In a cap and trade system, the costs borne by consumers is largely influenced by how the government distributes the permits that allow companies to emit carbon.  You might be tempted to think that the government distributing permits for free instead of charging companies for them (as is done for a significant time under Waxman-Markey and likely Kerry-Boxer) means no costs associated with the allowances will be passed along to consumers since there is no cost to pass on.  However, as paradoxical as this may seem, the exact opposite is the case.   

When a cap is instituted, a finite resource is made of an otherwise infinite resource.  Once this commodity is created, it behaves according to market forces just like any other commodity.  When the demand is high and the supplies are low, the price goes up.  This is true whether or not the permits to emit carbon are sold immediately upon their creation (as in the government selling permits directly to companies), or at some point in the future (as in companies selling to each other).  At some point, the commodity becomes worth real money as someone in the economy will demand to purchase it from someone else.  However, we must remember that those who must purchase the permits will ultimately pass the cost of those permits down to consumers.

This being the case, it becomes crucially important who receives the free permits because they will influence the prices consumers will pay for energy, take the profit from selling the free permits for themselves, and pass those profits along to their stockholders/investors.  When the government decides who should be given free permits, that decision affects who the winners and losers are, and to what degree.  As President Obama's Budget Director Peter Orszag explains in his testimony on cap and trade before Congress, the costs to consumers and the resulting windfall profits to companies can be quite dramatic: 

“Although the price increases triggered by a cap-and-trade program for CO2 emissions would be regressive, the policy’s ultimate distributional effect would depend on policymakers’ decisions about how to allocate the emission allowances. As noted above, those allowances would be worth tens or hundreds of billions of dollars per year. Who received that value would depend on how the allowances were distributed. 

 

“[G]iving all or most of the allowances to energy producers to offset the potential losses of investors in those industries…would exacerbate the regressivity of the price increases. On average, the value of the CO2 allowances that producers would receive would more than compensate them for any decline in profits caused by a drop in the demand for energy and energy-intensive goods and services that cause emissions. As a result, the companies that received allowances could experience 'windfall' profits, with the government regaining only part of that windfall through corporate income taxes. For example, one study suggested that if emissions were reduced by 23 percent and all of the allowances were distributed for free to producers in the oil, natural gas, and coal sectors, stock values would double for oil and gas producers and increase more than sevenfold for coal producers, compared with projected values in the absence of a cap.[1]  If emissions were instead reduced by 15 percent, as in the scenario discussed above, profits in those sectors would rise several fold. For example, in 2000, CBO examined the effects of reducing emissions from 1998 levels and estimated that under a 15 percent cut, the value of allowances would be 10 times as large as coal, oil, and natural gas producers’ combined profits in 1998 and more than double their profits in 2006.[2]  Because the additional profits would not depend on how much a company produced, they would be unlikely to prevent the declines in production and resulting job losses that would stem from the price increases. 

 

“In addition, those profits would accrue to shareholders, who are primarily from higher-income households, and would more than offset those households’ increased spending on energy and energy-intensive goods and services. Low income households, by contrast, would benefit little if allowances were given to energy producers for free, and they would still bear a disproportionate burden from price increases. Thus, giving away allowances would be significantly regressive, making higher-income households better off as a result of the cap-and-trade policy while making lower-income households worse off. That regressive outcome could occur even if the government used its share of the allowance value—received through corporate income taxes on the windfall profits—to provide lump-sum rebates to households.  “Giving away all of the allowances and using the government’s regained share of their value to reduce corporate tax rates would be particularly regressive. In that scenario (once again not including any benefits from reducing climate change), average household income would fall by 3.0 percent in the lowest quintile and rise by 1.9 percent in the highest quintile.”[3]

[2] Id Footnote in original: Specifically, CBO estimated that the value of those allowances would total $155 billion (in 2006 dollars). By comparison, profits for U.S. producers of oil, natural gas, and coal totaled $13.5 billion in 1998 (in 2006 dollars). Those companies’ total profits were substantially higher in 2006: $174 billion.

[3]Ibid Pgs. 9-11