I wrote earlier about some Congressional Budget Office testimony before Congress on the “distributional effects of cap-and-trade.” There are a few more things in there I want to discuss.

The CBO looked at three options for what to do with carbon revenue: rebate it to taxpayers, use it to lower corporate income taxes, or give it to polluters (by freely allocating pollution permits). They found the tax reduction best for reducing the overall economic impact of the program, but rebating to taxpayers by far the most progressive, shielding low-income taxpayers from the impact of energy price increases.

You see a tension: either use the money to increase economic productivity (by cutting taxes) or use it to increase equity (by putting it in the hands of low-income taxpayers).

Now, I find this irksome, this economic assumption that skewing wealth to top income earners is better for the economy. You see the same thing in arguments against increasing the minimum wage. But put that aside.

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Notice a glaring absence from the CBO’s list of possible uses for the revenue: using it to encourage renewables and efficiency. You might think — if you were, say, me — that plowing all that money into efficiency, renewables, and green infrastructure would both prevent undue energy price increases and boost overall economic productivity. But the economists at CBO don’t see it that way.

To understand why, check out this brief and somewhat bizarre discussion of using a portion of the revenue to fund “Increased Incentives for Energy-Saving Investments by Households.” Here’s why the CBO fears the notion:

… such incentives could increase the total costs (both public and private) of meeting the cap because they would encourage households to choose certain alternatives over others in adjusting to higher energy prices. For example, a tax credit for solar heating would encourage the use of that technology even if it was not the most cost-efficient alternative in the absence of the credit. Creating a tax-incentive system without distorting technology choices is difficult.

This is economese for that old bugaboo: “choosing winners.” The idea here is that the market will automatically respond to a price signal by selecting the lowest cost emission reduction options. Any attempt to fund or encourage one or the other of those options will distort the magic of the Invisible Hand, thereby raising total costs. That’s free market economics in a nutshell.

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It is also, for anyone who has witnessed the behavior of homo sapiens, frakking crazy. Practically the entire field of behavioral economics is a study of the way that market actors do not respond to incentives in rational ways. The list of cognitive biases is extensive, though poorly understood by the public and by most economists. People are poor at comparing the value of disparate options. They value near-term results over (greater) long-term results. They prefer avoiding (smaller) losses to acquiring (greater) gains. They herd with other people, even if the group behavior is subrational. Etc.

Perhaps the most deadly is simply status quo bias. Even if prices go up, people have a strong bias toward doing what they always done, with as little alteration as possible. It takes a great deal of inducement to break those patterns. So if it takes, say, a 20 percent return to induce a behavior or technology change, that means there are manifold opportunities to get 10-20 percent returns going unpursued. These are the low-hanging fruit that every bottom-up study finds and which many economists simply refuse to believe exist.

To the point, many of our cognitive biases work against investing in efficiency — it’s invisible and intangible, it requires substantial upfront investment for incremental long-term gain, it’s difficult to compare on fungible terms with energy services, and agents often do not capture the full value of the investment (say, investing in building efficiency when you plan to sell the building).

And that’s to say nothing of the institutional and market barriers to efficiency. Those do not vanish when a price is placed on carbon.

Smart public policy, including targeted public investment, can help nudge us toward those opportunities that have not crossed the cognitive threshold or overcome market barriers. They can help induce us to make investments or behavior changes that rational market actors would already have made.

As it happens, the American Council for an Energy-Efficient Economy (ACEEE) has a report on this subject: “Reducing the Cost of Addressing Climate Change Through Energy Efficiency.” Here’s what they say about the general topic;

Energy efficiency is the key to cost containment in a GHG cap-and-trade program. Although adding a carbon price signal to the cost of electricity and heating fuels is necessary and will have some energy-efficiency benefits, cap-and-trade programs that try to reduce emissions through price alone will be much more costly per ton reduced than a cap-and-trade program that includes proven techniques to deliver low-cost efficiency resources.

The report has a section specifically on use of auction revenues:

Investment is needed rising to about $15-20 billion each year for energy efficiency deployment programs and policies in the residential, commercial, and industrial sectors. This is in addition to the more than $6 billion each year needed for low-income energy efficiency programs, $8 billion for transportation policies and programs, and $3 billion for clean energy R&D. States and utilities should be provided funds to start and grow energy-efficiency programs as soon as possible, and before the cap has begun. Such funding should ramp up over about 507 years, then remain at a sustained level. …

We recommend funding for energy efficiency focusing on state and utility programs serving all customer classes, low income programs, third-party and end-user programs, and research, development and demonstration programs.

That’s more money than Obama’s budget proposal sets aside for all green investment, just devoted to efficiency. Putting that money into efficiency could serve the dual goal of reducing the total cost of the program and reducing the hit to low-income budgets. But to see how it can work you have to, unlike the CBO, acknowledge the presence of market and cognitive barriers to efficient allocation of capital.

(See also ACEEE’s 2008 paper on the role of energy efficiency in federal climate change legislation (PDF).)