A U.S. Cap-and-Trade Sytem Could Be “Mostly Dead” on Arrival

One of my children’s favorite movies when they were growing up was 1987’s Princess Bride. Masterfully directed by Rob Reiner, this fairy tale is loved by children of all ages but has an edge that keeps adults entertained as well. The movie’s well-crafted dialog has many unforgettable lines that are often repeated 20 years later. Billy Crystal as Miracle Max has one of the best lines in the movie. When examining Westley, he says, “See, there’s a big difference between mostly dead, and all dead. Now, mostly dead: He’s slightly alive.” Miracle Max is an optimist.

Not Business as Usual

On March 12, President Obama spoke to the Business Roundtable, an association of CEOs of the largest U.S. companies, about his climate change initiatives. The centerpiece of his presentation was his support of a CO2 cap-and-trade system with 100% of the allowances auctioned. The audience was respectful, but few CEOs were buying what the president was selling. (See "EPA to Reconsider Setting CO2 Standard for New Power Plants" for a more in-depth report of the meeting.) You might say his message was “mostly dead” on arrival.

With more than 60 leading business CEOs present for the meeting, it’s no stretch of the imagination to conclude that many of the group’s silent majority are concerned about the cost that purchasing emissions allowances will have on their international competitive edge and bottom lines. Member CEOs represent more than $5 trillion in annual revenues and nearly 10 million employees. If they are concerned, then so am I.

The group supports a number of policy objectives that are pragmatic in their approach and timeline. For example, companies are called on to publically report their emissions reductions, commit to improve their energy efficiency, support deployment of low-carbon technologies, and (my personal favorite), align any carbon reduction timetable with the “trajectory” of new technology introductions.

Their suggested approach to introducing new legislative remedies to reduce carbon emissions is to proceed in a stepwise manner, matching the latest in climate science findings with state-of-the-art technologies balanced within a policy framework that allows mid-course corrections based on current environmental and economic “feedback.” This approach seems reasonable and prudent to me.

President Obama, however, was not sympathetic to the business concerns of the Business Roundtable members nor to their pragmatic approach to introducing carbon controls at a rate that doesn’t overstress the economy and our pocketbooks. Obama must have his reasons for maintaining his position on initial allowance distribution, but he should avoid lecturing CEOs about how their businesses will respond to a carbon market price signal. He should also become more informed about the strategy he’s proposing, as twice during his speech he demonstrated a poor understanding of how a cap-and-trade system functions.

Drawing the Wrong Conclusion

The president warned the CEOs that he was loath to give away free allowances as part of any proposed cap-and-trade program and that he will follow through on a campaign pledge to auction 100% of allowances. Obama went on to say, “Now, the experience of a cap-and-trade system thus far is that if you’re giving away carbon permits for free, then basically you’re not really pricing the thing and it doesn’t work, or people can game the system in so many ways that it’s not creating the incentive structures that we’re looking for.”

Not quite true, Mr. President. This is a gross generalization of the economic effect of a cap-and-trade system and completely at odds with the recent experiences of the European Union (EU) greenhouse gas emissions trading scheme.

Initially, a generous, some say overly generous, number of allowances were granted to EU companies, including utilities, that were targeted for carbon emission reductions. However, the EU experience has clearly shown that even with a generous number of allowances distributed at the beginning of a program, the market price signals still came through loud and clear, and EU companies quickly responded. The key lesson learned by the EU is that a successful cap-and-trade system requires closely managing two elements: a well-designed emissions cap and the rate at which that cap is ratcheted down—not how the allowances are initially distributed.

Exaggerating Auction’s Benefits

Soon after, Obama made another gaff by holding up the success of the acid rain program. This program’s goal was to reduce sulfur dioxide emissions with a cap-and-trade program authorized by the 1990 Clean Air Act Amendments.

“We put in an auction system and a trading mechanism and, lo and behold, American ingenuity and American entrepreneurship and inventiveness created options that ended up being much cheaper than anybody had imagined—much cheaper than anybody had imagined,” said Obama.

Mr. President, the acid rain program only required the Environmental Protection Agency to auction 3% of its allowances when that legislation was signed in 1990! The rest were passed out free to utilities. However, we do agree that the program was an enormous success and a useful reference for future carbon legislation. But it’s not a template because the acid rain program focused solely on power plants rather than across the entire economy, as any carbon control legislation must.

Meet in the Middle

Auctioning 100% or 3% are the extremes of how many allowances should be initially distributed without cost to utilities and other carbon emitters. The Edison Electric Institute’s (EEI’s) January 14, 2009, Global Climate Point of Agreement (PDF) appears to me to be a more balanced and thoughtful approach to reducing the sticker shock that will come with any climate change legislation. The EEI’s proposal is to grant 40% of the initial allowances free and to distribute them proportional to current CO2 emissions, followed by a gradual transition to a full auction at some time in the future.

Obama’s extreme position on initial carbon allowance distribution places him at odds with the Business Roundtable and Wall Street. Many legislators on both sides of the aisle are already viewing this legislation with a jaundiced eye, and the latest polls seem to say Obama doesn’t have the votes to push through climate change legislation. I also believe those facts will not deter Obama from moving forward. If he does, I’m with Miracle Max when he told Westley, “Have fun storming the castle!”

—Dr. Robert Peltier, PE

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