NEXT STEP: A FAIR AND EFFECTIVE CO2 POLICY

In 2005 the combined use of 3.5 trillion kWh and 200 billion gallons of transportation fuels in the United States resulted in
the emission of 5.8 billion metric tons of CO2. The strong scientific consensus linking CO2 emissions to climate change
makes setting a limit or cap on CO2 emissions a critical first step that must then be folded into an overall program that will
require the creation of an energy industry capable of providing the required kWh and gallons of fuel at a small fraction of
the CO2 emissions. This a technology challenge but it is also a major challenge for our politics: to design policies that will
move and reshape one of the largest industries in the world without producing a crippling backlash.

There is a tendency particularly among those heavily involved in the decade long fight to establish the scientific
consensus to believe that the science provides a trump card that can be played to override policy debates. This is a
serious mistake. Moving forward moves beyond science. To be successful, climate policy design decisions will have to
demonstrate that they can be effective, that is that they can provide critically needed energy and at the same time
drastically reduce CO2 emissions. The public will not support a program that it doesn’t believe will work. At the same time,
the policies will have to convince the public that they will be treated fairly in this new energy economy. Fairness will
ultimately mean convincing particularly average income working families, that their already fragile economic condition will
not be worsened. A climate program that places a crippling financial burden on families already on a razors edge of
solvency has the potential to produce a backlash capable of discrediting the core effort.

Lets get back to the cap and the most basic design questions. If the national cap were set initially at the 5.8 billion tons,
one scenario would be to require every major emitter to reduce their emissions to the baseline year. A cap immediately
places two substantial burdens on the energy industry. Every major emitter will be legally required to invest in
technologies that limit CO2 emissions to their individual cap and every major emitter will be required to have allowance or
permits matching their cap. Every emitter would have to hold permits or allowances to cover their baseline emissions and
they would have to invest in technology to cap emissions even if overall energy sales increased.

While there is a broad consensus on the need to cap or limit CO2 emissions, there is a major and important debate about
how the firms will obtain permits to cover their present emissions. There are only two options on the table: the permits can
be allocated/assigned to them or the firms can be required to purchase them through an auction. An auction will set a
price for CO2 permits and firms will be required to purchase those permits and make investments to reduce their CO2
emissions. The argument is the auction will ‘Make Polluters Pay” and serendipitously provide a very large pool of revenue
to be used for any number of purposes. “Making the Polluter Pay” seems to be so obviously ‘correct’ that auctioning is
now the preferred choice among progressive Democrats. Both the Clinton and Obama platforms call for a 100% auction of
permits.

A central and largely ignored question about the auction is who will ultimately pay the cost of the permits. In reality, the
polluters will not pay. The cost of the permits will fall through to the ultimate consumers of electricity, gasoline, and fuel oil.
The auction will produce a regressive, expensive, counter productive tax. A climate policy that keys off of a permit auction
will be widely seen as unfair and will produce a gigantic backlash.

Here are some take-away numbers to ponder. Under an auction, capping CO2 emissions at present levels will require the
purchase of 5.8 billion permits. Requiring the purchase of 5.8 billion permits, even at the consensus mid-range price of
$30 per ton, would impose a tax of $175 billion per year, which would be raised by increasing the price of electricity,
gasoline, natural gas and fuel oil. The tax collected would vary widely and unfairly by states and regions. To see how
unfairly the collection would trickle down you can look at what would happen to the cost of electricity in Ohio where much
of the electricity is generated using coal as a fuel. Electric rates in Ohio would have to be raised $3.81 billion per year,

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which would raise rates an average of 29.5%. Industrial customers would actually face a higher percentage increase since
their cost per kWh is lower than the overall average. (This does not include the higher prices they would face for heating
oil, gasoline and natural gas.) Ohio with 3.78% of the population would pay 5.62% of the total collected from auctioning
permits to the national electric sector. The Ohio tax burden would be 1.5 times the national average. The households and
industries in the industrial belt covering Pennsylvania, Ohio, Indiana, Illinois, and Michigan will bear a burden 1.3 times the
national average. At the other extreme, Washington State gets 50% of its electricity from federal hydroelectric damns.
Washington with 2.06% of the population would pay .616% of the total collected from the national electric sector. The
burden on Ohio would be nearly ten times what it would for the state of Washington. Selling or auctioning the permits will
be regressive, and expensive and ineffective as energy policy. (Source: Data, EIA, State Energy Data System.
Methodology, EIA, Greenhouse Gases in the United States)

The cost of the CO2 permits will fall disproportionately on the hard hit industrial states and like any tax on energy will be
regressive across households. This choice, to allocate or sell, will reach far beyond the realm of energy and
environmental policy. Coming on top of the decade long decline in household real incomes, loss of manufacturing jobs,
the collapse of housing values, concern over medical care and education, this ‘tax’ runs a real risk of creating an
enormous and entirely justified backlash against the politicians that imposed it and that could discredit the important
environmental goals it is intended to advance.

Behind the very public campaign to “Make the Polluters Pay” there is another argument offered that the auction will
prevent polluters from earning windfall profits unless they are made to pay for the permits. The argument here rests
squarely on the assertion that firms being allocated allowances would simply raise their prices to consumers even though
their costs had not increased. This assertion does not match the empirical evidence gained from the US and EU
experience. After twelve years of allocating SOx credits to electric generators there is no evidence they raised prices to
reflect the value of their allowances. The allowance allocated exactly match a liability that requires them to hold that
number of allowances. They can’t sell allocated allowances unless they are simultaneously prepared to buy an equal
number back from some other holder. The recent experience in the European Union is often cited as evidence for the
likelihood of a ‘windfall’ resulting from allocating allowances. The EU experimented with allocating CO2 allowances in
order to build experience with trading CO2 permits. But rather than set a scientifically based cap, they based the total
allocation on requests for permits. Some electric utilities and large industrial users asked for and received an allocation of
allowances in excess of what the knew their CO2 emissions were likely to total. As a result, they were allocated more
permits than they needed and were free to sell the excess permits. This created potential windfall profits but it is important
to realize that the windfall did not come from increasing prices. It came from a flawed, easily gamed allocation scheme.
The lesson here is that if regulators create a system that is transparently easy to game, it is reasonable to expect it to be
gamed. Again, the 15-year plus experience with the Clean Air Act provides no evidence to support a belief that windfall
profits will follow from an allocation of allowances.

These two arguments for auctions, to “Make the Polluters Pay’ and stop a windfall, offer two stunningly contradictory
views of how the energy industry works. The primary argument, that auctioning will “Make the Polluter Pay”, requires
believing that selling permits to emitters will result in them not passing on the costs of the permits, and instead paying for
their pollution out of profits. If that argument is penetrated, the proponents of auctions shift to argue that selling permits is
actually a way to prevent emitters from capturing a ‘windfall’ from allocated permits. The ‘anti-windfall’ theory requires
believing that even if the permits are given to emitters, they will pass on the costs to consumers even if they face no costs
themselves.

The ultimate tragedy here is that an auction or any CO2 tax is an ineffective way to stabilize CO2 emissions. Beyond a
hard cap, stabilizing emissions will require deploying and improving ‘CO2 neutral’ energy producing technologies. The
best approach to meeting this technology challenge is a set of efficient incentives for private industry to move into this

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market with the ‘cost’ of those incentives being paid for from a broad based, progressive tax. On the other hand, the
bedrock support for energy or CO2 taxes often rest on moral grounds: consumers use too much energy, houses and cars
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are too big, families drive too many miles, we are ‘addicted’ to fossil fuels, and so on. Getting the price increased and
‘right’ through taxes it is believed will force consumers to correct their actions. This tension between technology and
morality is of critical importance in how climate policies will be accepted or rejected. Morality leads to a tremendous,
destructive backlash. To move technology, provide a direct incentive for both deployment and improvement of clean
technologies and forget the multi-billion dollar tax.

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“And nowhere is moralization more of a hazard than in our greatest global challenge. The threat of human-induced
climate change has become the occasion for a moralistic revival meeting. In many discussions, the cause of climate
change is overindulgence (too many S.U.V.’s) and defilement (sullying the atmosphere), and the solution is temperance
(conservation) and expiation (buying carbon offset coupons).” Pinker, S. “The Moral Instinct’ NYT 1/13/08

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