Update, April 30, 2009: Please also see two follow up posts:

***

mcdermottWashington’s Congressman Jim McDermott just released a new climate plan, but I can’t quite wrap my head around it. It gets some things right, but it may cause some relatively serious problems too.

Here’s how he described it in a recent blog post:

In brief, here’s how it would work: Producers of products and resources that emit greenhouse gases would be required to purchase a Federal Emission Permit. We establish a cap through permits that would be available in an increasingly limited supply. The price for a permit would be established by the Secretary of the Treasury and periodically calibrated to ensure that demand for the permits does not exceed an annual, national allocation.

I understand how Treasury could specify a set price for carbon permits: that’s a lot like a carbon tax. And I understand how it can specify a quantity of carbon permits: that’s essentially a carbon cap. But I’m mystified: how can Treasury specify both a supply of carbon permits and a price for each permit? In practice, that’s neither tax nor cap — it’s more like a federal carbon ration, which carries some serious risks for consumers and for carbon policy more generally.

How is this supposed to work?

Let’s say that Treasury announces that it will sell a fixed quantity of permits at a fixed price.

If the Treasury sets the price too low, demand for permits will exceed supply. In other words, firms will want to purchase more permits than the Treasury is selling. In that case, the government will have two options: A) sell more permits than the cap allows; or B) pick and choose which firms get permits, and how many. Neither option is good.

Option A erodes the environmental integrity of the program. Option B has a tangle of problems connected to it, including the following. The firms that get picked will get cheap permits while their competitors may get nothing. The end result—skipping over the economics of permit allocation — is that lucky firms will reap windfall profits from consumers in the amount of the difference between the government-set price and the “real” price that would have been set by supply and demand in an open auction. In fact, such a scheme could worsen economic inequities. (Go here for more on how windfall profits happen.)

If the Treasury sets the price too high, the supply of permits will exceed demand. In other words, the government will be selling more permits, at higher prices, than folks want to purchase. That’s basically just an aggressive carbon tax—one that reduces emissions faster than the cap alone would mandate. From environmental perspective that’s okay, but it begs the question: why all the funny business with permits? Why not just set an aggressive carbon tax instead?

And if the Treasury sets the price just right? Well, I’m not so sure that will ever happen. There’s really no reason to think that the Treasury can accurately forecast carbon demand and then correctly pick a price to match supply. The government has been rather bad at forecasting energy prices and demand. Even the polluting firms themselves can’t do it accurately for their own industries. It seems a bit like asking Tim Geithner to forecast the price of your house in 2010.

Let’s dig a bit deeper into the weeds.

  • The way the bill works is by requiring the Treasury to deploy a carbon price-setting scheme in five-year increments. Basically, the government will guess at how prices will affect domestic carbon consumption and then they set carbon prices to achieve their reduction targets. If the government guesses wrong, the bill allows for some interim price adjustments in order to achieve the law’s emissions targets.

    I believe it’s possible to read the bill in such a way that there’s not really a carbon cap at all. I’m not much for parsing legislation-ese, but the bill appears to allow firms to acquire more carbon permits than the Treasury wants in circulation. (The Treasury makes up the difference by adjusting future prices.) If this is indeed how the law works — and I’m genuinely unsure about that — then it is basically an adjustable carbon tax—albeit one that employs a system of permits for no apparent reason.

    If McDermott’s bill really is just an adjustable carbon tax—a good policy idea, by the way — it could be designed in simpler way. No fancy permit system required!

    But the bill’s effects get murkier still by giving companies a full refund on unused permits. I’m not so sure this is a good idea.

    A guaranteed refund will almost certainly boost demand for the permits. After all, if you’re a polluting firm, there’s no downside to purchasing more permits than you really need. You’ll cushion your operations by grabbing as many as you can get; and later you’ll returning any unused permits for a full refund.

    But boosting demand leads to the rationing problem I mentioned earlier: if there’s a fixed supply of carbon permits then the government will have to pick and choose which firms get permits, and how many. And even if there is not a fixed supply of carbon — and hence no real cap — a guaranteed refund will probably still drive up prices unnecessarily because demand for the refundable permits will rise beyond the level of real demand for real carbon.

    So let’s have at it. Someone please explain to me how the system is supposed to work!

    But quickly, before I go, I’ll mention that the McDermott bill does move a few things in the right direction:

    • It regulates greenhouse gas emissions upstream, which is smart.
    • It prioritizes the economic security of vulnerable families and communities, which is a great way to make carbon pricing fair.
    • And it sets up an import-fee and export-credit system for producers of carbon intensive goods, which is complicated but potentially important.

    Coverage at Publicola here. And here is the full text of the bill, which is co-sponsored by Oregon Congressman Earl Blumenauer.

    ***

    Update, April 30, 2009: Please also see two follow up posts: