Political Presents Under the Tree

The Seattle Times reported recently that Governor Gregoire favors allocating free carbon credits to companies in Washington as part of the cap-and-trade system she advocates. Companies would be allowed to emit the same amount of CO2 as they have in the past. If they are able to reduce their emissions, they can sell the allowances they were given from the government. The allocations would decline year to year, but the initial allocation would be based on historical emissions - plus politics.

This system was used in Europe and led to some companies being given large excesses of carbon credits which they then sold on the market. In short, government gave something of value (carbon credits) to companies who then profited from them. Worse, a recent report by the Government Accounting Office found that politicians handed out presents, choosing winners and losers when it came to handing out allocations, leaving some industries short and others long.

Most power generation facilities were short whereas industrial facilities, including iron and steel; manufacturing ceramics; and pulp, paper, and board manufacturing were long. Member states allocated the shortage to the power sector because they believed this sector could reduce emissions at a lower cost than covered entities in other sectors. In addition, there were concerns that compliance with the ETS (emissions trading system) would create costs for covered entities that compete with facilities outside the EU that are not subject to carbon limits. Therefore, member states generally allocated the surplus to the globally competitive industrial sectors and the shortage to the power sector, which does not generally compete with entities outside the EU.

In other words, politicians changed the allocations arbitrarily to favor some sectors over others for political reasons. This is a major problem with cap-and-trade. Free allocations allow politicians to hand out favors to those they like and punish others. Some of these accounting games have already occurred.

It is one reason why the EU is not likely to meet the Kyoto targets. Governments over allocated credits in an effort to limit the impact on the economy, making it difficult to reach the targets.

The alternative to free allocation is auctioning. There are some advantages to this system, but the version of auctioning favored by the environmental community would be worse than free allocations and would amount to a multi-billion dollar tax increase in the middle of a recession.

A complex system like cap-and-trade invites accounting tricks and political favoritism. That's why many who once favored cap-and-trade are looking to other alternatives to reduce the risk from CO2. Unfortunately, Washington seems mired and married to a bad system.