Cap and Trade for Dummies - What Everyone Should Know

CAP AND TRADE, noun, [kap-and-treyd] — An environmental policy in which the government sets a “cap” on carbon dioxide emissions and then creates a financial market in which companies can trade permits to emit those gas.

A recent Rasmussen Reports survey found that over 75 percent of Americans don’t understand cap-and-trade. Given the high stakes of climate change, it’s imperative that we educate the public to clarify any points of confusion. To do that, the U.S. Climate Task Force has compiled the following ten-step guide to understanding the current federal climate change policy debate.

1. The Goal: Reducing Greenhouse Gas Emissions
We have a moral imperative to get climate policy right. And since rising concentrations of greenhouse gases (GHG) lead to global warming, the right measure will certainly be one that reduces these emissions.

In the United States, GHG emissions come primarily from the release of carbon dioxide (CO2) in energy use (heating our homes, cooling our groceries, driving to work, etc.). Experts agree that to decrease those emissions that lawmakers must place a real or implicit price on CO2 to incentivize businesses and consumers to invest in more energy-efficient products and technologies.

The disagreement starts when deciding just how to set that price. Cap-and-trade is just one of the strategies proposed to achieve that.

2. Decoding Basic Cap-and-Trade Structure
Under cap-and-trade, lawmakers place an annual limit or “cap” on GHG emissions. Officials then auction off or give away permits that allow companies to produce only a set amount of those emissions. Since some companies emit more than others, the government also creates a new market to facilitate the trade of these permits. The market dynamic sets the price of CO2 emissions.

The core idea is that businesses that can cut their emissions targets most cheaply will do so and sell permits to those who cannot. In theory, this reciprocal action would keep total emissions under the set cap.

But here’s the catch. Examples from existing cap-and-trade systems, like the European Trading Scheme (ETS), indicate that the policy is unlikely to reduce GHG emissions and more likely, instead, to introduce new, trillion-dollar risks for the global financial system. (See step No. 8 “Examples from the European Trading System: a Cautionary Tale.”)

3. Setting Emissions “Caps” and the Guesswork Involved
The cap-and-trade system outlined in the latest version of the Waxman-Markey bill calls for a 17% reduction in America’s GHG emissions by 2020. But that target is problematic. Rather than employ scientific fact and rigorous analysis, policymakers seemed to have based this emissions “cap” on speculation -- hardly a good basis for policy mandates.

The factors that Congress would have to know in order to effectively set emissions caps are essentially unknowable right now (and for much of the period covered by Waxman’s legislation). Setting realistic caps requires a comprehensive knowledge of all the factors that influence energy and land use. These include:

* changes in population density and distribution;
* economic growth rates;
* mix of energy sources
* change in energy prices;
* technological advances and breakthroughs; and
* turnover of the nation’s capital stock, to name a few.

Some factors like population growth and energy prices can be estimated reasonably well over the short-term. However, as the planning horizon moves further away, the ability to accurately assess all of these factors diminishes greatly.

The probability of knowing most of them well enough to set realistic caps is -- statistically speaking -- zero. If these factors cannot be known reasonably well for 2020, those for 2050 are mere speculation.

4. Distributing Emissions Permits (A Special Interest Bonanza)
Cap-and-trade requires a complex, bureaucratic system and, as such, doesn’t offer much transparency for public scrutiny -- a trait that allows a great deal of lobbying and closed-door dealings. Consider, for instance, that the Waxman-Markey bill hasn’t even passed out of committee, and politicians are already offering up billions of dollars in free emissions credits to favored industries.

Though the White House budget is counting on the sale of emissions permits to bring in $624 billion in revenue, the latest version of the Waxman-Markey bill would give away up to 85% of permits to favored industry for free.

That means those “free” permits to industry would cost taxpayers approximately $55 billion in the first year alone. (Given these provisions, it’s not surprising that many environmental groups have recently pulled their support of the bill.)

A 2007 Congressional Budget Office study found that “giving away allowances could yield windfall profits for the producers that received them by effectively transferring income from consumers to firms’ owners and shareholders.” And this cost isn’t just theoretical; European families have already witnessed spikes in their energy bills as a result of these CO2 freebies. (See step No. 8 “Examples from the European Trading System: a Cautionary Tale.”)

5. Market Risks: Opportunities for future Bernie Madoffs and Enrons
The government-regulated trade of CO2 creates a complex financial system susceptible to manipulation by Wall Street opportunists.

Since the auctioning procedure for emissions permits would be open to all bidders -- including institutional investors and hedge funds -- there’s an increased likelihood for purely speculative price formation. Additionally, the securitization of CO2 permits would turn them into financial tools that could be sold directly or wrapped in risky packages -- just as Wall Street did with the sub-prime mortgages that brought our financial system to its knees.

As we’ve already experienced with the recent housing crisis, the reality of an opaque, complex trading system like a cap-and-trade scheme fraught with corruption, manipulation, noncompliance and mismanagement is this.

· high profits for Wall Street/market traders;
· high energy prices for consumers; and
· negligible GHG reduction for the environment.

6. Driving “Green” R&D Investment
Extreme CO2 price fluctuations under a cap-and-trade policy could mean serious trouble for another one of America’s environmental goals: incentivizing clean energy research and development.

Market instability makes long-term business planning and investing much more uncertain and, as a result, far more expensive. Cap-and-trade’s inherent volatility would only exacerbate these kinds of problems, generating greater fluctuations associated with the price of emissions allowances. Sharp drops in CO2 prices would cause investment in clean-technology research to drop as well, diluting the policy’s main purpose: to encourage investment in low-emission energy.

Without a reasonable amount of predictability, an emissions trading policy could actually create a disincentive for companies currently interested in pouring capital into “green” programs.

7. Environmental Justice
The risks associated with cap-and-trade pose a risk not only to our “green” goals, but to our economic as well.

By enabling the creation of risky financial tools and handing out too many permits at no cost to favored industries, a CO2 trading system would heavily burden American families.

Research indicates that implementation of a U.S. emissions market could drive up energy costs for Americans anywhere from several hundred to a several thousand dollars per year. And because low-income families spend a greater percentage of their earnings (12- 25%) on energy, this burden would fall heaviest on those least able to afford it.

Attempts to achieve a cleaner environment shouldn’t come at the cost of pushing poor families even further into poverty. Yet, that’s exactly where we are heading if climate change remedies, particularly a cap-and-trade system, widen the wealth gap in this country.

8. Examples from the European Trading System: a Cautionary Tale
Despite all of the costs and risks detailed here, a U.S. cap-and-trade system would not likely deliver on its main goal: addressing climate change.

According to a report by the Government Accountability Office (GAO), there’s little, if any, evidence that the European Trading System has made any impact on emissions in Europe. In fact, a recent study in Nature found that once we set aside carbon offsets, emissions under the ETS have actually increased by 10 percent.

9. Alternative Solutions to Climate Change
The bottom line is it’s clear that there’s a great deal more room for public debate on the relative benefits of the leading policy options (cap-and-trade and a revenue-neutral carbon tax). Consequently, Washington needs to put aside political expediency and work with scientists, economists and opinion leaders to deliver workable climate change legislation based on merit.

10. The Need for a Healthy Debate
While we at the U.S. Climate Task Force believe that a revenue-neutral carbon tax is a superior approach for a number of reasons, we also believe that it’s even more important to engage in a full and open debate on the subject.

And sharing “Cap and Trade for Dummies” with the public is a good place to start.