Suitcase of MoneyOver at Washington Policy Center, Todd Myers had a post a couple of weeks ago that gets something importantly right. Free allocation of carbon permits in a cap and trade system is a bad idea. Take it away, Todd:

This system was used in Europe and led to some companies being given large excesses of carbon credits which they then sold on the market. In short, government gave something of value (carbon credits) to companies who then profited from them. Worse, a recent report by the Government Accounting Office found that politicians handed out presents, choosing winners and losers when it came to handing out allocations, leaving some industries short and others long.

That’s a good point. Not only is it free allocation inefficient, but it’s ripe for abuse and favortism. Forget about fairness for consumers for a moment — a subject we’ve written a lot about — free allocation is not even fair for the firms that will be regulated under cap and trade. It’s very difficult, and perhaps impossible, to develop a principled, rational, and fair way to hand out permits for free.

The most popular scheme for free allocation gives out permits based on historical emissions. This is sometimes called “grandfathering”. The European cap and trade program took this approach (albeit in some peculiar ways) and it’s possible that Washington may head down the same path. Unfortunately, grandfathering can cause some very problematic inequities.

Consider how this might work in practice.

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  • Imagine that there are two steel firms in your state: Green Steel and Brown Steel. Let’s say that in 2005, Green Steel decided to radically upgrade its efficiency. Maybe Green Steel was getting hassled by air quality regulators, or maybe its existing equipment was nearing the end of its lifespan, or maybe it saw change coming and wanted to get ahead of its competitors. The reason doesn’t much matter, just the result: that Green Steel spent a lot of its own money (or, more likely, borrowed money) to upgrade its equipment and operations. After making the investments, by 2006 Green Steel became the cleanest and most efficient steel operation in the region.

    By contrast, Brown Steel has done nothing. They operate a heavily polluting plant and they’re happy just they way they are.

    Now fast-forward to 2012 when carbon permits are given away on the basis of historical pollution. Assuming that the historical reference period is sometime after 2006, Brown Steel will get a truckload of free permits (enough to cover, or nearly cover, its large emissions profile) while Green Steel will get a comparative pittance (because its emissions are smaller). And remember: these permits are worth something. They can be sold for cash.

    Brown Steel can cash in. They can sell a portion of their permits and then use the proceeds to upgrade their equipment. (More precisely, they’ll use some financing arrangement.) The result is that by 2013 or so, Brown Steel will be just as clean and efficient as Green Steel. That’s good news for the environment, but it’s hardly fair. Green Steel had to pay out of its own pocket to act responsibly (and Green Steel’s early action was a particular benefit to the climate), while Brown Steel did nothing and essentially used public funds to become just as competitive.

    How do we fix the problem? By auctioning. If we sell the permits at a public auction, Green Steel will reap the rewards of its responsible action because they’ll have to spend less to purchase permits than will their main competitor. In fact, all across the economy, cleaner firms will have a leg up on dirtier ones. Then, Brown Steel will want to do what Green Steel did years ago: upgrade their systems and get clean. The result for the environment is just the same in either scenario, but the fairness implications are much different.

    Plus, if we’ve auctioned the permits, we may even choose to use a portion of the revenue to help Brown Steel do the right thing. With a transparent strings-attached loan, for example, we might give Brown Steel a helping hand in a way that would be much harder to accomplish with a big grant of free tradeable permits.

    Auctioning is just better. So it should come as no surprise that the European system is transitioning toward an auction. And that most federal cap and trade proposals have intended to auction a large share of their permits. And that the RGGI system in the northeast is auctioning almost all permits. And that Governor Schwarzenegger has said that he intends for California to eventually auction all of its permits.

    So Todd Myers is right. Sort of.

    Unfortunately, Todd’s solution to the problem of free allocation isn’t the obvious one—auctioning — but rather to toss out cap and trade entirely. That’s a bummer because the fix is really pretty do-able. It’s got big benefits. And it’s a fix that progressives are working hard to make a reality.

    Update, 2:30: In an email, Todd says:

    I toss out cap-and-trade but offer another alternative and one you even like. You make it sound like I have contrived a complaint about cap-and-trade to do nothing, which is not my position as you know. At least give me some love for that.

    Sure, sure. I was trying to limit the topic to cap and trade, but Todd does deserve a little love here. He’s proposed a revenue-nuetral carbon tax for Washington state. (We even wrote a favorable blog post about it.) The proposal is similar, in fact, to British Columbia’s carbon tax, about which we’re on record as big supporters.

    For too many reasons to include in this post, we prefer cap and trade to taxes. Not that we’re opposed to taxes, mind you—we like them quite a bit actually—just that we believe cap and trade to be the better tool for addressing climate emissions. So I hate to see cap and trade rejected over something that can be so easily fixed.