Timing flexibility could be delivered in many ways. Some cap-and-trade proposals allow permits for emitting carbon to be shifted across years. Yet these "banking and borrowing provisions" are typically limited. Alternatively, setting a floor and a ceiling on allowance prices each year could provide flexibility without sacrificing the ultimate goal. Setting a minimum auction price for allowances would encourage more emissions reductions when the costs were low. A price ceiling, implemented by selling additional allowances at that ceiling price, would mean fewer reductions when costs were high. Regulators could periodically adjust the price floor and ceiling to ensure that emissions reductions were on track for achieving a long-term target. A carbon tax also would provide timing flexibility.
A second way to reduce costs under a cap-and-trade program involves the method for initially distributing emissions allowances. The key questions here are whether some or all of the allowances will be sold by the government or given away -- and, if they are sold, how the revenue will be used.
Cap-and-trade programs create a new commodity: the right to emit carbon. With a constraint on total emissions, allowances would suddenly be highly valuable -- likely to be worth more than $100 billion per year. Selling them would provide revenue to offset some of the costs of the program. For example, revenue could be used to lower existing taxes that dampen economic activity. Following this path, the cost to the U.S. economy of a 15 percent cut in emissions might be half as large as it would be if the allowances were given away.
Another possible use of revenue from auctioning allowances is to offset the effects that higher energy prices would have on low- and moderate-income households. Although such price increases encourage greater efficiency in reducing emissions, and are thus essential to the success of a cap-and-trade program, they would impose a disproportionate burden on low- and moderate-income households. The Congressional Budget Office has found that if the allowances were sold and the revenue used to provide equal rebates to every household, lower-income households could be financially better off because the rebate would be larger than the average increase in their spending on energy-intensive goods. Alternatively, the distributional consequences could be offset by increasing the earned-income tax credit or boosting food stamp benefits.
By contrast, granting allowances free to emitters would not be well suited to reducing either the macroeconomic costs or the distributional effects of a cap-and-trade program. Businesses would raise energy prices for their customers regardless of whether the allowances were auctioned or given away. Indeed, providing free permits to energy producers and energy-intensive firms would be equivalent to auctioning the permits and simply giving the proceeds to the firms. The result would be a lost opportunity to use the money to offset the costs of emissions reductions as well as the potential creation of regressive "windfall profits" for the relatively high-income shareholders of those companies.