According to the EPA, carbon dioxide emissions from  fossil fuel combustion accounted for approximately 80 percent of all  greenhouse gas emissions in 2007. Placing a price on emissions is likely to raise the cost of production of  many goods and services. On the other hand, research suggests that policy  makers could mitigate or eliminate these effects by selling allowances to  covered entities through auctions and returning the revenue back to  consumers in the form of lump-sum rebates or tax adjustments. According to one study,  governments produce approximately 13 percent of U.S. carbon dioxide  emissions, and the allowance consumption associated with these  emissions could cost governments an additional $16.6 billion. For example, markets for emissions allowances would require  oversight, and the distribution of auction revenues could require  additional personnel or a new entity to administer payments. Different Methods of Allocating Emissions Allowances Will Affect Government, Covered Entities, and Consumers

The design of a cap-and-trade program’s allowance allocation plan—the  ways in which tradable allowances are allotted to covered entities at the  outset of the program—will help determine how costs and benefits are  distributed across the economy, according to available literature. Therefore, the principal consideration in  designing an allowance allocation plan is how to distribute the allowances  in a way that helps to achieve certain goals: for example, to offset the  program’s economic impact on disproportionately affected industries or to  generate revenue that could be redistributed to consumers or used for  other purposes. Auctioning Allowances Could Generate Substantial Revenue and Provide Other Key Benefits

Selling allowances to regulated entities could provide several benefits. Free Allocation of Allowances May Ease Entry Into Emissions Regulation but Can Increase the Overall Cost of the Program

Free allocation could help establish political support at the outset of a cap- and-trade program and compensate covered entities for any decrease in  profits they might experience as a result the program, but it could also  have some disadvantages. Since these cuts may be  more expensive than the reductions that would have otherwise taken  place, the overall cost of the cap-and-trade program would increase. Furthermore, attempts to keep energy prices low could increase the cost  of the program to the economy. Rising prices for energy and energy- intensive goods are critical to the success of the program, because these  “price signals” create incentives for both covered entities and consumers  to conserve energy, and thereby reduce emissions of greenhouse gases. This  could reduce the economic efficiency of a cap-and-trade program, since  some of the less costly emissions reduction opportunities would be  forgone. The Effects of a Cap- and-Trade Program Depend on the Use of Revenues or Allowance Value

The establishment of a cap-and-trade program creates opportunities for  the government to direct the value of allowances in a variety of ways. For  the purposes of this testimony, we assessed five options that are  frequently discussed in the economic literature, although numerous other  options exist. Second, the government could distribute lump-sum  rebates to consumers, who would likely pay the bulk of the economic  costs associated with a cap-and-trade program. Third, revenues could be  used to expand the Earned Income Tax Credit to assist low-income  working families. However, ‘recycling’ auction revenues through the tax code could partially  or wholly offset costs that result from inefficiencies in the tax code, as  well as potential costs imposed by the cap-and-trade program, according  to a review of economic literature and interviews conducted with  economists. Economic analyses suggest  that reducing tax rates would do little to compensate low-income  individuals that may be disproportionately affected by the cap-and-trade  program. The  funds could be distributed, for example, using existing government  programs, such as the income tax system or other benefit transfer  programs. However, this study suggests this option would  affect low-income households differently depending on their location. Free Allocation of Allowances

Allocating free allowances to covered entities can help establish political  support at the outset of a cap-and-trade program and compensate covered  entities for any increased costs they incur as a result. Most of the benefits of freely allocated allowances will accrue to the  shareholders of entities that receive them by compensating shareholders  for any declines in stock value they might experience as a result of the  cap. However, the overall effects of this approach would depend  largely on the extent to which it creates incentives to reduce energy use,  according to economists we spoke with. Funding Climate-Related Programs or Activities

Revenues generated through allowance auctions could also be directed  toward climate-related programs or activities, including the research and  development of low-carbon technologies, programs to promote energy- efficiency, or mitigation and adaptation activities abroad. For example, using  auction revenue to support weatherization improvements for homes or the  purchase of energy-efficient appliances could lower these households’  energy consumption and expenditures.
Why GAO Did This Study

Congress is considering proposals to establish a price on greenhouse gas emissions through a cap-and-trade program that would limit overall emissions and require covered entities to hold tradable emissions permits, or allowances, for their emissions. The purpose of such a program is to raise the cost of activities that produce emissions and thereby provide an economic incentive to decrease emissions. Carbon dioxide, which results from burning fossil fuels, is the primary greenhouse gas and accounts for about 80 percent of U.S. emissions. A cap-and-trade program would increase the cost of burning fossil fuels and other activities that generate emissions and potentially raise costs for consumers. A key decision is the extent to which the government offsets these costs. For example, the government could sell the allowances and then return the revenues to covered entities or households. The government could also give away some or all of the allowances. According to the Congressional Budget Office, the value of the allowances could total $300 billion annually by 2020. Today's testimony provides preliminary results of ongoing work assessing the potential effects of (1) allowance allocation methods, and (2) options for distributing program revenues or the economic value of allowances. GAO reviewed economic literature and interviewed experts in climate policy, including those involved in existing cap-and-trade programs.

What GAO Found

The method for allocating allowances in a cap-and-trade program can have significant economic implications for the government, regulated entities, and households. Most importantly, a cap-and-trade system would create a market for a valuable new commodity: emissions allowances. The government could allocate these allowances to regulated entities in three main ways. First, it could auction all of the allowances and collect a significant amount of revenue that it could use, for example, to compensate households affected by the cap-and-trade program. Second, it could give away the allowances to entities affected by the program and thereby transfer the value of the allowances to those entities. This could enhance the program's appeal to covered entities but could also increase the program's overall cost to the economy if it reduced incentives for those entities to decrease their emissions. Third, the government could give away some allowances and auction the rest. For example, studies have suggested that freely allocating 6 to 21 percent of the allowances created by a cap-and-trade program would be sufficient to compensate entities in energy-intensive industries for any profit losses incurred as a result of the cap-and-trade program. According to the economic literature and economists we interviewed, regardless of the mechanism for distributing allowances, consumers will bear most of the costs of a cap-and-trade system because most regulated entities will pass along their increased costs in the form of increased prices; however, these costs could be largely offset depending on how revenues are used. Available literature and economists we interviewed point to five main options for distributing a program's allowance revenues, although numerous other options exist. First, the government could lower the overall cost of the cap-and-trade program to the economy through accompanying reductions in taxes on income, labor, or investment. Second, auction revenues could be distributed to households through lump-sum payments, which could offset the higher consumer prices resulting from a cap-and-trade program and mitigate any disproportionate impacts on low-income households. Third, the government could expand the scope of the Earned Income Tax Credit to further benefit low-income working families. Fourth, the government could compensate regulated entities and their shareholders for lost profits by allocating them free allowances. Finally, revenues might be used to fund climate-related programs, such as research on low-carbon technologies, or used to support climate change mitigation activities in developing nations. Each potential use of revenues has trade-offs. For example, decreasing tax rates could lower the overall economic cost of the program; however, this approach may do little to compensate low-income consumers, who would receive greater benefit from a direct rebate. In addition, using revenues to dampen increases in energy prices may benefit ratepayers but reduce their incentives to conserve energy, potentially increasing the program's overall cost.