The Distributional Consequences of a Cap-and-Trade Program for CO2 Emissions
Excerpts:
Chairman McDermott, Congressman Linder, and Members of the Subcommittee, thank you for the invitation to testify this morning on the implications for low-income families of cap-and-trade programs that are designed to reduce U.S. emissions of carbon dioxide (CO2).
One option for reducing emissions in a cost-effective manner is to establish a carefully designed cap-and-trade program. Under such a program, the government would set gradually tightening limits on emissions, issue rights (or allowances) consistent with those limits, and then allow firms to trade the allowances among themselves. The net financial impact of such a program on low- and moderate-income households would depend in large part on how the value of emission allowances was allocated. By itself, a cap-and-trade program would lead to higher prices for energy and energy-intensive goods. Those price increases would impose a larger burden on low- and moderate-income households than on higher-income households, relative to either their income or total spending. Lawmakers could choose to offset the price increases experienced by low- and moderate-income households by providing for the sale of some or all of the CO2 emission allowances and using the revenues to compensate such households.
My testimony makes the following key points about those issues:
- Under a cap-and-trade program, firms would not ultimately bear most of the costs of the allowances but instead would pass them along to their customers in the form of higher prices. Such price increases would stem from the restriction on emissions and would occur regardless of whether the government sold emission allowances or gave them away.
- Price increases would be essential to the success of a cap-and-trade program because they would be the most important mechanism through which businesses and households would be encouraged to make investments and behavioral changes that reduced CO2 emissions. Those increases, however, would impose a larger burden, relative to their income, on low-income households than on high-income households.
- Policymakers would face trade-offs in deciding how to use the value of the allowances. For example, they might sell the allowances and use the revenue to reduce existing taxes that discourage the productive use of capital and labor. That strategy could lessen the overall cost that a cap-and-trade program would impose on the economy but would do little to offset the burden that the price increases would impose on low-income households. The Risk of Damage from Climate Change
How a Cap-and-Trade Program Would Work
As part of a global effort to reduce CO2 emissions, the United States is considering a cap-and-trade program that would seek to mitigate those changes by setting a limit on total emissions during some period and requiring regulated firms to hold rights, or allowances, to the emissions permitted under that cap. (Each allowance would entitle companies to emit one ton of CO2 or to sell fuel that would release one ton of CO2 when it was burned.) After the allowances for a given period were distributed, firms would be free to buy and sell the allowances among themselves. Firms that were able to reduce emissions most cheaply would profit from selling allowances to firms that had relatively high abatement costs. The trading aspect of the program would lead to substantial cost savings relative to command-and-control approaches—which would mandate how much entities could emit or what technologies they should use—because it would provide more flexibility in where and how emission reductions necessary to meet any given target were achieved.
Market Forces Would Determine Who Bore the Costs of a Cap
The rise in prices would impose a larger burden, relative to income, on low-income households than on high-income households for two reasons. First, low-income households spend a much larger fraction of their income than do high-income households. In addition, energy-intensive items compose a greater share of low-income households’ total expenditures. Data collected by the Bureau of Labor Statistics indicates that, measured as a share of income, spending on energy-intensive items by households in the lowest income quintile averages more than five times that by households in the highest income quintile (see Table 1).
Average Annual Household Expenditures on Energy-Intensive Items, by Income Quintile, 2007
| Quintile | All | ||||||||||||
| Lowest | Second | Middle | Fourth | Highest | Households | ||||||||
| | |||||||||||||
| Utility Expenditures | 1,203 | 1,596 | 1,840 | 2,181 | 2,847 | 1,934 | |||||||
| Gasoline Expenditures | 1,046 | 1,768 | 2,418 | 2,988 | 3,696 | 2,384 | |||||||
| _____ | _____ | _____ | _____ | _____ | _____ | ||||||||
| Total Spending on Energy-Intensive Items | 2,249 | 3,364 | 4,258 | 5,169 | 6,543 | 4,318 | |||||||
| Total as a Percentage of Income | 21.4 | 12.2 | 9.2 | 7.1 | 4.1 | 6.8 | |||||||
| | |||||||||||||
Source: Congressional Budget Office based on data from Bureau of Labor Statistics, Consumer Expenditure Survey, 2007
Although the price of energy-intensive items such as electricity, natural gas, home heating fuels, and gasoline would increase the most, the price of most items would rise in response to the imposition of a cap-and-trade program (because energy is an input for almost all goods and services). The price increases (as a percentage of income) for items that were not energy-intensive would account for approximately 40 percent of the total price increases for households.
The price increases caused by a cap-and-trade program would impose additional costs on households. For example, without incorporating any benefits to households from lessening climate change, CBO estimates that the price increases resulting from a 15 percent cut in CO2 emissions could cost the average household roughly $1,600 (in 2006 dollars), ranging from nearly $700 in additional costs for the average household in the lowest one-fifth (quintile) of all households arrayed by income, to about $2,200 for the average household in the highest quintile.
The higher prices that would result from a cap on CO2 emissions would reduce demand for energy and energy-intensive goods and services and thus create losses for some current investors and workers in the sectors of the economy that supply such products. Investors might see the value of their stocks decline, and workers could face higher risk of unemployment as jobs in those sectors were cut. Stock losses would tend to be widely dispersed among investors because shareholders typically diversify their portfolios.
Increased Incentives for Energy-Saving Investments by Households
The increase in energy prices that would result from a cap-and-trade program would encourage businesses and households to adjust their energy usage. Using revenues from auctioning allowances to subsidize household investments that reduced carbon dioxide emissions would lower the cost to households of adapting to higher energy prices.
However, incentives for energy-saving investments in combination with a cap-and-trade program would not reduce CO2 emissions below the level set by the program.