Auctioning vs. Granting Carbon Credits

In this weekend's Sunday New York Times Greg Mankiw, the Harvard professor of economics, criticizes the cap and trade bill working its way through Congress for giving out instead of auctioning off many allowances.  Mankiw who in the past has supported a tax on carbon as a simpler alternative to a cap and trade system, correctly points out, quoting President Obama, that a cap and trade system that auctions allowances can resemble a carbon tax.  If the auction revenues are used to offset other taxes, as with a carbon tax, any negative effect of the regime on the economy can be minimized. 

He goes on, however, to make an oddly flawed argument that should not go uncorrected. 

Criticizing the House bill that gives away allowances to utilities in lieu of auctioning them off, he says this will harm the economy by requiring consumers to pay more without recapturing revenues that could be used to offset taxes. The current bill by encouraging "lower real take home wages, reduced work incentives and depressed economic activity", he argues, will harm the economy.

Not true.

To the degree allowances are handed out at the beginning, consumers as well as utilities are given a pass and do not have to pay more for energy.  Some inefficient producers who need to buy credits on the exchange may raise prices to consumers or earn less profits.  However, other efficient producers will receive income from selling credits, letting them lower prices or increase profits. The overall impact on the economy of a cap depends on the level of the cap.  If sufficiently low, everyone will have to invest in new technology to cut emissions.  If sufficiently high, no one will. 

The real difference between auctioning off and handing out allowances is the first sends a stronger, immediate price signal, while the latter sends a weaker one likely to kick in later. 

Auctioning the allowances, like a tax, is a transfer away from industry and consumers to the government.  At best, the government can return the money by, for example, cutting a different tax.  If it keeps the money, the auctions act like a fiscal drag.  In contrast, granting allowances postpones the economic impact.  (For the record, there are reasons one might want to put off pain: first the current economic slump and second, the fact that low carbon alterantives to current fuels are growing steadily cheaper, meaning the cost of cutting emissions may be lower in the future.)

I have argued that with a new president in office and Cophenhagen coming up next year, this is the year to pass climate change legislation.  The bill can be strengthened later.  Others may disagree.  However, while auctioning credits may make for a stronger signal than granting them, it will not reduce the impact on the economy.