Yesterday, White House science adviser John Holdren told The Washington Post that the Obama administration might soften its stance that 100 percent of the carbon permits under a cap-and-trade system need to be auctioned off. That's not overly shocking. Ed Markey and Henry Waxman in the House have hinted at a similar compromise. Environmentalists don't like it, but any climate bill capable of snagging 60 votes in the Senate will have to make some concessions to industry lobbyists. (Electric utilities are already agitating to have up to 40 percent of carbon allowances given out for free to distributors and merchant coal generators.)
A compromise would mean that some lucky companies get pollution allowances for free rather than having to buy them from the government at an auction. This won't ease the burden for consumers at all. Unregulated utilities that receive free permits will still hike up fossil-fuel prices (to compensate for the opportunity cost of not selling their allowances). Utilities that are tightly regulated, meanwhile, might pass along savings to electricity consumers, but for the economy-wide cap to work, carbon prices would then have to rise even higher in other sectors. Peter Orszag explained it all in his Senate testimony last year.
The primary issue here is distributive. If the government auctioned off all carbon permits, it would raise more revenue to rebate to consumers, making the overall system progressive—low-income Americans would actually come out ahead. But if permits are handed out for free, there's less money available for consumer rebates, while the companies that received free permits would reap profit windfalls—as happened in Europe initially. This would make the cap more regressive, as the Congressional Budget Office chart below shows. The impact of a 100 percent auction is shown on the left; the effects of a 100 percent giveaway are on the right—presumably a final bill would come somewhere in the middle:
That said, as long as you set the cap correctly, emissions should decline no matter how you dole out permits. And free handouts, in moderation, can be useful as subsidies to prevent some of the more energy-intensive industries like cement, paper, and chemicals from fleeing to China, where they'd be able to pollute unabated.
But this is one design aspect of cap-and-trade that needs to be eyed closely. In theory, only industries that are genuinely at risk of vanishing should get free permits—and the permits ought to be phased out as quickly as possible. If electric utilities are just grubbing for free allowances they don't actually need in order to boost profits, then the system has gone very badly awry.