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.