Energy & Entrepreneurs, Economic Analysis #1 

Cap and Trade and a Costly Mess

by Raymond J. Keating

There appears to be a strange assumption at work in political and policy arenas regarding the costs of a government regulatory undertaking that would impose significant costs throughout most of the economy. 

The assumption is that a system is available whereby costs imposed by this massive regulatory intrusion could somehow be substantially reduced.  That a cap-and-trade system mandating reductions in carbon-dioxide (CO2) emissions would not be too burdensome for consumers, workers, businesses and the economy.

Two reports published in late April provide additional evidence that this amounts to mere wishful thinking.

There is interest in Congress and on the campaign trail to adopt a Kyoto-style mandate for the U.S. to reduce CO2 emissions in response to the perceived threat of so-called manmade global warming.  The government would cap CO2 emissions, and either hand out or auction off CO2 emission credits.  These credits could be traded in the market based on some companies reducing emissions and being sellers, and others being buyers to cover additional emissions. And therefore, everybody's happy.

This might sound nice to some in theory.  But what's the reality?

Financial Times Looks at Cap-and-Trade Schemes

Well, on April 26, the Financial Times served up an investigation of European versions of this regulatory scheme.  The Kyoto Protocol went into effect for 160 countries in 2005, and is due to expire in 2012. Under the agreement, developed nations are supposed to reduce emissions by about 5 percent below 1990 levels by 2012. Part of the regulatory apparatus to do that is through carbon credits and emissions trading.

Among the items that the Financial Times found:

• "Companies and individuals being charged over the odds for the private purchase of European Union carbon permits that have plummeted in value because they do not result in emissions cuts."
• "The price of carbon in the EU scheme more than halved last year after it was revealed that more permits had been issued than were needed in the first phase, from 2005 to 2007."
• In the voluntary market - outside of the Kyoto Protocol and EU emissions trading schemes - "it is often difficult for buyers and brokers to verify the existence and effectiveness of projects" in remote areas meant to provide reductions in emissions. Also, there is "funding of carbon reductions that could have happened anyway... Under the Kyoto protocol, qualifying projects must be ‘additional,' meaning, in most cases, that they would not be economically viable without carbon credits. The FT has, however, uncovered examples where carbon credits have merely provided another source of revenue to projects that would have happened anyway."
• "Companies seeking to cancel out their greenhouse gas production face big variations in the price of a tonne of carbon dioxide. So big are the differences ... that buyers cannot tell whether they are getting good value, or whether their money is being swallowed up in administration fees or brokers' profits."

The cited problems with "carbon markets" led to an editorial in the same issue calling for a shift to a system of taxation.  The editorial argued that "carbon markets leave much room for unverifiable manipulation. Taxes are better, partly because they are less vulnerable to such improprieties."  It later continued on to make a case for taxes as a kind of positive for business: "While short-term politics favour markets, taxes would be better in the long term because industry needs certainty for investments years hence. A government committing to painful taxes signals seriousness of its intentions."  In reality, though, taxes are no better than this regulatory scheme.  Indeed, the case can be made that taxes would be even worse, as there would be no means for recognizing which industries need more emissions and which do not.  But the fundamental point remains that costs rise for consumers and businesses whether through a cap-and-trade scheme, or through direct taxation.

This Financial Times editorial made another point worth considering: "Yet most of the political appeal of markets is that they hide the true costs to consumers. That is why carbon markets exist in the first place. For this reason it is unlikely that governments would offset the invisible burden of markets by changing visible taxes."  The problem in this statement is one of terminology.  True, private markets do not hide costs to consumers. They do the exact opposite. In reality, it is government regulation that hides the true costs of government action from consumers.  And that is really what's at work here - not markets, but regulation.  It is incorrect to label a cap-and-trade system as a "market;" it is merely another form of government regulation.

CBO and Shifting Costs

The second report issued late last month (on April 25) came from the Congressional Budget Office.  It was titled "Trade-Offs in Allocating Allowances for CO2 Emissions."

The point of the paper was to assess which cap-and-trade system under a government mandated reduction in CO2 emissions would be less costly.  Also, at times, the tone of the piece seemed intent on downplaying the costs a bit.  But the costs of heading down this regulatory path will be significant - no matter how government tries to allocate or disguise them.  And in the end, that came through clearly in the CBO report.  For example:

• "Regardless of how the allowances were distributed, most of the cost of meeting a cap on CO2 emissions would be born by consumers, who would face persistently higher prices for products such as electricity and gasoline."
• "In addition, workers and investors in parts of the energy sector - such as the coal industry - and in various energy-intensive industries would be likely to experience losses as the economy adjusted to the emission cap and production of those industries' goods declined."
• "Researchers conclude that much or all of the allowance cost would be passed on to consumers in the form of higher prices. Those price increases would disproportionately affect people at the bottom of the income scale."
• "As some parts of the energy sector and various energy-intensive industries adjusted to a decline in demand for their goods, current workers and investors in those industries would experience costs in the form of lower wages, job losses, and reduced stock values."
• "Over the long term, producers in industries with high CO2 emissions would adjust to lower levels of demand by leaving the industry or by expanding less. In the near term, however, expectations about earnings on existing capital in those sectors would fall, resulting in losses to shareholders and owners."
• "Any policy that reduced U.S. emissions of carbon dioxide would inevitably create costs for existing workers. Job losses could occur throughout the economy but would probably be especially large (in percentage terms) in industries associated with high-carbon fuels."

There is no getting around the costs when government chooses to insert itself into the economy in a significant way. Cap-and-trade emissions trading or taxes, it really does not make that much difference. Costs will be higher. Businesses and investors will suffer.  Consumers will be hurt. Jobs will be lost. Economic growth will be restrained. That is the economic reality if government decides to mandate reductions in CO2 emissions.

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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.