Policy Peril Segment 6: Cap and Trade (Updated August 25, 2009)
Today’s excerpt from CEI’s film, Policy Peril: Why Global Warming Policies Are More Dangerous Than Global Warming Itself, is on cap-and-trade.
What is cap and trade?
Cap-and-trade is Al Gore’s (and the environmental community’s) leading “solution” to the alleged “climate crisis”–the centerpiece, for example, of the Kyoto Protocol climate treaty.
There are many technical issues in the design and implementation of a cap-and-trade program, but the basic idea is as follows.
The government establishes a legal limit–a “cap”–on the total quantity of greenhouse gases that regulated (“covered”) entities may emit. Each covered entity must acquire one federally-created or -certified allowance (permit, ration coupon) for every ton of carbon dioxide-equivalent (CO2-e) greenhouse gases it emits. The total number of allowances allocated exactly equals the number of tons permissible under the cap. Thus, as the cap tightens, the supply of coupons shrinks, and emissions from covered entities decline.
An entity with high emission-reduction costs may simply decide to cut its energy use and economic output, but it may also buy surplus coupons from an entity with lower emission-reduction costs. The buying and selling of ration coupons is the “trade” part of cap-and-trade.
“Market-based” is a misnomer
Supposedly, cap-and-trade leads to an economically-“efficient” solution. Participants are motivated to innovate and search for cheap emission-reduction opportunities not only to minimize their own costs but also to generate surplus coupons they can sell in the carbon trading market.
Cap-and-trade is often called “market-based” because each business, spurred by the desire to minimize costs and (if possible) amass surplus coupons it can sell for a profit, determines where and how to cut its emissions. This is in contrast to “command-and-control” regulation in which a central authority prescribes the emission rates (e.g. lbs. of Co2 per Megawatt hour of electricity generated or sold) or energy efficiencies covered entities must achieve, or the fuel types (e.g. wind, solar, geothermal) or technologies (e.g. carbon capture and storage) they must use.
In practice, however, cap-and-trade legislation typically contains buckets of command-and-control provisions. For example, the Waxman-Markey cap-and-trade bill (about which more later) mandates electric generation from renewable sources and imposes tough new efficiency standards for buildings, appliances, transport systems, and industry.
More fundamentally, as my colleague Myron Ebell points out in his testimony on Waxman-Markey, cap-and-trade is not really “market-based.” Cap-and-trade “subordinates markets to central planning. It takes the most important economic decisions [e.g. what kinds of energy technologies will dominate the market and how much consumers will have to pay for energy] out of the hands of private individuals acting in the market and puts them in the hands of government.”
Far from being “based” on the market, cap-and-trade would effect a gigantic expansion of government power and control over markets. The “cap” in cap-and-trade creates a government-run rationing system for the carbon-based fuels that supply 85% of our energy. Our liberties are at risk, as Myron explains in his testimony:
If enacted, Title III [the cap-and-trade portion of Waxman-Markey] would be the single largest government intervention in the economy since the Second World War. That was the last time–and we hope it remains the last time–when people had to present ration coupons in order to buy gasoline (and many other products including cars, tires, sugar, coffee, meat, cheese, butter, and shoes). While the debate has focused on costs, far too little attention has been paid to the extent that political and economic freedoms would be lost or impinged upon under cap-and-trade. I urge the Committee and the House to consider seriously and deeply the threat to our liberties posed by putting government in charge of how much and what type of energy we can consume.
Today’s Policy Peril excerpt
In today’s Policy Peril film excerpt, Dr. David Kreutzer, an economist with the Heritage Foundation, discusses his team’s analysis of the Lieberman-Warner bill (S. 2191), the leading cap-and-trade bill of 2008. You can view today’s film clip here. To watch Policy Peril from start to finish, click here. Previous posts in this series are available immediately below.
Enough preliminaries; here’ s the text of today’s film excerpt:
Narrator: Okay, so the global warming scare is built on speculation and hype. Now let’s look at the other side of the equation–the policies being promoted to combat global warming. What are they, and what are the associated risks?
Several bills in Congress call for deep emission cuts by 2050. The most prominent in 2008 was the Lieberman-Warner bill. It would require a 70% emissions cut.
Dr. David Kreutzer (Heritage Foundation): When we analyzed the impact of the Lieberman-Warner bill, we found three things: Incomes go down, taxes go up, and jobs go away.
Narrator: Lieberman-Warner would reduce cumulative U.S. GDP by $5 trillion during 2012 to 2030. Let’s put that in perspective. A typical hurricane striking a U.S. coastal community does about $5 billion in damage.
In the portion of the film just after today’s clip, Dr. Kreutzer compares the economic damage from Lieberman-Warner to that caused by a typical landfalling hurricane:
Dr. Kreutzer: Well, adjusting for increases in wealth over the next 20 years, that means that the damage done by Lieberman-Warner in economic terms is the equivalent of over 600 hurricanes. Now, normally we have slightly less than two hurricanes per year that make landfall. So this is orders-of-magnitude worse than the damage that would be done by these weather storms, the hurricanes. That’s a big hit to the economy.
Cap-and-trade is an energy tax
The Heritage Foundation study of Lieberman-Warner is available here. The Heritage folks point out what should be obvious. Eighty-five percent of U.S. energy comes from carbon-based (greenhouse gas-emitting) fuels. Capping emissions therefore means capping (restricting) energy use and/or compelling suppliers and consumers to switch from lower-cost fossil fuels to more expensive “alternative” energy sources.
Cap-and-trade “works” (reduces emissions) by making carbon-based energy more costly for consumers. Peter Orszag, President Obama’s budget director, unequivocally affirmed this point in his April 24, 2008 Senate Finance Committee testimony (p. 3) when he was Director of the Congressional Budget Office (CBO):
Under a cap-and-trade program, firms would not ultimately bear most of the costs of the allowances but instead would pass them along to their customers in the form of higher prices. Such price increases would stem from the restriction on emissions and would occur regardless of whether the government sold emission allowances or gave them away. Indeed, the price increases would be essential to the success of a cap-and-trade program because they would be the most important mechanism through which businesses and households would be encouraged to make investments and behavior changes that reduced CO2 emissions.
Barack Obama put the point more bluntly in January 2008, when campaigning as a presidential candidate. He said:
Under my plan of a cap-and-trade system, electricity rates would necessarily skyrocket . . . because I’m capping greenhouse gases, coal power plants, natural gas — you name it — whatever the plants were, whatever the industry was, they would have to retrofit their operations. That will cost money; they will pass that money on to consumers.
In short, cap-and-trade is an energy tax by another name. As Myron likes to say: “There are three things you need to know about cap-and-trade: It’s a tax, it’s a tax, it’s a tax.” And since energy is the lifeblood of modern economies, energy taxes or their regulatory equivalent unavoidably raise consumer prices, reduce economic output, and reduce employment.
Energy tax impacts
The Heritage study estimated the following impacts from the cap-and-trade component of Lieberman-Warner:
- Cumulative GDP losses are at least $1.7 trillion and could reach $4.8 trillion by 2030 (in inflation-adjusted 2006 dollars).
- Single-year GDP losses hit at least $155 billion annually and could exceed $500 billion (in inflation-adjusted 2006 dollars).
- Annual job losses exceed 500,000 before 2030 and could approach 1,000,000.
- The average household will pay $467 more each year for its natural gas and eletricity (in inflation-adjusted 2006 dollars).
A study by the National Association of Manufacturers and the American Council for Capital Formation came to similar conclusions. According to NAM/ACCF, Lieberman-Warner would:
- Raise natural gas prices for residential consumers by 26% to 36% in 2020, and 108% to 146% in 2030.
- Raise electricity prices for residential consumers by 28% to 33% in 2020, and 101% to 129% in 2030.
- Raise gasoline prices by 29% or $1.10 (based on prices prevailing as of June 2008).
- Reduce GDP growth by $151 billion to $210 billion in 2020, and $631 to $669 billion in 2030 (in 2007 dollars).
- Reduce net job creation by 1.2 million to 1.8 million in 2020, and 3 million to 4 million in 2030.
Charles River Associates also projected heavy economic impacts. In their analysis, Lieberman-Warner would:
- Reduce real annual household spending by an average of $800 to $1,300 in 2015.
- Reduce GDP by $160 billion to $250 billion in 2015.
- Produce net job losses of 1.5 million to 2.3 million in 2015.
The frothings of right-wing paranoia, you say? Well, then EPA, too, must be part of the vast right-wing conspiracy. In EPA’s analysis , Lieberman-Warner would:
- Increase gasoline prices by $0.53 a gallon in 2030.
- Reduce U.S. GDP by $238 billion to $983 billion in 2030.
- Increase electricity prices by 44% in 2030.
All pain for no gain
All in all, not a pretty picture! Yet Lieberman-Warner would have no measurable impact on global temperatures for many decades, if ever. Assuming for a moment the correctness of the scientific basis for these policies, Lieberman-Warner would prevent 0.013ºC of global warming by 2050, Dr. Patrick Michaels estimates. Even if all industrialized countries adopt Lieberman-Warner, total global warming averted is 0.11ºC by 2050–too little for scientists to detect.
With this abysmal cost-benefit ratio (trillions in costs for undetectable global warming reductions), it is small wonder that S. 2191 died in the Senate in June 2008.
Rube Goldberg Green
But perhaps the main reason Lieberman-Warner fizzled is that the U.S. Chamber of Commerce exposed the bill as a Rube Goldberg scheme rife with mandates, regulation, and red tape. The Chamber’s Lieberman-Warner flow chart is one of those pictures worth a thousand words. Please take a moment to behold the infernal complexity of it all!
The sausage factory known as the “legislative process” always mingles and mangles cap-and-trade with prescriptive mandates, special-interest carve outs, and bureaucratic empire building.
Special-interest manipulation and gaming are an unavoidable affliction. Consider Europe’s emissions trading system (ETS), which was a bonanza for special interests during the first three years of its operation (2005 to 2007). In Europe’s Dirty Secret: Why the EU Emissions Trading Scheme isn’t working, the British think tank Open Europe details a host of abuses, including:
- Governments over-allocated allowances to domestic firms (to reduce costs and create competitive advantage), collapsing credit prices from €33 to €0.20 per ton, “meaning that the system did not reduce emissions at all.”
- Utilities got free allocations, passed the imaginary costs onto customers in the form of higher electric rates, and then sold the coupons they didn’t need — double dipping at the expense of industrial manufacturers and consumers.
- Small institutions like hospitals did not get free coupons and ended up subsidzing well-connected energy companies.
Dr. Kreutzer’s colleague Ben Lieberman (who also appears in Policy Peril) testified recently before the Senate Foreign Relations Committee on Europe’s experience with cap-and-trade. Ben’s take on the hearing is a knee-slapper:
I was the only one on the panel who thought the problems in Europe were not fixed. The repesentative from Shell said that the original problem was the over-allocation of free allowances, which has since been corrected–and he then argued for more free allocations for refiners. A BASF representative also said the problem with free allocations had been fixed–and went on to say that the chemical industry needs more free allocations.
The Heritage Foundation analysis of Lieberman-Warner also found that it would transfer immense wealth from consumers to special interests. Later on in Policy Peril, Dr. Kreutzer comments:
Dr. Kreutzer: The Lieberman-Warner bill also enacts a huge transfer from the consumers of energy to groups that are picked out–special interest groups that Congress would designate. So after America has lost $5 trillion in income, there will be another $5 trillion taken and transferred from energy consumers.
Because even an idealized cap-and-trade program is the regulatory equivalent of an energy tax, its economic impact is regressive, meaning that it imposes a relatively greater burden on poor households, who spend a larger share of their income on energy and other basic necessities. The Congressional Budget Office (CBO) report, Tradeoffs in Allocating Allowances for CO2 Emissions (April 2007), is crystal clear on the point:
Regardless of how allowances were distributed, most of the cost of meeting a cap on CO2 emissions would be borne by consumers, who would face persistently higher prices for products such as electricity and gasoline. Those price increases would be regressive in that poorer households would be a larger burden relative to their income than wealthier households would.
Mirage of regulatory predictability
Proponents spout a lot of happy chatter about how cap-and-trade will create a “predictable” regulatory framework for businesses, because Congress will specify in advance how much and how fast emissions must decline. But this claim ignores the enormous potential of cap-and-trade bills to spawn a new era of regulatory litigation, creating uncertainty and delays for business investment. Have a look again at the U.S. Chamber chart of Lieberman-Warner. The bill contains 300 regulations and mandates, each of which most go through the bureaucratic process illustrated in the center of the chart. Many of those rulemakings would likely be litigated.
Moreover, the “predictability” most important to business is cost predictability. Uncertainty regarding compliance costs makes it difficult for businesses to plan and attract capital for major projects. Key point: A cap produces cost uncertainty precisely to the extent that it achieves emissions certainty.
That is, when the quantity of emissions is fixed by law, covered firms have to comply regardless of what it costs, and any number of factors outside the covered entity’s control — unseasonable weather, natural disasters, energy crises, business cycles — can affect cost.
Proponents of greenhouse gas cap-and-trade schemes tout the Clean Air Act’s Acid Rain sulfur dioxide (SO2) emissions trading system as a model. But as Ken Green, Stephen Hayward, and Kevin Hasset of the American Enterprise Institute point out:
SO2 trading prices have varied from a low of $70 in per ton in 1996 to a high of $1500 per ton in late 2005. SO2 allowances have a monthly volatility of 10 percent and an annual volatility of 43 percent over the last decade.
The potential for cap-and-trade to generate allowance-price volatility — hence energy-price volatility — is vast. As Green, Hayward, and Hasset also note, in 1994, California’s South Coast Air Quality Management District (SCAQMD) launched RECLAIM (Regional Clean Air Incentives Market), an emissions trading program for SO2 and nitrogen oxides (NOx). SCAQMD estimated that SO2 and NOx would be reduced by 14 and 8 tons per day respectively, by 2003, at half the cost of prescriptive, command-and-control approaches. The authors comment:
RECLAIM never came close to operating as predicted and was substantially abandoned by 2001. Between 1994 and 1999, NOx emissions fell only 3 percent, compared to a 13 percent reduction in the five years before RECLAIM. There was extreme price volatility aggravated by California’s electricity crisis of 2000. NOx permit prices ranged from $1,000 to $4,000 per ton between 1994 and 1999, but soared to an average price of $45,000 per ton in 2000, with some individual trades over $100,000 per ton. Such high prices were not sustainable, and SCAQMD removed electric utilities from RECLAIM in 2001.
Waxman-Markey: impacts and offsets
The big kahuna of cap-and-trade bills this year is the American Clean Energy and Security Act (ACES), H.R. 2454, commonly known as Waxman-Markey for its co-sponsors, House Energy and Commerce Chairman Henry Waxman (D-CA), and Energy & Environment Subcommittee Chairman Ed Markey (D-MA).
On March 31, 2009, Waxman and Markey circulated a “discussion draft” of ACES. On May 13, 2009, Dr. Kreutzer and the Heritage team published their economic impact assessment of the cap-and-trade provisions. The discussion draft cap-and-trade program aimed to reduce greenhouse gas emissions from covered sources 20% below 2005 levels by 2020, 42% below by 2030, and 83% below by 2050. The Heritage analysis projected that, by 2035, the bill would:
- Reduce cumulative GDP by $7.5 trillion.
- Lower average annual employment by 844,000 jobs, reducing employment by 1.9 million jobs in peak years.
- Raise electricity rates 90% after adjusting for inflation.
- Raise inflation-adjusted gasoline prices by 74%.
- Raise an average family of four’s yearly energy bill by $1,500.
- Increase inflation-adjusted federal debt by 29%, or $33,400 additional debt per person.
A key uncertainty in estimating the economic impacts of a cap-and-trade program is the extent to which covered entities may meet their obligations by earning or purchasing “offsets.” An offset is a credit for greenhouse gas-reducing investments in economic sectors or geographic regions not subject to the cap. For example, offsets may be awarded for investing in tree plantations in developing countries (trees remove CO2 from the air).
The Breakthrough Institute contends that the offset provisions in Waxman-Markey are so generous they all but eliminate any real constraint on U.S. domestic CO2 emissions until 2025 or 2030. Indeed, the bill authorizes up to 2 billion tons in offsets for domestic projects and 1.5 billion tons in offsets for international projects. (All of which, incidentally, is tacit admission that the costs of cap-and-trade can be severe and must in some way be mitigated or limited.)
Other analysts note that offsets are highly susceptible to fraud and creative accounting. For example, a Chinese company might increase its emissions of hydrochloroflourocarbons (HCFCs), which are very potent synthetic greenhouse gases, just so offset-seeking U.S., European, and Japanese businesses can pay the Chinese company to reduce those emissions. Assuring the integrity of an offset is “challenging,” says the Government Accounting Office (GAO), “because it involves measuring the reductions achieved through an offset project against a projected baseline of what would have occurred in its absence.” The House of Representatives had an offset program to achieve “carbon neutrality,” but abandoned it after finding out the program was paying farmers to do what they would do anyway (use tilling practices that keep the carbon buried in the soil). Award enough dubious offsets, and the Waxman-Markey cap becomes a leaky sieve.
On the other hand, the Heritage Foundation’s May 13, 2009 study argues that the bill, perhaps recognizing the potential for fraud, “includes significant hurdles for those wishing to use offsets.” Heritage assumes in its analysis that offsets will alleviate the stringency of the caps by 15%.
Charles River Associates (CRA), in a May 2009 study commissioned by the U.S. Black Chamber of Commerce, assumes full use of international offsets, notwithstanding well-known “difficulties in measuring, veryifying, and ensuring the permanence” of the emission reductions claimed for such projects. Under this assumption, total U.S. emissions from 2012 to 2050 to exceed the cap by about 30%–double the 15% assumed in the Heritage analysis. Accordingly, the CRA study of Waxman-Markey, as introduced on May 15, 2009, projected smaller although still significant economic impacts.
Under the Waxman-Markey cap-and-trade program, CRA estimates:
- Retail natural gas rates would increase by 10% in 2015, 16% in 2030, and 34% in 2050 relative to the baseline in the Energy Information Administration’s (EIA) Annual Energy Outlook 2009 (AEO09).
- Retail electric rates would increase by 7.3% in 2015, 22% in 2030, and 45% in 2050 relative to the AEO09 baseline.
- The per-gallon cost of gasoline would increase by 12 cents in 2015, 23 cents in 2030, and 59 cents in 2050 relative to baseline levels.
- U.S. employment would decline by 2.3 million to 2.7 million jobs in each year of the policy through 2030 relative to baseline levels (even after accounting for “green job” creation).
- Average wages would decline by $170 in 2015, $390 in 2030, and $960 in 2050 relative to basline levels.
- Average household purchasing power would decline by $730 in 2015, $830 in 2030, and $940 in 2050 relative to baseline levels.
- GDP in 2030 would be 1.1% or $350 billion lower than the baseline level.
Rejected consumer protections
Waxman and Markey introduced their bill in the House on May 15 and the House Energy and Commerce Committee appoved a marked-up (amended) text on June 5. It is quite revealing what amendments the Committee rejected.
On largely party-line votes, Committee Democrats voted down:
- Rep. Fred Upton’s (R-MI) amendment suspending the Act if the EPA Administrator determines that the U.S. unemployment rate has reached 15% as result of the Act.
- Rep. Lee Terry’s (R-NB) amendment suspending the Act if the price of gasoline exceeds $5 a gallon.
- Rep. Roy Blunt’s (R-MO) amendment suspending the Act if retail electricity prices increase by more than 10%.
Waxman-Markey grows and grows
Heritage Foundation’s analysis of Waxman-Markey as approved by the House Energy and Commerce Committee on June 5 is available here. To obtain enough votes needed for passage, Waxman and Markey and House Speaker Nancy Pelosi (D-CA) kept expanding the bill with more and more goodies for utilities and other affected interests. Between Committee approval on June 5 and placement on the House Calendar on June 19 the bill grew from 742 pages to about 1,200 pages. Then, at 3:00 a.m. the night before the House floor vote on June 26, the bill grew by almost 300 pages, finally weighing in at 1,427 pages. Most House members had no idea what they were voting on. Waxman-Markey as passed is so complicated that CBO needed 156 closely-printed pages just to summarize the bill’s provisions.
On August 6, 2009, David Kreutzer and his Heritage Foundation colleagues (Karen Campbell, William Beach, Ben Lieberman, and Nicolas Loris) released their analysis of Waxman-Markey as passed. The results are not too different from their initial analysis of the Waxman-Markey discussion draft. Under Waxman-Markey as passed:
- Impose a defacto energy tax on the U.S. economy costing $5.7 trillion during 2012-2035.
- Cumulative GDP losses are $9.4 trillion between 2012 and 2035.
- Single year GDP losses are $400 billion in 2025 and will ultimately exceed $700 billion.
- Net job losses approach 1.9 million in 2012 and could approach 2.5 million in 2035.
- A family of four on average will pay $839 more per year on energy-related utility costs.
- Cumulative manufacturing output is $585 billion lower than the baseline amount by 2035 .
- Gasoline prices will rise by 58% ($1.38 more per gallon) and residential electricity rates will rise by 90%.
A report by the American Council for Capital Formation (ACCF) and the National Association of Manufacturers (NAM), using the National Energy Modeling System (NEMS) developed by the Energy Information Administration (EIA), arrives at similar results:
- In 2030, inflation-adjusted GDP is reduced by 1.8% ($419 billion) under a low-cost scenario and by 2.4% ($571 billion) under a high cost scenario compared to the baseline forecast. For perspective, Social Security payments to retirees in 2008 totaled $612 billion.
- Cumulative GDP losses during 2012-2030 range from $2.2 trillion under the low-cost case to $3.1 trillion under the high cost case.
- In 2030, industrial output levels are reduced by between 5.3% and 6.5% under the low- and high-cost scenarios.
- Even when “green jobs” are factored in, total U.S. employment averages 420,000 to 610,000 fewer jobs each year under the low- and high-cost scenarios than under the baseline forecast. By 2030, there are between 1,790,000 and 2,440,000 fewer jobs overall.
- Electricity prices are 5% to 8% higher by 2020, and by 2030 electricity prices are between 31% and 50% higher.
- In 2030, household income declines from $730 in the low-cost case to $1,248 in the high cost case.
Postage stamp per day?
You may have heard from supporters that Waxman-Markey would cost the average family only $175 per year in 2020, or about a postage stamp per day, according to analyses by the Congressional Budget Office (CBO) and the EPA. That’s a small price to pay, we’re told, to save the planet!
The Heritage team’s rebuttal is worth quoting at length. Here’s their take on the EPA analysis:
First, the EPA employs a technique from the financial world called “discounting” to reduce the value [of the Waxman-Markey economic impacts]. For example, the EPA estimates that the inflation-adjusted cost per household in 2050 will be $1,287. However, after this value is discounted to the present, the cost is $140 per household . . . If a househhold must pay $1,287 in 2050, the $140 represents the amount that household would have to pay into an interest-bearing account today so that hte interest would allow it to grow to $1,287 by 2050. Discounting can be a legitimate tool for cost-benefit and investment analysis where costs are paid and benefits are received at different times. Thus, both are discounted to the same point in time and compared. Without discounted environmental impacts for comparison, using the technique, here, does little except undercount the cost that families will actually pay in 2050.
Second, the EPA measures consumption, not income. The broadest and best measure of cost if lost income–lost GDP. Consumption only comes after taxes and savings are deducted. Igoring lost savings and lost payments for government services underestimates sthe cost by about 40%.
Third, the EPA measures cost per household. Households are not necessarily families. One person living alone counts as a household, as do three single people sharing an apartment. The EPA uses an average household size of 2.6 people. Converting from this EPA household size to a family of four adds more than 50% to the cost estimate.
So, EPA’s $174 cost per household is actually above $2,700 (even after adjusting for inflation) when presented as lost income per family of four. That is not a postage stamp per day.
Regarding the CBO analysis, the Heritage team writes:
The CBO study, on the other hand, does not even attempt a comprehensive measure of lost income and it explicitly states so in footnote 3 of its report . . . The CBO’s methodology effectively measures the administrative costs of collecting and distributing the allowances rather than the full economic cost.
Additional commentary by Dr. Kreutzer the CBO and EPA analyses is available here, here, and here.
More pain for no gain
A final observation: Even if you think global warming is a big problem, Waxman-Markey would have no discernible effect on global temperatures or sea level rise even if all industrialized nations adopt it. Paul C. Knappenberger, my colleague at the free-market energy blog, Masterresource.Org has written brilliantly and extensively on these matters (see here, here, here, here, and here).