Is Cap and Trade a Dead Policy Walking?

In his February 24 speech to Congress, President Barack Obama asked Members “to send me legislation that places a market-based cap on carbon pollution.” So yesterday, House Energy and Commerce Committee Chair Henry Waxman took the first step by introducing his cap-and-trade plan. Yet sometimes, the political sands shift underneath a policy approach that was once viable, even embraced broadly, and its chances of becoming law ebb away. Until the media and the public make the connection between the policy and the new environment, the approach becomes a dead policy walking. It happened to Social Security privatization and the flat tax -- good riddance to both -- and now it appears to be overtaking cap-and-trade.

Cap-and-trade combines a regulatory cap on greenhouse gas emissions with a market-based scheme to trade as financial instruments the “permits” to produce those emissions. For all of cap-and-trade’s initial promise as an answer to climate change, the current financial crisis has made its vulnerabilities painfully clear. The strategy would have the government create trillions of dollars in new, asset-based financial instruments. These emissions-right-backed securities, like their cousins, mortgage-backed securities, also would throw off a host of new derivatives to be profitably traded by the “professionals.” Unsurprisingly, cap-and-trade’s fiercest promoters include Wall Street institutions that see emissions-permit trading as a lucrative new market that could earn them billions in new fees, commissions and, while it lasts, speculative gains. But after Wall Street’s meltdown, the proposition for another round of the financial merry-go-round that produced the worst economic crisis in our lifetimes seems either very naïve or very cynical.

That’s not the only tricky problem facing cap-and-trade. The other part of the policy’s design, the hard cap on emissions, ensures that the prices of the permits will be very volatile. Here’s why. The cap in cap-and-trade is set as a percentage reduction in annual emissions, figured from some baseline. The problem is that no one can forecast with precision how much energy American businesses and households will need from one year to the next, because no one knows how cold the winter will be, or how hot the summer, or how fast the economy will grow a year from now. When energy companies see that demand is going to outpace the forecast, so they will need more permits to keep on selling energy, the price of those permits will rise sharply. It’s not just theory: We use a small-scale cap-and-trade program to reduce the emissions that produce acid rain, and the price of those permits moves up and down an average of more than 40 percent per year. In the same vein, Europeans adopted their own cap-and-trade system for energy emissions a few years ago, and the price of their permits has moved up or down by an average of 17 percent per month.

For years, economists have worried that this basic feature of cap-and-trade would produce new volatility in energy prices. They’ve also cautioned that the result would likely be less investment in climate-friendly fuels, since no one would know what the price of their carbon content would be. Now there’s another, equally serious problem: The unavoidable volatility of the prices of emission permits also would attract furious financial speculation, since speculators live off of volatile prices. And we now know the risks that we all run when rampant speculation occurs in financial instruments tied to our economic foundations, such as housing -- or energy.

Like the excesses that helped create our current crisis, the financial markets for emissions permits also could well produce serious insider trading and manipulation. That’s because the final purchasers of the permits, large energy companies and utilities, would see shifts in demand for the underlying energy coming before anyone else. This information would create golden opportunities for insider profits and market manipulation, and erecting a “Chinese wall” inside the companies to segregate the production division from the trading division would work no better than it has on Wall Street. That may explain why until its own collapse, Enron was a prominent advocate of cap-and-trade.

The only reason to play another round of Russian roulette with the economy would be if cap-and-trade were the only way to address climate change. Happily, it isn’t: Many economists and some politicians support the major alternative, carbon-based taxes with rebates. This approach would create no new financial instruments to trade and abuse, and produce no additional price volatility, because the price of carbon would be set. It also would be relatively simple to administer and enforce. And it can be designed to recycle its revenues in payroll tax reductions or rebates. In this way, the carbon tax would change the relative price of different forms of energy, based on how much damage they do to the climate, while protecting people from the additional, direct costs of the tax itself. The revenues could also be recycled as a flat payment to each American household, providing relatively more help to low and middle-income families. The policy’s only real weakness is that it has no cap. But the tax rate could be adjusted periodically if actual emissions exceed its goal. And modeling shows that a carbon tax of about $50 per-ton of CO2 would produce slightly larger reductions in emissions than last year’s leading cap-and-trade proposal, the Warner-Lieberman bill.

For years, many politicians and environmental leaders have believed that any kind of tax to deal with climate change would be dead on arrival. That may be changing, especially if the tax is paired up with rebates to take away much of its political sting. More importantly, the costs and lessons of the financial crisis may effectively swamp the prospects for cap-and-trade. If cap-and-trade has become a dead policy walking, those who care deeply about climate change will find that a carbon tax system has become the last, reasonable policy standing.