Equity and Efficiency in Cap-And-Trade:  Effectively Managing the Emissions Allowance Supply

Adele Morris
adele morris
Adele Morris Former Senior Fellow - Economic Studies

October 26, 2009

This paper is part of a series of studies on the policy design issues for cap-and-trade. As part of the Energy Security Initiative Policy Brief Series, this paper focuses on emissions allowances.


A cap-and-trade system to control U.S. greenhouse gas (GHG) emissions as proposed in recent draft legislation, for example in H.R. 2454, the American Clean Energy and Security Act (ACESA), creates a limited and declining number of emissions allowances each year (the “cap”). Each allowance is worth one ton of carbon dioxide (CO2) or its equivalent in other greenhouse gases. The program requires firms with emissions that fall under the cap (the “covered entities”) to surrender to the government enough allowances to cover their emissions. The cap declines each year in order to satisfy long-run emissions targets. For example, ACESA sets U.S. emissions goals for 2020 and 2050 that are 17 percent and 83 percent, respectively, below 2005 levels. To achieve the capped levels at least cost, the program allows firms to buy and sell allowances (the “trade” part of cap-and-trade), creating a market that induces the least-cost emissions abatement. The allowance market thus creates a transparent price for the right to emit greenhouse gases.

Policymakers are keenly interested in the likely effect of the cap-and-trade system on their constituents. This paper summarizes the economic literature on the “incidence” (a.k.a. the “distributional effects”) of cap-and-trade climate policy, meaning all the ways people may be made better or worse off as a result of the policy.

One often hears about how a particular climate policy approach might benefit corporations as opposed to individuals or vice versa. This paper takes the perspective of the economic literature, which examines the effects of climate policy on individuals and different categories thereof, not the effects on individuals vis-à-vis corporations. Only people can bear the costs and benefits of the program. Although the legal system treats firms as if they were people, the ultimate economic burdens and benefits of climate policy fall not on legal entities but on the owners of firms (shareholders), workers, consumers, and other individuals.

This paper considers the distributional effects of cap-and-trade across different sets of people, including consumers, shareholders, household income groups, and geographic regions, and it explores the role of policy design in determining those effects. The paper describes how the incidence of the program depends on how market forces transmit the costs of emissions abatement through the economy and how the program can create large transfers from one group to another, especially through the way the government doles out allowances. Finally, it explains how the allocation of allowances can lower or raise the overall costs to the economy by reducing other economic distortions or by inducing higher-cost abatement.

Section 2 of this paper reviews existing studies of the incidence of a cap-and-trade system and explains how and when market forces transmit the price on carbon from covered entities to consumers. Section 3 explains how the ultimate economic incidence of the program depends critically on how the government distributes the value of the allowances, either in the form of the allowances themselves or via the proceeds of allowance sales. Section 4 explores how the way in which the government devolves allowances can affect not only the distribution of costs but also the overall level of the costs to the U.S. economy. It also examines other potential uses of the value of allowances, such as enhanced energy research and development funding. Section 5 concludes.

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