Climate Reality Eludes the Business Press

By John Miller, Dollars and Sense. Posted August 27, 2008.

Cap and Spend. As the Senate opens debate on its mammoth carbon regulation program this week, the phrase of the hour is "cap and trade." This sounds innocuous enough. But anyone who looks at the legislative details will quickly see that a better description is cap and spend. This is easily the largest income redistribution scheme since the income tax.

-- Wall Street Journal editorial, June 2, 2008

Climate Reality Bites. Cap and trade is a tax imposed on business, disguising the true costs and thus making it more politically palatable. In reality, firms will merely pass on these costs to customers.

... politicians like cap and trade ... because it gives them a cut of the action and the ability to pick winners and losers. Some of the allowances would be given away, at least at the start, while the rest would be auctioned off, with the share of auctions increasing over time. This is a giant revenue grab.

The Environmental Protection Agency estimates that this meddling would cause a cumulative reduction in the growth of GDP by between 0.9% and 3.8% by 2030.

-- Wall Street Journal editorial, May 27, 2008

The Wall Street Journal's editors are celebrating having dodged a big-government bullet when the cap-and-trade global warming bill sponsored by Joe Lieberman and John Warner, as amended by Barbara Boxer, went down to defeat this June in the Senate.

But the Lieberman-Warner Climate Security Act of 2008 was a fairly low caliber munition in the fight against global warming. While undoubtedly the most comprehensive global warming bill ever to reach the Senate floor, its emission reductions fell well short of those called for by environmental groups or by the Clinton and Obama campaigns.

Inside Cap-and-Trade

"Cap-and-trade," introduced in the 1990 Clean Air Act to regulate sulfur dioxide (SO₂) emissions or acid rain, is now the favorite form of environmental regulation for politicians and big business. They find it far preferable to either command-and-control regulation, such as federal directives ordering electrical power plants to install smokestack scrubbers, or emissions taxes, such as a broad-based carbon tax.

Cap-and-trade, referred to variously as incentive-based regulation or market-based regulation, works this way. The federal government sets a mandatory, nationwide cap on carbon dioxide (CO₂) emissions that it gradually reduces. At the same time the government requires companies, or any emitter, to hold allowances for their emissions. Typically each allowance entitles a company to emit one ton of CO₂.

After the government either auctions off allowances or issues them to companies based on their energy output or usage, holders are free to buy and sell them. Companies that can reduce emissions cheaply, usually those with newer plants, will likely cut their emissions below the standard for their industry and sell their unused allowances (or, if allowances are auctioned rather than issued for free, buy fewer of them), reducing their abatement costs. Companies with relatively high abatement costs, usually those with older plants, can be expected to buy additional permits (either from other companies or the government) at a price well below their cost of abatement so that they can reduce emissions by less than the industry standard. The flexibility, or "non-uniform abatement," afforded by permit trading allows the least costly abatements to be carried out first, lowering the overall cost of meeting any given environmental target.

The Climate Security Act would have required the Environmental Protection Agency (EPA) to establish a cap-and-trade program to cover U.S. electrical power, transportation, manufacturing, and natural gas sources that together account for 87% of U.S greenhouse-gas emissions. Beginning in 2012, the EPA would steadily reduce the cap on total emissions, down to 71% below their 2005 level by 2050.

Over the life of the program the EPA would auction off the majority of allowances, but initially about 40% would be given away, ostensibly to help industries make the transition to lower emissions. Revenue from the auctions, estimated at $5.6 trillion over the life of the bill, would be used to finance some relief for the poor to offset increases in utility bills, training and assistance for workers, deficit reduction, research on clean-energy technologies, and an array of subsidies for electric and gas utilities, the coal industry, auto manufacturers, oil refiners, and the nuclear industry.

Big But Not Big Enough

That is the giant revenue grab the Journal's editors protest. Still, it's over the top to compare $5.6 trillion over four decades -- that's $147 billion a year, or less than 6% of current federal government revenue -- to the income tax, which increased government revenue nearly eightfold when it became a broad-based tax during World War II. And today, the $869.6 billion collected in payroll taxes in 2007 and redistributed through the Social Security system dwarfs the revenues that would be collected by this cap-and-trade proposal.

Alas, as big as the editors say it is, the Lieberman-Warner plan would not have brought about the 80% emissions reduction (below 1990 levels) the Nobel Prize-winning Intergovernmental Panel on Climate Change (IPCC) says is necessary by 2050 to avoid the worst effects of climate change. Next year's new president will be more favorably disposed to regulating greenhouse gases than the Bush administration, which threatened to veto the Lieberman-Warner bill. Barack Obama favors a cap-and-trade system that would reduce carbon emissions to "80% below 1990 levels by 2050" and would "require all pollution credits to be auctioned."

John McCain supports what could best be described as "cap-and-trade lite." His plan would set limits on greenhouse gases at 66% below 2005 levels, not so different from the Lieberman-Warner proposal, but well short of the level recommended by the IPCC. It would issue permits to polluters for free, at least initially, then convene a commission to determine what share of future allowances would be provided for free versus auctioned.

McCain opposed the Climate Security Act because in his view it did not offer enough aid to the nuclear industry. While the support for nukes in the Lieberman-Warner bill was not explicit, it was quite generous. Karl Grossman, host of the nationally syndicated TV program "Enviro Close-Up," estimates that $544 billion in subsidies for the development of new nuclear power plants were buried in the bill. The bill would have effectively doubled government subsidies for the nuclear industry, already the single most subsidized industry in the energy sector -- but that was not enough for McCain.

Auction or Issue?

Besides this alleged revenue grab, what has got the Wall Street Journal editors in a lather is that the Senate bill would have auctioned off the majority of its permits instead of giving them away free.

For environmental groups such as Friends of the Earth, the "polluter pays" principle demands that 100% of pollution permits be auctioned. The amended Lieberman-Warner plan fell well short of that standard. The 40% of permits it would have given away in the initial phase went well beyond the 15% level the Congressional Budget Office estimates affected companies would need to compensate their shareholders for any decline in the value of their stock caused by a drop in demand for energy and energy-intensive products following regulation. In fact, the CBO worries that the bill's permit giveaways could end up as "windfall profits" for oil, gas, coal, and other polluting industries.

Even mainstream, conservative economists disagree with the editors. Greg Mankiw, former chair of Bush's Council of Economic Advisers, headed the list of hundreds of economists who signed the Southern Alliance for Clean Energy (SACE) Economist Statement urging that permits be auctioned off, not given away.

As the SACE statement made clear, whether permits are issued or auctioned will not affect energy prices or deter corporations from passing on the cost of abatement to consumers through higher prices. In either case, market forces of supply and demand will determine those price changes for any particular product. Giving away permits to polluters will not protect families and businesses from higher energy prices.

Indeed, higher energy prices carry a benefit: they prompt energy conservation. That is already evident this summer in the United States, where rising gas prices have driven spending on energy as a share of wage income above 6% -- higher than during the 1974-75 and 1990-91 oil price shocks. Cars now outsell SUVs by the largest margin since 1996, GM is preparing to sell off its Hummer brand, mass transit ridership has increased, and bicycle sales are up.

For an economist, auctions are superior to allocations not because they prevent higher prices but because they ensure the government has the resources necessary to offset those higher costs. How the government spends the auction revenue determines who bears the burden of the cost of cutting CO₂ emissions.

Energy price increases are regressive, hitting low-income consumers hardest. The CBO estimates that a 15% reduction in greenhouse gas emissions, the goal of the Lieberman-Warner bill for 2020, would cost the poorest fifth of families 3.3% of their after-tax income, but only about half that (1.7%) for the richest fifth of families.

But using only about 14% of the total value of the permits, lawmakers could fund a rebate program that would erase the bill's impact on the poorest 20% of households and provide significant relief to those in the next poorest fifth, according to a recent study by the Center on Budget and Policy Priorities (CBPP). Unfortunately, the Lieberman-Warner bill would have allotted low-income consumers only about half of what the CBPP recommends, and it would have delivered those benefits via a hodgepodge of mechanisms as opposed to the straightforward climate tax credit the center proposed.

Other proposals would devote most or all of the revenue from allowance auctions to compensating consumers for the higher energy costs they would face following new CO₂ regulations. For instance, the "sky trust" plan is modeled after the Alaska Permanent Fund, which pays out an annual share of oil earnings to each resident of the state. A sky trust would use the revenue from auctioning off CO₂ permits to issue an annual dividend check to every U.S. resident.

How much compensation would such a plan provide? The MIT Emissions Prediction and Policy Analysis model estimates that a cap-and-trade program that cuts carbon emissions to 50% below 1990s levels by 2050, somewhat less stringent than the amended Lieberman-Warner bill, would generate $392 billion in auction revenues in 2020. That sum would finance dividend checks of $963 per person -- enough to compensate all but the most well-to-do households for the higher energy costs they would face if the Lieberman-Warner emissions goal for 2020 were met, according to the CBO.

But these results are predicated on auctioning off 100% of initial allowances and on a political willingness to devote the revenues generated by cap-and-trade regulation to promoting economic justice. Strangely enough, both of these policies should be popular with the Wall Street Journal set. Auctioning all permits would eliminate corporations' incentive to lobby for favorable treatment (i.e., the free permits). In addition, distributing every dollar of auction revenue to the public in the form of dividends would drain Washington's coffers of the money that the federal government might otherwise use to finance the kind of industrial policy adventure that so concerns the Journal editors.

How Fast Will We Grow?

Lawmakers could also devote allowance revenues from a cap-and-trade program to reducing the cost to corporations of meeting the new emissions targets, in an effort to sustain economic growth.

Would the Lieberman-Warner plan, or even a more aggressive cap-and-trade policy, slow economic growth? How much? The answer is not altogether clear and depends heavily on the responsiveness of innovation to higher carbon or energy prices.

The EPA estimates suggesting that cap-and-trade will cause a cumulative reduction in GDP growth of between 0.9% and 3.8% by 2030 reported by the editors are quite alarming. But those estimates need to be examined critically and put into context. First, the Congressional Research Service (CRS) described the upper range of the EPA's estimates as an outlier, quite different from the estimates produced by the seven other models the CRS examined. Among the other models, 2.7% was the largest projected decline in GDP, and five of the seven models projected a loss of 1% of GDP or less.

On top of that, the models' predictions of U.S. GDP in the year 2030 under business as usual (i.e., without cap-and-trade) vary far more than their projections of the economic impact of a carbon cap. When Nathaniel Keohane and Peter Goldmark of the Environmental Defense Fund examined these same studies, they found that each of them projects average U.S. economic growth of 2.5% to 3% a year over this period, and each predicts the U.S. economy will be more than twice as large in 2030 as it was in 2005 even after taking into account whatever dampening effect cap-and-trade has on economic growth.

As they put it, these economic models predict that U.S. GDP will reach $26 trillion around January of 2030 under business as usual. With a carbon cap, it will get there by April.

While not cost free, cap-and-trade regulation is "surprisingly affordable" according to Keohane and Goldmark. Plus, the size of U.S. GDP two or four decades from now will depend more on other macroeconomic conditions than on the cost of curbing carbon emissions.

A Green Industrial Policy

Along with a partial cap-and-dividend program or a rebate for low-income consumers, there is a case to be made for spending much of the revenue from auctioning permits on an environmental industrial policy to dramatically reduce our dependence on fossil fuels. Pioneering environmental scientist and activist Barry Commoner insists that public policy needs "to confront the corporate domain at its most powerful and guarded point -- the exclusive right to govern the systems of production" if it is to transform the environment and the economy.

"If managed properly, ending dependence on fossil fuels and building a clean energy economy could generate millions of good jobs," argues economist Robert Pollin, co-director of the Political Economy Research Institute. Pollin estimates that investments in conservation and renewable energy to match a 25% cut in spending on fossil fuels over a 20-year period would produce a net increase of about 2.5 million jobs. Sadly, that is not what the Climate Security Act of 2008 was about. It devoted more monies to fossil fuel and coal than to promoting renewable energy, clean technology, and mass transit.

But fixing the climate, as Commoner has always said, will not happen with half-measures that reward corporate America.

              

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John Miller is professor of economics at Wheaton College and a member of the Dollars & Sense collective.

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