E C O N O M I C R E P O R T O F T H E P R E S I D E N T

Box 7-4. Should Regulators Allocate or Sell Tradable Permits?The Administration has proposed a domestic greenhouse gastradable permit program for 2008-12. Implementing a tradable permitprogram would require industries covered by the program to restricttheir greenhouse gas emissions to comply with the Kyoto Protocolemissions target. Abating greenhouse gas emissions involves costsassociated with investing in new technologies, fuel switching, andother means of reducing emissions. As the energy sector becomesmore competitive over the next decade, the costs of controlling emissionswill be reflected in consumer prices. For example, the Administration’seconomic analysis of the Kyoto Protocol found that a tradablepermit price of $23 per ton of carbon equivalent would increase energyprices to consumers by about 5 percent in 2010.A key question in implementing a tradable permit system is the distributionof permits. For example, the government can allocate (giveaway) permits to firms, or it can sell permits to firms through auctions.So long as the tradable permit market is efficient, the price of energy toconsumers is likely to be the same in either case. Permits will bescarce, and the price of energy will reflect the cost of buying a permitor taking abatement measures regardless of how the permits wereoriginally distributed. Producers who receive free permits will be likeowners of particularly low cost oil wells when oil prices go up: they willsell at the market price and reap windfall profits. In contrast, an auctionallows the government to capture the value of the permits, becausecompetition should lead companies to bid away almost the full valueof any potential windfall profits from owning the permits.Allocating permits to firms would result in handing over assets valuedin the tens to hundreds of billions of dollars annually. Becausethese firms can pass on most of the cost of reducing emissions to consumers,allocating permits would provide these firms with significantwindfall profits and allow them to enjoy higher profits under climatepolicy than without climate policy. On the other hand, if the governmentsells permits, it will receive revenue in the tens to hundreds ofbillions of dollars annually. Although energy firms would make lowerprofits under an auction system, the permit revenue could, for example,be recycled back into the economy through tax cuts. Recentresearch has found that such revenue recycling could reduce the coststo society resulting from the use of greenhouse gas permits by up toabout 80 percent.Allocating permits to energy industries would significantly increase thevalue of their equity, whereas selling permits would lower it. Analternative is to follow a hybrid approach that combines elements of bothallocating and auctioning. Recent research has estimated that allocatingcontinued on next page...Chapter 7 | 251