The Dismal Economics of Climate Regulation

The Dismal Economics of Climate Regulation

Jeff Kueter Fall 2009

The U.S. Congress is now moving towards the creation of a cap-and-trade system. Proponents see the system, which has been strongly endorsed by President Barack Obama, as a market-oriented, cost-effective approach to reducing greenhouse gas emissions.

In any transaction, however, discerning consumers should weigh the benefits of the purchase against its costs. As such, the American public deserves a clear understanding of the costs of the House of Representatives’ proposed cap-and-trade program, not to mention the environmental return.

Economics is said to be the dismal science. The economics of the proposed regulations of human greenhouse gas emissions show just how dismal it can be.

The Goals of Cap-and-Trade

Cap-and-trade is designed to “cap” greenhouse gas emissions by establishing a maximum amount of emissions allowed each year. Over time, the government would reduce these caps, yielding steady reductions in greenhouse gas emissions.

The American Clean Energy and Security Act (ACESA), approved by the House of Representatives in June, would reduce greenhouse gas emissions economy-wide by 3 percent by 2012, 20 percent by 2020, 42 percent by 2030, and 83 percent by 2050.

Thus, under ACESA, the U.S. must reduce its emissions by 0.2 gigatons of carbon dioxide equivalent (CO2e) by 2012. The bill then seeks reductions of 1.46 gigatons by 2020, 3 gigatons by 2030, and 6 gigatons by 2050. In the July meeting of the G-8, President Obama further committed the U.S. to reducing its emissions by 80 percent in 2050.

While understanding the goals of cap-and-trade are important, there are other pertinent questions that need to be asked. How much will emissions fall? Will the projected reduction reduce temperatures? Moreover, will that fall in temperatures avert the asserted catastrophic consequences associated with global warming?

The Projected Drop in Emissions

According to the U.S. Energy Information Administration, energy-related carbon dioxide (CO2) emissions are projected to rise to 40 gigatons worldwide by 2030. They forecast that the U.S. will produce 6.4 gigatons of CO2 in 2030, meaning that the ACESA would result in roughly a 50 percent decline in emissions from U.S. sources. The last time the U.S. had an emissions level that low was the early 1900s.

However, absent similar international agreements with binding targets, the ACESA reductions would simply slow the rise of worldwide CO2 emissions. During the same period, Chinese emissions would nearly double, jumping from 6 gigatons in 2006 to 11.7 gigatons in 2030.

Enough Reduction?

Recent efforts to predict the impact on global temperature revealed that, “by the year 2050, [ACESA] would result in a global temperature ‘savings’ of about 0.05ºC regardless of the [Intergovernmental Panel on Climate Change] scenario used—this is equivalent to about 2 years’ worth of warming.” In other words, this is a negligible gain. In fact, Greenpeace disavowed the bill as it came to the House floor, noting that the cap needed to be significantly higher to yield emission reductions large enough to avert their catastrophic projections.

What legislators need to understand is that the rising world population and accompanying economic growth will fuel increasing greenhouse gas emissions for the foreseeable future. Both the International Energy Agency and the U.S. Energy Information Administration forecast that fossil fuels will account for 80 percent of the energy consumed to power homes and businesses, as well as to transport goods and people well into mid-century, even with the mitigating effects of government initiatives that promote alternative transportation fuels and electric power generation options.

So long as worldwide demand for fossil fuels remains high, greenhouse gas emissions will continue unabated. ACESA will not reduce these emissions in any meaningful way.

Costly Caps

Like most other cap-and-trade proposals that came before it, ACESA caps greenhouse gas emissions, divides the allowable emissions into 1-ton permits, and establishes a market where those permits may be bought and sold.

The Kyoto Protocol called for the creation of an international cap-and-trade system. European nations even went so far as to establish a functioning market. Legislation to construct a U.S. system has been debated in the U.S. Senate in recent years, largely under the leadership of Senators John McCain (R-AZ) and Joe Lieberman (I-CT).

A Marshall Institute study of legislation debated in the Senate in 2008 projected declines in gross domestic product (GDP) ranging from 0.3 percent to 3 percent, and consumption losses of 0.8 percent to 1 percent per year, which roughly translated to $1,100 per family of four, rising to $2,979 in 2050.

While the percentages may not seem high, in a trillion dollar economy, compounding annual reductions creates staggering losses. Lower-end estimates showed that a cap-and-trade system could increase electricity costs by 15 percent, gasoline prices by 13 percent, and natural gas prices by 20 percent. More than 500,000 jobs could be lost, even after accounting for the growth in “green jobs.”

Projections for ACESA show similar results. Charles River Associates predicts that the legislation will yield GDP losses of 1 percent by 2015, 1.3 percent by 2030, and 1.5 percent by 2050. Job losses ranged from 2.3 to 2.7 million jobs after including the offsetting expansion of green jobs. The Heritage Foundation, for its part, projects real GDP losses of $9.4 trillion (for 2012 to 2035), 1.1 million jobs lost, and rising energy prices. Inflation-adjusted electricity rates could rise a whopping 90 percent by 2035, gasoline prices by 58 percent, and natural gas prices by 55 percent.

Not surprisingly, proponents of the legislation scoff at such estimates. Citing the Environmental Protection Agency (EPA) and the Congressional Budget Office (CBO), members took to the House floor during the final ACESA debate and proclaimed, “This bill will cost the typical family less than that of a postage stamp per day.”

This message, of course, was meant to soothe the fears of a public already nervous about their economic prospects. But even the CBO and EPA show huge costs. The CBO, in its latest report, projected that by 2020, the net economy-wide annual cost of the cap-and-trade program would be $22 billion. The EPA further found that the legislation would reduce average annual household consumption by 0.1 to 0.2 percent. By way of background, both CBO and EPA have been criticized for including generous assumptions into their projections that produce estimates at the lower range.

Selling Hot Air for Cool Cash

How the allowances—the 1-ton permits to emit CO2—are distributed makes a huge difference. If the allowances are auctioned, rather than given away, the revenue from the auction can be returned to the public as a way of defraying the projected rise in energy costs.

Peter Orszag, now head of President Obama’s budget office, testified as director of the CBO before the U.S. Senate last year that allowances would have a value of $145 billion in 2012. Over time, he stated, as the cap became more stringent, the value of the allowances would grow.

However, Orszag also warned lawmakers not to give away the allowances. Doing so, he warned, would have a devastating impact on low-income Americans. Poor households would see their energy costs rise, while companies receiving the free permits would enjoy huge “windfall profits.” This would create other problems, too. Rising energy prices would force other firms to reduce output for carbon-intensive goods creating “concentrated income losses” in selected areas.

Despite these and other warnings, intensive lobbying and deal-making in the House of Representatives resulted in giving away at least half of the allowances in order to secure the votes necessary to approve ACESA. As Orszag warned, free allowances mean smaller auction revenues for the government to help consumers offset increasing heating and gasoline bills.

The “Other” Costs of Cap-and-Trade

The direct economic impact of cap-and-trade is daunting, but the market needed to make the system function will add further costs.

For one, there will be costs associated with price volatility. The prices of permits will move sharply, even with a so-called “safety valve,” which puts a ceiling on how high prices can rise. In Europe, which introduced its own trading system after the Kyoto Protocol, the price of permits shifted 17.5 percent per month over the first two years of trading. The much-praised sulfur dioxide trading program in the U.S. has a monthly volatility of 10 percent, and annual volatility averaging 43 percent, even with a safety valve. Sulfur dioxide permits ranged in price from $66/ton in 1997 to as much as $860/ton in 2006.

Energy demand, in the short run, is inelastic. Thus, small changes in demand relative to supply will produce sharp price movements. This, combined with the expected volatility in the price of permits, can inject considerable uncertainty into the marketplace. As is always the case, companies will need to spend money to hedge against the associated risks. Companies can be expected to pass along the costs of that risk to consumers.

It is also important to note that projections of the overall cost of cap- and-trade rarely calculate the costs of monitoring and enforcement activities. How these complex tasks will be executed is ill-defined, leaving open a wide range of options, potential costs, and areas for mischief.

At minimum, any enforcement system must monitor emissions, oversee trades, and be able to audit both. Allowable “offsets” will require particularly close scrutiny. Offsets are CO2 reductions taken by actors not covered by the legislation in the U.S. or abroad. Offsets are purchased to take the place of CO2 reductions that would otherwise be required of the purchaser. Who will certify these reductions is still unclear. But validation is essential to the credibility of the system. And according to one estimate, the cost to verify and enforce a cap-and-trade program will come to billions of dollars annually.

Finally, there are lobbying costs associated with the cap-and-trade program. Industry and environmental group lobbying leading up to the House’s approval of ACESA offers a glimpse of what is to come. Expensive lobbying will become a permanent component of the system as companies jostle for preferred positions in the distribution of free allowances or in securing preferential rulings on their offsets. Spending on the order of several billion dollars per year can be expected as companies compete for $150 billion in permits.

Consider a Carbon Tax

The proposed cap-and-trade program will cost Americans a significant amount of money. By definition it has to. If energy prices do not rise enough to change consumer behavior, expected environmental returns will fall short.

Proponents claim that the cap will spur new innovations in energy efficiency or carbon-free sources of energy. Even assuming this is true, it will take time to develop these new technologies and it will cost time and money for American businesses to integrate them, and for American consumers to purchase and use them. In the meantime, under the cap-and-trade system, American families will spend more—both for energy and for goods and services that use energy.

In the end, a carbon tax may be a more cost-effective way to produce the desired reduction in greenhouse gases. Some studies show that a carbon tax is up to five times more cost effective than cap-and-trade, and the majority of such studies also conclude that a carbon tax is far superior. Whether such a tax proposal will garner serious consideration in this Congress remains to be seen.

A cap-and-trade system will be enormously costly and, without enforceable worldwide reductions in greenhouse gases, the U.S. will bear a huge financial burden while obtaining, at best, limited environmental returns.

Jeff Kueter is president of the George C. Marshall Institute.