For an $80 billion program, President Barack Obama’s cap-and-trade proposal is very short on specifics. His budget plan [PDF] provides only the briefest policy rationale for cap-and-trade, describing it as “a policy approach that dramatically reduced acid rain at much lower costs than the traditional government regulations and mandates of the past.”

The acid-rain program’s regulatory costs were indeed low, partly because emission allowances were freely allocated to industry. But Obama’s plan calls for 100 percent auctioning of allowances, which erases the perceived cost advantage and puts cap-and-trade on par with carbon taxes in terms of political viability.

To ameliorate cost impacts, the plan would allocate most (80 percent) of the auction proceeds to a permanent $800 “Making Work Pay” tax cut for working families; but with cap-and-trade nothing is ever “permanent.” Carbon trading prices in Europe have dropped from over $30 to $10 per ton CO2 over the last year, and in the U.S. northeastern states allowances are currently selling at a meager $3 per ton. Obama’s plan is betting on $20 per ton, but linking the nation’s tax system to an erratic revenue source would be imprudent.

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The obvious, but unanswered, question is why a 100-percent auction would be preferable to a fixed-price sale of allowances, i.e. a carbon tax, which could simply be set at $20 per ton. There would be no price volatility.

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Regarding the claim that cap-and-trade “dramatically reduced acid rain,” the reduction was not sufficiently dramatic to actually solve the acid rain problem. Further reductions would yield an estimated societal return-on-investment of 2,500 percent from health and environmental benefits, and yet emission trading creates no incentive for such further reductions even when costs are far below initial expectations. The EPA has been trying for years to institute rules for more stringent acid rain regulations, but under the current cap-and-trade regime the rules cannot be strengthened without an Act of Congress — or a very protracted court battle. The implications for global climate policy should be clear.

A carbon tax would create a stable price signal and a predictable investment climate that would be more conducive to long-term investments in clean-energy technology and infrastructure. Alternatively, a price floor applied to allowance auctions would avert the kind of price erosion and collapse that has characterized prior trading systems. Had a price floor been applied in the acid rain program, there may have been no need for the EPA’s new rules.

Irrespective of whether carbon pricing revenue comes from an auction or from a fixed-price sale of allowances, the allocation of the revenue to a Making Work Pay tax cut would be problematic because consumers would not be equitably compensated for high energy costs. The tax burden would shift, not just onto wealthy taxpayers, but also onto low-income groups such as retirees on fixed incomes or people who expend a relatively large portion of their income on energy. The tax cut would have to somehow be linked to energy consumption to make it equitable.

A simpler and more direct way to mitigate energy costs — one that is not discussed or considered in Obama’s plan — would be to apply most of the carbon pricing revenue to subsidize energy prices, e.g. at a uniform cents-per-kilowatt-hour rate for electricity. If the revenue is allocated to industry as an energy production subsidy it would have much the same cost-cutting effect as free allocation of allowances — but with one crucial difference: Clean and renewable energy technologies would also qualify for the subsidy, and would therefore not be disadvantaged by the allocation method. Competition from subsidized clean energy would deter polluting industries from passing their costs onto consumers, and would make fossil-fuel energy progressively less economically viable as clean energy attains economies of scale and gains market share. (By contrast, free allocation is equivalent to giving all of the revenue to polluters.)

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For example, if the electricity industry comprises 90 percent fossil-fuel energy and 10 percent renewable, then the subsidy would reduce the net tax on fossil fuels by a factor of ten while providing a per-kilowatt-hour subsidy of nearly ten times that amount to renewable energy. The same net tax could even support a much greater subsidy if the subsidy were focused on new renewables, excluding legacy hydroelectric and nuclear power. Eventually, as carbon is phased out of the electricity industry, the clean-energy subsidy would automatically diminish and the net tax on fossil-fuel energy would increase until the latter becomes uneconomical.

In essence, the subsidized-energy approach replaces the big “stick” of a high tax with a big “carrot” of high subsidies, which can be equally effective at incentivizing clean energy deployment. Carrots might succeed where sticks have so far failed to achieve political consensus on federal climate policy.

[Revised 3/22/2009]