Making sense of cap-and-rebate

Obama’s cap and trade plan would rebate at least 80% of the revenue collected from carbon permits directly back to taxpayers. David Roberts asks a question that I think has been puzzling a lot of people:

> Say you put a price on carbon and rebate the revenue.

> Business costs rise, but they get that money back by raising prices for consumers.

> Consumer costs rise, but they get that money back via rebates.

> **Who, in this scenario, has any new incentive to shift to low-carbon electricity or efficiency?**

Short answer: everyone.

This is genuinely confusing. Under a cap-and-trade system, the question of whether carbon emissions are reduced is almost entirely divorced from the question of what happens to the money raised from taxing carbon.

Let’s say I’m your utility, and I raise your energy prices such that, at present rate of consumption, your bill will rise to $50,000 per year. Then I hand you an annual rebate check for $50,000. You can do one of two things.

1. Give the money right back to me to pay your energy bill. Money is shuffled. Nothing changes.
2. Use part of the $50,000 to install a solar hot water heater, put in triple-glazed windows, and replace your light bulbs. Then you set your programmable thermostat two degrees lower, throw away your second fridge, and hang a clothesline. All of this will cost you a few thousand dollars, and you’ll slash your energy use in half. Now, year after year, you pocket $25,000 from the rebate check.

This example uses exaggerated numbers, obviously, but it helps to show where the “money shuffling” criticism of cap-and-rebate goes wrong (and more realistic numbers don’t change the basic math). When you raise the relative price of energy, people shift their consumption patterns, even if they have more money to spend. They don’t simply plow the extra cash straight back into energy.

Note, also, that people’s behavior doesn’t really depend on getting that rebate check. If I raise your annual energy bill to $50,000, you’d be a fool not to install the solar water heater and clothesline regardless. The rebate just changes the distributional consequences of the carbon cap. Under a rebate scenario, you actually wind up richer. Under a permit giveaway scenario, the utlity winds up richer. This is the wacky, counterintuitive thing about cap-and-trade: the system works regardless of how you dispose of the money raised. Rebating it to consumers has the nice property of offsetting the regressive nature of higher energy prices without undermining the environmental integrity of the system.

There are other, more subtle problems with the money-shuffling criticism. For example, it ignores the action of the cap. If for some reason people don’t change their energy consumption patterns when they get their rebate checks, then the cap is going to bite. Carbon permits are in fixed supply, so they will become more expensive. Prices will continue to rise until people do change their consumption patterns.

A third problem is the notion that businesses don’t care about carbon costs because they can pass them on to the consumer. In the real world, businesses care about costs an awful lot. Fortunes are made and empires built on the ability to squeeze costs out of the supply chain. When carbon carries a price, businesses that can find efficiencies or switch to non-carbon sources of energy will be able to pass those savings on to their customers. Then their competitors will go out of business. Then environmental bloggers (like me) will do happy little dances, writing about the smart green companies that are growing rapidly, hiring new employees, and wringing a profit from the new green economy. Hoo-ray!

**Update:** Grist also published a nice piece from Michael Livermore on how cap-and-rebate is more fair to low-income taxpayers.

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adam

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  1. Eric Green - March 25, 2009

    There is more to consider than what is presented here. People are subject to price effects and income effects (micro-economic theory refers to them as price elasticity and income elasticity). And what is not well known is how people of different income levels are affected by these effects (at least when it comes to residential electricity consumption). Metcalf, and others, proposes a similar redistribution of tax revenue generated by a carbon tax to minimize welfare affects. However, it is unclear what this redistribution will actually do. Some people will certainly try to invest in energy saving devices, as suggested. But if the income effect outweighs the price effect, there is potential for consumption to increase. By consumption, I do not necessarily mean increased use of energy, but, perhaps, increased consumption of other goods. Since a majority of our nation’s goods are not produced nationally, we would be displacing the carbon production to other countries. Thus, a border tax has been suggested, but this may be far more difficult to pass, politically.
    I think most people realize, but fail to accept, that we must stop consuming so much. And sometimes this means we have to feel a pinch in the pocket. I’m not suggesting that we should allow the regressive nature of carbon policy to continue, but it may be prudent not to redistribute all the revenue just so you can make the policy more politically appealing.

  2. Adam Stein - March 25, 2009

    Well, we need to stop consuming *carbon*, and the best way to achieve that end is not by making people poorer, but shifting consumption patterns via price signals. Also, innovation, efficiency standards, etc.

  3. Anonymous - March 25, 2009

    Actually, the only way that you are going to achieve complete termination of carbon production is through command and control (non-market forces) or through collaborative global efforts that recognize the externalities associated with carbon. Both are far larger than what the consumer is able to control.
    I actually think some people do need to be made poorer. I am not sure why we are not talking about carbon policy as being progressive instead of regressive. Why not use the revenue for health care or education, or perhaps even “weatherization” stamps instead of food stamps. Even if people of lower income were made poorer by not redistributing the revenue (and their consumption would go down), they would be better off because of the increased benefits provided to them.

  4. Dan Porter - July 2, 2009

    Inaccurate example and assumptions:
    If people reduce their consumption/dependence on the utility, their bill will go down and so will their rebate.
    You seem to assume:
    1. the rebate will remain the same
    2. the rebate will equal any bill increase
    3. a cap on credits signifies a real cap on carbon
    4. carbon is not a renewable energy source

  5. Adam Stein - July 2, 2009

    I do assume #1. That’s a known precondition for making rebate systems work properly: the rebate shouldn’t be proportional to the recipient’s energy consumption.
    I don’t assume #2, and it doesn’t make a difference to the analysis. In fact, I explicitly assume otherwise in the paragraph beginning, “Note, also, that people

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