a good. Proponents of the polluter pays notion
would likely argue that if products are priced to reflect environmental costs — air
pollution, land use, GHG emissions — demand for these products may decline.
Advocates of polluter pays maintain that the environment and the services it
provides are a shared public good. Under this framework, facilities should have to
pay for the right to pollute (i.e., emit GHGs). If allowances are provided at no cost
to emission sources, the polluter pays principle would be violated.
Potential Minimization of Costs on Society
If Congress decides to use an auction to distribute emission allowances to
covered sources — as opposed to providing allowances to covered sources at no cost
— the auction revenues could be used to substantially minimize the overall costs on
society of the cap-and-trade program.
Economic studies have found that, if revenues are used in the most economically
efficient manner, the overall costs imposed by a cap-and-trade program could be17
reduced by approximately 50%. Economists maintain that the most economically
efficient application of revenues would be to offset reductions in taxes on desirable18
activities, such as employment or personal income. The opportunity to use
allowance value in this manner and thus minimize overall costs to this extent is19
unique to the auction mechanism. However, many observers argue that applying
auction revenues in this fashion is politically unlikely.20 Other potential uses of the


17 This cost savings estimate is based on an analysis that simulated a cap-and-trade program
with a 22% emission reduction between 2000 and 2080. Lawrence H. Goulder, Mitigating
the Adverse Impacts of CO2 Abatement Policies on Energy-Intensive Industries (2002),
Resources for the Future Discussion Paper.
18 See e.g., Goulder (2002); Anne E. Smith and Martin T. Ross, Allowance Allocation: Who
Wins and Loses Under a Carbon Dioxide Control Program? (2002), Charles River
Associates; Dallas Burtraw, et al., The Effect of Allowance Allocation on the Cost of Carbon
Emission Trading (2001), Resources for the Future.
19 A carbon tax system, which is not within the purview of this report, could achieve the
same result, if carbon tax proceeds were applied in a similar manner.
20 See e.g., Robert W. Hahn, Greenhouse Gas Auctions and Taxes: Some Practical
Considerations (2008), AEI Center for Regulatory and Market Studies; Robert Stavins, A
U.S. Cap-and-Trade System to Address Global Climate Change (2007), The Hamilton
(continued...)

auction revenues may or may not generate overall economic cost savings. These
options are discussed later in this report.
Avoidance of Economic Concerns from No-Cost Distribution
Auctions would avoid several of the undesired economic effects that are likely
to occur if allowances are provided to covered sources at no cost. These concerns are
discussed in greater detail later in the no-cost distribution section. In brief, they
include:
!Inefficient and inequitable price signals in the electricity sector;
!Potential overcompensation to covered sources; and
!Challenges with allotting allowances to new and retiring sources.
Auction Design Issues
Although many of the cap-and-trade proposals in the 110th Congress would
employ an auction to some degree, none of the bills specifies the design of the
auction. A recent study that examined auction design issues for the Regional
Greenhouse Gas Initiative (RGGI) found that “careful attention to auction design can
be critical to an auction’s success in achieving the goals specified for the auction.”21
Design Considerations. The success of an auction is typically measured by
both its efficiency and revenue generation.22 In an emission auction context,
efficiency is achieved when the parties that receive the allowances are the parties that
place the most value on the allowances. Other attributes of an auction that may be
used to measure its success include:
Price discovery. In a cost-effective emissions trading program, the allowance
price should mirror (or closely follow) the marginal cost of emission reduction —
i.e., the cost of reducing the last, most expensive ton. An effective auction should
help identify the allowance price that is near to the marginal cost of reduction.23
Protection against market manipulation. Auctions should discourage or
prohibit bidding behavior that would create inefficient outcomes in the market. For
example, collusion among bidders may artificially lower the allowance price.
Another concern is hoarding, in which one party makes speculative bids above the
competitive price, in order to capture a disproportionately large percentage of the
allowances.


20 (...continued)
Project, Brookings Institution.
21 Charles Holt et al., Auction Design for Selling CO2 Emission Allowances Under the
Regional Greenhouse Gas Initiative (2007), prepared for RGGI Working Group staff..
22 Holt et al. (2008).
23 Note that this value will fluctuate daily with changes in fuel prices and energy demands.

Minimize transaction costs. Substantial administrative or transaction costs
could reduce the cost-effectiveness of using an auction. Moreover, high transaction
costs could place smaller firms at a disadvantage.
Transparency and fairness. The rules should be readily available to all
parties and should not favor certain participants.
Design Options. Certain auction designs may provide advantages or
disadvantages, depending on the auction’s primary objective. For example, some
auction designs in certain contexts may favor revenue generation; others may be
more efficient in terms of matching the market price.
Policymakers may undertake further study before specifying the particular
auction logistics. Although economic studies have examined the performances of
different auction formats in other contexts, “relatively few papers have examined the
relative merits of each of these auction forms in multi-unit [e.g., emission
allowances] auctions.”24 One option for Congress would be to direct an implementing
agency to devise the most appropriate auction format, based on the ranking of
objectives provided by Congress.
Policymakers may consider various auction designs . In general, auction designs
are distinguished by (1) the number of rounds for bidding — generally one round
(often called “sealed bid”) versus multiple rounds; and (2) whether there is a uniform
price or individual price (“discriminatory” price) for each buyer. Examples of
auction designs with different combinations of these two characteristics include the
following:
Discriminatory Price, Sealed-Bid Auction. This type of auction is used
in EPA’s SO2 emission trading program.25 In this system, parties submit a sealed bid,
containing multiple offers to purchase a set number of allowances at certain prices.
The implementing agency opens the bids and distributes allowances, starting with the
highest offer, until the supply is exhausted. For example, consider a hypothetical
auction, in which the supply of allowances is 20 units and the highest bidder offered
$100 per allowance for 15 allowances, and the second highest bidder offered $90 per
allowance for 10 allowances: the highest bidder would receive 15 allowances for
$100/allowance; the second highest bidder would receive 5 allowances at
$90/allowance.
Uniform-Price, Sealed-Bid Auction. This type of auction is similar to the
above format — discriminatory price, sealed-bid — with one major difference: the
price paid by all bidders is the highest rejected bid (i.e., the second-highest bid).
Using the above scenario, the highest bidder would receive 15 allowances at
$90/allowance, and the second-highest bidder would receive 5 allowances at


24 Holt et al. (2008).
25 More information on EPA’s SO2 emission trading auction is at [http://www.epa.gov/
airmarkets/trading/ factsheet-auction.html #how].

$90/allowance. Ireland used this design to implement its auction for the EU ETS.26
In addition, in a study prepared for RGGI officials, researchers recommended using
this approach.27
Uniform-Price, Multi-Round (English Clock) Auction. In an emission
allowance auction using this format, the auctioneer would post a allowance price and
parties would offer the quantity they are willing to buy at the posted price. The first
posted price would be set at a low level, so that demand would exceed supply. The
auctioneer would continue posting higher prices at set time intervals, until demand
is less than (or equal to) the allowance supply. The posted price that produces this
outcome would become the allowance price for all bidders. Virginia used this
auction type to sell nitrogen oxide emission allowances pursuant to the “NOx SIP28
Call.”
Reserve Price. One issue that arguably transcends auction design
considerations is whether or not the auction should have a reserve price, and if so, at
what level. In an auction, a reserve price is a price set by the seller, below which the
seller refuses to part with the item for sale. In a large volume, multi-unit auction that
is expected to have substantial participation (i.e., high demand for the items for sale),
a reserve price would all but guarantee a revenue stream. In a cap-and-trade
allowance emissions auction, a reserve price would operate much like a minimum tax
or price floor.
A reserve price may address certain logistical concerns, such as bidder
collusion, that are often associated with auctions. In addition, a reserve price may
provide assurance to parties making emission reductions that the reductions will have
some value in the allowance market. For example, if a covered source can expect a
reserve price to be set at a certain level (e.g., $10/ton), and the source makes multiple
reductions, each at a per-ton cost below the expected reserve price, the source can
have confidence that its efforts will be cost-effective.
The authors of the RGGI auction study recommended that RGGI participants
set a reserve price when conducting allowance auctions, concluding:
A compelling justification for a reserve price can be found in the academic
literature and from previous experience with auctions, and the reserve price
would help the auction achieve the criteria [e.g., the design criteria discussed29


above] set out in this report.
26 Ken Macken (Ireland Environmental Protection Agency), Presentation for RGGI Auction
Workshop, March 2006, at [http://www.rggi.org/documents.htm].
27 Holt et al. (2008).
28 For more information about Virginia’s auction, see William Shobe, Presentation for RGGI
Auction Workshop, March 2006, at [http://www.rggi.org/documents.htm].
29 Holt et al. (2008).

Because a reserve price (if established) could influence revenue flows from an
auction, Congress may consider addressing this issue specifically in legislative text,
rather than leave this matter open for interpretation to an implementing agency.
Auction Frequency. EPA’s SO2 emissions trading program holds annual
auctions to distribute a small percentage of allowances. Likewise, S. 2191 would
direct the implementing agency to conduct annual auctions. However, policymakers
may consider holding more frequent auctions (e.g., every quarter).
More frequent auctions could provide several benefits, both for covered sources
and to the efficiency of the program. More auctions would give covered sources
more flexibility to incorporate unanticipated events — e.g., higher electricity demand
due to warmer than expected temperatures. If auctions were held more frequently,
the allowances sold would be in smaller lots. This may help facilities, particularly
smaller operations, maintain cash flow.
In terms of efficiency, smaller, more frequent auctions would likely reduce the
potential for parties to manipulate the market (e.g., from speculative hoarding). More
auctions may increase market liquidity by making allowances available for purchase
in more frequent intervals.
The potential downside to having multiple auctions per year is that covered
sources may face additional transaction costs. However, the authors of the RGGI
auction study stated:
past experience suggests that a significant proportion of the administrative cost
of holding auctions is related to the initial set-up ... and that incremental costs of
repeating a particular auction type will be low in comparison to these initial30
costs.
After considering the “costs, risks, and benefits,” the study authors
recommended that participating RGGI states use a quarterly auction to allocate
emission allowances.31


30 Ibid.
31 Ibid.

No-Cost Distribution to Covered Sources
Emission trading programs, in the United States32 and abroad,33 have generally
distributed the vast majority of allowances at no cost to sources directly subject to a
cap. In recent years, however, support for auctions has gained momentum. This
momentum likely reflects a better understanding of the benefits of using auctions, as
well as increased scrutiny of the effects of distributing allowances at no cost.34 This
section discusses the potential benefits and concerns of allotting allowances to
covered sources at no cost.
Potential Benefits
Mitigation of Disproportionate Costs. The primary argument in support
of no-cost distribution is that carbon-intensive industries are expected to face
disproportional costs under a carbon-constrained system. These industries maintain
they should receive compensation (i.e., free allowances) for the financial losses
imposed by the cap-and-trade program. The financial losses may lead to loss of jobs
in particular industries. The compensation may be considered a form of transition
assistance for industries and industry employees most impacted by a GHG emissions
cap.
This argument is perhaps stronger for industries that may have a more difficult
time including the costs of emission reduction in the price of their products. For
example, certain U.S. industries may be more vulnerable to foreign competition,
especially if their competitors are located in nations without GHG emissions caps.
For these industries, increasing the price of their materials (to reflect the cost of
emissions abatement) may entail a comparative disadvantage. Moreover, if foreign
competitors in these industries increase their market share as a result of a U.S. cap-
and-trade program, the foreign facilities (in uncapped economies) are likely to
increase their GHG emissions. This potential scenario is described as emissions
leakage, a constant concern in climate change policy.
In other economic sectors, particularly the electricity generation sector, that do
not face foreign competition, facilities are expected to pass along the vast majority
of the emission reduction costs. This would entail higher prices for consumers,


32 Although EPA annually auctions a small percentage of the allowances in its sulfur
dioxide (SO2) cap-and-trade program (pursuant to Title IV of the 1990 Clean Air Act
Amendments), most of the allowances are provided at no cost to emission sources, based on
their historical emissions. See CRS Report RL34235, Air Pollution as a Commodity:
Regulation of the Sulfur Dioxide Allowance Market, by Larry Parker and Mark Jickling.
33 The European Union’s (EU) Emissions Trading Scheme (ETS), a CO2 cap-and-trade
program that applies to power plants and certain carbon-intensive industries, allowed
countries (between 2005-2008) to auction up to 5% of allowance allocations. Only 4 of 25
countries used auctions at all, and only Denmark auctioned the full 5%. See CRS Report
RL34150, Climate Change: The EU Emissions Trading Scheme (ETS) Enters Kyoto
Compliance Phase, by Larry Parker.
34 See e.g., Cameron Hepburn, et al., “Auctioning of EU ETS phase II allowances: how and
why?” (2006) Climate Policy 6(1): 137-160.

which includes businesses and households. However, price increases would likely
reduce consumer demand,35 potentially lowering the profits of carbon-intensive
industries.36
Political Feasibility. Cap-and-trade programs, both domestic and
international, have usually provided allowances to covered sources at no cost; this
free allocation to covered sources is arguably a means to garner support for an
emissions reduction program. Moreover, industries may prefer to receive allowances
at no cost rather than compete for a share of auction revenues: a transfer of free
allowances may be more “politically secure than government promises of37
compensation from auction revenues.”
Concerns
Undesirable Effects in the Electricity Sector. As the electricity sector38
accounts for the largest percentage (34% in 2006) of GHG emissions in the United
States, it would play a major role in the effectiveness of a cap-and-trade program.
There is concern that if allowances are distributed to electric utilities at no cost, the
electricity consumers who purchase electricity under a price-regulated structure
would receive a price signal that is weaker than the signal received by consumers in
unregulated (or competitive) markets.39 In contrast, an auction distribution system
would enable electricity generators, in both price-regulated and competitive markets,
to send a comparable price signal to consumers.40
In the United States, the price consumers pay for electricity may be determined
by a state regulatory body — often described as cost-of-service regulation — or the
price may be subject to market forces — often described as deregulated or
competitive. In general, the regulatory structure varies by the type of facility and/or
the state in which the electricity is generated. In 2007, the more traditional, price-
regulated electric utilities generated approximately 60% of the total net electricity
generated in the United States.41 The remaining 40% of electricity was generated by


35 This may vary by the product sold and the level of price increase. Some products may
display a relatively inelastic price/demand relationship. This discussion is beyond the scope
of this report.
36 For industry-specific estimates, see e.g., U.S. EPA, EPA Analysis of the
Lieberman-Warner Climate Security Act of 2008 (2008).
37 National Commission on Energy Policy, Allocating Allowances in a Greenhouse Gas
Trading System (2007), p. 10.
38 U.S. EPA, Inventory of U.S. Greenhouse Gas Emissions and Sinks: 1990-2006 (2008),
Table ES-7, at [http://epa.gov/climatechange/emissions/usinventoryreport.html].
39 See e.g., National Commission on Energy Policy, Allocating Allowances in a Greenhouse
Gas Trading System (2007).
40 Dallas Burtraw, Prepared Testimony before the House Select Committee on Energy
Independence and Global Warming, January 23, 2008.
41 The above percentages are calculated by CRS with data from the Energy Information
(continued...)

facilities that are unregulated in terms of their ability to set a price for the electricity
they generate.
A comparison between Figure 1 and Figure 2 demonstrates the difference in42
price signals that the two regulatory frameworks would send. These figures present
a distribution of electricity price changes that consumers could expect under a43
cap-and-trade system that included the electricity sector. For example, under an
auction system (Figure 1), a large percentage of consumers would face an increase
of $8/Mwh; approximately equal numbers of consumers would face either higher or
lower prices.
In Figure 1, the change in electricity price for both “regulated” and
“competitive” regions is fairly symmetrical. The (rise-and-fall) shape of the column
heights, which is generally identical for both the price-regulated and competitive
regions, reflects the different electricity-generating fuel portfolios that exist44
throughout the country. Regions with higher carbon content fuel portfolios are
expected to experience higher electricity prices under a cap-and-trade system.


41 (...continued)
Administration’s 906/920 database, available at [http://www.eia.doe.gov/cneaf/electricity/
page /eia906_920.html ].
42 These figures are from Dallas Burtraw, Prepared Testimony before the House Select
Committee on Energy Independence and Global Warming, January 23, 2008. This
testimony cites the author’s more in-depth study: Dallas Burtraw and Karen Palmer,
Compensation Rules for Climate Policy in the Electricity Sector (2007), Resources for the
Future Discussion Paper.
43 These figures are provided for illustrative purposes only.
44 For example, electricity in some states or regions may use higher percentages of coal or
renewable energy than other areas. See CRS Report RL34272, State Greenhouse Gas
Emissions: Comparison and Analysis, by Jonathan L. Ramseur.

Figure 1. Change in Electricity Price by Region:
Allowances Distributed to Covered Sources with Auction
Source: Dallas Burtraw (Resources for the Future), Prepared Testimony before the House Select
Committee on Energy Independence and Global Warming, January 23, 2008.
Figure 2. Change in Electricity Price by Region:
Allowances Distributed to Covered Sources at No Cost


Source: Dallas Burtraw (Resources for the Future), Prepared Testimony before the House Select
Committee on Energy Independence and Global Warming, January 23, 2008.
However, when covered sources receive allowances at no cost (Figure 2),
consumers in price-regulated and competitive regions experience dramatically
different price changes. Note the asymmetrical shape of the columns, as compared
to those in the previous figure. In most of the price-regulated regions, the electricity
price would remain the same (or decrease), while the price would increase in most
of the competitive regions.

The different consumer impacts identified in Figure 1 and Figure 2 result from
the dissimilar market structures — price-regulated versus competitive — that
determine the price of electricity for U.S. consumers. The different impacts reflect
the electric- generating facilities’ varied abilities to pass through all types of costs to
consumers in the form of higher electricity prices. In an auction, the costs to utilities
would include both the costs of mitigation and the costs of purchasing allowances.
Under a no-cost distribution system, utilities would have mitigation costs and
opportunity costs associated with the allowances (discussed above).
If policymakers auction allowances to electric utilities, both price-regulated and
competitive-market utilities would include the cost of purchasing emission
allowances in the price of electricity. However, if allowances are distributed at no
cost to utilities, only competitive-market utilities would be able to pass along their
opportunity costs.
Because price-regulated facilities would not be able to pass through the
opportunity costs associated with free allowances, consumers in these areas would
effectively receive the benefit of the “free” allowances in the form of stable or lower
electricity bills (Figure 2). Consumers in competitive areas would not receive the
benefit of “free allowances” and would thus face disproportionate price increases.
This consequence would erode the effectiveness of the cap-and-trade program,
because consumers would likely not receive a price signal that is strong enough to
encourage conservation or energy efficiency improvements.
The effects of this inefficient outcome may be magnified, because
approximately 75% of coal-fired electricity was generated by price-regulated utilities
in 2007.45 Thus, consumers that utilize more-carbon intensive electricity would face
a weaker price signal than consumers using less carbon-intensive electricity.46
The price disparities that consumers with comparable fuel portfolios would
experience under different electricity regulatory structures would be both unfair and
inefficient. An auction would eliminate both of these concerns. Consumers in price-
regulated and competitive regions (with similar carbon-intensive electricity profiles)
would experience more equitable impacts. Moreover, the costs of the cap-and-trade
program would be included in the price of electricity in each market structure. This
result is necessary if the carbon price is to modify consumer behavior: e.g., spur
energy conservation efforts or the installation of more energy efficient technologies.
Overcompensation to Covered Entities. If covered entities receive, at
no-cost, GHG emission allowances in proportion to their emissions, there is concern
that the recipients would be overcompensated for the compliance costs imposed by


45 Calculated by CRS with data from the Energy Information Administration’s 906/920
database, available at [http://www.eia.doe.gov/cneaf/electricity/page/eia906_920.html].
46 National Commission on Energy Policy, Allocating Allowances in a Greenhouse Gas
Trading System (2007).

a cap-and-trade program.47 Depending on the percentage of emission allowances
auctioned, an auction could avoid overcompensation.
This potential outcome is a function of several factors. First, the aggregate
value of the GHG emission allowances is expected to be substantially greater than
the aggregate costs of making emission reductions pursuant to the emissions cap.48
(See Figure 3 and surrounding discussion below.) Second, if covered sources
receive allowances at no cost, they would retain the benefits of these allowances,49
which are essentially a form of currency. Although it may be counterintuitive,
covered entities are expected to raise the price of their products, even if entities50
receive allowances at no cost. Thus, covered sources would receive the financial
benefit of the allowances and the gains associated with higher prices.51 These52
benefits are often described as “windfall profits.”
A windfall profit result has been observed in cap-and-trade models53 and in the
largest existing cap-and-trade program: the European Union’s (EU) Emissions
Trading Scheme (ETS). The EU ETS established a cap-and-trade program for power
plants and certain carbon-intensive industries, allocating virtually 100% of the
allowances at no cost to covered entities between 2005 and 2007 (“Phase 1”). One
study estimated that power plants in the United Kingdom received windfall profits5455
of 800 million euro (approximately $1 billion) per year; a separate study estimated


47 See Lawrence H. Goulder, Mitigating the Adverse Impacts of CO2 Abatement Policies on
Energy-Intensive Industries (2002), Resources for the Future Discussion Paper; Anne E.
Smith and Martin T. Ross, Allowance Allocation: Who Wins and Loses Under a Carbon
Dioxide Control Program? (2002), Charles River Associates.
48 Compared to other emissions trading programs — namely, the U.S. SO2 emissions (acid
rain) program — the ratio of allowance value to compliance costs is expected to be much
greater.
49 As discussed above, price-regulated electric utilities represent a critical exception.
50 This is due to the opportunity costs that an entity would face if it used (i.e., surrendered
to the implementing agency for compliance) its allowances. Instead of using the allowance,
the entity could have sold it for its market value.
51 However, higher prices could reduce consumer demand and potentially lower profits
(discussed below).
52 U.S. Congress, Senate Committee on Energy and Natural Resources, Design Elements of
a Mandatory Market-Based Greenhouse Gas Regulatory System, Chairman and Ranking
Member Statement: Climate Change Conference (2006), 109th Congress.
53 Goulder (2002) simulated a U.S. cap-and-trade program that would require a 23%
emission reduction. In the model’s scenario that distributed allowances at no cost to energy
producers (coal, oil, natural gas), the coal sector profits increased by 155% after two years
of the program.
54 Converted using exchange rate of 1.25 (average rate in 2005), provided by
[http://www.oanda.com].
55 IPA Energy Consulting, Implications of the EU Emissions Trading Scheme for the UK
Power Generation Sector (2005), Prepared for the United Kingdom Department of Trade
(continued...)

windfall profits for power plants in the Netherlands at 300 million to 600 million
euro ($378 million - $750 million)56 per year.57 However, the EU ETS Phase 1
allowance price (for reasons beyond the scope of this report) dropped dramatically
in April 2006 and never recovered.58 Thus, the windfall profits were only generated
in the first year (2005) of the program.
Nevertheless, a 2008 study estimated that European power plants are expected
to continue to receive windfall profits during the second phase (2008-2012) of the
EU ETS. For example, German plants are projected to generate the most windfall
profits: between 14 billion and 22 billion euro ($21 billion - $33 billion)59 over that
time period.60 In recognition of this projection, the European Commission (EC) has
proposed to address this issue, stating: “taking into account their ability to pass
through opportunity costs, full auctioning should be the rule from 2013 onwards for
the power sector.” In addition, the EC has proposed that free allocation in other
sectors would gradually phase out, so that by 2020, auctions would distribute 100%
of the allowances.61
Treatment of New and Retiring Sources. An auction distribution format
would address economic inefficiencies and concerns of fairness regarding new
emission sources and facilities that are near retirement. A recurrent auction creates
a level playing field for these two categories of sources. In contrast, a distribution
strategy that allots allowances at no cost based on prior year emissions
(“grandfathering”) could provide a considerable advantage to existing facilities. A
free allowance effectively subsidizes currently operating facilities, which may be62
using outdated, inefficient technologies. Moreover, if entities receive allowances
at no cost, the financial gain imparted in the allowance could serve as an incentive


55 (...continued)
and Industry.
56 Converted using exchange rate of 1.25 (average rate in 2005), provided by
[http://www.oanda.com].
57 Jos Sijm et al., “CO2 Cost Pass-Through and Windfall Profits in the Power Sector,”
Climate Policy 6 (2006): 49-72.
58 See CRS Report RL34150, Climate Change: The EU Emissions Trading Scheme (ETS)
Enters Kyoto Compliance Phase, by Larry Parker.
59 Using exchange rate of 1.5, provided by [http://www.oanda.com].
60 Point Carbon Advisory Services, EU ETS Phase II — The Potential and Scale of Windfall
Profits in the Power Sector (2008), Prepared for World Wildlife Fund.
61 Proposal for a Directive of the European Parliament and of the Council amending
Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance
trading system of the Community (January 23, 2008), at
[http://ec.europa.eu/envi ronment/climat/emi ssion/ets_post2012_en.htm] .
62 In some cases, where the firm might shift these operations to a foreign, unregulated
country, such incentives might make sense. Raymond J. Kopp, 2007, Allowance Allocation,
Resources for the Future.

to extend the facility’s operation beyond a time that would otherwise be efficient to
cease operations.63
Distribution of Allowance Value:
Options and Considerations
By limiting the annual number of emission allowances available for compliance
purposes, a cap-and-trade system creates emission allowances. Emission allowances
would become a valuable new commodity, potentially accounting — in aggregate —
for tens or hundreds of billions of dollars (Table 1 and surrounding discussion). To
whom and for what purpose the value of allowances is distributed would affect (1)
the overall cost to society of a cap-and-trade program and (2) which parties bear the
costs of the program. Policymakers would face a choice between minimizing the
costs imposed on the entire economy (society’s costs) or using the allowance value64
for other purposes. The latter choice covers a range of options. Congress could
choose to provide assistance to specific industries or groups, or choose to distribute
the allowance value to support various objectives. To provide an example, Appendix
B of this report identifies the allowance and auction revenue distribution strategies
proposed by S. 2191.
The first part of this section provides an overview of some key concepts and an
estimate of the total allowance value that may be available for distribution in a cap-
and-trade program. The second part examines the range of options for distributing
allowance value. This is followed by a discussion of policy considerations.
Overview and Estimate of Allowance Value
Compliance Costs Versus the Value of Emission Allowances. A
cap-and-trade program would impose costs: covered entities would comply by
reducing their own emissions, purchasing emission reductions (credits) from other
covered entities, or (if allowed) buying offsets from non-covered sources that have
reduced, avoided, or sequestered emissions.65 The combined costs of these activities66
are the “compliance costs” of the cap-and-trade program.
The compliance costs are different from the aggregate value of emission
allowances. In the early years of a cap-and-trade program, the aggregate value of
allowances would likely dwarf the costs of making (or finding) emission reductions.


63 Markus Ahman et al., “A Ten-Year Rule to Guide the Allocation of EU Emission
Allowances,” Energy Policy 35 (2007):1718-1730.
64 However, some objectives, if met — namely, technology advancement — may also reduce
the overall costs of the program. This is discussed below.
65 See CRS Report RL34436, The Role of Offsets in a Greenhouse Gas Emissions
Cap-and-Trade Program: Potential Benefits and Concerns, by Jonathan L. Ramseur.
66 These costs may be described with different terms in different publications: e.g., program
costs, mitigation costs, or economic costs.

Figure 3 depicts this contrast: the area under the emissions cap curve represents the
number of allowances; the area between the emissions cap curve and the business-as-
usual curve represents the required reductions. The former area will be larger as long
as the emission reduction target is less than 50% of the emissions baseline.67
The compliance costs represent the sum of the costs of each ton of reduction,
and the cost of each reduced ton will vary. For example, some projects may present
“low-hanging fruit” reduction opportunities, whereas investments in extra capital
(e.g., carbon capture technology) may represent a more expensive reduction option.
Consider a simplified example:68 policymakers set a 7-ton cap on an economy
that currently emits 10 tons. The 3 tons that must be reduced cost $1, $5, and $10,
respectively. The cost of the last, most expensive ton — the marginal cost — is $10.
Because the marginal cost largely establishes the market price of emission
allowances in a cap-and-trade, each emission allowance has a value that is
approximate to the marginal cost.69 Therefore, in this example, the value of the
allowances would equal $70, but the compliance costs would be only $16.
Figure 3. Number of Allowances vs. Number of Reductions


sReductions
on
si
is
m
G EAllowances
GH
Time
Business-as-UsualEmissions Cap
Source: Prepared by CRS. The concept for the figure comes from National Commission on Energy
Policy, Allocating Allowances in a Greenhouse Gas Trading System (2007).
67 For the more stringent cap-and-trade proposals in the 110th Congress, this threshold would
not be reached until approximately 2040. See CRS Report RL33846, Greenhouse Gas
Reduction: Cap-and-Trade Bills in the 110th Congress, by Larry Parker and Brent
Yacobucci.
68 Raymond J. Kopp, Allowance Allocation (2007), Resources for the Future.
69 The option to bank emission allowances would likely alter this calculus. In anticipation
that allowance prices will increase in subsequent years, covered sources would likely
purchase more allowances than are needed for compliance purposes in the early years of the
program.

Estimates of Allowance Value. Whether or not Congress sells the
allowances through an auction (and generates revenues) or distributes the allowances
at no cost, the allowances would have monetary value.
To put the allowance value in context, consider the Lieberman-Warner Climate
Security Act of 2008 (S. 2191), an “economy-wide”70 cap-and-trade proposal that
was reported out of the Senate Environment and Public Works Committee May 20,

2008. At the request of Senators Lieberman and Warner, EPA prepared an economic71


analysis of provisions of S. 2191. One of the primary results of the analysis is the
estimated price range for emission allowances. From these price estimates, potential
auction revenues can be identified, because the legislation specifies the percentage
of allowances to be auctioned in each compliance year. Table 1 lists the estimated
annual action revenues that would be generated under provisions of S. 2191. In
addition, the table provides an estimate of revenues that would be generated if 100%
of the emission allowances were auctioned. This latter estimate represents an
approximation of the aggregate value of the emission allowances in a given year.
Table 1. Estimates of Auction Revenue under the Framework of
the Lieberman-Warner Climate Security Act of 2008 (S. 2191)
S. 2191 w/
S. 2191100%
Auction
Tot a l P ercentage EstimatedEm ission EstimatedAnnual EstimatedAnnual
Year Allow ancesAvailabl e ofAllow ances Allow ance Auc t i o n Auc t i o n
(mtCO2-e)AuctionedPrice Range($/mtCO2-e)Revenue ($ billions)Revenue($ billions)
20155,45629.5%$29 - $40$47 - $64$158 - $218
20204,92436.5%$37 - $51$67 - $92$182 - $251
20254,39248.5%$48 - $65$101 - $139$211 - $285
20303,86062.8%$61 - $83$147 - $201$235 - $320
20353,32869.5%$77 - $106$179 - $245$256 - $353
20402,79669.5%$98 - $135$191 - $263$274 - $377
20452,26469.5%$125 - $173$197 - $272$283 - $392
20501,73269.5%$159 - $220$192 - $265$275 - $381
Source: Prepared by the Congressional Research Service with estimates of annual emission allowance
prices provided by U.S. EPA, EPA Analysis of the Lieberman-Warner Climate Security Act of 2008
(2008), p. 27.
Note: The price range represents the results of two separate models. For more information, see
Appendix 1 of EPAs analysis of S. 2191. In addition, the figures in the “Total Allowances Available”
column are from the reported version of S. 2191 (May 20, 2008) and do not include proposed changes
for deficit reduction purposes.


70 Typically, “economy-wide” proposals would cover the vast majority of the nation’s GHG
emissions by capping electricity generation, carbon-intensive industries, and the
transportation sector. Depending on the design of the program, some sectors (e.g.,
agricultural or residential) may be excluded from the cap.
71 U.S. EPA, EPA Analysis of the Lieberman-Warner Climate Security Act of 2008 (2008).

To put the auction revenues/allowance value in context, consider the federal net
tax revenue from the three largest revenue sources for Fiscal Year 2007:72
!individual income tax: $1,118 billion;
!employment taxes: $838 billion;
!corporate income taxes: $368 billion.
Options for Allowance Value Distribution
Provide Transition Assistance to Carbon-Intensive Industries.
Several economic studies have estimated the percentage of allowances (a comparable
amount of auction revenues could also be used) that would provide compensation for
projected profit losses to specific carbon-intensive industries. The findings include
the following:
!Goulder found that 13% of the emission allowances would
compensate the fossil fuel producing industry (coal mining, oil and73
natural gas extraction) for lost profits.
!Burtraw and Palmer concluded that the electric-generating
industry’s estimated profit losses could be offset with 6% of the
emission allowances.74
!Smith and Ross estimated that 21% of the allowances would
compensate the combined losses of primary energy producers and
electric utilities (i.e., a combination of the sectors examined in the
other two studies).75
Although these studies analyzed the net effects to certain economic sectors,
there are likely to be winners and losers within the sectors, particularly in electricity
generation. For instance, some facilities, such as coal-fired plants, are expected to
see greater losses, while others — hydroelectric or renewable energy plants — may
see a gain in profits.76
The above estimates consider that allowances would be provided to coveredth
sources in perpetuity. However, some cap-and-trade proposals in the 110 Congress
(e.g., S. 2191 and S. 1766) would generally phase-out free allocation as the


72 U.S. Internal Revenue Service, Internal Revenue Service Data Book 2007, Publication

55B, issued March 2008.


73 Lawrence H. Goulder, Mitigating the Adverse Impacts of CO2 Abatement Policies on
Energy-Intensive Industries (2002), Resources for the Future Discussion Paper.
74 Dallas Burtraw and Karen Palmer, Compensation Rules for Climate Policy in the
Electricity Sector (2007), Resources for the Future Discussion Paper.
75 The authors found a range of 9% to 21%, but noted that the 21% was consistent with the
scenario presented in Goulder’s study. Anne Smith et al., Implications of trading
Implementation Design for Equity-Efficiency Trade-Offs in Carbon Permit Allocations
(2002), Charles River Associates.
76 Dallas Burtraw and Karen Palmer, Compensation Rules for Climate Policy in the
Electricity Sector (2007), Resources for the Future Discussion Paper.

percentage of allowances to be auctioned increases. As such, the initial percentage
of allowances provided at no cost in these bills is higher than estimates that provide
for indefinite distribution at a set percentage. For example, during the first five years
of the program established by S. 2191, fossil fuel-fired power plants would receive
19% of the emission allowances at no cost.77 This percentage would gradually
decline to zero by 2031.78
Offset Reductions in Distortionary Taxes. Economic theory generally
supports a tax policy that would reduce taxes on favored activities (increased
employment or personal income) and increase taxes on less desirable behavior79
(increased pollution). Auction revenues could be used to offset reductions in the
taxes that apply to desirable activities.
Using auction proceeds in this manner has been described as yielding a double-
dividend: (1) reduced GHG emissions and (2) reduced market distortions from the
taxes on desirable behavior. In the early 1990s, some economists suggested that the
double-dividend effect would be strong enough to keep the overall costs to society
relatively small or even negative.80 However, more recent economic studies indicate81
that the costs imposed by the cap-and-trade program could act as an additional tax,
which would most likely (at least in the United States)82 exceed the benefits of
revenue recycling.
Several economic studies have estimated the cost savings to society that auction
revenues could provide.83 A cap-and-trade program is expected to impose an


77 Section 3901 (reported May 20, 2008).
78 In addition, note that S. 2191 would not provide allowances directly to the coal industry,
although petroleum producers/importers would receive a small percentage (2%).
79 The rationale for this policy is that taxes on desirable activities create market distortions,
discouraging increased levels of desirable actions. Assuming the same amount of revenue
could be collected, economic policy would favor placing the tax on activity that is generally
considered undesirable. Further discussion is beyond the scope of this report.
80 Ian Parry, “Fiscal Interactions and the Case for Carbon Taxes over Grandfathered Carbon
Permits,” in Climate Change Policy (Dieter Helm, editor), Oxford University Press (2005);
Intergovernmental Panel on Climate Change Working Group III, Climate Change 2001:
Mitigation, (Cambridge, UK: Cambridge University Press, 2001) Chapter 8.
81 This is referred to as the “tax-interaction effect” in economic literature. See e.g., Ian
Parry, “Fiscal Interactions and the Case for Carbon Taxes over Grandfathered Carbon
Permits,” in Climate Change Policy (Dieter Helm, editor), Oxford University Press (2005)
82 There is some evidence that the double-dividend benefits are stronger in Europe than in
the United States, because the former has a more stringent tax system. Intergovernmental
Panel on Climate Change Working Group III, Climate Change 2001: Mitigation,
(Cambridge, UK: Cambridge University Press, 2001) Chapter 8, citing several studies.
83 See Lawrence H. Goulder, Mitigating the Adverse Impacts of C)2 Abatement Policies on
Energy-Intensive Industries (2002), Resources for the Future Discussion Paper; and Anne
E. Smith and Martin T. Ross, Allowance Allocation: Who Wins and Loses Under a Carbon
Dioxide Control Program? (2002), Charles River Associates; Dallas Burtraw, et al., The
(continued...)

economic cost on society.84 A frequently cited study found that auctioning
allowances could reduce the projected costs between 21% and 47%.85 The range of
potential cost savings reflects different uses of the auction revenues. If policymakers
were to distribute the revenues to U.S. households in “lump-sum” payments — e.g.,
increase the standard tax deduction or mail payments to households — the cost
savings would be on the lower end of the spectrum. Alternatively, if Congress
decided to use the revenues to reduce taxes on labor or investment, society’s costs
would be minimized. Figure 4 shows the relative differences in society costs when
different allocation strategies are used.
Figure 4. Relative Differences in Cap-and-Trade Program’s Cost to
Society with Different Emission Allocation Strategies


ty
cie
So
to
m
ra
og
Pr
of
ts
os
C
100% Auction, Revenues Used to100% Auction, RevenuesAllocations Distributed at Noative
Cut Marginal Tax RatesDistributed in Lump-Sum toCost to Regulated Entitiesl
Hous e hol dsRe
Source: Prepared by CRS with data from Lawrence H. Goulder, Mitigating the Adverse Impacts of
CO2 Abatement Policies on Energy-Intensive Industries (2002), Resources for the Future Discussion
Paper.
Distribution to Non-Covered Entities. Non-covered entities may receive
free allowances (sometimes referred to as “set-asides”) or a percentage of the auction
revenues. For example, Congress may decide to allot allowance value to electricity
consumers, particularly those in low-income households. The rationale for this
distribution policy is that specific subsets of society are expected to bear a
disproportionate percentage of the costs of a cap-and-trade program.
Whether covered sources receive allowances at no cost or purchase them
through an auction, economic principles predict that covered sources would pass
along their opportunity costs or purchase costs, respectively, in the same manner as
83 (...continued)
Effect of Allowance Allocation on the Cost of Carbon Emission Trading (2001), Resources
for the Future.
84 See CRS Report RL34489, Climate Change: Costs and Benefits of S. 2191, by Larry
Parker and Brent Yacobucci.
85 Goulder (2002). This analysis simulated a cap-and-trade program with a 22% emission
reduction between 2000 and 2080.

an actual expense: e.g., installing more efficient technology or switching to more
expensive (but less carbon-intensive) fuels. Covered sources have demonstrated this
behavior in two cap-and-trade programs, in which the vast majority of allowances
was provided at no cost: the European Union’s Emission Trading System (EU-ETS)
and the U.S. sulfur dioxide emissions trading program.86
Because of cost pass-through, consumers, particularly households, are ultimately
expected to bear the majority of the costs associated with a cap-and-trade program.
Figure 5 illustrates the relative distribution of costs to different groups in a cap-and-
trade program.87 The figure is based on a cap-and-trade scenario that would auction
100% of the emission allowances to fossil fuel producers (often referred to as
“upstream” sources). Households and businesses experience the vast majority (89%)
of the costs. Moreover, the household percentage is potentially understated, because
many businesses would likely pass through some of their increased energy/electricity88
costs in the form of higher prices for their goods and services.
Figure 5. Relative Distribution of Costs Using
Upstream Auction (without Revenue Redistribution)


4%7%


35%


54%


Fossil Fuel ProducersFossil Fuel-Fired Power Plants
Business/Industry Hous eholds
Source: Prepared by CRS based on the data from the National Commission on Energy Policy,
Allocating Allowances in a Greenhouse Gas Trading System (2007).
Note: The percentages above do not account for any offsetting income from allowance allocation.
The figure illustrates the relative distributions that would occur if allowances were auctioned to fossil
fuel producers (“upstream”), without recycling the revenues.
86 Congressional Budget Office, Trade-Offs in Allocating Allowances for CO2 Emissions
(2007), Economic and Budget Issue Brief.
87 This figure is based on a National Commission on Energy Policy (NCEP) proposal that
would lead to a relatively modest reduction in GHG emissions compared to those requiredth
under current proposals in the 110 Congress. Thus, this figure is illustrative and only
useful for comparing relative differences.
88 National Commission on Energy Policy, Allocating Allowances in a Greenhouse Gas
Trading System (2007).

The figure is instructive for the allocation debate, because it shows a starting
point for cost distribution. However, the cost percentages depicted in Figure 5 do
not account for distribution of auction revenues. In a real cap-and-trade system that
employs an auction, auction revenues would be used to support specific objectives,
or allotted to various parties.
Distribution to Support Specific Objectives. Policymakers may also
consider distributing a percentage of the allowances or auction revenues to support
a range of objectives, including:
!Technology development: Promotion of emission mitigation
technology is widely recognized as a vital step towards making
substantial GHG emission reductions.89 S. 2191 would distribute the
majority of its auction revenues (approximately 52%) to promote
energy-related technologies: low-carbon energy sources, carbon
capture and storage (CCS),90 and cellulosic biofuels.
!Energy efficiency: Improvements in energy efficiency could make
considerable contributions in achieving GHG emission reductions.
Although energy efficiency may involve technology advancements,
new technologies must be used in order to realize the efficiency
gains. In some cases, parties may need incentives beyond the
efficiency gains to induce behavioral changes. For example,
allowance value could be distributed to support efficiency gains at
places — residences, commercial buildings — that are unlikely to be
covered by an emissions cap.
!Biological sequestration: Trees, plants, and soils sequester carbon,
removing it from the earth’s atmosphere. Allowance values could
be allotted to provide financial incentives for landowners to engage
in activity — e.g., conservation tillage, reforestation — that would
increase sequestration on their land. Although some of these actions
may qualify as offsets (if allowed in a cap-and-trade program), some
activities may need additional incentives or be unable to satisfy the
offset approval process.91
!Adaptation efforts: Some level of global warming (and associated
effects) will occur regardless of emission reduction efforts taken
today, because previous and current GHG emissions will have long
term climate impacts. Therefore, some contend that investment
(e.g., allowance value) should focus on preparing communities to
adapt to the effects of a changing climate.


89 See e.g., CBO, Evaluating the Role of Prices and R&D in Reducing Carbon Dioxide
Emissions, (2006).
90 See CRS Report RL33801, Carbon Capture and Sequestration (CCS), by Peter Folger.
91 See CRS Report RL34436, The Role of Offsets in a Greenhouse Gas Emissions
Cap-and-Trade Program: Potential Benefits and Concerns, by Jonathan L. Ramseur.

!Deficit reduction: Another proposal for the use of allowances or
auction revenue is to address a budget deficit that may result from a
cap-and-trade program. A portion of the allowances or auction
proceeds could be set aside to offset projected revenue shortfalls.
This option is sometimes described as making the program
“revenue-neutral.” In addition, Congress may consider using
allowance value to offset shortfalls beyond those that are related to
the cap-and-trade program.
Policy Considerations
The distribution of allowance value would present policymakers with a series
of trade-offs. The primary options for applying the allowance value involve (1)
minimizing the overall costs of the cap-and-trade program imposed on society; (2)
alleviating the disproportionate costs borne by subgroups in society; and (3)
providing funding to support other policy objectives, such as technological
development. Intertwined among these options is a trade-off between regressive or
progressive impacts.
Reduce Costs, Alleviate Burdens, or Promote Technology. Economic
studies indicate that using auction revenues (i.e., revenue recycling) to offset
reductions in distortionary taxes (labor, income) would be the most efficient use of
the revenues and yield the greatest benefit to society as a whole. These studies show
that if the revenues are used for other purposes, economic efficiency would suffer and
the overall cost of the program would be higher (Figure 4).92
The opportunity to substantially lower overall costs is a unique attribute of the
auction allocation strategy. Some argue that using auction revenues to offset tax
reductions is an unlikely outcome.93 In general, when the government obtains new94
revenue, it tends to fund new or existing programs rather than reduce existing taxes.
Indeed, none of the cap-and-trade bills in the 110th Congress has proposed to use95
revenues in this manner.
Moreover, the most efficient manner of revenue recycling would generally
spread the cost reductions throughout the economy, while certain groups would be
expected to bear a disproportionate percentage of the costs of a cap-and-trade
program. In particular, industries that cannot pass along their increased costs (for


92 However, if additional funding for technology advancement leads to faster development
of low-carbon technologies, the cost of the program may decrease (discussed below).
93 Robert W. Hahn, Greenhouse Gas Auctions and Taxes: Some Practical Considerations
(2008), AEI Center for Regulatory and Market Studies; Robert Stavins, A U.S. Cap-and-
Trade System to Address Global Climate Change (2007), The Hamilton Project, Brookings
Institution.
94 Ibid, citing Gary Becker and Casey Mulligan, “Deadweight Costs and the Size of the
Government (2003),” Journal of Law and Economics 46(2).
95 Another obstacle to this approach may concern Congressional committee jurisdiction
issues. A cap-and-trade proposal that would restructure elements of the tax code may
overlap with multiple committee jurisdictions.

competitive reasons or otherwise) would face higher costs compared to other
economic sectors. Ultimately, consumers are expected to absorb the vast majority
of the program costs. As discussed above, policymakers may consider compensating
— through free allowances or auction revenues — specific industries and/or
providing assistance to households that would face higher energy (e.g., electricity and
gasoline) prices. Such compensation would forgo the opportunity to reduce the
overall cost of the emission program.
Using allowance value for other purposes — e.g., technology development —
would impart a trade-off. While such allotments would limit the allowances
available for the purposes described above — reduced overall costs or relief for
disproportionate impacts — new technologies, in particular, could have a
considerable impact on the costs of an emissions reduction program. This is
particularly the case if technologies can be commercialized ahead of their projected
schedules96 or if unanticipated low- or zero-carbon alternatives can be developed.
The amount of funding allotted to technology development under S. 2191 would
represent a substantial increase, compared to current federal funding for emission
reduction and low-carbon technologies. Although allocating allowance value to
technological development could yield considerable gain, the return in terms of
additional investment to promote technology improvements remains uncertain.97 In
a recent study, the author found:
While academics have extensively studied how revenues from auctions can be
used to make the tax system more efficient, they have not done much research on
examining the impact of using such revenues for retiring debt or increasing
government investment.
In short, if allowance value is used to increase funding to existing programs or
provide funding for new programs, the return on investment is uncertain. For
example, some programs may be operating at full capacity, and additional funding
may not provide comparable impacts. Moreover, the marketplace already provides
incentive for technological change, and a cap-and-trade program would increase the
incentive to develop low-carbon or zero-carbon energy alternatives.
Regressive or Progressive Economic Effects. Another trade-off for
policymakers is whether the emission allocation strategy would produce regressive
or progressive economic results.98 The Congressional Budget Office (CBO) analyzed
the distributional effects of a cap-and-trade program under four different scenarios:


96 For example, the cost models for S. 2191 make assumptions about the availability of CCS.
When this technology actually goes online, it will likely have a substantial impact on the
cost of a cap-and-trade program.
97 For more discussion of recent modeling results regarding technological development, see
CRS Report RL34489, Climate Change: Costs and Benefits of S. 2191, by Larry Parker and
Brent Yacobucci.
98 Analogous to a regressive tax policy, a regressive allocation strategy would
disproportionately impact lower income households. In contrast, in a progressive
distribution scheme the ratio of cost to income would increase as income rises.

!Allowances auctioned and auction revenues distributed to
households in a lump-sum payment;
!Allowances provided to covered sources at no cost;
!Allowances auctioned and revenues are used to cut corporate income
taxes; and
!Allowances auctioned and revenues used to cut payroll income
taxes.
The results are presented in Figure 6. As the figure indicates, an auction that
distributed the revenues to households in a lump-sum payment would yield the most
progressive results. In contrast, the most regressive result occurs when allowances
are provided to covered sources at no cost. The two other options that would cut tax
rates would also produce regressive results. However, these two strategies would
substantially lower the overall cost of the cap-and-trade program, a result not
captured by Figure 6.
Figure 6. Comparison of After-Tax Household Income Changes
(by Quintile) Imposed by Emissions Cap, Using Different
Emission Allocation and Revenue Distribution Strategies


3
2
1ange
h
0 C
ge
-1nta
e
-2rc
Pe
-3
-4
LowestSecond ThirdFourthHighest
Income Quintiles
Lump-Sum Distribution to HouseholdsNo-Cost Distribution to Covered Sources
Revenue Recycling: Cut Payroll TaxesRevenue Recycling: Cut Corporate Taxes
Source: Prepared by CRS with data from the CBO: the no-cost distribution scenario data are from
CBO, Who Gains and Who Pays Under Carbon-Allowance Trading? The Distributional Effects of
Alternative Policy Designs (2000); the other three scenario data are from CBO, Trade-Offs in
Allocating Allowances for CO2 Emissions (2007), Economic and Budget Issue Brief.

Appendix A. What Is a Cap-and-Trade System?
A cap-and-trade system would create an overall limit (i.e., a cap) on GHG
emissions from the emission sources covered by the program. Cap-and-trade
programs can vary by the sources covered. The covered sources are likely to include
major emitting sectors (e.g., power plants and carbon-intensive industries), fuel
producers/processors (e.g., coal mines or petroleum refineries), or some combination
of both.
The emissions cap is partitioned into emission allowances. Typically, one
emission allowance represents the authority to emit one (metric) ton of carbon
dioxide-equivalent (tCO2-e). The “equivalent” is necessary, because GHGs other
than CO2 — methane, nitrous oxide, sulfur hexafluoride, hydrofluorocarbons, and99
perfluorocarbons — vary in their global warming potential (GWP). Thus, GHG
emissions are presented in a standard form of measure (CO2-e).
In general, policymakers may decide to distribute the emission allowances to
covered entities at no cost (based on, for example, previous years’ emissions), sell
the allowances through an auction, or use some combination of these strategies. This
report examines issues associated with these allocation options.
Covered entities that face relatively low emission-reduction costs would have
an incentive to make reductions beyond what is required, because these further
reductions could be sold (i.e., traded) as emission credits to entities that face higher
emission-reduction costs. Other mechanisms, such as banking or offsets, may be
included to increase the flexibility of the program.
At the end of each established compliance period (e.g., a calendar year), covered
sources would be required to surrender emission allowances to cover the number of
tons emitted. If a source did not have enough allowances to cover its emissions, the
source would be subject to penalties.
For more information, see U.S. Environmental Protection Agency (EPA), Office
of Air and Radiation, Tools of the Trade: A Guide To Designing and Operating a
Cap and Trade Program For Pollution Control (2003); CRS Report RL33799,
Climate Change: Design Approaches for a Greenhouse Gas Reduction Program, by
Larry Parker.


99 GWPs are used to compare gases to carbon dioxide, which has a GWP of 1. For example,
methane’s GWP is 25, and is thus 25 times more potent a GHG than CO2. GWPs are
typically based on estimates provided by the Intergovernmental Panel on Climate Change
(IPCC).

Appendix B. Allowance Allocation Strategy under S. 2191 (as Reported)
Table 2. Emission Allowance Allocation under S. 2191
2012 2015 2020 2025 2030 2035 2040 2045 2050
Allowances Sold through an Auction
Early Auction5%
Auction 21.5% 29.5% 36.5% 48.5% 62.8% 69.5% 69.5% 69.5% 69.5%
Allowances Distributed at No Cost
2012 2015 2020 2025 2030 2035 2040 2045 2050
States
Energy Savings2%2%2%2%2%2%2%2%2%
Building Efficiency1%1%1%1%1%1%1%1%1%
Programs that Exceed Fed. Targets2%2%2%2%2%2%2%2%2%
General Allocation - by LIHEAP Share1.5%1.5%1.5%1.5%1.5%1.5%1.5%1.5%1.5%
iki/CRS-RL34502Population Share1.5%1.5%1.5%1.5%1.5%1.5%1.5%1.5%1.5%Fossil Production CO2 Share1.5%1.5%1.5%1.5%1.5%1.5%1.5%1.5%1.5%
g/w
s.orMas Transit1%1%1%1%1%1%1%1%1%
leakTransition Assistance
://wikiFossil Fueled Electric Plants19%19%16%10%1%Rural Electric Cooperatives1%1%1%1%1%
http
Pilot Program for VA and MT0.2%0.2%0.2%0.2%
Energy-Intensive Manufacturing10%10%8%4%
Petroleum Production/Importers2%2%2%1.00%0.25%
HFC Producers/Importers2%2%2%1.00%0.25%
Other Purposes or Recipients
Early Action5%2%
Tribal Communities0.5%0.5%0.5%0.5%0.5%0.5%0.5%0.5%0.5%
Low/Midle-Income Electricty Consumers9%9%9%9%9%9%9%9%9%
Low/idle-Incoe Natural Gas Consuers22%2%22%2%2%2%2
Carbon Capture and Sequestration4%4%4%4%4%
Domestic Agriculture and Forestry5%5%5%5%5%5%5%5%5%
International Forest Protection2.5%2.5%2.5%2.5%2.5%2.5%2.5%2.5%2.5%
Landfill and Coal Mine CH4 Reduction3%3%3%3%3%3%3%3%3%
Source: Prepared by CRS.



Table 3. Auction Revenue Distribution under S. 2191
Off-the-Top Allocation of Auction Revenues (in $1,000s)
2012 2015 2020 2025 2030 2035 2040 2045 2050
BLM Emergency Firefighting Fund$150$150$150 $150$150$150$150$150$150
Forest Service Emergency Firefighting Fund$430$430 $430 $430$430$430$430$430$430
Climate Security Act Management Fund$1,071$1,211$1,393$1,586$1,776$1,950$2,086$2,149$2,092
Percentage Allocation of Remaining Revenues
2012 2015 2020 2025 2030 2035 2040 2045 2050
Technology Deployment
Zero- or Low- Carbon Energy Technology16.6%16.6%16.6%16.6%16.6%16.6%16.6%16.6%16.6%
Advanced Coal and Sequestration Technology13.0%13.0%13.0%13.0%13.0%13.0%13.0%13.0%13.0%
Fuel from Cellulosic Biomass3.1%3.1%3.1%3.1%3.1%3.1%3.1%3.1%3.1%
Advanced Technology Vehicles Manufacturing6.2%6.2%6.2%6.2%6.2%6.2%6.2%6.2%6.2%
Sustainable Energy Program13.0%13.0%13.0%13.0%13.0%13.0%13.0%13.0%13.0%
TO TA L 52.0% 52.0% 52.0% 52.0% 52.0% 52.0% 52.0% 52.0% 52.0%
Energy Assistance Fund
LIHEAP 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0%
Weatherization 4 .5% 4 .5% 4 .5% 4 .5% 4 .5% 4 .5% 4 .5% 4 .5% 4 .5%
Rural Energy Assistance4.5%4.5%4.5%4.5%4.5%4.5%4.5%4.5%4.5%
iki/CRS-RL34502TO TA L 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0%
g/wClimate Change Worker Training Fund
s.orDOE University Programs1.3%1.3%1.3%1.3%1.3%1.3%1.3%1.3%1.3%
leakTO TA L 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%
Adaptation Fund
://wikiDOI - Wildlife Conservation and Restoration6.3%6.3%6.3%6.3%6.3%6.3%6.3%6.3%6.3%
httpDOI - Adaptation Activities3.4%3.4%3.4%3.4%3.4%3.4%3.4%3.4%3.4%
DOI - Cooperative Grant Programs0.9%0.9%0.9%0.9%0.9%0.9%0.9%0.9%0.9%
DOI - Tribal Wildlife Grants0.2%0.2%0.2%0.2%0.2%0.2%0.2%0.2%0.2%
Land and Water Conservation Fund
DOI LWCF Sec. 6 Grants0.3%0.3%0.3%0.3%0.3%0.3%0.3%0.3%0.3%
DOI LWCF Sec. 7 Acquisitions0.6%0.6%0.6%0.6%0.6%0.6%0.6%0.6%0.6%
USDA Forest Legacy Program Sec. 7 Acquisitions0.3%0.3%0.3%0.3%0.3%0.3%0.3%0.3%0.3%
USDA LWCF Sec. 7 Acquisitions0.6%0.6%0.6%0.6%0.6%0.6%0.6%0.6%0.6%
SUBT OT AL 1.8% 1.8% 1.8% 1.8% 1.8% 1.8% 1.8% 1.8% 1.8%
Forest Service Adaptation Activities0.9%0.9%0.9%0.9%0.9%0.9%0.9%0.9%0.9%
EPA Adaptation Activities0.9%0.9%0.9%0.9%0.9%0.9%0.9%0.9%0.9%
Army Corps of Engineers Adaptation Activities1.8%1.8%1.8%1.8%1.8%1.8%1.8%1.8%1.8%
Department of Commerce Adaptation Activities1.8%1.8%1.8%1.8%1.8%1.8%1.8%1.8%1.8%
TO TA L 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0%
Energy Independence Acceleration Fund2.0%2.0%2.0%2.0%2.0%2.0%2.0%2.0%2.0%
Climate Change and National Security Fund5.0%5.0%5.0%5.0%5.0%5.0%5.0%5.0%5.0%
Source: Prepared by CRS.
Notes: CRS estimates of off-the-top revenues based on allowance price projections from the EPA/ADAGE-TECH scenario in U.S. EPA, EPA Analysis of the
Lieberman-Warner Climate Security Act of 2008 (2008). Higher allowance price estimates would lead to higher auction proceeds. CRS estimates of firefighting fund
requirements based on historic data. Estimate of administration cost (“CSA Management Fund”) based on EPAs estimate of 1% of total allowance value.