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See Inside July 2009

Act Now on Global Warming--Energy after the Kyoto Protocol Expires

Boost the price on energy from carbon and give the proceeds back to consumers



Matt Collins

This December 7 the United Nations Framework Convention on Climate Change will convene a 12-day meeting in Copen­hagen to confront one question: How do we respond to global warming when the five-year period for reducing carbon emis­sions under the Kyoto Protocol expires in 2012? The U.S. was not a party to Kyoto, but if this country balks once more, Copen­hagen may fail to get productive commitments from other nations as well. That’s a recipe for climate catastrophe. To show the world leaders soon to gather in Copenhagen that this country is serious about cutting its own carbon emissions, U.S. lawmakers must raise the price on the use of fossil fuels.

Yet how to do so without hurting the little guy? For many economists, a tax imposed on end users of fossil fuels is the most direct approach. A tax high enough to be useful, however, would be dead on arrival in Congress. In his campaign last fall, President Barack Obama called for a “cap and trade” plan that would auction off carbon dioxide (CO2) emissions allowances to big carbon polluters.

In many ways, though, the continuing debate over taxes versus cap and trade is beside the point. The priority is to put a price on carbon and to do so in a way that avoids the pitfalls of the largely ineffectual European efforts under Kyoto. The cap-and-trade emissions trading system (ETS) set up by the European Union issued so many free emissions allowances that the system had virtually no effect on climate. The excessive supply of allowances led to wild fluctuations in price. Some of Europe’s worst polluters collected windfall profits.

President Obama’s initial plan for a “100 percent auction” of emissions allowances would correct many of those deficiencies. The allowances would be sold, not distributed for free. The cap would be set, ideally with expert scientific consultation, to make an appropriately deep cut in total CO2 emissions. The market, working within the cap, would minimize the pain by spreading the costs. Energy providers could buy, sell and trade their allowances—and then pass their additional expenses along to their customers.

Not surprisingly, energy providers and their supporters in Congress are digging in for a fight. Unless the government issues allowances for free, they argue, consumers will face crippling price hikes. Regrettably, the administration has signaled its willingness to cave and reconsider the 100 percent auction.

There is a way, however, to keep strong price signals on fossil fuels without emptying consumers’ wallets: send the proceeds of the auction back to citizens as rebates. Energy from fossil fuels would become more expensive, as it must, yet the rebates would help offset the extra costs to consumers. Politically, that could be enough to win passage. Peter Barnes, an entrepreneur who has promoted the mechanism for years, calls it cap and dividend.

Here’s how it might work: Next year and in each year thereafter, Congress would set an overall cap on fossil fuels extracted by upstream energy producers, which David A. Weisbach of the University of Chicago Law School identifies as “fewer than 3,000 entities”—petroleum refiners, coal mines and domestic natural gas processors—“plus imports at a few locations.” The cap would be divided into allowances that would be offered at auction, though a floor price would be set to ensure that the price signal is sent. Only the 3,000 energy producers would be eligible to purchase them. To keep the legislation simple and pork-free, the proceeds would go directly to U.S. citizens—not to research programs in alternative energy, “concept car” demonstrations, and the like.

To adjust emissions caps in the future, the allowances would expire periodically, perhaps as often as once a year. That would help the system to respond to changes in projections of total atmospheric CO2 and to offer all parties a chance to learn from the program. It would also limit some—though by no means all—of the possibilities for creating derivative securities based on the emissions allowances.

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