from Energy, Security, and Climate and Energy Security and Climate Change Program

IER Study is Wrong on Kerry-Lieberman

June 30, 2010

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The Institute for Energy Research has published an analytically weak study written by Chamberlain Economics (CE) that distorts the Kerry-Lieberman energy and climate bill and overstates its costs. Expect it to be much-cited in the coming weeks.

I want to focus on one particular thing that the study does, since I expect some others will decide to copy it, since it is important, and since it is wrong.

The study claims that the bill is highly regressive, i.e. that it will hit poor people disproportionately. How does it do this? The bill gives a large amount of money (in the form of free emissions allowances) to local electricity distribution companies (LDCs) and instructs their regulators to ensure that they use that money for the benefit of ratepayers. Since poorer people tend to spend a larger fraction of their income on electricity, that would tend to blunt any regressive elements of cap-and-trade, as the study authors themselves note. The study, however, argues that the LDCs will actually transfer the value of the allowances to their shareholders instead. Since the typical shareholder tends to be richer than the typical person, this makes the bill regressive.

But their argument for why LDCs will transfer the value of the allowances to shareholders is weak. The LDCs are regulated. The study must therefore argue that they will be able to massively game the regulators:

“Lawmakers can specify the statutory or legal incidence of free emission allowances, but they do not control the actual economic incidence. The ultimate beneficiaries of LDC subsidies are not determined by the text of legislation or the intentions of Congress; they are determined by the economic behaviorof profit-maximizing firms operating within an imperfect state and local regulatory regime.”

So far so good. Whether firms can actually game the regulators in this case depends on the details of the circumstances at hand. The authors continue:

“The question of who benefits from LDC subsidies is analytically similar to the tax incidence question of who pays state and local gross receipts taxes. States typically place the statutory incidence of these taxes on businesses, mandating that revenue officials—who represent the regulatory regime enforcing tax provisions—oversee that firms do not in fact forward-shift burdens onto consumers. In practice, economists widely acknowledge that profit-seeking firms routinely forward-shift gross receipts tax burdens, directly contradicting the statutory incidence specified by lawmakers in legislation.”

Right. But those firms aren’t regulated. If a regulator could say “you aren’t allowed to pass on those tax costs to consumers” then we’d be comparing apples with apples. As it is, we aren’t. The authors also point to the European experience, where the value of free allowances was passed on to consumers. Again, there was no regulatory barrier to doing this, so the case is irrelevant.

The authors, to their credit, go beyond this sloppy analogy, and make a more careful argument about Kerry-Lieberman. They go through some basic microeconomics to argue (I’m simplifying a bit here) that since utilities’ costs will rise under cap-and-trade, and since regulators won’t be able to tell exactly how much of any cost increase is due to cap-and-trade, utilities will be able to play the regulators in a way that lets them capture some of the allowance value.

This would be fair if this exercise was about estimating costs. But it isn’t. It is about measuring value. The regulator knows the value of the free allowances: it is equal to the number of allowances given out for free multiplied by the value of the allowances at auction. If the LDCs cannot account for having spent that money on public purposes, the regulator will know. The CE authors try to make this complicated, but it’s actually pretty simple.

I won’t get into all the other problems with the study here. My biggest other pet peeve is how the study calculates negative employment impacts, which is says will be huge (500,000+ jobs lost by 2015). Short version of the critique: you can’t use an input-output table to estimate employment impacts if all you know is the aggregate GDP impact of the bill (which is all the CE authors know); you need to know the impact on output on a sectoral basis. It turns out that the bill hits capital-intensive sectors disproportionately, so its employment impacts are considerably smaller than what the CE folks project. I’ll expand on this if enough people ask for it in the comments.