June 25, 2010

The Problem With Cap and Trade

FROM- The American Spectator

By C. Boyden Gray

The pending climate legislation that has spent so many months languishing in Congress was stripped of its initial momentum by the deep worldwide recession, the administration's failure in Copenhagen to get commitments from China sufficient to allay concerns about continued job migration from the U.S., the scandal over some of the science, and the struggle over health care reform. But the principal reasons for the demise -- the huge tax and trading boon to the banking industry in Wall Street and London -- deserve some further scrutiny.

The sponsors of so-called cap and trade legislation claimed that it was based on the hugely successful acid rain cap and trade program put into effect by the 1990 Clean Air Act Amendments (CAAA). As will be discussed more fully below, this characterization is highly inaccurate, because the Waxman-Markey bill and Senate counterparts created a $3 trillion tax and commodities market where the CAAA had done nothing of the sort. This feature of the climate legislation hurt its electoral chances by allowing Republicans accurately to portray the bills as a huge tax while scaring off at least half a dozen centrist Democratic senators worried about having to contain another Wall Street derivatives meltdown because of the proposed pollutive materials commodities market.

As criticism of the tax intensified over the course of the last year, climate bill sponsors responded by promising the return of the allowance revenues to taxpayers and by erecting a whole set of new financial protections parallel to the current financial reform effort. This triggered understandable skepticism -- since if the money were truly to be returned to its source there would be no point in collecting it in the first place. Moreover, there would also be no need for financial protections, unless there were something else going on. It's the "something else" that is really at the heart of the problem and that deserves further examination.

That "something else" has to do with the only true short-term beneficiaries of the whole exercise -- namely the bankers and traders of London and Wall Street who were ready to collect huge profits from trading carbon under the proposed legislation. The junior senator from New York put it best in an October 21, 2009, op-ed in the Wall Street Journal, where she said that as a result of the legislation, the "financial market [was] poised to deliver significant growth." She explained that the "carbon permits [under the climate bills] could quickly become the world's largest commodities market, growing to as much as $3 trillion by 2020," and that "New York's financial talent, expertise and institutions are uniquely suited" to run this new market.

Acknowledging the need to address the regulatory aspects of a new set of derivative trading, Sen. Kirsten Gillibrand observed that "Congress should integrate carbon trading into comprehensive financial reform," but she cautioned that the derivatives contracts should be allowed to be customized and not forced to be standardized and thus made fully transparent in any new regulatory structure. Finally, she noted that it was essential to the "ultimate benefit for New York that the market for carbon-emission permits is internationally integrated."

London was equally enthusiastic. Carbon could become "one of the fastest-growing markets ever, with volumes comparable to credit derivatives inside of a decade," said the head of emissions trading at Merrill Lynch's offices in London. According to another promotional article, London already "trades more carbon than any other city in the world," thanks to the European Emissions Trading System (ETS) set up by the EU after the Kyoto Treaty. As a result of carbon trading requirements, said the article, "carbon emissions are bound to become the world's biggest market....this is a bull market and great to invest in."

The Times of London further quoted a leading London trader as saying that "Europe will be the centre of the global market as a result of taking the lead....London is the leading centre and will remain so for years to come. The preparation has taken place here, and other financial centres are not so advanced...."

It is entirely true that climate leadership originated in Europe, especially in the UK, where much of the scandal over possibly manipulated science has also been centered. Given this background, it is hard to believe that ordinary greed did not trigger the rush to create an unnecessary windfall for traders. But the resulting backlash against bankers who stood to profit from cap and trade could have been easily avoided by actually following the model the measure's advocates said they were copying.

As noted, the White House and the sponsors of the Waxman-Markey legislation passed last year prominently asserted that their proposals were based on the successful acid rain cap and trade program by the CAAA in 1990. But the acid rain reduction and other successes based on it did not involve the impossibly complicated $1 trillion auction/tax/allowance reallocation scheme that Waxman-Markey features, as a result of the political logrolling necessary to secure the close 219-212 House vote.

To the contrary, all previous cap and trade programs have been based on an annual reduction of allowances initially allocated on the basis of an average of previous emissions that were well documented -- a simple formula that has been totally abandoned by Waxman-Markey.

Moreover, no one ever accused the acid rain program (or any of the others) of giving away "free" allowances, despite the lack of an initial auction for the permits. There was in fact nothing "free" about any of it, because utilities had to start reducing their acid rain emissions from day one, ultimately having to spend billions ($6 billion in the case of Duke Energy alone) to meet the requirements. But without a huge float of auctioned allowances, there were no financial machinations, and with no revenues collected, no political fights over revenue distribution that have so poisoned the current climate debate.

The acid rain program was itself based in part on a similarly successful -- and auction -- free-trading system established in 1982 to accelerate the phase-out of lead in gasoline. The next pro-posal after the 1990 CAAA was RECLAIM, which was established in 1994 by California and which successfully initiated nitrogen oxide and sulfur oxide trading within the state -- again without an auction.

Subsequently, the EPA established successful trading programs for nitrogen oxide in the eastern U.S. and later, during the George W. Bush administration, for sulfur oxide in the Clean Air Interstate Rule (CAIR) intended to achieve a further 70 percent reduction beyond the original 50 percent cut in the 1990 CAAA. There were no auctions for these successful programs. (The U.S. Court of Appeals for the District of Columbia Circuit subsequently questioned the legality of the CAIR trading system, which is now being revised.)

Supporters of the carbon dioxide auction have frequently cited the European ETS as the real reason auctions are necessary. The first phase of the ETS did not use an auction and over-allocated the allowances, producing utility windfalls and carbon dioxide prices so low as to be meaningless. But the proximate reason for the problem was that there was no reliable baseline emissions data, as we have had for decades in the case of utilities here in the U.S.

The European Commission has corrected this mistake for the second (and successful) phase that is now in effect -- but without an auction, it must be quickly noted. There are proposals to launch a 60 percent auction for the third phase, but that auction would probably be discretionary with the member states, which may not impose them for many of the same reasons militating against an auction in the U.S.

To be sure, the Waxman-Markey legislation tries to avoid the trillion-dollar tax implications of a 100 percent auction by temporarily seeking to provide "free" allowances to coal and natural gas customers. But these allowances will have to be auctioned to the emitters anyway, and there is no guarantee that the proceeds will actually get into the hands of those who have to pay the tax.

Over time, in any event, the system would revert to a 100 percent auction to provide trillions of dollars in revenues for unrelated budget proposals (and triggering protectionist import tariffs to curb trade with nations that have not imposed the same tax). One can understand the desire for deficit-reduction revenues. But they should not come out of a climate change program, which will be costly even without auctions and the success of which depends on the cap reduction level, not on the revenues collected. (Indeed, one group that has pushed for an auction, U.S. Climate Action Partnership, stresses that emission reductions under cap and trade are the same whether an auction is used or not.)

The superior efficiency of emission trading markets has been demonstrated over and over again. But the efficient reduction of carbon emissions need not depend on the levy of a huge tax or the establishment of the biggest commodities market ever created, and benefits of the trading should go to the public, not Wall Street or London.


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