Obama Budget Reveals Outlines of His Cap-and-Trade Proposal-Cap-and-Dividend the Featured Approach

February 26, 2009

President Obama’s newly released “budget blueprint” provides several important clues to his approach for a carbon cap-and-trade program. The specific elements discussed include (1) a 100% auction of carbon allowances; (2) recycling the bulk of those auctions revenues back to consumers by extending President Obama’s “Making Work Pay” tax credit for working individuals and families; (3) use of some of those revenues to invest $150 billion into clean energy projects and research over ten years; and (4) targeting GHG reductions of 14% below 2005 levels by 2020, and 83% below those levels by 2050. The sale of allowances would commence in 2012, suggesting the cap would begin in that year, or the following year (2013). Some commentary on these issues is below.

100% Auction. During the campaign, Obama steadfastly insisted upon a 100% auction, to address alleged “windfall profits” issues for power companies in the event of a free allocation, and to provide funding for his “green jobs” and “green technology” programs. That 100% auction stance has been reiterated in the budget blueprint, and will likely serve as one of the most contentious issues in the debate over cap-and-trade legislation. Notably, both House and Senate legislators last year were willing to compromise on this issue by giving away a large portion of allowances initially, and then phasing out that free allocation over time so that a 100% auction prevailed. While the cap-and-trade outline set out in the budget blueprint may contain markers for some specifics that are starting points for debate, this may not be one of them, since the Obama climate change team has appeared unwilling to compromise on this issue. As well, the Administration has apparently attempted to defuse one of the more contentious issues over a 100% auction by recycling most of the revenues back to the consumers who ultimately paid for them, and not diverting those proceeds to health care or deficit reduction or other matters unrelated to climate change.

Cap-and-Dividend Revenue Recycling. The budget does reveal where the auction revenues will go at least for two categories. First, $150 billion over ten years (about $15 billion per year) will be devoted to funding investments in “clean energy.” While that figure matches precisely what Obama promised in the campaign, this allocation may now also cover the lion’s share of federal government investments in climate change R&D, as well as funding for clean energy initiatives.

Second, about $64 billion per year will be dedicated to funding and extending the “‘Making Work Pay” tax cut, in order to “compensate families” for the costs of a cap-and-trade bill. Funding that tax cut with allowance revenue is largely consumer compensation relief for rising power and other prices brought on by a carbon cap-and-trade program. This approach follows a policy generally know as “cap-and-dividend.” Under “cap-and-dividend” a 100% auction of carbon allowances is employed, but some, much, or all of that revenue is recycled back to the consumers who ultimately paid for the allowances in order to mitigate consumer impacts from rising power and other prices. The specific mechanisms used to redistribute the income can vary, from a per capita rebate, to a reduction in income taxes, or a grant to the states for them to decide how best to mitigate consumer prices increases (e.g., through a combination of investments in energy efficiency and low and middle class consumer rebates). The key metric by which cap-and-dividend is measured is the extent to which it is “progressive” or “regressive.” A carbon cap-and-trade bill is very regressive since energy-related costs are a much larger proportion of low-income consumer budgets. Hence, the notion is that a cap-and-dividend policy should seek to be progressive and overcompensate low and even middle income consumers, to preserve their “real incomes.” Obama’s approach appears to seek a very specific progressive policy that targets compensation for low and middle income consumers, since the Marking Work Pay tax cut is higher for lower income citizens and phases out altogether as upper-middle class incomes are reached. More specific analyses will be needed to address the extent of progressivity under the Making Work Pay tax credit, and whether some lower income citizens are left out of that approach.

Third, while total numbers and specifics for distribution of all the allowance auction proceeds were not provided, the two numbers that were provided equal about $ 79 billion per year. Conventional wisdom suggests that an initial carbon auction will raise about $100 billion (this assumes about a $20/ton allowance price, and will fluctuate depending upon the specifics of the cap-and-trade program). Based on this, the cap-and-dividend approach would recycle about 64% of allowance revenues back to consumers, which would cover the 40% share of power sector auction revenues (the largest and most direct consumer cost hit) as well as some of the transportation sector revenues. The tax rebate and the clean energy revenue allocations would potentially leave about $21 billion per year left to be allocated, which the budget blueprint indicates will go to “families, communities and business” to help with the transition to a low carbon economy. Further specifics on these distributions are not provided, but would be expected to include assistance to state and local governments, and climate change adaptation funding.

The Obama revenue allocation approach provides a blueprint for what will also likely be a very hotly contested issue in Congress. While the specifics will likely change, it does lay down some very clear markers, to wit: (1) low and middle class consumer mitigation will be a very prominent feature in revenue allocations; (2) green energy programs are to receive substantial funding; and (3) auction revenues will not be diverted to non climate change purposes.

14% Cap Reduction in 2020. Another hotly contested issue in developing climate change legislation is how fast the cap declines through 2020. The notion is that it will take some time for new technologies to be developed and deployed, from carbon sequestration to new and smarter transmission lines for renewables to more fuel efficient cars, and until they are ready, the decline in the cap should be relatively slow to prevent a massive and expensive switch to natural gas as the only available “at scale” compliance option. This issue is likely to prove divisive as well. In the Senate last year, as Lieberman-Warner- Boxer proceeded through the legislative process, the 2020 cap decline steadily increased at each stage of the process until it was almost 20% by 2020 in the Boxer substitute. Environmental groups believe the Boxer substitute is now the starting point, and have been calling for declines in excess of 20% by 2020, pointing to science that suggests global warming may be increasing faster then previously thought. In contrast, the draft Dingell-Boucher bill released last autumn called for a 6% decline in the cap by 2020. Even Obama campaigned on a figure higher than the 14% decline contained in the budget blueprint. Hence, we would read the 14% decline by 2020 as a willingness to compromise on this issue with industry, and as a marker for Congress signaling the possibility of a higher decline by 2020, but firmly rejecting calls for the cap to decline by 20% or more by 2020.

For more information, please contact the members of our Climate Change team or the authors.