Cap & Trade: No Free Lunch

One thing I still miss about living in the New York metro area is receiving the Times on my front doorstep every morning. So instead of pouncing on Tom Friedman's latest column the morning it's published, I often don't see it for a couple of days, until I run across it on the Internet. The net effect is to raise the bar for Friedman remarks on which I feel compelled to comment, because they're usually superseded by other, more interesting topics on which to blog. Unfortunately, the theme of Mr. Friedman's column of last Saturday is likely to be with us for some time, working its way insidiously into our assessment of energy and climate policy. Cutting through its convoluted logic, it suggests that we can significantly increase the price of energy to send a signal concerning greenhouse gas emissions but somehow end up spending less on energy and becoming richer in the process. While I continue to support the basic idea of a cap & trade system for managing our emissions, touting it to the public as a free lunch seems likely to set us up for a future backlash not unlike the one the financial industry is now experiencing, after we learned that the cheap credit we've enjoyed came with a steep hidden price.

In his script for a hypothetical speech by President Obama, Mr. Friedman sets out his thesis this way: "Yes, the cost of gasoline or kilowatt hours will rise in the short term. But in the long term, your actual bills and expenses will go down because your car, appliances and factory will become steadily more productive and give you more power for less energy." This exaggeration of the basic principle that higher energy prices stimulate greater energy efficiency incorporates several basic fallacies, the most important of which is that while higher prices affect all consumers and businesses more or less immediately--some businesses may have hedged their energy purchases for a time--their capital stock of energy-consuming devices turns over slowly. It also ignores the diminishing returns to higher fuel economy. Someone buying a new, more efficient car might offset most or all of the fuel price increase via higher fuel economy, but the other 93% of car owners are stuck with higher bills for at least another year. The only means by which the remainder of the population can manage this higher expense is through reduced consumption, if not of energy then of other goods and services. We saw that effect on steroids last year, and we are still living with the hangover from it. But even the consumer who bought the frugal car might be worse off, if it cost much more than the model he would have bought otherwise. In effect, he traded some wealth for lower expenses.

The impact on businesses looks similar. While business investment is hardly a zero-sum game, higher investment in energy efficiency would come at least in part at the expense of other kinds of investment, perhaps in new computer equipment or staff hiring or training. Higher prices on energy thus promote improvements in energy productivity at the expense of other kinds of productivity. Although this certainly reduces expenses, it would take some time to reduce them in absolute, rather than merely relative terms, and without increasing top-line revenue. That might sound equivalent in terms of its impact on profits, but it often isn't. Expense improvements tend to get competed away in the marketplace, and are thus often not sustainable sources of earnings. So while business investment in energy efficiency might ultimately shield consumers from higher prices for finished goods and services, it seems unlikely to do much for corporate profits or stock valuations.

Mr. Friedman's assertion ultimately rests on an energy analogy to the experience of the electronics industry. If there is a Moore's Law for energy, it has yet to be discerned, let alone quantified. In the early phases of any new technology, "experience curve" effects can emulate Moore's Law-style improvements for a while. Then, as cumulative output grows the rate of change slows dramatically. Last year's DOE study on the feasibility of obtaining 20% of our electricity generation from wind energy included some interesting observations on cost. While the cost of new wind power fell dramatically between the 1980s and 2000, in classic experience-curve fashion, that decline appears to have bottomed out in 2002 and actually reversed somewhat since then. Moreover, when wind capacity is pushed further along its supply curve, the cost of incremental capacity is expected to go up, as prime wind locations are exhausted and new development is forced into more expensive regimes, in coastal waters or further from markets. Creating a bigger market for energy efficiency won't necessarily drive the cost of efficiency dramatically lower than it is now, or will be once the wave of efficiency investments triggered by $100 oil and $10 natural gas rolls through.

Like Mr. Friedman, I believe we should put a price on emissions of greenhouse gases--if not this year then fairly soon--in order to promote efficiency and the adoption of cleaner technologies over time. However, we shouldn't imagine this will be easy or cheap, let alone something that will create mountains of new wealth out of, literally, thin air. Haven't we all just been through something like that, to our regret? We can't suddenly start collecting fees on behalf of an environmental service--storing our waste carbon in the atmosphere--that has been free since the dawn of time and expect that this won't impose a burden on someone. More precisely, it represents a different kind of wealth transfer than the one we all complained about last year--sending our money to OPEC--in which those who use energy (most of which is still derived from fossil fuels) will send money to those who use less of it and to those who are developing new ways of producing and using it with fewer emissions--and of course to those administering these programs. That should benefit investors in green technology, but someone else will get the bill.