The Lieberman-Warner bill would place mandatory caps and reductions on greenhouse gases (mainly CO2), as well as caps on industries in the U.S. responsible for emitting 75 percent of greenhouse gases. The system is designed to reduce emissions by 70 percent by 2050. Sounds like a great idea, right? Not so fast.

An April 2007 Massachusetts Institute of Technology report estimated the annual cost of implementing these schemes between $263 billion and $366 billion. The estimated annual cost for a family of four is $3,500 to $4,900, with a disproportionate share from low-income families. In November 2007, the Congressional Budget Office estimated that a modest 15 percent reduction in CO2 emissions would cost consumers $100 billion annually, and similarly found that low-income families would bear the brunt.

In reality, the cap and trade proposals are nothing more than a regressive tax that will cause a massive redistribution of wealth upward, with no real benefit. The proposals would mandate emission reductions (read energy usage), which can only be obtained by curtailing output. The result: economic recession.

The Emissions Trading Scheme: The European Experience

In 2004, the European Union adopted the Emissions Trading Scheme as the primary mechanism to ensure compliance of their Kyoto Protocol obligations. Trading of emissions credits began in 2005, with an initial trading period set for 2005-07 and a second one for 2008-12, coinciding with the Kyoto Protocol’s expiration.

The E.T.S was designed to include only large industrial carbon dioxide sources, including the following:
- Combustion installations over 20 megawatts
- Oil refining installations
- Cokes, iron, and steel production
- Lime and cement production
- Glass production
- Ceramics
- Paper and pulp production

Each member state was required to define an allocation plan for emissions credits consistent with its commitment under the Kyoto Protocol, and to comply with E.U. rules on competition and state subsidies.

Despite high hopes, the E.T.S. has not worked. The program will not meet the member states’ obligations under Kyoto, and the price of emissions credits for the first trading period have plunged from around $30 a ton in March 2006 to less than $1 per ton by February 2007. Thus, the cost to companies for exceeding their emissions allowance is essentially zero. Futures prices for emissions credits in the second trading period remain high, due to uncertainties over future allocations, caps, and changes to the program.

Several factors have led to the failure of the first phase. Among the problems: initial caps were set too high (they were estimated at 3 percent higher than actual emissions); the program was too complex; there was no transparency in how the credits were allocated; and there was major inequality among the member states. In some states, the covered industries represented as little as 30 percent of emissions, whereas in others, they accounted for 70 percent.

The E.T.S. has had a number of unintended economic consequences. In Germany, for example, electricity prices rose by almost 25 percent during the first trading period, while German electricity generators earned extra-normal profits of several billion euros. Electricity prices are set to rise 10 percent this winter in the U.K. Cement producers across southern Europe now face competition from Morocco and Algeria, as producers there are not subject to emissions purchase. The net result is increased global emissions and job loss within Europe.

A recent study has suggested that continuation of the E.T.S. through 2012 will result in a net reduction in gross domestic product across the E.U.-15, ranging from 1.3 percent for Great Britain to 3.3 percent for Italy. In other words: recession.

A Primer on Cap and Trade

A cap and trade scheme is a government policy tool that mandates reductions in emissions though market-based incentives. In its simplest form, it has several components.

- A cap (limit) is set on emissions, which must be lower than the “business as usual” emissions.
- Companies either purchase, or are issued, allowances (or credits) by the government which permit a certain amount of emissions.
- The cap is lowered over time.
- Companies that reduce their emissions below their allowance are permitted to sell their credits.
- Companies that exceed their allowance must purchase credits.
- A market is set up to trade emissions allowances with the price controlled by the free market.

Consider two companies, Company A and Company B. At the beginning of the program each emits equal levels of CO2, and the cap and trade program requires a 10 percent reduction. Company A upgrades its facilities and is able to achieve a 20 percent reduction; Company B cannot reduce its emissions due to high costs or other reasons. Under the scheme, Company A is permitted to sell 10 percent of its allowances, while Company B must buy an additional 10 percent to comply. The price is set by the market for emissions allowances, with prices rising as the cap is lowered. Thus, the cost of not reducing emissions increases over time, and Company B can continue to purchase credits but eventually its products will be priced out of the market.

In the abstract, this sounds like a great idea: the government mandates the maximum emissions level and the free market determines the credits’ value and ultimate allocation. In reality, it’s not quite so simple. The cost of reducing emissions can vary significantly. In some cases, it may be impossible to reduce emissions without developing new technologies and processes. With cap and trade, the burden of investing in new technologies will likely fall on those companies that can least afford it. It is a triple burden, as not only must they purchase emissions credits to stay in operation, but they also must invest in technology and upgrades while writing off long-term investments in existing facilities. Who pays for all this? Customers and employees, through higher prices and lower wages. Companies with emissions credits to sell will reap a windfall, which will benefit their shareholders.

What Will Emissions Trading Mean in the U.S.?

The Congressional Budget Office has estimated that CO2 emissions trading in the U.S. could be worth as much as $300 billion per year by 2020. Coupled with the costs of implementation (another $300 billion or so), we are looking at half a trillion dollars annually. Where will all that money come from? Consumers and taxpayers, of course – with a disproportionate amount from lower income groups. Where will it all go? Special interests, shareholders, congressional pork, and overseas. Indeed, the special interests are already lining up to influence this legislation.

As the emissions caps are gradually reduced, credits will become more expensive – that’s due to the basic laws of supply and demand. One consequence will be the introduction of extreme price volatility in the marketplace. Consider what happens if we have a very hot summer or very cold winter. Electric power companies will need to buy additional credits to generate the electricity required to cool (or heat) homes and businesses. These costs will be passed on to consumers.

To illustrate that point, let’s consider the case of a small rural electric co-operative. It is impossible for a small co-op to be as efficient as a major municipal utility, or any large utility. One simple reason is line loss. As electricity flows through a wire, a small amount is lost as heat. One way to view this is as friction. There is a certain amount of friction to the flow of electrons in the wire, resulting in heat (or energy loss). Now look at a rural co-op, which may have miles of wire for each customer, versus a municipal utility, which may have less than a quarter mile for each customer. Additionally, building a power plant is often a 50-year investment, requiring hundreds of millions of dollars – or in the case of a nuclear plant, billions. While large electric companies can more readily make these investments and shift more of their generation to nuclear over the next 20 years, smaller companies and co-ops cannot. By virtue of physics and their operations, small rural co-ops are destined to be purchasers of emissions credits, while large electric utilities are destined to be sellers. The money will flow from the rural customers to the shareholders of large companies, which are well positioned to take advantage of cap and trade.

Under cap and trade, the burden of investment in new technologies falls on those who can least afford those investments. Additionally, it is a triple burden. Not only must they purchase emissions credits to stay in operation, but they must also invest in technology and upgrades at the same time – while writing off existing long-term investments in power plants or manufacturing facilities. Ultimately, the costs will reside (again) with those who can least afford it – consumers and taxpayers already facing surging energy prices.

Indeed, prices are certain to rise, because only a limited number of credits will be available to manufacturers and power producers. As the credits become scarcer, the price of the remaining ones will rise dramatically. And those costs incurred by manufacturers and power producers will be passed on to consumers. What will happen when some businesses can’t purchase the credits needed? What will they do? Close their doors? Curtail production?

As population increases, demand for energy and products continue to rise: it always has. As that occurs, U.S. producers will be unable to compete with foreign companies that don’t have to purchase credits. Thus, jobs and manufacturing (and carbon dioxide emissions) will be “outsourced” to other countries – eliminating any benefits from the program.

How do we level the playing field for U.S. producers? The only answer is to implement an import tariff based on carbon dioxide emissions. But the complexity – not to mention the cost – required to implement such a scheme boggles the mind. None of the legislation before Congress today contains any such provisions.

It’s unlikely that the cap and trade legislation now pending in Congress will have any significant impact on global CO2 emissions. If cap and trade becomes law, these schemes will require a reduction in energy consumption, and thus G.D.P., in the U.S., resulting in economic recession and a major redistribution of wealth. Additionally, strict implementation of these schemes across the developed world will likely hold down prices for fossil fuels. Why? Well, cap and trade should reduce demand for these fuels in the developed countries. That will mean lower prices for fossil fuels and that will encourage more fossil fuel use in developing countries.

Although many complain about them, higher energy prices have a positive effect: they encourage the free market to invest in improved efficiencies and alternative sources. Indeed, oil at $100 per barrel could drive those efficiencies and spur development of new technologies, and do so without cap and trade.

The answer is simple: Let the free market work. Higher prices will encourage the shift toward new fuels and efficient conversions. But for that shift to work to its best advantage, we cannot cripple the economy with taxes and mandated recession. An economy in recession has less money to invest in research and development. Instead, we should provide incentives for companies to develop new technologies through tax credits: use the carrot, not the stick.

Larry Kealey is a Houston-based energy consultant.

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