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.

Not-So-Grand Compromise

This week Senators John Kerry (D-MA) and Joe Lieberman (I-CT) finally released the draft energy and climate bill they had been working on with Senator Lindsey Graham (R-SC.) From all accounts, it was intended to serve as a response to the various criticisms of the climate bill the House of Representatives passed last summer, but in particular as a means for attracting support from Senators whose primary concerns about energy are focused on US energy security and competitiveness. Unfortunately, events have a way of disrupting even the sagest strategies. A cursory review of the new bill--all I've had time for thus far--reveals the degree to which it has been altered in response to the ongoing Gulf Coast oil spill. In the process, unless I've misread its revised provisions on offshore drilling, the expected "grand compromise" has turned into a poisoned chalice, at least for oil.

Like its climate-legislation predecessors and most major bills from the last several Congresses, Kerry-Lieberman (originally Kerry-Graham-Lieberman) starts out at 987 pages and is likely to grow much larger, as it accumulates support one vote--and thus typically one new provision or modification--at a time. I simply haven't had a chance to read the whole thing in detail, yet. Once I've done so, I'll comment on its other key provisions, including the cap & trade mechanism at its heart, which seems to have been influenced by the "cap & dividend" proposal of Senators Cantwell (D-WA) and Collins (R-ME). With so much attention currently directed at offshore drilling, that's where I focused my brief review.

While the bill was being prepared, there was much speculation about the incentives it would include for expanded offshore drilling, which, along with expanded support for new nuclear power, was regarded as one of the principal carrots to be offered to those in Congress who wouldn't otherwise be inclined to support a standalone cap & trade bill. Whatever form those incentives were expected to take, the bill's skimpy offshore drilling "subtitle" looks disappointing, if not downright negative.

On the positive side, it would extend the same royalty-sharing benefits to states pursuing new drilling that the four main Gulf Coast producer states of Texas, Louisiana, Mississippi, and Alabama currently receive from oil & gas exploration and production in the federal waters off their coastlines: 37.5% of lease premiums collected and the same percentage of production royalties. This is something that states such as mine, with an official state policy supporting drilling, have been calling for. But while it will be favorably received in Virginia, other states, particularly in the West and Midwest, regard this as an unreasonable diversion of federal revenue. Even if the Deepwater Horizon hadn't blown up, this provision would have been a tough sell.

The rest of the offshore oil subtitle appears to have been hastily modified in response to the spill. Among other things, it offers states a veto over new drilling within 75 miles of their shores. A glance at the map for the planned Lease Sale 220 offshore Virginia shows that at least a portion of it falls within 75 miles of the Delaware and Maryland coasts. Nor do I think this is an unreasonable provision; as we've seen in the Gulf, a spill off Louisiana clearly affects the shorelines and marine activities of neighboring states. By itself, this provision, which I believe was altered from an original 50 mile exclusion, would not rule out a resumption of new offshore leasing and drilling, once the causes of the current spill have been identified and new measures and regulations put into effect to reduce the risk of another occurrence to an acceptable level--however the Congress and administration might specify "acceptable".

The problem lies in Section 1205, which defines the impact studies that must be done prior to opening up an area for drilling. As drafted, paragraph (h)(2) effectively extends the 75 mile limit on the veto rights of non-drilling states, if the government's assessment "indicates that a State would be significantly impacted by an oil spill resulting from drilling activities within an area identified in a 5-year (leasing) plan". Under this paragraph, Florida or Alabama could potentially veto any new drilling off Texas or Louisiana. I'm not a lawyer, but that's what the text appears to say.

Without dismissing the legitimate concerns of neighboring states, this raises all sorts of practical problems. An exchange I had earlier this week with a Maryland-based blogger highlights one of them. He was blogging in support of Senator Ben Cardin's (D-MD) stance against any offshore drilling on the Atlantic coast. However, as I noted in my comment on his posting, Maryland consumed 272,000 barrels per day of oil in 2008, not one barrel of which was either produced or refined in that state. Just how far should offshore drilling be removed in order to satisfy the concerns of a state that is entirely reliant on energy produced by other states and foreign sources, which must bear whatever risks it entails? Is Louisiana far enough away? Is Saudi Arabia?

As compromises go, this one doesn't look very tempting. Unless I've misread the bill's offshore drilling provisions, it appears that their effective result would be to end all offshore drilling, not just in areas that were recently released from long-standing drilling moratoria, but in the long-established zones of the Gulf Coast that are becoming America's energy breadbasket. That would surely qualify as the kind of overreaction to the Gulf Coast spill of which the International Energy Agency has just warned, emphasizing the unintended consequences that we would risk. Perhaps those looking for something in exchange for supporting limits on greenhouse gas emissions will regard the bill's significant support for nuclear power as sufficient, though I'm skeptical. They could probably get the same thing in an energy-only bill, perhaps in exchange for a national renewable electricity standard. As for the crucial source of domestic transportation energy we would forgo if we turned our back on offshore drilling, there is currently no substitute available soon enough, or in sufficient quantities, to make up for its loss.

What's the Alternative to KGL?

Although I haven't yet seen the latest discussion draft of the "tri-partisan" energy and climate proposal of Senators Kerry, Graham and Lieberman (KGL), I've been thinking about its rumored provisions for a while. These apparently include a cap & trade system for the electricity sector, eventually expanding to include most industries, and a "carbon fee" on petroleum fuels that would be linked to the cap & trade market, along with measures to increase domestic energy production from a wide range of sources, including oil. It occurs to me that the most important question about the resulting legislation may not concern its actual contents, but what we ought to compare it to.

For all the remaining uncertainty about the risks of climate change, which this week's Economist details, the US regulatory baseline for it has already moved beyond doing nothing. Having issued its Endangerment Finding, the EPA is gearing up to regulate greenhouse gas emissions from both stationary and mobile sources. Almost any other approach to these emissions would be preferable, since regulating point sources ignores the fundamental differences between CO2 and the traditional pollutants like the oxides of nitrogen or sulfur they've been dealing with for decades. If we fail to capitalize on the helpful reality that all GHG emissions anywhere are essentially equivalent in their effect on the climate, we likely won't tackle the cheapest reductions first, and that could cost us a fortune. Yet even without some form of national greenhouse gas legislation or regulations, these emissions are already being regulated at the state level through efforts such as California's A.B. 32 and the Regional Greenhouse Gas Initiative. In that context, whatever one's assessment of the underlying science, we all have a stake in Congress passing the most practical and cost-effective greenhouse gas legislation possible. Sadly, the blatant favoritism and profligate spending of the Waxman-Markey bill that passed the House last spring disqualify it on both of these criteria.

One of the biggest challenges for KGL is ensuring that their bill doesn't end up as a bloated monstrosity like Waxman-Markey. You don't need 1,000 or more pages to define a cap & trade regime or a carbon tax, or to set up "cap & dividend", under which most of the money collected from selling emissions permits would flow back to taxpayers. (That approach has its own problems.) You do need hundreds or thousands of pages, however, to accommodate all the pork and giveaways that seem to be necessary to get any major legislation passed these days, one vote at a time. Careful scrutiny of the text of the Waxman-Markey bill suggests that there is not a majority of this Congress--or perhaps of any actual Congress we're likely to get--that sees the necessity of crafting a clear response to climate change as trumping the need to score goodies for their districts and favorite causes or constituencies. Messrs. K, G and L have their work cut out for them, finding enough support for their proposal through its primary provisions, rather than accreting dozens or hundreds of tit-for-tat favors.

Perhaps the key to a successful bi/tri-partisan bill could be found in its approach to the uses of the enormous revenues it would generate. The healthcare bill that passed the House last weekend only achieved deficit neutrality by taking a huge bite out of the revenues and savings that might otherwise have gone to bringing Medicare or Social Security back into balance, and that's not a partisan talking point. If we are indeed facing an entitlements crisis on the scale that many expect, and some form of consumption tax is on the horizon as the only viable revenue alternative to a return to the bad old days of confiscatory taxation on upper-income Americans who already pay 86% of all the federal income tax collected, then energy might be a good place to start. A fee of 25 cents per gallon--roughly equivalent to $25/ton of CO2 emitted--on gasoline, diesel and jet fuel would collect on the order of a half-trillion dollars over 10 years.

If KGL do go down the path of a carbon fee on petroleum, the biggest mistake they could make would be to follow the advice of the economists and experts who advise collecting it as far "upstream" as possible. Taxing refineries is a sure recipe for offshoring one of the few remaining basic manufacturing industries in this country that has managed to remain globally competitive, even if it has fallen on hard times recently. Likewise, taxing US oil & gas exploration and production would make them uncompetitive with foreign sources free from such burdens. Instead, since most of the emissions from the petroleum value chain occur during consumption, rather than production, the best place to apply a carbon fee--can't call it a tax--is at the gas pump. This would subject domestic and imported fuels to the same cost without having to go through gyrations to manage "leakage", only to find out later that they violate international trade rules. Best of all, the government already has the mechanism in place to collect such a fee without adding another expensive bureaucracy: Simply tack it onto the federal fuel excise tax and post the amount on every fuel dispenser whenever it changes.

In a perfect world, we'd establish a price on carbon using a simple and transparent cap & trade mechanism and return every penny collected to the public, in order to minimize the burden on the economy while shifting it in the direction of greater energy efficiency and lower emissions. In the last several years it has become abundantly clear that we don't live in that world, if we ever did. I still favor cap & trade as an efficient mechanism for price discovery, but not if its implementation comes with as much baggage as Waxman-Markey carried. I will eagerly await the details of the KGL proposal to see whether they can navigate the narrow gap between an effective, efficient approach to GHG management and the political forces seeking to feast on the bonanza it represents.

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.

Time to Choose

Last week's finding by the US Environmental Protection Agency that greenhouse gas emissions "threaten the public health and welfare of current and future generations" should not have come as a surprise. It has been virtually inevitable since the Supreme Court decision in Massachusetts v. EPA two years ago, and it was rendered imminent by the election last November of Barack Obama, who made responding to climate change a centerpiece of his presidential campaign. Whatever you might believe about the risks of climate change, we no longer have a choice between addressing them or ignoring them. Representative Edward Markey (D-Mass.), who chairs the Select Committee on Energy Security and Global Warming, responded to the finding by saying, "It is now a choice between regulation and legislation." I don't think that's quite accurate, particularly since his own proposed climate legislation includes many strong regulatory features. Instead, I believe the choice lies between relying primarily on an explicit price for emissions to nudge consumers and businesses away from emissions-intensive activities, and employing a more prescriptive approach using mandates, "standards", and air pollution-style rules on smokestacks and tailpipes. Long-time readers won't need to infer my position on this matter from the way I've described that choice.

I've argued the case for cap & trade numerous times on this blog and in front of various audiences, corporate and public. I've also expressed my misgivings about the imposition of a strict cap & trade system in the middle of a recession, particularly if the government intends to use the revenues from cap & trade to fund a dog's breakfast of non-energy programs, rather than returning the bulk of it to taxpayers. I've even suggested that under some circumstances a simple carbon tax might be preferable to cap & trade, since both serve the purpose of establishing a price for emissions, to which our market economy must respond by shrinking emissions-intensive sectors and growing low-emissions ones, including the renewable energy sector with its vaunted "green jobs." I've spent less time, however, examining the regulatory approach, perhaps because I regarded it as self-evidently inferior, particularly if it looks more constraining than the version of cap & trade that might accompany it. It is abundantly clear that many others do not share that view.

The main appeal of the regulatory path is that it would build on long experience in managing other environmental impacts--including many from energy systems--under existing federal and state air and water quality regulations, the federal Renewable Fuel Standard (RFS), and numerous state-level renewable electricity standards (RPSs) and other regulations. But these programs also illustrate some of the severest drawbacks of this approach, in the complexity and overlapping nature of these rules. Regulating emissions that are not incidental to, but rather a fundamental consequence of the use of our principal energy sources would add further layers of complexity without subtracting any, as cap & trade might eventually be expected to. We already have trading in Renewable Energy Certificates (RECs) for state RPS compliance, Renewable Identification Numbers for compliance with the federal RFS, and sulfur and nitrogen credits for compliance with the Clean Air Act's rules for criteria pollutants. And because the GHG emissions from motor vehicles are determined largely by how much fuel they consume, efforts at regulating tailpipe emissions become de facto fuel economy regulations, in conflict with the federal Corporate Average Fuel Economy regs. (This is the matter on which California eagerly awaits a waiver from the administration to pursue its legislated Low-Carbon Fuel Standard.) With all due respect to the dedicated professionals at the EPA, anyone contemplating leaving the regulation of greenhouse gas emissions to that agency should be required to pass a test demonstrating that they understand the EPA's notice implementing the RFS for 2009, which involves the comparatively much simpler task of setting the required ethanol percentage in gasoline for the year.

We are now at the point that I have long feared we would be, if we mislabeled carbon dioxide as a pollutant. While the consequences of excess CO2 and other naturally-occurring greenhouse gases certainly live up to the terms the EPA has applied in its finding, unleashing a pollution mentality to solve climate change will be counter-productive and unnecessarily expensive, when dealing with a phenomenon for which a ton of CO2 emitted, captured or avoided in Boston is exactly equivalent in its climate impact to a ton emitted, captured or avoided in Beijing. We would have been much better served if the Supreme Court had paraphrased the Hitchhikers Guide to the Galaxy and found that CO2 was "almost, but not quite, entirely unlike" pollution, yet here we are.

By next year's Earth Day, the 40th anniversary of the first one, I expect that we will have made our choice between these competing approaches. We see signs of this in the apparent determination of the administration to arrive at the Copenhagen climate conference this December having taken concrete steps here, and in the competing cap & trade bills making their way through the Congress. I can understand that opponents of strict legislation on climate change might regard the EPA's endangerment finding as a high-stakes game of chicken. But whether it serves as an implicit threat or merely an insurance policy against protracted legislative delay, it--rather than inaction--represents the new baseline. Anyone who has been sitting on the fence must now decide which approach is likely to be more effective in dealing with the US contribution to global warming, while simultaneously doing less harm to our economy. After long and careful scrutiny of the options, and after spending a career in an industry that has already been regulated to the gills, I find pricing emissions by far the most attractive solution. This is anything but a trivial decision, though it is one that must be made, and soon, before the default option becomes as inevitable as the endangerment finding was.

It's the Economy

Yesterday afternoon I attended a panel discussion in the Capitol building, featuring one Senator, two Members of the House of Representatives, the new CEO of API and two senior journalists from Newsweek, which hosted the event. The discussion covered a wide array of energy topics, including offshore drilling, taxation, renewables, and climate change. Although there weren't many surprises, I was not expecting to hear such uniform skepticism on the prospects for passage this year of a cap & trade bill regulating emissions in the manner proposed by President Obama. With the exception of the Honorable Doc Hastings (R, WA), who questioned the contribution of anthropogenic CO2 to climate change, the common theme appeared to be that the dire state of the economy and the need for sensible energy policy take precedence over stronger action targeting greenhouse gas emissions. In this regard, these elected representatives are attuned to the views reflected in a new national Gallup poll. For the first time since at least the mid-1980s, a majority of Americans place a higher priority on the economy than on protecting the environment. As much as that shift might disappoint environmentalists, a sound economy is the logical precondition for building a sustainable national policy to address climate change.

All three Congressional participants on yesterday's panel were from states or districts with a vested interest in energy. If anything, I would have been more surprised if this group had indicated unwavering support for the immediate imposition of cap & trade. Senator Landrieu (D, LA) represents a state that ranks fourth in US oil production, without counting the contribution from federal waters offshore Louisiana. Representative Rahall (D, WV) chairs the House Natural Resources Committee and hails from a major coal state. And while Washington might not be top of mind as an energy state, Congressman Hastings's 4th District encompasses Columbia River hydroelectric dams, a nuclear power plant, and the DOE's Hanford nuclear site. Still, the concerns expressed by both Democrats suggest that the President cannot count on a party line vote to deliver cap & trade, if it is seen as threatening vital industries and the health of the economy as a whole.

A few weeks ago, I examined the President's proposed budget and the levels of cap & trade permit revenue it included. Since then, the non-partisan Congressional Budget Office has analyzed the budget and concluded that its estimates of the ten-year federal deficit relied on overly-optimistic assumptions of future economic growth and would likely be $2.3 trillion worse than forecast. At the same time, it appears that the original estimate of $646 billion in revenue from cap & trade was highly conservative, with likely proceeds in the range of $1.3-1.9 trillion. Those figures are certainly more in line with the level of carbon prices necessary to stimulate large emissions reduction. $12/ton of CO2 wouldn't cover even the lowest-cost estimate for carbon capture and sequestration, let alone make solar power competitive with natural gas. The roughly $35/ton consistent with $1.9 trillion in permit revenue from 2012-2019 comes much closer to the mark. However, unless the Congress goes along with the President's plan to refund most of the proceeds to taxpayers, that more realistic outcome would result in a much bigger net tax on a weaker economy than the President's staff assumed.

This creates a terrible dilemma. From the perspective of those most concerned about the risks of climate change, we are very late in putting a price on emissions of CO2 and other greenhouse gases, in order to accelerate the transition to greener energy sources and bolster the existing incentives for renewable energy and efficiency investments. Yet it is also apparent from both the Gallup poll and long experience in observing developing countries that unless the economy returns to healthy growth, the wherewithal to pay such a price--and perhaps more importantly the political will to impose it--won't be sufficient. Poor countries, or those that feel poor, are understandably reluctant to pay for environmental protection, particularly when the consequences of not paying are deferred for years or decades. Anyone questioning that logic should spend a moment revisiting Maslow's Hierarchy of Needs.

Any cap & trade bill introduced this year must take into account the dramatic changes since last year's Boxer-Lieberman-Warner bill was debated. It must be structured to minimize the impact on the struggling economy. In practical terms, that means deferring the onset of emissions caps until a recovery is confirmed to be well underway and diverting no more than the President's target of $15 billion per year for energy R&D from the refund of all proceeds to taxpayers, including the businesses that will be burdened with buying trillions of dollars worth of emissions permits. Failure to do so would jeopardize the recovery and doom cap & trade. That's crucial, because mitigating climate change won't be accomplished within the term of one President; it requires commitments that must be sustained for decades. If those commitments are pitted against the public's aspirations for prosperity, they are unlikely to be sustained long enough to do any good.

Spending Cap & Trade's Proceeds

The new administration submitted its first federal budget to Congress yesterday. It projects a cumulative deficit of $8 trillion from 2009-18, even after the inclusion of two substantial new revenue sources: It increases taxes on the top quintile of income-earners, who already account for 86% of the revenue collected by the personal income tax, and for the first time it includes revenue from the auctioning of permits for greenhouse gas emissions under a cap and trade system, the enabling legislation for which has yet to be drafted, let alone introduced. Since this is an energy blog, not a tax policy blog, I will focus on cap & trade, the full implications of which for the economy hinge on the details of its implementation and the disposition of funds it collects.

Seeing that cap & trade has become sufficiently imminent for it to be included in the federal government's income and expense budget evokes an odd feeling. I've been thinking about cap & trade for more than a decade, and I've been writing about it for at least the last five years. Yet as convinced as I am of the necessity of setting a price for carbon dioxide and other GHGs emitted to the atmosphere, and of a market as the best means of determining that price, I can't avoid the sense that the timing is off. We had all better hope that the economy will be recovering strongly by 2012, when the President's budget assumes auctioning of emissions permits will begin. Yet if that were truly certain, the significant expenditures beyond the 2009-10 period in the recently-passed economic stimulus bill would have been unnecessary. The degree of risk posed by this new tax--which it surely is, no matter how it is labeled--depends on how its revenues are recycled into the economy.

The President's budget contemplates spending $15 billion per year of the proceeds from cap & trade on energy research, development and deployment, with the lion's share going to renewable energy and the so-called smart electricity grid. (The assumption of higher taxes on oil and gas production reinforces my concern that the administration misunderstands the importance of new hydrocarbon sources in enabling the transition to a greener energy economy.) The budget proposal also indicates that much of the balance will be returned to taxpayers and to lower-income Americans who would be most affected by the energy price increases that cap & trade will cause. Congress may have other ideas, however, as evidenced by the debate over last year's Boxer-Lieberman-Warner cap & trade bill. And therein lies the problem.

In a perfect world, the sole purpose of cap & trade would be to monetize the environmental externality cost associated with GHG emissions, and then to refund 100% of the revenue to taxpayers, resulting in no net drain on the private sector. Advocates of this approach call it "cap and dividend." In the context of trillion-dollar deficits and expanded social programs, I am skeptical that consumers, who will ultimately pay the new levy on carbon in higher prices for energy and a wide variety of goods and services, will get much of it back in tax cuts or rebates. The political dynamic now in place makes that unlikely; the need to fund new programs and the urgency of reducing the budget shortfall will probably prove irresistible to the diverse coalition within the majority party, including a key swing group of deficit hawks.

If cap & trade will not be implemented as cap & dividend, but as a new source of funding for government programs, the timing of its onset looks crucial for ensuring the sustained recovery of the US economy. I understand the urgency behind enacting cap & trade. Concerns about the risks of climate change are increasing, and the administration would like to be able to demonstrate tangible US leadership at December's Copenhagen climate summit. Yet if our economy continues to shrink, we may not need cap & trade to meet the President's near-term climate goals, and if cap & trade is seen as harming the economic recovery, it would be less likely to be preserved by subsequent administrations. Better to delay the auctioning of permits for a year or two, or make it contingent on a threshold level of economic growth--with negligible incremental impact on the environment--than to wager the sustainability of tough climate policy on a premature start date.