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The Problem With a ‘Cap-and-Trade’ System

Monday, November 17, 2008

It will be very costly, but probably ineffective as a means of reducing greenhouse gas emissions.

Now that Democrats have won the presidency and expanded their majorities in both houses of Congress, they will be under enormous pressure from environmentalists to implement a “cap-and-trade” system for regulating carbon dioxide and other greenhouse gas (GHG) emissions. Barack Obama has called for significant reductions in GHG emissions, and he favors a cap-and-trade approach. According to recent polls, a bare majority of Americans say they support government regulation of GHG emissions, and 59 percent support a cap-and-trade program.

However, Obama will inevitably find that establishing the type of cap-and-trade scheme he endorsed during the campaign may not be possible—or desirable. In recent years, various cap-and-trade bills have been proposed on Capitol Hill, but none has come close to passing. The most recent casualty was the Lieberman-Warner Climate Security Act, which died in the Senate this past June.

The premise of cap-and-trade legislation is that the social costs of GHG emissions—which scientists believe are contributing to global warming—are not reflected in their actual costs. By bringing the actual costs of GHG emissions more in line with their social costs, the thinking goes, we would create a more efficient system and slash our emissions. Because GHG emissions are a byproduct of energy production, basic economics tells us that a cap-and-trade regime should lead to higher energy costs.

What basic economics cannot tell us is how much energy costs will increase. That depends on the cost of replacing “dirty” energy sources with cleaner fuels and adopting less energy-intensive production processes. A 2007 McKinsey study predicted that GHG emissions could be lowered to anywhere from 7 percent to 28 percent under their 2005 levels by 2030 for less than $50 per ton of carbon dioxide equivalent abated.

If a cap-and-trade bill eventually reaches President Obama’s desk, chances are it will be littered with exemptions and loopholes.

That seems ambitious, but less so than the energy plans proposed by both presidential candidates. The Obama plan calls for much steeper reductions, aiming to slash emissions to 80 percent below their 1990 levels by 2050. Without major new technologies, achieving such enormous reductions is going to be economically (and politically) impossible.

Americans have conflicting views on energy and climate policy. While 52 percent favor government regulation of GHG emissions, 74 percent support increased offshore drilling. This past summer, 60 percent of Americans said that developing new sources of energy should be a more important priority than protecting the environment, and 75 percent reported that rising gas prices had caused financial hardship for them or their households.

Such a divergent set of priorities cannot possibly come together in a coherent energy policy, which explains why neither presidential candidate offered one. Instead, they talked about cutting GHG emissions and increasing oil shale production in the same speeches. They railed against high gas prices, even though higher gas prices lead to changes in consumer behavior and lower GHG emissions—which both candidates advocated. (They also touted “clean coal,” which doesn’t exist.)

Of course, making contradictory promises is what politicians do. Making actual policy reforms will be much more difficult.

Obama wants to auction off 100 percent of GHG emissions permits. But evidence from the European Union suggests that industries will lobby hard to win exemptions from the new rules or to set the “caps” high enough that they prove ineffective in actually reducing emissions. If the Obama plan becomes law, companies will maneuver for free emissions permits and other goodies. Congressmen and senators will demand that carbon-intensive industries in their districts or states be shielded from adverse economic consequences.

When the Lieberman-Warner bill was being debated, nine Democratic senators came out against the legislation and wrote a letter to Democrats Harry Reid, the Senate majority leader, and Barbara Boxer, chair of the Senate Environment and Public Works Committee. Their letter stressed the need to balance environmental goals with economic realities, to distribute the burden of emissions reductions evenly among states, and to protect U.S. manufacturing jobs.

If the next Congress moves to pass cap-and-trade legislation, plenty of lawmakers—particularly those from the Upper Midwest and the Rust Belt—will voice similar concerns. Which means that if a cap-and-trade bill eventually reaches President Obama’s desk, chances are it will be littered with exemptions and loopholes. It will still be very costly, but probably ineffective as a means of reducing GHG emissions.

Abigail Haddad is a research assistant at the American Enterprise Institute.

Image by Darren Wamboldt/The Bergman Group.

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