Thursday, April 30, 2009

A Case for Free Carbon Allowances

The notion that carbon credits need to be auctioned-off is counterproductive to the effort to reduce greenhouse gas emissions (GHGs). A free allowance system will produce a more acceptable, more efficient, cheaper and deeper GHGs reductions quicker.

Do you remember the childhood story of Stone Soup? The story is reproduced below. To extrapolate, it is a story of how a community will perform a collectively beneficial act if it is approached in a gradual non-threatening way. There is no doubt that a carbon constraining regime will be like the weary soldiers in the story: an uncertain threat to the community. That threat is both economic and philosophical and no one knows how the villagers will react. I fear an auction will play out negatively. By contrast, allocating allowances for free poses little threat allowing the villagers to gradually adjust to the carbon-constraints and then contribute as they can, because they want to…not because they have to. Why risk the policy equivalent of organ rejection? In the end, policymakers and politicians would rather be eating the community-developed soup, than wearing it.

I reject the premise espoused by auction advocates that evil “windfalls” might occur if carbon allowances are given away for free. In fact, I embrace that concept…it is what will spur carbon reductions. The best way to reduce GHGs is to allow people to make money doing it. The financial incentive to cash in on GHGs reductions will inspire tremendous innovation since every emitter (and consultant and inventor) will be thinking about how they can make money so the only windfall will be in the gold rush of GHGs reductions.

Following on this thought, a free allowance approach will result in quicker and deeper GHGs reductions than an auction approach. Under either an auction or free allowance approach there will be a rush of immediate reductions. However, the rush will peter out in the auction setting as the market (or non-market market as I called it last week) begins to settle in and everyone adjusts to the new carbon costs. They will either absorb the costs or pass them along as a cost of doing business like they do with inflation or increased health care costs. Thus, the pressure to further reduce GHGs will come only from the declining cap. But in the free allowance world, every GHGs reduction becomes revenue, and since making money is a stronger incentive than reducing costs (which is why energy efficiency is such a hard sell) the free allowance system and its money-making aspects will lead to greater reductions sooner, deeper and cheaper than the auction system.

The auction approach will inevitably increase energy costs. By contrast, free allowances will not increase costs very much, if at all. There would be no upfront costs and the costs of reducing the emissions, even to meet a declining cap, would be only the cost of the delta of the initial free allocation and the subsequent allocation…a much smaller cost than if they were allocated by auction.

If GHGs allowances were given away for free we wouldn’t have to figure out who is in or out of the program…everyone could be in. This means we can get a GHGs-reducing system up and running quickly. It may not be a perfect system but it could be a good one and then improved over time. Allocating allowances in any other way triggers complicated and politically-driven machinations that cause delay and weakens the final program. It will create undeserving losers and undeserving winners, either economically or from a business position. We should not let perfection be the enemy of the good.

I have already debunked the “anti-windfall” rationale for an auction. There are two other arguments that auction advocates make in favor of that approach. One is to set a carbon price. While there is some merit to this argument, it is not as strong as the advocates would have you believe. Things get priced in the marketplace all the time without an auction…generally cost plus profit. For carbon it doesn’t matter what the starting price is…we could draw a price out of a hat and announce it as the opening market cost…by days end the sellers and buyers would do what they do every day on the New York Stock Exchange or the local Target: haggle until market-clearing price is established. In the alternative, the government could allocate 98% of the carbon credits for free and then auction off the remaining 2% to set a market price. The money could go to the entity running the carbon market to audit an expansive offset program.

This leads me to the second reason advocates argue for an auction: to raise revenue. This is both a bad and wrong reason. Increasing the cost of energy so that money can be raised to offset those increased costs is ridiculous. It is also inherently unfair, since clearly not everyone adversely affected by the higher costs can be made whole. Nor should the revenue be used to subsidize non-GHG emitting technologies. Such subsidies will inherently stymie market-driven innovation.

In sum, instead of pursing a carbon auction, policy makers should pursue a free allowance approach since it is much more likely to yield a carbon-reducing program sooner that will actually get GHGs reductions in the most sustainable, efficient and least costly way.

The Story of Stone Soup
A fable which was written down by Marcia Brown in 1947; the story exists in many variations throughout the world. This one is said to be an old French story (sometimes it is said to be Russian), and is therefore not copyrighted.

Three soldiers trudged down a road in a strange country. They were on their way home from the wars. Besides being tired, they were hungry. In fact, they had eaten nothing for two days.

"How I would like a good dinner tonight," said the first. "And a bed to sleep in," added the second. "But that is impossible," said the third.

On they marched, until suddenly, ahead of them, they saw the lights of a village. "Maybe we'll find a bite to eat and a bed to sleep in," they thought.

Now the peasants of the place feared strangers. When they heard that three soldiers were coming down the road, they talked among themselves. "Here come three soldiers," they said. "Soldiers are always hungry. But we have so little for ourselves." And they hurried to hide their food. They hid the barley in hay lofts, carrots under quilts, and buckets of milk down the wells. They hid all they had to eat. Then they waited.

The soldiers stopped at the first house. "Good evening to you," they said. "Could you spare a bit of food for three hungry soldiers?" "We have no food for ourselves," the residents lied. "It has been a poor harvest."

The soldiers went to the next house. "Could you spare a bit of food?" they asked. "And do you have a corner where we could sleep for the night?" "Oh, no," the man said. "We gave all we could spare to the soldiers who came before you." "And our beds are full," lied the woman.

At each house, the response was the same -- no one had food or a place for the soldiers to stay. The peasants had very good reasons, like feeding the sick and children. The villagers stood in the street and sighed. They looked as hungry as they could.

The soldiers talked together. The first soldier called out, "Good people! We are three hungry soldiers in a strange land. We have asked you for food and you have no food. Well, we will have to make stone soup." The peasants stared.

The soldiers asked for a big iron pot, water to fill it, and a fire to heat it. "And now, if you please, three round smooth stones." The soldiers dropped the stones into the pot.

"Any soup needs salt and pepper," the first soldier said, so children ran to fetch salt and pepper.

"Stones make good soup, but carrots would make it so much better," the second soldier added. One woman said, "Why, I think I have a carrot or two!" She ran to get the carrots.

"A good stone soup should have some cabbage, but no use asking for what we don't have!" said the third soldier. Another woman said, "I think I can probably find some cabbage," and off she scurried.

"If only we had a bit of beef and some potatoes, this soup would be fit for a rich man's table." The peasants thought it over, then ran to fetch what they had hidden in their cellars. A rich man's soup, and all from a few stones! It seemed like magic!

The soldiers said, "If only we had a bit of barley and some milk, this soup would be fit for a king!" And so the peasants managed to retrieve some barley and milk.

"The soup is ready," said the cooks, "and all will taste it, but first we need to set the tables." Tables and torches were set up in the square, and all sat down to eat. Some of the peasants said, "Such a great soup would be better with bread and cider," so they brought forth the last two items and the banquet was enjoyed by all. Never had there been such a feast. Never had the peasants tasted such delicious soup, and all made from stones! They ate and drank and danced well into the night.

In the morning, the villagers gathered to say goodbye. "Many thanks to you," the people said, "for we shall never go hungry now that you have taught us how to make soup from stones."

See also ... for a discussion of the history of The Story of Stone Soup.

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