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George Washington Journal of Energy and Environmental Law




Climate change legislation is one of the Obama administration's top priorities. The administration has proposed regulating carbon emissions using a cap-and-trade program. If adopted, the program will place a cap on the aggregate carbon emissions of certain firms. Under the program, the government will create emissions permits in an amount corresponding to the cap and will require certain firms to surrender a permit for each ton of carbon emitted. After the government initially distributes permits, firms will be able to buy and sell them on a secondary market.

Both the administration and many economists prefer that the government initially distribute permits by auction. Auctioning permits would raise billions of dollars in revenue and force firms to pay for their emissions. Nevertheless, Congress seems unlikely to adopt legislation that auctions all permits. In prior cap-and-trade programs, including the acid rain program, the government gave away permits to the firms required to surrender them. Similarly, the Waxman- Markey cap-and-trade bill passed by the House of Representatives in June of 2009 gives away a large portion of permits.

Assuming that the government gives away emissions permits, an important unresolved issue is whether recipient firms should pay federal income tax on any permits that they receive. This Article addresses that question.

After adoption of the acid rain cap-and-trade program, which regulates sulfur dioxide emissions, the Internal Revenue Service ("IRS") issued administrative guidance that allows firms receiving sulfur dioxide permits to exclude the permits from income. This means that the permits are not taxed when received. Instead, excluded permits have a tax cost basis of zero, so a firm that sells permits that it received for free will be taxed on the full amount of the sales proceeds. The result is that free permits are not permanently exempt from tax, but instead the tax is deferred. Tax deferral provides firms with a benefit similar to receiving an interest-free loan from the government. So deferral is valuable to firms and costly to the government.

This Article argues that the government should not extend the tax exclusion that currently applies to free sulfur dioxide permits to free carbon permits. Instead, free carbon permits should be taxed when received, which would eliminate costly tax deferral.

Part I discusses the general features and likely distributive effects of a carbon cap-and-trade program. In the long rull, consumers will bear most of the program's Lusts as the prices of carbon-intensive goods and services increase.Nevertheless, after the program is adopted, some firms may suffer transition losses as increased costs reduce their profits. Additionally, the government can alter the program's distributive effects through its control over permits. For example, the government could give permits to firms to avoid price increases or to compensate firms for transition losses. If, as seems likely, the government gives permits away, the resulting distributive effects will depend largely on whether the recipient firms are subject to rate regulation. State regulators will likely require that rate-regulated firms use any permits that that they receive to benefit their customers, e.g., by keeping prices low. Permits allocated to unregulated firms, however, generally will benefit those firms' shareholders, not their customers and not consumers. Unregulated firms that are required to surrender permits will increase prices to reflect the opportunity cost of using permits in the production process. This means that unregulated firms will increase prices even if they receive permits for free because surrendering permits entails giving up the potential revenue that could be earned from selling them . In short, giving permits to unregulated firms generally will not protect consumers.

Parts II and III consider the appropriate tax treatment of permits given to unregulated firms. Part 11 argues that because the permits will be valuable and easy to sell and will generally benefit shareholders, unregulated firms that receive permits for free have economic income that should be taxed. Part II also addresses and rejects the argument that free permits should not be taxed because they will merely compensate firms for transition losses. Although cap-andtrade may cause transition losses, free allocation of permits may overcompensate at least some firms, causing them to be better off than if cap-and-trade were not adopted. As a result, the case for a tax exclusion for free permits is not especially strong. Moreover, because a tax exclusion entails a tax basis of zero, it miay produce a significant lock-in effect that causes firms to refuse to sell their permits in order to avoid paying tax on the resulting gain. This lock-in effect may increase the overall cost of the cap-and-trade program.

Additionally, Part III argues that firms should be taxed even if it turns out that the permits that they receive serve only to compensate them for transition losses. Ideally, the government would not use free permits to compensate firms because doing so will invite wasteful lobbying and may result in overcompensation. Compensating transition losses also effectively rewards firms that have failed to anticipate climate change legislation and to take steps to reduce their carbon emissions. This may discourage firms from anticipating future changes in the law, particularly new environmental regulations, which might result in excessive investment in technologies that are harmful to the environment. In short, compensating firms is a bad idea in principle and should be avoided. But if the government chooses to give permits away, then taxing the permits when received will at least reduce the net amount of any compensation. This is desirable because it moves us toward the optimal amount of compensation, i.e., zero.

Part IV examines the appropriate tax treatment of permits given to local distribution companies ("LDCs"), which are rate-regulated firms that distribute electricity and natural gas to residential, commercial, and industrial users. The Waxman-Markey bill allocates a substantial share of permits to LDCs ostensibly for the benefit of consumers. Because LDCs are rate-regulated firms, state regulators will require that they use any permits that they receive to benefit their customers, e.g., by selling the permits to finance rebates. As a result, LDCs arguably will not have economic income from receiving permits.

Nevertheless, Part IV argues that LDCs should be taxed on any permits that they receive. The rationale is as follows. Giving permits to LDCs is bad policy. If LDCs use their permits to provide rebates, the rebates may reduce the incentive to conserve electricity and natural gas and may produce windfalls for the shareholders of the LDCs' commercial and industrial customers. There are more efficient and effective ways for the government to relieve the burden that cap-and-trade imposes on consumers. For example, the government could simply auction permits and send rebates directly to consumers. As a consequence, it would be better if LDCs received no permits. But if they do receive permits, then taxing the permits will reduce their net cost to the government and their net value to LDCs. This may be beneficial because it will reduce the amount of any rebates, thereby increasing the incentive to conserve and limiting windfalls to shareholders. It will also increase the amount of revenue available to the government for use in reducing the deficit, cutting taxes, or increasing spending on other programs.

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