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Testimony: 

Before the Committee on Finance, U.S. Senate: 

United States Government Accountability Office: 
GAO: 

For Release on Delivery: 
Expected at 10:00 a.m. EDT:
Tuesday, August 4, 2009: 

Climate Change Policy: 

Preliminary Observations on Options for Distributing Emissions 
Allowances and Revenue under a Cap-and-Trade Program: 

Statement of John Stephenson, Director: 
Natural Resources & Environment: 

GAO-09-950T: 

GAO Highlights: 

Highlights of GAO-09-950T, a testimony before the Committee on Finance, 
U.S. Senate. 

Why GAO Did This Study: 

Congress is considering proposals to establish a price on greenhouse 
gas emissions through a cap-and-trade program that would limit overall 
emissions and require covered entities to hold tradable emissions 
permits, or allowances, for their emissions. The purpose of such a 
program is to raise the cost of activities that produce emissions and 
thereby provide an economic incentive to decrease emissions. 

Carbon dioxide, which results from burning fossil fuels, is the primary 
greenhouse gas and accounts for about 80 percent of U.S. emissions. A 
cap-and-trade program would increase the cost of burning fossil fuels 
and other activities that generate emissions and potentially raise 
costs for consumers. A key decision is the extent to which the 
government offsets these costs. For example, the government could sell 
the allowances and then return the revenues to covered entities or 
households. The government could also give away some or all of the 
allowances. According to the Congressional Budget Office, the value of 
the allowances could total $300 billion annually by 2020. 

Todayís testimony provides preliminary results of ongoing work 
assessing the potential effects of (1) allowance allocation methods, 
and (2) options for distributing program revenues or the economic value 
of allowances. 

GAO reviewed economic literature and interviewed experts in climate 
policy, including those involved in existing cap-and-trade programs. 

What GAO Found: 

The method for allocating allowances in a cap-and-trade program can 
have significant economic implications for the government, regulated 
entities, and households. Most importantly, a cap-and-trade system 
would create a market for a valuable new commodity: emissions 
allowances. The government could allocate these allowances to regulated 
entities in three main ways. First, it could auction all of the 
allowances and collect a significant amount of revenue that it could 
use, for example, to compensate households affected by the cap-and-
trade program. Second, it could give away the allowances to entities 
affected by the program and thereby transfer the value of the 
allowances to those entities. This could enhance the programís appeal 
to covered entities but could also increase the programís overall cost 
to the economy if it reduced incentives for those entities to decrease 
their emissions. Third, the government could give away some allowances 
and auction the rest. For example, studies have suggested that freely 
allocating 6 to 21 percent of the allowances created by a cap-and-trade 
program would be sufficient to compensate entities in energy-intensive 
industries for any profit losses incurred as a result of the cap-and-
trade program. According to the economic literature and economists we 
interviewed, regardless of the mechanism for distributing allowances, 
consumers will bear most of the costs of a cap-and-trade system because 
most regulated entities will pass along their increased costs in the 
form of higher prices; however, these costs could be largely offset 
depending on how revenues are used. 

Available literature and economists we interviewed point to five main 
options for distributing a programís allowance revenues, although 
numerous other options exist. First, the government could lower the 
overall cost of the cap-and-trade program to the economy through 
accompanying reductions in taxes on income, labor, or investment. 
Second, auction revenues could be distributed to households through 
lump-sum payments, which could offset the higher consumer prices 
resulting from a cap-and-trade program and mitigate any 
disproportionate impacts on low-income households. Third, the 
government could expand the scope of the Earned Income Tax Credit to 
further benefit low-income working families. Fourth, the government 
could compensate regulated entities and their shareholders for lost 
profits by allocating them free allowances. Finally, revenues might be 
used to fund climate-related programs, such as research on low-carbon 
technologies, or used to support climate change mitigation activities 
in developing nations. Each potential use of revenues has trade-offs. 
For example, decreasing tax rates could lower the overall economic cost 
of the program; however, this approach may do little to compensate low-
income consumers, who would receive greater benefit from a direct 
rebate. In addition, using revenues to dampen increases in energy 
prices may benefit ratepayers but reduce their incentives to conserve 
energy, potentially increasing the programís overall cost. 

View [hyperlink, http://www.gao.gov/products/GAO-09-950T] or key 
components. For more information, contact John Stephenson, (202) 512-
3841, stephensonj@gao.gov. 

[End of section] 

Mr. Chairman and Members of the Committee: 

I am pleased to be here today to discuss our preliminary observations 
on different options for distributing allowances and revenue under a 
potential cap-and-trade program intended to address climate change. 
Elevated concentrations of greenhouse gases in the atmosphere as a 
result of the combustion of fossil fuels and other sources may cause 
significant changes in the earth's climate.[Footnote 1] Potential 
impacts from climate change include rising sea levels and shifts in 
weather patterns, both of which pose threats to coastal and other 
infrastructure. Concerns about the potential effects of climate change 
have led Congress to consider legislation that would limit greenhouse 
gas emissions nationwide. Because the harm caused by U.S. emissions of 
greenhouse gases is not generally incorporated into the underlying 
costs of goods and services, many proposals to limit greenhouse gas 
emissions involve placing a price on greenhouse gases emitted by 
businesses and other entities covered under the program (hereafter 
referred to as "covered entities"). In this way, the price on emissions 
would provide covered entities with an economic incentive to emit less. 
It could also provide consumers with incentives to reduce their 
consumption of carbon-intensive goods and services. The impact of these 
incentives depends on the program's stringency. 

One option for pricing emissions is a cap-and-trade program, in which 
the government would limit the overall quantity of emissions and issue 
permits to covered entities. These permits--also known as allowances-- 
would each represent a set quantity of greenhouse gas emissions, such 
as one metric ton. Allowances could be purchased and sold, creating a 
market in which the price of emissions fluctuated with supply and 
demand. The government could also generate substantial revenue through 
this program by selling allowances to covered entities, as opposed to 
giving them away for free. Recently, the House of Representatives 
passed H.R. 2454, the American Clean Energy and Security Act, which 
would, among other things, create a cap-and-trade program covering 
about 85 percent of U.S. emissions. 

In addition to potentially providing the benefits of emissions 
reductions, a cap-and-trade program could also impose costs on covered 
entities and consumers. The most obvious cost would be a likely 
increase in the cost of energy derived from fossil fuels, the main 
source of man-made greenhouse gas emissions. Covered entities could see 
their production costs increase as a result and could either accept 
lower profits or, more likely, pass costs on to consumers.[Footnote 2] 
In the absence of compensatory measures by the government, a cap-and- 
trade program could have a disproportionate impact on low-income 
households, since they generally spend a higher percentage of their 
income on energy and energy-intensive goods and services than do higher-
income households. 

Congress is considering various mechanisms for distributing allowances 
in a cap-and-trade system, including auctions, free allocation to 
certain covered entities, or a combination of both. The choice of 
mechanism could have significant effects on the distribution of costs 
and benefits throughout the economy. At the request of this committee, 
we have work under way on the collection and distribution of revenues 
in programs intended to address climate change and will release a 
report on these topics later this year. My testimony today focuses on 
(1) the effects of various methods of allocating allowances on 
government, consumers, and covered entities; and (2) options for 
distributing the program's revenue or economic value of emissions 
allowances. 

To address these objectives, we drew on ongoing work for this 
committee, which will result in a final report later this year. 
Specifically, we reviewed and analyzed academic and professional 
literature produced by industry associations, research organizations, 
academic institutions, and environmental groups, including 
international research. We also analyzed literature from government 
agencies, including the Congressional Budget Office (CBO), the 
Congressional Research Service, and the Environmental Protection Agency 
(EPA). We did not independently assess the validity of data, 
assumptions, or methodologies underlying the economic studies we 
reviewed. We also reviewed documents from international and state-level 
organizations that operate cap-and-trade programs to address climate 
change--including the U.S.-based Regional Greenhouse Gas Initiative 
(RGGI), a coalition of 10 Northeast states that has implemented a cap- 
and-trade program for electricity generators, and the European Union's 
Emissions Trading Scheme--and interviewed individuals familiar with 
these programs.[Footnote 3] In addition, we conducted semi-structured 
interviews with leading economists and researchers selected on the 
basis of their expertise in climate or tax policy. Finally, we drew on 
previous GAO reports and testimonies.[Footnote 4] We conducted our work 
from December 2008 to August 2009 in accordance with all sections of 
GAO's Quality Assurance Framework that are relevant to our objectives. 
The framework requires that we plan and perform the engagement to 
obtain sufficient and appropriate evidence to meet our stated 
objectives and to discuss any limitations in our work. We believe that 
the information and data obtained, and the analysis conducted, provide 
a reasonable basis for any findings and conclusions in this product. 

Background: 

According to the Intergovernmental Panel on Climate Change--a United 
Nations organization that assesses scientific, technical, and economic 
information on the effects of climate change--global atmospheric 
concentrations of greenhouse gases have increased markedly as a result 
of human activities over the past 200 years. These gases trap heat that 
would otherwise escape the earth's atmosphere, contributing to climate 
change. Climate change is a long-term and global issue because 
greenhouse gases disperse widely in the atmosphere once emitted and can 
remain there for an extended period of time. Among other potential 
impacts, climate change could threaten coastal areas with rising sea 
levels, alter agricultural productivity, and increase the intensity and 
frequency of floods and tropical storms. Carbon dioxide is emitted in 
by far the largest volume of any greenhouse gas, and most emissions are 
caused by fossil fuel combustion. According to the EPA, carbon dioxide 
emissions from fossil fuel combustion accounted for approximately 80 
percent of all greenhouse gas emissions in 2007. 

Placing a price on emissions is likely to raise the cost of production 
of many goods and services. The size of the impact will depend on the 
price of allowances, as well as the ability of producers to substitute 
less emission-intensive processes and inputs. While some studies 
suggest that the overall impact would be modest, a cap-and-trade 
program could have a disproportionate effect on covered entities that 
rely heavily on fossil fuels, such as electricity generators. According 
to the Energy Information Administration (EIA), electricity generators 
derived about 49 percent of their electrical power from coal in 2007. 
The combustion of coal generates about twice as much carbon dioxide per 
unit of energy as the combustion of natural gas, the next most common 
fuel source for U.S. electricity generation, according to EIA. 

Due to changes in the regulation of electricity markets, certain 
companies may be limited in their ability to pass on emissions 
reduction costs to their customers. Historically, electricity was 
generated, transmitted, and distributed by local monopolies. These 
companies were overseen by regulators who restricted the entry of new 
companies, approved investments and retail prices, and determined 
profits. Since the 1970s, efforts have been made to "restructure" 
electricity markets by introducing more competitive conditions. At the 
wholesale level, federal regulators have introduced market-based 
pricing, although these markets can take a variety of forms. About half 
the states have made efforts since the 1990s to restructure how retail 
prices are set, generally seeking to increase competition in 
electricity sales. According to EIA, 14 of these states--located in New 
England and the upper Midwest, plus Texas--currently operate retail 
markets in which customers may choose among competing power suppliers. 
The other states where restructuring was introduced have either 
suspended or repealed these efforts. In the remaining states, 
regulators still approve utility costs and prices. In addition to 
covered utilities, which are mostly investor-owned, most states also 
have utilities that are owned either by the public (such as through a 
municipality) or cooperatively by customers themselves. Such utilities-
-which currently account for about one-quarter of electricity sales-- 
generally set prices at cost instead of maximizing profits. 

In markets where regulation and international competition are not major 
factors, it is likely that consumers will ultimately bear most of the 
costs associated with pricing emissions. These costs are expected to 
disproportionately affect low-income consumers, who tend to spend a 
higher proportion of their incomes on energy products like electricity, 
heating, and gasoline. EPA has estimated that the cap-and-trade program 
in the American Clean Energy and Security Act would cost the average 
household $80 to $111 per year. A similar study by CBO estimated 
average household costs to be $175 per year, with some lower-income 
households receiving a net benefit. On the other hand, research 
suggests that policy makers could mitigate or eliminate these effects 
by selling allowances to covered entities through auctions and 
returning the revenue back to consumers in the form of lump-sum rebates 
or tax adjustments. 

If the government were to 'recycle' revenue through tax reductions, it 
could also realize benefits to the overall economy in the form of 
"economic efficiency." Many economists view certain taxes as 
inefficient or "distortionary," because they shift resources away from 
their most highly valued use. For example, efficiency costs may arise 
because taxes on labor income may affect job choices or hours worked. 
Most economists agree that minimizing the efficiency cost of the 
revenue raised to fund government services is an important objective of 
tax policy, among other objectives such as distributing the burden of 
taxation equitably. 

The effects of emissions pricing on consumers and industry will also 
vary by region. While some recent studies suggest that this variation 
would be minimal, it may be more substantial for low-income households. 
[Footnote 5] Areas that get most of their electricity from coal, the 
most emissions-intensive source, may see a greater electricity cost 
increase than areas that rely heavily on natural gas, nuclear energy, 
or hydropower. One study has estimated that the cost burden as a 
percentage of household income would range from about 1.9 percent in 
the East South Central region to about 1.5 percent in the West North 
Central region. 

A cap-and-trade program would also affect federal, state, and local 
governments, which purchase energy intensive goods and would be 
responsible for the program's implementation. According to one study, 
governments produce approximately 13 percent of U.S. carbon dioxide 
emissions, and the allowance consumption associated with these 
emissions could cost governments an additional $16.6 billion.[Footnote 
6] Furthermore, price increases could increase government payments-- 
such as Social Security benefits and federal pensions, which are 
indexed to prices--and reduce personal income tax collections. Finally, 
depending on the details of the program, a cap-and-trade program could 
increase the administrative burden on the government relative to a 
business-as-usual situation. For example, markets for emissions 
allowances would require oversight, and the distribution of auction 
revenues could require additional personnel or a new entity to 
administer payments. 

Different Methods of Allocating Emissions Allowances Will Affect 
Government, Covered Entities, and Consumers: 

The design of a cap-and-trade program's allowance allocation plan--the 
ways in which tradable allowances are allotted to covered entities at 
the outset of the program--will help determine how costs and benefits 
are distributed across the economy, according to available literature. 
The method of allowance allocation will generally not affect the level 
of emissions reductions achieved by the program, because allocation is 
independent of the overall cap. Therefore, the principal consideration 
in designing an allowance allocation plan is how to distribute the 
allowances in a way that helps to achieve certain goals: for example, 
to offset the program's economic impact on disproportionately affected 
industries or to generate revenue that could be redistributed to 
consumers or used for other purposes. To accomplish these goals, three 
basic design choices are available: allowances may be sold through an 
auction or other means, distributed for free, or dispensed using a 
combination of these methods. 

Auctioning Allowances Could Generate Substantial Revenue and Provide 
Other Key Benefits: 

Selling allowances to regulated entities could provide several 
benefits. First, it would generate a source of revenue that the 
government could use to defray the economic costs associated with 
emissions reductions or direct toward other purposes. These revenues 
could be substantial: in June 2009, CBO reported that the American 
Clean Energy and Security Act would generate annual revenues of $45 
billion by the year 2019 by auctioning of a percentage of the 
allowances. Earlier CBO estimates indicated that annual allowance 
revenues could range between $30 billion and $300 billion by roughly 
the same time period if all allowances were auctioned, although this 
proposal is not part of the bill.[Footnote 7] 

Some existing cap-and-trade programs have already sold allowances 
through auctions or commodity exchanges. For example, several member 
states participating in the European Union's Emissions Trading Scheme 
(ETS)--including Ireland, Hungary, Lithuania, the United Kingdom, and 
Germany--have generated revenues from allowance sales; in Germany, 
these totaled approximately $1.2 billion in 2008. The level of 
auctioning is expected to increase as the program moves toward its 
third phase, which is to begin in 2013. In the United States, the 
Regional Greenhouse Gas Initiative--a regional cap-and-trade program 
involving 10 northeastern states--has conducted four auctions since it 
began auctioning allowances in 2008. These auctions, held quarterly, 
have each raised between $38 million and $118 million for programs to 
promote energy efficiency and assist low-income households with energy 
costs, among other things.[Footnote 8] Given the revenue generation 
potential of auctions, many experts we consulted as part of a prior 
study suggested that a cap-and-trade program should maximize the level 
of auctioning.[Footnote 9] 

Auctioning may confer other additional benefits, according to available 
literature and researchers we spoke with. For example, many economists 
favor auctioning because of its transparency and because it discourages 
behaviors motivated by a desire to gain free allowances, such as 
"baseline inflation." This occurs when a firm attempts to boost the 
number of allowances it receives by increasing its emissions prior to 
the outset of a cap-and-trade program. Auctioning can also help ensure 
that new entrants to an industry face the same emissions reduction 
costs as existing firms. Finally, auctioning could decrease the 
possibility that covered entities earn windfall profits as a result of 
the cap-and-trade program, particularly in restructured regions where 
prices are determined largely by market factors. Covered entities could 
earn windfall profits if they pass along the "opportunity costs" of 
free allowances--that is, the revenue foregone by not selling them--in 
the form of increased electricity prices. For example, in the first 
phase of the European Union's ETS, electric utilities that received 
free allowances reaped substantial profits by charging ratepayers for 
the opportunity cost of those allowances.[Footnote 10] 

On the other hand, auctioning does not offer compensation to covered 
entities, particularly those that face disproportionate costs due to a 
cap-and-trade program. The government will also incur certain 
administrative costs associated with designing and administering the 
auctions, although these activities could be funded using part of the 
auction revenues. Moreover, the effectiveness of allowance auctions 
will depend partly on their design.[Footnote 11] 

Free Allocation of Allowances May Ease Entry Into Emissions Regulation 
but Can Increase the Overall Cost of the Program: 

Free allocation could help establish political support at the outset of 
a cap-and-trade program and compensate covered entities for any 
decrease in profits they might experience as a result the program, but 
it could also have some disadvantages. Two principal options are 
available when allocating allowances for free: "grandfathering" or 
"output-based updating allocation." Grandfathering involves allocating 
allowances based on historic (pre-regulation) emissions measures, while 
output-based updating allocation involves adjusting the number of 
allowances provided to an entity based on its recent production levels. 
Available literature indicates that since past emissions measures do 
not change, grandfathering may be less susceptible to manipulation than 
output-based updating allocation. However, research suggests that 
grandfathering is unlikely to prevent the "leakage" of economic 
activity--including production, jobs, and emissions--to countries where 
greenhouse gases are not regulated.[Footnote 12] As we have previously 
reported, leakage may be of particular concern to firms in certain 
energy-intensive industries that face international competition--such 
as primary metals, paper, and chemicals--as these firms could find it 
more difficult than other covered entities to pass on costs to 
consumers by raising prices.[Footnote 13] Grandfathering could also 
provide an advantage to existing facilities, which are more likely to 
have outdated, inefficient technologies in place. 

Output-based updating allocation could also present trade-offs. As we 
have previously reported, output-based updating allocation could 
provide incentives for covered entities to maintain or increase 
production, potentially reducing the likelihood that these entities 
would move production to countries that are not subject to emissions 
regulations. However, output-based updating allocation could also 
decrease incentives for covered entities to engage in conservation and 
reduce their energy intensity, depending on how the program is 
designed. Moreover, some research indicates that an output-based 
approach would subsidize entities in certain industries, forcing 
entities in other sectors to make deeper cuts in their emissions in 
order to meet the overall cap. Since these cuts may be more expensive 
than the reductions that would have otherwise taken place, the overall 
cost of the cap-and-trade program would increase. In addition, some 
research suggests that maintaining output may not always be a 
worthwhile goal: for example, the contraction of output from a high- 
emissions sector may be one of the most cost-effective means by which 
to reach the overall emissions target. 

Furthermore, attempts to keep energy prices low could increase the cost 
of the program to the economy. Rising prices for energy and energy- 
intensive goods are critical to the success of the program, because 
these "price signals" create incentives for both covered entities and 
consumers to conserve energy, and thereby reduce emissions of 
greenhouse gases. To the extent that price signals are not preserved, 
fewer households and businesses will change their behavior in response 
to these signals. This could reduce the economic efficiency of a cap- 
and-trade program, since some of the less costly emissions reduction 
opportunities would be forgone. 

The structure of the U.S. electricity generation sector--which 
represents roughly 40 percent of domestic carbon dioxide emissions-- 
could affect whether price signals reach energy users. Since the price 
of electricity is regulated in certain regions, generators that receive 
free allowances in these regions may not be able to pass along the 
costs associated with an emissions price to residential and commercial 
electricity users. If costs are not passed through, incentives for 
conservation decrease. A diminished price signal could also have 
indirect effects--for example, if the price of energy intensive goods 
does not rise in relation to other goods, consumers have less of an 
incentive to purchase fewer of these goods. 

Considering the limitations of free allocation, some analyses have 
advocated limiting the use of free allowances to specific subsets of 
carbon intensive industries. Several studies suggest that freely 
allocating between 6 and 21 percent of all allowances would be enough 
to compensate these industries--which include coal-fired power plants, 
fossil fuel suppliers, and energy intensive manufacturers--for profit 
losses related to emissions regulation.[Footnote 14] In 2007, CBO 
reported that less than 15 percent of allowances would be sufficient to 
offset net losses in stock value as a result of the program. 

The Effects of a Cap-and-Trade Program Depend on the Use of Revenues or 
Allowance Value: 

The establishment of a cap-and-trade program creates opportunities for 
the government to direct the value of allowances in a variety of ways. 
For the purposes of this testimony, we assessed five options that are 
frequently discussed in the economic literature, although numerous 
other options exist. First, the government could reduce the overall 
cost of the program by reducing taxes on capital or income that 
currently make the economy less efficient. Second, the government could 
distribute lump-sum rebates to consumers, who would likely pay the bulk 
of the economic costs associated with a cap-and-trade program. Third, 
revenues could be used to expand the Earned Income Tax Credit to assist 
low-income working families. Fourth, policymakers could compensate 
covered entities for their increased costs through free allocation--an 
approach equivalent to selling allowances on the market and 
transferring all the revenue to covered entities. Finally, revenues 
could help fund climate-related programs or activities, including 
research and development, energy-efficiency programs, or international 
aid to developing countries that face challenges in mitigating and 
adapting to climate change. 

Reducing Existing Taxes: 

Using program revenues to reduce marginal tax rates--whether from 
individual income or payroll or taxes, corporate income taxes, or taxes 
on capital gains or investments--can reduce economic distortions in the 
tax code and lower the overall cost of the program. The benefits of tax 
reduction depend on the extent to which these taxes currently distort 
economic activity, according to literature and economists we spoke 
with. For example, existing taxes on labor or capital can discourage 
individuals from participating in the labor force or investing money. 
The structure of the tax code can also create distortions by directing 
spending toward certain areas where the buyer has a tax advantage, such 
as homeownership or employer-provided medical insurance. 

A cap-and-trade program could further exacerbate these tax distortions, 
according to economic literature. This so-called "tax interaction 
effect" could occur because a cap-and-trade program may have some of 
the same effects as a tax. Specifically, covered entities that face 
additional costs due to an emissions price will generally pass on their 
increased costs to consumers in the form of higher prices, thereby 
reducing the amount of goods that consumers can purchase. Because a 
loss of purchasing power effectively represents a decrease in real 
wages, incentives to work may also decrease. These effects could 
ultimately raise the cost of the program to the economy, according to 
economic literature we reviewed. 

However, 'recycling' auction revenues through the tax code could 
partially or wholly offset costs that result from inefficiencies in the 
tax code, as well as potential costs imposed by the cap-and-trade 
program, according to a review of economic literature and interviews 
conducted with economists.[Footnote 15] For example, because an 
emissions cap could cause prices to rise--and real wages to fall--a 
reduction in labor, income, or capital taxes could provide efficiency 
gains and help reduce the overall cost of the program. 

These efficiency gains may present trade-offs. Economic analyses 
suggest that reducing tax rates would do little to compensate low- 
income individuals that may be disproportionately affected by the cap- 
and-trade program. According to these analyses, most benefits from 
reduced taxes would accrue to higher income households, regardless of 
the tax targeted for reduction. Moreover, in the absence of 
supplemental policies, the benefits of reducing labor taxes will not 
reach individuals who do not file tax returns. To close this gap in 
coverage, the government could supplement a tax reduction with payments 
issued through existing systems, such as the Electronic Benefit 
Transfer system or state-based food stamp programs.[Footnote 16] 
However, using a combination of systems could increase the 
administrative burden and complexity of the program, and may require 
additional governmental coordination. In addition, adjusting the 
payroll tax rate may be complicated since these taxes represent social 
security and Medicare financing contributions. 

Lump-Sum Rebates for Consumers: 

Another way to distribute revenues to consumers would be to distribute 
lump-sum rebates to consumers. Such a program could take many forms, 
but the underlying goal would be to compensate consumers or households 
through rebates of a specific amount. The amount of the rebate could be 
based on a simple per-capita formula with checks of equal size--also 
known as "cap-and-dividend"--or could account for household size, 
region, or other factors. 

An important advantage of lump-sum rebates, according to many 
economists, is that they help offset the costs of a cap-and-trade 
program on consumers, particularly on low-income households. Depending 
on the design of the program, certain consumers may even experience a 
net benefit. However, research indicates that distributing lump-sum 
rebates would forgo the efficiency gains that could be achieved through 
tax reductions, making the program comparatively more expensive to the 
economy overall. 

The ultimate cost of lump-sum rebates and the resulting effects on 
consumers would depend in part on the program's administration. The 
funds could be distributed, for example, using existing government 
programs, such as the income tax system or other benefit transfer 
programs. For example, one economist has proposed that the government 
could provide rebates for taxes paid on the first $3,660 of each 
worker's earnings, leading to a maximum rebate of $560 per worker. 
Alternatively, the government could develop a new distribution 
mechanism, although this approach would carry additional administrative 
costs. While using a single existing mechanism for rebate delivery 
would be the simplest and most transparent option, it would exclude 
individuals that did not participate in that program--for example, 
rebates that use the tax system would exclude individuals that do not 
file tax returns. The government could encourage these individuals to 
file through outreach campaigns, a strategy used when stimulus checks 
were distributed under the Economic Stimulus Act of 2008. Evidence 
suggests that such efforts could encourage more individuals to file-- 
for example, of the 150 million individual income tax returns processed 
for tax year 2008, approximately 9 million claimed only the economic 
stimulus payment. However, any outreach effort would entail additional 
costs and administrative requirements. 

Policymakers could also design a rebating system that uses a 
combination of mechanisms to maximize coverage, although this strategy 
would increase the program's complexity, given the need for program 
coordination, as well as the risk of fraud or duplicate rebates. 

Expanding Earned Income Tax Credit: 

Several proposals for distributing revenue involve expanding the Earned 
Income Tax Credit (EITC) program. The EITC was enacted in 1975 and was 
originally intended to offset the burden of Social Security taxes and 
provide a work incentive for low-income taxpayers. It is a refundable 
federal income tax credit, meaning that qualifying working taxpayers 
may receive a refund greater than the amount of income tax they paid 
for the year. According to one study, approximately half of all 
households would benefit from this approach, with lowest-income 
households with children reaping the highest gains.[Footnote 17] 
However, this study suggests this option would affect low-income 
households differently depending on their location. Low-income 
households in the Northeast, for example, could see about a 2 percent 
gain in income, compared to a 7.4 percent gain in Texas.[Footnote 18] 
Some research also indicates that the EITC may encourage labor activity 
for low-income workers. 

Using the EITC to distribute revenue, however, may involve trade-offs. 
For example, as the Treasury Inspector General for Tax Administration 
has reported, the EITC has been vulnerable to taxpayer error in the 
past, due in part to changes in eligibility and the tax code. Prior 
reviews by the IRS and GAO also suggest that errors are common--for 
example, an IRS study has reported that the EITC program has an 
erroneous payment rate estimated to be between 23 and 28 percent. 
[Footnote 19] 

Free Allocation of Allowances: 

Allocating free allowances to covered entities can help establish 
political support at the outset of a cap-and-trade program and 
compensate covered entities for any increased costs they incur as a 
result. However, as noted earlier, free allocation can raise the cost 
of the program if such allocation decreases incentives to conserve 
energy and reduce emissions in one sector and forces other sectors to 
make less efficient reductions. In addition, economic literature 
suggests that a grandfathering approach to free allocation would do 
little to discourage the leakage of economic activity, jobs, and 
emissions, since covered entities' variable costs of production would 
remain unchanged. An output-based approach to free allocation, on the 
other hand, could reduce the likelihood that covered entities would 
relocate or decrease production, although it could also reduce their 
incentives to decrease emissions. 

Most of the benefits of freely allocated allowances will accrue to the 
shareholders of entities that receive them by compensating shareholders 
for any declines in stock value they might experience as a result of 
the cap. However, consumers are unlikely to see these benefits in the 
form of lower prices, since most covered entities will pass on costs 
associated with a cap-and-trade program, even when they receive 
allowances for free. Free allocation is therefore likely to benefit 
those with higher incomes more than those with lower incomes. 

The administrative burden associated with free allocation of allowances 
depends primarily on how policymakers determine the relative 
allocations to each industry. A grandfathering approach, for example, 
would require the government to select a set of years with which to 
determine a baseline. An output-based approach would require the 
government to define a baseline, which could prove challenging. As one 
economist we interviewed pointed out, "output" could be subject to 
numerous interpretations, each with its own implications for equity. 

The government could also direct the recipients of free allowances to 
use these allowances for the benefit of consumers. For example, HR 
2454, as passed by the House on June 26, allocates some allowances to 
electric and natural gas local distribution companies (LDC) for the 
benefit of retail ratepayers.[Footnote 20] Distributing free allowances 
through LDCs may go some way toward mitigating regional differences in 
cost impacts, according to some researchers. However, the overall 
effects of this approach would depend largely on the extent to which it 
creates incentives to reduce energy use, according to economists we 
spoke with. Importantly, if benefits to electricity customers were 
conferred in the form of decreased energy rates, the incentives for 
energy conservation may diminish and the overall cost of the program 
could increase. This may be particularly true for residential 
customers, according to economists we interviewed, since industrial 
customer may have other reasons to pursue efficient practices. To help 
preserve incentives, LDCs could allow electricity rates to rise and 
rebate consumers through the fixed portion of their utility bills--that 
is, the portion not based on energy use. However, this approach assumes 
that electricity customers will differentiate between the fixed and 
variable portions of their utility bill when assessing their costs, as 
opposed to simply looking at the bottom line amount, which could remain 
largely unchanged. Several economists and researchers we spoke with 
expressed skepticism that customers would react to the price signal if 
their total energy costs did not change, although some said that 
distributing rebate checks separately from the utility bill could 
address this concern. 

The effect of this approach on consumers will depend on other factors. 
If both residential and business customers receive benefits, for 
example, the benefits conveyed to businesses may not get passed along 
to their customers. According to a CBO analysis of H.R. 2454, most of 
the allowance value given to local distribution companies would benefit 
business customers. The analysis also estimates that 63 of percent 
allowance values conferred to businesses would ultimately benefit the 
highest earning 20 percent of households, since these households are 
more likely to be shareholders.[Footnote 21] In addition, the way in 
which benefits are conveyed to customers--for example, through lower 
prices, investments in energy efficiency, or other means--will depend 
on the state public utility commissions that regulate the LDCs. While 
some organizations have expressed concern that past regulation has been 
uneven, several economists and state officials we spoke with expressed 
confidence that the existing regulatory structure could effectively 
ensure that customers received the benefits. 

Funding Climate-Related Programs or Activities: 

Revenues generated through allowance auctions could also be directed 
toward climate-related programs or activities, including the research 
and development of low-carbon technologies, programs to promote energy- 
efficiency, or mitigation and adaptation activities abroad. Beyond 
their environmental benefits, such programs could also convey 
efficiency gains, if they lowered the cost of emissions reductions. The 
development of renewable energy sources, for example, could ultimately 
lower covered entities' total expenditures on emissions allowances. 
Funding for efficiency programs could also offset costs for households 
through reduced energy demand. Some research organizations have also 
suggested that funding in these areas could create job opportunities, 
and in the long run could help ensure greater economic stability due to 
energy security. 

Economic research suggests that an emissions price, on its own, will go 
some way toward promoting low-carbon technologies and the efficient use 
of energy. However, economists we spoke to said that there are certain 
instances--known as "market failures"--where opportunities for 
reduction may not be captured. For example, builders and owners of 
rental properties may not have incentives to consider energy efficiency 
in the construction and renovation of these properties, since they may 
not be responsible for paying electricity and heating costs. In these 
cases, subsidies for efficient construction or renovation may be 
appropriate. In addition, certain technologies--such as carbon capture 
and storage--may face cost barriers that could be mitigated through 
grants or subsidies.[Footnote 22] Other technologies may need 
nationwide infrastructure that could require additional funding at the 
federal level--for example, an enhanced transmission grid to transmit 
renewable energy. While many economists we spoke with said funding such 
activities could be beneficial, several also cautioned that selecting, 
implementing and evaluating these programs could pose challenges. 

Technology Research and Development: 

Developing and promoting low-carbon technologies could provide 
important benefits and significantly reduce the cost of emissions 
reductions in the long run, according to available information. 
However, firms may be dissuaded from conducting research if they are 
prevented from appropriating all of the associated benefits--for 
example, if other firms are able to copy and profit the new technology 
without penalty. As a result, several economists we spoke with 
recommended allocating part of the allowance revenues for research and 
development to help overcome these cost barriers. However, several also 
noted that it is difficult to determine how to allocate such funds 
effectively. For example, selecting which technologies receive funding 
places the government in the position of attempting to choose the best 
technologies rather than allowing the market to make that 
determination. Overall, research suggests that funding technologies in 
the early stages of development may be more cost-effective than using 
revenues to commercialize existing technologies. 

Energy Efficiency Programs: 

Investments in energy efficiency have the potential to alleviate some 
of the effects of the cap-and-trade program on households. For example, 
using auction revenue to support weatherization improvements for homes 
or the purchase of energy-efficient appliances could lower these 
households' energy consumption and expenditures. Some research suggests 
that tax credits, for example, can have a significant impact on 
efficiency investments by homeowners and businesses. However, several 
researchers have noted that the implementation of such programs has 
been unpredictable in the past, in part because it is difficult to 
determine whether these activities would have occurred anyway. 

Aid to Developing Countries: 

Allowance revenues could also be used as aid to developing countries, 
either in the form of grants, loans, or other means of assistance. Such 
aid could target activities that reduce greenhouse gas emissions in 
these countries--for example, programs that aim to deploy low-carbon 
technologies in areas where they would not normally be financially 
feasible. Revenue could also support adaptation activities that could 
help these countries prepare for and adjust to the project effects of 
climate change. 

Several economists and researchers we spoke with supported directing 
some portion of auction revenue for international aid efforts. Some 
highlighted an obligation on the part of developed countries, which 
represent the bulk of greenhouse gas emissions to date, to help less 
developed nations deal with potential problems associated with climate 
change, such as food shortages, water quality problems, and the 
increased risk of malnutrition or disease. In addition, research 
indicates that the developing world presents low-cost opportunities for 
emissions reduction--for example, avoiding landfill waste through 
composting--as well as opportunities to prevent future emissions in 
those countries that are rapidly developing their energy, industrial, 
and transportation infrastructures. Furthermore, some researchers noted 
that the provision of mitigation or adaptation aid to developing 
countries may essentially be a prerequisite to these countries' 
participation in an international agreement to limit emissions. 

Mr. Chairman, this concludes my prepared statement. I would be happy to 
respond to any questions that you or other Members of the Committee 
might have. 

Contacts and Staff Acknowledgments: 

For further information about this statement, please contact John 
Stephenson, Director, at (202) 512-3841 or stephensonj@gao.gov. 
Individuals who made key contributions to this testimony include 
Michael Hix, Assistant Director; Cindy Gilbert; Robert Grace; Richard 
Johnson; Jessica Lemke; Ben Shouse; Jeanette Soares; Ardith A. Spence; 
and Vasiliki Theodoropoulos. 

[End of section] 

Footnotes: 

[1] The six primary greenhouse gases are carbon dioxide, methane, and 
nitrous oxide, as well as three synthetic gases including 
hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride. 

[2] Profits could also decrease if costs were passed on to consumers, 
who would likely reduce their consumption in response to higher prices. 

[3] The European Union Emission Trading scheme, which commenced 
operation in January 2005, is the world's largest greenhouse gas cap- 
and-trade system. 

[4] See GAO, Climate Change Trade Measures: Considerations for U.S. 
Policy Makers, [hyperlink, http://www.gao.gov/products/GAO-09-724R] 
(Washington, D.C.: July 8, 2009) and International Climate Change 
Programs: Lessons Learned from the European Union's Emissions Trading 
Scheme and the Kyoto Protocol's Clean Development Mechanism, 
[hyperlink, http://www.gao.gov/products/GAO-09-151] (Washington, D.C.: 
Nov 18, 2008). 

[5] See Kevin Hassett, Aparna Mathur, and Gilbert Metcalf, The 
Incidence of a U.S. Carbon Tax: A Lifetime and Regional Analysis, 
Working Paper 14023 (Cambridge, Mass.: National Bureau of Economic 
Research, January 31, 2008); and Dallas Burtraw, Richard Sweeney and 
Margaret Walls, The Incidence of U.S. Climate Policy: Alternative Uses 
of the Revenue from a Cap-and-Trade Program, Discussion Paper 09-17 
(Washington, D.C.: Resources for the Future, June 2009). 

[6] Dinan, Terry M. and Rogers, Diane Lim. Distributional Effects of 
Carbon Allowance Trading: How Government Decisions Determine Winners 
and Losers. National Tax Journal, 55(2), 199-221. 

[7] Auctioning under Cap and Trade: Design, Participation and 
Distribution of Revenues Before the Senate Comm. on Finance, 111th 
Cong. (2009) (statement of Douglas Elmendorf, Director, Congressional 
Budget Office). CBO notes that the actual value of the allowances would 
depend on the design of the cap-and-trade program. 

[8] Data provided by Environment Northeast, a non-profit environmental 
research and advocacy organization. 

[9] See [hyperlink, http://www.gao.gov/products/GAO-09-151]. 

[10] As one economist whose work we reviewed has noted, opportunity 
costs can more easily be passed on to consumers in deregulated energy 
markets, as is common in the European Union, where the market price of 
electricity reflects costs associated with buying and selling 
allowances. 

[11] A large body of literature exists on the design of allowance 
auctions, including aspects such as timing, frequency, size, 
requirements for participation, and existence of a reserve price. We 
did not evaluate auction design features as part of this testimony. 

[12] Specifically, as allowance prices rise, production may shift to 
abroad to existing competitors or new firms; in addition, regulated 
entities may shift some of their production to facilities that exist in 
countries without binding emissions limits. If leakage were to occur, 
the resulting increase in emissions in those countries may largely 
offset some of the environmental benefits of the cap-and-trade program. 

[13] For further information, see GAO, Climate Change Trade Measures: 
Considerations for U.S. Policy Makers, [hyperlink, 
http://www.gao.gov/products/GAO-09-724R] (Washington, D.C.: July 8, 
2009). 

[14] See Jonathan L. Ramseur, "Emission Allowance Allocation in a Cap- 
and-Trade Program: Options and Considerations." Congressional Research 
Service, June 2, 2008. 

[15] A significant body of economic research indicates that ultimately 
the costly tax-interaction effect will be larger in magnitude than the 
beneficial effects of recycling revenue through the tax code, implying 
that the overall cost of an emissions price is somewhat larger than the 
costs of carbon reductions. However, the magnitude of the recycling 
effect is dependent on the details of the program that is implemented. 

[16] The Electronic Benefit Transfer (EBT) is an electronic system that 
allows a recipient of government benefits like food stamps to use these 
benefits at a retailer. 

[17] The 2009 EITC thresholds require that earned income and adjusted 
gross income must each be less than $43,279 ($48,279 if married filing 
jointly) with three or more qualifying children. The threshold drops to 
$13,440 ($18,440 if married filing jointly) with no qualifying 
children. 

[18] Burtraw, Dallas, Richard Sweeney, and Margaret Walls, "The 
Incidence of U.S. Climate Policy," Resources for the Future discussion 
paper 09-17. 

[19] Department of the Treasury, IRS Earned Income Tax Credit (EITC) 
Initiatives (2008) and see also GAO, IRS's 2008 Filing Season Generally 
Successful Despite Challenges, although IRS Could Expand Enforcement 
during Returns Processing, [hyperlink, 
http://www.gao.gov/products/GAO-09-146] (Washington, D.C.: 2009). 

[20] The bill defines 'electricity local distribution company' as an 
electric utility that, among other things, has a legal, regulatory, or 
contractual obligation to deliver electricity directly to retail 
consumers in the United States, and whose retail rates are regulated. 

[21] Congressional Budget Office, The Estimated Costs to Households 
From the Cap-and-Trade Provisions of H.R. 2454 (June 19, 2009). 

[22] Carbon capture and storage involves capturing CO2 from a power 
plant's emissions, transporting it to an underground storage location, 
and then injecting it into a geologic formation for long-term storage. 

[End of section] 

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