An economy-wide cap on climate warming emissions – our preferred climate policy – has one enormous sticking point: once the cap is in place, who gets the right to pollute?

That’s the core of the debate over the “allocation” of emissions permits. Literally billions of dollars are at stake. And not too surprisingly, just about every industry you can think of believes that, once strict emissions limits are imposed, they should get a generous slice of permits for free.

Much of this is just money-grubbing, plain and simple. Permits will have a market value, so giving away permits is a lot like giving away free money. Free permits will mean big windfall profits to large emitters – an idea that shareholders and execs love, but consumers and taxpayers should hate.

But in some cases, the arguments against free emissions permits aren’t so clear-cut. In much of the U.S. West, for example, investor-owned electric utilities can’t set their own prices; instead, their rates are set by public utility commissions. And if those commissions are attentive and careful, the investor-owned utilities have a pretty hard time raising prices to capture “windfall” profits. Moreover, some utilities are actually owned by the public, or by the customers they serve – which makes the whole “windfall” issue moot.

Many utilities are arguing – in good faith, we think – that it would be better to simply give utilities permits, so that customers don’t have to pay for the cost of buying permits at an auction. Free permits will benefit consumers, their argument goes, by limiting electricity rate increases.

Are the utilities right about this? Could free allocation to utilities be a real boon to consumers?

We don’t think so. In fact, handing out permits to utilities for free has the potential to backfire, raising the overall cost of emissions reductions – thereby increasing the cost that consumers pay for all of their other energy needs.

There are four reasons that “protecting” electricity consumers from rate increases would likely backfire, raising costs for everyone in an economy-wide cap. Three reasons are economic, one is political. Taking each in turn…

1. Lower power prices discourage efficiency.

If electricity stays cheap – and, in particular, if electricity prices don’t reflect the true cost of emissions – fewer people will upgrade their old fridges, unplug the extra freezers in the garage, or install super-efficient ground-source heat pumps. (If power’s cheap, why not just stick with the old fridge?)

More generally, cheap electricity means that it takes longer for any efficiency upgrade to pay for itself – which undermines the incentive for paying for the upgrade in the first place. As a result, keeping electricity prices low could undermine incentives for households and businesses to trim their consumption – which is often among the cheapest ways to reduce emissions.

2. Inconsistent prices encourage climate-disrupting fuel choices.

If electricity rates remain low, but natural gas and fuel oil prices have a “carbon price” attached to them – as they will under a comprehensive cap-and-trade system – then electric power prices will look awfully enticing. Some folks will likely switch from, say, gas heat to electric heat. And others will choose to stick with their electric heat rather than switch to gas.

From the consumer’s perspective, this makes sense: they’re choosing a cheaper fuel option. But from the climate’s perspective, electric resistance heat is a bad deal. As long as the western power grid gets its marginal electric power from natural gas and coal, switching to electric resistance heat is a far worse choice for the climate than heating directly with natural gas.

In the same way, if gas prices rise but electricity stays cheap, we could see big boosts in electric cars or plug-in hybrids. If the electricity comes from renewable sources–great! But if it’s from coal-fired plants, it could be worse for the climate than plain-old gasoline.

So in general, until we squeeze most of the fossil power out of the electricity grid, switching away from direct fossil fuel use, and towards electricity, can increase climate-disrupting emissions.

3. Once a cap is in place, lower electricity prices might increase total household spending on energy.

This is counterintuitive, we know. But here’s why.

Electricity is a great place to find cheap emissions reductions. There are already low-carbon alternatives to coal-fired power – especially new wind and solar – and the Northwest Power and Conservation Council, among others, has already identified scores of low-cost ways to reduce end-use consumption.

However, if low power prices boost consumption (see points 1 and 2 above) then it gets harder to satisfy demand with efficiency and new renewables alone. A boost in power demand could give old, dirty coal-fired power plants a stay of execution – with a much slower phase-out of coal from the West’s generation mix.

If coal-fired power plants remain active for longer, the emissions cap will force steeper reductions in transportation and industrial emissions. Those kinds of reductions could easily cost more per ton than reductions in coal power – and those higher costs will translate into higher market prices for carbon permits. Higher permit costs, in turn, will get passed through to households as higher prices for gas, diesel, heating oil, natural gas, manufactured products, food, you name it.

So in the end, free permits to electricity could mean that consumers face lower prices for electricity, but far higher costs for all other fossil energy. And on balance, since electricity represents a relatively small share of household emissions – particularly here in the hydro-rich Northwest – the modest savings on power could be overwhelmed by higher permit costs in other sectors.

The whole point of a cap-and-trade system is to find the cheapest emissions reductions, wherever they may be. By diluting the price signal in electricity, we may wind up creating higher permit costs in other sectors – costs that, in the aggregate, loom larger in family budgets.

4. Granting free permits to one part of the energy industry – utilities – makes it far more likely that we’ll grant free permits to other parts as well.

This is a political argument rather than an economic one. If utilities get free allowances, other energy companies will insist on getting the same treatment. They’ll howl. They’ll rail. They’ll insinuate and lobby and grease palms. (They’ll do all these things anyway.)

So if the electric utilities carry the day, and successfully argue for free permits, it’ll be a lot harder to say “no” to the natural gas utilities, the propane distributors, the big industrial emitters, the pipeline companies, and ultimately even big oil – the industries that really can extract windfall profits from their customers.

These are four reasons to think that handing out free permits to the utility sector is a mistake. Our impression, and it’s only that, is that all too often, utility sector folks – even the public-spirited ones – tend to overemphasize electricity in their thinking. (Not surprising.) Electricity is a small part of the carbon game in the Northwest.

But we’re convinced that arguing for free allowances for electric utilities is NOT standing up for utility customers. Utility customers don’t just buy electricity. They also drive, heat their homes, and pay for food and manufactured goods. The way to serve them is not to keep electricity prices low, it’s to keep carbon prices low.

And that means utilities should buy their permits at auction, just like everyone else.

By Clark Williams-Derry