Neutralizing the Adverse Industry Impacts Of CO2 Abatement Policies: What Does It Cost?

The most cost-effective policies for achieving CO2 abatement (e.g., carbon taxes) fail to get off the ground politically because of unacceptable distributional consequences. This paper explores policies designed to address distributional concerns. Using an intertemporal numerical general equilibrium model of the U.S., we examine how efficiency costs change when CO2 abatement policies include elements that neutralize adverse impacts on energy industries. We find that desirable distributional outcomes can be achieved at relatively low cost in terms of efficiency: without substantial added cost to the overall economy, the government can implement carbon abatement policies that protect profits and equity values in fossil fuel industries. The key to this conclusion is that CO2 abatement policies have the potential to generate rents that are very large in relation to the potential loss of profit. By enabling firms to retain only a very small fraction of these potential rents, the government can protect firms' profits and equity values. Thus, the government needs to grandfather only a small percentage of CO2 emissions permits or, similarly, must exempt only a small fraction of emissions from the base of a carbon tax. Each of these government policies involves only a small sacrifice of potential government revenue. Such revenue has an efficiency value because it can be used to finance cuts in pre-existing distortionary taxes. Because these policies give up little of this potential revenue, they involve only a small sacrifice in terms of efficiency. We also find that there is a very large difference between preserving firms' profits and preserving their tax payments. Allowing firms to enjoy a dollar-for-dollar offset to their payments of carbon taxes (through industry-specific cuts in corporate tax rates, for example) substantially overcompensates firms, raising profits and equity values significantly relative to the unregulated situation.