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Reilly, Rowe and Tierney: Guidelines for Reliable, Affordable Cap-and-Trade

Seventeen years have passed since President George H.W. Bush traveled to Rio de Janeiro and joined world leaders in pledging to stabilize greenhouse gases from human activities. Since then, U.S. emissions have increased 14 percent while global emissions have risen nearly 36 percent. Clearly a new global effort is needed. And time is of the essence.

[IMGCAP(1)]But the world will not act unless and until the U.S. takes decisive action at home. Fortunately, we are closer than ever before. Recent passage of the Waxman-Markey bill in the House and the focused, ongoing debate in the Senate signal a real opportunity to pass comprehensive climate legislation in this Congress. We must not allow that opportunity to escape. We must not forget that cap-and-trade systems harness market forces to find the lowest-cost solutions to climate issues.

Enacting a well-designed national cap-and-trade program is a demanding task. There are a host of key issues — many of which are complex. Yet addressing these issues will enable us to fashion a compliance program that will prove far more cost-effective than traditional command and control regulation. Set forth below is our view on how best to address the most challenging of these issues.

Containing Costs and Reducing Price Volatility

Cost remains the core objection to mandatory limits on U.S. emissions. But costs can be mitigated by the adoption of an overarching cap-and-trade system with an effective cost-containment mechanism. We believe that simplifying and strengthening the cost-containment provisions in the House legislation are critical to building a bipartisan consensus.

While we still favor a simple price cap, a properly designed reserve allowance provision, like that found in the House bill, can be effective as a mechanism for managing economic risk. However, the provision must be revised to reduce uncertainty, not add to it. Specifically, we believe that the size of the allowance reserve must be increased; the mechanism for determining the “trigger price— must be more transparent, predictable, and affordable over time; and the reserve should be drawn from “out years,— not the early years, to further protect against high initial cost.

Supporting U.S. Competitiveness

Absent mitigating measures, a cap on domestic greenhouse gas emissions would increase costs to the energy-intensive sector and could lead to the off-shoring of domestic industry. Successful climate legislation must address this concern. Fortunately, recent analysis indicates that the additional costs to energy-intensive sectors can be mitigated to a large extent through allocation measures and investment policies worth around 10 percent to 15 percent of the overall allowance value generated by the program. Effective clean technology programs for energy-intensive industry can also mitigate increased costs.

Engaging major trade partners to do their part in addressing their own carbon emissions will require a combination of carrots and sticks. Current legislative proposals provide positive inducements (such as technology assistance) for participation by other nations. In addition, the United States must work with other countries to develop forceful and coordinated responses to international trade and competitiveness concerns if major emitting nations fail to adopt comparable climate policies over some reasonable time frame.

Using Emission Allowance Allocations and Revenue Recycling as a Deliberate Transition Strategy

Deciding who gets the benefits of emissions allowances distributed for free is a critical fairness issue as we transition toward a system that relies on auctions as the means to allocate allowances into the economy. In our view, initial allocations should accomplish several important objectives: protecting households, especially low- and moderate-income households, from adverse economic impacts; supporting energy-intensive industries in making a viable transition to a smaller carbon footprint; funding incentives for increased investment in the research, development and deployment efforts to advance no- and low-carbon technologies and for investment in adaptation measures. Importantly, none of these allocations will undermine the environmental cap in a cap-and-trade system. While allocation affects the distribution of economic benefits and burdens, it does not reduce environmental results. This distinction is critical.

Congress should strive for allocation designs that are simple, clear and transparent. The approach we recommended in 2007 provides a reasonable basis for compromise and transition: Start by allocating a significant percentage of allowances for free to affected industry and consumers, while remaining allowances are auctioned. Over time, the quantity of allowances allocated for free would decline to allow for a gradual transition to a full auction. Recognizing that the revenue streams generated over time will be significant, it is appropriate to begin exploring the fiscal implications and possible uses, including recycling revenues.

Regarding allocation within the electric utility industry, we generally support an approach endorsed by the U.S. Climate Action Partnership, the Edison Electric Institute, the National Association of Regulatory Utility Commissioners and others. Under this proposal, the initial allocation amount to the power sector is close to the full level of allowances required to avoid disruptive price impacts during the early phases of program implementation. Further, the approach that passes along to retail electricity customers the economic value of allowances allocated for free to local electric utilities will further support this transitional goal.

Overseeing Markets

There must be vigorous oversight of emerging allowance markets, requiring new rules to govern reporting, disclosure and other activities. Some oversight requirements arise from the specific features of carbon-allowance markets and should be addressed in climate legislation, as begun in the House legislation. Congress should address other oversight issues in the context of broader planned reforms of financial markets. Major features of any oversight program must be consistent with an emerging consensus on the need to identify and reduce systemic risks. We recognize that it may take some time for Congress to revamp financial market reforms more generally, and we support interim measures to increase transparency in efficient greenhouse gas markets. In addition, we strongly believe that a robust cost-containment mechanism for the initial years of a climate program can serve as an insurance policy to limit manipulation or excessive speculation.

Allowing Domestic and International Offsets

The economic benefits of offsets are clear. By allowing for the substitution of lower-cost emission reductions outside of a domestic emissions cap for higher-cost reductions available under the cap, offsets can reduce the costs of a U.S. program. This is important not just for the nation’s economy as a whole but also for individual firms as they pursue ways to comply with the cap in efficient and innovative ways. Offsets can also provide markets and valuable incentives for agricultural emissions mitigation and help fill the critical need for private-sector investments necessary to transition developing countries to lower carbon energy systems; thus they are a vital element of an effective global approach.

A domestic offsets program could include set-aside allowances for agriculture to encourage innovation and experimentation and reward early action while ensuring the environmental integrity of the traditional offsets program. But offsets raise a variety of policy and implementation issues that will contribute to uncertainty about their availability and impact on program costs. Offsets programs like that in the House bill are not by themselves adequate to provide cost-containment in the early years of a U.S. cap-and-trade program. That’s why an additional cost-containment mechanism (as proposed above) is needed to manage economic risks. Over time, however, we expect offsets to play a larger and more critical role in cost and emission reductions as implementation issues are resolved.

We believe that if Congress can come to agreement on the five major issues outlined above, it will be most of the way home toward reliable and cost-effective climate legislation.

But, as two Republicans and a Democrat, we see a problem. The issue of climate and energy legislation has become so polarized and partisan that many moderates in both parties are not engaging in the difficult spadework of developing the seeds of legislative compromise. Of course, many other provisions — efficiency, renewable energy, oil and gas production, nuclear energy, and carbon capture and storage among them — are extremely important to balanced energy legislation and rightly included in legislative proposals. These, too, should be part of any compromise.

The policy solutions are available. And reaching them sooner rather than later is critical to the nation’s ability to avoid a more costly strategy in the future.

William K. Reilly is senior adviser at TPG Inc. and former administrator at the Environmental Protection Agency. John W. Rowe is chairman and CEO of Exelon Corp. Susan Tierney is managing principal of the Analysis Group and former assistant secretary of Energy. The writers co-chair the bipartisan National Commission on Energy Policy.

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