Climate Change Policy: Preliminary Observations on Options for Distributing Emissions Allowances and Revenue under a Cap-and-Trade Program
Published: 2009-08-04T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Congress is considering proposals to establish a price on greenhouse gas emissions through a cap-and-trade program that would limit overall emissions and require covered entities to hold tradable emissions permits, or allowances, for their emissions. The purpose of such a program is to raise the cost of activities that produce emissions and thereby provide an economic incentive to decrease emissions. Carbon dioxide, which results from burning fossil fuels, is the primary greenhouse gas and accounts for about 80 percent of U.S. emissions. A cap-and-trade program would increase the cost of burning fossil fuels and other activities that generate emissions and potentially raise costs for consumers. A key decision is the extent to which the government offsets these costs. For example, the government could sell the allowances and then return the revenues to covered entities or households. The government could also give away some or all of the allowances. According to the Congressional Budget Office, the value of the allowances could total $300 billion annually by 2020. Today's testimony provides preliminary results of ongoing work assessing the potential effects of (1) allowance allocation methods, and (2) options for distributing program revenues or the economic value of allowances. GAO reviewed economic literature and interviewed experts in climate policy, including those involved in existing cap-and-trade programs.
section_title: What GAO Found
paragraphs: The method for allocating allowances in a cap-and-trade program can have significant economic implications for the government, regulated entities, and households. Most importantly, a cap-and-trade system would create a market for a valuable new commodity: emissions allowances. The government could allocate these allowances to regulated entities in three main ways. First, it could auction all of the allowances and collect a significant amount of revenue that it could use, for example, to compensate households affected by the cap-and-trade program. Second, it could give away the allowances to entities affected by the program and thereby transfer the value of the allowances to those entities. This could enhance the program's appeal to covered entities but could also increase the program's overall cost to the economy if it reduced incentives for those entities to decrease their emissions. Third, the government could give away some allowances and auction the rest. For example, studies have suggested that freely allocating 6 to 21 percent of the allowances created by a cap-and-trade program would be sufficient to compensate entities in energy-intensive industries for any profit losses incurred as a result of the cap-and-trade program. According to the economic literature and economists we interviewed, regardless of the mechanism for distributing allowances, consumers will bear most of the costs of a cap-and-trade system because most regulated entities will pass along their increased costs in the form of increased prices; however, these costs could be largely offset depending on how revenues are used. Available literature and economists we interviewed point to five main options for distributing a program's allowance revenues, although numerous other options exist. First, the government could lower the overall cost of the cap-and-trade program to the economy through accompanying reductions in taxes on income, labor, or investment. Second, auction revenues could be distributed to households through lump-sum payments, which could offset the higher consumer prices resulting from a cap-and-trade program and mitigate any disproportionate impacts on low-income households. Third, the government could expand the scope of the Earned Income Tax Credit to further benefit low-income working families. Fourth, the government could compensate regulated entities and their shareholders for lost profits by allocating them free allowances. Finally, revenues might be used to fund climate-related programs, such as research on low-carbon technologies, or used to support climate change mitigation activities in developing nations. Each potential use of revenues has trade-offs. For example, decreasing tax rates could lower the overall economic cost of the program; however, this approach may do little to compensate low-income consumers, who would receive greater benefit from a direct rebate. In addition, using revenues to dampen increases in energy prices may benefit ratepayers but reduce their incentives to conserve energy, potentially increasing the program's overall cost.

section_title: Letter
paragraphs: I am pleased to be here today to discuss our preliminary observations on  different options for distributing allowances and revenue under a potential  cap-and-trade program intended to address climate change. Elevated  concentrations of greenhouse gases in the atmosphere as a result of the  combustion of fossil fuels and other sources may cause significant  changes in the earth’s climate. Potential impacts from climate change  include rising sea levels and shifts in weather patterns, both of which pose  threats to coastal and other infrastructure. Concerns about the potential  effects of climate change have led Congress to consider legislation that  would limit greenhouse gas emissions nationwide. Because the harm  caused by U.S. emissions of greenhouse gases is not generally  incorporated into the underlying costs of goods and services, many  proposals to limit greenhouse gas emissions involve placing a price on  greenhouse gases emitted by businesses and other entities covered under  the program (hereafter referred to as “covered entities”). In this way, the  price on emissions would provide covered entities with an economic  incentive to emit less. It could also provide consumers with incentives to  reduce their consumption of carbon-intensive goods and services. The  impact of these incentives depends on the program’s stringency.
One option for pricing emissions is a cap-and-trade program, in which the  government would limit the overall quantity of emissions and issue  permits to covered entities. These permits—also known as allowances— would each represent a set quantity of greenhouse gas emissions, such as  one metric ton. Allowances could be purchased and sold, creating a  market in which the price of emissions fluctuated with supply and  demand. The government could also generate substantial revenue through  this program by selling allowances to covered entities, as opposed to  giving them away for free. Recently, the House of Representatives passed  H.R. 2454, the American Clean Energy and Security Act, which would,  among other things, create a cap-and-trade program covering about 85  percent of U.S. emissions.
In addition to potentially providing the benefits of emissions reductions, a  cap-and-trade program could also impose costs on covered entities and  consumers. The most obvious cost would be a likely increase in the cost of  energy derived from fossil fuels, the main source of man-made greenhouse  gas emissions. Covered entities could see their production costs increase  as a result and could either accept lower profits or, more likely, pass costs  on to consumers. In the absence of compensatory measures by the  government, a cap-and-trade program could have a disproportionate  impact on low-income households, since they generally spend a higher  percentage of their income on energy and energy-intensive goods and  services than do higher-income households.
Congress is considering various mechanisms for distributing allowances in  a cap-and-trade system, including auctions, free allocation to certain  covered entities, or a combination of both. The choice of mechanism could  have significant effects on the distribution of costs and benefits  throughout the economy. At the request of this committee, we have work  under way on the collection and distribution of revenues in programs  intended to address climate change and will release a report on these  topics later this year. My testimony today focuses on (1) the effects of  various methods of allocating allowances on government, consumers, and  covered entities; and (2) options for distributing the program’s revenue or  economic value of emissions allowances.
To address these objectives, we drew on ongoing work for this committee,  which will result in a final report later this year. Specifically, we reviewed  and analyzed academic and professional literature produced by industry  associations, research organizations, academic institutions, and  environmental groups, including international research. We also analyzed  literature from government agencies, including the Congressional Budget  Office (CBO), the Congressional Research Service, and the Environmental  Protection Agency (EPA). We did not independently assess the validity of  data, assumptions, or methodologies underlying the economic studies we  reviewed. We also reviewed documents from international and state-level  organizations that operate cap-and-trade programs to address climate  change—including the U.S.-based Regional Greenhouse Gas Initiative  (RGGI), a coalition of 10 Northeast states that has implemented a cap-and- trade program for electricity generators, and the European Union’s  Emissions Trading Scheme—and interviewed individuals familiar with  these programs. In addition, we conducted semi-structured interviews  with leading economists and researchers selected on the basis of their  expertise in climate or tax policy. Finally, we drew on previous GAO  reports and testimonies. We conducted our work from December 2008 to  August 2009 in accordance with all sections of GAO’s Quality Assurance  Framework that are relevant to our objectives. The framework requires  that we plan and perform the engagement to obtain sufficient and  appropriate evidence to meet our stated objectives and to discuss any  limitations in our work. We believe that the information and data obtained,  and the analysis conducted, provide a reasonable basis for any findings  and conclusions in this product.
subsections: section_title: Background
paragraphs: According to the Intergovernmental Panel on Climate Change—a United  Nations organization that assesses scientific, technical, and economic  information on the effects of climate change—global atmospheric  concentrations of greenhouse gases have increased markedly as a result of  human activities over the past 200 years. These gases trap heat that would  otherwise escape the earth’s atmosphere, contributing to climate change.  Climate change is a long-term and global issue because greenhouse gases  disperse widely in the atmosphere once emitted and can remain there for  an extended period of time. Among other potential impacts, climate  change could threaten coastal areas with rising sea levels, alter  agricultural productivity, and increase the intensity and frequency of  floods and tropical storms. Carbon dioxide is emitted in by far the largest  volume of any greenhouse gas, and most emissions are caused by fossil  fuel combustion. According to the EPA, carbon dioxide emissions from  fossil fuel combustion accounted for approximately 80 percent of all  greenhouse gas emissions in 2007.
Placing a price on emissions is likely to raise the cost of production of  many goods and services. The size of the impact will depend on the price  of allowances, as well as the ability of producers to substitute less  emission-intensive processes and inputs. While some studies suggest that  the overall impact would be modest, a cap-and-trade program could have a  disproportionate effect on covered entities that rely heavily on fossil fuels,  such as electricity generators. According to the Energy Information  Administration (EIA), electricity generators derived about 49 percent of  their electrical power from coal in 2007. The combustion of coal generates  about twice as much carbon dioxide per unit of energy as the combustion  of natural gas, the next most common fuel source for U.S. electricity  generation, according to EIA.
Due to changes in the regulation of electricity markets, certain companies  may be limited in their ability to pass on emissions reduction costs to their  customers. Historically, electricity was generated, transmitted, and  distributed by local monopolies. These companies were overseen by  regulators who restricted the entry of new companies, approved  investments and retail prices, and determined profits. Since the 1970s,  efforts have been made to “restructure” electricity markets by introducing  more competitive conditions. At the wholesale level, federal regulators  have introduced market-based pricing, although these markets can take a  variety of forms. About half the states have made efforts since the 1990s to  restructure how retail prices are set, generally seeking to increase  competition in electricity sales. According to EIA, 14 of these states— located in New England and the upper Midwest, plus Texas—currently  operate retail markets in which customers may choose among competing  power suppliers. The other states where restructuring was introduced  have either suspended or repealed these efforts. In the remaining states,  regulators still approve utility costs and prices. In addition to covered  utilities, which are mostly investor-owned, most states also have utilities  that are owned either by the public (such as through a municipality) or  cooperatively by customers themselves. Such utilities—which currently  account for about one-quarter of electricity sales—generally set prices at  cost instead of maximizing profits.
In markets where regulation and international competition are not major  factors, it is likely that consumers will ultimately bear most of the costs  associated with pricing emissions. These costs are expected to  disproportionately affect low-income consumers, who tend to spend a  higher proportion of their incomes on energy products like electricity,  heating, and gasoline. EPA has estimated that the cap-and-trade program  in the American Clean Energy and Security Act would cost the average  household $80 to $111 per year. A similar study by CBO estimated average  household costs to be $175 per year, with some lower-income households  receiving a net benefit. On the other hand, research suggests that policy  makers could mitigate or eliminate these effects by selling allowances to  covered entities through auctions and returning the revenue back to  consumers in the form of lump-sum rebates or tax adjustments.
If the government were to ‘recycle’ revenue through tax reductions, it  could also realize benefits to the overall economy in the form of  “economic efficiency.” Many economists view certain taxes as inefficient  or “distortionary,” because they shift resources away from their most  highly valued use. For example, efficiency costs may arise because taxes  on labor income may affect job choices or hours worked. Most economists  agree that minimizing the efficiency cost of the revenue raised to fund  government services is an important objective of tax policy, among other  objectives such as distributing the burden of taxation equitably.
The effects of emissions pricing on consumers and industry will also vary  by region. While some recent studies suggest that this variation would be  minimal, it may be more substantial for low-income households. Areas  that get most of their electricity from coal, the most emissions-intensive  source, may see a greater electricity cost increase than areas that rely  heavily on natural gas, nuclear energy, or hydropower. One study has  estimated that the cost burden as a percentage of household income  would range from about 1.9 percent in the East South Central region to  about 1.5 percent in the West North Central region.
A cap-and-trade program would also affect federal, state, and local  governments, which purchase energy intensive goods and would be  responsible for the program’s implementation. According to one study,  governments produce approximately 13 percent of U.S. carbon dioxide  emissions, and the allowance consumption associated with these  emissions could cost governments an additional $16.6 billion.  Furthermore, price increases could increase government payments—such  as Social Security benefits and federal pensions, which are indexed to  prices—and reduce personal income tax collections. Finally, depending on  the details of the program, a cap-and-trade program could increase the  administrative burden on the government relative to a business-as-usual  situation. For example, markets for emissions allowances would require  oversight, and the distribution of auction revenues could require  additional personnel or a new entity to administer payments.
section_title: Different Methods of Allocating Emissions Allowances Will Affect Government, Covered Entities, and Consumers
paragraphs: The design of a cap-and-trade program’s allowance allocation plan—the  ways in which tradable allowances are allotted to covered entities at the  outset of the program—will help determine how costs and benefits are  distributed across the economy, according to available literature. The  method of allowance allocation will generally not affect the level of  emissions reductions achieved by the program, because allocation is  independent of the overall cap. Therefore, the principal consideration in  designing an allowance allocation plan is how to distribute the allowances  in a way that helps to achieve certain goals: for example, to offset the  program’s economic impact on disproportionately affected industries or to  generate revenue that could be redistributed to consumers or used for  other purposes. To accomplish these goals, three basic design choices are  available: allowances may be sold through an auction or other means,  distributed for free, or dispensed using a combination of these methods.
subsections: section_title: Auctioning Allowances Could Generate Substantial Revenue and Provide Other Key Benefits
paragraphs: Selling allowances to regulated entities could provide several benefits.  First, it would generate a source of revenue that the government could use  to defray the economic costs associated with emissions reductions or  direct toward other purposes. These revenues could be substantial: in  June 2009, CBO reported that the American Clean Energy and Security Act  would generate annual revenues of $45 billion by the year 2019 by  auctioning of a percentage of the allowances. Earlier CBO estimates  indicated that annual allowance revenues could range between $30 billion  and $300 billion by roughly the same time period if all allowances were  auctioned, although this proposal is not part of the bill.
Some existing cap-and-trade programs have already sold allowances  through auctions or commodity exchanges. For example, several member  states participating in the European Union’s Emissions Trading Scheme  (ETS)—including Ireland, Hungary, Lithuania, the United Kingdom, and  Germany—have generated revenues from allowance sales; in Germany,  these totaled approximately $1.2 billion in 2008. The level of auctioning is  expected to increase as the program moves toward its third phase, which  is to begin in 2013. In the United States, the Regional Greenhouse Gas  Initiative—a regional cap-and-trade program involving 10 northeastern  states—has conducted four auctions since it began auctioning allowances  in 2008. These auctions, held quarterly, have each raised between $38  million and $118 million for programs to promote energy efficiency and  assist low-income households with energy costs, among other things.  Given the revenue generation potential of auctions, many experts we  consulted as part of a prior study suggested that a cap-and-trade program  should maximize the level of auctioning.
Auctioning may confer other additional benefits, according to available  literature and researchers we spoke with. For example, many economists  favor auctioning because of its transparency and because it discourages  behaviors motivated by a desire to gain free allowances, such as “baseline  inflation.” This occurs when a firm attempts to boost the number of  allowances it receives by increasing its emissions prior to the outset of a  cap-and-trade program. Auctioning can also help ensure that new entrants  to an industry face the same emissions reduction costs as existing firms.  Finally, auctioning could decrease the possibility that covered entities  earn windfall profits as a result of the cap-and-trade program, particularly  in restructured regions where prices are determined largely by market  factors. Covered entities could earn windfall profits if they pass along the   “opportunity costs” of free allowances—that is, the revenue foregone by  not selling them—in the form of increased electricity prices. For example,  in the first phase of the European Union’s ETS, electric utilities that  received free allowances reaped substantial profits by charging ratepayers  for the opportunity cost of those allowances.
On the other hand, auctioning does not offer compensation to covered  entities, particularly those that face disproportionate costs due to a cap- and-trade program. The government will also incur certain administrative  costs associated with designing and administering the auctions, although  these activities could be funded using part of the auction revenues.  Moreover, the effectiveness of allowance auctions will depend partly on  their design.
section_title: Free Allocation of Allowances May Ease Entry Into Emissions Regulation but Can Increase the Overall Cost of the Program
paragraphs: Free allocation could help establish political support at the outset of a cap- and-trade program and compensate covered entities for any decrease in  profits they might experience as a result the program, but it could also  have some disadvantages. Two principal options are available when  allocating allowances for free: “grandfathering” or “output-based updating  allocation.” Grandfathering involves allocating allowances based on  historic (pre-regulation) emissions measures, while output-based updating  allocation involves adjusting the number of allowances provided to an  entity based on its recent production levels. Available literature indicates  that since past emissions measures do not change, grandfathering may be  less susceptible to manipulation than output-based updating allocation.  However, research suggests that grandfathering is unlikely to prevent the  “leakage” of economic activity—including production, jobs, and  emissions—to countries where greenhouse gases are not regulated. As  we have previously reported, leakage may be of particular concern to  firms in certain energy-intensive industries that face international  competition—such as primary metals, paper, and chemicals—as these  firms could find it more difficult than other covered entities to pass on  costs to consumers by raising prices. Grandfathering could also provide  an advantage to existing facilities, which are more likely to have outdated,  inefficient technologies in place.
Output-based updating allocation could also present trade-offs. As we  have previously reported, output-based updating allocation could provide  incentives for covered entities to maintain or increase production,  potentially reducing the likelihood that these entities would move  production to countries that are not subject to emissions regulations.   However, output-based updating allocation could also decrease incentives  for covered entities to engage in conservation and reduce their energy  intensity, depending on how the program is designed.  Moreover, some  research indicates that an output-based approach would subsidize entities  in certain industries, forcing entities in other sectors to make deeper cuts  in their emissions in order to meet the overall cap. Since these cuts may be  more expensive than the reductions that would have otherwise taken  place, the overall cost of the cap-and-trade program would increase. In  addition, some research suggests that maintaining output may not always  be a worthwhile goal: for example, the contraction of output from a high- emissions sector may be one of the most cost-effective means by which to  reach the overall emissions target.
Furthermore, attempts to keep energy prices low could increase the cost  of the program to the economy. Rising prices for energy and energy- intensive goods are critical to the success of the program, because these  “price signals” create incentives for both covered entities and consumers  to conserve energy, and thereby reduce emissions of greenhouse gases. To  the extent that price signals are not preserved, fewer households and  businesses will change their behavior in response to these signals.  This  could reduce the economic efficiency of a cap-and-trade program, since  some of the less costly emissions reduction opportunities would be  forgone.
The structure of the U.S. electricity generation sector—which represents  roughly 40 percent of domestic carbon dioxide emissions—could affect  whether price signals reach energy users.  Since the price of electricity is  regulated in certain regions, generators that receive free allowances in  these regions may not be able to pass along the costs associated with an  emissions price to residential and commercial electricity users. If costs are  not passed through, incentives for conservation decrease. A diminished  price signal could also have indirect effects—for example, if the price of  energy intensive goods does not rise in relation to other goods, consumers  have less of an incentive to purchase fewer of these goods.
Considering the limitations of free allocation, some analyses have  advocated limiting the use of free allowances to specific subsets of carbon  intensive industries.  Several studies suggest that freely allocating between  6 and 21 percent of all allowances would be enough to compensate these  industries—which include coal-fired power plants, fossil fuel suppliers,  and energy intensive manufacturers—for profit losses related to emissions  regulation. In 2007, CBO reported that less than 15 percent of allowances  would be sufficient to offset net losses in stock value as a result of the  program.
section_title: The Effects of a Cap- and-Trade Program Depend on the Use of Revenues or Allowance Value
paragraphs: The establishment of a cap-and-trade program creates opportunities for  the government to direct the value of allowances in a variety of ways. For  the purposes of this testimony, we assessed five options that are  frequently discussed in the economic literature, although numerous other  options exist. First, the government could reduce the overall cost of the  program by reducing taxes on capital or income that currently make the  economy less efficient. Second, the government could distribute lump-sum  rebates to consumers, who would likely pay the bulk of the economic  costs associated with a cap-and-trade program. Third, revenues could be  used to expand the Earned Income Tax Credit to assist low-income  working families. Fourth, policymakers could compensate covered entities  for their increased costs through free allocation—an approach equivalent  to selling allowances on the market and transferring all the revenue to  covered entities. Finally, revenues could help fund climate-related  programs or activities, including research and development, energy- efficiency programs, or international aid to developing countries that face  challenges in mitigating and adapting to climate change.
subsections: section_title: Reducing Existing Taxes
paragraphs: Using program revenues to reduce marginal tax rates—whether from  individual income or payroll or taxes, corporate income taxes, or taxes on  capital gains or investments—can reduce economic distortions in the tax  code and lower the overall cost of the program. The benefits of tax  reduction depend on the extent to which these taxes currently distort  economic activity, according to literature and economists we spoke with.  For example, existing taxes on labor or capital can discourage individuals  from participating in the labor force or investing money. The structure of  the tax code can also create distortions by directing spending toward  certain areas where the buyer has a tax advantage, such as  homeownership or employer-provided medical insurance.
A cap-and-trade program could further exacerbate these tax distortions,  according to economic literature. This so-called “tax interaction effect”  could occur because a cap-and-trade program may have some of the same  effects as a tax. Specifically, covered entities that face additional costs due  to an emissions price will generally pass on their increased costs to  consumers in the form of higher prices, thereby reducing the amount of  goods that consumers can purchase. Because a loss of purchasing power  effectively represents a decrease in real wages, incentives to work may  also decrease. These effects could ultimately raise the cost of the program  to the economy, according to economic literature we reviewed.
However, ‘recycling’ auction revenues through the tax code could partially  or wholly offset costs that result from inefficiencies in the tax code, as  well as potential costs imposed by the cap-and-trade program, according  to a review of economic literature and interviews conducted with  economists. For example, because an emissions cap could cause prices  to rise—and real wages to fall—a reduction in labor, income, or capital  taxes could provide efficiency gains and help reduce the overall cost of the  program.
These efficiency gains may present trade-offs. Economic analyses suggest  that reducing tax rates would do little to compensate low-income  individuals that may be disproportionately affected by the cap-and-trade  program. According to these analyses, most benefits from reduced taxes  would accrue to higher income households, regardless of the tax targeted  for reduction. Moreover, in the absence of supplemental policies, the  benefits of reducing labor taxes will not reach individuals who do not file  tax returns.  To close this gap in coverage, the government could  supplement a tax reduction with payments issued through existing  systems, such as the Electronic Benefit Transfer system or state-based  food stamp programs. However, using a combination of systems could  increase the administrative burden and complexity of the program, and  may require additional governmental coordination.  In addition, adjusting  the payroll tax rate may be complicated since these taxes represent social  security and Medicare financing contributions.
section_title: Lump-Sum Rebates for Consumers
paragraphs: Another way to distribute revenues to consumers would be to distribute  lump-sum rebates to consumers. Such a program could take many forms,  but the underlying goal would be to compensate consumers or households  through rebates of a specific amount. The amount of the rebate could be  based on a simple per-capita formula with checks of equal size—also  known as “cap-and-dividend”—or could account for household size,  region, or other factors.
An important advantage of lump-sum rebates, according to many  economists, is that they help offset the costs of a cap-and-trade program  on consumers, particularly on low-income households. Depending on the  design of the program, certain consumers may even experience a net  benefit. However, research indicates that distributing lump-sum rebates  would forgo the efficiency gains that could be achieved through tax  reductions, making the program comparatively more expensive to the  economy overall.
The ultimate cost of lump-sum rebates and the resulting effects on  consumers would depend in part on the program’s administration. The  funds could be distributed, for example, using existing government  programs, such as the income tax system or other benefit transfer  programs. For example, one economist has proposed that the government  could provide rebates for taxes paid on the first $3,660 of each worker’s  earnings, leading to a maximum rebate of $560 per worker. Alternatively,  the government could develop a new distribution mechanism, although  this approach would carry additional administrative costs. While using a  single existing mechanism for rebate delivery would be the simplest and  most transparent option, it would exclude individuals that did not  participate in that program—for example, rebates that use the tax system  would exclude individuals that do not file tax returns. The government  could encourage these individuals to file through outreach campaigns, a  strategy used when stimulus checks were distributed under the Economic  Stimulus Act of 2008. Evidence suggests that such efforts could encourage  more individuals to file—for example, of the 150 million individual income  tax returns processed for tax year 2008, approximately 9 million claimed  only the economic stimulus payment. However, any outreach effort would  entail additional costs and administrative requirements.
Policymakers could also design a rebating system that uses a combination  of mechanisms to maximize coverage, although this strategy would  increase the program’s complexity, given the need for program  coordination, as well as the risk of fraud or duplicate rebates.
section_title: Expanding Earned Income Tax Credit
paragraphs: Several proposals for distributing revenue involve expanding the Earned  Income Tax Credit (EITC) program. The EITC was enacted in 1975 and  was originally intended to offset the burden of Social Security taxes and  provide a work incentive for low-income taxpayers. It is a refundable  federal income tax credit, meaning that qualifying working taxpayers may  receive a refund greater than the amount of income tax they paid for the  year. According to one study, approximately half of all households would  benefit from this approach, with lowest-income households with children  reaping the highest gains. However, this study suggests this option would  affect low-income households differently depending on their location.  Low-income households in the Northeast, for example, could see about a 2  percent gain in income, compared to a 7.4 percent gain in Texas. Some  research also indicates that the EITC may encourage labor activity for low- income workers.
Using the EITC to distribute revenue, however, may involve trade-offs. For  example, as the Treasury Inspector General for Tax Administration has  reported, the EITC has been vulnerable to taxpayer error in the past, due  in part to changes in eligibility and the tax code. Prior reviews by the IRS  and GAO also suggest that errors are common—for example, an IRS study  has reported that the EITC program has an erroneous payment rate  estimated to be between 23 and 28 percent.
section_title: Free Allocation of Allowances
paragraphs: Allocating free allowances to covered entities can help establish political  support at the outset of a cap-and-trade program and compensate covered  entities for any increased costs they incur as a result. However, as noted  earlier, free allocation can raise the cost of the program if such allocation  decreases incentives to conserve energy and reduce emissions in one  sector and forces other sectors to make less efficient reductions. In  addition, economic literature suggests that a grandfathering approach to  free allocation would do little to discourage the leakage of economic  activity, jobs, and emissions, since covered entities’ variable costs of  production would remain unchanged. An output-based approach to free  allocation, on the other hand, could reduce the likelihood that covered  entities would relocate or decrease production, although it could also  reduce their incentives to decrease emissions.
Most of the benefits of freely allocated allowances will accrue to the  shareholders of entities that receive them by compensating shareholders  for any declines in stock value they might experience as a result of the  cap. However, consumers are unlikely to see these benefits in the form of  lower prices, since most covered entities will pass on costs associated  with a cap-and-trade program, even when they receive allowances for free.  Free allocation is therefore likely to benefit those with higher incomes  more than those with lower incomes.
The administrative burden associated with free allocation of allowances  depends primarily on how policymakers determine the relative allocations  to each industry. A grandfathering approach, for example, would require  the government to select a set of years with which to determine a baseline.  An output-based approach would require the government to define a  baseline, which could prove challenging. As one economist we interviewed  pointed out, “output” could be subject to numerous interpretations, each  with its own implications for equity.
The government could also direct the recipients of free allowances to use  these allowances for the benefit of consumers. For example, HR 2454, as  passed by the House on June 26, allocates some allowances to electric and  natural gas local distribution companies (LDC) for the benefit of retail  ratepayers. Distributing free allowances through LDCs may go some way  toward mitigating regional differences in cost impacts, according to some  researchers. However, the overall effects of this approach would depend  largely on the extent to which it creates incentives to reduce energy use,  according to economists we spoke with. Importantly, if benefits to  electricity customers were conferred in the form of decreased energy  rates, the incentives for energy conservation may diminish and the overall  cost of the program could increase. This may be particularly true for  residential customers, according to economists we interviewed, since  industrial customer may have other reasons to pursue efficient practices.  To help preserve incentives, LDCs could allow electricity rates to rise and  rebate consumers through the fixed portion of their utility bills—that is,  the portion not based on energy use. However, this approach assumes that  electricity customers will differentiate between the fixed and variable  portions of their utility bill when assessing their costs, as opposed to  simply looking at the bottom line amount, which could remain largely  unchanged. Several economists and researchers we spoke with expressed  skepticism that customers would react to the price signal if their total  energy costs did not change, although some said that distributing rebate  checks separately from the utility bill could address this concern.
The effect of this approach on consumers will depend on other factors. If  both residential and business customers receive benefits, for example, the  benefits conveyed to businesses may not get passed along to their  customers. According to a CBO analysis of H.R. 2454, most of the  allowance value given to local distribution companies would benefit  business customers. The analysis also estimates that 63 of percent  allowance values conferred to businesses would ultimately benefit the  highest earning 20 percent of households, since these households are more  likely to be shareholders. In addition, the way in which benefits are  conveyed to customers—for example, through lower prices, investments  in energy efficiency, or other means—will depend on the state public  utility commissions that regulate the LDCs. While some organizations have  expressed concern that past regulation has been uneven, several  economists and state officials we spoke with expressed confidence that  the existing regulatory structure could effectively ensure that customers  received the benefits.
section_title: Funding Climate-Related Programs or Activities
paragraphs: Revenues generated through allowance auctions could also be directed  toward climate-related programs or activities, including the research and  development of low-carbon technologies, programs to promote energy- efficiency, or mitigation and adaptation activities abroad. Beyond their  environmental benefits, such programs could also convey efficiency gains,  if they lowered the cost of emissions reductions. The development of  renewable energy sources, for example, could ultimately lower covered  entities’ total expenditures on emissions allowances. Funding for  efficiency programs could also offset costs for households through  reduced energy demand. Some research organizations have also suggested  that funding in these areas could create job opportunities, and in the long  run could help ensure greater economic stability due to energy security.
Economic research suggests that an emissions price, on its own, will go  some way toward promoting low-carbon technologies and the efficient use  of energy. However, economists we spoke to said that there are certain  instances—known as “market failures”—where opportunities for  reduction may not be captured. For example, builders and owners of  rental properties may not have incentives to consider energy efficiency in  the construction and renovation of these properties, since they may not be  responsible for paying electricity and heating costs. In these cases,  subsidies for efficient construction or renovation may be appropriate. In  addition, certain technologies—such as carbon capture and storage—may  face cost barriers that could be mitigated through grants or subsidies.  Other technologies may need nationwide infrastructure that could require  additional funding at the federal level—for example, an enhanced  transmission grid to transmit renewable energy. While many economists  we spoke with said funding such activities could be beneficial, several also  cautioned that selecting, implementing and evaluating these programs  could pose challenges.
subsections: section_title: Technology Research and Development
paragraphs: from a power plant’s emissions,  transporting it to an underground storage location, and then injecting it into a geologic  formation for long-term storage. result, several economists we spoke with recommended allocating part of  the allowance revenues for research and development to help overcome  these cost barriers. However, several also noted that it is difficult to  determine how to allocate such funds effectively. For example, selecting  which technologies receive funding places the government in the position  of attempting to choose the best technologies rather than allowing the  market to make that determination. Overall, research suggests that  funding technologies in the early stages of development may be more cost- effective than using revenues to commercialize existing technologies.
section_title: Energy Efficiency Programs
paragraphs: Investments in energy efficiency have the potential to alleviate some of the  effects of the cap-and-trade program on households. For example, using  auction revenue to support weatherization improvements for homes or the  purchase of energy-efficient appliances could lower these households’  energy consumption and expenditures. Some research suggests that tax  credits, for example, can have a significant impact on efficiency  investments by homeowners and businesses.  However, several  researchers have noted that the implementation of such programs has  been unpredictable in the past, in part because it is difficult to determine  whether these activities would have occurred anyway.
section_title: Aid to Developing Countries
paragraphs: Allowance revenues could also be used as aid to developing countries,  either in the form of grants, loans, or other means of assistance. Such aid  could target activities that reduce greenhouse gas emissions in these  countries—for example, programs that aim to deploy low-carbon  technologies in areas where they would not normally be financially  feasible. Revenue could also support adaptation activities that could help  these countries prepare for and adjust to the project effects of climate  change.
Several economists and researchers we spoke with supported directing  some portion of auction revenue for international aid efforts. Some  highlighted an obligation on the part of developed countries, which  represent the bulk of greenhouse gas emissions to date, to help less  developed nations deal with potential problems associated with climate  change, such as food shortages, water quality problems, and the increased  risk of malnutrition or disease. In addition, research indicates that the  developing world presents low-cost opportunities for emissions  reduction—for example, avoiding landfill waste through composting—as  well as opportunities to prevent future emissions in those countries that  are rapidly developing their energy, industrial, and transportation  infrastructures. Furthermore, some researchers noted that the provision of  mitigation or adaptation aid to developing countries may essentially be a  prerequisite to these countries’ participation in an international agreement  to limit emissions.
Mr. Chairman, this concludes my prepared statement. I would be happy to  respond to any questions that you or other Members of the Committee  might have.
section_title: Contacts and Staff Acknowledgments
paragraphs: For further information about this statement, please contact John  Stephenson, Director, at (202) 512-3841 or stephensonj@gao.gov.  Individuals who made key contributions to this testimony include Michael  Hix, Assistant Director; Cindy Gilbert; Robert Grace; Richard Johnson;  Jessica Lemke; Ben Shouse; Jeanette Soares; Ardith A. Spence; and  Vasiliki Theodoropoulos.
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