Analysis of Cap and Trade Shows Harsh Economic Realities

Posted by Steven Zweig on January 13, 2010 at 1:19 pm

The potential economic cost of a cap and trade system in the US has drawn heavy criticism. (image: southcarolina1670.files.wordpress.com)

Since everything costs money, there is an economic dimension to every policy decision.

The proposed implementation of a cap and trade policy in the US aimed at reducing greenhouse gas emissions is no exception. The idea behind it is that the amount of carbon any given emitter—such as a power plant—can give off is capped or limited. To emit more than that, additional emissions allowances must be purchased, which, of course, costs money. Therefore, cap and trade is, at its heart, a tax on carbon—it makes it more expensive to emit. And since carbon emissions are a by-product of all combustion, it’s really a tax on burning fuel: coal, natural gas, and oil. In trying to restrict or reduce carbon emissions, the government increases the cost of generating power, providing heat, and many other industrial activities. Cap and trade is therefore as much economic regulation as environmental.

As economic regulation, it may be disastrous. There are a number of different problems with or challenges to it as economic policy. This is not to say that it is or should be a non-starter—the benefits may outweigh the cost. But any honest discussion of cap and trade MUST include the economic costs of the policy, which can be roughly organized into the following issues:

1) Cap and trade will cost the average American. Lest you think that this concern is just propaganda from Obama administration enemies, the administration itself has admitted that the costs of cap and trade will trickle down to American families. For example, in September 2009, a Treasury Department study found that the cost to taxpayers would be between $100 billion and $200 billion per year, equivalent to a 15 percent income tax hike. That study was based on one particular methodology—assuming that all allowances are auctioned by the government (rather than given away for free) and converting the resulting income into its equivalent in tax receipts. Other methodologies find other costs, ranging from, from example, a MIT study cited by cap and trade advocates that puts the cost at $800 per family per year, to the $3,100 per family per year quoted by House Republican John Boehner.

In fairness, nobody knows for sure what the additional cost will be—not only is there little precedent to look to, but many details remain up in the air. But given that even cap and trade supporters find an annual average cost of several hundred dollars per year, it’s simply not reasonable to posit carbon reduction without cost. (And not logical, either—does anyone really think that businesses paying more for carbon will absorb that cost without passing it on to consumers?)

2) Can we afford it in a recession? Unemployment remains high, underemployment even higher, and, stock market gains notwithstanding, a prodigious amount of personal and corporate wealth has been wiped out. Is this the time to increase costs? Shortly, there will be a chance to see what Californians think: a state assemblyman is trying to put a ballot initiative before voters that would suspended the state’s own cap and trade scheme (passed in 2006; to become effective in 2012) until a time when state unemployment, currently at 12.3 percent, falls below 5.5 percent. What seemed supportable when the economy was growing and unemployment barely touched 5 percent seems dangerous when 1 in 8 are out of a job. The problem is not only the additional cost to cash-strapped taxpayers—a study commissioned for the California Small Business Roundtable pegged the cost of California’s cap and trade scheme at up to $3,857 per household—but also the potential to drive business and much-needed jobs away.

3) Anything other than universal cap and trade will encourage outsourcing economic activity to polluters. The problem is that in our global age, there’s always a race to the bottom—businesses will relocate, or at least outsource production and services, to the least expensive place they can. That’s why toys are made in China and IT call centers are in India. One of California’s concerns about their own cap and trade scheme is it might drive energy-intensive industries across state borders, to Texas to Nevada, where there are no such limitations on carbon emissions.

Or cap and trade might drive industry overseas, to places like China and India. The developing world has been resisting the same hard limits on emissions that they want the developed world to embrace. If it’s cheaper to emit carbon in China or India, it’s also cheaper to manufacture there; when you stack that advantage with the advantage of low wages, it’s easy to imagine a cap and trade regime that’s not universally applied throughout the world driving business to countries that have not accepted emissions limits.

Worse, those countries are generally the “dirtiest” on a per capita basis. They have lower-tech, less efficient infrastructures on average, as well as markedly less environmental, health, and worker safety regulation of all types. Shifting industry to the developing world results in more pollution than keeping it in the developed world, which means that anything less than completely universal cap and trade may end up increasing carbon emissions.

4) Under cap and trade, trade in carbon allowances may turn in the next big financial bubble. A study by a respected, pro-environment nongovernmental organization, Friends of the Earth International, says that the world’s largest functioning cap and trade market may create the next apocalyptic financial meltdown. That’s the European Union’s carbon market, in which a cap and trade scheme has been operating for several years. The problem is, in the words of FoE: “The majority of the [carbon allowance] trade is carried out not between polluting industries and factories covered by carbon trading schemes, but by banks and investors who profit from speculation on the carbon markets—packaging carbon credits into increasingly complex financial products similar to the ‘shadow finance’ around sub-prime mortgages which triggered the recent economic crash.”

That shouldn’t be surprising: Wall Street and its global counterparts have shown they will speculate in any and everything in which they can make a buck. That’s Wall Street’s purpose and its reason for existence; it’s no more exceptional or unusual for Wall Street to speculate than it is for scorpion to sting. That means if cap and trade is implemented, special care must be taken to prevent financial players from jumping in, dominating, and distorting the market, with potentially disastrous results.

Beyond Europe, actual experience with carbon trading is limited. U.S. cap and trade legislation, for example, has not yet passed Congress. However, some states are not waiting on federal legislation. Instead, they’re looking to form their own or regional cap and trade markets—in particular, a number of Northeastern states have already formed a functioning cap and trade marketplace. That may provide the chance to accrue experience with cap and trade on a manageable scale, though as per California’s concern, it does create that potential for a race to the bottom.

The largest functioning U.S. cap and trade market is the Regional Greenhouse Gas Initiative centered around New York. First mapped out in 2003, it’s had some success, though more in terms of raising revenue so far than in reducing carbon. This revenue can be applied for good, public purposes; the money raised by RRGI in New York is used to fund a Green Jobs/Green New York Act which pays for energy-saving projects.

That’s also a feature of the California plan currently under attack—carbon allowances will be sold to businesses, allowing the government to pocket the revenue and return it to its citizens. However, that’s not a feature of all cap and trade plans, which leads to the fifth cap and trade economic issue:

5) Qui bono, or who benefits? The cap and trade legislation working through Congress calls for giving away a large number of carbon allowances to certain industries. The industries (like utilities or steel manufacturers) that get free allowances will reap large benefits compared to industries (like oil or food packaging) that have to pay for their initial allocation. Moreover, giving away any substantial number of allowances will result in a net transfer of wealth from the country at large to the recipients of the free allowances. In both cases, these transfers come about because the holders of free licenses can sell them to other businesses, which then pass the cost along to consumers.

This was found in Europe’s experience, where “an allocation approach that gives all allowances for free to directly affected industries will have the overall effect of transferring some wealth from the broad public (in this case consumers) to those industries.” Thus, any scheme or mechanism for allocating carbon allowances that plays favorites will create economic winners and losers.

Of course, if you don’t give allowances away—if you monetize completely the right to emit carbon by selling all allowances (at auction or otherwise), you still need to contend with a sixth economic cap and trade issue:

6) Money from cap and trade is difficult to account for and may be easily diverted. Any time an enormous new pool of money is created, there’s an equally enormous temptation for fraud, corruption, and gerrymandering. For example, half of New York’s Green Jobs/Green New York funds were diverted away from their intended use to the general state budget, going the way of such other diverted funds as pension plan or unemployment fund contributions. In Europe, $7.4 billion of tax revenue was lost in a just a year-and-half from cap and trade fraud.

As discussed above, if you don’t capture the benefit of selling carbon allowances for the state, private parties may instead snatch up the benefit. But if you do try to capture it, you leave it open to the same problems that beset every large, new, public revenue source. Is it possibly the case that any cap and trade plan simply too large, with too much money at stake, to be run fairly and efficiently? At a time of spiraling budget deficits and soaring spending, do we really want to take billions more out of the private sector and put it into government hands? But if not, what’s the alternative—do we let a relative handful of private parties monetize a public resource for their own benefit?

There is no simple right answer. The point, though, is that cap and trade is arguably more complex on the economic side than on the environmental or scientific side. It’s therefore vital to consider the economic issues as carefully as ecological ones. It’s even worth considering, as suggested by the Director of the University of California Energy Institute, whether cap and trade is even the right way to reduce carbon.

That gentleman, Dr. Severin Borenstein, contends that it’s almost impossible to set the cost of emitting carbon just right—too low, and you don’t affect meaningful reductions in emissions; too high, and you risk substantial economic harm. That’s why he advocates technological fixes—investing heavily in new energy sources and greater energy efficiency—as a better solution than taxing carbon.

Borenstein might be right. He might be wrong. But given the manifest complexities of cap and trade, it’s a point worth considering. After all, at this point a substantial portion of not just U.S. policymakers but world leaders have been spending a great deal of time and effort on designing a cap and trade plan for more than a year, with little to show for it. It’s possible that this shows that setting up a fair and workable cap and trade system is a problem without a solution.