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That First Step Is a Doozy

Sunday, March 22, 2009

The Obama administration is finding that greenhouse gas control is hard in practice, especially the very first step.

The Obama administration’s headlong rush to create a trading market for greenhouse gas control has stumbled at the very first step, over how one kicks off such a market. The administration would be wise to look before it leaps: mistakes made in the initial creation of an emission-trading market become increasingly difficult to repair as the participants quickly gain a vested interest in the status quo.

President Barack Obama and the leadership of the Democratic Party have long championed the establishment of stringent controls over U.S. greenhouse gas emissions: President Obama has repeatedly promised to set up controls that would cut U.S. greenhouse gas emissions to their 1990 level by 2020 and down to 80 percent of the 1990 level by the year 2050.

Such reductions could be achieved in a number of ways. One could use regulation, as the EPA is preparing to do, requiring energy users to increase their efficiency. But regulations can only nibble around the edges of the issue, and it is well known that regulations are costly, economically damaging, and prone to creating perverse consequences.

The additional cost for U.S. utilities to continue doing business in the year after the cap is estimated at $40 billion.

Alternately, one could slap a tax on the carbon content of fuels and let the market sort out how it wants to cut emissions in order to avoid the tax. That is the approach that most economists (and policy wonks such as myself) agree would be the most efficient. Environmentalists dislike the tax for several reasons. They think it is politically unsalable and will not guarantee a given certain level of reductions: those stubborn energy-using humans might simply opt to pay the tax and keep emitting. Even worse, taxes are entirely too transparent. Environmentalists do not want people to see the cost of greenhouse gas mitigation too clearly, because the public might reject it as too costly.

Finally, one could use a mechanism called emission trading, or “cap and trade,” which ostensibly harnesses the power of the market to find least-cost emission reduction approaches and allows a great deal of obfuscation and special-interest politics into the process. This is the favored approach of environmentalists, the Democratic leadership, and President Obama. But the administration is already stumbling at the very first step, which suggests that it should take a deep breath and think things through.

Here’s how cap and trade works in theory: First, the government establishes a national limit on the quantity of greenhouse gases that can be emitted in a given year. This is called the “cap.” It is generally understood that this cap will decline every year, meaning that fewer and fewer emissions will be allowed over time, until it is deemed that we have reached a level of emissions that will not harm the environment by causing climate change (Environmentalists more or less put that value at zero). After setting the cap, the government then allocates shares of the total allowed emissions to those entities that generate such emissions. In the case of greenhouse gases, that includes pretty much every business in the country that produces or consumes energy. The holders of such emission shares then trade among themselves, allowing this new carbon market to find the least costly ways to reduce emissions.

Giving permits to emitters based on their emission history rewards the least efficient businesses most highly.

But putting theory into practice is not easy, as the administration is finding—the very first step, the allocation process, is fraught with peril. There are two ways one can allocate the shares of annually allowable emissions, which are sometimes called “carbon permits,” or “emission allowances.” This is usually done through a system of free allocation, where the government gives out permits to emitters based on their historical emission history, minus the amount of emissions they are expected to cut in order to meet the cap. Another way to allocate emissions is by establishing an auction and letting emitters bid on them. And there are hybrids, with partial auctioning that phases in over time. But there are pitfalls in all of these approaches.

Let’s start with free allocation. With free allocation regulators are, in a sense, rewarding the least efficient businesses most highly, as businesses with the oldest, least efficient technology can reap a windfall by increasing their efficiency, shuttering old facilities, and then selling the permits they were given for free to those who are already using the most efficient technology available. Another problem with free allocation is that it is easy for the government to give out too many permits—it does not really know and cannot easily judge how hard it will be for companies to make emission reductions, and businesses have a vested interest in exaggerating that difficulty when they are haggling over their share during the allocation process. If it is easier than the government thought, surplus permits will flood the market, reducing their cost, and not making it worthwhile for companies that need to buy permits to take actions that reduce emissions. Eventually, the glut dries up, but if that happens too quickly, a spike in permit prices can happen that leads the government to step in and break the cap, rather than allow high permit prices to cripple the economy. Also, there are favored interest groups that will be given overly generous allocations, leaving a steeper challenge for disfavored groups to get their emissions under the cap. One can only imagine how a left-leaning allocator would view giving carbon permits to, say, schools as opposed to coal mines. Or private radio stations rather than public broadcasting stations.

Auctioning permits off from the beginning reduces the probability of over-allocation because firms will carefully consider how many permits they need, based on their understanding of the costs and benefits of either buying permits or installing new equipment. Auctioning also does away with the politicization of the allocation process.

One can only imagine how a left-leaning allocator would view giving carbon permits to, say, schools as opposed to coal mines.

But the problem here is the instantaneous cost that firms have to shell out in order to continue doing business in the year after the cap is established. Estimated costs for U.S. utilities alonenot  counting greenhouse gas emitters in manufacturing or other sectorsare in the range of $40 billion per year using current permit prices as they are being traded in the European market. Not only will businesses scream bloody murder, the public will also, since most of that cost will immediately hit consumers’ wallets as the prices of energy, goods, and services rise and keep rising every year as the cap tightens. Not only will costs of everything increase, but the impact will be highly regressive, landing harder on the poorest of the population, who spend a greater percentage of their household income on energy than do the wealthier. Finally, there is the politically unacceptable transfer of wealth from coal states to natural-gas states such as California, where incomes are considerably higher.

The Obama administration’s headlong rush into a cap-and-trade system should be reconsidered. It has clearly not thought through even the first step—the allocation process—so it cannot possibly have given sufficient thought to the design of the new carbon-currency it is about to create. With such a huge swath of the economy’s productivity based on energy production and consumption, the government will be creating a new financial instrument of massive proportion. Did the current economic turmoil not teach us the importance of deliberation in creating new kinds of poorly understood financial instruments?

Kenneth P. Green is a resident scholar at the American Enterprise Institute.

Image by Darren Wamboldt/The Bergman Group.

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