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. 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. 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.