The method for allocating allowances in a cap-and-trade program can have significant economic implications for the government, regulated entities and households, claims a report released Tuesday, Aug. 4, 2009, by the Government Accountability Office (GAO).

The GAO report takes a look at emission allowances as an economic commodity, and concluded that extreme care must be taken to make sure normal principles of capitalism are allowed to drive the market for that commodity.

The report highlights three ways that the allowances could be allocated:

1. Auction: The EPA 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.
2. Giveaway: The agency 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 program’s appeal to covered entities but could also increase the program’s overall cost to the economy if it reduced incentives for those entities to decrease their emissions.
3. Mix it up: 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.

Notably, the report states, flat-out, that the cost of CO₂ control will ultimately come down to consumers. "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 increased prices; however, these costs could be largely offset depending on how revenues are used."

Available literature and economists interviewed for the report pointed to five main options for distributing a program’s allowance revenues, although the GAO noted that numerous other options exist.

1. 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.
2. 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.
3. The government could expand the scope of the Earned Income Tax Credit to further benefit low-income working families.
4. The government could compensate regulated entities and their shareholders for lost profits by allocating them free allowances.
5. 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, the report said. 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 program’s overall cost.