[Senate Hearing 111-182]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-182
 
                  ALLOCATION ALLOWANCES OF GREENHOUSE 
                              GAS EMISSION

=======================================================================



                                HEARING

                               before the

                              COMMITTEE ON
                      ENERGY AND NATURAL RESOURCES
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   TO

RECEIVE TESTIMONY ON THE COSTS AND BENEFITS FOR ENERGY CONSUMERS AND 
ENERGY PRICES ASSOCIATED WITH THE ALLOCATION OF GREENHOUSE GAS EMISSION 
                               ALLOWANCES

                               __________

                            OCTOBER 21, 2009


                       Printed for the use of the
               Committee on Energy and Natural Resources



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               COMMITTEE ON ENERGY AND NATURAL RESOURCES

                  JEFF BINGAMAN, New Mexico, Chairman

BYRON L. DORGAN, North Dakota        LISA MURKOWSKI, Alaska
RON WYDEN, Oregon                    RICHARD BURR, North Carolina
TIM JOHNSON, South Dakota            JOHN BARRASSO, Wyoming
MARY L. LANDRIEU, Louisiana          SAM BROWNBACK, Kansas
MARIA CANTWELL, Washington           JAMES E. RISCH, Idaho
ROBERT MENENDEZ, New Jersey          JOHN McCAIN, Arizona
BLANCHE L. LINCOLN, Arkansas         ROBERT F. BENNETT, Utah
BERNARD SANDERS, Vermont             JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   JEFF SESSIONS, Alabama
DEBBIE STABENOW, Michigan            BOB CORKER, Tennessee
MARK UDALL, Colorado
JEANNE SHAHEEN, New Hampshire

                    Robert M. Simon, Staff Director
                      Sam E. Fowler, Chief Counsel
               McKie Campbell, Republican Staff Director
               Karen K. Billups, Republican Chief Counsel



                            C O N T E N T S

                              ----------                              

                               STATEMENTS

                                                                   Page

Bingaman, Hon. Jeff, U.S. Senator From New Mexico................     1
Ellerman, A. Denny, Ph.D., Senior Lecturer (Retired), Center for 
  Energy and Environmental Policy Research, Massachusetts 
  Institute of Technology........................................     4
Metcalf, Gilbert E.,, Ph.D., Professor of Economics, Tufts 
  University, Medford, MA........................................     9
Murkowski, Hon. Lisa, U.S. Senator From Alaska...................     2
Palmer, Karen, Darius Gaskins Senior Fellow, Resources for the 
  Future.........................................................    16
Stone, Chad, Chief Economist, Center on Budget and Policy 
  Priorities.....................................................    22

                                APPENDIX

Responses to additional questions................................    59


            ALLOCATION ALLOWANCES OF GREENHOUSE GAS EMISSION

                              ----------                              


                      WEDNESDAY, OCTOBER 21, 2009

                                       U.S. Senate,
                 Committee on Energy and Natural Resources,
                                                    Washington, DC.
    The committee met, pursuant to notice, at 9:38 a.m. in room 
SD-366, Dirksen Senate Office Building, Hon. Jeff Bingaman, 
chairman, presiding.

OPENING STATEMENT OF HON. JEFF BINGAMAN, U.S. SENATOR FROM NEW 
                             MEXICO

    The Chairman. Why don't we go ahead with the hearing. Today 
the hearing is on allowance allocation and auction impacts on 
the energy sector in connection with the House-passed 
legislation on cap and trade. I think it's important we try to 
have an understanding of this aspect of the cap and trade bill 
that came from the House and what it would mean for the energy 
sector, various parts of the energy industry, and consumers, 
and on prices.
    Several basic questions come to mind which I hope we can 
address today. First and foremost, we need to have a good 
understanding of what the appropriate level of free allocation 
should be if there is an appropriate level. Obviously, there's 
an inherent question, threshold question, as to whether, if 
we're trying to send a price signal in order to provide an 
incentive for folks not to use energy from carbon-emitting 
sources, to what extent do we want to mitigate that price 
signal. I guess that's what we wind up doing with free 
allocation of allowances.
    Many market-based programs in the past have freely 
allocated emission permits. The experience with the first phase 
of the European Union's emissions trading program has shown 
that this is not necessarily the preferred approach with the 
greenhouse gas trading market.
    We also need a better understanding of the uses of free 
allowances. For example, many bills before Congress propose to 
distribute allowances not only to entities that need to comply 
with the program, but also to advance additional objectives and 
goals. That is the same for auction revenue, which in many 
cases is also divided among a variety of different purposes.
    So I hope witnesses today can help educate us on the value 
of using allowances for different purposes other than the 
simple purpose of complying with the program, if that's 
appropriate. Over the course of the debate on climate change, 
many have become more and more persuaded that the main priority 
for allowance allocations auctions should be to return revenue 
to ratepayers and consumers. I guess again that raises a 
question of to what extent do we want to mitigate any signal, 
price signal that is embedded in a cap and trade system.
    So that's some overview of some of the issues. I'm sure 
that the witnesses can enlighten us on others. Let me turn to 
Senator Murkowski.
    [The prepared statement of Senator Bunning follows:]
   Prepared Statement of Hon. Jim Bunning, U.S. Senator From Kentucky
    Thank you Mr. Chairman. I look forward to the hearing today to 
discuss the policies of allocations and allowances under a cap and 
trade program.
    Ultimately, this will decide who will bear the greatest costs of 
paying for this bill.
    While I believe that all Americans will pay for this bill, the 
costs will be disproportionally shouldered by the states that have more 
carbon based resources than other states.
    In my home state of Kentucky over 95% of electricity is generated 
by coal. Estimates show that if passed Kentucky will be one of the 
highest impacted states by cap and trade legislation.
    Kentucky families will have to pay more than their fair share under 
this bill. They will feel it when they go to fill up their gas tanks, 
heat and cool their homes and use electricity as well as the costs of 
practically all goods and services.
    What's even more disturbing is the solution that the Administration 
and the authors of the American Clean Energy Act propose to solve this 
problem.
    They create a type of ``green'' welfare to help low income 
households affected by an increase in consumer energy prices. At a time 
when our Supplemental Nutrition Assistance Program is rife with fraud, 
we do not need to be expanding the funding we give to recipients.
    I also do not believe that an expansion of the Earned Income Tax 
Credit is an effective way to target low income households.
    Instead of expanding government welfare and taxing energy 
consumers, Congress should focus on providing pro growth policies that 
can achieve our environmental goals without bankrupting our industries.
    I thank the witnesses for appearing before the committee today and 
appreciate their comments. I look forward to continuing the 
conversation on this issue and discussing the entire scope of the cost 
of enacting climate change legislation.
    Thank you Mr. Chairman.

        STATEMENT OF HON. LISA MURKOWSKI, U.S. SENATOR 
                          FROM ALASKA

    Senator Murkowski. Thank you, Mr. Chairman. I appreciate 
our third in the ongoing series of educational opportunities on 
the issue of climate and what you have afforded the committee 
members. I think it has been exceptionally important, very 
helpful, and very constructive.
    I think it is important that our focus stays broad. I think 
as we address the issue of climate change and climate policy, I 
think we recognize that it's not just about finding something 
quick; it's about doing something right. I think we're taking 
the time in this committee to really learn and understand.
    The legislation that we've been focused on as we've had 
these panels, the House-passed energy and climate bill, I don't 
believe was a product of that type of debate. There was only 
one piece of legislation considered and the members and the 
stakeholders that were involved were more concerned about who 
was going to receive these free permits under the bill than the 
program's overall direction and design. While this approach did 
lead to the bill's passage, it's now created a situation where 
our Nation's energy producers are battling one another over 
policy decisions worth hundreds of billions of dollars in 
coming decades.
    That is not my statement. That was a quote from last 
Sunday's New York Times.
    Now, some may view division within the energy industry as 
useful, but I think we should view it as a warning sign. By 
picking winners and losers within a cap and trade system, as 
the House did, they didn't necessarily develop a better bill. 
It advantaged some energy resources and it disadvantaged 
others. This has become particularly clear over the past 
several months. We've had a wide range of groups that have 
formed with hopes of receiving favorable or at least fair 
treatment in whatever is to come out of the Senate. Permit 
allocations, rather than the merits of any given technology, 
are viewed as the key to keeping entire industries and 
companies competitive. Of course, this has done little to 
improve the counterproductive and I think very polarized nature 
of the climate debate, which is unfortunate.
    The House managed to complete its bill by giving permits 
away to more than 20 categories of recipients. It's like doling 
out pieces of the pie. But as climate legislation is developed 
here in the Senate, we're faced with the harsh reality that 
there's not much pie that is available to satisfy all the 
groups that are vying for them to repeat this process a second 
time.
    We need to remember that each additional permit that we 
give away takes us further from the full auction which the 
President has endorsed and who will ultimately have the final 
say on any legislation that reaches his desk.
    So this morning I hope that we can discuss not only who 
wants the free permits and how they might be distributed, but 
whether or not those permits should be given away for free in 
the first place. I'm committed to finding out which of our 
options is most economically efficient and environmentally 
effective, not necessarily which is the most politically 
expedient, and I intend to approach this entire debate from 
that perspective. But I think it's particularly important as we 
have the discussion here this morning.
    Our climate policy, no matter what form it takes, is meant 
to be an environmental program, not an appropriations bill. By 
imposing cap and trade we're basically creating a new form of 
currency and any permits given away will hold massive financial 
value. In this context, you can almost view it as earmarks, 
decade-long earmarks, and with us in a position of having to 
make immediate decisions about who should receive them, and 
that will have lasting consequence.
    Accordingly, we should view attempts to secure free permits 
with a healthy dose of skepticism and I think some concern.
    We should also ask ourselves if certain permit distribution 
schemes expose us to a proliferation of middlemen, and if we 
determine that there is a more transparent and efficient way to 
ease the impacts of cap and trade. The reality of free permits 
will phaseout over time and should allow us to have this 
conversation now instead of postponing it to some future date.
    In the end, I suspect that our witnesses will tell us that 
no matter how we approach permit allocation, American consumers 
will ultimately bear the burden of compliance costs. These 
costs are significant. We had the testimony of the panel last 
week; some of the Federal agencies put the cost per household 
as high as $1,870 per year beginning in the year 2030. So we've 
got to acknowledge these costs rather than pretending that they 
don't exist or trying to hide them.
    We need to admit that the impacts of climate policies are 
as real as the consequences of climate change itself. I think 
this is how we get to the open and honest debate that is best 
to move this forward.
    I look forward to the comments from the witnesses this 
morning, and again, Mr. Chairman, I thank you very sincerely 
for the very good conversations that we've been able to have 
within this committee on this issue.
    The Chairman. Thank you very much.
    Let me introduce our distinguished panel of witnesses. Dr. 
Denny Ellerman is the Senior Lecturer with the Center for 
Energy and Environmental Policy Research at MIT. Thank you very 
much for being here. He's consulted with us before and we 
appreciate that.
    Dr. Gilbert Metcalf is Professor of Economics at Tufts 
University. Thank you very much for being here.
    Dr. Karen Palmer is Senior Fellow with Resources for the 
Future, and we appreciate you being here.
    Dr. Chad Stone, the Chief Economist with the Center on 
Budget and Policy Priorities. Thank you for being here.
    Dr. Ellerman, why don't each of you take 6 to 8 minutes and 
give us the main points that you think we need to understand 
about this whole issue of allowance allocation, and then we'll 
have some questions.

    STATEMENT OF A. DENNY ELLERMAN, PH.D., SENIOR LECTURER 
(RETIRED), CENTER FOR ENERGY AND ENVIRONMENTAL POLICY RESEARCH, 
             MASSACHUSETTS INSTITUTE OF TECHNOLOGY

    Mr. Ellerman. Thank you, Mr. Chairman, Senator Murkowski, 
and members of the committee. Good morning. My name is Denny 
Ellerman. I am an economist and recently retired Senior 
Lecturer at MIT. My research focus for the past 15 years has 
been the evaluation of cap and trade systems as they've been 
implemented in the United States and Europe. I want to thank 
you for this opportunity to testify and to congratulate you for 
convening this hearing on one of the most difficult and least 
well understood aspects of cap and trade systems, namely the 
allocation of the allowances that are the essential mechanism 
by which these systems operate.
    I would ask that my written testimony be included in the 
record. My oral remarks summarize that testimony, which makes 
three points.
    The Chairman. Yes, we will include each witness's full 
statement in the record.
    Mr. Ellerman. Thank you.
    First, allocation is a distinctive feature of cap and trade 
systems, but it is unique when compared with a tax or command 
and control approach only in being explicit and transparent 
with respect to identifying the recipients of the scarcity rent 
that is created by all of these alternatives. Any effective 
constraint on emissions will make the right to emit valuable 
and it will create this scarcity rent. The rent takes the form 
of allowance value in a cap and trade system. In a tax 
alternative it takes the form of tax revenues.
    There is no name for the rent in the command and control 
approach because it is so well hidden. Still, it exists and it 
is determined by the differential effect of the regulation and 
its implementation on affected facilities. In neither of the 
alternatives to cap and trade is the assignment of the scarcity 
value as explicit and transparent as it is in a cap and trade 
system. That does not make it any easier to enact one, but it 
exists and it is one of its merits.
    My second point is that the familiar dichotomy between 
auctioning and free allocation is incomplete and I would 
suggest even misleading in confusing the means of distributing 
allowances with the ultimate beneficiaries of allowance value. 
It makes little difference whether a recipient receives $1,000 
in free allowances or $1,000 in auction revenues, and we have 
experience with both forms of distribution.
    For instance, allowances can be auctioned and the proceeds 
returned to regulated entities, as is done for the 3 percent 
annual auction in the U.S. SO2 trading program. They 
can as easily be freely allocated to nonregulated entities, 
such as is proposed in the Waxman-Markey or, for that matter of 
fact, the Kerry-Boxer legislation.
    Moreover, neither government nor corporations, who are the 
usually presumed recipients of allowance value, are the 
ultimate beneficiaries. They are only legal vessels through 
which allowance value passes to the various households, who are 
also the ultimate bearers of the cost of the cap.
    When government or unregulated entities receive the 
allowance value, the ultimate household beneficiaries are those 
providing labor or capital in the form of their savings for 
designated public uses, which could be encouraging renewable 
energy, energy R and D, adaptation, carbon capture and 
sequestration, or it could be those paying taxes should the 
revenue be used to reduce taxes or the deficit. The revenue 
could even be given to directly designated households, such as 
low-income ones or all households, in a cap and dividend 
approach.
    When corporate entities receive the allowance value, the 
ultimate recipients are shareholders, the government through 
increased corporate tax revenues, and even consumers when the 
corporate entity is regulated on some cost basis, as are many 
electric utilities.
    My third point is that allowance is a deeply political and 
even philosophical issue that affects not only equity among 
income classes, regions, and industries, but also the size of 
government. For any given household, its net benefit will 
depend upon the carbon content of the goods and services that 
it uses and for which it will pay and the extent to which that 
household benefits from the allocation provisions. The split 
between government and private activity will depend on whether 
allowances are used to fund government activity that would not 
otherwise occur or, alternatively, used to reduce taxes or the 
deficit or perhaps returned directly to households on some 
basis.
    In closing, let me note that the basic issues of allocation 
are ones with which you are fully familiar. It may not be easy 
to decide how the allowance value created by a cap should be 
used, but no set of people is more appropriate to the task than 
the legislative branch of government, consisting of the elected 
representatives of the households who will both bear the cost 
of the cap and ultimately benefit from the allocation of the 
allowance value created by the cap.
    Thank you for your attention. That concludes my testimony.
    [The prepared statement of Mr. Ellerman follows:]
    Prepared Statement of A. Denny Ellerman, Ph.D., Senior Lecturer 
    (Retired), Center for Energy and Environmental Policy Research, 
                 Massachusetts Institute of Technology
     My name is Alfred Denny Ellerman. I am an economist and have 
recently retired after seventeen years as a Senior Lecturer at the 
Sloan School of Management at MIT where I have been associated with two 
research groups, the Center for Energy and Environmental Policy 
Research and the Joint Program on the Science and Policy of Global 
Change. My testimony reflects my personal beliefs and should not be 
taken to represent the positions of MIT or of any of the research 
groups with which I have been associated.
    My field of specialization is energy and environmental economics 
and for the past fifteen years my research has focused on the use of 
tradable permits for regulating air emissions. During this time, I have 
been involved in extensive assessments of the US cap-and-trade programs 
for regulating SO2 and NOX emissions and most 
recently with the European Union's CO2 emissions trading 
program. The results of this research have been reported in numerous 
articles and other presentations and most prominently in two books 
presenting ex post evaluations of the US SO2 trading system 
and the EU's CO2 trading system. The appendix to this 
testimony provides a list of the published results of this research, 
which is the basis of the testimony that I am presenting today.
    More specifically, today's testimony is limited to the allocation 
of the tradable permits, or allowances, created by these systems. These 
allowances are the distinctive feature of cap-and-trade systems and 
their distribution and surrender against emissions provides the 
essential mechanism by which these systems operate. The specific points 
that I will make are the following.

          1) Allowance allocation is unique only in the explicitness 
        and transparency with which the allowance value, or scarcity 
        rent, created by the cap is distributed.
          2) The dichotomy between auctioning and free allocation is 
        incomplete and misleading in confusing the means of 
        distributing allowances with the recipients of allowance value.
          3) Allocation is deeply political and, I would suggest, even 
        a philosophical issue concerning the appropriate uses of the 
        newly created allowance value, which is best addressed by the 
        legislative branch.
     allocation is unique only in its explicitness and transparency
    Any constraint on emissions, whether it be by means of a cap, a 
tax, or a prescriptive regulation (also know as ``command-and-
control''), will limit those emissions, thereby giving value to the 
right to emit and creating what economists call scarcity rent. The most 
familiar example of scarcity rent is the purchase price or rent paid 
for the use of land.
    When a cap is chosen as the means to limit emissions, the scarcity 
rent is embodied in the allowances that must be surrendered by 
regulated entities in an amount equal to their emissions. Allowance 
value is a more convenient term than scarcity rent, but we should 
always remember that the value embodied in allowances reflects the 
scarcity created by the cap.
    When a tax is chosen as the means to limit emissions, the scarcity 
rent takes the familiar form of tax revenues. For a tax that would be 
expected to have the same effect on emissions as a cap, the tax 
revenues will be the same as allowance value on an ex ante basis. The 
ex post result may differ according to the way each of these 
alternatives operates in response to departures from expectation. As 
you are well aware, collecting tax revenue is not the end of the 
process. Those revenues will be used (or we might say in this context, 
``allocated'') in some manner. In this sense, the tax alternative to 
cap-and-trade shares the explicitness and transparency of allocation in 
cap-and-trade. In fact, if it is decided that all allowances will be 
distributed entirely through auctioning, the allocation issue is 
identical, namely, deciding what to do with the tax or auction revenue. 
In this limiting case, the difference in the nature of allocation 
between the cap-and-trade and tax alternatives is very slight. In both 
cases, the government is the immediate recipient of the scarcity rent 
and it must decide what to do with it.
    When prescriptive regulation is chosen as the means to limit 
emissions, the scarcity rent is equally present but very well-hidden. 
This may make the enactment of prescriptive regulation easier, but 
there should be no mistaking that a scarcity rent is created and 
allocated, usually through the subsequent regulatory process. A 
familiar form of creating and distributing this rent is the imposition 
of more demanding standards on new facilities than on those existing at 
the time the legislation or regulation is imposed. A perfect example is 
the new source performance standard under the existing Clean Air Act, 
which has increased the value and extended the useful lives of existing 
facilities to the benefit of the owners of those facilities. More 
generally, any difference in regulatory treatment between new and 
existing facilities, or among existing facilities (as often occurs in 
the regulatory process), will make the favored facilities the effective 
recipients of the scarcity rent created by this form of regulation.
    And, if the prescriptive regulation has the same effect on 
emissions as a cap, the rents thereby created and received by the 
favored faciliites will be equal in value to that embodied in 
allowances. Thus, when a cap-and-trade system distributes allowances 
entirely through free allocation, the result is very similar to that 
resulting from an equivalent set of prescriptive regulations. The main 
differences, setting aside efficiency and effectiveness, are that the 
allocation is neither explicit nor transparent and the scarcity rent is 
attached to the favored facilities instead of being separable and 
tradable as allowances.
   the auction/free allocation dichotomy is incomplete and misleading
    Allocation debates are often framed as a choice between auctioning 
and free allocation. This dichotomy is incomplete and misleading in 
focusing on the means of distributing allowances instead of the 
recipients of the newly created allowance value. Either means of 
distributing allowances can be and have been used to benefit any 
desired recipient.
    For example, three percent of the allowances in the US Acid Rain or 
SO2 trading program are auctioned, but the revenues are 
returned to the regulated entities from whose free allocations the 
auctioned allowances had been withheld. Conversely, allowances could be 
allocated directly and freely to various entities that do not have an 
obligation to surrender allowances equal to emissions, such as is 
proposed in the House-passed Waxman-Markey legislation. These 
recipients will receive the allowance value by selling the allowances 
freely allocated to them to regulated entities facing a requirement to 
surrender allowances equal to emissions.
    From the standpoint of allocation, what matters is not so much the 
means by which the allowances are distributed as it is the identity of 
the ultimate recipient. The most that can be said of the auctioning/
free allocation dichotomy is that there is a presumption concerning the 
immediate recipient of the allowance value, namely, the government for 
auctioning and regulated entities, usually corporations, for free 
allocation. However, this need not be the case and it has not always 
been so.
    The ultimate and real recipient of allowance value depends on a 
number of conditioning factors. When allowances are auctioned by the 
government, the funds so produced can be used for any number public 
purposes, such as reducing taxes on labor or capital, encouraging 
certain activities (energy R&D, energy conservation, faster deployment 
of renewable energy, carbon capture and sequestration, or nuclear 
energy), paying for other government programs (health care, social 
security), reducing government deficits, or compensating incumbent 
emitters or even households. All of these alternative uses imply 
different recipients for the newly created allowance value.
    Some examples can be cited. In the only cap-and-trade program for 
which complete auctioning has been adopted, the Regional Greenhouse Gas 
Initiative in the northeastern US, most participating states have 
chosen to dedicate auction revenue to funding renewable energy and 
energy conservation programs. In the few auctions that have occurred in 
the European CO2 emissions trading system, auction revenues 
have been used for defraying the government expense of administering 
the program (Ireland), as a general revenue (Denmark), and for climate 
related purposes (Germany and the UK).
    Whatever the public purposes being served, all of the allowance 
value will flow ultimately to households in proportion to the extent 
that particular households provide labor or capital services to favored 
activities or that particular households are beneficiaries of the 
designated public purposes. Even deficit reduction, which would have no 
direct impact, will have a differential effect on households in that 
the borrowing needs of government will be thereby reduced leading to 
lower interest rates, which will benefit borrowers and disadvantage 
savers.
    It is also possible to by-pass all of these public purposes and 
distribute the allowance value directly to households in what could be 
seen as compensation for the increased costs that households will 
inevitably bear. Although this could be done by free allocation, in 
which case households would sell the allowances to regulated entities, 
a far simpler and more efficient means of distributing allowance value 
to households would be to auction the allowances and distribute the 
proceeds directly to households.
    When allowances are freely allocated to regulated entities, 
typically corporations, whether those entities will benefit depends 
first on whether the entity is price-regulated. If the regulated entity 
is subject to some form of cost-based price regulation, as are many 
electric utilities, the allowance value would, in theory, pass through 
entirely to the rate payers of that utility, who would receive the 
allowance value in reduced electricity rates. Since no cost is incurred 
for the freely allocated allowances, there is no cost to recover in 
retail rates. If the corporate entity is not price regulated, as are 
some power generation companies and most other corporations, free 
allocation results in higher profits for those corporate entities. 
These profits may offset other losses that the corporation may incur as 
a result of incorporating the cost of carbon in the prices of the 
products produced by these entities, but the profits will still be 
higher by the value of the free allocation than they would be in its 
absence.
    In this case of corporate recipients that are not price regulated, 
it is important to note that the corporations receiving the free 
allocation are only the immediate recipients of the allowance value, 
and not the ultimate recipients, in the same manner as the government 
in the case of auctioned allowances. Any increase in profits will be 
subject to federal and state corporate income taxes so that somewhat 
more than a third of the allowance value will be returned to 
government. The remainder will accrue to shareholders as dividends or 
increases in equity value, whether the shares are held directly or 
through mutual funds or pension funds.
    Thus, it is not enough to simply say that allowances should be 
auctioned or allocated freely. The real issue is the use to which the 
newly created value will be directed and the households that will 
thereby ultimately receive the benefit of the allowance value.
     allocation is a deeply political and even philosophical issue
    The eventual and inevitable trickling down of allowance value to 
households, along with that of carbon cost, makes allocation an issue 
of equity, with all that that term implies of immediate political 
pressure and broad philosophical concerns, as well as one of deciding 
the share of society's resources that will be subject to public 
direction. The equity implications are principally regional and by 
income and others are better qualified than I to address these issues.
    As for the mix of publicly and privately directed activity, a clear 
distinction must be made between the reallocation of resources 
occasioned by the cap and the reallocation associated with allocation. 
The decision to limit greenhouse gas emissions necessarily implies a 
reallocation of society's resources towards reducing these emissions 
and that decision will itself create winners and losers. In both the 
market-based means of accomplishing this objective--cap-and-trade or a 
carbon tax--the exact reallocation of resources is determined by 
consumers and producers as they adjust to the new price on greenhouse 
gas emissions.
    However, as previously noted, the cap also creates a scarcity rent 
and the allocation of that rent has additional implications for the 
allocation of society's resources. The diagram* attached to this 
testimony illustrates the relative magnitudes of the resources required 
for abatement and those associated with the scarcity rent. In this 
diagram, the horizontal axis reflects emissions with business-as-usual 
emissions given a value of 100 and the vertical axis represents the 
marginal or incremental cost of an additional unit of emission 
reduction. The units depicted here are without denomination and are 
purely illustrative. The diagonal line reflects the relationship 
between the two when abatement is efficient, namely, that the cost of 
the next ton of abatement is always higher than the last one. The two 
shaded areas reflect the total resources associated with abatement (the 
triangle labeled cost) and the scarcity rent (the rectangle) when a 25% 
emissions reduction is contemplated. As can be easily visualized, the 
relation between these two areas will vary depending on the emission 
reduction being chosen, as well as the slope and curvature of the line 
representing the marginal cost of abatement.
---------------------------------------------------------------------------
    * Attachments have been retained in committee files.
---------------------------------------------------------------------------
    Two limiting cases can illustrate the effect of allocation on the 
mix of public and private endeavor. First, imagine a case in which the 
allowance value is completely auctioned and the all the proceeds are 
used to fund additional expenditure programs. In this limiting case, 
the mix of publicly and privately funded activity would shift to the 
public sector by an amount equal to the scarcity rent.
    For the opposite limiting case, imagine that the proceeds from the 
auctioning of allowances--the rectangle--are distributed entirely and 
directly to households. Government expenditure would be no greater in 
this case than it was before the limit on greenhouse gas emissions was 
enacted. Households would still pay whatever they are going to pay for 
the carbon content of the goods and services they use, but they will 
also receive a compensating payment of their share of the scarcity rent 
that is created by the cap. If the distribution to households was per 
capita, those consuming products with a higher than average carbon 
content would face a net cost, while those with a lower carbon 
footprint would receive a net benefit.
    One could argue for either of these polar cases on grounds of 
public policy or philosophical preference, or for any mix of the two, 
and this mix might change over time. Equally valid public policy 
arguments can be made for allocating resources to particular public 
purposes and for directly compensating consumers for the increased 
carbon costs that they will bear. Philosophical preferences enter the 
discussion not only concerning the equity implications of different 
uses but also concerning the appropriate mix between public and private 
endeavor.
    In setting forth these two limiting cases, I do not suggest that 
either is per se desirable or not. As legislators, you recognize that 
consensus lies somewhere in the middle: that some of society's 
resources should and will be dedicated to public uses and equally that 
government need not, and indeed cannot, determine the use of all of 
society's resources. My closing observation is that no one is better 
qualified than you, the elected representatives of all the people, to 
weigh the pros and cons of all the competing uses and to decide the 
appropriate use of the scarcity rent that is created by any constraint 
on emissions.

    The Chairman. Thank you very much.
    Dr. Metcalf, go right ahead.

STATEMENT OF GILBERT E. METCALF, PH.D., PROFESSOR OF ECONOMICS, 
                 TUFTS UNIVERSITY, MEDFORD, MA

    Mr. Metcalf. Chairman Bingaman, Senator Murkowski, and 
members of the committee, thank you for this invitation to 
testify this morning.
    I'm going to refer to a couple of figures in my written 
testimony, so I assume and hope you all have copies of that in 
front of you.
    I wish to make the following points this morning. Past cap 
and trade programs have freely allocated permits, the two big 
ones, but this does not mean that Congress has to freely 
allocate permits in this legislation. There's no lock-in in 
that regard.
    The second point I want to make is that allowance 
mechanisms differ on the basis of simplicity, transparency, 
efficiency, and distribution. All things equal, the more simple 
and transparent the better.
    Third, a cap and trade system is likely to 
disproportionately impact low-income households. Addressing 
impacts on these households should be an important element of 
any allowance allocation scheme.
    Finally, allocation to natural gas and electricity 
customers through local distribution companies, LDCs, can blunt 
some of the impact of carbon pricing, but if it is not done 
carefully it can raise the cost of achieving targets 
significantly.
    So as background, cap and trade legislation acts like a tax 
in raising the price of carbon-based fuels and other carbon 
inputs that release greenhouse gases. Higher prices serve as 
the tool in Adam Smith's invisible hand to guide the economy to 
more productive and socially efficient outcomes. But it is 
important at the outset to distinguish between the cost of 
reducing emissions and the revenues that could be raised of 
permits are fully auctioned.
    Figure 1 in my testimony illustrates that distinction. In 
that figure, the costs of reducing emissions rise with the 
stringency of the program, and this upward-sloping curve shows 
permit prices for different levels of emission reductions going 
from the least stringent at zero to the most stringent, 100 
percent reduction.
    If we consider a cap and trade system that mandates a 25 
percent reduction in emissions, say, the price of permits would 
equal P as shown in that figure. The value of the permits 
created in the program is the product of the permit price times 
the number of permits allocated or auctioned, and this is shown 
in the figure as the area of rectangle A.
    The key point is that this is a transfer rather than a 
social cost. The cost of the reduction, of the emission 
reductions, is shown in the figure by the triangle labeled B. 
This is the actual cost to society of reducing greenhouse gas 
emissions.
    As this figure makes clear, the value of permits is not the 
same as costs of reducing emissions. Also note that the value 
of permits dwarfs the initial costs of emission reductions.
    Allowance systems can be assessed on a number of 
dimensions. Four stand out, as I mentioned before: simplicity, 
transparency, efficiency, and distribution. Simplicity and 
transparency help engender public trust that the government is 
being a good steward of the rents created through the cap and 
trade program.
    One particularly transparent and simple approach, 
allocation approach, would be a cap and dividend scheme, where 
permits are auctioned and the revenue is then returned to 
households through an equal carbon dividend check. This 
approach is similar in spirit to the economic stimulus checks 
provided to taxpayers in 2008.
    Another approach that I discuss elsewhere is to provide a 
capped credit of payroll taxes from auction revenue along with 
an adjustment to social security and transfer benefits for 
nonworkers.
    While a cap and dividend approach is both highly 
transparent and simple, it foregoes the opportunity to achieve 
important efficiency benefits by using the revenue to lower 
existing tax rates. A recent analysis I did with colleagues at 
the MIT Joint Program on the Science and Policy of Global 
Change illustrates the tradeoffs. Figure 2 in my testimony 
shows the distributional impacts of two allocation schemes.
    The first is a cap and dividend approach, while the second 
uses the revenue to reduce marginal income tax rates and 
thereby increase efficiency of the income tax system. The cap 
and dividend approach is distinctly progressive. This is the 
dashed line in that figure. Lower income households, which are 
at the left end of this figure, benefit on balance from the 
combination of carbon pricing and the carbon dividend.
    The solid line in this figure shows the net distributional 
impact of the income tax cut with carbon pricing. This policy 
is modestly regressive. More to the point, it blunts the sharp 
regressivity of carbon pricing, but it can't undo it 
altogether.
    While less progressive, cutting the income tax reduces the 
efficiency loss of the cap and trade system by over 12 percent 
in the modeling results that we did. These are but two of many 
possible allocation mechanisms.
    The next point is that allocation design can also have 
significant impacts on the overall efficiency of the program. 
Here a clear example is the design of mechanisms to provide 
benefits to electricity and natural gas consumers through local 
distribution companies. If poorly designed, the LDC rate relief 
may lead to consumer misperception that electricity and natural 
gas prices have fallen when in fact at the margin they're going 
up.
    We ran two different simulations of permit allocations for 
LDCs. In the first one we assumed that the LDCs are able to 
design the program to pass on the value of the permits that is 
correctly perceived by households that this is not lowering the 
price of energy, either electricity or natural gas. In other 
words, we're giving it back in a lump sum fashion unrelated to 
energy consumption.
    The second simulation treats the allocation as lowering the 
price of electricity or natural gas and thereby undoing this 
price signal that we want to send households.
    Finally, we report a simulation in which permits are freely 
allocated to covered sectors, as has been done in the European 
Union emission trading scheme and the acid rain program for 
SO2 trading in this country. Results are shown in 
figure 3 in my written testimony.
    The first thing to note is that free allocation of permits 
to covered sectors, as was done in the emission trading scheme 
in Europe, is sharply regressive. That is that solid line 
that's upward sloping, showing more benefits are accruing to 
high income households.
    If we carve out permits for LDCs to use for rate relief, 
this eliminates the regressivity in the lower half of the 
income distribution and blunts it in the upper half. If, 
however, the LDC program is misperceived to reduce electricity 
and natural gas prices for consumers, then every household is 
made worse off than when the policy is designed to avoid this 
misperception. The efficiency loss from consumer misperception 
of energy prices raises the costs of the cap and trade program 
by over 30 percent. So this speaks to the importance of policy 
design in writing the rules carefully to avoid this problem.
    Ideally, any allocation mechanism should address the 
regressivity of carbon pricing in a way that does not forego 
opportunities for gains in economic efficiency. However the 
balance between efficiency and equity is struck, it is 
important to avoid diluting the price signal required to 
achieve maximal emission reductions at minimal cost.
    Thank you very much.
    [The prepared statement of Mr. Metcalf follows:]
     Prepared Statement of Gilbert E. Metcalf, Ph.D., Professor of 
                Economics, Tufts University, Medford, MA
    Chairman Bingaman, Senator Murkowski, and Members of the Committee, 
thank you for the invitation to testify this morning on the issue of 
permit allocation in cap and trade systems. I wish to make the 
following points in my testimony today.

   The allocation of carbon revenues is a distinct question 
        from the choice of policy instrument (cap and trade, carbon 
        fee, hybrid systems). No particular approach constrains 
        Congress in any way from choosing different schemes and goals 
        for allocation of the scarcity value created by the cap 
        (analogous to the revenue from a carbon fee). In this regard, 
        past cap and trade programs provide too limiting a view of the 
        possible design choices.
   Allocation mechanisms differ on the basis of simplicity, 
        transparency, efficiency and distributional outcomes. All 
        things equal more simplicity and transparency is generally 
        better. While allocation rules have clear distributional 
        implications they can also have important efficiency 
        consequences.
   A cap and trade system acts much like a broad based energy 
        tax in raising the price of energy intensive commodities and 
        reducing returns to factors of production (labor, capital and 
        natural resource owners). Like a broad based energy tax, a cap 
        and trade system is likely to disproportionately impact 
        lowincome households. Addressing impacts on low-income 
        households should be an important element of any allowance 
        allocation scheme.
   Allocation design matters for efficiency as well as 
        distribution. Allocations to natural gas and electricity 
        customers through LDCs can blunt some of the impact of carbon 
        pricing but if not done carefully can raise the costs of 
        achieving targets significantly.
                             i. background
    The United States has taken important steps towards enacting 
comprehensive climate change policy. President Obama campaigned in 2008 
in part on a platform of reengaging in the international negotiations 
on climate policy and supported a U.S. cap and trade policy with 100 
percent auctioning of permits. Congress has moved rapidly in 2009 with 
the House of Representatives voting favorably on the American Clean 
Energy and Security Act of 2009 (H.R. 2454) in late June. Earlier this 
month Sens. Boxer and Kerry filed S. 1733, the Clean Energy Jobs and 
American Power Act. This bill also proposes a cap and trade system for 
greenhouse gases.
    Cap and trade legislation acts like a tax in raising the price of 
carbon based fuels and other covered inputs that release greenhouse 
gases. Raising the price of carbon based fuels is an essential 
component of a greenhouse gas control program. Higher prices send the 
appropriate market signals to consumers to reduce consumption of 
carbon-intensive products and to firms to adjust production processes 
to reduce greenhouse gas emissions. Higher prices serve as the tool in 
Adam Smith's invisible hand to guide the economy to more productive and 
socially efficient outcomes.
    The monies involved in a cap and trade program can be significant. 
The Congressional Budget Office estimated last June that H.R. 2454 
would increase federal revenues by nearly $850 billion between 2010 and 
2019. Since the bulk of permits are freely allocated in early years of 
the program, spending would also increase over that period by roughly 
$820 billion.\1\
---------------------------------------------------------------------------
    \1\ See Congressional Budget Office, ``H.R. 2454 American Clean 
Energy and Security Act of 2009 Cost Estimate,'' (Washington, DC: 
Congressional Budget Office, 2009) The CBO treats freely allocated 
permits as both revenue and spending. Ignoring impacts on other tax 
revenues the free allocation of $100 of permits would be scored as $100 
of revenue and $100 of spending. CBO's scoring approach is described in 
Congressional Budget Office, ``Assessment of Potential Budgetary 
Impacts from the Introduction of Carbon Dioxide Cap-and-Trade 
Policies,'' (Washington, DC: Congressional Budget Office, 2009).
---------------------------------------------------------------------------
    It is important at the outset to distinguish between the costs of 
reducing greenhouse gas emissions and the revenues that could be raised 
if permits are fully auctioned. Figure 1* illustrates the distinction.
---------------------------------------------------------------------------
    * Figures 1-3 have been retained in committee files.
---------------------------------------------------------------------------
    This graph shows how the cost of reducing greenhouse gas emissions 
rises as a program is made increasingly stringent. The curve labeled 
MAC shows the cost of abatement as emissions reductions rise measured 
in dollars per ton of carbon dioxide equivalent. For small cuts in 
emissions the cost of reducing emissions--and the resultant price for 
an emissions permit--is low. But as the required reductions rise so do 
the costs and the resultant permit price.
    Consider a cap and trade system that mandates a 25 percent 
reduction in emissions. The price of permits would equal p as shown in 
Figure 1. The value of the permits created in this program is the 
product of the permit price times the number of permits allocated or 
auctioned. This is shown in Figure 1 as the area of the rectangle A. 
This value would be received by the government if it were to auction 
all of the permits. It would be received by households and/or firms to 
the extent that the permits are freely allocated. Regardless of how the 
permits are allocated, they have a value equal to the area of this 
rectangle. Allocation rules simply determine who receives this permit 
value.
    The cost of the reduction in this figure is shown by the triangle 
labeled B. This is the actual cost to society of reducing greenhouse 
gas emissions. It includes the cost of using higher priced electricity 
generating sources that emit fewer greenhouse gas emissions per kWh of 
electricity, the costs of carbon capture and storage and the cost of 
improving vehicle efficiency in the transport system among other 
things.
    As Figure 1 makes clear the value of permits is quite different 
than the costs of reducing greenhouse gas emissions. The figure also 
makes a conceptual point that is borne out by a number of analyses of 
greenhouse gas control programs: the value of permits dwarfs the 
initial costs of greenhouse gas reductions. This simply reiterates the 
point that permit allocation is a very important topic for 
Congressional consideration.
                    ii. policy choice and allocation
    Much debate has ensued both in academic circles and in policy 
circles over the relative merits of cap and trade systems and carbon 
taxes for controlling greenhouse gas emissions.\2\ This is not a 
hearing about instrument design but it is worth making the following 
point: the choice of instruments is entirely distinct from the decision 
about allocation of the value of permits in a cap and trade system. 
This value--technically known as the scarcity value of emissions--can 
be allocated in exactly equivalent ways regardless of the choice of 
instrument used to impose a carbon price.\3\
---------------------------------------------------------------------------
    \2\ A recent symposium in the Review of Environmental Economics and 
Policy is but one example of this discussion. See the papers by 
Nathaniel Keohane, ``Cap and Trade, Rehabilitated: Using Tradable 
Permits to Control U.S. Greenhouse Gases ``Review of Environmental 
Economics and Policy 3, no. 1 (2009), Gilbert E. Metcalf, ``Designing a 
Carbon Tax to Reduce U.S. Greenhouse Gas Emissions,'' Review of 
Environmental Economics and Policy 3, no. 1 (2009), and Brian C. 
Murray, Richard G. Newell, and William A. Pizer, ``Balancing Cost and 
Emissions Certainty: An Allowance Reserve for Cap-and-Trade,'' Review 
of Environmental Economics and Policy 3, no. 1 (2009).
    \3\ See David Weisbach, ``Instrument Choice Is Instrument Design,'' 
(Washington, DC: American Tax Policy Institute, 2009) for discussion of 
this point.
---------------------------------------------------------------------------
    Conversely no particular approach constrains Congress in any way 
from choosing different schemes and goals for allocation of the 
scarcity value created by the cap (analogous to the revenue from a 
carbon fee). A decision by Congress to use a cap and trade system to 
control greenhouse gas emissions in no way limits Congress from 
allocating permits to achieve any desired policy goals. In this regard, 
past cap and trade programs provide too limiting a view of the possible 
design choices. The two major cap and trade systems in place are the 
U.S. Acid Rain Program and the European UnionEmission Trading Scheme. 
The Acid Rain Program requires permits for sulfur dioxide emissions 
from all significant electric generators. The EU Emission Trading 
Scheme requires permits from electricity generators and certain energy 
intensive industries. In both systems permits are allocated to the 
covered sectors at essentially no cost.
    That the two extant major cap and trade systems do not auction 
permits to any significant degree does not preclude Congress from 
auctioning permits for greenhouse gas emissions. Indeed the stakes for 
auctioning are much larger. The scarcity rents for either of these two 
existing systems are dwarfed by the projected rents from a U.S. cap and 
trade system. The real question before Congress is the best use of 
these scarcity rents. While the focus on revenue use is clear if 
permits are auctioned, the question is no less relevant if permits are 
freely allocated.
            iii. criteria for evaluating allocation systems
    Allocation systems can be assessed on a number of important policy 
dimensions. Four dimensions of particular importance are simplicity, 
transparency, efficiency and distributional outcomes. All things equal 
more simple and transparent systems are generally better. In its effort 
to achieve a variety of goals H.R. 2454 has designed an exceedingly 
complex allocation scheme that is far from transparent. Simplicity and 
transparency help engender public trust in a program that the 
government is being a good steward of the rents created through the cap 
and trade program.
    One particularly transparent and simple allocation scheme is a Cap 
and Dividend scheme whereby every U.S. household receives an equal 
carbon dividend check. This approach is similar in spirit to the 
economic stimulus checks provided to taxpayers in 2008. Payments could 
be made on an annual or quarterly basis to all individuals with a valid 
Social Security Number. Filing for the payment could be made quite easy 
as part of the income tax form 1040 and a simple one-page form for non-
income tax filers. Another approach that I discuss elsewhere is to 
provide a capped credit of payroll taxes along with an adjustment to 
Social Security and transfer benefits for non-workers.\4\
---------------------------------------------------------------------------
    \4\ This is described in Gilbert E. Metcalf, ``A Proposal for a 
U.S. Carbon Tax Swap: An Equitable Tax Reform to Address Global Climate 
Change,'' (The Hamilton Project, 2007).
---------------------------------------------------------------------------
    While a cap and dividend policy is both highly transparent and 
simple, it foregoes the opportunity to achieve important efficiency 
benefits by using the revenue to lower existing tax rates. The 
efficiency losses from taxes, referred to by economists as deadweight 
loss, rise with the square of the tax rate. So modest reductions in tax 
rates can have significant efficiency benefits. A large literature in 
Economics consistently demonstrates the efficiency benefits of using 
carbon revenue to lower existing tax rates.
    The trade-off between a cap and dividend approach and tax rate 
reduction approach illustrates a tension between achieving 
distributional and efficiency goals.
    While recycling greenhouse gas revenues through tax rate reductions 
has efficiency benefits, it may not fully offset the regressivity of 
carbon pricing. Carbon pricing, whether through a carbon tax or a cap 
and trade system, has similar distributional impacts as broad-based 
energy taxes. It disproportionately impacts lower income households for 
whom energy expenditures constitute a higher share of income than 
occurs for higher income households.
    A recent analysis I did with colleagues at the MIT Joint Program on 
the Science and Policy of Global Change illustrates the trade-offs.\5\ 
In our analysis we consider a variety of allocation schemes for a $15 
per ton of carbon dioxide equivalent (CO2e) cap and trade 
system covering all greenhouse gases. The model takes into account 
income sources for households of different income groups as well as 
spending patterns. A cap and trade system--like any greenhouse gas 
pricing system--will affect households by raising the prices of carbon-
intensive products and also potentially lower wages, resource rents and 
returns to capital. We model all of these impacts and trace income and 
spending changes to individual households sorted by income.
---------------------------------------------------------------------------
    \5\ Sebastian Rausch et al., ``Distributional Impacts of a U.S. 
Greenhouse Gas Policy: A General Equilibrium Analysis of Carbon 
Pricing,'' (Washington, DC: American Tax Policy Institute, 2009)
---------------------------------------------------------------------------
    Table 1 shows the income groups that we considered in the model. 
Our model is able to trace income and spending changes for the lowest 
income groups with household income less than $10,000 to the richest 
groups with household income in excess of $150,000. The model is 
calibrated to 2006 and all dollar amounts are reported in real 2006 
dollars.

                 TABLE 1.--INCOME GROUPS IN US-REP MODEL
------------------------------------------------------------------------
                                                   Cumulative Population
          Income class              Description     for whole US (in %)
------------------------------------------------------------------------
hh1                               Less than                         7.3
                                   $10,000
hh10                              $10,000 to                       11.7
                                   $15,000
hh15                              $15,000 to                       21.2
                                   $25,000
hh25                              $25,000 to $                     31.0
                                   $30,000
hh30                              $30,000 to                       45.3
                                   $50,000
hh50                              $50,000 to                       65.2
                                   $75,000
hh75                              $75,000 to                       78.7
                                   $100,000
hh100                             $100,000 to                      91.5
                                   $150,000
hh150                             $150,000 plus                   100.0
------------------------------------------------------------------------

    Figure 2 shows the distributional impacts of two allocation 
schemes. The first is a cap and dividend scheme where revenue from a 
fully auctioned cap and trade permit system is given back to households 
in a lump-sum fashion. Impacts are measured in dollars as a percentage 
of household income and include both the changes in costs of purchasing 
goods and services, changes in factor incomes and any deadweight loss 
from behavioral responses to pricing greenhouse gas emissions.\6\ 
Income changes include the check each household receives as its share 
of the permit revenue net of permit revenue kept by government to 
replace reductions in other taxes to maintain overall revenue 
neutrality in the U.S. government budget. The second uses the revenue 
to reduce marginal income tax rates.
---------------------------------------------------------------------------
    \6\ Technically we measure equivalent variation, a dollar based 
measure of the change in household wellbeing arising from the program. 
We divide this by a measure of full household income including the 
value of leisure and housing services.
---------------------------------------------------------------------------
    The cap and dividend approach is distinctly progressive (dashed 
line). Lower income households benefit on balance from the combination 
of carbon pricing and the carbon dividend. Net benefits as a percentage 
of annual income are between 0.1 and 0.2 percent for the lowest income 
households and fall to between -0.2 and -0.3 percent of income for the 
highest income households.
    While the cap and dividend allocation approach may be appealing on 
distributional grounds it foregoes any efficiency benefits resulting 
from lowering tax rates. The solid line in Figure 2 shows the net 
distributional impact of the income tax cut. This policy is modestly 
regressive. More precisely, the rebate of income tax revenue cannot 
undo the sharp regressivity of carbon pricing. Low income households 
lose between 0.15 and 0.25 percent of income while the loss for the 
highest income groups approaches zero. While less progressive, cutting 
the income tax reduces the efficiency loss of the cap and trade system 
by over twelve percent.
    These are but two of many possible allocation mechanisms. It is 
certainly possible to construct allocation schemes that combine tax 
rate reductions with allocations that address the regressivity of 
carbon pricing. However this is done it would be preferable to design 
as simple and transparent an allocation formula as possible.
                    iv. policy design and efficiency
    Allocation design can also have significant impacts on the overall 
efficiency of the cap and trade policy. A clear example here is the 
design of mechanisms to provide benefits to electricity and natural gas 
consumers through local distribution companies (LDCs). The American 
Clean Energy and Security Act of 2009 allocates roughly one-third of 
the permits to LDCs between 2012 and 2030 for consumer relief. The bill 
is clear that it does not intend this permit value to be used to lower 
electricity and natural gas rates. But it is less clear on how this 
value is to be distributed and how we avoid consumers misperceiving 
this value as a reduction in energy prices.
    If the value of the permits allocated to LDCs is returned to 
customers on their monthly bill it is quite likely that many consumers 
will misperceive this as a reduction in the price of consuming 
electricity and natural gas. To explore the consequences of a poorly 
designed program that energy consumers misunderstand, we ran two 
different simulations of allocations to LDCs. In the first one we 
assume that LDCs design a program to pass on the value of LDC permits 
that is correctly perceived not to lower the price of a kWh of 
electricity (or therm of natural gas). Rather the allocation is a lump 
sum allocation unrelated to individual household energy consumption. 
The second simulation treats the LDC allocation as lowering the price 
of electricity or natural gas. This leads to a smaller decline in 
energy consumption by LDC customers thereby leading to more expensive 
emission reductions elsewhere. Finally we also report a simulation in 
which permits are freely allocated to the covered sectors on the basis 
of historic emissions with no permits set aside for customer relief 
through LDCs. Results are shown in Figure 3.
    The first thing to note is that free allocation of permits to 
covered sectors on the basis of historic emissions is sharply 
regressive. This policy simulates permit allocations under the Acid 
Rain Program in the United States and the EU's Emission Trading Scheme. 
It is regressive because the free permit allocation conveys a windfall 
gain to owners of firms receiving those permits. Since capital is 
disproportionately held by higher income households the regressive 
outcome occurs.
    Carving out one-third of the permits for LDCs to use for rate 
relief eliminates the regressivity in the lower half of the income 
distribution and blunts it in the upper half. If, however, the LDC 
program is misperceived to reduce electricity and natural gas rates for 
consumers then every household is made worse off than when the policy 
is designed to avoid this misperception. This is a clear case where 
policy design matters in the details. The efficiency loss from consumer 
misperception of energy prices raises the costs of thecap and trade 
program by over thirty percent.\7\
---------------------------------------------------------------------------
    \7\ This understates the incremental efficiency loss as our 
simulations held permit prices fixed rather than emissions. Holding 
emissions fixed would have required increased costly reductions 
elsewhere to achieve the emissions target driving up the cost of the 
program further.
---------------------------------------------------------------------------
    Another area of concern is regional distribution. Here one must 
tread more cautiously. While it is tempting to allocate a portion of 
permits to different regions based on the costs those regions will face 
due to prior investment in carbon intensive technologies, we risk 
enshrining older carbon intensive technologies through subsides offered 
to provide rate relief to customers in those regions.
    If regional allocation adjustments are considered they should pass 
a number of tests. First, they should be temporary and short lived to 
provide the incentive to make a rapid transition to newer and cleaner 
technologies. Second, it would be preferable to provide benefits in the 
form of support for new technology substitution rather than customer 
rate relief. This would further speed the transition to a less carbon-
intensive regional economy. Third, any regional reallocations should 
take into account the fact that certain regions have become less carbon 
intensive as a result of past investments. Those investments have often 
led to higher energy prices now being borne by regional ratepayers. 
According to the Energy Information Administration, for example, 
Connecticut, New York and Massachusetts are ranked in the top five 
states for high residential electricity prices. These states receive a 
higher than average share of electricity from nuclear power plants.
                               v. summary
    Enacting a carbon price through a greenhouse gas emissions cap and 
trade system will help the United States move to a carbon free economy 
in the most efficient manner possible. Passing cap and trade 
legislation, therefore, should be at the top of the political agenda 
for Congress and the Administration. Thus it is laudable that the 
Senate Energy and Natural Resources Committee is holding these hearings 
on allocation.
    Key to thinking about allocations is that this is fundamentally a 
decision over the rights to the scarcity rents from restricting 
greenhouse gas emissions. These rents dwarf rents from any previous cap 
and trade program and so the allocation mechanism deserves careful 
study.
    I have argued in this testimony that past allocation decisions in 
those cap and trade programs should in no way constrain Congress as it 
designs allocation mechanisms in greenhouse gas legislation. Moreover 
it should strive to develop a simple andtransparent mechanism that 
engenders public trust in the stewardship of these public atmospheric 
rents.
    Any allocation mechanism should address the regressivity of carbon 
pricing ideally in a way that does not forego the opportunity for gains 
in economic efficiency through the possibility of tax rate reduction. 
However the balance between efficiency and equity is struck, it is 
important to design the mechanism carefully to avoid customer 
misperceptions that any return of allowance value is diluting the price 
signal required to achieve maximal emission reductions at minimal cost.
    I would be happy to answer any questions members of the Committee 
may have.Thank you for the opportunity to testify today.

    The Chairman. Thank you very much.
    Dr. Palmer.

   STATEMENT OF KAREN PALMER, DARIUS GASKINS SENIOR FELLOW, 
                    RESOURCES FOR THE FUTURE

    Mr. Palmer. Thank you, Senator Bingaman and Senator 
Murkowski and distinguished members of the panel, for this 
opportunity to testify today. I am a Senior Fellow at Resources 
for the Future. RFF neither lobbies nor takes positions on 
specific proposals, so the views I present today are my own.
    I'm going to focus on the effects of allocating 
CO2 emission allowances on the price of electricity 
and the overall cost of a CO2 cap and trade program. 
I want to make three points:
    First, the traditional approach that was used in title 4 
for SO2 allowances of allocating emission allowances 
for free to electricity generators will result in regional 
disparities in the electricity price effects of climate 
regulation. These disparities are the result of differences 
across States in how electricity markets are regulated.
    Second, allocating allowances to local distribution 
companies is one way to reduce regional disparities in 
electricity costs. However, this approach raises the overall 
cost of a climate policy relative to an allowance auction and 
tends to make households worse off.
    Third, a cap and dividend approach that grants some portion 
of the allowance value directly to households deserves serious 
attention. Such an approach can offset costs to households 
without raising overall costs of a climate policy and can be 
implemented in combination with other allowance approaches.
    Now I want to briefly explore each of these three points in 
a bit more detail. First, the regional disparity in price 
effects occur because utility regulators set electricity prices 
that do not reflect the value of allowances that a utility 
obtained free of charge in those States where prices are 
regulated. However, in States with deregulated electricity 
markets the value of emission allowances that are used to 
produce electricity will be reflected in electricity prices 
even if they were obtained for free. Thus a disparity arises 
across States.
    One approach to eliminating this disparity is to sell a 
larger share of allowances in an auction. This has the 
political disadvantage of raising electricity prices in States 
with regulated electricity generation markets.
    Allocating allowances to local distribution companies is 
another approach that overcomes regional differences due to 
regulation and is the option incorporated in H.R. 2454. Local 
distribution companies are the entities that distribute economy 
to households and businesses and they are regulated in all 
States, and there are also analogous entities for natural gas. 
As regulated entities, distribution companies are expected to 
return the value of the free allowances that they receive to 
their customers. As a result, in all States electricity costs 
to consumers are lower under this approach than with an 
auction.
    However, if these lower costs are perceived as lower prices 
they're going to come at a cost in terms of economic efficient. 
This is best illustrated by comparing to an allowance auction. 
With an allowance auction, consumers face the full cost of more 
CO2-intensive forms of electricity generation in the 
price they pay for electricity. As a result, an auction 
provides stronger signals for consumers to conserve economy, 
albeit at a political cost of higher electricity prices.
    Allocation to local distribution companies mutes the 
electricity price effects of cap and trade across the country. 
While this has political appeal, unfortunately it raises the 
overall cost of the policy relative to an allowance auction. To 
achieve the same level of domestic CO2 reductions, 
the CO2 allowance price could be as much as 12 to 15 
percent higher without allocation to local distribution 
companies as it would be with an allowance auction.
    Consumers will not be insulated from this higher overall 
cost. The smaller increases that they see in their electricity 
bills will be offset by higher increases in the price of 
gasoline and other goods and services. On average, households 
across the country are worse off as a result.
    Greater reliance on a cap and dividend approach can improve 
this situation for households and lower the overall cost of the 
policy. A cap and dividend approach distributes some portion of 
the allowance value directly to households through a mechanism 
other than the electric bill. This approach avoids the pitfalls 
of lowering electric bills and adversely affecting conservation 
incentives for consumers.
    Research at Resources for the Future suggests that 
narrowing the scope of allocation to both electric and natural 
gas distribution companies that's found in H.R. 2454 to focus 
exclusively on households and substituting a cap and dividend 
approach for those allowances currently apportioned on behalf 
of commercial and industrial customers to local distribution 
companies, as well as the allowance to low income households 
and to States for home heating oil distribution, could improve 
the efficiency of the policy and its effects on households.
    Such a reform of the H.R. 2454 allocation policy would 
reduce the CO2 allowance price in 2015 by roughly 14 
percent and lower the annual cost to households by nearly $80, 
which is roughly half the annual cost to households incurred 
under allocation to local distribution companies as currently 
specified in the legislation and that we find in our research.
    Thank you for the opportunity to testify today. I look 
forward to the discussion.
    [The prepared statement of Ms. Palmer follows:]
   Prepared Statement of Karen Palmer, Darius Gaskins Senior Fellow, 
                        Resources for the Future
                          summary of testimony
    This testimony focuses on the effects of different methods of 
allocating carbon dioxide (CO2) allowances on the price of 
electricity paid by consumers and the cost of a cap-and-trade program. 
The traditional approach of allocating emissions allowances to 
electricity generators will result in regional disparities in the 
electricity price effects of a climate policy, in part because of 
different regulatory frameworks across states. In those states where 
prices are set by regulators, the price of electricity will not reflect 
the value of emissions allowances that the utility obtained free of 
charge. However, in regions with deregulated generation markets, the 
value of emissions allowances used to produce electricity will be 
reflected in the electricity price even if they were received for free. 
Two ways to reduce this disparity are to auction a greater share of 
allowances or to allocate allowances to local distribution companies 
instead of to generators. As regulated entities, local distribution 
companies are expected to pass the value of the free allocation on to 
their customers, thus reducing the impact of a cap-and-trade policy on 
electricity consumers. However, this approach is likely to result in 
higher allowance prices and thus could ultimately leave households 
worse off than they would be if more allowances were auctioned. Greater 
reliance on a cap-and-dividend approach, under which a portion of the 
value of emission allowances is distributed to households on a per 
capita basis, could improve the delivery of compensation to households 
and lower the overall cost of the policy.
                               testimony
    Mr. Chairman, thank you for the opportunity to testify before the 
Senate Committee on Energy and Natural Resources. My name is Karen 
Palmer, and I am a senior fellow at Resources for the Future (RFF), a 
57-year-old research institution based in Washington, DC, that focuses 
on energy, environmental, and natural resource issues. RFF is 
independent and nonpartisan, and shares the results of its economic and 
policy analyses with environmental and business advocates, academics, 
government agencies and legislative staff, members of the press, and 
interested citizens. RFF neither lobbies nor takes positions on 
specific legislative or regulatory proposals. I emphasize that the 
views I present today are my own.
    From both scholarly and practical perspectives, I have studied the 
performance of emissions cap-and-trade programs, including evaluation 
of the sulfur dioxide (SO2) emissions allowance trading 
program created by the 1990 Clean Air Act Amendments. I have conducted 
analysis and modeling to support both state and regional efforts to 
design trading programs, including the Regional Greenhouse Gas 
Initiative in the Northeast and the California carbon dioxide 
(CO2) cap-and-trade program under AB32. Currently I serve on 
the New York State RGGI Advisory Committee, advising the New York State 
Energy Research and Development Authority on how to use the RGGI 
allowance auction revenue, and on the New York State Independent System 
Operator Environmental Advisory Council. Additionally, I serve on the 
EPA Science Advisory Board's Environmental Economics Advisory Council. 
Recently, with colleagues at RFF, I have conducted economic analysis of 
mechanisms to contain the costs and the variability of costs of 
implementing climate policy.
    Today I will focus on the effects of different methods of 
allocating CO2 allowances on the price of electricity paid 
by consumers and the cost of a cap-and-trade program. The electricity 
sector is responsible for 40 percent of U.S. CO2 emissions, 
but, according to the recent EIA analysis of the Waxman Markey cap-and-
trade bill, it will be responsible for over 80 percent of total 
domestic CO2 emissions reductions from energy use during the 
early years of the program.
    I want to highlight four main points about cap and trade and 
allowance allocation within the electricity sector:

   The traditional approach of allocating emissions allowances 
        to electricity generators will result in regional disparities 
        in the electricity price effects of a climate policy, in part 
        because of different regulatory frameworks across the states.
   There are different approaches to dealing with these 
        disparities that have different consequences for economic 
        efficiency.
   Allocating allowances to local distribution companies, the 
        approach included in the American Clean Energy and Security Act 
        (H.R. 2454), addresses this issue, but in a way that increases 
        cost for the economy as a whole. The particulars of the 
        approach outlined in the legislation may be difficult to 
        implement in practice.
   Greater reliance on a cap-and-dividend approach, under which 
        a portion of the value of emission allowances is distributed to 
        households on a per capita basis, will achieve the goal of 
        compensating consumers and do so at a lower cost.

    The allowances created by an emissions cap-and-trade program could 
be allocated in several different ways. Historically, under most cap-
and-trade programs, including the Title IV SO2 program and 
the first and second phases of the EU Emissions Trading Scheme, 
allowances have been primarily distributed for free to electricity 
generators based on some fixed measure of historic fuel use or 
emissions levels. One notable exception to this practice is the 
Regional Greenhouse Gas Initiative (RGGI), a program to cap emissions 
of CO2 from electricity generators in ten northeastern 
states that took effect in the beginning of this year. Nearly 90 
percent of the CO2 allowances created by RGGI are sold in a 
series of quarterly auctions. The auction approach will also be used to 
distribute a majority of the allowances in the next phase of the EU 
Emissions Trading Scheme.
    addressing regional disparities in electricity price effects of 
                             climate policy
    Allocating allowances for free to generators will have differential 
impacts on electricity prices across states depending on how 
electricity generation markets are regulated. In those states where 
prices are set by regulators based on average cost of supply, the price 
of electricity will not reflect the value of emissions allowances that 
the utility obtained free of charge. Regulated utilities are only 
allowed to recover costs that they actually incurred (plus an allowed 
regulated rate of return on investments) from utility customers. 
However, in regions with deregulated generation markets, the value of 
emissions allowances used to produce electricity will be reflected in 
the electricity price even if they were received for free. Thus, a 
federal cap-and-trade policy with free allocation to generators will 
have an uneven effect on electricity prices across states. The effect 
would be striking. The change in electricity prices around the country 
would depend more on regulation and market structure than on the 
CO2 emissions associated with electricity generation and 
consumption.
    One way to reduce the differences in price effects across states 
would be to auction a greater share of the allowances. Auctioning and 
free allocation have similar effects on electricity prices in states 
with deregulated electricity markets. There, electricity producers will 
charge a price for electricity that makes it worthwhile to use an 
allowance to produce electricity instead of selling the allowance to 
another firm for its full value. In regulated regions, when generators 
have to pay for the allowances that they require to produce 
electricity, the costs of those allowances also will be reflected in 
the prices consumers pay for electricity. So, the disparity across 
states in price effects will be reduced, but it will lead to higher 
prices for consumers in regulated regions.
    Note that moving from free allocation to generators to greater use 
of an auction will reducedifferences across states in the effect of the 
CO2 regulation on electricity price, but it will not 
eliminate those differences. Price impacts will vary across regions 
depending importantly on the mix of fuels used to supply electricity in 
the state. Generally the states with the most CO2-intensive 
generation--those that rely largely on coal--tend to be the states with 
lower costs. Research that I've conducted with colleagues at RFF 
indicates that even when 100 percent of the allowances are sold in an 
auction, consumers in those coal-intensive states continue to have 
electricity prices that are well below the national average as shown in 
Exhibit 1.* This figure displays the anticipated regional electricity 
price impacts of a cap-and-trade program like Waxman Markey, but 
assuming that 100 percent of the allowances are sold in an auction. 
Regions are arrayed according to the emissions intensity of electricity 
generation. Not surprisingly, those regions with the greatest 
CO2 intensity have the largest price effects, but it is 
worth noting that they continue to have electricity prices well below 
the national average.
---------------------------------------------------------------------------
    * All exhibits have been retained in committee files.
---------------------------------------------------------------------------
    Allocating allowances to local distribution companies is another 
approach that overcomes regional differences due to regulation and is 
the option incorporated in H.R. 2454. Local distribution companies are 
the regulated entities that distribute electricity to households and 
analogous entities exist for natural gas. These companies are regulated 
everywhere, even in states where electricity generation markets have 
been deregulated. As regulated entities, the distribution companies are 
expected to act in the public interest and thus to return the value of 
any emissions allowances that they receive for free to the customers 
that they serve. This approach will cushion the price impacts of a 
climate policy for electricity consumers in both deregulated and 
competitive regions, and can eliminate regional disparities in the 
price effects of a cap-and-trade regulation.
    Exhibit 2 illustrates the distribution of price impacts of a cap-
and-trade program according to the size of the market subject to a 
price effect of the magnitude indicated in the categories on 
thehorizontal axis. The top panel shows that under the auction the 
price impacts are largest, but theyare fairly similar between regulated 
regions (indicated by blue) and deregulated regions (indicated by 
yellow and labeled as competitive). The middle panel shows how 
allocating allowances for free to generators helps consumers in 
regulated regions, but not in deregulated regions. The last panel shows 
how allocation to local distribution companies can lower the 
electricity price effects and restore symmetry in impacts between 
regulated and deregulated regions.
               efficiency effects of allowance allocation
    So far I have focused on the distributional effects of allocation 
on electricity prices across regions, but there are important economic 
efficiency consequences that should not be overlooked. An auction 
approach to allocation will yield the most efficient outcome because it 
ensures that the full costs of more CO2-intensive forms of 
electricity generation are passed along to electricity consumers. Under 
this approach, consumers have a sense of the true costs of the 
electricity they use and thus have the appropriate incentives to reduce 
their consumption. However, this alignment of incentives is achievable 
only at the political cost of higher electricity prices.
    Allocation to local distribution companies mutes the electricity 
price effects of cap and trade across all regions of the country and 
while this has political appeal, unfortunately it raises the cost of a 
cap-and-trade policy overall relative to an auction approach. This 
increase in overall cost occurs because when consumers see lower 
electricity prices, they have less incentive to conserve electricity 
and generators will use more CO2 allowances. Greater 
emissions reductions will have to come from other sectors and this will 
raise the cost of emissions allowances. As indicated in the bottom 
panel of Exhibit 2, in order to achieve the same level of domestic 
reductions, the CO2 allowance price could be as much as 12 
percent to 15 percent higher with allocation to local distribution 
companies as it is with an allowance auction. Consumers will not be 
insulated from this higher overall cost. The smaller increases that 
they see in their electricity bills as a result of allocation to 
distribution companies will come at the cost of higher increases in the 
price of gasoline and goods and services that have a high 
transportation cost component.
    Hence, it is important to ask the question: Are households better 
off because of the effort to subsidize their electricity prices? In 
fact, on average, they are worse off because the value of other goods 
and services will be higher as a result and households will face a 
greater overall cost from climate policy.
 important issues related to allocation to local distribution companies
    Despite these efficiency concerns, allocation to local distribution 
companies has many proponents, especially as a transition strategy to 
soften the impact on household electricity costs in the near term and 
give consumers an opportunity to adopt more efficient appliances as 
existing ones wear out. In that spirit, H.R. 2454, which initially 
allocates 30 percent of the allowances to electric distribution 
companies and another 9 percent to natural gas distributors, calls for 
allocation to local distribution companies to last until 2026, when it 
begins to phase out, and it will be completely phased out by 2030. The 
logic of a transition period has appeal, but the twenty-year horizon is 
much longer than necessary to provide the opportunity for households 
and businesses to make a transition to more efficient capital 
investments. H.R. 2454 also includes some provisions that seek to limit 
the extent to which this approach to allocation mutes incentives for 
conservation. The details of these provisions and other aspects of how 
the policy is implemented have important implications for consumers.
    One important feature of allocation to local distribution companies 
is the basis for apportionment of the allowances among companies. How 
this approach to allocation affects consumers in different regions will 
depend on the basis for the apportionment. A variety of different 
metrics are available. For example, if allowances are apportioned based 
on the share of the national population within a distribution company's 
service territory, then consumers in more populous states will benefit 
relative to those in other parts of the country. If allowances are 
apportioned based on the emissions intensity of electricity consumed 
within a distribution company's territory, the coal-intensive states 
will see more of the benefit. In H.R. 2454, apportionment to local 
distribution companies is based on a combination of two criteria: 
electricity consumption and CO2 emissions, with each having 
a 50 percent share. Our research suggests that thisapproach results in 
higher effective per kWh subsidies to utilities in the Midwest and the 
lowestsubsidies to utilities in the Northeast and on the west coast.
    The second important feature is related to how allowance values 
appear on monthly electricity bills. The goal of allocation to local 
distribution companies is to compensate households for the costs 
imposed by climate policy. If this compensation could be distributed in 
a form that is independent of the amount of electricity that a consumer 
purchases--in other words as a fixed amount of money per month--then, 
in theory, it would not diminish consumers' incentives to conserve 
electricity relative to an auction approach. H.R. 2454 seeks to make 
this happen by directing that the allowance value be used to reduce the 
fixed part of the electricity bill ``to the maximum extent possible.''
    In practice, however, this approach is nearly unworkable. The 
organization and presentation of electricity bills are the prerogative 
of the local distribution companies with oversight from state public 
utility commissions. Electricity bills typically do not separate the 
fixed and variable portions of the charge in this way, especially for 
residential class customers. Exhibit 3 provides an example of a recent 
residential bill from Maryland. In order to see how the total bill 
breaks down into different categories of cost, we have to go to the 
second page of the bill. What we find is very little in the way of 
fixed charges. Even the parts of the bill for arguably fixed costs 
(those that don't vary with the amount of electricity consumed) such as 
distribution tend to be expressed in volumetric terms. The two 
exceptions to this are the small monthly customer charge of $6.65 and 
the $2.75 RGGI credit, which is a distribution of a portion of the RGGI 
CO2 allowance auction revenue back to Maryland electricity 
consumers. This leaves a net of just under $4.00 per month in fixed 
charges, roughly 2.5 percent of the total $161 bill. This suggests 
little room for a fixed charge refund and little reason to believe that 
the customer would be able to find it if it were there.
    Moreover, arguably, most customers don't read page two when they 
pay their electric bills. As a busy soccer mom and professional woman I 
can tell you that customers do not tend to distinguish between the 
fixed and variable components of the bill. Instead they focus on the 
total bill or, perhaps, the average charge per kWh if that information 
is presented. If either of those goes down, customers probably figure 
that electricity got cheaper and their consumption would be likely to 
increase based on these simple measures of electricity cost.
    The problem is compounded further if one appreciates the incentives 
that a fixed-charge rebate creates for a proliferation of customer 
accounts. Property owners may have an incentive to open new accounts to 
earn additional rebates. In addition, households vary substantially in 
size and composition. A rebate that is fixed on a per-account basis 
will not match any criteria of equity with respect to household 
composition. Finally, we cannot ignore the enormous numbers of families 
in multi-unit residential buildings. While economists would argue the 
benefits of separate metering for these buildings, it is often not 
done. A rebate per account would invite controversy and strategic 
behavior as a consequence.
    One might expect more sophisticated behavior from commercial-and 
industrial-class customers, who might recognize their true marginal 
production costs. The implementation of the rebates to consumers, 
however, will require oversight of state-level public utility 
commissions to determine, for example, how much of a rebate to the 
fixed portion of a bill a large customer should receive compared to a 
small customer. If they were to receive the same size rebate it would 
seem unfair, or even potentially absurd if they were of very different 
size. But, if they receive different rebates, then those rebates would 
actually hinge on the volume of electricity they consume, so we are 
right back at the beginning. H.R. 2454 acknowledges this complication 
for industrial customers, and the final version of the proposed 
legislation allows for rebates to industrial customers to be placed in 
the variable portion of the bill. In any case, the final outcome of 
this particular feature of implementation actually will be decided in 
50 different ways across the states, where Public Utility Commissions 
interpret their missions to protect the public in different ways. The 
outcome is beyond the reach and determination of the legislation as 
currentlyspecified.
          cap and dividend and other uses of allowance revenue
    If, as noted above, the ultimate goal of allocation to local 
distribution companies is to compensate residential electricity 
consumers for the costs imposed by a climate policy, then another way 
to achieve that compensation would be to distribute some portion of the 
value of the allowances directly to households through a mechanism 
other than the electric bill. Such an approach, known as cap and 
dividend, would avoid the pitfalls of lowering electric bills and 
incentives to conserve and yet would help to offset higher costs of 
electricity and other energyintensive goods and services that 
households consume.
    Research at RFF suggests that narrowing the scope of allocation to 
local energy distribution companies and substituting a cap-and-dividend 
approach for it could improve both the efficiency and effects on 
households of the policy. Such an approach redirects the portion of the 
allowance value going to local distribution companies (both electric 
and gas) intended for ultimate distribution to commercial and 
industrial electricity consumers, as well as the portion scheduled to 
go to home heating and low-income households, to a cap-and-dividend 
allocation, leaving only the residential portion of allocation to local 
distribution companies intact. Such a reform of the H.R. 2454 policy 
would improve its efficiency, reducing the CO2 allowance 
price by roughly 14 percent in 2015, and lowering the annual cost to 
households by nearly $80, roughly half of the cost they incur under 
allowance allocation to local distribution companies as specified in 
the legislation.
    Allowance revenues could also be used for a host of other purposes. 
One approach that is popular with economists would be to use allowance 
revenue to lower income taxes. This would bring economic efficiency 
benefits because it reduces the disincentives for work and productive 
activity associated with income taxation. Another option would be to 
use some portion of allowance revenue to promote program goals through 
direct investment in research and development in clean energy 
technologies or by providing tax breaks for private research and 
development as well as direct investment in new technologies for 
particularly vulnerable industries. In several of the RGGI states, a 
large portion of the CO2 allowance revenue is being directed 
toward investment in energy efficiency programs and this policy 
experiment shouldprovide important lessons for federal initiatives in 
this regard.

    The Chairman. Thank you very much.
    Dr. Stone, go right ahead.

STATEMENT OF CHAD STONE, CHIEF ECONOMIST, CENTER ON BUDGET AND 
                       POLICY PRIORITIES

    Mr. Stone. Thank you. Chairman Bingaman, Senator Murkowski, 
and other members of the committee, thank you for the 
opportunity to testify on this important topic. I am Chief 
Economist at the Center on Budget and Policy Priorities, a 
public policy organization working on budget and policy issues 
at the Federal and State level with a special emphasis on low-
income programs.
    One of the key messages you've heard today is that there 
are two important aspects to how a cost-effective climate 
policy like cap and trade affects consumers. The first is the 
effect due to putting a price on carbon, i.e., making it more 
expensive to continue to use dirty energy. The second is the 
effect due to how the emissions allowances that are the 
instrument for enforcing the cap on emissions are allocated or 
howe the revenue arising from auctioning them is used. Trying 
to judge the effect of the policy on consumers by focusing on 
just one or the other side of this equation will give an 
incomplete and misleading picture.
    My testimony focuses on how these two effects play out, 
with a special emphasis on low income households. The essential 
points of my testimony can be summarized as follows. They're 
elaborated on in my complete statement, my written statement.
    First, low income households bear a disproportionate burden 
of the costs associated with effective policies to reduce the 
use of carbon-based energy because they spend a higher 
proportion of their budgets on energy and energy-intensive 
goods and services than higher income households do. That's the 
cost from putting a price on carbon's side of the equation.
    The bad news is there without well-designed policies to 
offset the impact of these costs on low income households' 
budgets, policies that are effective at controlling greenhouse 
gas emissions and achieving the benefits of fighting global 
warming could push more families into poverty and make many of 
those who are already poor still poorer.
    The good news--and this is important--is that this dire 
outcome is preventable. There are effective ways to use a 
portion of the revenue that can be captured through the 
auctioning of emissions allowance to protect low income 
households. That's the ``how do you use emissions allowances'' 
side of the equation. So you have the costs, but you can offset 
the impact of those costs on vulnerable populations through the 
wise use of emissions allowance value.
    The Waxman-Markey bill passed by the House contains 
provisions to do just that, using existing mechanisms with 
widespread reach to deliver benefits efficiently to the most 
vulnerable households. My written testimony contains a detailed 
discussion of the principles for effective low income relief 
that we at the Center on Budget Policy Priorities have 
developed based on our experience over the years in designing 
and evaluating low income policies.
    In the House bill, low income households receive their 
share of the benefits from the free allocation of allowances to 
utilities that is the main form of broad-based consumer relief 
in the bill. But that falls far short of filling the gap in the 
budgets of low income households from putting a price on 
carbon.
    The main policy in the House bill that helps low income 
households is the direct energy refund delivered through the 
existing electronic benefit transfer systems, or EBT, that 
States use to deliver food stamp benefits and a variety of 
other cash assistance. Together with the utility-based relief, 
this direct refund provision ensures that the average person in 
the poorest fifth of the population does not incur financial 
loss as a result of climate change legislation.
    I would add as an aside that it's important to ensure that 
States have adequate resources to administer programs that will 
fall under their responsibility.
    Special attention to protecting low income households 
remains essential when policymakers consider broad-based 
consumer relief that extends farther up the income scale to 
middle income households. As I have just described, for 
example, the House recognized that the utility-based relief it 
relied on to provide broad-based consumer relief was 
insufficient by itself to fully protect low income households.
    It is also essential to have an effective delivery 
mechanism for reaching low income households. Tax-based 
policies alone, for example, would fail to reach the millions 
of low income households that do not file tax returns. 
Similarly, making sure that you have the right delivery 
mechanism is one of the most important challenges in a cap and 
dividend approach also for reaching those populations that are 
generally not easy to each in the low income group.
    My written testimony elaborates on a number of these 
points, and in wrapping up I would like to point to a couple of 
other things. First, last week you heard testimony about the 
effects of climate policy on the economy generally. My reading 
of the evidence is that the net cost per household on an 
economy-wide basis is relatively modest, especially in early 
years. But it is important to remember that that relatively 
modest net cost--that's the triangle in Dr. Metcalf's 
testimony; we economists are big on sophisticated mathematics, 
like triangles and rectangles.
    But it is important to remember that the relatively modest 
net cost is composed of a gross cost from putting a price on 
carbon and a gross financial benefit from how the allowance 
value is used. How the allowance value is used will determine 
the distribution of costs and benefits, and that can differ 
greatly among different policies, also as Dr. Metcalf's 
testimony pointed out.
    Second, my testimony contains a more detailed discussion of 
the policy advantages of direct refunds to consumers over other 
approaches to providing consumer relief and in particular 
echoes some of the concerns you have heard about the utility-
based relief that's in the House bill, the LDC allocation.
    Finally, as the Senate moves forward with its deliberations 
I hope that they will build on the solid foundation of low 
income assistance that is in the House bill. I discuss things 
in my testimony that can be done to improve on that policy and 
to extend relief farther up the income scale to moderate income 
households. But the basic structure of providing a benefit to 
all eligible households that is adequate to offset their 
average loss of purchasing power and to use a portion of the 
allowance value to fund that benefit is critical to meeting the 
key goal of ensuring that the policies necessary to reduce 
greenhouse gas emissions do not add to the hardship of people 
who are already experiencing substantial hardship and are 
already struggling to get by.
    Thank you and I look forward to the questions.
    [The prepared statement of Mr. Stone follows:]
Prepared Statement of Chad Stone, Chief Economist, Center on Budget and 
                           Policy Priorities
    Chairman Bingaman, Ranking Member Murkowski, and other members of 
the Committee, thank you for the opportunity to testify on this 
important topic. The focus of my testimony will be on how low-income 
households will be affected by climate change policy and the allocation 
of greenhouse gas emissions allowances.
    The essential points of my testimony can be summarized as follows:

   Low-income households bear a disproportionate burden of the 
        costs associated with effective policies to reduce the use of 
        carbon-based energy because they spend a higher proportion of 
        their budgets on energy and energy-intensive goods and services 
        than higher-income households do.
   The bad news is that without well-designed policies to 
        offset the impact of those costs on low-income households' 
        budgets, policies that are effective at controlling greenhouse 
        gas emissions and achieving the benefits of fighting global 
        warming could push more families into poverty and make many of 
        those who already are poor still poorer.
   The good news is that this dire outcome is preventable. 
        There are effective ways to use a portion of the revenue that 
        can be captured through the auctioning of emissions allowances 
        to protect low-income households.
   The Waxman-Markey bill passed by the House contains 
        provisions that do just that, using existing mechanisms with 
        widespread reach to deliver benefits efficiently to the most 
        vulnerable households. The House provisions ensure that the 
        average person in the poorest fifth of the population does not 
        incur a financial loss as a result of climate change 
        legislation.
   Special attention to protecting low-income households 
        remains essential when policymakers consider broad-based 
        consumer relief that extends to middle-income households. The 
        House, for example, recognized that the utility-based relief it 
        relied on to provide broad-based consumer relief was 
        insufficient by itself to fully protect low-income households.

    Similarly, tax-based policies alone would fail to reach the 
millions of low-income households that do not file tax returns. The 
challenge in a cap-and-dividend approach is how to design a delivery 
mechanism that reaches low-income households.
    In the rest of my testimony, I elaborate on these points with 
further discussion of the impact of cap-and-trade on households. I then 
describe the principles the Center on Budget and Policy Priorities has 
developed for designing concrete proposals for low-income relief and 
how those principles are implemented in the House climate bill. 
Finally, I discuss the advantages that direct refunds, like those in 
the low-income provisions of the House bill, have over other ways of 
delivering consumer assistance.
               the impact of cap-and-trade on households
    The key points I want to make about the impact of cap-and-trade on 
households are illustrated by the information in the chart* above. The 
data in the chart come from the Congressional Budget Office's analysis 
of the House bill and were part of CBO Director Elmendorf's testimony 
before this committee last week.\1\ The yellow lighter-shaded negative 
bars show the hit as a percentage of household income to the average 
household in different parts of the income distribution from putting a 
price on carbon. The blue darker-shaded positive bars show CBO's 
estimate of the financial benefits flowing to the average household in 
different parts of the income distribution as a result of how the House 
bill allocates emissions allowances and uses the revenue from auctioned 
allowances. The markers on the line identify the net costs or benefits 
in different parts of the income distribution, which are the proper 
measure of the distributional impact of the complete policy. As always 
in these kinds of analyses it is important to remember that these 
estimates do not include the benefits that are the raison d'etre of the 
whole policy--the economic, environmental, and security benefits that 
derive from encouraging the transition to a clean energy economy.
---------------------------------------------------------------------------
    * Graphic has been retained in committee files.
    \1\ Statement of Douglas W. Elmendorf, Director, ``The Economic 
Effects of Legislation to Reduce Greenhouse-Gas Emissions,'' before the 
Committee on Energy and Natural Resources, United States Senate, 
October 14, 2001, Table 2, page 26.
---------------------------------------------------------------------------
    The bars at the extreme right of the chart show that, on average, 
across all households, the costs associated with capping emissions are 
somewhat larger than the financial benefits that are available to be 
distributed through the use of emissions allowance value. Thus, there 
is a modest net cost to the economy (before accounting for the economic 
and environmental benefits of capping emissions) over and above what 
can be recycled back to households through the use of allowance value. 
This net cost, not the gross cost due to the cap, is the right measure 
of the average cost per household of the policy, because it takes into 
account the financial benefits from the use of allowance value to 
offset much of the costs due to higher energy prices. However, the fact 
that the net costs per household are modest on an economy-wide basis is 
not sufficient to conclude that the costs to vulnerable populations 
would be small without explicit policies to protect them.
    As the chart illustrates, low-income households experience the 
gross costs of the policies necessary to reduce greenhouse gas 
emissions more acutely than higher-income households do. In dollar 
terms, the impact is smaller for these households because their income 
and consumption are smaller. But as a share of their income, as the 
chart shows, the impact is substantially greater.
    Without any compensating financial relief to low-income households, 
the burden of these costs would increase poverty and hardship. 
Fortunately, the House bill delivers sufficient financial benefits to 
the poorest 20 percent of the population, that, on average, these 
households do not incur a net financial loss, but rather receive a 
small net financial gain. (Even with this positive average net benefit 
for the bottom quintile, however, there inevitably still will be many 
low-income households whose individual costs are not fully offset by 
the benefits they receive.)
    The net distributional impacts shown in the chart depend heavily on 
the specific emissions allocation decisions made in the House bill. 
Under that bill, 15 percent of emissions allowance value is set aside 
explicitly for low-income energy refunds. These refunds are the 
principal reason that the average low-income household does not suffer 
a net financial loss. If, for example, this allowance value had been 
used instead for additional utility-based relief spread uniformly 
across the population, low-income households would have been net losers 
on average. Similarly, if a smaller percentage of allowance value were 
devoted to low-income relief and the average low-income refund were 
smaller, more low-income households would incur net losses and the size 
of the losses for those who incur them would be larger.
    Decisions about how to use allowance value involve trade-offs. For 
example, analysis indicates that the net economy-wide costs of limiting 
emissions can be lowered some by using allowance value to reduce 
marginal income tax rates. However, the benefits from reducing tax 
rates are skewed toward high-income taxpayers, and low-income 
households will be worse off than shown in the chart (and very likely 
net losers) because they do not benefit from the lower costs to the 
economy. Conversely, if most of the allowance value is used for per 
capita rebates or direct tax credits and refunds based on household 
size rather than income, the benefits flowing to low-and moderate-
income households will be even larger than those shown in the chart, 
and the benefits to upper income households will be smaller.
     principles of low-income relief implemented in the house bill
    Much of the Center on Budget and Policy Priorities' work on climate 
change policy has focused on developing concrete proposals to shield 
low-income households from increased poverty and hardship in a way that 
is effective in reaching them, efficient (with low administrative 
costs), and consistent with energy conservation goals.\2\ Our work has 
been guided by the following six principles:
---------------------------------------------------------------------------
    \2\ See Sharon Parrott, Dottie Rosenbaum and Chad Stone, ``How to 
Use Existing Tax and Benefit Systems to Offset Consumers' Higher Energy 
Costs Under an Emissions Cap,'' Center on Budget and Policy Priorities, 
April 20, 2009.

          1. Protect the most vulnerable households.--Climate change 
        legislation should not make poor families poorer or push more 
        people into poverty. To avoid that outcome, climate refunds 
        should be designed to fully offset higher energy-related costs 
        for low-and moderate-income families.
          2. Use mechanisms that reach all or nearly all eligible 
        households.--Eligible working households could receive a 
        climate refund through the tax code, via a refundable tax 
        credit. But many other households are elderly, unemployed 
        (especially during recessions), or have serious disabilities 
        and are not in the tax system. Climate refunds need to reach 
        these households as well. Hence, the primary mechanism for 
        reaching low-income households should be a broad mechanism that 
        does not rely on the tax code.
          3. Minimize red tape. Funds set aside for consumer relief 
        should go to intended beneficiaries, not to excessive 
        administrative costs or profits.--Accordingly, policymakers 
        should provide assistance to the greatest degree possible 
        through existing, proven delivery mechanisms rather than new 
        public or private bureaucracies.
          4. Adjust for family size.--Larger households should receive 
        more help than smaller households because they have higher 
        expenses. Families with several children will generally consume 
        more energy, and consequently face larger burdens from 
        increased energy costs, than individuals living alone. Various 
        other tax benefits and means-tested assistance vary by 
        household size; this one should as well.
          5. Do not focus solely on utility bills.--For low-and middle-
        income households, higher home energy prices will account for 
        less than half of the total hit on their budgets from a capand-
        trade system. This is because goods and services across the 
        economy use energy as an input or for transportation to market. 
        Furthermore, about 20 percent of the households in the bottom 
        quintile of the income spectrum have their utility costs 
        reflected in their rent, rather than paying utilities directly. 
        Policymakers should structure climate refunds so they can help 
        such families with the rent increases they will face as a 
        result of climate policies, as well as with the higher prices 
        that households will incur for gasoline and other products and 
        services that are sensitive to energy costs.
          6. Preserve economic incentives to reduce energy use 
        efficiently.--Broad-based consumer relief should provide 
        benefits to consumers to offset higher costs while still 
        ensuring that consumers face the right price incentives in the 
        marketplace and reduce fossil-fuel energy consumption 
        accordingly. A consumer relief policy that suppresses price 
        increases in one sector, such as electricity, would be 
        inefficient, because it would blunt incentives to reduce fossil 
        fuel use in that sector. That would keep electricity demand 
        elevated relative to what it would be if consumers saw 
        electricity prices rise, and it would place a greater burden on 
        other sectors and energy sources to provide the emissions 
        reductions the cap requires. The result would be that emissions 
        reductions would be more costly to achieve overall and 
        allowance prices would be higher. Consumers might pay less for 
        electricity, but prices would rise still more for other items.

    With these goals in mind, the Center has designed a ``climate 
refund'' that would efficiently offset the average impact of higher 
energy-related prices on low-and moderate-income households. That 
refund would be delivered each month to very low-income households 
through state Electronic Benefit Transfer (EBT) systems, which are 
essentially debit card systems that states already use to provide food 
stamps, TANF, and other forms of assistance to low-income families, the 
elderly, and others. The EBT mechanism is the centerpiece of a climate 
refund proposal because of its unique ability to reach large numbers of 
low-income households (including those that are outside the tax 
system). Proposals to reach low-income working households and others 
farther up the income scale need to rely on additional mechanisms, 
particularly refundable tax credits.
    The climate bill passed by the House provides robust protection to 
low-income households consistent with these principles.\3\ The bill 
uses proceeds from the sale of 15 percent of the emissions allowances 
to reimburse low-income households for the higher costs they will face 
for energy and energy-intensive goods and services under the bill. This 
low-income assistance is in addition to relief that would be provided 
to all consumers, regardless of income, by provisions in the bill that 
give free emissions allowances to retail electric and gas companies 
(called local distribution companies, or LDCs) for the purpose of 
providing their customers with relief on their utility bills.
---------------------------------------------------------------------------
    \3\ See, Dottie Rosenbaum, Sharon Parrott, and Chad Stone, ``How 
Low-Income Consumers Fare in the House Climate Bill,'' Center on Budget 
and Policy Priorities, October 7, 2009.
---------------------------------------------------------------------------
    Under the House bill, low-income families with children, seniors, 
people with disabilities, and other low-income individuals would be 
eligible for a monthly federal benefit, administered through their 
state's human services agency, to offset the loss in purchasing power 
caused by the other provisions of the bill. This benefit would be 
delivered electronically onto the same debit cards that states now use 
to deliver food stamps and other benefits. The bill also uses a portion 
of the proceeds from auctioning 15 percent of the allowances to finance 
an expansion in the now-very-small component of the Earned Income Tax 
Credit (EITC) for low-income workers who do not live with children, the 
one low-income group most likely to be missed by the benefit provided 
through the state human services agencies. This EITC expansion would 
help offset the rising costs those workers would face as a result of 
the climate legislation. It also would reduce taxes for the one group 
of Americans who must pay federal income taxes despite living below the 
poverty line and who thus are taxed deeper into poverty.
    Under the bill, households with incomes under roughly 160 percent 
of the poverty line--about $35,000 a year for a family of four in 
2009--would qualify for a monthly energy refund that would be delivered 
through the EBT system that state human service agencies operate. 
Households with incomes below 150 percent of the poverty line would 
qualify for a full benefit; the benefit would begin to phase down for 
households with incomes above this income level and phase out at 
roughly 160 percent of the poverty line. Based on Congressional Budget 
Office (CBO) cost estimates and estimated average refund amounts, 
approximately 70 million individuals would participate in the refund 
program.
    The Energy Information Administration (EIA, the statistical agency 
of the Energy Department) would calculate each year how much, on 
average, the higher energy prices resulting from the climate policies 
would reduce the purchasing power of households with incomes at 150 
percent of the poverty line. The EIA would make this calculation for 
households of different sizes, since energy consumption--and, thus, the 
loss of purchasing power that results from higher energy costs--varies 
by household size. EIA would base these calculations on the market 
value of emissions allowances, other economic costs of capping carbon 
emissions, and the ``carbon footprint'' of low-income households in 
this income range, which can be derived from government data on 
consumer expenditures. A household's benefit would equal the amount 
that EIA calculated that energy prices would rise that year for a 
household of that size as a result of the legislation, after taking 
into account the relief the household would receive through the free 
allocation of permits to local utility companies. The benefit would be 
delivered on a monthly basis.
    The legislation directs state human service agencies to 
automatically enroll certain groups of individuals into the refund 
program. This includes food stamp households, and low-income seniors 
and people with disabilities who participate in the Supplemental 
Security Income (SSI) program or receive the low-income subsidy for the 
Medicare prescription drug program. (All low-income seniors and people 
with disabilities who participate in both the Medicare and Medicaid 
programs are automatically enrolled in the low-income subsidy for the 
prescription drug program and, thus, would automatically receive the 
energy refund benefit.)
    While the Food Stamp Program (now called the Supplemental Nutrition 
Assistance Program) reaches most very poor families with children, some 
people have incomes below 150 percent of the poverty line but do not 
participate in the Food Stamp Program, SSI, or the low-income subsidy 
program for the Medicare prescription drug benefit. These households 
would be permitted to apply for the refund. Recognizing the importance 
of ensuring that those who are eligible know about and can easily 
enroll in the program, the bill includes several additional provisions 
to facilitate participation by eligible low-income households.
    While the Energy Refund Program delivered through state human 
service agencies' EBT systems is likely to reach a large share of 
eligible seniors, people with disabilities, and families with children, 
one group is unlikely to have high participation in the program--non-
elderly adult workers who do not live with children. Only about one in 
four eligible working adults without children in the home participates 
in the Food Stamp Program. The bill provides consumer relief to these 
individuals by expanding the Earned Income Tax Credit for workers 
without children.
    Currently, the EITC for this group is very small--the maximum 
benefit in 2009 is just $457, far below the maximum benefit of $3,043 
for a family with one child. Moreover, the EITC for adults who do not 
live with children is too small to ensure even that single workers 
living below the poverty line are not taxed deeper into poverty. In 
addition, the current EITC for workers without children has such a low 
eligibility limit that a full-time minimum wage worker is wholly 
ineligible for the credit.
    The House bill provides consumer relief to these workers through an 
expansion of the childless workers' EITC. The maximum benefit would 
remain very modest compared with the EITC benefit for families with 
children--in 2012, the maximum EITC credit for a single worker without 
children would be $932, or less than one-third the benefit for a parent 
with one child. In addition, the bill would raise the income level at 
which the credit begins to phase out, from $7,620 in 2012 dollars (69 
percent of the poverty line) to $11,640 in 2012 dollars (about 105 
percent of the poverty line; the end of the phase-out range would be 
raised to about 160 percent of the poverty line). Much of the increased 
EITC would offset the loss of purchasing power these workers will face 
as a result of the climate legislation. The remainder of the EITC 
increase would go to reducing the tax bills of these poor and near-poor 
workers.
    The low-income provisions of the House bill provide a sound 
foundation for the Senate to build on in its climate deliberations. 
While the House bill would provide enough consumer relief to fully 
offset most low-income families' increased energy costs, some 
households--such as those that rent poorly-insulated apartments or have 
inefficient appliances--will face increased costs that exceed the 
amount of relief they receive. These households could have difficulty 
making ends meet even with the consumer assistance provided in the 
bill. For that reason, as the legislation moves forward, it could be 
strengthened by providing additional funds for the Low-Income Home 
Energy Assistance Program (LIHEAP), a program that provides energy 
assistance to low-income consumers and often targets aid on those who 
face utility shut-offs or other hardships. The consumer relief 
provisions also could be strengthened by extending the consumer relief 
either through the EBT mechanism, or more likely through an income tax 
credit, to families with incomes somewhat above the eligibility cut-off 
for the House bill's relief provisions. As I discuss in the next 
section of this testimony, providing direct refunds based on household 
size using the EBT mechanism and a refundable tax credit has much to 
recommend it as a model for providing consumer relief farther up the 
income scale as well.
  the advantages of direct refunds over other forms of consumer relief
    Refunds are an effective way to deliver consumer relief. They can 
be provided easily through the federal tax system and state EBT 
systems, with no need for new agencies or bureaucracy at the state or 
federal level. Also, refunds protect households against the loss of 
purchasing power from higher energy-related prices without blunting 
consumers' incentives to respond to those higher prices by conserving 
energy and investing in energy efficiency improvements. Because energy-
related products will cost more, households with the flexibility to 
conserve energy or invest more in energy efficiency will get more value 
for their budget dollar by taking these steps than by using their 
rebate to maintain their old ways of consumption. At the same time, 
refunds help households that cannot easily reduce their energy 
consumption to avoid a reduction in their standard of living.
    Other proposals for consumer relief generally lack one or more of 
these advantages, pose other serious problems, or lack crucial details 
needed to know how they would work in practice.
                     universal ``cap and dividend''
    The proposal closest in spirit to refunds is the universal ``cap-
and-dividend,'' approach often associated with energy entrepreneur 
Peter Barnes.\4\ Under this proposal, all emissions allowances in a 
cap-and-trade system would be auctioned and the proceeds divided evenly 
among all Americans on a per capita basis, mirroring the concept that 
all Americans have an equal stake in the planet's future.
---------------------------------------------------------------------------
    \4\ See Testimony of Peter Barnes, before the Committee on Ways and 
Means, U.S. House of Representatives, September 18, 2008, http://
waysandmeans.house.gov/media/pdf/110/barnes.pdf.
---------------------------------------------------------------------------
    The dividend would equal the average per capita loss of purchasing 
power that results from climate-change legislation. Therefore, the 
dividend would be smaller than the actual losses that high-income 
individuals would experience due to higher energy-related costs, 
because they have above-average per capita energy expenditures. It 
would be somewhat larger than the actual losses of low-income 
individuals.
    There are a number of similarities between cap and dividend and the 
Center's refund approach. Both focus on consumer relief. The cap-and-
dividend approach has the advantage of simplicity: everyone would 
secure a share of the revenues while still facing an incentive to 
reduce their carbon emissions. Nevertheless, cap and dividend raises 
several concerns.

   The primary issue is that distributing all revenues from the 
        auction of emissions allowances as dividends would leave no 
        money for other climate-related priorities, which would have to 
        be funded from other sources.
   On a more technical front, cap and dividend would require an 
        implementation mechanism. Barnes has suggested that households 
        would receive monthly payments, preferably into their bank 
        accounts (as is done with Social Security). This would entail a 
        significant expansion of the Social Security infrastructure or 
        the creation of a similar administrative system. It would also 
        require ensuring that all Americans are signed up with 
        appropriate banking services or that a more universal system of 
        debit cards than currently exists is created. While these are 
        not necessarily insurmountable barriers, developing such a 
        system would be a considerable undertaking.
   Finally, under a per capita dividend, the size of a family's 
        dividend would be tied strictly to the number of people in the 
        family. The evidence suggests, however, that energy 
        expenditures increase less than in proportion to family size. 
        (In other words a family twice as large as another consumes 
        less than twice as much energy.) Refunds are better suited to 
        providing a more appropriate family-size adjustment.\5\
---------------------------------------------------------------------------
    \5\ CBPP's proposed refund, and the one in the House bill, would 
adjust for family size but would take into account ``economies of 
scale'' in meeting families' needs. In other words, a family of four 
would get a larger refund than a family of two, but not one that was 
twice as large, as would be the case under a per-capita cap-and-
dividend approach.
---------------------------------------------------------------------------
                       payroll or income tax cuts
    Some have proposed using climate change revenues to cut payroll tax 
rates or individual or corporate income tax rates. Such options would 
be less effective than a refundable tax credit in preserving the 
purchasing power of low-and middle-income consumers.
    For example, in its analysis of trade-offs in the design of cap-
and-trade legislation, CBO found that if all the revenue from 
auctioning emissions allowances were used to reduce payroll tax rates, 
households in the bottom 60 percent of the distribution would get a 
smaller benefit from the tax cut, on average, than they would lose from 
higher energy prices.\6\ Those in the next 20 percent would come out 
even and the top 20 percent of the population would get a tax cut that 
exceeded their increase in energy costs. Using all the auction revenues 
to cut corporate taxes would be even more regressive, since the 
benefits of corporate tax cuts are concentrated still higher up the 
income scale. Using auction revenues to provide households refunds that 
vary by family size but do not increase as income climbs would not have 
these regressive effects.
---------------------------------------------------------------------------
    \6\ Congressional Budget Office, ``Tradeoffs in Allocating 
Allowances for CO2 Emissions,'' April 25, 2007, http://
cbo.gov/ftpdocs/89xx/doc8946/04-25-Cap_Trade.pdf; and ``Options for 
Offsetting the Economic Impact on Low-and Moderate-Income Households of 
a Cap-and-Trade Program for Carbon Dioxide Emissions,'' letter to the 
Honorable Jeff Bingaman, Chairman, Committee on Energy and Natural 
Resources, United States Senate, June 17, 2008, http://www.cbo.gov/
ftpdocs/93xx/doc9319/06-17-ClimateChangeCosts.pdf.
---------------------------------------------------------------------------
    The main argument for using climate change revenues to cut tax 
rates rests on the concept of economic efficiency. Economic analysis 
suggests that charging firms for emitting pollutants (as under a cap-
and-trade system) could dampen economic activity. By cutting tax rates 
at the same time, policymakers could reduce these economic efficiency 
losses. But, as the CBO analysis emphasizes, policymakers face a trade-
off between achieving efficiency gains and achieving distributional 
goals. Moreover, the economic efficiency gains CBO identifies are 
relatively modest, and the effect of the tax rate cuts that produce 
those modest gains would almost surely be to leave low-and middle-
income consumers worse off and to cause inequality in the United States 
to widen further.\7\
---------------------------------------------------------------------------
    \7\ For low-and moderate-income consumers not to be worse off under 
a proposal that uses all of the auction proceeds to lower tax rates, 
the additional economic activity generated by the tax cut would have to 
be so great that it raised workers' incomes by enough to increase their 
after-tax income by more than what they lose due to higher energy 
prices. Credible estimates of the economic efficiency gains from using 
climate change revenues for tax-rate reductions show those gains to be 
very small, however, compared with what would be needed to produce such 
a result. For example, in the analysis that CBO has relied upon to 
estimate the efficiency gains under an approach that uses all of the 
auction proceeds to cut tax rates, the efficiency gains would be equal 
to only 0.3 percent of GDP. That is far too small to offset the net 
loss that low-and middle-income consumers would bear as a result of 
losing more from higher energy prices than they would gain from the 
reduction in tax rates.
---------------------------------------------------------------------------
    Distributional analysis by Resources for the Future reinforces the 
CBO analysis.\8\ The RFF analysis finds that the benefits of cutting 
marginal tax rates would mainly go to upper-income individuals. In 
contrast, providing refunds to low-and middle-income consumers would 
result in the best outcome for those consumers.
---------------------------------------------------------------------------
    \8\ Dallas Burtraw, Rich Sweeney, and Margaret Walls, ``The 
Incidence of U.S. Climate Change Policy: Where You Stand Depends on 
Where You Sit,'' Resources for the Future, September 2008, http://
www.rff.org/News/Features/Pages/ClimatePolicyOptions.aspx.
---------------------------------------------------------------------------
    A reduction in payroll tax rates does not fare as well as a flat 
refund on distributional grounds: the size of the benefit from a 
payroll tax cut is higher for those with higher earnings, and seniors 
and others without earnings would receive no rebate. The first concern 
can be partially addressed by switching from a cut in payroll tax rates 
to a rebate of payroll taxes paid up to a fixed cap. Workers above a 
certain modest level of earnings would all receive the same size 
rebate. Workers with very low earnings, however, would receive only a 
partial rebate, and people with no earnings would still be left out.
    Those problems can partly addressed by switching to a refundable 
income tax credit based on the amount of payroll taxes paid (up to a 
maximum amount) and making seniors and people receiving federal 
disability benefits eligible for a similar size tax credit.\9\ At that 
point, the modified payroll tax proposal would look a lot like low-and-
middle-income refunds.
---------------------------------------------------------------------------
    \9\ Gilbert E. Metcalf, ``A Proposal for a U.S. Carbon Tax Swap: An 
Equitable Tax Reform to Address Global Climate Change,'' The Brookings 
Institution (Hamilton Project), October 2007.
---------------------------------------------------------------------------
                       energy efficiency programs
    Measures to encourage or require investments in economic efficiency 
can reduce the overall demand for energy, thereby limiting the size of 
the hit to consumers' pocketbooks from increased energy-related prices 
under an emissions cap. But energy efficiency programs should not be 
viewed as a substitute for rebates as a means of addressing the impact 
of climate change legislation on consumers' budgets. Cost-effective 
investments in energy efficiency can contain cap-and-trade costs but 
the need for consumer assistance will remain.
    Recent analyses offer an encouraging assessment of the potential of 
energy efficiency to reduce energy use and contain cap-and-trade costs, 
but they also point to the challenge of finding ways to achieve those 
efficiencies.\10\ For example, Resources for the Future researchers 
examining the efficiency and distributional effects on households of a 
range of climate policy options concluded that a policy that would 
invest in energy efficiency ``is one of the most progressive we 
examined and would lead to lower allowance prices... however, the 
implementation of this kind of policy is one of the most problematic of 
any that we consider.''\11\ That is because, according to RFF, it is 
``unclear'' whether the direct investment of emissions allowance value 
could overcome the persistent barriers that now impede the adoption of 
cost-effective energy efficiency improvements, ``and indeed what 
institutions could be employed to achieve this result.''\12\ In other 
words, both the promise of energy efficiency and the challenge of 
achieving that promise on a very large scale are great.
---------------------------------------------------------------------------
    \10\ See McKinsey Global Energy and Materials, ``Unlocking Energy 
Efficiency in the U.S. Economy, July 2009, http://www.mckinsey.com/
clientservice/electricpowernaturalgas/downloads/
US_energy_efficiency_full_report.pdf;
    \11\ Dallas Burtraw, Rich Sweeney, and Margaret Walls, ``The 
Incidence of U.S. Climate Policy: Where You Stand Depends on Where You 
Sit,'' RFF Discussion Paper 08-28, September 2008. http://www.rff.org/
rff/documents/rffdp-08-28.pdf
    \12\ Ibid.
---------------------------------------------------------------------------
    To the extent that measures to encourage or require cost-effective 
investments in economic efficiency can reduce the overall demand for 
energy, they can lower the costs of meeting the emissions cap and hold 
down the allowance price, thereby limiting the size of the hit to 
consumers' pocketbooks. But as long as emissions allowances have a 
significant value, that hit will not be eliminated and direct consumer 
relief will be warranted.
    If the gains from efficiency investments are broad-based throughout 
the economy, the aggregate hit to consumers will be lower than it would 
be without those efficiency gains, but the low-income share of the hit 
would not necessarily change much. In other words, if a certain 
percentage of the allowance value would be appropriate for offsetting 
the hit to low-income consumers when the allowance price is $30 per ton 
of carbon-dioxide, the same percentage would be appropriate if broad-
based efficiency investments lowered the price to $20 per ton for the 
same aggregate emissions reductions. The hit to consumers' budgets 
would be smaller across-the-board, but the low-income share would be 
the same.
    Energy efficiency efforts that achieve across-the-board reductions 
thus do not change the percentage of allowances needed to provide 
relief to low-and moderate-income households. But what about efficiency 
investments like weatherization assistance targeted specifically at 
that group?
    In principle, such investments could over time reduce the aggregate 
carbon footprint of the low-income population relative to the 
population in general and reduce the percentage of allowances that 
would be required to provide adequate low-income protection. In 
practice, however, there are two significant problems.
    First, existing weatherization and other energy efficiency programs 
have traditionally operated on a very small scale and would likely take 
many years to scale up to reach a substantial portion of the low-and 
moderate-income population. For example, until this year the 
Weatherization Assistance Program, which helps low-income households 
make their homes more energy efficient through measures such as better 
insulation, served only a few hundred thousand homes a year.\13\ The 
American Recovery and Reinvestment Act of 2009 (ARRA) provided a 
temporary injection of funds aimed at increasing the pace of 
weatherization to a million homes per year. But even if it is possible 
to ramp up to that pace cost-effectively and sustain it over many 
years, it would still take decades just to reach the 37 million low-
income households that are eligible for LIHEAP assistance. In the 
meantime, many eligible households would continue to face high costs 
while waiting for their homes to be weatherized. Direct refunds, in 
contrast, can reach tens of millions of low-and moderate-income people 
immediately.
---------------------------------------------------------------------------
    \13\ See the LIHEAP Annual Report to Congress for Federal Fiscal 
Year 2005.
---------------------------------------------------------------------------
    Second, the energy efficiency programs most often discussed as a 
substitute for rebates are generally limited to home energy efficiency. 
Yet higher home energy costs account for less than half of the loss in 
household purchasing power that would be caused by an emissions cap. To 
provide full relief to households, the energy efficiency measures would 
have to be so effective as to compensate not only for the increased 
costs in home energy but also for the increase in the cost of gasoline 
and other products.
    As a complement to direct refunds, energy efficiency investments 
can play a very valuable role in reducing the energy costs of those 
low-income households that have particularly high costs because they 
live in old poorly insulated houses or have old energy-inefficient 
appliances. That would reduce the percentage of households whose budget 
hit from climate legislation exceeds the amount of the relief they 
receive through the legislation. But energy efficiency investments 
would not reduce the need for direct refunds to offset the remaining 
costs for these households and for all the other low-income households 
who would still face higher costs for their home energy, gasoline, and 
the array of goods and services that use energy in their production or 
transportation to market.
           using utility companies to provide consumer relief
    The most straightforward way to offset the impacts of a cap-and-
trade system on consumers' budgets is for the government to sell the 
emissions allowances to the electricity generators, petroleum refiners, 
and other entities that are required to hold them in a cap-and-trade 
system and to refund the proceeds to consumers, or at least to refund 
enough of the proceeds to offset the increased costs that consumers up 
to certain income levels would bear.
    The utility company approach embodied in the House bill and in the 
Kerry-Boxer bill just introduced takes a different tack and allocates a 
portion of the emissions allowances free to local utility companies. 
The local utilities, or LDCs, would not have a direct use for the 
allowances they were given, because they do not generate the 
electricity they distribute and thus don't themselves emit greenhouse 
gases. Instead, the utility companies would sell the allowances and use 
the proceeds to offset the higher prices they would have to pay under a 
cap-and-trade system for the electricity generated by their affiliates 
or that they purchase in the competitive wholesale market. State 
utility regulators would then have the task of making sure that LDCs 
used their valuable emissions allowances as intended to keep higher 
prices for fossil fuels from translating into higher utility bills.
    Several considerations militate against using an LDC approach that 
is aimed at keeping customers' bills from increasing as the primary 
vehicle for consumer relief in climate change policy. Four concerns in 
particular, stand out.\14\
---------------------------------------------------------------------------
    \14\ See Chad Stone, ``Holding Down Increases in Utility Bills Is a 
Flawed Way to Protect Consumers While Fighting Global Warming,'' Center 
on Budget and Policy Priorities, June 3, 2009, and Chad Stone and 
Hannah Shaw, ``Senate Can Strengthen Climate Legislation by Reducing 
Corporate Welfare and Boosting True Consumer Relief,'' Center on Budget 
and Policy Priorities, July 10, 2009.

    Such an approach would not offset the bulk of consumers' increased 
costs. As noted earlier in this testimony, increased utility bills 
would account for less than half of the impact of higher energy-related 
prices on consumers' budgets. Therefore, having LDCs suppress increases 
in utility bills would fall well short of restoring consumers' lost 
purchasing power due to the higher energy prices. This is even more 
true for middle-income households than it is for low-income ones. As 
one moves up the income scale, increases in costs for items other than 
home utility bills make up an increasing share of the impact of higher 
---------------------------------------------------------------------------
energy prices on families' budgets.

   State regulation of LDCs is uneven. Proponents of the LDC 
        approach argue that LDCs are regulated utilities and will be 
        required to use the allowances they are given to benefit 
        consumers. In fact, the quality of state utility regulation is 
        uneven across the country. The mere fact that utilities are 
        regulated is not a guarantee that free allowances to LDCs will 
        produce well-targeted and effective consumer relief everywhere. 
        LDCs' ideas of what would be the best use of the allowances 
        would not necessarily align with policymakers' goals. This 
        problem would be lessened if Congress sets rules for how the 
        LDCs are to use these funds, and the House bill and Kerry-Boxer 
        dictate that they should be used for the benefit of ratepayers. 
        Depending on the strength of the regulators in a state, 
        however, some of the funds still might not be used in optimal 
        fashion or might go for overhead or turn up in utility 
        companies' bottom lines.
   This approach would cause prices for other forms of energy 
        and energy-related products to rise more and would raise the 
        overall cost of meeting the cap. Keeping utility bills low 
        under a cap-and-trade system would blunt the ``price signal'' 
        that an emissions cap is designed to send in order to encourage 
        more efficient home (and other) energy consumption. It thus 
        would keep electric and gas consumption higher than it 
        otherwise would be. (This effect might be lessened by certain 
        federal rules specifying how the LDCs are to deliver the 
        consumer relief, but it would not be eliminated.\15\) 
        Reductions in the use of other forms of energy would then have 
        to be greater in order to produce total emissions reductions 
        sufficiently large to comply with the overall emissions cap. 
        The result would be a less cost-effective pattern of emissions 
        reductions, higher allowance prices, and higher economy-wide 
        costs.
---------------------------------------------------------------------------
    \15\ Providing relief in the form of reductions in the fixed 
portion of utility bill charges, which the House bill and Kerry-Boxer 
encourage to the maximum extent practicable, preserves the price signal 
of higher rates in the variable portion of the bill to the maximum 
extent possible, but that effect is largely blunted if consumers look 
only at the bottom line of their bill, where they would not experience 
the ``sticker shock'' that could prompt changes in behavior.

    A substantial share of the resources going to utilities to provide 
their customers relief from higher energy prices would instead go to 
business profits. The House bill and Kerry-Boxer stipulate that LDC 
relief should be delivered to ratepayer classes (residential, 
commercial, and industrial) in proportion to their energy use. That 
means that over 60 percent of the relief the bill would distribute 
through utilities would go to utilities' business customers, not 
individual households. A Congressional Budget Office analysis concludes 
that businesses would retain this relief as added profit rather than 
pass it on to their customers in the form of lower prices for their 
products. The profits from lower utility bills for businesses would 
primarily benefit the high-income households who own or hold stock in 
the firms. About 63 percent of the allowance value given to utilities 
to benefit their business customers would ultimately go to the highest-
---------------------------------------------------------------------------
income 20 percent of households, according to CBO.

    From a distributional standpoint, the last concern is particularly 
serious. It is the main reason why the net hit to households in the 
richest 20 percent of the population shown in Figure 1 above is so 
modest compared with the hit to the middle 60 percent of the 
population. A different possibility is that business customers will in 
fact pass the relief they receive on to their customers. But this 
outcome is no better because it leads to the third problem identified 
above: a serious weakening of the price signal that raises allowance 
prices and the cost of meeting the cap.
    The bottom line is that seeking to benefit consumers by giving 
emissions allowances free to LDCs to keep down their customers' bills 
puts policymakers on the horns of a dilemma. If they structure the LDC 
relief for businesses so it focuses on the fixed part of firms' utility 
bills as the House bill analyzed by CBO does, they will essentially be 
providing windfall profits--or corporate welfare--on a wide scale, with 
highly regressive results. If, instead, they try to require LDCs to 
provide relief on the variable portion of the bill (or if businesses 
respond only to their bottom-line utility costs), they will be blunting 
the incentive to reduce consumption, thereby causing prices for other 
energy-related products to climb further and raising the economic costs 
of combating global warming.
    A better alternative exists. The Senate would be well-advised to 
scale back the LDC portion of the House bill--especially the large 
amount of the LDC relief earmarked for commercial and industrial 
users--and to devote the freed-up funds to direct consumer relief for 
moderate-and middle-income households to supplement the relief that the 
bill provides to low-income households. The LDC relief and other 
business protections in the House bill are scheduled to phase out 
between 2026 and 2030 but there are benefits to starting with a smaller 
allocation to begin with and phasing it out more quickly.
                               conclusion
    One of the key goals of an effective but fair climate policy is to 
ensure that the policies necessary to reduce greenhouse gas emissions 
do not increase the depth and extent of poverty by reducing the 
purchasing power of low-income households. The Waxman-Markley House 
bill provides that insurance with strong low-income protections. 
Together, the LDC relief and low-income refund ensure that the average 
low-income household is fully protected against the loss of purchasing 
power it would otherwise experience as a result of the policies 
necessary to meet the cap on greenhouse gas emissions. However, low-
income households with particularly high energy costs and moderate-
income households with incomes too high to qualify for the low-income 
refund are not fully protected. As the Senate moves forward with its 
deliberations it can strengthen the protection for those groups by 
supplementing the low-income protection with some additional funding 
for LIHEAP and by extending eligibility for direct refunds farther up 
the income scale.
    It is critical, however, that the relief provided to low-income 
households not be diluted. In other words, any direct relief for 
moderate-income households to supplement their LDC relief will need to 
come on top of the 15 percent allocation for direct low-income relief 
the House provides, rather than being taken out of it. Reducing the 
size of the low-income refund in order to provide direct relief farther 
up the income scale would mean that a greater portion of low-income 
households ended up with relief that failed to offset the full increase 
in energy costs they faced. Moreover, for those low-income people for 
whom even the current low-income refunds would fall short of offsetting 
their energy cost increases (because the cost increases they faced were 
well above the average), diluting the low-income refunds would cause 
their budgets to be squeezed even more. The result would be 
significantly more hardship, with the legislation pushing more families 
into poverty and making many of those who already are poor still 
poorer.

    The Chairman. Thank you very much. You all have given us a 
lot of things to try to understand and ask questions about.
    So let me start with a few questions. Dr. Metcalf, in your 
testimony, and I believe Dr. Ellerman did this too and maybe 
the others as well, there's a distinction made between the 
costs of reducing greenhouse gas emissions--that was the 
triangle in your figure there--and the revenues raised if 
permits are fully auctioned. There's a chart that--we had this 
hearing last week with the Congressional Research Service as 
one of the witnesses, and they presented a chart* as part of 
theirs, that this reflects. Basically, it's a chart that tries 
to distinguish between the compliance costs, being the lower 
sort of yellowish area and the allowance value, being that plus 
the maroon area there.
---------------------------------------------------------------------------
    * Graphic has been retained in committee files.
---------------------------------------------------------------------------
    I guess what I'd be interested in knowing is where does 
this cost impact come out with regard to consumers? I mean, if 
we're saying that the costs of reducing greenhouse gas 
emissions is represented by the yellowish area on that chart 
and the total value of the allowances is substantially 
greater--I think you made reference to the fact that ultimately 
the burden falls on households of the system. Where do 
consumers come out in this?
    Mr. Metcalf. So that's a great question and a really 
important point. The yellow area there, if we look at the 
height there in 2012 at the left end, that corresponds to my 
triangle in the maroon area to my rectangle. So this is all 
being reflected in higher prices for goods and services, both 
the combination of the compliance costs and allowance value. 
It's showing up in higher prices for goods and services, higher 
prices for gasoline, for home heating oil, for all the 
adjustments that households make to adjust to the higher 
prices.
    Some of this we capture in the form of the permit revenue, 
which we can then use to compensate people. But some of these 
real costs, these are the costs of, say, switching from coal-
fired electricity to natural gas-fired electricity, or co-
firing biomass with coal, or carbon capture and storage. These 
are the real costs of reducing carbon emissions that get 
embedded into the costs along with the permit price.
    So the value of the permits can compensate us for some of 
those costs, but it doesn't compensate us for all. That part 
that it doesn't, that's the real cost to society.
    The Chairman. Dr. Ellerman, did you have any comment on 
this distinction between the cost of compliance and the value 
of the overall permits being generated as part of this system?
    Mr. Ellerman. Yes. The point I would make, I think the 
cost, we can think of that as consumers pay both for the 
resources that will be diverted from other uses, let's say 
consumption, government, investment for abatement to reduce 
emissions. That will require some resources. That triangle 
represents those resources that are not available for other 
uses, but we've decided to use for reducing emissions.
    The remainder, the rectangle, the scarcity rent allowance 
value, is essentially a transfer. It's not a subtraction from 
what's available for consumption, investment, and government, 
but it is a redistribution within that, which will all go to 
households, and there's some question as to what households. If 
it's given, for instance, in free allocation to corporations, 
if they're not cost regulated then it would go to shareholders 
first, government, others, all of these means of distribution.
    If it's done for government expenditure, its savings, 
whoever works in those industries will derive some benefit from 
that. So I think one way to think about it is that that larger 
triangle, which is the subject of allocation, are really 
transfer payments and we need to pay attention to who the 
recipients are and who are the appropriate recipients and the 
appropriate uses of that extra value, which is not a 
subtraction from resources being used in the economy.
    The Chairman. Am I accurate that--I think you made the 
point, Dr. Ellerman, that allocating allowances and auctioning 
allowances and allocating the money is essentially the same 
thing. Is there some efficiency, though, that is achieved by 
doing the latter of those, that is auctioning allowances and 
distributing money, rather than giving allowances itself? Is it 
a more refined way to achieve policy objectives, or is that not 
the case?
    Mr. Ellerman. It depends on what we think corporations do 
with the allowances they receive and the extent to which they 
realize the opportunity costs. I realize I'm using some jargon 
here. But I think as a first approximation I'd say no, I don't 
think it makes any difference. What matters is who the 
recipients are, and whether--the usual economic arguments for 
efficiency have to do with rebating taxes, that Dr. Metcalf 
explained.
    But I don't think there's any greater efficiency associated 
with auctioning per se than there is with free allowance.
    The Chairman. Dr. Palmer, did you want to comment?
    Mr. Palmer. I think it depends on who is receiving the free 
allocation. When allowances are freely distributed to 
generators that need them for compliance, then you're going to 
get this regional disparity in price impacts that I talked 
about, where folks who live in regions where electricity is 
sold in a market and it's been essentially deregulated will see 
the cost of using those allowances as they use them up to 
generate electricity in the prices they pay, but folks who live 
in regions where electricity prices are set by regulators won't 
see that effect. That's an issue both in terms of this regional 
disparity issue and also in terms of the incentives that folks 
in different regions are going to have to conserve electricity, 
which is an important part of the compliance strategy to 
achieve our target.
    The Chairman. Dr. Stone, did you want to comment?
    Mr. Stone. Yes. I have a chart on the second page of my 
written testimony which is actually from Director Elmendorf, 
CBO Director Elmendorf's testimony last week before this 
committee. It's drawn from that. It's not his chart. What the 
chart illustrates is this question. The bottom yellow bars are 
by income group and over on the right for the economy as a 
whole, the costs imposed on the economy by putting a price on 
carbon. That's it doesn't matter whether you auction or give 
them away.
    Subject to the qualifications that Dr. Palmer made, that 
doesn't change very much. The blue are the financial 
redistributions back to households out of the allowance value, 
and you have a lot of discretion over how that works. This 
shows what happens in the House bill according to CBO. But Dr. 
Metcalf showed some other possible distributional outcomes, 
which is the net difference between the costs and the benefits. 
That's the line.
    So you have a lot of control over how the blue bars are 
distributed across income groups, but the costs are pretty much 
independent of what you do.
    The Chairman. Senator Murkowski.
    Senator Murkowski. Thank you, Mr. Chairman.
    Dr. Palmer, I want to go back to your discussion about the 
regional disparity, because I understand that with the House 
bill the EPA analysis on that basically showed that utilities 
in the coastal States get most of the free permits. In other 
portions or States, the Western, Midwest, and Southern States, 
they get a fraction of the permits that they need.
    As we look at the impact throughout the Nation and the 
regional disparities, to use your terminology, the discussion 
gets really important. A State like mine, where our cost of 
living and our energy costs are already through the roof, the 
threat of something that would cause them to escalate further--
when you're paying eight bucks a gallon for gas, you don't know 
how you're going to be able to go much higher.
    One of the informal analyses that we've seen has suggested 
that the bill's direct cost per household in Alaska could be 22 
times higher than that in New York. Many of the impact 
assistance programs that are contained in the House bill are 
based on population, so again that's not going to help us in a 
State like Alaska, where we have such a small population, and 
wouldn't account for the significant regional differences that 
we experience with the cost of living.
    Is there any precedent out there to structure or some 
defensible way that we could build climate legislation that 
would account for this cost of living disparity that we have? 
How do we address something like that?
    Mr. Palmer. That's a very good question. When prices for 
energy are so high, prices in and of themselves, one of the 
benefits of that is that the impact of controlling carbon and 
this price for carbon allowance is going to be the same 
everywhere. So the percentage increase on the price that you 
would face is actually probably smaller than in other places 
where prices are lower.
    So therefore the impact is going to be differently felt 
according to that. But I think an important thing about local 
distribution company allocation that is talked about in H.R. 
2454 is that if you move away from that approach, which really 
focuses on electricity consumption per se, if you've got, like 
in a rural State where there's a lot of energy consumption 
that's related to other activities, such as driving or the cost 
of getting milk delivered to Alaska, for example, or other 
products--there's just a lot of transportation costs associated 
with distant States. I'm familiar with this because I grew up 
in northern Maine.
    Moving away from something that focuses primarily on 
lowering people's electric bills to something that focuses on 
using allowance value to compensate households, so a greater 
shift to a cap and dividend approach, would be helpful in that 
regard because it would help address this different mix of 
consumption.
    Senator Murkowski. Yet your dividend that goes to each 
household would be the same in Alaska as New York, and if I'm 
paying eight bucks a gallon in Alaska and I'm paying two bucks 
in New York----
    Mr. Palmer. Right.
    Senator Murkowski [continuing]. My dividend doesn't go as 
far as the New Yorker's dividend.
    Mr. Palmer. That's a good point. You could restructure the 
dividend allocation to be based on some other metric, similarly 
to the way it's done in----
    Senator Murkowski. Is there precedent for that?
    Mr. Palmer. No. That's a good question.
    Senator Murkowski. Do any of you have a response or are you 
aware of anything? Dr. Ellerman? Dr. Stone, I think you were 
ready to jump in.
    Mr. Stone. It's difficult to do. In most Federal programs 
we don't. Certainly in the tax code we really don't have much 
in the way of that kind of specialized--we wouldn't have a 
specialized tax credit for people in different States. That's 
hard.
    But I would harken back to an important point that Dr. 
Palmer made, which is if you focus on just one piece of the 
cost, whether it be electricity in some places or 
transportation in other places, you miss the fact that it's not 
all--that States don't get hit by all of the parts the same. So 
the regional disparity is less severe when you focus on the 
broad impacts than when you focus on any particular piece of 
the impact.
    A lot of the impact is the indirect part, the fact that 
goods are transported to market and manufactured using energy. 
That's much more uniform across households and regions. So the 
extent of the regional variation can be exaggerated in 
discussions, although I wouldn't tell the Senate not to worry 
about it.
    Senator Murkowski. I don't want to be argumentative, and I 
want to get Dr. Metcalf's perspective on this. But in a State 
like mine where we don't have roads and you have one barge, 
that comes in the spring, and if you're lucky you get one in 
the fall and you're locked into whatever the fuel prices are in 
the lower 48 and you have those transportation costs, all 
things are not even.
    Dr. Metcalf?
    Mr. Metcalf. It's hard to argue the fact that there is some 
regional disparity, particularly with States like Alaska and 
Hawaii that have very unique energy systems. The one cautionary 
note I would say, though, is that when--so one could certainly 
make regional adjustments. We have regional adjustments to the 
CPI. There are certainly ways to do this.
    One caution, though, is that if you are not careful you 
begin to, with regional adjustments for the fact that in the 
Midwest we have more coal-fired electricity and therefore 
higher electricity prices and a higher impact in those 
Midwestern States, you run the risk of enshrining the carbon-
intensive technology that we are actually trying to move away 
from.
    So you face a real delicate balance here of how you can 
address fairness issues, regional fairness issues, with 
providing the right signal. Again, the key point is to 
provide--not to blunt the market signal by giving adjustments 
that somehow are reducing that price at the margin. I think 
that's what you want to try to avoid.
    Senator Murkowski. Thank you, Mr. Chairman.
    The Chairman. Senator Dorgan.
    Senator Dorgan. My understanding is that Senator Corker has 
to leave. I'd be happy to yield my time if I could be 
recognized following.
    The Chairman. Senator Corker.
    Senator Corker. Thank you, and I very much appreciate that, 
and appreciate much of the thinking that you've brought to 
this.
    Mr. Chairman, I want to tell you this is an excellent 
panel. I know we're not well attended today, but it's these 
details that are the essence of trying to figure out what 
policy will work and will not. I want to thank our witnesses. I 
think this is an outstanding panel.
    Senator Bingaman and I visited the EU in 2007 and ever 
since that time, in the event we're going to have cap and 
trade, I have very much focused on cap and dividend, because 
what you see in these bills is using proceeds from cap and 
trade to either grow government--not about climate change, but 
to grow government--or to buy off--I hate to be so crass, but 
it's just a fact--to buy off various interest groups.
    So the whole notion of this dividend is to me essential. 
Dr. Metcalf, the issue of trying to figure out how do you 
return the money back to people in an appropriate way is a key 
issue. In other words, if you're not going to let any of this 
money grow government and you really don't want to buy off 
interest groups through earmarks, you want to make sure the 
money doesn't leave consumers. You still have the price signal 
because carbon costs more. Then figuring out how to return it 
is a very, very important thing.
    So I know you've talked about 15 percent going to low 
income groups, and then there's a notion of lowering a payroll 
tax. Would that combination work, giving 15 percent out to the 
lower income groups and then at the same time lowering payroll 
tax? What is an appropriate way of dealing with that?
    Mr. Metcalf. So the 15 percent referred to some of the LDC 
proposals and proposals in Waxman-Markey. My view all along has 
been that we should have 100 percent auctioning, with return of 
the revenue to make it revenue neutral, so we don't confound 
climate policy with debates over the appropriate size of 
government. I think we want to keep these distinct.
    Senator Corker. I think that is absolutely dead on. I thank 
you so much for saying that.
    Mr. Metcalf. A proposal that I describe in a different 
paper than the one underpinning my testimony today talked about 
using the revenue, the auction revenue, to lower the payroll 
tax in a way that provides some incentives for more work 
effort, for more labor supply, so we get some efficiency 
benefits, and it also helps to address some of the impacts on 
low income households, particularly if you combine it with some 
benefit, some augmenting of benefits.
    So I think one of the advantages--one of the virtues of 
auctioning is that you don't run into this problem that has 
been described by other members of the committee, that once you 
have permits to give away in a sense you can start funding 
programs in a way that doesn't run through the normal 
appropriations process.
    Senator Corker. Those permits--and again, I wish there 
were--I hope there are a lot of people listening. Those permits 
are marketable securities that are equal to cash when one 
receives them. They can sell them. It's like receiving a share 
of IBM stock. People talk about--hopefully IBM stock. People 
talk about those as if they're free, of no value. But when that 
is received it is a marketable security, is that correct?
    Mr. Metcalf. Absolutely.
    Senator Corker. I very much appreciate your testimony and 
would look forward--and certainly, Dr. Stone, if you want to 
weigh in.
    Mr. Stone. If I could. As the proponent of the 15 percent 
for low income, that actually is on a small scale, for low 
income folks, a direct refund like cap and dividend. So it's 
part of a cap and dividend. If you wanted to extend that 
farther up the income scale, you would build on it with a 
refundable tax credit of some sort or the payroll tax proposal 
that Dr. Metcalf has. Then people say what about seniors and 
vets. Then, you would add in direct payments like we did in the 
stimulus if you wanted to go the direct income payment route.
    So the low income 15 percent allocation is actually in the 
spirit of cap and dividend.
    Senator Corker. I have numbers of questions and I know 
Senator Dorgan has given me time, so I'm not going to go over. 
I very much appreciate his courtesy.
    I will say in general that if somehow the American people 
could trust and that those of us involved in this legislative 
process could trust that not one penny at the end of the day 
was going to leave consumers and either go into corporate 
pockets or government coffers, but 100 percent of that was 
going to be returned and we knew it was never going to be 
utilized as a source of funding additional size of government, 
I think it would go a long ways toward mitigating some of the 
contentiousness over this.
    But when they see bills like we've seen from the House and 
now it's getting ready to be proposed in the Senate, where they 
realize, whether it's efficient or not--and I very much 
appreciate your academic presentation--it's still a tranference 
of wealth from one person to another that we are deciding. I 
think it's that huge distrust that has done more damage to this 
debate than almost anything else.
    With that, I'll stop. Thank you, Mr. Chairman.
    The Chairman. Senator Dorgan.
    Senator Dorgan. Mr. Chairman, thank you.
    The issue of efficiency is a really interesting concept. 
Obviously, when you strive to accomplish a goal you wish to do 
it with the greatest efficiency. On the other hand, the issue 
of efficiency in many cases would ignore the regional impacts 
that could be very, very substantial. If you come from a region 
of the country where a substantial amount of coal is used to 
produce electricity, you will have a much more significant 
burden under almost any scenario, than other regions of the 
country that do not use a large amount of coal. So should we 
just say efficiency matters and that's the priority and it 
doesn't matter what the impact is? The answer to that would 
clearly be no.
    I wrote down the phrase ``enshrining carbon-based 
technologies.'' That's what you said, Dr. Metcalf. The issue 
here is how do you reduce the emission of CO2 and do 
it in a way that doesn't cause chaos in the country. How do you 
do it from the standpoint of economics or the financial 
circumstances of a family who is out there purchasing energy?
    We in North Dakota, for example, use exactly twice as much 
fuel as the average New Yorker does. It's not because we just 
drive around all day just for fun with our arm out the window. 
It's because we have to drive twice as far to get parts for the 
combine, or to go to the next town, and so on.
    So the impact of somebody saying we're going to increase 
fuel prices evenly would create twice the burden on the North 
Dakota citizen than on the citizen of New York. I point that 
out because I think that this is really critical in trying to 
construct something, to understand where are the dislocations 
and whatelse you need to be addressing, in addition to people 
with low income.
    Dr. Metcalf, if you were to construct a system here for 
reducing carbon, considering all the factors--efficiency and so 
on--what kind of a system would you construct? Would you 
construct a cap and trade system or a carbon fee? How would you 
approach it?
    Mr. Metcalf. My first preference would be a carbon charge 
approach, carbon fee. I think it's the simpler approach. It's 
fairly straightforward, setting a price. I think this is really 
what we want to focus on. We avoid the risk of fluctuations in 
price. Price fluctuations are what cause economic uncertainty 
and costs of adjustment for firms.
    As I've said elsewhere, I would use that revenue--I would 
look at lowering other taxes in a way that provided some 
distributional benefits as well as efficiency benefits, and 
cutting the payroll tax with a capped cut in the payroll tax is 
a way to do that.
    Now, just one comment on the regional issue. Work I've done 
with colleagues has shown that if we look at the increase in 
prices of goods and services, while it's true that North Dakota 
drivers drive a lot because it's a big State, a rural State, if 
you look at the overall impact of carbon pricing, taking into 
account all the impacts--heating, driving, cost of goods and 
services--the regional impacts if we look at the spending side 
are really not that large. So that you get perhaps bigger 
impacts in one area, but lower impacts in another.
    So I think we need to be careful not to overstate the 
regional differences. We don't want to understate it, either. 
But I think that that is perhaps not as large as it appears.
    Senator Dorgan. Obviously we'll look at the specifics on 
the regional impacts of a carbon fee. My understanding is that 
some of these impacts can be very substantial.
    I agree with you that a carbon fee is a much more 
straightforward approach. It is also true that you probably get 
less efficiency with a carbon fee. It's also true that with a 
carbon fee you have more price certainty than with a cap and 
trade on the, quote, ``trade side,'' unquote. It's very hard to 
know exactly where a carbon market moves unless you establish a 
price collar, which itself is an admission that you've got a 
problem with having this be a cork that floats on the issue of 
whatever the free market system decides or however much 
speculators want to be involved.
    So I feel that a much more straightforward approach would 
be a carbon fee and also accompanying that with a dividend. The 
question then is how would you structure the dividend so that 
you try to prevent the substantial dislocations that could 
exist.
    The other question then outside of that is, if your 
dividend moves most of the revenue back to the American people, 
which I would want to do, then how do you raise the funding 
that is necessary for the research and technology to 
decarbonize the use of coal, just as one example, which I think 
is going to require a lot of money? I'm more inclined to 
support a very minimal wirage charge, which some have suggested 
could at a very low percentage, raise a substantial amount of 
money over a 10-year period or so.
    But I do think that we should be appropriating that money. 
As an appropriator, I would come down favoring this approach.
    But let me ask Dr. Ellerman. You heard Dr. Metcalf talk 
about a carbon fee and then his notion of distribution. Your 
reaction to that?
    Mr. Ellerman. With respect to the tax versus the cap and 
trade, I think these can be made very largely equivalent. There 
is a difference in where the price if fixed or whether it 
varies and whether--the alternatives is whether the emissions 
are fixed and limited or whether they vary, as they do under 
the tax. That's a well known point.
    I am less worried about the variability of the price. I 
think we face that in all sorts of things, like oil, a variety 
of commodities, wheat, you name it. We deal with prices and 
there are mechanisms to deal with those instabilities.
    So I think--and there aren't any proposals--the name of the 
game in town seems to be cap and trade. Fine. We could do a tax 
system. Let someone come forward and do that, put that forward. 
We haven't seen it.
    I think on the distributional point, I think this is the 
real essence. It is interesting, I think, to think of a moment 
of--emphasis here has been very much on going back to 
households in some manner and then how do you balance these 
income differences, regional, industry type differences. I 
think it's worth noting that in the legislation that we have 
sort of under consideration or that has been considered in the 
House, as well, and is fairly similar to that which has been 
proposed in the Senate by Senators Kerry and Boxer, that there 
are several ways to try to deal with this.
    One, you have the sort of per capita rebate that kicks in 
at a later period and goes to all households straight. You have 
the low income one that starts from the beginning, and that is 
aimed at dealing with the regressivity of energy prices and 
helping low income. My understanding of the LDC fix, the 
distribution to local distribution companies, is an attempt to 
deal with regional inequities. I would agree with the 
qualifications that Karen Palmer has brought up on that, but I 
think that--and whether they have the right balance, how you 
deal with these differential fuel price or gasoline consumption 
issues, there are many different ways in which you can try to 
do that.
    But the basic notion there is the LDC to deal with regional 
problems, particularly with respect to coal use, the low income 
assistance for regressivity, and the rest per capita, all 
households getting their rebate.
    Senator Dorgan. Mr. Chairman, my time has expired. Can I 
just in 30 seconds say that I appreciate my colleague's 
forebearance. Despite the fact we're talking about climate 
change legislation, either by a cap and trade or a carbon fee 
and climate change, my desire would be--and I've spoken on the 
floor several times about this--that we take the energy bill 
that we passed in this committee in June to the floor and pass 
it before we address climate change legislation. This 
committee's energy legislation moves significantly in the 
direction of addressing climate change, maximizing renewables, 
creating a national RES, building efficiency, all the things 
you would do to try to address climate change.
    It has been reported because of my floor speeches that I 
don't support addressing climate change. That's not the case at 
all. I believe we ought to do it in two steps. First, take up 
the energy bill that has passed this committee, which I think 
has a lot to commend in the way of addressing climate change, 
and pass that. Second, the Senate should move to a climate 
change bill. But I don't think that's going to happen this year 
in any event. That's my own view. So I hope we don't end the 
year without taking up the Senate energy bill that we passed 
out of this committee, which I think addresses climate change 
in a very significant way.
    The Chairman. Thank you very much.
    Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Dr. Ellerman, the allowance allocation formula in the 
House-passed Waxman-Markey bill calls for a 50-50 average 
formulation, based half on retail electricity sales and half on 
carbon-weighted electricity sales. Do you agree that this puts 
high carbon intense States, like my home State of Kentucky, at 
a severe disadvantage?
    Mr. Ellerman. I hesitate on the severe disadvantage. I 
think 50-50 strikes me as----
    Senator Bunning. Let's just compare it to New York, 
California, and other States that would profit.
    Mr. Ellerman. It will be at a disadvantage compared to what 
would be a 100 allocation according to emissions or, let's say, 
the emissions----
    Senator Bunning. If it were one or the other.
    Mr. Ellerman. Right, if it were one or the other. You can 
go anywhere from 100 percent one to the other and mix it.
    Senator Bunning. You could just do a carbon tax and that 
would hit everybody in every State equally, I would hope.
    Mr. Ellerman. No. Let's say the cost of the allowances is 
going to hit households equally in all States. The question on 
the LDC formula is the rebate that comes back to consumers.
    Senator Bunning. That's the big enchilada.
    Mr. Ellerman. That's right and that could be--whether 50-50 
is the right number is----
    Senator Bunning. We happen in Kentucky to think it's not 
the right number, and I can tell you people from Wyoming and my 
good friend from South Dakota and Illinois and Indiana and Ohio 
think that that's the wrong number. We would have a much better 
chance of passing the energy bill that we passed out of this 
committee a long time ago and get that done and get on with 
some type of cap and tax or cap and trade, whatever you want to 
call it.
    The goal of allocating allowances is to help transition 
carbon-intensive sources under a cap and trade system to this 
system, while also reducing the impact of increased cost to 
consumers. Is this correct?
    Mr. Ellerman. Of the transition assistance--consumers in 
some form--or let's say households in some form are going to 
receive all of this money. It's going to come back to 
households. There's no one else to receive it. They may be 
shareholders.
    Senator Bunning. Present.
    Mr. Ellerman. Present and future, and future.
    Senator Bunning. We haven't written the final bill yet.
    Mr. Ellerman. That's right. No, but I mean whatever the 
bill and the provisions, my general point would be households 
will be the recipients of this.
    There are legitimate transitional provisions which we see 
in the currently proposed bills, which are phasing out over 
time. I think those are intended to deal with that. Now, that 
grants on the interim additional allowance value to particular 
industries, particular activities, renewable energy, coal 
carbon capture and sequestration, energy R&D, whatever happens 
to be the designated purpose.
    I'm a believer that you are the people who need to decide 
that.
    Senator Bunning. I agree with you, but my biggest problem 
is singling out individual States that will be so 
disadvantaged--Utah, Kentucky, South Dakota, and many others--
if in fact the Waxman-Markey bill is passed as presently 
constructed.
    Dr. Metcalf, is cap and trade--would you call it a 
regressive energy tax?
    Mr. Metcalf. Any form of carbon pricing, whether it's cap 
and trade or a carbon charge, any of these approaches that 
raises the price of carbon by itself is going to be regressive. 
But what's important to consider is the net impact, which takes 
into account the use of the revenues or the value of the 
scarcity rent.
    Senator Bunning. If my good friend Senator Corker--if that 
is the case, in his formula for returning the money and making 
sure it doesn't go anywhere but to the consumer, then I don't 
think it's regressive.
    Mr. Metcalf. So the two points I'd make, as I demonstrate 
or discuss in my written testimony, a cap and dividend 
approach, auction all the permits, 100 percent of the permits, 
and return them all through a dividend; then that would be 
quite progressive.
    On the other hand, with a free allocation of permits to 
industry, to the covered sector, as has been done in previous 
cap and trade programs, that would be sharply regressive, 
because those benefits would go to the shareholders, who tend 
to be higher income households.
    Senator Bunning. Thank you.
    I'm just at the end, but I have a question for Dr. Stone.
    The Chairman. Go on.
    Senator Bunning. In your testimony you described the relief 
provision provided to low income households in Markey-Waxman 
through the supplemental nutrition assistance program and 
expanding the earned income tax credit. Both of these proposals 
target a specific segment of low income households; is that 
correct?
    Mr. Stone. Senator, actually the combination very broadly 
covers low income households.
    Senator Bunning. Let me follow up, then. If that is the 
goal, if the goal is to provide relief to energy consumers that 
are most affected by increased energy costs, these proposals 
will not affect those workers as they are energy consumers, but 
are not qualified under EITC whether they are part-time 
employees or whether they're unemployed; is that correct?
    Mr. Metcalf. The very low income population, the bottom 20 
percent of the population that the low income proposal is aimed 
at, they have incomes that will qualify them to get the 
benefits through the electronic benefit transfer system. It's 
not an increase in food stamps. It's using the same mechanism 
that we use for food stamps to deliver the benefit.
    Senator Bunning. Will it not also affect middle class 
consumers?
    Mr. Metcalf. The Waxman-Markey bill does not have 
provisions for direct refunds to middle class consumers. It 
does it through the LDC allocation, which we've had some 
criticism about.
    Senator Bunning. OK. Thank you.
    The Chairman. Senator Bennett.
    Senator Bennett. Thank you very much, Mr. Chairman.
    I apologize to the panel for having been required at 
another committee so that I didn't hear the testimony directly. 
But I've enjoyed the questioning and the answers. My overall 
reaction is that Rube Goldberg is still alive and well and 
dwelling in the House of Representatives.
    This is an incredible mess. We're talking about taking 
money from people in an effort to cure the planet. We're going 
to spend some of that money, clearly, in ways that produce no 
new tangible economic benefit, because it costs money to 
sequester carbon and there's no impact on quality of living, on 
the standard of living. It costs money to do the kinds of 
things you're talking about, and that money will be spent, but 
the standard of living will stay the same.
    We say it's worth spending that money because it will save 
the planet. But somehow there's going to be more money than 
that that is spent in the actual costs of remediating carbon, 
that will be available to be distributed in some way because 
we're creating this system. Trying to follow the threads of 
where it will come from and where it will go and who will be 
disadvantaged and how the government will step in and see that 
this person is made whole and this entity is made whole and 
this entity is punished for depending on coal, and this group 
is benefited for depending on natural gas, becomes an 
incredible mess.
    As I sit here and listen to all of this, it just becomes 
mind-boggling to figure out how in the world is this all going 
to work. So it seems to me, Dr. Metcalf, I'm glad to hear your 
comment. If indeed our whole purpose in doing this is to cause 
people to emit less carbon, let's put a tax on it that is 
dependable, that will not turn into credit default swaps, 
because if you think the speculation that went on in the 
securitization of mortgages produced a mess, look at the 
speculation that's going to go on in the securitization of 
these swaps and these alternatives. These will be sliced and 
diced and traded all over the world and speculated on.
    Why don't you just say, let's put in a tax, let's let the 
marketplace reward those people who avoid the tax by getting 
more efficient with respect to carbon, and punish the people 
who pay the tax by continuing to emit too much carbon, and let 
the whole problem solve itself?
    Now, tell me why I'm off base with that reaction? That's my 
visceral response as I listen to all of this here this morning, 
that how in the world are we going to make any of this make any 
sense? Yes, sir.
    Mr. Metcalf. You've laid out a number of good points. I 
have been a forceful advocate over time for a carbon charge 
approach, as opposed to cap and trade. But let me just speak--
as someone who does support that, let me just speak up in 
defense of cap and trade in the following sense: that you have 
an opportunity to write a cap and trade legislation that 
incorporates many of the advantages of a tax-based approach, 
that is simple and transparent.
    It really has to do with what you decide to do with the 
permits, with the revenue from permits. So step one, by 
auctioning all of the permits you avoid a lot of the Rube 
Goldberg structure because you're not giving this group some 
permits and that group some permits. Then the issue then comes 
down to what are we going to do with the revenue, which is a 
distributional question. Then you can do this in as transparent 
a fashion as you could with a carbon tax.
    So if we are locked into the road of cap and trade, then I 
implore you to construct a system that is simple and 
transparent, and it can certainly be done.
    Senator Bennett. Dr. Palmer.
    Mr. Palmer. Another advantage that folks here have pointed 
out today of a carbon fee or tax approach is there is more 
certainty about what the cost is going to be. So it's helpful 
for planning for corporations. I think you can bring that 
feature to a cap and trade program as well by introducing a 
price collar approach, where, for example, if you followed Dr. 
Metcalf's recommendation that 100 percent of the allowances be 
auctioned off, and I think that would be ideal, then you could 
impose the floor part of the price collar, the price, minimum 
price, through a reservation price or reserve price in an 
allowance auction. They have a feature like that in the 
regional greenhouse gas initiative allowance auctions that they 
have.
    You could also have a price ceiling as well, and that would 
help to add to the cost certainty.
    Senator Bennett. To the complexity.
    Mr. Palmer. It would add to the complexity, but having----
    Senator Bennett. I'm sorry.
    Dr. Ellerman.
    Mr. Ellerman. Yes. I'd make the one point, for the 
attractions of a tax, which you laid out some of them, it still 
doesn't address the problem of what do you do with the tax 
revenues. That problem remains with a tax and it has to be 
dealt with. It can't be avoided. It is exactly the same problem 
that you deal with--that is the subject of this hearing, which 
is what to do with the allowance allocation and the revenues, 
if you want to put it in those terms, or the value that's 
created by those allowances. I don't think a tax avoids that 
problem. You'll have exactly the same problem.
    Senator Bennett. I understand that.
    Mr. Stone.
    Mr. Stone. If we come to have a 1986 tax reform moment and 
we all of a sudden say, this is all too complicated, let's 
revisit, I think a lot of what the revisiting would be about 
was what Dr. Metcalf was talking about, is simplifying and 
talking about how you use the allocation. The difference 
between a carbon tax and cap and trade, especially if you have 
some limits on the fluctuations in the price in the cap and 
trade system, really turn out not to be that important. What 
really matters is what you do with the allowance value or the 
tax revenue that you collect.
    Senator Bennett. Seeing as how we're sitting on a $79 
trillion unfunded liability for Medicaid--or Medicare, I can 
think of a way, of someplace to put the revenue.
    Mr. Stone. Deficit reduction is another way.
    Senator Bennett. My time has gone. My frustration as I 
listen to this whole thing just spills over, because I think we 
have fallen in love, Dr. Metcalf, with the idea of cap and 
trade is the way to solve this. Now we keep running into 
problems and as we run into problems, well, we'll solve this 
this way. We solve this that way, and I end as I began: Rube 
Goldberg is alive and well in the way this whole thing keeps 
getting bigger and more complex, and ultimately raises the 
question of why are we doing this.
    Thank you, Mr. Chairman. I apologize for the emotion here, 
but it gets pretty hard when I try to figure out why some of 
this makes sense.
    The Chairman. We're glad we could have this hearing to 
clear up all these matters in your mind.
    Senator Cantwell.
    Senator Cantwell. Thank you, Mr. Chairman.
    I understand the Senator from Utah's frustration, but I 
think all the witnesses here actually, even though you have 
different philosophies and different approaches to the climate 
issue, I think are all more or less supporting more of a cap 
and dividend approach. Is that correct, something that would 
basically set a price or limit, but then distribute money back 
to consumers. Is that correct?
    Mr. Stone. With a modification. We certainly at the Center 
on Budget think that direct refunds to households rather than 
an approach based on utilities and things like that is the way 
to go. We think there also are----
    Senator Cantwell. Because the utilities don't necessarily 
translate all that back to the consumer?
    Mr. Stone. Yes, especially the part going to business 
customers, it's very uncertain how that's going to play out, 
yes.
    But we recognize that there are some legitimate other 
policies, investments--the parts that in your bill you would go 
through the authorization and appropriations process to fund. 
So that a 100 percent refund of dividends squeezes out all 
those other possibilities. So that would be the caveat.
    Senator Cantwell. Dr. Palmer.
    Mr. Palmer. I would agree with a lot of what Chad had to 
say, that there are important market failures related to 
research and development and things that we need to do to move 
forward new technologies that, while putting a price on carbon 
will hopefully help substantially in that regard, it still may 
be necessary to provide additional funding for research and 
development.
    There could also be opportunities on the energy efficiency 
front. I think there's a lot of uncertainty there. We've seen a 
lot of studies that suggest that there are all these free 
energy savings that people aren't taking advantage of. But an 
important part of getting ready to find ways to take advantage 
of that is to try and understand better what will work. I know 
in the regional greenhouse gas initiative they're using a lot 
of their allowance revenues, some States, most of them, to fund 
energy efficiency, and it would be important to learn from 
those efforts what types of programs work and what don't.
    Senator Cantwell. Dr. Gilbert, a more transparent, elegant 
process, giving money back to consumers and keeping them whole?
    Mr. Metcalf. I've talked in previous research about using 
proceeds to reduce the payroll tax so that we get some 
incentives in labor supply. I think there is some need for 
spending to support pure research and development.
    I also think there are some very low-cost things that ought 
to be looked at in terms of making energy prices more 
transparent to consumers. So things as simple as having washing 
machines that have a green, yellow, and red light that will be 
a green light when energy prices, when the cost of generating 
electricity is low, and red when they're high; things that 
allow consumers to respond to prices that they can't do 
currently.
    I would say that the stimulus package that was passed 
earlier this year has a lot of money in there for energy 
efficiency. So I would be cautious about putting more money 
into the hopper until we're sure that we can spend that money 
effectively.
    Senator Cantwell. But sending a price signal and then 
giving the consumer something, both information and ability to 
mitigate and cushion, is a good idea?
    Mr. Metcalf. Yes, absolutely.
    Senator Cantwell. Thank you.
    Dr. Ellerman, did you want to add anything to that? Are you 
on the cap and dividend approach?
    Mr. Ellerman. Yes. I think we need to keep in mind the 
fundamental objective here is to put a price on greenhouse gas 
emissions in order to limit them. My personal preference is cap 
and dividend. It's simple, elegant in many ways. But I also 
recognize there are political realities and much of this has 
been brought out. So I think the notion, whatever transition--
my basic philosophy would be whatever it takes to get a price 
on carbon at the level you will decide and such.
    I think the key point is whatever transitional assistance 
that we should avoid what could be--what Senator Murkowski 
described as decade-long earmarks. They can be phased out over 
time and ultimately it should in some proportion go to 
consumers and households according to regions, income. Those 
need to be decided.
    Senator Cantwell. I think that, Dr. Ellerman, I think that 
the politics here is that there's people on both sides of the 
aisle on this committee who think that the shenanigans that has 
preceded this is just not going to be tolerated when it comes 
to cap and dividend or a cap and trade bill. I'm not going to 
tolerate it and I'm sure my colleagues aren't, either.
    We can't just continue to have the notion that some trading 
regime is going to like magically work and that carbon futures, 
as my colleague was saying, is going to be cut up into 
tranches, as they already are being done in Europe today, 
carbon futures, and then traded around, and the mystery of all 
of this driving up the price. We already know what it's done to 
oil. I don't think we need to have it done to carbon futures.
    Thank you, Mr. Chairman.
    The Chairman. Thank you.
    Senator Barrasso.
    Senator Barrasso. Thank you, Mr. Chairman. I appreciate all 
of the witnesses and their testimony.
    Last week we were here in the same hearing room and the 
Congressional Budget Director, Doug Elmendorf, was here 
testifying to this committee and he said that the House-passed 
global warming bill will slow economic growth in the next 
decade, actually in the next few decades, he said, and cause 
significant job losses in the fossil fuel industry. He said 
there is going to be a lag between when the changes happen to 
the fossil fuel industry and then the green jobs may come, but 
there's going to be a lag and there's going to be significant 
drag on the economy, a reduction in the gross domestic product.
    Also, the Environmental Protection Agency has testified 
that drastic CO2 emissions cutbacks made in the U.S. 
are virtually worthless if the developing nations of China and 
India do not do anything to cut their own emissions.
    So as we look at the impact, the potential impact on the 
communities--and certainly I'm from a State in Wyoming where we 
have significant amounts of fossil fuels, the coal capital of 
the world, where half of the electricity in the United States 
comes from coal--if Congress is going to pass this massive 
energy tax, which I view it as, a large unfunded mandate, 
what's the government's responsibility? I'm going to ask each 
of you: What would you think the Federal Government's 
responsibility is in terms of paying for the losses that are 
going to happen in the communities, for police officers, for 
teachers, for the different services in the communities, to 
help fix the roof on the hospital? What is going to be the 
Federal Government's obligation to help these individuals in 
these communities who are now dependent on the jobs of fossil 
fuel and helping this Nation's economy?
    So if we would start with Dr. Ellerman and maybe work our 
way down through the panel.
    Mr. Ellerman. I would reiterate the point I just made on 
the transition assistance. I think there is a legitimate 
political argument for that. This will have impacts. The people 
who are impacted by it should be assisted in adjusting to the 
new price relationships and the new economy. You know best how 
to do this in different ways, but I think the basic point that 
some transition assistance is needed. It doesn't need to be the 
decade-long earmark, but that that assistance is needed, I take 
that as a given.
    That can be done by auction revenues. It can be done by 
free allocation.
    Senator Barrasso. Dr. Metcalf.
    Mr. Metcalf. I think temporary transition assistance is 
certainly something that could be on the table. But I do want 
to point out, though, that the various studies, including the 
ones that Doug Elmendorf referenced, are talking about 
reductions looking ahead 10, 15 years, are reductions in GDP 
relative to where we would be in a no-policy world. In that 
world we're still seeing growth in GDP. It's just not growing 
quite as rapidly as it would in the absence of policy.
    The other thing I'd note is that, as well as costs, there 
are also benefits. We're going to see increased demand for 
natural gas in the short term. This is going to be a transition 
fuel, and we're seeing a lot of development of natural gas in 
western States.
    We're also going to see greater demand for wind and solar. 
So I think there are some opportunities as well as costs. So 
what I think States need to be looking at are how to take 
advantage of the opportunities as well as react to the costs.
    Senator Barrasso. Dr. Palmer. Just before you do, last week 
we heard at this table--when I asked specific questions about 
natural gas, they don't agree with what we just heard here in 
this testimony, that there is the question about whether it was 
independent and how it all played out. So there was no clarity 
on what the future was going to be on natural gas.
    Yes?
    Mr. Palmer. I think an important thing to keep in mind 
about all the studies that were presented last week is they 
were looking at a baseline where there isn't an alternative 
approach to regulating CO2. I think one of the 
virtues of this debate that's going on in the Senate is that 
the alternative is not the no-CO2 policy scenario 
that all these folks are comparing to, but that the EPA might 
go ahead and actually under its authority now regulate 
CO2 using the Clean Air Act.
    Most people expect that when that occurs, that the prices 
or the costs introduced by that approach to regulation will be 
substantially higher than the types of approaches that we're 
looking at here. So I think it's important to keep that in 
mind.
    Senator Barrasso. It's going to generate a lot of suits as 
well if they do that using their 25,000 tons as opposed to the 
hundredth of that for emissions which the law currently calls 
for, as they try to define it a little differently and tweak 
out several groups.
    Dr. Stone.
    Mr. Stone. Yes, thank you. We're talking about a situation 
in which we're going to be transforming or changing the 
composition of how we produce goods and services, moving from--
moving toward more clean energy and other ways of doing things.
    That does impose transition costs, as Director Elmendorf 
said. But I want to reiterate what Dr. Metcalf said, which is 
these costs to GDP are really quite small. We're talking about 
off of a much higher level standard of living in the future 
when they occur than we are talking about now. So it is 
important to have transition assistance and it's important to 
help encourage the transition into the sectors that will play a 
bigger role in the economy.
    If we look at the United States over the 20th century and 
the beginning of the 21st century, the economy in 1999 does not 
look at all like the economy in 1959 or the economy in 1909. 
There's been lots and lots of changes in the sectoral 
composition of what we're producing, without leading to losses 
of jobs that are permanent over the long run.
    It absolutely matters to pay attention to short-term 
adjustments and to ease those transitions. But it's not 
necessarily a long-run problem.
    Senator Barrasso. Thank you.
    Thank you, Mr. Chairman.
    The Chairman. Thank you very much.
    Let me ask another few questions here. Dr. Palmer, here's a 
quotation from your testimony. You say: ``In regions with 
deregulated generation markets, the value of emissions 
allowances used to produce electricity will be reflected in the 
electricity price even if they were received for free.'' Now, 
that's what happened in Europe in the first phase as I 
understand it to a great extent.
    Dr. Ellerman, you've made a real study of this. Many of the 
rest of you may have as well. But I'd first ask Dr. Ellerman, 
do we have in the House-passed legislation protections against 
the value of these allowances essentially being factored in by 
utilities as a justification for raising electricity rates, 
even when they're freely allocated?
    Mr. Ellerman. I think the short answer is it depends on 
what 50 public utility commissions decide to do. The intention 
is clearly to do that, and there is a question of how to refund 
the money to consumers without affecting the price of 
electricity. So you could imagine it as lower electricity bills 
or you could imagine simply an annual check that is sent to the 
local distribution company, that consumers pay the prices they 
would pay for the carbon and the carbon revenues collected by 
the local distribution company are simply sent to the 
household. That would avoid those.
    But I think if 50 public utility commissions indeed do what 
is instructed and what is intended by the House provision, then 
I think it would avoid that.
    The Chairman. Let me just ask Dr. Palmer. My understanding 
is that that would be the case, obviously, with regulated 
utilities, where the charges they can charge are set by the 
public utility companies, but in a deregulated setting you're 
saying that the cost of electricity is going to go up. The more 
free allowances the utility gets, the higher they will raise 
the electric rates or the electric price; is that a correct 
understanding of what you're saying or not?
    Mr. Palmer. Not so much that the more free allowances that 
they get, but that every time they produce a megawatt hour of 
electricity using fossil fuel they have to basically consume 
some allowances. Even if they got those allowances for free, 
they're making a choice when they produce the electricity 
between selling the electricity at a price that compensates 
them for using that allowance or selling the allowance.
    So they are going to bid into the market for electricity a 
price that compensates them for using that allowance, whereas 
in the bill, where allowances are being allocated to 
distributors, that's a separate consideration because they 
don't really have a compliance obligation. But there is an 
important role in that case that the public utility commissions 
will play in determining exactly how that value gets allocated 
back to consumers.
    I would argue that it's very difficult to expect that the 
public utility commissions will do that in a way that doesn't 
end up influencing the price that consumers perceive themselves 
to be paying for electricity.
    The Chairman. Dr. Metcalf, did you have any views on this 
issue?
    Mr. Metcalf. Just that it is critical that we avoid a 
situation where consumers are under the impression that the 
price of electricity is going down because of this rebate of 
revenue which is being given to deal with the regional 
disparities, as Dr. Ellerman pointed out. Even if it's put on 
the bill in big red letters saying ``This is money you're 
getting back that is not affected by how much electricity you 
consume,'' I think people just look at the bottom line of their 
bill and say, what's the amount of the check I need to write. 
So it's very easy for them to be confused by this, and this 
drives up the cost of cap and trade if we do that.
    The Chairman. So you're back to the issue of how we design 
the rebate, and it needs to be a lump sum rebate?
    Mr. Metcalf. If you're going to do an LDC--if you're going 
to do rebates through the LDC, I think, as Denny pointed out, 
it would be better to keep it separate from the utility bill, 
through say quarterly checks from the LDCs rather than 
embedding it into the bill.
    The Chairman. OK. Let me call on Senator Murkowski for 
questions.
    Senator Murkowski. I'm mulling over that last statement, 
because in Alaska we have a dividend system. We have our 
Permanent Fund dividend. We receive an annual check from the 
State. It comes from the revenues that are derived from our oil 
resource up north.
    I wish that I could tell you that every Alaskan who 
receives a Permanent Fund dividend understands and appreciates 
where that money has come from. There's not a nexus between 
where this revenue was derived from and the fact that it's now 
in my hand or in my bank account.
    So the suggestion that we need to separate the dividend 
checks from the utilities, I'm following you there. But if it 
is an annual check or a quarterly check that comes to the 
American public, I'm not convinced that they appreciate that 
this is your dividend that is coming to you because of this cap 
and trade, cap and dividend approach that we have.
    You have said several times here this morning, Dr. Metcalf, 
that simpler is better. I think I've heard it from all of you. 
There have been some suggestions about how we can be more 
transparent with this, but I'm not as verbal as my colleague 
here in expressing the frustration with the complexity of it, 
but I think we all acknowledge that as simple as we want to try 
to make it, this is a very complicated initiative.
    Senator Cantwell is working on a cap and dividend type of 
approach. Her proposal is shorter by hundreds of pages than 
anybody else I've seen, and it's still very complicated.
    Is there really any way to make any form of a cap and 
dividend, cap and trade program truly transparent, truly simple 
and understandable and free from the prospect of manipulation, 
as Senator Cantwell has mentioned? Is it possible?
    Dr. Ellerman.
    Mr. Ellerman. Yes, I think it's possible. I think that 
market manipulation is a separate issue from the allocations. 
That is in how the market behaves, how it would be regulated, 
and that would be sort of a separate subject. But I think the 
allocation, the let's say complexity of the issue, resides in I 
think the difficulty of the many different impacts that this 
has and how you have to deal with them politically.
    I don't think there is a simple answer. I would, for 
instance, make the comment to Senator Bennett that Rube 
Goldberg is also alive and well in the tax code, and a tax 
solution will not simplify the problem from the standpoint of 
what you do with the revenue that's collected, as you have in 
the allowance case.
    So I don't think there is a simple solution. One elegant, 
simple one is just take all the money and give it back to 
households equally. But that doesn't address your issue that 
you raised. It doesn't address the issues that were raised by 
the gentlemen from Kentucky and Utah, or the low income issue 
cited by Dr. Stone and others.
    So I think it is going to be more complex. Nor does it 
address the transitional issues that are inevitably going to 
accompany the program. So how you mix all this together--I 
think it's the nature of the beast is that it is going to be 
complicated.
    Senator Murkowski. Thank you, Mr. Chairman and thank all 
the witnesses. I appreciate the comments and the assistance 
this morning.
    The Chairman. Senator Bunning.
    Senator Bunning. Just a couple questions. I want to make 
sure that I understand the exact reason that we're going to go 
to a cap and trade system. It's my understanding that if China 
and India and Russia, those three countries, do not sign on to 
a global agreement of some sort, that 20 years from now we will 
have more emissions and more pollutants in the air than we have 
presently.
    So the United States has been tasked by certain people with 
leading the reduction of carbon emissions in their energy 
production. Why is the United States going to punish their 
economy and 20 years from now we have got more pollutants in 
the air if we did nothing?
    Go right ahead, anybody?
    Mr. Metcalf. A couple of brief comments. This is an 
international problem and it requires international action.
    Senator Bunning. Good. I agree 100 percent.
    Mr. Metcalf. So I view the action that the United States 
takes by passing a bill as a first mover action to take the 
lead to begin to break the impasse. We can't----
    Senator Bunning. No, you've got to let me in, because----
    Mr. Metcalf. I would say that China is----
    Senator Bunning. Our Secretary of State has asked that 
question of the Indian foreign minister and of the China 
foreign minister on energy and got exactly an N-O answer: We 
are not going to do this in China and we are not going to do it 
in India presently.
    Mr. Metcalf. We have to be careful as to what they're 
saying they are and are not going to do, because they're not 
going to--China is actually taking considerable action to 
reduce emissions in the auto industry and in the utility----
    Senator Bunning. Is that why China is going to open up 94 
new coal-fired generating plants----
    Mr. Metcalf. It's a fast-growing country.
    Senator Bunning [continuing]. With no restrictions? At 
least when we open up a coal-fired generating plant in Kentucky 
or anywhere else in the United States, there are at least new 
technologies used in coal-fired generating.
    I brought up in an energy bill that we passed coal to 
liquids, using coal to make liquids, liquification or 
gasification at the end of the line, and boy, I got so much 
pushback from the environmental community you'd have thought I 
was the monster from Kentucky.
    But the fact of the matter is there's got to be a 
transition period from where we're at now and where we want to 
be 20 years from now. We can lead, but we need followers, and 
we need a global agreement on carbon emissions if we're going 
to be successful. Does anyone disagree with that?
    Mr. Ellerman. I would make the point that there have to be 
leaders; we see ourselves as leaders. There will have to be 
followers, and if there are not followers then action will be 
taken. No Congress can bind Congresses with respect to the 2050 
target and that would be changed if there are no followers. But 
you have to start somewhere.
    Senator Bunning. Doug Elmendorf, Dr. Elmendorf, has made it 
perfectly clear that we injure our economy to a certain degree. 
Now, depending on the grandness of the economy--and right now 
what was a $14 trillion economy is not a $14 trillion economy, 
because we're in a very strong recession. But down, 20 years 
down the road, we should be doing a little better than $14 
trillion, and it's all relative.
    But China is growing at 8 to 10 percent and India is going 
to be the largest populated country in the world in 20 years. 
They do not have any birth control restrictions on their 
population. So we're dealing with very large populations. So if 
we're going to lead, we must have them to follow us.
    Is there any disagreement?
    Mr. Metcalf. No, but I would just add that I think they 
will follow, for the following reason----
    Senator Bunning. I wish I was as confident.
    Mr. Metcalf. The damages that China and India are going to 
incur from the loss of glacial waters in the Himalayas, which 
is the source of water for these countries.
    Senator Bunning. We also were going to have an ice age in 
the 1980s. In the early 1980s, we were going to go back and 
have an ice age. So the science is not perfect.
    Mr. Metcalf. The science is not perfect, but I think the 
risks are great and I think they recognize the risks. I think 
this is why, as Dr. Ellerman says, we can be leaders and I 
think we can have some confidence that they will follow. But if 
they don't follow, then future Congresses change the rules.
    Senator Bunning. Yes. In the meantime, the dollar is worth 
74 cents and our economy is not turning the corner, no matter 
what the stock market says. The economy is not turning the 
corner to come out of recession. I worry about that because I 
have 40 grandkids, and we're $12 trillion in debt, not counting 
the liability that we have built up in Medicare. So I worry 
about that in the future, that we're going to restrict our 
economy and let China and India and Russia go right on past us.
    So I hope that we get a global agreement in leading.
    Thank you.
    The Chairman. Senator Bennett.
    Senator Bennett. Thank you, Mr. Chairman.
    Talking about refunding the money to consumers, the 
clearest and easiest way to refund money to consumers is to not 
take it from them in the first place. I just make that 
observation here.
    All right, let's look at--talk has been made about green 
jobs, about renewable energy, whatever. Let's look at the 
reality of the physical plant. If we're going to have the 
promised land, where all of our energy comes from non-
emitting--and I use the word ``non-emitting'' rather than 
``non-polluting'' because CO2 is not a pollutant, 
the Supreme Court to the contrary notwithstanding. 
CO2 is required for life, let's understand that. But 
all right.
    In the language here, a non-emitting situation in the 
United States. It's the only one we can control. Let the 
Chinese and the Indians take care of themselves. The promised 
land of a non-emitting energy plant in the United States, which 
is going to be predominantly nuclear, with some solar, maybe 
some wind, tidal, geothermal, all of these wonderful things--
I'm for it. I voted for the subsidies that have gone into the R 
and D for these things. It's the right thing to do.
    It's 30 years away. Physically it's 30 years away. To build 
that many nuclear plants, to open up that much geothermal, to 
physically produce the promised land is 30 years away, and the 
bridge to the promised land is built out of fossil fuels. That 
is I think an indisputable fact. If I'm wrong, you can tell me. 
But I haven't been able to find any indication that that's not 
the reality.
    So the question is, assuming we get on with it--and every 
time I've tried to move forward on the nuclear thing I get 
stopped by the same people that are pushing Waxman-Markey in 
the name of let's take care of the environment. But that's a 
separate issue.
    If we're going to get to the promised land, if we're going 
to build the bridge to the promised land out of fossil fuels in 
the most efficient way possible, what is the role of cap and 
trade in building that bridge? Yes, sir.
    Mr. Stone. The role of cap and trade, which would be the 
same role as the carbon tax if that was the substitute, is to 
create a price signal that encourages people to make the 
investments faster than they otherwise would to move the 
promised land forward a little sooner, to in the mean time find 
ways to reduce their use of fossil fuels.
    The reason we have the cap tighten gradually is because it 
will take time for those things to happen. So there is a reason 
why you want to raise the prices and give the money back, 
because you're doing two different things. You're raising the 
prices of a particular commodity to discourage their use and 
encourage the development of substitutes----
    Senator Bennett. Let me interrupt you for just a minute. I 
fear that one aspect of cap and trade will be to distort to 
building of the bridge. In other words, the marketplace says we 
want to go to natural gas, that is the least emitting of all of 
the fossil fuels we can use. Will cap and trade--forget cap and 
trade drives you toward nuclear and solar. Will cap and trade 
create a dynamic within the building of the bridge that says 
less coal and more natural gas?
    Mr. Stone. The price signal doesn't distinguish. The price 
signal says take the best path. If you allocate emissions 
allowances, you make bets on particular technologies rather 
than others, you may win, you may lose; you may distort, you 
may correct the market failure. But the price signal itself, 
which is the key feature of cap and trade and of a carbon tax, 
is to have a level playing field with respect to where you make 
your decisions.
    Mr. Ellerman. Let me make the point, I think it's easy to 
overestimate what are the effects of a carbon price. Future 
growth, whether it's in China or the United States or Europe, 
depends on much more than just a carbon price or its absence. 
If there's one lesson that we can draw from the existing cap 
and trade programs in the European Union as well as the 
SO2 and NOX programs in the United 
States, it's that they're effective in reducing emissions and 
the side effects are small.
    A point I make to many people about the European system is 
Europe doesn't look any different today than it did before 2005 
when they had a carbon price. No one suggests that the economic 
problems of unemployment and other things in Europe today, 
which we have the same type of problem, are due to a carbon 
price. It's simply the side effects have been small.
    The same with respect to, say, the SO2 program 
and the effects on the coal industry. Yes, there were effects 
within the coal industry, but what had been predicted about 
large switching to gas simply did not occur, because low sulfur 
coal was cheaper than gas.
    I think as a general rule I would argue that we find that, 
yes, there are these effects, they have to be dealt with, but 
they're small, and what does happen is emissions are reduced. 
That's the beauty of the proposals, of these sort of systems.
    Senator Bennett. If I may, if indeed Europe looks the same 
as it did before because the effects are small, I think the 
case could be made that the impact on emissions has been 
equally small. I don't think Europe is any farther along in 
meeting their Kyoto goals than we are. As a matter of fact, I 
don't think many countries in Europe are as far along in 
meeting the Kyoto goals.
    We didn't sign onto Kyoto. Al Gore did, but the Congress 
did not. Yet the greatest drop in fossil fuel use in the United 
States has come as a result of the recession and nothing else. 
We've seen a dramatic drop in fossil fuels simply because the 
economy has slowed down.
    So we could have that other discussion, but I buy your 
point that the impact has not been too great, but ask you to 
consider the other side of it, that maybe the impact of the cap 
and trade system in reducing emissions has not been that great 
either.
    Mr. Ellerman. I think it must be admitted, the emission 
reduction is small. It's in the order of, we estimate or I 
estimate, around 3 to 5 percent of what emissions would 
otherwise have been. But that's only in the first years. What 
it will be in the future we will see. But we can say that it 
has reduced emissions modestly. The ambition was modest of the 
program at its start. The feared or hoped-for side effects, 
depending on the perspective, have not been as great as people 
thought.
    But it has achieved the objective, which is limiting 
emissions.
    Senator Bennett. Any other comments?
    Mr. Metcalf. I think with a significantly higher price, 
higher than what we have seen in Europe, going down the road 
into the future, I think we will see as a transition the use of 
natural gas.
    I think the other thing to keep in mind is we have the, I 
believe, second largest reserves of coal in the world. As the 
Senator from Wyoming pointed out, over half of our electricity 
comes from coal. We are a tremendously innovative society and I 
have great confidence that we're going to use that coal, but 
that we can figure out a way to use it without releasing 
emissions. So I think there are great opportunities here.
    But pricing is part of what we'll need to get to that 
future.
    Senator Bennett. You think that cap and trade will drive us 
toward that innovation that would not otherwise take place?
    Mr. Metcalf. It's a necessary step. It won't do it all by 
itself. We'll need R and D. But without carbon pricing the 
alternative will be a regulatory approach with the EPA, which 
will be much more costly.
    Senator Bennett. I agree with that.
    Mr. Palmer. Just to reiterate something that Dr. Metcalf 
said, I think that history has shown us that cap and trade does 
lead to very innovative approaches, particularly with regard to 
SO2 control. Initially people thought that in order 
to achieve the goals of the program we would have a lot of 
scrubbers installed, and we did see firms actually looking for 
innovative, cost-effective ways to reduce CO2 
emissions that they didn't anticipate would work before the 
program, like coal blending and things.
    I think once there's a price signal on CO2 
you'll see similar types of innovations.
    Senator Bennett. I'm a little less excited about the 
example of the SO2 thing because it was not a 
worldwide problem like this one. It was restricted to a single 
industry in a single country, and in that circumstance it 
worked. I'm a little less convinced that it's going to work 
when you're dealing with the Indians. I've talked to the 
Indians, too, and I know exactly how much we can depend on the 
Indians cooperating.
    Thank you, Mr. Chairman, for your indulgence.
    The Chairman. Let me thank all the witnesses. I think this 
has been useful testimony for us. We appreciate it, and that 
will conclude our hearing.
    [Whereupon, at 11:47 a.m., the hearing was adjourned.]
                                APPENDIX

                   Responses to Additional Questions

                              ----------                              

   Responses of A. Denny Ellerman to Questions From Senator Murkowski
    Question 1. There is a great deal of money at stake in any carbon 
market that Congress may seek to create, and some portion of this value 
will be reflected in costs that covered entities, consumers, or others 
incur. We heard at a separate Energy Committee hearing on October 14th 
about the projected costs of the House bill.
    I am concerned about the significant risk that allowances and their 
attendant compliance usage will be made even more expensive if 
stringent state and regional programs are allowed to drain the federal 
supply of allowances. While any real solution to global warming must be 
global in scale, we're also trying to get a handle on how much our 
domestic efforts will cost and state and regional approaches may 
complicate, or harm, these efforts.
    If federal climate legislation does not explicitly preempt state 
and regional programs, as well as the regulatory approach being pursued 
by the EPA, do you believe the end result will be higher compliance 
costs, assuming the ultimate environmental objectives are held 
constant?
    Assuming preemption is included, how would you recommend phasing 
out the allowances associated with existing state and regional 
programs?
    Answer. If a federal cap-and-trade program is in place, state and 
regional programs covering a subset of the same sources, as well as 
prescriptive, source-specific federal regulation under the Clean Air 
Act covering the same sources, will only add cost with no environmental 
gain. It should be noted that this conclusion holds only if these 
additional regulations require some sources to reduce emissions more 
than they would in response to the price resulting from the federal 
cap. These sources would incur more costs, and their extra abatement 
will--with an unchanged federal cap--allow other sources to abate less 
and to incur less cost. Still, the net cost from a national perspective 
will be greater since the added costs of the sources subject to double 
regulation will be greater than the savings accruing to sources subject 
only to the federal cap-and-trade program. The complicated interaction 
between state and federal regulation is discussed more thoroughly in a 
paper written by a colleague and me in the third essay in the 
collection on cap-and-trade design that can be downloaded at http://
web.mit.edu/ceepr/www/publications/DDCF.pdf.
    My recommendation for the phasing out of existing state and 
regional program allowances is to allow those allowances which had been 
acquired at some cost to be converted into federal allowances on a 
comparable cost basis, as is provided in the Waxman-Markey legislation. 
Thus, whatever a covered entity or intermediary had actually spent on 
state or regional allowances would be converted at cost to federal 
allowances. Disallowing a ton-for-ton substitution would discourage 
speculation in state and regional allowances and resulting distortions 
in the federal system. Accounting issues in determining the cost-basis 
of state allowances and the equivalent federal allowance value will 
have to be addressed, but these are manageable technical issues. Such a 
provision would also require some small set aside within the federal 
cap for this purpose.
    Question 2. Cap-and-trade's advocates have consistently stated 
their desire to protect consumers from price increases brought on by 
such programs. So far, their answer has been to increase the number of 
permits given away for free, in hopes that the recipients will pass 
less of a burden on to consumers.
    Is there a more straightforward and transparent way to make the 
consumer whole, regardless of the structure of the program itself?
    Would it make sense to cut out the middlemen, and directly 
compensate Americans for their increased expenses instead?
    Answer. The most straightforward and transparent way to make the 
consumer whole is to rebate the proceeds of an allowance auction 
directly to consumers or households, for instance, on a per-capita 
basis, somewhat in the manner of stimulus checks or the payments from 
the Alaska Petroleum Trust. The key issue is how to deal with the 
differing impact of the carbon cost by region and income category. For 
instance, households in regions where electricity is predominantly 
coal-fired will face higher costs than consumers in regions with little 
coal-fired electricity. Similarly, energy costs constitute a somewhat 
larger share of expenditure for lower income households than higher 
income households. The free allocation to local distribution companies 
and the provisions to fund low and moderate income programs in the 
Waxman-Markey bill are attempts at dealing with these two problems, 
respectively. Whether the means chosen to do so, as well as the 
allocation shares and criteria, are appropriate can be debated, but 
some provision to deal with these concerns will likely be required. I 
would recommend phasing out such provisions over time bearing in mind 
that there will always be regional differences in cost reflecting 
differing resource endowments and demographic characteristics.
    Question 3. A great deal of effort on the part of regulated 
entities--and even non-regulated entities--has gone into securing free 
permits at the outset of the House and Senate cap-and-trade programs. 
The importance of these free permits is apparent in the number of 
blanks left in the recently circulated Senate bill.
    As a matter of economics, is Congress any less capable of 
addressing the priorities reflected in permit allocations by spending 
auction revenues or tax receipts instead?
    Answer. Congress can address priorities equally by allocating 
permits or by deciding the use of auction revenues or tax receipts. 
There are slight technical differences in that a permit allocation is a 
share of allowance value in contrast to appropriations which are 
typically fixed sums. Perhaps more importantly, permit allocations are 
not subject to annual determination, like appropriations, so that 
recipients likely view permit allocations as less subject to subsequent 
change and therefore more secure and more valuable. The fundamental 
decision--how to use the value created by a cap or by a tax--is the 
same and best addressed by the legislative branch.
    Question 4. Some have raised concerns about the detrimental impact 
that giving away free permits might have on the liquidity and stability 
of a carbon market. Dr. Ellerman recently wrote that ``free 
allowances... reduce the value of the flexibility afforded by banking. 
As a consequence, the price impact of short run shocks to the system 
are magnified, resulting in a suboptimal allocation of emissions 
reductions through time and raising the cost of the system.''
    Assuming we want to design the most efficient and straightforward 
climate program, can you elaborate on this issue for us and how we can 
account for it in legislation?
    Answer. This quote is drawn from an article analyzing the causes of 
the price spike in the US SO2 allowance market in late 2005 
in which we (including my two co-authors) concluded that the large, 
existing bank, which should have prevented the spike, or at least 
dampened its magnitude, was not available to the market because of the 
interaction of free allocation with electric utility rate regulation. 
In essence, electric utility regulation provided little incentive to 
utilities with large banks to sell a portion of their banks even if 
they thought that the sales could be made up by later purchases at 
lower, future prices.
    More fundamentally, this behavior reflects an asymmetry that exists 
when free allocation is not coupled with borrowing. Any installation 
that finds itself short in some compliance period must purchase 
allowances to cover emissions; however, installations that are long are 
under no compulsion to sell. This problem is avoided if it is possible 
for installations to borrow even if for only as little as a year ahead.
    In a well-functioning market with all participants having the 
flexibility to bank and to borrow, we can be reasonably confident that 
the resulting prices accurately reflect current expectations with 
respect to present and future prices. However, when borrowing is not 
permitted, proper market clearing depends on the ability of 
installations that are long in that period, or holders of banked 
allowances, to make the appropriate calculations and to be willing to 
sell to those who are short in the current period. If these longs do 
not do so, for either regulatory or behavioral reasons, prices will be 
higher than they should be driven by the need of owners of short 
installations to purchase allowances as the only means of being in 
compliance. Borrowing provides these participants with the flexibility 
to comply with future vintage allowances if they expect next period 
prices to be lower or they can abate more in the next period at lower 
cost.
   Responses of A. Denny Ellerman to Questions From Senator Cantwell
    Question 1. What effect does the point of regulation have on 
regional disparities in household costs, when one accounts for both 
direct and indirect costs on consumers from the carbon price signal? 
And does less (uniform) coverage affect the (indirect) carbon costs 
passed down to consumers in different regions?
    Answer. The point of regulation (what entity is required to 
surrender allowances against emissions) will have no effect on 
household costs. Whether the point of regulation is ``upstream'' (where 
the carbon first enters the commercial chain) or ``downstream'' (at the 
point of emissions) only determines the point at which carbon cost is 
incorporated into the final price of goods and services. In this 
respect, all the carbon (and other) costs faced by households are 
indirect in that they are already embodied into the price of the goods 
or services consumed.
    The distinction between direct and indirect costs is usually 
applied to industrial facilities that are regulated downstream for 
their own emissions (direct costs) but also consume electricity into 
which the cost of carbon has already been incorporated (indirect cost). 
A cap-and-trade (or a comparable tax) system will impose both of these 
costs on the industrial facility, but for those purchasing that 
facility's output, both costs are included in the sale price and 
therefore constitute what would be considered an ``indirect'' cost for 
those purchasers and other downstream users.
    I do not see how the point of regulation would affect regional 
disparities which will depend upon the carbon content of goods and 
services (for instance, electricity) consumed in a region and how the 
prices of goods or services in that region are formed.
    Question 2. Combined with a 100 percent auction of allowances, what 
effect would an equal per capita distribution of the auction revenues 
have on the regional disparities in net household costs from a carbon 
policy? How are indirect carbon costs embedded from the production 
process of goods and services factored in?
    Answer. A strictly per capita distribution of auction revenue would 
tend to under-compensate the average household in regions characterized 
by more carbon use and to over-compensate the average household in 
regions characterized by less carbon use. Electricity provides a good 
example of how household carbon cost might differ. Where electricity is 
predominantly generated by coal, households would face a larger 
absolute and relative increase in electricity prices as a result of 
carbon policy than in regions where electricity is generated 
predominantly by less carbon-intensive means. Similar disparities would 
exist with respect to household gasoline costs between states that are 
predominantly rural and others that are predominantly urban.
    The embedding of indirect costs has been discussed in the previous 
response. In general, producers can be expected to incorporate the full 
costs of all inputs into whatever they produce. When those inputs 
already include the carbon cost, as would be the case with electricity 
purchased by manufacturers, the carbon cost component will be embedded 
along with all other costs in the price of the final output.
    Question 3. What is the simplest and fairest way to compensate all 
energy consumers while specifically maintaining a robust carbon price 
signal and protecting household incomes of the entire lower and middle 
classes? Roughly, what portion of the allowance value is necessary to 
keep the majority of households whole?
    Answer. The simplest way is to rebate auction revenues directly to 
households perhaps on a per capita basis. Whether that would be the 
fairest way is open to debate since the carbon content of household 
energy use varies by region and energy expenditures constitute a larger 
share of total expenditure for low income households than for higher 
income households. Thus, it could be argued that a direct distribution 
to households should be adjusted to take regional and income 
differences into account, even though it would detract from the 
simplicity of a straight per capita distribution. Still, all households 
will not be entirely compensated because energy use varies among 
households even when income category and region are held constant. At 
best, we can hope to make appropriate adjustments for average 
households. So long as the distribution to households is not made 
dependent on ongoing energy use, the carbon price signal will be robust 
in encouraging less carbon use by all.
    The question about the appropriate share of allowance value refers 
presumably to direct compensation of households through a rebate or 
cap-and-dividend mechanism since all allowance value is ultimately 
returned to households. A dedication of allowance value to specific 
uses, such as carbon capture and sequestration (CCS) or renewable 
energy (RE), will reduce the amount of the direct rebate and thus make 
the rebate recipients less whole, although those households associated 
with CCS or RE either through investment or labor would benefit by 
these dedications. Such uses can be justified and in the interest of 
all if the funds were to lead to earlier deployment of cheaper low 
carbon technologies without subsidy in the future.
    Question 4. Are lump sum payments to all Americans legally residing 
in the United States feasible?
    Answer. This is a technical question about which I am not qualified 
to comment. I am told by those who have looked at the issue that it is 
feasible using tax, social security, and other lists, although there 
are problems. Stimulus checks are an often cited example.
    Question 5. H.R. 2454 gives away a significant share of allowance 
value much of which goes to the largest historic emitters of carbon 
dioxide. Are these allowance giveaways likely to distort the carbon 
price signal and dampen incentives for businesses and individuals to 
become more efficient and transition to lower-carbon energy sources? 
Second, doesn't the granting of free allowances to selected industries 
necessarily entail the government picking winners and losers in its 
allocation decisions, which will bias fuel and energy technology 
choices?
    Answer. I believe you are referring to the provisions in HR 2454 
that provide allowances to local electricity distribution companies 
(LDCs). These companies are responsible for the distribution of 
electricity and not for its generation. As a consequence, they do not 
generate any emissions and they do not face an obligation to surrender 
allowances. Their only means of realizing the value of the allowances 
allocated to them is to sell them to those who are required to 
surrender allowances, namely, the generators from whom they buy power 
for distribution to retail customers. A further important point is that 
LDCs are all subject to state public utility commission (PUC) 
regulation. The intent is that LDCs will use the revenues from the sale 
of allowances to offset the additional cost of the electricity that 
they purchase and thereby to reduce the impact on retail electricity 
rate-payers. This ``LDC fix'' treats regulated and deregulated 
generators alike and ensures that rate payers will receive the benefit 
of free allocation assuming that state PUCs follow the intent as stated 
in HR 2454. This distribution of free allowances to LDCs is also 
intended to address the regional disparities referred to in my response 
to question 3 since 50% of the distribution is according to the 
historical emissions from electricity generation in the states.
    Whether the LDC fix would distort the carbon price signal would 
depend upon how the PUC returned the revenues from the sale of the 
allowances to rate-payers. For instance, if the monies were returned to 
rate-payers in a manner that seemed to reduce the cost of electricity, 
a distortion would occur. Alternatively, if the monies were returned to 
rate-payers by a separate check, the distortion would be avoided.
    Granting free allowances to selected industries certainly favors 
the recipient industries but it does not necessarily bias those 
industries' fuel and energy technology choices. So long as the free 
allocation does not depend on current or future emissions, the 
incentive to adopt less carbon-intensive fuels and energy technologies 
would be maintained. This result obtains because the use of a freely 
allocated allowance incurs an opportunity cost in that the recipient 
foregoes the revenue from selling the allowance if it is used to cover 
emissions. Profit-maximizing firms can be expected to recognize this 
lost opportunity and to price that cost into their sales prices. It is 
the same as if the government had given a cash grant to the company 
that was unrelated to its current or future emissions (as distinct from 
past emissions).
    Question 6. Won't both the dampening of the carbon price signal and 
the selecting of winners and losers outside of the market increase 
overall costs of reducing emissions? Assuming that a main goal of a 
climate policy is to establish a consistent carbon price signal, 
wouldn't it make more sense to rely strictly on market mechanisms by 
auctioning all of the allowances and avoiding the potential distortions 
that go along with giveaways of allowances or allowance value?
    Answer. As discussed above, free allocation of allowances need not 
distort the carbon price signal. It all depends on how the free 
allocations are handled by recipients or intermediaries (such as LDCs). 
The potentially distorting effect of how state PUCs might handle free 
allocations to LDCs under their jurisdiction has already been 
mentioned. It is also argued by some that the recipients of free 
allocations do not recognize opportunity cost, especially when 
receiving more allowances than their emissions as occurred in the 
European Union's Emissions Trading System. In fact, one of the emerging 
arguments for auctioning is that it ensures that the carbon price will 
be recognized since all emitters will be forced to pay cash for 
allowances, just as they do for other inputs. However, auctioning does 
not deal with the distributional issue, namely, what to do with the 
auction revenues. Auctioning does ensure that the carbon price signal 
is undistorted.
                                 ______
                                 
      Responses of Chad Stone to Questions From Senator Murkowski
    Question 1. There is a great deal of money at stake in any carbon 
market that Congress may seek to create, and some portion of this value 
will be reflected in costs that covered entities, consumers, or others 
incur. We heard at a separate Energy Committee hearing on October 14th 
about the projected costs of the House bill.
    I am concerned about the significant risk that allowances and their 
attendant compliance usage will be made even more expensive if 
stringent state and regional programs are allowed to drain the federal 
supply of allowances. While any real solution to global warming must be 
global in scale, we're also trying to get a handle on how much our 
domestic efforts will cost and state and regional approaches may 
complicate, or harm, these efforts.
    If federal climate legislation does not explicitly preempt state 
and regional programs, as well as the regulatory approach being pursued 
by the EPA, do you believe the end result will be higher compliance 
costs, assuming the ultimate environmental objectives are held 
constant?
    Assuming preemption is included, how would you recommend phasing 
out the allowances associated with existing state and regional 
programs?
    Answer. The climate change work by the Center on Budget and Policy 
Priorities has focused on the design of programs to assist low-income 
households and we do not have specific recommendations about how to 
address the issue of what is the best way to integrate existing state 
programs into a national program. Certainly, keeping the costs of 
meeting the emissions cap as low as is reasonably possible consistent 
with other policy objectives would be one of the key criteria in 
assessing different approaches to achieving an effective national 
system.
    Question 2. Cap-and-trade's advocates have consistently stated 
their desire to protect consumers from price increases brought on by 
such programs. So far, their answer has been to increase the number of 
permits given away for free, in hopes that the recipients will pass 
less of a burden on to consumers.
    Is there a more straightforward and transparent way to make the 
consumer whole, regardless of the structure of the program itself?
    Would it make sense to cut out the middlemen, and directly 
compensate Americans for their increased expenses instead?
    Answer. Market-based approaches to reducing greenhouse gas 
emissions like cap-and-trade or a carbon tax work by making it more 
expensive to continue to engage in economic activity that leads to 
greenhouse gas emissions. ``Putting a price on carbon'' gives 
households and businesses an incentive to conserve energy and make 
investments in alternative clean sources of energy and energy 
efficiency, but it also imposes costs that are ultimately borne by 
consumers. At the same time, these approaches generate substantial 
resources, whether in the form of carbon tax revenue or allowance 
value, which can be used to mitigate the cost impact on consumers.
    The main approach to mitigating the cost impact on energy consumers 
in the House bill and in the Kerry-Boxer bill is to allocate free 
emissions allowances to local distribution companies (LDCs), the 
utilities that sell directly to retail customers, with the requirement 
that the LDCs use the allowance value to benefit their customers. This 
approach should be distinguished from an approach that gives free 
allowances to electricity generators with no restrictions on their use. 
The LDC approach is intended to avoid conferring windfall profits on 
utilities. However, such utility-based relief has a number of inherent 
limitations.
    Providing relief directly to consumers is a preferable policy. That 
is the approach taken in the low-income provisions of the House energy 
bill, where 15 percent of the emissions allowance value is set aside to 
fund energy refunds for qualifying households. The Kerry-Boxer bill in 
the Senate also sets aside some allowance value (though an insufficient 
amount compared with the House) to fund low-income energy refunds.
    A policy of direct refunds is a more attractive alternative to a 
utility-based approach for delivering broad-based consumer relief. 
Policymakers would decide the size of the refund and how far up the 
income scale to extend eligibility to receive the refund. A sound 
approach building off existing delivery mechanisms would be to provide 
the refund as a refundable tax credit for households above a certain 
income threshold while relying on the electronic benefit transfer (EBT) 
system to deliver relief to low-income households, many of whom are not 
required to file a tax return. The House low-income provision provides 
a refund to most low-income households through the EBT system; low-
income childless workers, who are unlikely to participate in a program 
that uses EBT, receive an increase in the earned income tax credit.
    Direct refunds preserve the ``price signal'' that encourages 
businesses and households to make cost-effective decisions to reduce 
their carbon footprints while restoring the purchasing power to 
consumers' budgets that otherwise would be lost due to the higher 
prices of energy and energy-intensive products.
    Question 3. A great deal of effort on the part of regulated 
entities--and even non-regulated entities--has gone into securing free 
permits at the outset of the House and Senate cap-and-trade programs. 
The importance of these free permits is apparent in the number of 
blanks left in the recently circulated Senate bill.
    As a matter of economics, is Congress any less capable of 
addressing the priorities reflected in permit allocations by spending 
auction revenues or tax receipts instead?
    Answer. Congress could achieve the same priorities reflected in 
permit allocations through the disposition of the proceeds from 
auctioning 100 percent of the emissions allowances or through decisions 
about how to spend the receipts from a carbon tax that achieves an 
equivalent reduction in emissions. In cases where allowances are given 
away free for specific purposes, Congress could achieve the same 
objective by using an equivalent amount of auction proceeds or tax 
revenue to subsidize that purpose. The real question is whether the 
purpose represents a sound policy, not whether it is funded by a free 
allocation or by auction proceeds.
    For example, instead of giving allowances to LDCs and requiring 
them to use the allowances for the benefit of their customers, Congress 
could provide an equivalent amount of money out of auction proceeds or 
tax revenues and require that they use that money for the benefit of 
their customers. Utility-based relief is a problematic way to deliver 
consumer relief, but the question of whether the policy itself is sound 
or not does not hinge on the means of financing it. There could be 
administrative or transactions cost differences between free 
allocations and spending auction revenues or tax receipts that would 
lead to the choice of one method over the other for some specific 
purposes, but in general free allocations are not a necessary condition 
for Congress to meet its priorities.
    Question 4. Some have raised concerns about the detrimental impact 
that giving away free permits might have on the liquidity and stability 
of a carbon market. Dr. Ellerman recently wrote that ``free 
allowances... reduce the value of the flexibility afforded by banking. 
As a consequence, the price impact of short run shocks to the system 
are magnified, resulting in a suboptimal allocation of emissions 
reductions through time and raising the cost of the system.''
    Assuming we want to design the most efficient and straightforward 
climate program, can you elaborate on this issue for us and how we can 
account for it in legislation?
    Answer. To the extent that free allowances to emitters that need to 
hold allowances lead to a thinner market for allowances, there could be 
increased volatility. That concern does not apply to free allowances to 
entities that have to sell the allowances they receive in order to 
obtain the funds they need to carry out the purpose of the free 
allocation (e.g. free allowances to LDCs in competitive electricity 
markets). For LDCs in regulated markets, requiring arms-length 
transactions between the LDC operation and the generating operation 
would reduce the concern about the market being too thin, but if the 
market were already sufficiently liquid to mitigate excess volatility, 
such a requirement would impose additional transactions costs.
       Responses of Chad Stone to Questions From Senator Cantwell
    Question 1. What effect does the point of regulation have on 
regional disparities in household costs, when one accounts for both 
direct and indirect costs on consumers from the carbon price signal? 
And does less (uniform) coverage affect the (indirect) carbon costs 
passed down to consumers in different regions?
    Answer. Economic analysis suggests that the point of regulation 
does not significantly affect the ultimate ``incidence'' of the costs 
of putting a price on carbon. Thus, whether the charge for the carbon 
in coal is collected at the mine mouth or from the electricity 
generator that burns the coal to produce electricity, the price to 
consumers of coal-based electricity will be about the same. Regions 
that are more heavily dependent on coal-based electricity will 
experience larger effects than less coal-dependent regions, but not 
because of the point of regulation. Similarly the indirect carbon costs 
will depend primarily on the amount of carbon embodied in the good or 
service, not on who is required to hold the allowance for the carbon 
(the point of regulation).
    I am not aware of systematic regional differences in the proportion 
of non-covered emissions versus covered emissions. According to the EPA 
analysis of the Kerry-Boxer bill, ``The economic literature shows small 
variations in the gross costs of climate policy across regions.'' This 
literature looks at the full effect, including not only home energy, 
but also gasoline, and indirect effects. The main source of regional 
variation is home energy but home energy accounts for less than half 
the total impact. The variability across regions is much less as a 
percentage of the total impact than it is of just the home energy 
impact.
    Question 2. Combined with a 100 percent auction of allowances, what 
effect would an equal per capita distribution of the auction revenues 
have on the regional disparities in net household costs from a carbon 
policy? How are indirect carbon costs embedded from the production 
process of goods and services factored in?
    Answer. The net impact on households at different income levels or 
in different regions depends on the relationship between their gross 
cost (the impact on their budget due to policies that ``put a price on 
carbon'') and the financial relief they receive as a result of how 
emissions allowances are used.
    The gross costs, which vary across individuals at different income 
levels and in different regions, are determined by their individual 
``carbon footprint.'' That is the amount of carbon embodied in their 
home energy consumption, their gasoline consumption, and all the other 
goods and services where carbon is embodied indirectly through the 
energy intensity of their production or transportation. The gross costs 
incurred by individuals and regions are largely unaffected by whether 
emissions allowances are given away or auctioned.
    The one important exception is free allocations to electricity 
generators. In competitive markets, generators would charge the same 
prices whether they received allowances for free or had to buy them in 
the market. But in regulated markets generators probably would not be 
allowed to pass on the ``opportunity cost'' value of free allowances 
whereas they could pass on the costs of purchased allowances. This 
difference does not apply to free allocations to LDCs where the free 
allowances are used to benefit retail customers, assuming that public 
utility regulation of the LDC allowances works the way it is intended 
to work.
    Auctioning 100 percent of allowances and using the proceeds to fund 
an equal per capita distribution of the auction revenues would not 
affect the distribution of costs, but it would affect the distribution 
of net financial impacts, and in a progressive way. Low-and middle-
income households in general would receive per capita energy refunds 
that on average would be greater than their gross costs while higher 
income households on average would have costs that exceed their 
refunds. The net financial benefit of 100 percent auctions and per 
capita refunds would be slightly smaller in higher-cost regions and 
slightly higher in lower-cost regions. As discussed in the answer to 
question 1, however, differences across regions, once all the costs are 
factored in, are relatively modest.
    Question 3. What is the simplest and fairest way to compensate all 
energy consumers while specifically maintaining a robust carbon price 
signal and protecting household incomes of the entire lower and middle 
classes? Roughly, what portion of the allowance value is necessary to 
keep the majority of households whole?
    Answer. Direct refunds through refundable tax credits and payments 
delivered through the electronic benefit transfer system (EBT) for low-
income households, many of whom do not file income taxes because they 
are not required to, are the simplest and most direct way to compensate 
consumers while preserving the carbon price signal. Refunds are an 
effective way to deliver consumer relief. They can be provided with no 
need for new agencies or bureaucracy at the state or federal level. 
Refunds protect households against the loss of purchasing power from 
higher energy-related prices without blunting consumers' incentives to 
respond to those higher prices by conserving energy and investing in 
energy efficiency improvements. Because energy-related products will 
cost more, households with the flexibility to conserve energy or invest 
more in energy efficiency will get more value for their budget dollar 
by taking these steps than by using their rebate to maintain their old 
ways of consumption. At the same time, refunds help households that 
cannot easily reduce their energy consumption to avoid a reduction in 
their standard of living.
    There are two approaches commonly considered: per capita dividends 
and refunds based on household size. Under a per capita dividend, the 
size of a family's dividend would be tied strictly to the number of 
people in the family. The evidence suggests, however, that energy 
expenditures increase less than in proportion to family size. (In other 
words a family twice as large as another consumes less than twice as 
much energy.) Refunds are better suited to providing a more appropriate 
family-size adjustment.
    Our rough calculations indicate that a household-based refund equal 
to the average ``hit'' to households in the middle quintile (fifth) of 
the population that phased out in the fourth (next-to-the-highest) 
quintile would cost about 60-70 percent of the allowance value and 
fully protect the bottom 60 percent of the population as a group. The 
refund would be uniform for households of the same size, hence lower-
income households (who generally have lower costs) would, on average, 
come out ahead, whereas households in the top 40 percent would not be 
fully compensated.
    Question 4. Are lump sum payments to all Americans legally residing 
in the United States feasible?
    Answer. Such delivery should be feasible, but there is no single 
existing mechanism that can be used right out of the chute. It should 
be relatively straightforward to use the tax system to reach the 
majority of people, who file income tax returns. Seniors and veterans 
who do not file income tax returns could be reached through direct 
payments like those used in the economic recovery legislation. That 
leaves low-income households that are not required to file income tax 
returns. They can be reached through the EBT system. Because there is 
no single delivery mechanism capable of reaching everyone, there will 
be an issue of coordination among delivery mechanisms to assure maximum 
coverage without duplication. CBPP has looked into ways of doing this 
for a household-size based refund.
    Question 5. Your testimony suggests that it would be possible to 
reach the lowest income quintile of the population with direct refunds 
through existing federal and state programs like EBT, Temporary 
Assistance for Needy Families, Social Security, the Supplemental 
Nutritional Assistance Program, LIHEAP, etc. This segment of the 
population would be the most difficult to reach otherwise, since many 
of the people in the lowest income bracket don't have bank accounts and 
aren't required to file income tax returns. If it is possible to reach 
this segment of the population, couldn't those in higher income 
brackets be reached readily and, if so, do you see advantages to a 
policy that auctions more allowance value and refunds it directly to 
households, rather than relying on LDCs to distribute allowance value 
allocated to them for free?
    Answer. As discussed in the answer to question 3, direct refunds 
through tax credits and payments delivered through the electronic 
benefit transfer system (EBT) for low-income households are the 
simplest and most direct way to compensate consumers while preserving 
the carbon price signal. As discussed in the answer to question 4, it 
will be important to take into consideration the importance of 
coordinating delivery in order to assure maximum coverage while 
avoiding duplication of coverage.
                                 ______
                                 
     Responses of Karen Palmer to Questions From Senator Murkowski
    Question 1a. There is a great deal of money at stake in any carbon 
market that Congress may seek to create, and some portion of this value 
will be reflected in costs that covered entities, consumers, or others 
incur. We heard at a separate Energy Committee hearing on October 14th 
about the projected costs of the House bill.
    I am concerned about the significant risk that allowances and their 
attendant compliance usage will be made even more expensive if 
stringent state and regional programs are allowed to drain the federal 
supply of allowances. While any real solution to global warming must be 
global in scale, we're also trying to get a handle on how much our 
domestic efforts will cost and state and regional approaches may 
complicate, or harm, these efforts.
    If federal climate legislation does not explicitly preempt state 
and regional programs, as well as the regulatory approach being pursued 
by the EPA, do you believe the end result will be higher compliance 
costs, assuming the ultimate environmental objectives are held 
constant?
    Answer. It depends on what programs and regulations you are talking 
about preempting. If the ultimate environmental objectives are held 
constant (a single cap on national emissions of CO2, for 
example) then a single cap and trade program will be the most efficient 
(lowest cost) approach to achieving that goal. There is clearly an 
economic logic for preemption of state and regional cap and trade 
programs. However, there is precedent for allowing states to have 
stricter environmental standards than federal standards so there may be 
other reasons why states would want to go further. Also, most current 
state climate policies are not of the cap and trade variety but instead 
seek to limit emissions by encouraging energy efficiency, the adoption 
of renewables or sustainable land use policy. To the extent that these 
policies seek to promote a number of goals in addition to mitigation of 
climate change, they should probably not be preempted. Although, 
clearly if they are operating largely on sectors that are covered by 
the emissions cap and trade program, these policies won't be able to 
achieve further reductions in emissions beyond those called for by the 
federal cap unless federal allowances are retired.
    Question 1b. Assuming preemption is included, how would you 
recommend phasing out the allowances associated with existing state and 
regional programs?
    Answer. There are at least two important considerations in phasing 
out of state and regional programs. One is that these programs will 
have developed a bank of CO2 emissions allowances and those 
allowances should be honored in the new federal cap and trade program. 
This would be an important way of giving credit for early action. These 
banked allowances should be usable to cover some portion of their value 
(in terms of tons of CO2) under the prior regional program. 
There is precedent under the transition from the Title IV to the CAIR 
program to honor allowances of earlier vintages at one ton for one ton 
even though the SO2 caps under CAIR are much stricter than 
the Title IV program. This approach could be taken here as well. 
Alternatively, allowances could be traded in based on the relative 
value. Because the RGGI program is not very stringent, RGGI allowances 
are trading for a low price compared to allowance prices expected under 
a federal cap and trade program. These allowances could be exchangeable 
for federal allowances based on the initial price of the of RGGI 
allowances of that vintage (original acquisition cost) relative to the 
initial price for federal CO2 allowances (or some forecast 
of that price). For example, if RGGI allowances originally sold for 
$3.50 and the initial price of a federal CO2 allowance is 
$7.00, then an entity holding RGGI allowances could trade in two RGGI 
allowances for one federal allowance.
    The second issue is that regional cap and trade programs such as 
the RGGI program create a pool of revenue for the participating states 
through the auctioning of allowances. States are using this pool of 
money to help promote the program goals of encouraging energy 
efficiency and development of clean energy sources. Allocating a 
portion of the allowance value under a federal program to the states 
(presumably not just those states involved in RGGI, but all states) 
will help to continue these efforts at the state level.
    Question 2a. Cap-and-trade's advocates have consistently stated 
their desire to protect consumers from price increases brought on by 
such programs. So far, their answer has been to increase the number of 
permits given away for free, in hopes that the recipients will pass 
less of a burden on to consumers.
    Is there a more straightforward and transparent way to make the 
consumer whole, regardless of the structure of the program itself?
    Answer. I think it would be much more straightforward to auction 
the allowances and then use the revenue to compensate consumers 
directly. Ideally this compensation would not be linked to energy 
consumption so there would be clear signals that prices have increased. 
As a practical matter, it may be desirable on distribution or 
compensation grounds to do some linking (such as through allocation to 
local distribution companies for residential customers only) to help 
reduce some regional differences, but this approach should be time 
limited with a transition to a more complete cap and dividend approach.
    Question 2b. Would it make sense to cut out the middlemen, and 
directly compensate Americans for their increased expenses instead?
    Answer. Yes. A cap and dividend approach makes a lot of sense and 
work at Resources for the Future suggests that it will lower the cost 
of the cap and trade program and improve the outcome of households in 
virtually all regions of the country relative to an LDC allocation 
similar to that proposed in HR 2454.. This compensation should be 
independent of a particular household's expenditures on energy in order 
to provide the right signals for energy conservation, which will be an 
important part of the strategy to reduce emissions.
    Question 3. A great deal of effort on the part of regulated 
entities--and even non-regulated entities--has gone into securing free 
permits at the outset of the House and Senate cap-and-trade programs. 
The importance of these free permits is apparent in the number of 
blanks left in the recently circulated Senate bill.
    As a matter of economics, is Congress any less capable of 
addressing the priorities reflected in permit allocations by spending 
auction revenues or tax receipts instead?
    Answer. As a matter of economics, allocating allowances and 
allocating tax receipts are equivalent. It could be argued that there 
might be fewer transaction costs for the economy as a whole associated 
with holding a centralized allowance auction and then allocating the 
tax revenue directly.
    Question 4. Some have raised concerns about the detrimental impact 
that giving away free permits might have on the liquidity and stability 
of a carbon market. Dr. Ellerman recently wrote that ``free 
allowances... reduce the value of the flexibility afforded by banking. 
As a consequence, the price impact of short run shocks to the system 
are magnified, resulting in a suboptimal allocation of emissions 
reductions through time and raising the cost of the system.''
    Assuming we want to design the most efficient and straightforward 
climate program, can you elaborate on this issue for us and how we can 
account for it in legislation?
    Answer. I haven't studied this particular issue in detail and I'm 
not familiar with Dr. Ellerman's writings on the topic but I will offer 
a few perspectives on potential differences in banking behavior between 
free allocation and an auction. Free allocation to LDCs will lead to 
higher allowance prices than would occur with an auction and thus there 
will be weaker incentives for taking early action to reduce emissions 
beyond legal requirements in the early years and to build up a bank. 
Experimental economics research suggests that free allocation of 
allowances to generators may create some sort of endowment effect that 
results in higher allowance prices than would occur with greater 
auctioning.
    If incentives to bank are not optimal, one way to deal with 
potential price fluctuations and short run shocks would be to include a 
price collar for allowances. The price collar would include both a 
ceiling and a floor on allowance prices and these values would escalate 
over time. The floor could be enforced through a reserve price in an 
allowance auction, below which allowances would not be sold. The high 
side of the price collar would act like an emissions fee, in that if 
the market price of allowances reached that level, emitters could just 
pay a fee for every ton emitted instead of purchasing allowances.
      Responses of Karen Palmer to Questions From Senator Cantwell
    Question 1. What effect does the point of regulation have on 
regional disparities in household costs, when one accounts for both 
direct and indirect costs on consumers from the carbon price signal? 
And does less (uniform) coverage affect the (indirect) carbon costs 
passed down to consumers in different regions?
    Answer. I have not studied this question directly but I suspect 
that point of regulation (which is different from point of allocation) 
won't really have different regional effects. However, which sectors 
are covered by the program will have an effect that depends on which 
forms of energy are used in which region. For example, if a program 
were to focus on the electricity sector only, it could result in 
greater fuel switching by end users out of electricity and this would 
result in emissions leakage. Also, the relative shares of electricity 
and other fuels in total household energy use will differ across 
regions of the country and that will affect the impact on households of 
different program scopes.
    Question 2. Combined with a 100 percent auction of allowances, what 
effect would an equal per capita distribution of the auction revenues 
have on the regional disparities in net household costs from a carbon 
policy? How are indirect carbon costs embedded from the production 
process of goods and services factored in?
    Answer. According to modeling work done by some of my colleagues at 
RFF, moving from a 30% LDC allocation to 100% cap and dividend will 
clearly lower the cost of the cap and trade program to households in 
all regions, with the possible exception of the Ohio Valley where 
average cost per household rises slightly. This analysis accounts for 
both direct energy use and increase cost of energy embedded in goods 
and services. The latter is account for using an input output matrix on 
carbon content developed by Hassett, Mathur and Metcalf in a 2007 
National Bureau of Economic Research working paper titled ``The 
Incidence of a US Carbon Tax: A Lifetime and Regional Analysis.'' Also, 
the 100% cap and dividend is after setting aside roughly 14% of the 
allowance value to cover increased costs of direct energy use to local, 
state and federal government resulting from the climate policy. Thus, 
the 100% is actually 100% of 86% of the allowance value.
    Question 3. What is the simplest and fairest way to compensate all 
energy consumers while specifically maintaining a robust carbon price 
signal and protecting household incomes of the entire lower and middle 
classes? Roughly, what portion of the allowance value is necessary to 
keep the majority of households whole?
    Answer. The simplest and fairest way to achieve these goals would 
be to use a cap and dividend approach to allocate allowances. This 
approach helps compensate lower income households by keeping the cost 
of the program low. However, it is impossible to compensate everyone 
for their costs under the cap-and-trade policy. Using a cap and 
dividend approach for the 86 percent of allowance value not required to 
cover allowances required for direct government energy use, should 
fully compensate the bottom five income declines and that is the best 
that can be achieved.
    Question 4. Are lump sum payments to all Americans legally residing 
in the United States feasible?
    Answer. Lump sum payments to all Americans are feasible and could 
follow a model like the Alaska Permanent Fund which allocates oil 
revenues on a pro rata share to all adults who were legal residents in 
Alaska during the prior year. Limiting allocations to adults as is done 
in Alaska would seem to make the most sense.
    Question 5. In your testimony (p.7), you state that a cap-and-
dividend approach to allowance value distribution could improve 
efficiency and limit impacts of the policy on households compared with 
one that would use local distribution companies (LDCs) as the primary 
means of distributing value to consumers. Could you explain how 
eliminating the LDC allocation for commercial and industrial consumers 
in H.R. 2454 would improve its efficiency? If a cap-and-dividend 
approach would be more efficient, why not distribute all of the 
allowance value that way, including the LDC portion allocated for 
residential consumers?
    Answer. Despite congressional intensions to the contrary (at least 
as expressed in HR 2454) the way that an LDC allocation provides 
compensation is to reduce the perceived or actual price of electricity 
relative to what it would have been if those allowances had been sold 
at an auction, which economists agree is the most efficient way to 
allocate emissions allowances. Lower electricity price means lower 
incentives to conserve and thus greater demand for allowances in the 
electricity sector. This will raise the price of allowances and mean 
that more reductions have to come from other parts of the economy. 
Eliminating the LDC allocation for commercial and industrial customers 
will preserve the allowance cost pass through for those customers 
classes and mute this effect. Keeping LDC for residential customers 
would help address some of the distributional concerns about regional 
differences in household energy consumption, but distributing all of 
the allowance value through cap and dividend would be the most 
efficient approach.
    Question 6. In your testimony, you mention that auctioning more 
allowances can actually reduce regional disparities in electricity 
prices. This seems to counter the conventional wisdom that the free 
allocation of allowances helps to level prices among regions. Can you 
elaborate how this works exactly?
    Answer. The regional disparities that I was addressing here are the 
disparities between those regions that have cost of service regulation 
of the electricity sector and those regions that rely on markets to 
price electricity generation. When allowances are allocated for free to 
generators, which has been the approach used in most cap and trade 
programs to date, then the effect of these free allowances on 
electricity prices will differ across states depending on how 
electricity markets are regulated. For those states where competitive 
markets set electricity prices, the value of allowances allocated 
freely to generators will be reflected in electricity prices. However, 
for those states where electricity prices are set according to cost of 
service regulation, the value of allowances received for free will not 
be included in prices paid by customers. Those, free allocation to 
generators creates a disparity across regions. This disparity can be 
addressed either by auctioning allowances to all generators, which will 
lead to higher prices everywhere, versus free allocation to local 
distribution companies, which will tend to reduce regional disparities 
in prices, but at lower levels.
                                 ______
                                 
  Responses of Gilbert E. Metcalf to Questions From Senator Murkowski
    Question 1. There is a great deal of money at stake in any carbon 
market that Congress may seek to create, and some portion of this value 
will be reflected in costs that covered entities, consumers, or others 
incur. We heard at a separate Energy Committee hearing on October 14th 
about the projected costs of the House bill.
    I am concerned about the significant risk that allowances and their 
attendant compliance usage will be made even more expensive if 
stringent state and regional programs are allowed to drain the federal 
supply of allowances. While any real solution to global warming must be 
global in scale, we're also trying to get a handle on how much our 
domestic efforts will cost and state and regional approaches may 
complicate, or harm, these efforts.
    If federal climate legislation does not explicitly preempt state 
and regional programs, as well as the regulatory approach being pursued 
by the EPA, do you believe the end result will be higher compliance 
costs, assuming the ultimate environmental objectives are held 
constant? Assuming preemption is included, how would you recommend 
phasing out the allowances associated with existing state and regional 
programs?
    Answer. How federal climate legislation interacts with state and 
regional policy is an important question. In principle policies could 
operate in tandem. Compliance costs rise, however, to the extent that 
rules and coverage differ between national and sub-national systems. 
Given the global nature of climate change, no good reason exists for 
state- or region-specific policy.
    Since many of the sub-national greenhouse gas programs have 
included permit auctions, simple pre-emption of sub-national programs 
would be unfair to companies that purchased permits in good faith. 
Allowing firms to use permits from these programs that were purchased 
prior to some specified date in lieu of federal permits (at a 
legislated conversion rate) would be reasonable.
    Question 2. Cap-and-trade's advocates have consistently stated 
their desire to protect consumers from price increases brought on by 
such programs. So far, their answer has been to increase the number of 
permits given away for free, in hopes that the recipients will pass 
less of a burden on to consumers.
    Is there a more straightforward and transparent way to make the 
consumer whole, regardless of the structure of the program itself?
    Would it make sense to cut out the middlemen, and directly 
compensate Americans for their increased expenses instead?
    Answer. Auctioning permits and using some of the proceeds to 
compensate consumers for higher energy costs would be preferable to the 
use of free permits allocated to LDCs. Using revenue to rebate portions 
of the payroll tax, to expand the EITC or lower marginal tax rates on 
the income tax, or to provide a carbon rebate check to households are 
all possible ways to return money to households that are simple and 
more transparent than free permit allocation.
    Question 3. A great deal of effort on the part of regulated 
entities--and even non-regulated entities--has gone into securing free 
permits at the outset of the House and Senate cap-and-trade programs. 
The importance of these free permits is apparent in the number of 
blanks left in the recently circulated Senate bill.
    As a matter of economics, is Congress any less capable of 
addressing the priorities reflected in permit allocations by spending 
auction revenues or tax receipts instead?
    Answer. None at all.
    Question 4. Some have raised concerns about the detrimental impact 
that giving away free permits might have on the liquidity and stability 
of a carbon market. Dr. Ellerman recently wrote that ``free allowances. 
. .reduce the value of the flexibility afforded by banking. As a 
consequence, the price impact of short run shocks to the system are 
magnified, resulting in a suboptimal allocation of emissions reductions 
through time and raising the cost of the system.''
    Assuming we want to design the most efficient and straightforward 
climate program, can you elaborate on this issue for us and how we can 
account for it in legislation?
    Answer. I'm not familiar with this argument and would defer to Dr. 
Ellerman on this point.
   Responses of Gilbert E. Metcalf to Questions From Senator Cantwell
    Question 1. What effect does the point of regulation have on 
regional disparities in household costs, when one accounts for both 
direct and indirect costs on consumers from the carbon price signal? 
And does less (uniform) coverage affect the (indirect) carbon costs 
passed down to consumers in different regions?
    Answer. Point of regulation should have no bearing on the regional 
impacts of carbon pricing. Economic theory backed up by considerable 
empirical evidence support the view that the household burdens will be 
unaffected by the choice of point of regulation. This means that policy 
can be written to choose the point of regulation to minimize the 
administrative and compliance costs of the program. For example, 
choosing refineries as the point of regulation for crude oil (along 
with import location for finished petroleum products) leads to lower 
administrative costs than regulating oil either at the well head or the 
point of consumption. This occurs because we have only 150 refineries 
in the United States as opposed to thousands of wells or points of 
final consumption.
    Question 2. Combined with a 100 percent auction of allowances, what 
effect would an equal per capita distribution of the auction revenues 
have on the regional disparities in net household costs from a carbon 
policy? How are indirect carbon costs embedded from the production 
process of goods and services factored in?
    Answer. Coastal states tend to benefit from an equal per capita 
distribution of auction revenues relative to states in the middle of 
the country. This occurs because of the higher proportion of carbon-
free electricity and milder weather (on average) in coastal states. 
Regional variation is driven almost entirely by variation in the direct 
carbon costs (higher energy prices) rather than indirect carbon costs.
    Question 3. What is the simplest and fairest way to compensate all 
energy consumers while specifically maintaining a robust carbon price 
signal and protecting household incomes of the entire lower and middle 
classes? Roughly, what portion of the allowance value is necessary to 
keep the majority of households whole?
    Answer. It is important to distinguish the price signal from 
compensation mechanism. We can achieve any desired compensation 
distribution we wish for the same price signal. Any policy that 
potentially dilutes the price signal (e.g. free allocation to LDCs) can 
be replicated (in the sense of achieving the same distributional 
outcome) with a policy that maintains a strong price signal. The price 
signal is essential to help us achieve our goal of reducing greenhouse 
gas emissions at minimum cost.
    Question 4. Are lump sum payments to all Americans legally residing 
in the United States feasible?
    Answer. This is not my area of expertise. But I believe it would be 
relatively straightforward to reach most legal residents. Certain 
segments of the population (e.g. homeless families) would be difficult 
to reach. One concern with cash payments (as opposed to reductions in 
tax payments) is the potential for fraud. Experience with the Earned 
Income Tax Credit suggests that requiring Social Security numbers for 
dependents claimed in order to be eligible for EITC payments reduced 
the number of claimants significantly. This is not an intractable 
problem but does require careful program design and consultation with 
government agencies that have experience in making cash payments.
    Question 5. H.R. 2454 gives away a significant share of allowance 
value much of which goes to the largest historic emitters of carbon 
dioxide. Are these allowance giveaways likely to distort the carbon 
price signal and dampen incentives for businesses and individuals to 
become more efficient and transition to lower-carbon energy sources? 
Second, doesn't the granting of free allowances to selected industries 
necessarily entail the government picking winners and losers in its 
allocation decisions, which will bias fuel and energy technology 
choices?
    Answer. Permit giveaways should have no impact on the price signal 
so long as firms are not required (e.g. by state regulators) to use the 
free permits to lower energy prices. Rather permit giveaways alter the 
distribution of wealth.
    Question 6. Won't both the dampening of the carbon price signal and 
the selecting of winners and losers outside of the market increase 
overall costs of reducing emissions? Assuming that a main goal of a 
climate policy is to establish a consistent carbon price signal, 
wouldn't it make more sense to rely strictly on market mechanisms by 
auctioning all of the allowances and avoiding the potential distortions 
that go along with giveaways of allowances or allowance value?
    Answer. For both this and the last question it is important to 
distinguish between the price signal and distributional outcomes. A cap 
and trade program will lead to a higher price on emissions thereby 
providing the appropriate price signal. Allowance allocation (free 
versus auctioned permits) simply determine who receives the value of 
the permits. One way to see that is to recognize that free allocation 
of permits is equivalent to fully auctioned permits in which the 
revenue is then given to the groups that otherwise would receive free 
permits. Whether the permits are auctioned or allocated freely a firm 
faces an opportunity cost of emissions by either having to purchase an 
allowance from some other firm or by foregoing the opportunity to sell 
an allowance that it holds. This provides the price signal.
    Question 7. Many of the cap-and-trade proposals that Congress has 
considered in the past seem to necessitate the creation of a large, new 
bureaucracy to monitor greenhouse gas emissions from numerous sources. 
For administrative simplicity and efficiency, to what extent does the 
point of regulation matter?
    Answer. Point of regulation matters. A fully downstream system, for 
example, would require tens of thousands of firms and households to 
comply. A more upstream system has many fewer firms and reduces the 
administrative burden both on compliance and monitoring.
    Question 8. Would an upstream (i.e., wellhead, mine mouth, port of 
entry) cap that levied a consistent unit price on fossil carbon make 
sense for all fossil fuels (petroleum, coal and natural gas)?
    Answer. This would be a reasonable approach--and one that I have 
advocated elsewhere.
    Question 9. If the point-of-regulation were upstream, how could 
carbon capture and sequestration (CCS) efforts be fairly and 
appropriately compensated for the sequestered carbon? Would carbon 
credits in excess of the cap for the amount of sequestered carbon make 
sense?
    Answer. Under a fully upstream approach, carbon allowances could be 
provided to firms for their sequestered carbon by the government. These 
could then be sold on the open market. This provides exactly the same 
benefit as a system in which the firm engaging in CCS is statutorily 
responsible for submitting allowances for emissions.
    Question 10. I am intrigued by your discussion of the potential 
efficiency gains from distributing allowance value to American families 
through tax cuts rather than a lump sum per capita dividend. How likely 
is it that we would realize these efficiency gains in the real world, 
especially if distorting giveaways like those in the House-passed bill 
accompany these tax cuts? Is it possible that a lump sum per capita 
dividend could actually be equally or more efficient in the real world?
    Answer. Since the giveaways are lump sum in nature they do not 
create distortions. Giveaways simply lead to potentially perverse 
distributional outcomes. While it is possible for a lump sum 
distribution to be more efficient in the presence of other tax 
distortions, it is unlikely to occur here. Most analyses of allowance 
systems find the lump sum distribution to have the highest efficiency 
costs when compared to other allocations that auction allowances and 
use the proceeds to lower tax rates.

                                    

      
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