Is the US Ready for a Carbon Tax?

• While the Trump administration seeks to undo CO2 regulations, a group of former Republican officials has proposed a new, market-based emissions plan.
• This "carbon tax" looks simpler than EPA's Clean Power Plan or previous cap-and-trade legislation, but not simpler than the pre-Obama status quo.

The idea of taxing the carbon content of energy--and presumably the goods and services produced with it--is back in the news. A group of Republican "wise men" has floated it as an alternative to the regulation-based approach to emissions that the Obama administration pursued after its preferred "cap & trade" legislation died in the Congress.

Reduced to its basics, a carbon tax is a focused version of a consumption tax, based on usage rather than income or valuation. The level of the tax would be set by law, either as a fixed amount per ton of emissions or at an initial rate with preset future increases. What can't be known with certainty in advance is just how much a given level of carbon tax would reduce actual emissions.

This contrasts with the method of setting a price on carbon preferred by many other economists and environmental groups, called "cap & trade." In this approach, the government sets a cap, or maximum level, on emissions for a designated sector or the economy as a whole, while parties subject to the cap are allowed to trade emission allowances and credits with each other under that cap. Thus policy makers set the level of emission reductions, and allow the market to find the resulting price on carbon. In principal, that ought to be more efficient than the simpler carbon tax, because market forces should drive participants with low costs of cutting emissions to make the deepest reductions and then sell their excess cuts to others, for less than it would cost the latter to reduce by that amount.

From the late 1990s until 2009 or '10 I was convinced that cap & trade was the better approach to pricing emissions. However, the experience of watching the US Congress attempt to design a cap-and-trade system for the US economy cured my certainty. As I have described at length, the inclination of legislators to help favored companies, industries and sectors, combined with the extraordinary temptations created by the sheer scale of the revenue such a system would channel through the government's hands, revealed practical problems that look insurmountable in the real world, at least under our political system.

In fairness, cap-and-trade is currently used to promote emissions reductions in various jurisdictions, including California, the mainly northeastern states participating in the Regional Greenhouse Gas Initiative, and the European Union. From what I have observed, all of them have experienced technical difficulties involving the allocation of free allowances, inadequate liquidity, and other issues. The biggest practical problem is that the carbon prices these systems have tended to deliver might be characterized as the opposite of a Goldilocks price; i.e., they are typically high enough to generate substantial revenue, creating strong constituencies for their continuation, but too low to influence behavior very much.

For example, California's emissions credits currently trade at around $13 per metric ton of CO2, equivalent to $0.10 per gallon of gasoline containing ethanol. Would an extra $1 per fill-up make much of a difference in how much you drive, which car to buy when you replace your current car, or whether to sell your car (or forgo buying one) and take public transportation?

Moreover, California's emissions have been essentially flat since the state implemented cap-and-trade in 2012. However, since 2002 the state's electric utilities--historically the highest emitting sector--have operated and invested under a Renewable Portfolio Standard requiring them to increase the share of renewable energy in their generation mix to 20% by 2010, 33% by 2020, and now 50% by 2030. I suspect that accounts for most of the 7% drop in emissions since 2002, while the impact of a carbon price equivalent to 0.6 cents per kilowatt-hour (kWh) is likely lost in the noise. Of course a carbon tax would create its own political and practical complications.

First, consider how a carbon tax would affect different energy sources. As with cap & trade, a carbon tax should have its biggest impact on the highest-emitting forms of energy. In practice that would compound the current disadvantages for coal compared to abundant, low-priced natural gas and rapidly growing, essentially zero-emitting renewables like wind and solar power. At least on the surface, that seems at odds with the stated goal of the Trump administration to attempt to rescue the US coal industry and the communities that depend on it.

Like cap & trade, a carbon tax would also require a significant amount of new bookkeeping to track the path of "embedded emissions"--the CO2 and other greenhouse gases emitted at each step of a product or service's supply chain--through the economy. Some of this is already done voluntarily by companies participating in various sustainability reporting efforts, but it would be new for many others. The EPA, Department of Energy, and numerous non-governmental agencies have done much work to quantify such emissions, but a carbon tax would require a level of rigor and audit trail consistent with the creation of what amounts to a shadow currency within the economy.

A carbon tax also raises similar questions of how to spend the resulting revenue that have bedeviled cap & trade. At the current US emissions and assuming few sources were exempted, the proposed $40 per metric ton initial carbon tax would raise around $275 billion per year. That's 8% of this year's federal budget. It doesn't take a cynic to guess that the first inclination of any Congress enacting such a tax would be to hang onto this money to fund new programs, reduce the federal deficit, or some combination, rather than returning it to taxpayers as former Secretaries Baker and Schultz and the economists who back them suggest.

Their proposal would require that the proceeds of the carbon tax be rebated to essentially the same people who would be paying it at the gas pump or in their gas and electric bills. This sounds similar to the "Cap and Dividend" approach to cap & trade proposed by Senators Cantwell (D) and Collins (R) a few years ago. Their bill had the great advantage of simplicity, requiring just a fraction of the 1,427 pages of the 2009 Waxman-Markey cap & trade bill, the main purpose of which seemed to be to redistribute vast sums of money outside the tax code. But like W-M, it went absolutely nowhere.

Like it or not, that's my best guess of the fate of the current carbon tax idea, too. The biggest challenge facing a carbon tax today is that it would not be running as a simpler, more market-oriented alternative to prescriptive legislation or complex EPA regulations. After all, the administration's intention appears to be to eliminate the EPA's main emissions-reduction regulation, the Clean Power Plan, not to replace it.

And although the new US Secretary of State, Mr. Tillerson, is on record numerous times in support of a carbon tax, that position seems to have been put forward mainly in preference to cap & trade, rather than on its own merits in the absence of any other strict climate policy.

A carbon tax would raise the effective price of energy commodities in which we appear to have a global competitive advantage, at least for now. The current proposal may rebate the carbon tax on exports, but most economic activity starts and ends within this country. And as noted in the NY Times op-ed by Dr. Feldstein and the other economists backing this measure, the revenue recycling to consumers would be on an equal basis, rather than proportional to usage, so there would be winners and losers as with any redistributive taxation. Lower-income Americans driving older cars seem likelier to come out on the short end of that than wealthier consumers driving new cars that meet rising fuel economy standards.

Ultimately, we must ask why President Trump or his team would want to impose a new tax on US consumers and businesses to address a problem that has probably just become an even lower priority for them than it was. Notwithstanding Mr. Trump's demonstrated unpredictability, the simplest answer seems to be that he wouldn't.

EPA's CO2 Rule and the Back Door to Cap & Trade

• Significant differences in EPA's proposed state CO2 targets for the power sector are reviving interest in cap & trade as a way to reduce compliance costs.
• This compounds the EPA plan's controversy and raises serious concerns about how the resulting revenue would be used.

Earlier this month the US Environmental Protection Agency released for comment its proposal for regulating the CO2 emissions from existing power plants. It follows EPA’s emissions rule for new power plants published late last year but takes a different, more expansive approach.  If implemented, the “Clean Power Plan” would reduce US emissions in the utility sector by around 25% by 2020 and 30% by 2030.

One of its most surprising features is that instead of setting emissions standards for each type of power plant or mandating a single, across-the-board emissions-reduction percentage, it imposes distinct emissions targets on each state. Based on analysis by Bloomberg New Energy Finance, some states could actually increase emissions, while others would be required to make deep cuts. The resulting disparities have apparently triggered new interest in state and regional emissions trading as a means of managing the rule’s cost.

Although emissions trading has become more controversial in recent years, it proved its worth in holding down the cost of implementing previous environmental regulations, such as the effort to reduce sulfur pollution associated with acid rain. It works by enabling facilities or companies with lower-than-average abatement costs to profit from maximizing their reductions and then selling their excess reductions to others with higher costs. The desired overall reductions are thus achieved at a lower cost to the economy than if each company or facility were required to reduce its emissions by the same amount.

Although the Clean Power Plan doesn’t require that states establish such emissions trading markets, its lengthy preamble includes a discussion of existing state greenhouse gas “cap-and-trade” markets in California and the Northeast. It also points out that measures to comply with the new rule may generate benefits in the markets for conventional pollutants, including those for the recent cross-state pollution rule. Administrator McCarthy also mentioned the benefits of multi-state markets in her speech announcing the new rule.

A patchwork of cap and trade markets across the US, including the addition of new states to mechanisms like the Regional Greenhouse Gas Initiative (RGGI), might help mitigate some of the cost of complying with 50 different CO2 targets. However, it would still be a far cry from the kind of economy-wide, comprehensive CO2 cap-and-trade system once contemplated by the US Congress.

Cap and trade was an idea that had gained significant momentum and even begun to appear inevitable, prior to the onset of the financial crisis in 2008. To supporters, it looked like a better way to limit and eventually cut greenhouse gas emissions than through command-and-control regulations. And the price it would establish for emissions would be based on the cost of achieving a desired level of reductions, rather than being set arbitrarily, as a carbon tax would be, without any guarantee of actual emissions reductions. Opponents viewed it as an unnecessary or unnecessarily complicated drag on the economy and a tax by another name, coining the pejorative term “cap-and-tax”.

Although early US cap-and-trade bills were bipartisan, including one co-sponsored by Senator McCain, the 2008 Republican Presidential nominee, the debate over cap and trade took on an increasingly partisan tone in a period of widening polarization on most major issues. The Waxman-Markey climate bill, with cap and trade as a major provision, was narrowly passed when Democrats controlled the House of Representatives in 2009, but various Senate versions failed to attract sufficient support, even when Democrats held a filibuster-proof supermajority in that body. The chances of enacting cap and trade legislation effectively died when a Republican won the vacant Senate seat for Massachusetts in January 2010. However, viewing this as a purely partisan divide is simplistic, at best.

Aside from opposition by key Senate Democrats, including one whose campaign included a vivid demonstration of his stand against Waxman-Markey, the versions of “cap and trade” debated in 2009 and 2010 bore little resemblance to the original idea. Waxman-Markey was a 1400-page monstrosity, laden with extraneous provisions and pork. Its embedded allocation of free allowances strongly favored the same electricity sector now being targeted by EPA’s Clean Power Plan, at the expense of transportation energy, for which low-carbon options remain fewer and more costly. It would have created a de facto gasoline tax, while yielding fewer net emissions reductions than a system with a level playing field. Subsequent bills, such as the Kerry-Lieberman bill in 2010, took this a step farther, removing transportation fuels from cap and trade and effectively taxing them at a rate based on the price of emissions credits.

Along the way, national CO2 cap-and-trade legislation evolved from a fairly straightforward way to harness market forces to deliver the cheapest emissions cuts available, to a mechanism for raising and redistributing large sums of money outside the tax code. In some cases that would have been done directly, such as in the gratifyingly brief Cantwell-Collins “cap-and-dividend” bill, or as indirectly and inefficiently as in Waxman-Markey. It’s no wonder the whole idea became toxic at the federal level.

Although emissions trading for greenhouse gas reduction came up short in the US Congress, it took hold elsewhere. The EU’s Emissions Trading System (ETS) is an outgrowth of the Kyoto Protocol’s emissions trading mechanism, which was included largely at the urging of the US delegation to the Kyoto climate conference in 1997. The ETS is focused on the industrial and power sectors and covers 43% of EU emissions. It has experienced significant ups and downs over the sale and allocation of emissions credits.

Cap and trade also emerged as a preferred approach for some US states seeking to reduce their emissions. California’s emissions market was established via a provision of the 2006 Climate Solutions Act (A.B. 32), and RGGI currently facilitates trading among 9 mostly northeastern states. The relatively low prices of emissions allowances in these systems–particularly in RGGI, which has traded in the range of $3-$5/ton of CO2–suggests that they may still be capturing low-hanging fruit in the early phases of steadily declining emissions caps. Their effectiveness at facilitating future low-cost emissions cuts is hard to gauge, because they also don’t exist in a vacuum.

Except for Vermont, all of the states involved have renewable electricity mandates that by their nature deliver more prescriptive emissions cuts. These markets have also been implemented in a generally weak US economy, which has constrained energy demand, and against the backdrop of the shale revolution, which has yielded significant non-mandated emissions reductions. Nor have these state and regional approaches to cap and trade entirely avoided the debates over how to spend their substantial proceeds that plagued federal cap-and-trade legislation.

For many years my view of cap and trade was that if we needed to put a price on GHG emissions, this was a better, more efficient option than an arbitrary carbon tax, or other top-down method. My experience analyzing more recent “cap-and-trade” legislation left me with serious doubts about our ability to implement a fair and effective national cap-and-trade market for CO2 and other greenhouse gases within the current political environment. Whether on a unified basis or in aggregate across many smaller systems, the enormous sums it could eventually generate are simply too tempting to expect our legislators and government agencies to administer even-handedly.

Whatever its potential benefits and pitfalls, I can’t help seeing cap and trade as a distraction in the context of the EPA’s proposed Clean Power Plan. Even at its most efficient, cap and trade couldn’t render painless the wide disparities of a plan that would require Arizona to cut emissions per megawatt-hour by more than half, and states like Texas and Oklahoma to cut by 36-38%, while Kansas, Kentucky, Missouri, Montana and even California cut by less than a quarter–and under some scenarios might even increase their overall emissions. Cap and trade would merely be a footnote on the scale of transformation the EPA’s plan envisions for the US electricity sector.

A different version of this posting was previously published on Energy Trends Insider.

Chicago's Climate Exchange Shuts Down

I see that the Chicago Climate Exchange (CCX) will be winding down its CO2 trading operations by the end of the year and laying off staff. This is only surprising considering that the parent company of the CCX was acquired just this summer by the Intercontinental Exchange, though mainly for its successful European emissions trading market. In case you were wondering how long the odds against enacting cap & trade legislation in the US have become, the demise of the CCX is a signpost you can't ignore. If the symbolism of a popular Democratic governor using the Waxman-Markey climate bill for target practice during his recent successful bid for the US Senate wasn't clear enough, it looks like his bullet may have also hit the CCX.

I recall a meeting with one of the founders of CCX at Texaco's corporate headquarters in New York prior to my leaving the company at the end of 2001. At that time, Texaco's management was coming around to the idea that sooner or later emissions of CO2 and other greenhouse gases would carry a price, for the first time in human history. Cap & trade offered a proven way to discover that price, based on the pioneering experience of US markets for sulfur dioxide, a cause of acid rain, and nitrogen oxides. The principles of emissions trading had been embedded in the Kyoto Protocol, largely thanks to the efforts of the US delegation, and European countries were setting up the precursors of the EU Emissions Trading System to manage mandatory carbon reductions. Such developments still appeared to be somewhere over the horizon in the US, which never ratified Kyoto, but they seemed likely to find their way here, eventually. One of the main selling points of the CCX, which was based on voluntary emission reduction commitments by member companies, was that it would provide valuable early experience in a formal market for emissions reductions, giving participants a leg up when such trading was required by law. This argument didn't persuade my former employer, but a number of other companies signed up.

If this scenario now seems like a quaint strand of alternate history--a "what if?" that never materialized--that perspective is quite recent. The prospects for CCX and wider emissions trading looked reasonable for a long time. The value of the CCX contract peaked in mid-2008, when it had become apparent that the ultimate presidential nominees of both major US political parties would be candidates who supported cap & trade, with the Republican even having previously co-authored Senate legislation on the subject. After a severe dip during the worst of the financial crisis, the contract recovered to around $2/ton after the new administration took office, but then swooned again as the Waxman-Markey bill, with its heavily skewed version of cap & trade, neared passage. As the likelihood of parallel Senate action on climate legislation receded, it never really recovered.

In its editorial on the termination of the Chicago Climate Exchange, the Wall Street Journal suggested that the market has delivered its verdict and the idea of national-level cap & trade is now dead in the US. Perhaps, but it certainly doesn't signal an end to all CO2 trading here. Aside from the state and regional programs to which the Journal alluded, companies with global operations subject to emissions caps in other countries will still be active participants in non-US emissions markets, and firms that remain committed to voluntary reductions in the US may continue to trade with each other, via brokers, or with over-the-counter market makers.

For that matter, I can't help wondering whether cap & trade is truly as dead as a Monty Python parrot or just resting. I'm reluctant to let go of an idea I've supported for a long time, but I also still see significant advantages for cap & trade over other means of putting a price on greenhouse gas emissions. Although the idea of carbon pricing may have gone out of fashion in the US, major tax reform for the purpose of deficit reduction could make it much more difficult to provide the monetary incentives for renewable energy technologies that we do today. Without those subsidies or a price on CO2, renewables will have a hard time competing with fossil fuels. And if our only other choices for emissions reduction were mandates or the command-and-control approach for which the EPA is now gearing up, then cap & trade and the emissions trading that makes it work might no longer look quite so appalling to their critics. In that case, the companies that participated in the CCX during the last seven years might not have wasted their time, after all.

FYI, I'll be participating in a webinar on the sustainability aspects of natural gas next Monday at The Energy Collective . To sign up follow this link. In the meantime, I wish my US readers a very enjoyable Thanksgiving. New postings will resume next week.

Whither Cap & Trade?

Just a year ago it seemed a near-certainty that the US would eventually adopt some form of cap & trade mechanism for greenhouse gases (GHGs). After repeated failed attempts to pass cap & trade legislation in the Senate, the House of Representatives narrowly passed the Waxman-Markey bill, HR-2454, and the Senate was expected to follow, bolstered by a filibuster-proof Democratic majority and urged on by a popular new President. Then came the divisive debate over healthcare legislation, the off-year election of Republican Scott Brown in Massachusetts, Climategate, and an oil spill that among other things derailed the latest bi-partisan (tri-partisan?) Senate climate bill. Today, the prospects for climate legislation remain highly uncertain, while the clock runs out on the current Congressional session. And if all that weren't enough, the EPA has just issued new regulations covering interstate emissions of conventional air pollutants that could effectively terminate the highly-successful sulfur-dioxide market upon which cap & trade for GHGs was based. Can cap & trade survive these travails, and should it?

Time will tell whether Waxman-Markey represented the high-water mark of cap & trade in the US, or if the hiatus since then has merely been a pause in a long process of refining and ultimately adopting this approach. Heaven knows W-M was a highly-imperfect vehicle for cap & trade, with its allocation of emissions allowances skewed to the highest-emitting sector and with hundreds of pages of extraneous provisions that could set up all sorts of unintended or undesirable consequences. The last year has also seen a proliferation of variations on cap & trade that call into question the original formulation of an economy-wide cap on emissions implemented by means of requiring emitters to purchase allowances from a gradually-shrinking national pool of emissions credits, with the proceeds doled out by Congress for purposes including clean energy R&D and deployment, deficit reduction, and mitigation of the impact on consumers and selected businesses. The Cantwell-Collins bill, for example, proposes returning most of the allowance revenue directly to consumers, while the Kerry-Lieberman bill would exclude the transportation fuels sector from cap & trade, but impose on it a sort of carbon tax based on the price of traded allowances. Both of these approaches have complex pros and cons, and as with original cap & trade their effectiveness at reducing emissions without imposing crippling costs on the overall economy depends critically on their detailed provisions, negotiated exceptions, and how they would actually be implemented.

Cap & trade has also come under fire on more fundamental grounds. Some critics have questioned the desirability of creating a vast new financial market for emissions when the shortcomings of other financial markets have caused so much harm, while others have suggested that investing in innovation to make low-carbon energy and efficiency much more cost-effective has greater potential to reduce emissions in a world in which developed-country emissions are being eclipsed by those in developing Asia.

Against this backdrop EPA Administrator Jackson's repeated assurances that she prefers legislated cap & trade to enforcement under the Clean Air Act have become increasingly divorced from reality. Her agency's determination to proceed with enforcement next year if no bill is passed, coupled with its newly-issued rules for power-plant pollution, serve mainly to remind the market that emissions allowances are not a new form of fiat currency, with intrinsic value backed by fractional reserves and the full faith and credit of the US government, but a fragile construct, the value of which can be eroded or erased at the whim of this and other regulators or the courts. Today's Wall St. Journal describes the impact of the new air pollution rules on the SOx market. Any potential participant who imagines that something similar couldn't happen to a future greenhouse gas allowance market is not paying attention.

So despite the apparent enthusiasm of the majority party's Senate caucus for enacting some kind of comprehensive climate and energy bill this year, presumably including elements of cap & trade, we're left with serious questions about whether this is an idea whose time has come and gone. From my perspective, putting a price on GHG emissions is still an essential step if we're serious about reducing them by more than the amounts that have resulted from the inadvertent combination of the recession, cheap natural gas, and existing incentives for renewable energy and efficiency. Cap & trade still has significant theoretical advantages over an arbitrary carbon tax as a means of imposing such a price, but as we've seen the likelihood of cap & trade being enacted in such a pure form seems low in the messy world of US politics--perhaps as low as the chances of a pure and simple carbon tax.

The odds against cap & trade look long at this point. Realistically, the time left for bringing a full-blown climate bill to a vote in the Senate is measured in weeks, rather than months, before the dynamics of the mid-term election campaign take over. Notions of passing an energy-only bill and then grafting on Waxman-Markey's climate provisions via a House-Senate conference committee seem even less likely to produce a mechanism that could survive the political upheaval that the mid-terms appear likely to produce. Nor should anyone be considering the last-gasp option of trying to pass climate legislation in a lame-duck session after the November election. As the Congressional Budget Office recently determined, any sort of controls on emissions are likely to reduce overall US employment--"green jobs" notwithstanding--so getting this right must be treated as more important than just getting something through before the current window closes. I will be watching developments in the weeks ahead with great interest.

Regulating EV Recharging

A feature on the New York Times website tipped me off to a debate that's brewing in California concerning whether and how the state's Public Utilities Commission (PUC) should regulate facilities and firms that will recharge the electric vehicles expected to dot California's roads within a few years. From my own experience in attempting to involve my former employer in the recharging infrastructure for the old GM EV-1 in the late 1990s, I knew this wouldn't be a simple matter, but I had little appreciation for the complexities that have emerged in the last decade. How this gets resolved will have enormous implications for automakers and incumbent utilities, as well as for start-ups such as Better Place that some would like to treat as regulated utilities.

The discussion with the PUC hinges on some very thorny questions: Is a company that buys electricity for resale to consumers for the purpose of recharging electric vehicles--which takes in both battery-electric vehicles and plug-in hybrids--more like a utility or a gasoline distributor or retailer? Who should pay for installing recharging facilities, and how--and from whom--should these parties recover their investment? Should a consumer who already uses large quantities of electricity at home and pays at the top rate tier, which can hit $0.40/kWh in some areas, qualify for discounted power to recharge an EV? How should a customer be billed when recharging outside the service area of the utility from which he normally buys power? The list of such questions is long, and looming behind them are larger questions about how best to gauge the effect of EV recharging on greenhouse gas emissions and air quality concerns, and to manage its impact on the regional generating mix, and on grid stability and reliability. Many EV advocates assume that EVs are inherently grid-stabilizing and renewable power-enabling, though it's not hard to construct scenarios in which the opposite could be equally true, if they're not implemented properly.

The emissions aspect becomes even more interesting in light of the views I saw expressed in a PUC filing by Tesla Motors, Inc., a Silicon Valley manufacturer of high-end electric sports cars that recently qualified for a half-billion dollars in low-interest expansion loans from the federal government. Tesla sees the generation of tradable credits under either cap & trade or the state's Low-Carbon Fuel Standard as a significant source of revenue for the owners of EV recharging facilities, and they might be right, though when I converted the federal estimates of emission allowance values under Waxman-Markey of around $15/ton of CO2 to cents per kilowatt-hour, using California's natural gas-dominated average generating mix, I came up with a value of less than a penny per kWh. I have to wonder how excited utilities will be to take on the cost and risk of putting in EV rechargers for such a small reward, if they can't also make a profit selling power to EV drivers.

The whole notion of regulating resellers of electricity to EVs as utilities also raises serious questions about the alternative business models now under consideration by companies such as Better Place. Would offering EV services on a cents-per-mile basis, rather than cents per kWh, be deemed sufficiently transparent, and would they have to negotiate their profit margins and investment recovery with the PUC? That sounds like a great way to make it harder for anyone new to the scene to compete with traditional utilities in this area.

Fairly soon the California PUC will resolve most of these questions and in the process largely define the environment in which EVs will emerge in the biggest early market for them in the US, potentially setting the standards for their use throughout the US and beyond. I don't have a horse in this race, but I will be watching the outcome with great interest.

Misguided Incentives

Today's Wall St. Journal includes an interesting article on the emerging controversy concerning Germany's subsidies for solar power and their unintended consequences for that country's solar industry. It seems that solar incentives there have been so generous that they have discouraged German solar manufacturers from focusing on becoming competitive, rather than merely bigger. As a result, a growing share of the incentives is going to foreign firms that can sell these products cheaper. The hue and cry about this suggests that perhaps the original motivation behind the subsidy program, which not long ago was paying as much as a dollar per kilowatt-hour for power generated from solar panels, had at least as much to do with industrial policy as protecting the environment. In fact, Germany may have harmed the environment by wasting money on an impractical solution for such a cloudy place, when the same funds could have bought much greater emissions reductions in other areas of the economy. This should serve as a cautionary tale for those who are promoting similar incentives here, and for columnists--even those with a Nobel Prize in Economics--who argue that going green will be cheap. It won't be if we encourage the wrong technologies with bloated incentives.

At the heart of the solar debate in Germany is something called a "feed-in tariff" or FIT. It requires utilities to buy the output of qualifying solar power installations at a guaranteed fixed price well above the prevailing price in the power market. What's unique about the FIT compared to incentives such as the US federal renewable Production Tax Credit of 2.1 cents per kWh is that the funds to pay this green premium don't come from the government but from each utility's ratepayers. In other words, it is a mechanism for redistributing wealth from utility customers to the owners of solar installations, whether the affected ratepayers receive any solar power or not. The paradox of the FIT is that it makes the most sense when a technology is at its very earliest stages, producing so little energy that the cost to average utility customers is just pennies a month. The more solar power is produced and bought at inflated prices, the higher utility bills go and the less competitive the entire economy becomes.

So far, this just sounds like a political matter. Germany decided to nurture a large industry to build and install solar products and chose to pay for it by sending the bill to utility customers every month. That might even make a certain amount of practical sense, if not for two facts. First, the subsidy remains extravagantly generous, even after having been significantly reduced in recent years. It currently stands at a range of 34-43 €cent/kWh, depending on the kind of installation involved. At current exchange rates, that equates to $0.50-0.635/kWh. A recent study comparing levelized power costs for a variety of power technologies puts the cost of unsubsidized solar power between $0.26-.32 for the crystalline silicon photovoltaic cells that most German solar firms produce, based on an average capacity factor above 20%. After adjusting for Germany's much poorer solar intensity, the cost of solar power might rise to as much as $0.40/kWh, still well below the level of the FIT. This makes un-sunny Germany a remarkably attractive place to sell solar panels, and German companies haven't been the only ones to notice this. Suddenly the FIT looks like a means for Germans to subsidize Chinese solar firms, and that is not going down quite so well. More importantly for the success of Germany's solar industrial policy, the Journal indicates that the head of one of the country's largest solar module manufacturers is now arguing that German suppliers will not become efficient enough to compete in the global market for solar panels unless they are weaned off such generous support.

The high effective cost of the emissions reductions these subsidies are buying ought to be of equal concern to German policy makers. Even if you assume that each kWh of power generated by FIT-subsidized solar panels backs out a kWh generated from coal, the extra premium over the cost of other low-emission power sources such as wind is enormous. The difference in the average solar FIT vs. Germany's FIT for offshore wind of 13 €cent/kWh ($0.19/kWh) yields an effective cost of CO2 reduction from solar of about $400 per ton. That compares to a current price for emissions credits on the European Climate Exchange of around $19/ton CO2. The more you pay for reducing emissions, the less of them you can afford to reduce, even in a prosperous country like Germany.

At the end of the day, German politicians appear to have spent billions of Euros of German consumers' and businesses' money to build a solar industry that has thrived on the installation of high-costs solar panels in one of the least suitable countries for solar power imaginable, and that may not be able to compete internationally without drastic restructuring. This initiative has also failed dismally as climate policy, purchasing less than 5% of the emissions reductions that could have been bought had this money been spent on other, more cost-effective power technologies or on energy efficiency. The further irony is that much of the German investment in solar technology to date would have to be written off should it turn out that the current generation of technology can't be made cheaply enough under any circumstances, and crystalline silicon cells ultimately give way to cells relying on non-silicon thin-film techniques or novel nanotech-based designs. These are the perils of industrial policy masquerading as environmental policy, and it is hardly a winning case for the application of a similar FIT in the US.

Cap & Trade, Gas Prices and Uncertainty

Over the weekend a New York Times editorial critical of the energy industry for trying to stir up opposition to the Waxman-Markey climate bill prompted some further thought on the potential impact of the legislation on gasoline prices. The Times appears to accept the government's analysis suggesting that the increase would amount to no more than 20 cents per gallon by 2020, though this conventional wisdom collides with common sense, since such a low price on carbon seems unlikely to stimulate sufficient conservation and investments in efficiency to deliver on a steadily-shrinking national emissions cap. In particular, the Times seems unfazed by the way the bill's allocation of free emission allowances is stacked against the oil industry, suggesting that it, of all industries, can surely afford the extra burden. Yet it's precisely that distortion that I believe could throw all of the official estimates of future permit prices--and thus gas prices--into a cocked hat, when you consider the possible dynamics of a market established along these lines.

Let's start by stating the obvious: I don't have a detailed computer model of the energy markets and US economy to query on the likely outcome from the cap & trade system that would be instituted under Waxman-Markey, though I could probably come up with some drastically-undervalued credit default swaps for anyone who believes in the infallibility of such models. My assessment relies instead on logic and the experience of a career that included a long stint in energy commodity trading, including futures, options and derivatives. Based on that experience, I believe the crucial starting point for any attempt to understand how a new market might function is supply and demand: who has the commodity in question and who needs it.

Begin with demand. The Department of Energy's recent "flash estimate" of US CO2 emissions indicates that the electricity sector accounts for 41% of emissions, followed by transportation with 33%, and the non-electricity-related emissions of the industrial sector a distant third at around 17%. These three segments thus account for 91% of our CO2 emissions, by far the largest component of our greenhouse gas output. Under cap & trade, every ton of those emissions would have to be matched with a corresponding emission allowance, or the emitter would be liable for penalties at a multiple of the going price for allowances. Anyone who is given fewer allowances than their current emissions must thus either reduce their emissions directly or purchase allowances from others. But who are the likely sellers? A careful reading of the bill provides strong hints

Under President Obama's original concept of cap & trade, in which 100% of emission allowances would have been auctioned by the government to the emitters that needed them, all sectors of the economy would have been in the same position of needing to cover their entire shortfall in the market. The government would have been the primary seller, though as the market evolved, companies that found cheap ways to reduce their own emissions would have ended up reselling allowances they had bought earlier, at a profit. Under Waxman-Markey, by my tally roughly 60% of the emission allowances would be handed out to emitters such as utilities, refiners and other industrial firms. Another 30% or so would be doled out in lieu of cash to fund efforts such as renewable energy R&D and deployment, climate adaptation and assistance to low-income consumers. Something less than 10% would be auctioned by the government itself to fund deficit reduction and other initiatives.

So on a given day, who would be selling and who would be buying? Consider the utilities and merchant power generators. As generous as the bill's authors were to this sector, it would still be short allowances from day 1, with a gap between actual emissions and free allowances equal to roughly 4% of US emissions. Non-energy industrial firms probably wouldn't be selling, either, at least unless the price got high enough to stimulate the big investments in energy efficiency that haven't risen to the top of their capital budget priorities so far. Initially, they would need to acquire allowances equal to around 5% of all emissions. And that brings us to refiners, who under Waxman-Markey would be responsible for their own emissions plus all of the emissions from the end-use of their products by non-regulated consumers, yet would receive only a 2% allocation of free allowances. Depending on how upstream production and oil imports are counted, the gap that refiners would need to cover could amount to more than 31% of all US emissions, or 3/4ths of the allowances given to non-emitting entities or auctioned directly by the government. At the same time, they have only modest scope for further reductions in their own emissions, considering that they are already 90% energy-efficient, on average. Who would be likely to have the advantage in such a situation? It sure looks like a "sellers' market" to me.

I don't doubt that refiners could probably scoop up some relatively cheap allowances from groups that get handed these tickets and don't quite know what to do with them, though market sophistication--and for-fee advice on such matters--might spread quickly. But refiners wouldn't just need to sweep up the stragglers, here. They'd require the entire allowance streams of many of the legislation's chosen beneficiaries for years to come, nor could they risk coming up massively short in any year. To me that suggests an average acquisition price for allowances that could rise well above the notional $15-$20/ton expounded by the EPA and DOE, considering that the effective price ceiling provided by brute-force CO2 reductions such as carbon capture and sequestration is probably north of $50/ton, equating to 50 cents per gallon of gasoline. While an increase that high might not be the likeliest outcome, it is at least plausible, and it would be added not to current gas prices, which have been depressed by the recession, but to those that would prevail after the legislation went into effect, when the economy--and perhaps even fuel demand--was presumably growing again. It doesn't take a leap of imagination to combine these factors to get to the $4 per gallon that the Times appears to dismiss.

From the last sentence of the editorial, I have to conclude that the Times doesn't understand the rationale for cap & trade nearly as well as they think they do. The point of this approach and any well-structured legislation implementing it is not to wean the US off of petroleum, but to reduce our emissions of the greenhouse gases implicated in climate change. While that certainly implies lower emissions from the oil sector, and thus lower consumption, it is perverse and counter-productive to shelter higher-emitting sectors that have greater flexibility for reducing emissions. The Congress may have judged that consumers would complain more about higher electricity bills than about increases at the gas pump, which could always be blamed on other factors--and on a singularly unpopular industry. But in creating such a wide disparity of demand for allowances among business sectors, they risk driving the price of those allowances much higher than otherwise, imposing an unnecessary drag on the economy. Even if their protests are motivated by self-interest, the oil industry and oil consumers are right to point this out.

A Funny Thing Happened on the Way To Cap and Trade

How much of an unappetizing jumble can you put into a dog's breakfast, before the dog refuses to eat it? That is the question that the authors of the Waxman-Markey "climate bill" appear intent on testing, before it goes to an expected vote of the entire House of Representatives tomorrow. Aside from addressing truly momentous, economy-altering matters--a cap & trade system for greenhouse gas emissions and a national renewable electricity standard to promote green power even more than cap & trade would, anyway--this bill includes more than its share of tenuously-related add-ons, some of which might be nearly as significant as the provisions that have garnered the headlines. Nor has last week's Congressional Budget Office analysis settled all the questions about the bill's likely cost to the public, except to raise suspicions that if it truly amounted to only $175 per household per year, there wouldn't be so much fuss about it.

Let's start with those costs, before we come back to the miscellaneous provisions that begin on page 808 of 1092. The CBO examined the cap & trade provisions of Waxman-Markey and its issuance of free emissions permits to various sectors and groups. They then allocated the costs among all American households by quintile of income. That's an important detail, because of the bill's provisions for rebates and other assistance to lower-income families, the lowest-earning of which would actually come out ahead in their analysis. For the rest of us, I believe the key figures to focus on are not the estimated $235-340 per year "net cost", but the range of $555-1,380 per year in expected "gross costs" before "direct relief to households"--which if you read the bill doesn't look very direct at all. It consists mainly of those free emissions permit allocations that go to utilities and various other industries and groups, not consumers.

The other aspect of the CBO analysis to focus on is its assumptions, explicit and implicit. The key explicit one is the emissions permit price of $28/ton of CO2 from which these costs were derived. While it's certainly possible that permit prices might be that low in 2020--the equivalent of $0.25 on a gallon of gasoline or roughly $0.03/kWh on coal-fired electricity--in the long run they would likely rise much higher, in order to cover the cost of deeper, more difficult reductions in industrial and transportation emissions. The CBO's big, implicit assumption relates to the impact of cap & trade on the economy as a whole, which footnote 3 indicates is excluded, along with the impact of the bill's many other provisions. If cap & trade slows growth, as seems very likely, incomes would be lower and jobs less plentiful than otherwise--even if "green jobs" grew--and other taxes would need to increase to service the debt and cover growing entitlement costs. When you factor in these uncertainties, the probability that cap & trade would cost American families no more than a couple of hundred bucks a year looks low.

The other day I described the severe mismatch between actual US emissions and the sectors chosen in Waxman-Markey to receive the lion's share of free emission permits. The bill would also establish an "Emission Allowance Rebate Program" to help energy-intensive industries engaged in international trade. Remarkably, however, it states, "The petroleum refining sector shall not be an eligible industrial sector." So US refineries, which under this bill would be responsible for both their own emissions and those from the subsequent use of their products--in our cars, for example--could not seek relief for the permit costs associated with products they export to the Caribbean and other markets, while other industries could. That would hamper not only refinery profitability, but also their ability to produce a suitable mix of products for domestic consumption. Last year US refineries exported 1.8 million barrels per day of products to balance their operations and meet stringent US fuel specifications. Raising the cost of those exports would ultimately result in fewer US refineries and more petroleum product imports. That would make US fuel prices more volatile, while increasing the average Waxman-Markey premium at the pump, over and above the direct cost of emissions permits.

Now let's consider what else has been included in this bill. Among the surprises I found in its last few hundred pages was another $4 billion of funding for the cash-for-clunkers program I discussed last Friday, along with its extension until next April 1st. Another provision would give the Secretary of Transportation broad powers under an "Open Fuel Standard" to require auto makers to produce large volumes of flexible fuel vehicles--a key enabler for increasing the country's biofuel production above the amount that can safely be blended into ordinary gasoline. According to yesterday's Washington Post, it would also establish and fund a new multi-billion-dollar federal agency, the Clean Energy Deployment Administration, in apparent competition with the Department of Energy.

Moving further afield, Waxman-Markey would also impose sweeping new rules on energy commodity markets to allow the Commodity Futures Trading Commission to regulate derivatives and swaps and limit speculation. The CFTC would decide what constituted a "bona fide hedge" and what didn't, setting limits on how many contracts a non-hedging entity could hold--not just in the US but also on foreign exchanges dealing with US-based commodities. It would also control energy commodity speculation by index funds. And while these measures at least have a connection to energy, that certainly does not hold for Section 355, which would place strict limits on who could buy a credit default swap, and under what circumstances.

I hope you haven't concluded from the above that I am a wide-eyed idealist who is easily shocked by the way the world really works. This is not a case of liking an idea only in its most abstract form. Although I have long supported cap & trade as the best approach for reducing emissions, I always expected a certain amount of horse-trading to get there--and note that the Senate has yet to weigh in on this bill. Unfortunately, the central cap & trade provisions of Waxman-Markey have been sufficiently distorted to cast serious doubt on their likely efficacy in managing our actual emissions, while issues as important as the regulation of energy markets and credit default swaps surely warrant separate legislation that would expose these proposals to the scrutiny and transparency they deserve. This might be the way laws are made these days, but the insertion of a grab-bag of disparate provisions into a bill of this magnitude represents an act of legislative mischief. In the context of the similar process that shaped last year's version of cap & trade, the Boxer-Lieberman-Warner Bill, I have begun to wonder if it's even possible for cap & trade to be implemented effectively under our political system, or whether a simpler carbon tax might be less prone to this sort of excessive creativity.

Sequester Oil Instead of CO2?

I've been following developments in carbon capture and sequestration (CCS) for more than a decade, so I was intrigued to run across a novel suggestion for an entirely different approach, involving the "sequestration" of undeveloped oil instead of the CO2 emitted by power plants and other industrial facilities. Even allowing for the likelihood that this trial balloon by Ecuador is either intended to enhance its government's leverage in negotiations with potential oil developers, or constitutes an outright scam--the resources in question apparently lie beneath a designated national park--the idea of selling emissions offsets based on the carbon content of forgone oil output is just plausible enough to merit a bit of analysis.

The basic idea seems clever. If it's so hard to capture the CO2 from burning fossil fuels and prevent it from accumulating in the atmosphere, why not leave the carbon in the ground and take credit for that by selling emissions offsets? The benefit of such a transaction, in both environmental and economic terms, would hinge on two key parameters: the carbon content of the specific grade of oil involved and the extent of the reservoir holding it. In other words, how many barrels would be spared, and how many tons of CO2 would be avoided for each barrel? Neither figure could be determined with certainty without some actual drilling, but non-invasive seismic techniques might supply an estimate of the approximate size of the potential reserves involved, while the quality might be guessed by analogy to actual producing fields elsewhere in the country. With these estimates in hand, we could arrive at an approximate value for the avoided emissions.

Lacking detailed information on these Ecuadoran oil reserves, I'm going to punt on quantity and focus on quality and its implications for the unit price of the resulting emissions offsets. If there's enough oil there to be of commercial interest, then that ought to be a sufficient starting point to assess the merits of leaving it in the ground as a means of combating climate change. As a first approximation on quality, let's assume the oil is similar to the Oriente crude that makes up most of Ecuador's output. Oriente is a medium-sulfur, medium-gravity crude similar to the oil produced on the Alaskan North Slope and run in many US West Coast refineries. Its API gravity is listed at 29.2, corresponding to a density of approximately 308 lb. per barrel. Applying a little basic chemistry suggests that each bbl burned would emit roughly 1004 lb. of CO2, so if we knew what the oil was worth, we could easily derive a cost per ton of CO2.

Because the oil in question is still under the ground, its price can't be looked up on an exchange. However, companies are bought and sold on the basis of reserves that have yet to be produced. A recent report from IHS Herold and Harrison Lovegrove & Co., Ltd. indicated that the average value of such M&A transactions in 2008 implied a value of $11.51/bbl for proved reserves and $5.25 for "proved plus probable." The latter figure seems more relevant to the current situation, since the reserves in question couldn't be fully proved without precisely the kind of development work this idea is designed to avoid. Applying the lower "2P" figure to the CO2 calculation above results in an equivalent value of about $11 per metric ton of CO2 offset. That's roughly the same as the estimate for the proceeds from cap & trade implicit in the federal budget the Obama administration submitted to Congress and lower than the price at which offsets are trading on the European Climate Exchange.

The basic flaw in this analysis stems from the large difference between what a company might pay for the rights to oil still in the ground, compared to its ultimate value to both the resource owner and society once produced. Fundamentally, that value is much higher than the externality cost of the greenhouse gases that would be emitted along the way. If that weren't true, Europeans wouldn't pay the equivalent of $293/bbl to fuel their cars. Even if the oil in question were only worth today's long-dated futures price of around $75/bbl less production costs and a discount for quality versus West Texas Intermediate, the price of emissions offsets would have to approach at least $100/ton CO2 before the Ecuadoran government would be truly indifferent to leaving it undeveloped. At $100/ton, many other emissions reduction strategies would look more attractive, including the brute-force, industrial capture and sequestration of CO2 from smokestacks. However high the parasitic energy cost of such CCS, it would still allow most* of the energy content of fossil fuels to be applied to providing the global economy with electricity or transportation fuels, until other sources can expand enough to replace them.

The Washington Post article on this story concludes with a quote from a program director at the Nature Conservancy who characterized the idea as "probably ahead of its time." I'd go the next step and suggest that its inherent contradictions render it generally impractical. There are many reasons to forgo the development of some oil, and if Ecuador's Yasuni National Park is truly the marvel of biodiversity and unspoiled wilderness described, then leaving its oil untouched shouldn't require financial inducements extrapolated from guesses about the resources under its surface. At the same time, it's hard to see a country contemplating development of a less sensitively situated hydrocarbon resource being able to raise enough money from the sale of emissions offsets to make up for the opportunity cost of forgone profits, royalties and taxes from a production-sharing contract, not to mention the employment and other benefits to the national economy. Schemes like this shouldn't distract us from the urgent and important work of figuring out how to make true carbon capture and sequestration practical and cost-effective.

*(A good friend pointed out that my use of "most" here could be miscontrued to imply 90% or more. In fact, current estimates indicate that CCS would consume 1/4-1/3 of the energy output of a fossil-fuel fired power plant. That's consistent with the thermodynamics of combustion and CO2.)

The Non-Tax Tax

When President Obama campaigned in 2007 and 2008, cap & trade was the centerpiece of his strategy on climate change. The latest iteration of cap & trade legislation is being developed by the House Energy and Commerce Committee, within the broader Waxman-Markey Bill. After numerous hearings and comments, the revised bill is expected to be released later this week and put to a committee vote by Memorial Day. In the process, its approach to cap & trade has apparently evolved from an assumption that 100% of the emissions permits would be auctioned, to the current expectation that a large fraction of them would be allocated for some period at no cost to current emitters, particularly in the electric power sector. In some quarters, the potential impact of this change on the federal deficit is being viewed with alarm and treated as tantamount to a tax cut--never mind that the tax being reduced does not yet exist. For that matter, many politicians can't even agree on whether cap & trade constitutes a tax. I'm sympathetic, because while it has many of the same effects and features of a tax, it differs in at least one important respect: the revenue it raises is incidental to achieving its primary purpose.

One key feature of taxation shared by cap & trade is its potential to transfer large sums of money from taxpayers to the government. In that respect, cap & trade fits many people's definition of a tax. Since it would fall heaviest on consumers and productive industries, both of which are reeling from the effects of the current recession, I've argued for deferring its collection until economic growth has resumed. Even then, the more of its proceeds are recycled back to taxpayers in the form of relief on other taxes or simple rebates, the better the chances that it would not undermine a fragile recovery. Granting free allowances to current emitters--a form of temporary grandfathering--merely reduces the amount that would need to be recycled, as well as the risk that large portions would be diverted to other purposes. Although conventional wisdom has it that a similar allocation to the power sector and other industries in the first phase of the European Emissions Trading Scheme resulted in a windfall for utilities, the same result is far from certain here, because the structure of our power sector is different. But whether the value of these permits is captured by industry, government, or no one at all is ultimately immaterial to the real purpose of cap & trade, which is to put a tangible price on the marginal unit of carbon emitted. That's what will alter investment decisions and consumer behavior.

This is where cap & trade differs most from its first cousin, the simple carbon tax. A carbon tax would apply the same price--set by the government--to every ton of CO2 and other greenhouse gases (GHG). Since the US emitted 7.2 billion tons of GHG in 2007, the most recent year for which we have data, a carbon tax wouldn't have to be very high to raise a lot of money--but it also couldn't be so low that it didn't influence behavior. A tax of $20/metric ton of CO2-equivalent would add on average about $0.22 per gallon of gasoline and $0.012/kWh of electricity, while raising nearly $150 billion per year. If it took $100/ton to achieve the desired emissions reductions, that revenue could swell to over $700 billion per year--almost enough to close the budget gap, but also enough to be a serious drag on the economy. Cap & trade could deliver the same marginal cost of carbon, but with a significantly smaller net burden on the economy, by allocating a portion of the allowances at no cost.

The key to making that work would be to ensure that the total number of allowances auctioned and allocated each year created a shortage in the market; that's why you do this, anyway, as a means of shrinking emissions year after year. That shortage is what gives the allowances their value. If you issued exactly as many allowances as the tons of GHG we expected to emit next year, their value would be zero. But you also need to make sure that you don't grandfather so many emissions that no one needs to buy or sell allowances. If everyone can meet the target themselves, allowances would become worthless. So the trick is to give out just enough free allowances--reducing this allocation annually--to avoid creating a shock analogous to an oil price spike, but not so many to any participant or sector that they can opt out of trading and deprive the aftermarket of the liquidity it needs to function properly.

The problem today is that we already have a federal budget built upon the assumption of a certain level of revenue ($646 billion over the next 10 years) from the auctioning of emissions permits from a new system, the enactment of which remains uncertain. Once that revenue is in the budget, even if it has never been collected before, anything that reduces it risks throwing the whole edifice into disarray. This bit of aggressive planning has empowered two powerful constituencies: those who see cap & trade as a massive, and thus undesirable new tax, and those who see any weakening of it as a threat to fiscal stability. I will be watching with great interest as these groups grapple with cap & trade in the weeks ahead.

Taxing Carbon

While many observers were focused on the most obvious first represented by yesterday's presidential inauguration, I was thinking about another one: Barack Obama is the first US President elected on a platform that included putting a price on our emissions of carbon dioxide and other greenhouse gases to the atmosphere. Although the likelihood of that happening this year has receded somewhat, due to the weak economy, it would be just as momentous in a year or two. Either way, it's not a long interval in which to decide the best way to go about altering a practice that humanity has taken for granted since the discovery of fire. There are some very strong views on each side of the carbon tax vs. cap & trade dilemma.

Last week, the CEO of ExxonMobil made news when he came out in favor of a carbon tax, though in fairness, while Mr. Tillerson's remarks at the Woodrow Wilson Center in Washington, DC reflected a clear preference for a carbon tax over cap & trade, they fell short of advocating the immediate implementation of either. But however one chooses to parse his comments, the concerns he raised about cap and trade are entirely legitimate and must be addressed forthrightly in the political debate on limiting emissions of greenhouse gases (GHGs). One concern in particular seems likely to carry much more weight now than it would have a year or two ago:

"It is important to remember that a cap-and-trade system requires a new market infrastructure for traders to trade emissions allowances. This new 'Wall Street' of emissions brokers will take the emphasis away from the goal of reducing carbon emissions and focus its attention on trading on price volatility. For businesses and consumers, these market gatekeepers and resultant price swings add cost and they create uncertainty."

The idea of setting up a new market that will benefit traders and speculators is bound to raise some hackles, when these are widely viewed as having contributed to last summer's oil-price spike and to the larger financial crisis. If it weren't for one crucial shortcoming of a carbon tax, I would find Mr. Tillerson's arguments for its simplicity and predictability quite compelling, and the other justifications for cap & trade might be reduced to mere quibbles. To see why, let's consider the practical aspects of implementing either approach.

The ultimate goal of either cap & trade or a carbon tax is to reduce GHG emissions, in order to limit the extent of global warming and consequent changes in the earth's environment. These cuts are intended to begin gradually but quickly gather momentum to deliver substantial cumulative reductions in emissions within a few decades. Both cap & trade and a carbon tax would lend themselves to being carefully phased in, and either one could be rendered revenue-neutral, to minimize the undesired economic effects of a policy designed to alter our consumption patterns in fundamental ways, at least with regard to energy-intensive goods and services. In either system, vulnerable consumers and industries with few alternatives could be protected or given more time to adapt. And while cap & trade creates a strong incentive for companies and sectors with the lowest costs for reducing emissions to maximize their cuts and trade the resulting surplus with others who face higher costs, a carbon tax could be modified to allow some trading around the edges, capturing at least part of that benefit for the economy. The biggest distinction may also be the most basic: how is the price of emissions set in the first place?

In effect, the choice between a carbon tax and cap & trade boils down to a choice between the cost of CO2 being set by committee, or by markets. Whatever else disappointed investors might think about them, markets excel at price discovery. While I have little doubt that a blue-ribbon panel of economists, scientists and engineers could come up with a reasonable estimate of the level of carbon taxation required to reduce emissions by the desired amount, I have much more confidence in the logic of setting the desired level of emissions reduction in each year, and then allowing the price to emerge from the interaction of those whose livelihoods depend on meeting these limits, in real time. That preference is rooted in the risks of each approach.

If our hypothetical Carbon Price Committee sets the carbon tax too low, emissions will exceed the goal and they can ratchet the tax higher in the next period. However, if they set it too high, we'll beat the emissions targets, but the economy will shift too rapidly, and jobs and output in energy-intensive sectors will be shed faster than new, "green" jobs and products can be created. The result might look a lot like what we're experiencing today. Cap & trade has its own risks, though they tend to focus more on the effectiveness and efficiency of the program than on its consequences for the economy. Mr. Tillerson is right to identify problems of "verification and accountability," though there is already a large and growing body of experience in managing these issues, from the EU Emissions Trading System and from voluntary emissions trading--and the statutory SOx and NOx trading--that has been going on in the US for more than a decade.

In the final analysis, the decision to put a price on greenhouse gas emissions matters more than how it is implemented. At the same time, the latter choice will determine how effectively those reductions are achieved, and at what cost to the rest of the economy, where most of us will continue to earn our livelihoods and save for our future needs. I hope that the new administration will weigh these considerations carefully, in consultation with the Congress and all affected stakeholders, including our international trading partners, who could be affected in many ways by the result. The idea of a carbon tax deserves a fair hearing alongside cap & trade, once our leaders agree on the timing of limiting our emissions.

Candidates & Energy: Obama Revisited

The US Presidential election is now under three weeks away, after the longest campaign in living memory. Unsurprisingly, after several years of escalating oil prices, energy features prominently in the programs of both candidates, as does a response to growing concerns about climate change. Senator McCain and Senator Obama have spoken extensively on these issues, and both campaigns' websites feature lengthy discussions on US energy challenges and the possible solutions to them. Unfortunately, their ideas must be weighed in the context of a weakening economy and a federal budget deficit that may ultimately approach a trillion dollars per year. With their attention focused on the financial crisis and the shifting electoral map, it is not clear how much thought either campaign has devoted to reassessing their energy and climate programs in light of the changed circumstances in which the next administration will find itself. After flipping a coin, I will begin with Senator Obama and follow up with a review of Senator McCain's energy proposals within a week.

It seems appropriate at the start to remind my readers of this blog's determined non-partisan stance. My focus is on the candidates' energy policies and anything relevant to those, without making any endorsement. My goal is to provide my readers with insights on the energy aspects of these two candidates' proposals, including their pitfalls, based on my own perspective and experience. However important, energy is only one issue among the many upon which they should base their choice.

Senator Obama has a detailed, coherent energy plan, and his team has clearly spent a lot of time assembling and refining the energy proposals outlined on the campaign's website. Compared to the version I examined in January, during the primaries, the Senator's energy and climate framework has evolved and become more realistic. Although energy independence is still a major theme of Senator Obama's energy platform, his independence goal has become more specific and less ambitious. It is currently stated in terms of reducing our oil imports by an amount comparable to what the US receives today from the Middle East and Venezuela. That equates to around 3.3 million barrels per day, or roughly one-third of net US oil imports in 2007. As I noted recently, such a reduction just might be feasible, but not without a significant effort to ensure that US oil production does not continue to decline. Instead, Senator Obama appears to consider the US tapped out for oil, and apparently expects his energy independence goals to be met without more help from that quarter.

That assessment pervades his approach to the oil & gas industry, though recently he has described natural gas in more favorable terms. It is also consistent with his periodic citations of the "3% of reserves vs. 25% of consumption" soundbite, which drastically understates the remaining resource potential of the US. This may explain his 2006 vote against a modest expansion of the allowed drilling area in the Gulf of Mexico, and his restrained support for expanded access to oil & gas during this summer's Congressional debate on various drilling proposals.

If anything, he seems to regard the domestic oil industry not as a potential source of new supply, but as a source of new tax revenue. His short-term energy program leads off with one-time energy rebates--$1,000 per family or $500 per individual taxpayer--funded by a windfall profits tax on oil companies. He hasn't put a price tag on this, but assuming all taxpayers would be eligible, it would require on the order of $20 billion dollars per year in new taxes over the next five years. Although there are legitimate differences of opinion on the justification for such a tax, its consequences for future US oil output are unambiguous: what you tax more, you get less of. The most positive elements of the Senator's oil strategy feature some interesting ideas for extracting more oil from existing reservoirs through CO2 injection--simultaneously sequestering it. He also supports building a natural gas pipeline from Alaska to the lower-48.

With regard to climate change, Senator Obama shares my preference for an emissions cap with credit trading over a carbon tax. His version would be stricter than the one embodied in the Boxer-Lieberman-Warner Bill defeated earlier this year, with deeper cuts and auctioning of all credits. Although the latter reflects the view that partial auctioning in the EU's limited cap & trade system resulted in a windfall for emitting industries, it also increases the revenues that would be collected to well over $100 billion per year, based on current emissions and the likely cost of credits. The Congressional wrangling over how to spend the smaller windfall from Boxer-Lieberman-Warner was nearly enough to turn me against a policy I have promoted for nearly a decade. We also can't lose sight of the fact that, like a tax, cap-and-trade would raise energy costs for consumers and businesses. That may be a necessary evil, but it is still a fact that has received precious little attention in this campaign. If the price of emissions credits settles at the current European level, we would see gasoline go up by about $0.35/gal, and electricity prices rise by up to 3 cents per kilowatt-hour.

Nor would cap & trade supersede the existing system of selective incentives and tax credits. Initially, at least, it would be additive to these, and apparently also to Senator Obama's $150 billion plan to promote alternative energy technologies over the next 10 years, along with a new low-carbon fuel standard and a greatly-expanded federal biofuels mandate--from 36 billion gallons per year (BGY) by 2022 to 60 BGY by 2030. I still regard the 36 BGY target with its 21 BGY of cellulosic and other advanced biofuel as a stretch, since the first commercial-scale cellulosic biofuel plant has yet to start up. 60 billion gallons is beyond ambitious.

Not every element of Senator Obama's energy plan represents a departure from current policy. His proposal for a 4% per year improvement in Corporate Average Fuel Economy for vehicles is broadly consistent with the 35 mile-per-gallon fleet CAFE target for 2022 adopted in the Energy Independence and Security Act of 2007, and his proposed tax credit of up to $7,000 per car for plug-in hybrids and electric vehicles closely resembles the incentives included in the $700 billion rescue bill recently signed into law. And with regard to "clean coal", his approach seems similar to the Department of Energy's restructuring of its Futuregen program, earlier this year.

There is much to like about Senator Obama's positive vision of cleaner energy, focused on making America more self-sufficient. At the same time, it would impose the biggest and most intrusive changes on US energy markets since at least 1980, entailing the collection and redistribution of many hundreds of billions of dollars--not temporarily, as contemplated for the current federal intervention in financial markets, but on an effectively perpetual basis. The benefits of cutting our energy imports and greenhouse gas emissions to a more sustainable level would be significant, though if we are serious about reducing our reliance on unstable foreign oil suppliers, it is counter-productive to pit solar, wind and biofuels against domestic oil & gas, which today contribute roughly 30 times as much net energy to the US economy, and could do more. We may indeed be entering a new era of big government; however, while parts of the Senator's energy plan would stimulate new industries and new jobs, other portions would act as a drag on existing businesses, and on consumers. This may ultimately be necessary, in order to tackle climate change, but undertaking it during a recession would complicate efforts to revive the whole economy, not just its new green parts.

Climate Change and Unconventional Oil

While Americans are focused on the debate over expanded oil drilling, which might eventually add up to a million barrels per day of incremental oil production, a much larger expansion is underway north of the border, tapping Canada's oil sands reserves. Today's Financial Times (subscription required for full access) reports that environmentalists and socially-responsible investment funds are meeting today with Shell and BP, concerning the environmental and financial risks of the greenhouse gas emissions inherent in oil sands production. This has important implications for future oil supplies, particularly with oil prices falling to a level that might threaten further investment in oil sands, even without considering the cost of mitigating or offsetting the sector's CO2 emissions.

Worries about the greenhouse gas (GHG) emissions from oil sands operations are not new. Ten years ago my former company approached one of the large Canadian producers about employing Texaco's (now GE's) gasification technology to turn byproduct petroleum coke into gas to fuel the oil sands extraction process, incidentally creating an option for the CO2 to be sequestered in depleted oil and gas reservoirs. Neither the economics nor the consensus for action on climate change was sufficient to move ahead, at the time. But with Canada imposing stricter rules for industrial sources of CO2, and with a new global agreement on climate change in prospect at the end of 2009, that perspective may be shifting.

According to the FT, the groups in today's meeting in London are focused on the financial risks associated with emissions from oil sands--emissions that are several times larger than those from conventional oil production. Some are calling for a moratorium on new oil sands and oil shale projects. If oil were still over $120/bbl, that argument would carry little weight. Even if the most extreme estimate provided by Greenpeace were correct, suggesting that oil sands extraction emits 100kg more CO2 per barrel than conventional oil production, that would equate to under $4/bbl of extra cost, based on the price of 2012 emissions credits on the European Climate Exchange at current exchange rates.

Two factors render that figure more significant than it might appear. Falling oil prices are pushing new oil sands projects close to their breakeven point, according to Total, hampering the industry's ability to mitigate emissions. At the same time, the sheer magnitude of the oil sands expansion makes these emissions too large to ignore. The latest forecast from the Canadian Association of Petroleum Producers indicates that oil sands output should increase from 1.2 million barrels per day (MBD) last year to 2.8 MBD in 2015 and 3.5 MBD in 2020. Without making expensive changes in operations to reduce emissions and capture and store CO2, or buying emissions offsets, oil sands operations could increase Canada's current GHG emissions by as much as 10%. As a signatory to the Kyoto Protocol, the Canadian government cannot just look the other way, while these emissions mount.

There are many areas in which the goal of improving energy security aligns with reducing GHG emissions, including improved efficiency and more use of renewable energy. But oil sands--and by extension oil shale--represents a clear conflict between our desire to reduce our dependence on Middle Eastern oil and the need to halt the accumulation of greenhouse gases in the atmosphere. And with oil nearing $90/bbl, a $4 increase in production costs to manage CO2 could stall new development and reduce future oil output by enough to tip the global supply and demand balance even further in favor of OPEC and Russia. Unless the next administration is willing to sit down with our NAFTA partners to discuss a comprehensive North American approach to both energy and emissions, this matter will ultimately be settled in Ottowa, where neither the US Congress nor President can offer more than friendly advice.

Questioning Cap & Trade

For the last week or so I've been collecting editorials, op-eds and newspaper columns concerning the Senate's debate this week on legislation to cap US greenhouse gas emissions and establish a mechanism for trading credits among emitters. The range of opinion is broad, as are the sources, including the former Prime Minister of the UK, Robert Samuelson, George Will, and the editors of the New York Times, the Wall Street Journal and Washington Post. But whether pro or con, many of them appear to bypass some of the principle questions we should be asking about this legislation. The lead editorial in yesterday's WSJ comes close by focusing on the allocation of the enormous federal revenues that cap & trade would generate, but it misses the mark on the more fundamental question of considering the real alternatives to putting a cost on our emissions of carbon dioxide and the other GHGs.

Long-time readers of this blog know that I have supported cap & trade since before starting Energy Outlook at the beginning of 2004, dating back to my corporate career at Texaco, Inc., where I served on the company's Climate Change Council. I didn't arrive at that view in a single step. Besides undergoing something of a conversion experience on the risks of climate change itself, I spent a lot of time contemplating the various ways to manage these emissions, based on my engineering and financial background and commercial experience. The path by which the Congress is attempting to arrive at cap & trade skips at least one key step, even once you accept that the science is settled--which some still regard a debatable proposition. In particular, where is the vital public discussion on how best to reduce emissions, and why cap & trade rises above the other options?

Consider the Wall Street Journal's lead editorial on May 27. The Journal's editors referred to the pending Climate Security Act of 2008 as "the most extensive government reorganization of the American economy since the 1930s." They aren't necessarily wrong about that. They went on to describe the pitfalls of cap & trade as a "hidden tax" on the economy, and presented some of the obstacles to achieving the bill's emission-reduction goals. Unfortunately, their entire argument appeared to assume that the alternative to cap & trade was to do nothing, or to remain on the current path of voluntary abatement. But if climate change is the threat that most scientists believe, that is surely not possible.

There are two primary options for reducing emissions, with important variations on each. One option would simply extend the kind of environmental mandates that have been used for traditional air and water pollutants to greenhouse gases. This could be done by sector, by industry, or by technology, and it could be as simple as telling every emitter of CO2 and other GHGs--including consumers and the government itself--to begin reducing their emissions by 2.5% per year starting in 2010, subject to verification of compliance and stiff fines. That would deliver roughly the same emissions reductions by mid-century as the Boxer-Lieberman-Warner bill, and it would be much simpler than cap & trade. This approach would be complementary with and reinforce the effect of current incentives for new, less-emitting technologies, such as biofuels and renewable power.

The other main option is to establish a price for emitted greenhouse gases, and then to let the marketplace adjust to the monetization of this formerly free externality. Most economists and business leaders prefer this over mandates, because it would foster greater innovation and allow the most efficient companies and sectors to profit and grow, while gradually reducing the size and importance of the less-efficient. The economy would be transformed in the direction of higher GDP, instead of just lower output. Cap & trade represents an even more market-oriented subset of this approach, because rather than setting the level of a carbon tax and hoping that it reduces emissions by at least the desired amount, it specifies the increment of reduction required and allows the market to set the CO2 price and drive it towards the lowest marginal cost. So rather than seeing cap & trade as a top-down, bureaucratic drag on the economy, it might better be viewed as the means for achieving the necessary cuts in greenhouse gas emissions at the least burden on the rest of the economy.

In the process of selling cap & trade, we should avoid promising the public that it could be implemented at little or no cost to them, even if it generates long-term savings and growth. Yesterday I had a long conversation with Deron Lovaas of the Natural Resources Defense Council on this issue. His organization's analysis suggests that by 2020 consumers would actually spend less on energy than they do now, as higher efficiency vehicles and devices proliferated, and domestic energy production increased. While I certainly see the potential for that, I also definitely expect higher fuel prices short-term, as a result of the higher operating costs that cap & trade would impose on refiners and on oil, gas and power producers. Until vehicle fleets and capital stock have time to turn over, that will raise consumer outlays on energy. Mr. Lovaas also highlighted another aspect of the legislation that would promote carbon capture and sequestration, which when used as part of enhanced oil recovery could bring oil prices down by reducing imports. By its nature this, too, would take time to bear fruit. All of these effects reflect the complexity of the economy with which we would be interfering, and we should expect unforeseen consequences, both good and bad.

It is unlikely that the bill currently being debated in the Senate this week will become law this year. This is the opening salvo--or really just the most recent round--in a longer process that should also feature prominently in this year's presidential campaign, particularly since the remaining major-party candidates all support some version of cap & trade. As we attempt to build a national consensus for this measure, we can't afford to leave the public in the dark concerning the rationale behind the crucial choice between mandates and market-based solutions, and the pros and cons of cap & trade versus a carbon tax.