Thursday, June 5, 2008

Free Emissions Permits ≠ Costless

Now that it's officially McCain vs. Obama in the general election, the race is on to compare and contrast the candidates' policy positions. One difference I expect the media to feature prominently is how the candidates would allocate emissions permits under their respective cap-and-trade proposals. McCain wants to initially allocate most of the permits for free based on past emissions; Obama wants to allocate the permits through an auction. It's important to remember that handing out emissions permits free of charge does NOT mean that the companies receiving them bear no cost. An emissions permit received free of charge still entails an opportunity cost. The opportunity cost of a permit handed out for free is the price for which the company can sell the permit. Once emissions permits are handed out free of charge, then every company can either keep its allotment of permits or sell them to another company. Assume that Company X receives 10 emissions permits, but it only needs 7. Assume further that Company Y is willing to buy permits for $1,000 each. If Company X decides to keep all 10 permits, then the opportunity cost of keeping the 3 permits it doesn't need is price for which Company X could have sold those permits to Company Y -- in this case, $3,000. Similarly, if Company X only values the remaining 7 permits it needs at $500 each, then the opportunity cost of not selling those 7 permits to Company Y is $3,500 ($500 × 7). I think Obama's proposal to auction off the emissions permits is superior, especially given our current budget deficit. But McCain's proposal to allocate most of the permits for free based on past emissions is not necessarily a hand-out to big corporations less efficient [ed: poor word choice originally on my part]. I hope the difference is portrayed accurately in the media. Wishful thinking, I know.


James said...

I think you conflate opportunity cost with actual costs. The former might be more important for incentives, but it's not how we analyze whether something is a handout. So for instance, imagine a policy in which the US government pays me $100,000,000 per year minus $100,000 for every gallon of gas I use. By your logic, this would not be a handout, because the government would have imposed a huge opportunity cost on me: using a gallon of gas would cost me ~25,000 times what it would cost anyone else. Suffice it to say, I am willing to bear this opportunity cost. Please, please impose this opportunity cost on me.

Economics of Contempt said...

I'm not sure what you mean by "actual costs," but the distinction I was trying to draw was between oppportunity costs and budgetary outlays. McCain's plan wouldn't entail budgetary outlays, but would entail opportunity costs.

You're right about the handouts issue. That was a really poor choice of words. What I was trying to say was, "McCain isn't trying to forego efficiency to hand-pick the winners and give them the permits."

I guess I should have been much clearer in my terminology. It all made sense in my head!

James said...

I don't quite know how to think about this issue. Auctioning off the permits seems like a straightforward transfer from polluters to the government, while (if you are right, which I think you are) the incentive effects will be much the same as simply giving the permits away.

But I don't think we should think about a transfer to the government in neutral terms. Most government revenue comes at the cost of deadweight loss. I don't think that's the case with auctioning permits, though I could be missing something. If I'm right, we should think of permit auctions as tax-substitutes, reducing the overall deadweight loss from taxes.

Now, as a political matter, it may be that this transfer is unpopular with influential corporations (polluters). So... what if you used the revenue from permit auctions to offset general corporate taxes? This would help create a countervailing constituency for the policy, and it would be more socially efficient than just giving the permits away.