Upstream schemes target raw fuels – coal, crude oil and natural gas – at their sources, before they enter the energy grid. In an upstream system of regulation, suppliers of raw fuels would need permits for the CO2 that their fuels would release somewhere downstream. By contrast, midstream schemes focus on the points where fuels are transported, refined or distributed, while downstream schemes attempt to regulate the points – the many millions of points – where combusted fuels release their gases through tailpipes, chimneys and smokestacks. Hybrid systems target sources both up and down the carbon stream. A few economists favor a straight tax on CO2 – a long shot, since politicians are disinclined to support anything with the T-word attached.

Upstream proposals are getting the most attention for many reasons, according to Robert Repetto [profile], professor in the practice of economics and sustainable development at F&ES. He makes a strong case for them in a paper titled “National Climate Policy: Choosing the Right Architecture,” published in June for the Presidential Climate Action Project. Upstream schemes are more effective than other systems, he writes, because they account for almost 100 percent of all fuels by measuring them at their sources. Midstream schemes, on the other hand, detect less than half of CO2 emissions. Upstream systems are also easier to monitor and enforce, because only about 2,000 first-sellers of raw fuels do business in the United States. Putting the control gate farther downstream multiplies the emissions sources that must be tracked and, hence, the regulatory and bureaucratic headaches.

“Some people want to have mileage standards for cars, efficiency standards for household products, mandates and so on down the line,” says Repetto. “Their mindset is to identify all emission sources and design some particular regulation for each of them. A lot of these people,” he adds dryly, “are lawyers.”

Repetto also thinks upstream schemes are more fair than the alternatives, because the price increase at the source will be felt by everyone based on consumption. “If you’re using a ton of energy and putting out a disproportionate share of emissions,” he says, “you’ll pay a disproportionate share in terms of energy costs. Some uses will go on because they’re essential. If you’re running a semiconductor plant and have to maintain temperatures at a certain level, you’re going to go on doing it. But if you’re running a big-box warehouse and can save energy by keeping the huge doors on the loading dock closed, you might do that. If you have a Sunglass Hut and are leaving your door open to the pedestrian mall so that you’re air conditioning the sidewalk, you might close your door.” Everyone from the permit holders at the source to the end-users downstream will be motivated to use less fuel. This will have the dual benefit of tempering the price increases and spurring innovation in energy-efficient technologies.

Advocates of an upstream system agree on these advantages, but part ways on two important variations of it. The first: should the government give away some or all of the carbon permits – that is, the right to emit a set amount of CO2 – to energy suppliers to compensate them for rising fuel costs? Or should the permits be auctioned to raise revenue? And if some or all of the permits are auctioned, how should the money be used?

The second issue is thornier. Some economists favor a policy that puts a hard cap – an absolute limit – on CO2 emissions for a set period, and then lets the price of carbon permits fluctuate on an open market. Other economists want a policy that sets an upper limit on the price of permits and thus protects the economy against exorbitant increases in energy costs. In this model, if the permit price reaches the established ceiling, the government relieves the upward pressure on costs by issuing more permits, which causes the price to drop. Economists call this provision a “safety valve,” because it keeps permit prices from getting out of control and playing havoc with the economy. But those extra permits would also result in more emissions, which would puncture the CO2 cap. For that reason, most environmentalists and some economists, including Repetto, dislike safety valves. The upshot is that one side wants a hard cap on carbon emissions, while the other side wants a hard cap on permit prices.

Let’s start with the issue of permits (sometimes called allowances or allocations). Because the number of permits will be limited, they will be valuable. If the government gives them free to energy companies, critics say, the companies could make windfall, or excessive, profits. As proof, they point to the European Union (EU). In 2005, the EU began the first phase of its commitment to cut carbon emissions under the Kyoto Protocol. Most analysts now agree that the EU’s system has several gaping flaws, starting with its midstream control gate, which leaves out more than half of all carbon emissions. In hindsight, it’s also clear that the EU program blundered in its allocation of carbon permits. It not only gave all the permits free to power companies, oil refineries and energy-intensive industries, it also issued far too many after intensive lobbying by industry. These businesses reaped a double bonanza. Since the permits could be traded, companies could sell their surplus carbon credits to other energy users. And since the permits carried a monetary value, many companies also treated them as a cost on their books that could be passed on to consumers. The result was windfall profits. A study by the British government found that power companies in that country made about $1 billion from free allowances in 2005. The same happened throughout the EU. In June, the EU’s environmental commissioner announced that when the program’s next phase begins in 2012, most, if not all, of the permits will be auctioned – that is, businesses and industries will bid for the permits and market forces will set the price, with the revenues going to an EU carbon authority.

U.S. analysts and politicians took notice of the EU’s experience. In 2004, for instance, the National Commission on Energy Policy, a bipartisan group of 20 energy experts from industry, government, labor, academia and environmental groups that supports an upstream policy, recommended giving away 90 percent of the allowances; in April 2007, citing the EU’s experience, the commission changed its recommendation to half free, half auctioned.

Robert Stavins, Albert Pratt Professor of Business and Government at Harvard’s John F. Kennedy School of Government, has altered his views on allowances for the same reason. In a proposal that he’s developing for the Hamilton Project at the Brookings Institution, he will recommend an even split between free and auctioned permits, with the free ones phased out over 25 years. He thinks that any CO2 legislation will have to include free permits to be politically feasible. Most of the bills now floating around Congress call for some percentage of free allowances to industry, but none call for 100 percent, and most call for a phaseout of free permits.

On the other hand, auctioning the permits would generate huge revenues for the government. Estimates range from $50 billion to $300 billion annually. That makes Robert Mendelsohn [profile], Ph.D. ’78, Edwin Weyerhaeuser Davis Professor of Forest Policy and a professor of economics at the Yale School of Management, nervous. “If Congress would use the money to eliminate the Social Security tax, that would be fine,” he says, “but I strongly suspect that they will use it wastefully on pet projects.” For that reason, he would give away 90 percent of the allowances.

Repetto, on the other hand, would award only “a small fraction” of free allowances to a few energy companies to compensate them for the loss in sales caused by a CO2 program. The rest would be auctioned, with the money used in any number of socially beneficial ways: to cut the program’s costs through tax cuts or tax credits, encourage innovation in new technology or soften the program’s impact on vulnerable households and businesses.

Richard Morgenstern, a senior fellow at Resources for the Future (RFF), a Washington, D.C., think tank that focuses on the economics of environmental and energy issues, agrees with Repetto about the auction percentage: “The more the better.” But his thinking also has changed. In 2002, he wrote a paper in support of the “Sky Trust” variation on upstream schemes. Under Sky Trust, CO2 allowances would be auctioned and most of the money – Morgenstern suggested 75 percent – would be shared equally by all households in the form of a check. The other 25 percent would go to the states for distribution to affected parties. The idea was to galvanize public support for CO2 regulation, and the plan was praised by, among others, the Congressional Budget Office. But critics pointed out that it wouldn’t change people’s energy habits, because it wouldn’t reward conservation; it wouldn’t be fair – “Warren Buffett would get the same check as everybody else,” notes Repetto; and it would create another bureaucracy. Sky Trust fell off the radar.

Morgenstern doesn’t lament that, since he now would cut the “money pie” differently, spreading it to industries and small towns hurt by higher energy costs and to programs that encourage new energy technologies. “Designing a program that addresses multiple objectives is where the game is now,” he says.

No matter how these disagreements about allowances play out, the targets chosen for reducing CO2 would stay the same. That might not be true if the policy contains a safety valve, a more divisive issue. “The price cap or safety valve has emerged as perhaps the single most contentious element of the Commission’s 2004 proposal,” said a 2007 report by the National Commission on Energy Policy. “More than two years later, we continue to believe that the cost certainty provided by this mechanism is critical to forging the political consensus needed to move forward without further delay.”

Repetto understands the economic and political reasoning behind this position, but counters with economic and political arguments of his own. On the political side, he suspects that if a CO2 bill includes a safety valve that puts a ceiling on the price of carbon permits, the energy industry will lobby successfully to keep that ceiling as low as possible, because when permits reach the safety-valve price, the government issues more permits at that price. If this “trigger” price is low, companies spend less for the right to emit more CO2. “And then businesses won’t have to change anything,” says Repetto. “They’ll treat the cost as a price of doing business and pass it along,” with scant benefit to the environment.

His political argument leads into his economic one: a low trigger price would mean more permits, more CO2 emissions and a busted carbon cap. “If you think that the economic damages from climate change can mount very heavily if we don’t limit emissions,” he says, “then we need insurance against that happening – which means a stricter cap, not one that can be obliterated by a safety valve.”

The main argument for a safety valve is economic uncertainty. CO2 regulation would raise the price of energy, which would affect every level of society, from steel producers to retailers, suburban commuters and retirees in condos. It would cost more to make products, heat buildings, transport goods and drive to work. No one knows what sort of economic chain reactions might be put in motion as the effects of higher energy costs ricochet among industry, business, markets and consumers.

“There’s legitimate uncertainty about the future,” says RFF’s Morgenstern. “We could have a failure of some technology or another, or we could have unusual weather patterns, which could lead to a dramatic run-up in permit prices. A safety valve is designed to deal with that. It’s like an insurance policy.” For instance, if a nuclear plant had to be shut down or if power supplies were strained by a long stretch of extremely hot weather, the demand for energy from fossil fuels would spike. But before they could sell the extra fuel, suppliers would need to buy more carbon permits. The demand would drive up the price of permits, and those costs would be passed down through the entire economy.

As a cautionary example, Morgenstern points to RECLAIM, Southern California’s cap-and-trade program to reduce nitrogen oxide emissions. The program didn’t have a safety valve, and when an electric energy crunch hit in 2000 and 2001, the price of permits followed the law of supply and demand, spiking to 20 times their usual cost, causing an uproar. “The state responded by suspending the entire program for a while,” says Morgenstern, “which certainly didn’t do the environment any good.”

“If the market is given a hard cap and the right incentives, it will turn out the innovations we need...”

But neither would extra CO2 emissions, says Nathaniel Keohane. Now on leave from the Yale School of Management, where he is an associate professor of economics, Keohane is spending the year as senior economist on climate change policy at Environmental Defense. Like other environmental advocacy groups, Environmental Defense vehemently opposes a safety valve – a position shared, Keohane points out, with Shell, DuPont, GE, GM and other large corporations that are part of the United States Climate Action Partnership, a coalition of environmental groups and companies that supports valveless upstream regulation. Keohane agrees that the economic effects of CO2 regulation are uncertain, but echoes Repetto’s point that so are the economic effects of climate change, if greenhouse gases continue to accumulate.

“We know catastrophic damages are possible, but we don’t know how likely those are,” he says. “So do you protect the economy and gamble on the climate, or do you protect the climate and gamble that innovation will get us to where we want to go? We trust that if the market is given a hard cap and the right incentives, it will turn out the innovations we need to get to these emissions targets.”

Keohane adds that any CO2 legislation will need the support of the environmental community. “And that means no safety valve.”

“I know that environmental advocates are drawing a line in the sand and saying, ‘No safety valves,’” says Harvard’s Stavins, “but they need to recognize that what’s going to happen is that trading will be suspended, the system will be suspended and carbon emissions will not be constrained. That’s what happened in Southern California, and that’s what will happen in the United States, because no one is going to tolerate dramatically high prices. The virtue of the safety valve is that it manages price volatility and eliminates this upside uncertainty.”

Morgenstern thinks that a safety valve can help create public support for CO2 regulation and also counteract the energy industry’s inevitable scare tactics. “Back in the Kyoto days,” he says, “the industry ran very effective ads showing a couple sitting around their kitchen saying, ‘Gee, I want to do the right thing, but I don’t want to lose my job and bankrupt society.’ There will be ads like that again. The safety valve cuts the legs out of that entirely, because it sets in place a method that protects society and prevents things from getting uncontrolled. So you can do the right thing and you can get started on this process and ramp it up over time.”

Mendelsohn points out that a safety valve also reassures business and industry that prices won’t get out of hand before there’s time to adjust. “The price cap for carbon permits should rise over time,” says Mendelsohn, “because we think the problem is going to get more serious over time. That’s a good message to give to firms, because they know not only what they’re going to face immediately, but what they need to plan for in the future so they can make adaptations.”

Repetto counters that other mechanisms can moderate permit prices without sacrificing the carbon cap. For instance, he proposes letting firms “bank and borrow” CO2 credits across five-year periods. For instance, a firm that quickly implemented ways to conserve fuel and didn’t use all of its permits during one period could “bank” the surplus and use it in the future to expand operations. Likewise, if a company faced unexpected energy needs during one cycle, it could “borrow” credits against the next cycle and repay them then. This would give firms flexibility, time to plan and the means to ride out unexpected price increases – and the total CO2 emissions over 10 years would not change, so the carbon cap would be preserved.

A safety valve also would make trading difficult on the developing international carbon market, where price caps don’t exist. If the international price were lower than the U.S. trigger price, U.S. firms would buy permits abroad. If the domestic cap was lower than the international price, firms would buy permits to sell abroad. In both cases, more CO2 would be emitted. Far better, says Repetto, to have one global market for carbon.

If upstream legislation does include a price cap for permits, where should the cap be set? Again, opinions vary widely, though everyone agrees that the price should rise over time. Mendelsohn suggests starting at $2 to $10 per ton of CO2. The National Commission on Energy Policy recommends $10. Morgenstern proposes $12 to $15, which sounds reasonable to Stavins. To Repetto, these figures sound too low to send an economic signal strong enough to alter behavior and stimulate innovation. Pushed to name a number he could live with, he suggests $30. “There’s nothing intrinsically wrong with a price cap,” he adds, “if it were high enough so that it really was an insurance policy that guarded against improbable but catastrophic events.”

Repetto points out that a system without a safety valve would have another wonderful side-effect: the virtual elimination of our Byzantine system of energy subsidies, which distort the market and probably raise prices. Subsidies encourage increased production of energy by making it profitable for companies to extract fossil fuels in ways and places that otherwise wouldn’t be cost-effective. But an upstream system with no safety valve puts a hard cap on how much fossil fuel can be produced and consumed. Since a subsidy would be worthless without a permit and since permits would be limited, many subsidies would go unused.

In addition – and this clearly delights Repetto as an economist – if the permits are auctioned, energy companies end up paying for their subsidies. Repetto explains: “Think about an oil producer who has a subsidy, so he has oil that would be profitable to produce, but he can’t without a permit. So what is he going to try to do? Buy a permit. When he does that, he’s going to end up bidding up the price. So if the government auctions the permits, it gets the subsidy back, essentially by making the energy companies pay for their subsidies through higher permit prices. And here’s the kicker: since renewable-energy producers don’t need permits, they get to keep their subsidies. So in one fell swoop, you get rid of the fossil fuel subsidies and keep all the renewable-energy subsidies. It’s one of the neatest things about the system.”

Everyone agrees that action on CO2 by the United States will be irrelevant unless China and India pass their own strict regulations.

Though allowances and safety valves are the most divisive issues at the moment, any upstream regulation of CO2 will have to consider several other sticky matters. Some businesses claim that CO2 regulation will put them at a competitive disadvantage. “It’s a ridiculous argument,” says Repetto, who demolishes it in the paper for the Presidential Climate Action Project in June. He notes that industry always makes these dire predictions, “despite very little empirical support,” whenever environmental legislation is pending. He points out that most of our main trading partners (for example, Japan, Canada and the EU countries) have already enacted CO2 regulations, yet businesses from those countries are not moving here to escape their supposed competitive disadvantage. “And second, most of the sectors that would be hardest hit are nontradeables internationally” – commodities such as electricity, transportation, real estate and government services. The exceptions are energy-intensive industries such as chemicals, metals and cement, which could make a case for protection against imports from countries without CO2 regulations.

Countries without such regulations, which currently include the United States, are the biggest international issue. Everyone agrees that action on CO2 by the United States ultimately will be irrelevant unless big up-and-coming polluters such as China and India follow suit and pass their own strict regulations. According to the National Commission on Energy Policy, China is opening a new coal-burning power plant every seven to 10 days. The International Energy Agency estimates that in 2009 – a decade ahead of previous estimates – China will surpass the United States as the world’s biggest emitter of CO2. India expects its coal consumption to triple over the next 30 to 40 years, says Repetto, who has started studying the issue. But neither China nor India is likely to do anything about CO2 unless the United States, which is responsible for the lion’s share of the accumulated greenhouse gases caused by fossil fuels, acts first.

The time seems ripe. Every important constituency, except the White House, wants federal action. This general consensus comes with a few downsides. Everyone involved wants to leave their fingerprints on the regulations. “Most legislation is narrowly focused,” says Morgenstern, “but this will be a complicated piece of legislation, because it affects just about everybody in society, and many interest groups are energized by it. It’s hard for our political process to cut all the deals necessary to craft that kind of legislation. It’s probably fair to say that you need presidential leadership.”

In his paper, Repetto warns that the initial architecture of the legislation is crucial. If the wrong system is chosen or if political expediency prevails, the cost over a decade could be an extra $1.75 trillion, plus further damages to the environment. Bad policies are also hard to correct later because of “policy lock-in,” meaning that a new policy requires large investments of money, time and learning, investments that policy makers are reluctant to replace later on for an expensive new model. Similarly, bureaucracies and interest groups accumulate around the new policy and become its defenders against major change. That’s why it’s important to get the policy right the first time.

“I’m hopeful that what will come out of the legislative process is a good solid architecture that is both effective and cost-effective,” says Repetto. After that, he adds, comes the other big question: how ambitious will the government be in its CO2 targets and timetables?