Cap’n'Trade, Obama’s Shade of Green
by RGE Monitor, July 1 009
Today we look at U.S. and global efforts to reduce carbon emissions and slow global warming. Last Friday, June 26 2009, The U.S. House of Representatives approved the landmark America Clean Energy and Security Act by a narrow seven vote margin, including 44 no votes from Democrats. The legislation, also known as Waxman-Markey after its sponsors, or the climate bill, will face an even tougher audience in the Senate, where it must meet a 60-vote threshold. The Minnesota Supreme Court’s decision to seat Al Franken in the Senate may add to the Democrats’ leverage. The bill aims to cut 2005 emissions levels by 17% by 2020 and has at its core a Cap-and-Trade system which calls for mandatory caps on greenhouse gas emissions. Any companies wishing to emit above a certain level will need to purchase permits to do so. Additionally the bill requires large utilities to increase their use of renewable energies such as hydro, wind, solar and geothermal power generation.
The bill’s passage by the House is historic and will likely increase President Obama’s leverage in global climate negotiations as global leaders try to replace the soon-to-expire Kyoto Protocol. Detractors though point to its economic costs and the limited nature of the final legislation
How the Bill Works
At the heart of the bill is a Cap-and-Trade system, a market-based system which caps emissions at a certain level and allows large emitters to buy permits for additional emissions from other companies that emit less than the upper limit. The legislation calls for the number of permits to be reduced over time to encourage lower emissions. In practice, establishing a market for these permits will increase the cost of using carbon-based energy (especially electricity from coal), which will in turn reduce demand.
The revenue earned through auctioning would be distributed among households to offset the negative effect on their purchasing power from the higher cost of energy. Initial plans called for all or at least a majority of the permits to be auctioned but the vote-getting process increased the number allocated. The bill passed by the House calls for 85% to be allocated and 15% to be auctioned. Some of the allocated permits will go to utility companies, the idea being that they will either invest the proceeds in renewable fuels or temper price increases for consumers. This change reduces the potential revenue generation of the policy and runs the risk that low electricity costs could actually encourage greater usage.
Estimates of the total economic costs of the U.S. Cap-and-Trade program have varied widely. According to the Congressional Budget Office (CBO), the net annual economic cost of the Cap-and-Trade program in 2020 would be $22 billion—or about $175 per household. Analysis of the CBO results suggests that the implicit tax is relatively progressive. While this estimate has been accused of being understated (and it is worth noting that the Environmental Protection Agency came to an even lower estimate) it presented a baseline for analysis. Other estimates put the ultimate cost much higher. An analysis from the Heritage Foundation concludes that the Cap-and-Trade system described in the bill would cost the economy $161 billion by 2020–or about $1,870 per household. Such estimates do not necessarily account for changes in the price of energy that would occur naturally as a lack of investment limits production of fossil fuel based energy. Furthermore, they may not fully include the technological and efficiency gains that the current legislation hopes to encourage. For example, some of the allocations to utilities are granted with the expectation that they will be auctioned off and the proceeds will be used to fund renewable energy development. It’s worth noting, however, that there’s no guarantee the utilities will do this in practice.
Where the United States is concerned, the likely impact of the new price for carbon varies by sector. Utilities are likely to the most affected, especially in those regions that derive much of their power from coal-fired plants. The Midwest, the country’s already-shrinking industrial and manufacturing base and the home of many of its coal-fired plants, seems particularly vulnerable. (The distribution of allowances in the legislation is intended to find the funds to improve competitiveness of coal plants.)
The effects on agriculture are also varied. Recent Deutsche Bank research suggests that no-till agriculture, which limits disturbance of the soil, as well as reforestation and planting of vegetative buffers could derive significant carbon credits annually under a Cap-and-Trade regime. By some counts up to 20% of U.S. carbon emissions come from the release of carbon dioxide from farmland. However, the bill puts off to the future one contentious issue–the promotion of agricultural land to grow corn for ethanol, which critics suggest is very inefficient and contributed to global food shortages in 2008. The legislators also chose the Department of Agriculture, more likely to be sympathetic to farmers concerns, rather than the EPA, to be the regulator for approving carbon offsets.
The oil and metals sectors may also face vulnerabilities. Some analysts worry that emissions standards would encourage companies to keep inventories low and to import more refined fuels, contributing to idle capacity in U.S. refineries. However, it may also encourage the creation of cleaner processes or the development of carbon capture technologies, which are as yet far from being commercial. Overall, businesses have supported establishing a climate regime, given that clarity over regulatory responses is key to planning. However, there are still many uncertainties about how such a regime will be implemented.
There is also a growing fear that climate change policies could prompt trade protectionist policies. The risk that higher costs might accelerate a decline in the U.S. manufacturing base as more production is moved offshore has contributed to the suggestion that compensatory import taxes might be placed on carbon-intensive imported goods. President Obama, in saluting the bill’s passage, did insist that the U.S. not discriminate against imports. Doing so might lead to retaliatory protectionism and a further hit to trade. In a report released last week, the World Trade Organization (WTO) suggested that import taxes might be WTO-compliant if they limit distortions. Paul Krugman suggests that the WTO’s view is analogous to that for value added taxes. However, Martin Feldstein notes that the system could be very complex. With different countries each having country-specific caps and different tariffs, it could be very difficult to assess how comparable the measures are and what remedies might be needed. Thus the implications for international trade and trade law could be quite significant. Moreover, developing countries are petitioning for trade restrictions on carbon-reducing technologies to be lifted or for technology transfer of such goods. The mostly advanced economy companies who developed such expertise have been reluctant to cut prices.
Other Efficiency Steps
The administration’s energy policy more broadly tries to offset potential costs with new opportunities and technological advances to boost productivity growth. It aims to generate 25% of U.S. energy from renewable sources by 2025, create “green jobs” and reduce dependence on imported oil. Projects to develop renewable fuels and improve the efficiency of the power grid received funding in the stimulus bill, in part to offset the impact of the triple shock of lower energy demand, lower credit and lower hydrocarbon prices on renewable producers. President Obama’s team plans to spend $150 billion over the next decade to promote energy from solar, wind and other renewable sources, as well as energy conservation.
Other key steps include the May 2009 auto efficiency program, which requires the American fleet to increase to an average mileage standard of 39 miles per gallon (mpg) for cars and 30 mpg for trucks by 2016 – a jump from the current average for all vehicles of 25 miles per gallon. Doing so would create a new national standard, after many states have unilaterally taken more aggressive steps. A national standard could make it easier for car companies to supply different jurisdictions. Government estimates that oil consumption may fall 1.8 billion barrels from 2012 to 2016 and greenhouse gas emissions may fall by 900 million metric tons could be overoptimistic. They may, however, be more effective than the recently announced “cash for clunkers” program in which consumers receive a rebate for a new more fuel efficient vehicle if they turn in a gas guzzler. Yet the required fuel efficiency increase is rather low (only 4mpg) and the threshold is lower than the current national average. As such, the latter policy, which has been effective in stocking auto demand in countries like China, Germany and South Korea, might have limited effect in the United States. However the effects of such incentives may be temporary. If they elapse without a sustained increase in consumption, demand for autos could fall quickly especially in developed economies which already have a high number of cars per household.
These initiatives together hope to reduce the amount of oil the United States imports. The bulk of energy imports (oil, gas, electricity) come not from the Middle East but from Canada. An increasing amount of the oil supplied is bitumen from the oil sands, which continues to bear an expensive environmental and economic cost per barrel under current technology. Bitumen’s carbon footprint is improving though through technological innovation – and the fuel expended in transport is clearly lower than the amount needed to ship oil from Saudi Arabia. Yet there is still a long way to go. Given the shift towards energy efficiency and lower emissions fuel supply, Canadian authorities and producers are struggling to improve production so that their largest consumer will keep buying. On President Obama’s visit to Ottawa, his first foreign trip as president, he and Prime Minister Harper announced joint investment in carbon capture technology, adding to funds already pledged by the province of Alberta. Such measures hope to help the U.S. meet energy security needs without adding to environmental insecurity. However, carbon capture technology is still far from being commercial.
One of the biggest benefits of this legislation is that it provides a mechanism to set a price for carbon over the mid-term. Doing so will help households and businesses make investment and savings decisions. However, economists have long argued that a carbon tax would be more efficient than a Cap-and-Trade system, as it would be less complex and vulnerable to distortions. A carbon tax would set a specific cost per unit of carbon dioxide, thus establishing a clear cost for carbon. A Cap-and-Trade system, on the other hand, would set an upper limit for emissions, but the prices it established for carbon might be variable. Of course, introducing new taxes is rarely popular, particularly not during a recession, even if the tax option would be more efficient and have lower compliance costs.
The European Union’s experience with Cap-and-Trade over the past several years provides reason for caution. The first iteration of the policy, issued too many permits, undermining demand. With prices for carbon low, so was the incentive to reduce emissions. A reformulation improved this balance and emissions have been reduced, though European countries still have a significant space to reach their targets. The EU system allows companies to bank or store their allocations for the future or to borrow them from the future. The EU system also illustrates an effect of the global recession. The drastic reduction in industrial output has meant that many companies are producing well lower than their quotas and are seeking to sell their excess allocation. Several companies sought to raise cash by selling their carbon certificates, causing the price of carbon to plummet. A market-derived carbon price might actually be very volatile.
The Road to Copenhagen
World leaders will meet this December in Copenhagen to negotiate a replacement to the Kyoto Protocol, which expires in 2012. The Kyoto Protocol aimed at reducing emissions of 1990 greenhouse gases levels by 5.2% by 2012. The range that is now being discussed is around 25% to 40% of 1990 levels by 2020. The previous U.S. administration withdrew from ratifying the Kyoto protocol, saying it deemed it unfair for allocating reductions targets between developed and developing countries. The reluctance of emerging market economies to make emissions cuts that might stunt their growth could again be an obstacle to a deal later this year.
The United States and China are the world’s top two greenhouse gas emitters, together accounting for more than 40% of annual emissions. If the United States and China can become catalysts in bringing about a strategic transformation to a low-carbon, sustainable global economy, the world will take a giant step forward in combating climate change. Given the complexities of global discussions, analysts like Kenneth Lieberthal suggest that climate change is yet another policy arena that could be best tackled by a G-2, that is bilateral talks by the two countries. Despite its reluctance to take any steps that might reduce economic growth, China, has been taking some steps to curb emissions growth. China rivals the United States as a carbon emitter, despite having low levels per capita, but now has domestic interests to slowly make changes. In particular, the increase in pollution-related illness is taxing the Chinese health care system. Yet many of these measures, such as China’s own cash for clunkers program, may be of limited effect given the potential demand for primary energy. Coal remains the primary feedstock for Chinese electrical plants, although the country is planning to build several nuclear power plants and is sourcing more of its electricity from wind. China is now the world’s largest assembler of solar technology, but little is applied domestically. Should China choose to allocate a greater share of infrastructure spending towards power generation from renewable fuel sources, it could have a significant effect on global use of such technologies.
Chinese heavy industry has been particularly hard hit by slumping global demand, leading to emissions reductions. Electricity demand continues to fall, year-on-year (as of May at least), despite the aggressive government stimulus which has including new metals processing. In fact, the persistent weakness in industrial electrical demand suggests that overall growth could be weaker than some officials suggest. Electricity demand has tended to be a proxy for economic growth. A more domestically driven growth pattern might reduce the pace of Chinese new energy demand growth over time, however, suggesting that this correlation could change if more output is shifted to the services sector.
Coming to a global consensus might therefore be difficult. Already many European countries, including Sweden, which takes up the EU presidency today, may have hoped for a more aggressive commitment from Washington. Emerging and frontier market economies like South Africa, Mexico and the UAE are now taking measures to reduce their carbon footprint. Brazil has moved to reduce the destruction of its rain forests. However these countries continue to be wary of restrictions on emissions, arguing that advanced economies should bear the bulk of the costs. They are also pushing for more technology transfer from the companies and countries that developed some of these techniques.
Higher Carbon Costs and the Global Economy
A higher price for carbon-based energy could be one of several increased taxes and costs which weigh on U.S. consumption in the near future. Should the recovery in U.S. consumption be as sluggish as feared, such higher costs could be a limitation in the absence of real investment which might prompt productivity gains. Despite the risks of a new carbon price, this cost, plus the allocation of government and private sector funds, could spur innovation and energy savings technology that could lead to productivity growth.
Moreover, the cost of energy could increase quite substantially even in the absence of a carbon price. Even in 2009, there is a risk that higher oil prices might dampen any economic recovery. Further increases, perhaps to the $80-90 a barrel range, could keep the economy well in recessionary territory this year. Given current and past short-falls in oil investment, production growth might be quite sluggish going forward. If petroleum demand returns to trend, this could contribute to higher prices in 2010. Higher oil and coal prices could encourage a change in behavior that could boost the position of alternatives in the energy mix, even though carbon-based fuels – albeit higher cost ones – are likely to fuel the economy for years to come.