Chairman Pence and other members, thank you for the invitation to speak today on the distributional burden of a cap-and-trade system. In my remarks today I will explore the economic burden on households if policy makers adopt a cap-and-trade system resulting in an increase in carbon prices and subsequently an increase in energy and non-energy goods prices. My statement makes the following key points:

• Cap and trade systems increase costs of production for firms since firms will either need to undertake abatement measures to reduce carbon emissions (which may be costly) or they will need to buy permits from other firms to be able to continue emitting carbon without abatement. It can be shown that these costs will be incurred irrespective of whether the initial permits are auctioned or they are freely allocated. That result was borne out in the cap-and-trade programs for sulfur dioxide in the United States and for CO2 in Europe, where consumer prices rose even though producers were given allowances for free.

• These higher costs of production will translate to higher energy and product prices. In a paper that I co-authored with my colleagues at AEI, we estimate that a cap and trade system, with a $15 permit price, will increase the cost of everything--from food, clothing, shoes and home furnishings by about 1 percent, of gasoline by 7.7%, electricity 12.5%, and natural gas 12.3%. Of course, as previous experience with cap and trade programs has shown, permit prices are likely to be extremely volatile and rising over time, and our $15 price estimate is likely to be conservative. Other studies suggest that the price could be above $50 in 2015, close to $100 in 2030 and about $200 in 2050. We can safely project that our estimates will be some multiple of these higher prices i.e. our price increases will be much higher than we project here.

• The burden of these higher prices will be felt the most by the lower income households. As a fraction of income, this is about 4 percent of income for the bottom 10 percent of the population and about 1 percent of income for the top. In other words, the burden on the lower income households will be nearly 4 times the burden on the top income households. In terms of actual dollar values, the total cost of a cap and trade system on the bottom 10 percent of the population would be about $315 annually (in 2003 dollars), while on the top 10 percent it would be about $1324 annually (in 2003 dollars). For the average middle income household, it would be about $635 annually. Of course, if the permit prices are higher, then these costs could double or triple.
• The regional distribution of the burden will depend upon the nature of electricity regulation. If permits are auctioned, then we can assume that electricity regulators will allow firms to pass on the price increases to consumers. In this case, we find that the regional burden of cap and trade will be high but fairly evenly distributed. This is because while some regions have higher electricity consumption, others have higher gasoline consumption and yet others have higher home heating demands. It is true though that the states that rely on coal-intensive electricity production will bear a higher burden than the others.
• The picture changes however, if we allow permits to be freely allocated. In this case, it is likely that electricity regulators would not allow utilities to pass forward the costs of permits to consumers, while the higher costs will be transferred to consumers in the electricity deregulated states. In this case we find that the burden of cap and trade will shift from the coal-intensive states to those states that have moved ahead with electricity deregulation. The lower burden on the regulated states however means that we will obtain fewer reductions in emissions than would occur if permits were auctioned.

To conclude, we find that the burden of a cap and trade system will fall the most on the lower income groups. Second, the regional distribution of the burden will depend upon the nature of electricity regulation and the form of permit distribution. If permits are freely allocated, the burden will be felt most by consumers in states with electricity deregulation. This would simply aggravate an existing situation where deregulated states have been facing larger price hikes than regulated states making their consumers worse off.

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Aparna Mathur is a research fellow at AEI.