You explained the second point so I can understand it but I am still confused about the first point. My confusion is rooted in the difference between SO2, NOX and Hg controls and CO2 controls. Are the total costs to the economy for cap and trade vs. cap and auction the same for all pollutants? In a cap and trade program emissions have to be reduced and for SO2, NOX and Hg those reductions incur costs. As you say, the price of electricity will reflect the cost of those emissions abatement programs (which should equal the market price of permits in a well-functioning market) if utilities are setting prices competitively. If they have to buy the allowances in an auction and incur the abatement program costs doesn’t that add the auction cost to the abatement cost so the total cost to the ratepayer is higher?

I also have trouble with your analogy. I think there is a flaw that makes this statement incorrect: “If it doesn’t sell all of them, then there are still foregone economic opportunities (the possibility of selling allowances) that should be accounted for in the price of electricity.” Allowances represent a compliance obligation and the regulations impose penalties greater than the economic opportunities of selling them. So what foregone economic opportunities are there on allowances needed for compliance?

This is the same for a utility that receives emission allowances for free. If the utility does not need all of the allowances, then it can sell them. If it doesn’t sell all of them, then there are still foregone economic opportunities (the possibility of selling allowances) that should be accounted for in the price of electricity. The price of electricity will reflect the cost of the last unit of labor, and fuel, and capital, and emissions abatement (which should equal the market price of permits in a well-functioning market) if utilities are setting prices competitively. (It is potentially much more complicated in states that have not deregulated their electricity markets and state public utility commissions still determine rates.)

The total costs to the economy and to consumers will be the same under a 100% auction and a 100% gratis allocation. The DISTRIBUTION of the costs, will differ, however, between these two allocations. A 100% gratis allocation will more than compensate the stockholders of regulated firms – this is what happened for some EU utilities that saw their stock prices increase as EU ETS allowance prices rose. Wealthy stockholders would benefit from such a policy. A 100% auction, especially if revenues are used to lower payroll taxes, would be much less regressive and could be designed to be distributionally-neutral.

Second, minimizing the costs of achieving a given emissions goal requires that all sources pay the same amount for emitting a ton of carbon dioxide. The coal-fired power plant should pay more to generate a megawatt-hour of electricity because it emits more carbon dioxide than a natural gas plant. Since it emits more, it has to hold onto (or buy) more emission allowances, or pay more in emission taxes. If a natural gas plant and a coal plant had to expend the same amount per megawatt-hour to cover their CO2 emissions, then utilities would never face the incentive to switch from coal to lower or zero-carbon emitting power sources. The key thing is to make sure that all sources pay the same amount per unit of pollution (e.g., per ton of CO2), not per unit of economic production.

Here is the part I don’t understand. For pollutants like SO2, NOX and Hg there are commercially available, proven control technologies to reduce emissions from existing sources. In addition to retrofit control equipment, both SO2 and mercury can be controlled by using different fuel sources that have lower amounts of sulfur and mercury. NOX can also be controlled by modifying the way the fuel is burned. It is also possible to reduce SO2, NOX and mercury by changing the type of fuel used. If the market is efficient then the cost of allowances will equal the abatement costs necessary to reduce emissions to the level of the cap. It will take investment money to implement those controls. So if those allowances are auctioned, won’t that just add to the cost of the program because in the full auction the affected firms have to buy the allowances to participate in the market?

The key point for CO2 is that it is different from those pollutants. There is no commercially available retrofit control technology for CO2, differences in the amount of carbon in any particular fuel type are negligible, and aside from trying to burn a fuel more efficiently the way fuel is burned does not affect CO2 emissions. Therefore, the only way that CO2 can be reduced from an existing source is to run less, run more efficiently (good only for small reductions) or convert to a different type of fuel. In my mind that makes an auction for CO2 a viable alternative.

However I still have a problem with the 100% auction. Your posts made the point that it is important that all sources face the same marginal cost of abatement. The emissions of CO2 per MW produced at a coal-fired plant are approximately double the emissions at a gas-fired electric generating plant. If all the allowances are auctioned, then doesn’t that mean that firms with coal-fired sources will face higher costs and as a result the total cost of the program will be higher?

When judging cap-and-trade systems and carbon taxes on their merits, it’s critical to ask where the revenues go to be able to judge their effectiveness. A cap-and-trade system that hands out allocations to particular sectors subsidizes their pollution and minimizes the incentive to reduce emissions and puts more efficient players at an economic disadvantage.

Similarly a carbon tax’s emissions reducing impact could be wholly undermined if revenues go directly into subsidies for the targeted industries.