Will cap-and-trade—setting an ever-declining limit on emissions and then letting a commodities market sort out the distribution—rule the day? It’s the chosen method of the Obama administration and many Democrats in Congress to deal with carbon dioxide emissions. That’s the approach in the mammoth Waxman-Markey bill that has cleared the House Energy and Commerce Committee. But it faces difficulties in other House committees, including the powerful House Agriculture Committee.

Or will the allegedly simpler notion of a straightforward carbon tax, now the darling of much of the conservative punditry, some on the environmental left, and many in the electric-generating community, prevail? So far, it’s a toss-up.

Fred Hiatt, editorial page editor for The Washington Post, outlined the choice in a recent op-ed. He observed in early June, “Most economists would say the sensible approach would be to levy a tax on oil, gas, and coal and then get out of the way. Higher prices for those fuels would discourage use and encourage investment into wind power, conservation, and other good things.”

But cap-and-trade, largely built on the model of the SO2-trading regime of the 1990 Amendments to the Clean Air Act, has political leverage and intellectual backing. It’s the favorite of many congressional Democrats (who fear a “new taxes” attack from Republicans if the alternative energy tax gets proposed). It’s the choice of CO2-reduction mechanisms in the enormous bill that passed Henry Waxman’s committee in late May after many compromises to shape the bill to meet coal-state interests.

The Post’s Hiatt concluded, “Democratic leaders in the House have fashioned a 946-page climate change bill that forces industries to pay to exceed a gradually declining limit on carbon emissions. It’s a tax with deniability, and with huge enforcement challenges.

“In theory, it could work; some economists even prefer it to a tax because you can set a clearer emissions target. But if you’re going this route, design becomes crucial. During his campaign, Obama proposed to auction off the pollution permits. But to buy support in the House—where the bill has made it through only one committee so far—the bill’s authors had to promise to give away 85 percent of the allowances.”

Environmentalists, who once opposed the very notion of “pollution trading,” have joined the industry cap-and-trade advocates. Many electric utility firms, but not all, have also bought into carbon trading.

In Europe, CO2-emissions trading has been in effect for years, but it’s still a small market and may not be instructive for the U.S., according to the experts. The European Union market is limited to its member countries and critics argue that it’s without any bite in terms of actual greenhouse gas reductions. Yet the market is functioning and demonstrating that CO2 reductions are declining in value.

Waxman-Markey: What Does It Mean?

The House Energy and Commerce Committee in mid-May cleared the enormous bill. The legislation embraces a cap-and-trade regime that provides for pollution trading, albeit with many political and special interest nooks and crannies related to allocating the first round of emissions allowances. The committee approved the bill by a partisan vote of 33 Democrats in favor and 25 Republicans opposed. Once the House Agriculture and the Ways and Means Committees approves the bill, which is far from certain, it could come to the House floor for final action, perhaps as soon as next month.

Then it will go the Senate, where the prospects are even less propitious. It’s unlikely that any member of Congress voting on the bill will have actually read it by the time it comes to the floor for final passage, if that happens.

The cap-and-trade provisions in the House bill had strong support from “green” Democrats, such as House Energy and Commerce Committee Chairman Henry Waxman (D-Calif.) and Ed Markey (D-Mass.), chairman of a special House committee on climate change and a senior member of Waxman’s committee. They created the bill that the Obama administration supported.

Most national environmental groups, including the Natural Resources Defense Council (NRDC) and the Environmental Defense Fund (EDF), backed Waxman’s committee bill. A coalition of vertically integrated electric utilities with generation and distribution also bought into the bill, in part because the lawmakers agreed to an allocation of initial pollution permits to industries (85% in total) that would dramatically favor the existing utility companies, giving them free “allowances” before the market kicks off. The utilities would get about 35% of the total kick-off allowances.

Ironically, in 1990, the greens (excepting the EDF) were mostly skeptical of the SO2 cap-and-trade mechanism in the rewrite of the air act. Acid rain emissions trading, largely conceived and advanced by Dan Dudek, an economist with the EDF, with the support of the first Bush administration, relied on a market model that conventional environmental groups mistrusted. I recall David Hawkins of the NRDC—who was EPA clean air chief in the Carter administration—telling me that the pollution market would never work. He was wrong.

Fewer than a dozen folks, and no members of Congress, likely have read the Waxman-Markey bill, The Washington Post noted. That means they have missed myriad provisions in the bill. For example, The Post pointed out, the bill overrides many local building codes in favor of national codes if the local codes don’t meet a federal efficiency standard. That’s pretty autocratic, according to The Post. The provision got no discussion during hearings or markup. It appears to have been inserted in the bill language by stealth—no fingerprints or political DNA signatures remain.

 What’s a “License to Pollute”?

Conventional environmentalists viewed emissions trading in 1990 as “a license to pollute,” and lobbied vigorously and unsuccessfully against the SO2-trading program in favor of a traditional “command-and-control” regulatory regime. Their opposition was misguided, as some (but not all) economists and environmentalists would acknowledge today.

The SO2 market was probably the most effective environmental regulatory program in U.S. experience, according to many environmental policy analysts. In an interview in late May, A. Denny Ellerman, an economist at the MIT Sloan School of Management who has followed the SO2 market closely since it’s inception in the early 1990s, told MANAGING POWER, “The SO2 market has worked very well. Far beyond the predictions of both advocates and critics at the time.”

Ellerman was an advocate at the inception of the SO2-trading concept, as chief economist for the former National Coal Association (now part of the National Mining Association). “We had no idea it would work so remarkably well,” reducing SO2 pollution by half in the U.S. in just a few years, Ellerman said.

Command-and-Control and Litigation Hell

In 1989 and 1990, the electricity industry, supporting President George H.W. Bush, lobbied strongly for the SO2-trading regime in the Clean Air Act rewrite. The industry’s fear was command-and-control, characterized by the Clean Air Act of 1970, which tied industry into regulatory and litigation hell in courts throughout the decades to follow.

Under the command-and-control approach, the EPA called the shots and commanded environmental controls on power plants. Generators had to fight multiple battles in multiple legal venues, with multi-millions of dollars in legal costs, to make their case.

While the SO2 market thrived in the 1990s, the struggle over command-and-control regulation of NOx and ozone pollution continued at the EPA in the courts. The issues involved topics such as “new source review” and the meaning of whether plant maintenance constituted new construction. It was, for both the generators and the regulators, a regulatory and legal nightmare. The only beneficiaries were environmental lawyers for both the generators and the environmental groups.

Today, many environmentalists are pushing the CO2-trading regime as the best approach to reducing emissions. Some key electric utility generation companies, such as Chicago-based Exelon Corp., buy into that regulatory paradigm.

At the same time, many in the electricity industry argue for a carbon tax instead of a cap-trade regime, as demonstrated at the ELECTRIC POWER CEO Roundtable in Chicago in May. The industry is throwing up many of the arguments against the cap-and-trade plan that the greens suggested would accompany a SO2 market at the end of the 20th century. Rather than cap-and-trade, some in the electric generating industry now argue that a CO2 or Btu tax would be simpler, easier to implement, and more effective in reducing global warming gases.

Is Cap-and-Trade a Texas Showdown?

Here’s a skeptical notion, derived from my understanding of high-stakes poker: Industry may be arguing for an up-front energy tax, knowing it is political poison in Congress and cannot pass, leaving nothing in its place. That will warn the Obama administration off of any kind of energy tax in the future. That cynical notion may be wrong, but it can’t be dismissed. Look for “tells” in their take, the winks and twitches and grimaces that betray their hand.

Industry opponents of cap-and-trade make an interesting case. They argue that cap-and-trade recreates an energy version of the market for subprime mortgages and the slice-and-dice financial instruments created in the mortgage markets of the 21st century. It’s not necessarily obvious, according to economists who study the market, but it’s worth considering.

Some energy CEOs who are opposed to a cap-and-trade market—and it’s not clear whether they are a majority—argue that the carbon market will turn CO2 trading into an economic poker game, capable of manipulation by savvy card sharks, as they believe occurred in credit and mortgage markets. If so, they want the pot of poker chips, owned by the government, given to them to start the game. That is, they want the initial allowances—their stake in the game—distributed in advance, not auctioned off in a way that could produce very high values for CO2 emissions, cutting into company profits and raising customer electric rates.

Many environmentalists have argued for a full auction of allowances to the private sector in exchange for real dollars, which they believe will generate large returns for the federal government. Some in the environmental groups and some in the Obama administration say they believe the windfall proceeds from the emissions auction could support of the costs of a new health care regime.

Congress isn’t buying. The Waxman-Markey bill allocates the vast majority (85%) of the initial CO2 allowances to various industry groups up front. That’s a major concession to the power industry, making the whole idea of a trading market for CO2 more palatable to the electric distributors and generators.

Some in the electric industry also raise the specter of carbon markets replicating the current financial meltdown in credit and housing. Carbon emissions allowances are—hold your breath now—a door to new derivatives markets. Some in the electric industry argue that speculators can use the carbon-allowances market to derive new tradable securities, in this case the price of future CO2 emissions, insure against market default, and so on, mimicking the collapsed mortgage market. That also came up at the ELECTRIC POWER Industry Executives Roundtable.

There’s no real dispute about whether cap-and-trade could lead to a derivatives market. I asked William W. Hogan, noted energy economist at Harvard’s Kennedy School of Government, if a spin-off was possible. “Sure,” he said, “and there’s nothing wrong with that. In principle, there’s no reason there couldn’t be a market for forward trading of carbon allowances,” if the cap-and-trade program envisioned in the Waxman-Markey legislation in the House is enacted into law. The derivatives market “provides a price-hedging path, and helps the market function more efficiently,” Hogan said.

Secondary markets, Hogan said, are useful. They provide ways to protect against price swings and cover risks. In a market as big as it looks like the CO2 market will be, it strikes Hogan as impossible that anyone could fiddle the market to its advantage. So hedging instruments will be valuable to all players in the market.

The development of futures markets, and the ability to hedge price positions and mitigate risk, Hogan said, is entirely worthwhile. Will that offer ways to game the market to the advantage of speculators? “There will always be Enrons,” Hogan said, adding that he has never seen convincing evidence that Enron was actually able to manipulate electric energy market prices during its heyday, despite attempts to game the system. Enron’s real problems, he says, came in its fraudulent manipulation of its balance sheet, not in trading positions.

Pointing to the Hunt brothers’ attempt to corner the silver market in the 1970s, Hogan explained that if a market participant can’t control the physical basis of a market, it cannot manipulate the market. That fact, he said, was true of electricity, a huge and diverse market, and will be true of CO2, an enormous and diverse market, incapable of capture by any market player. “Nobody is big enough to corner this market,” Hogan said.

Some CEOs Prefer Carbon Taxes

Some in the coal-burning utility industry have decided to oppose the cap-and-trade model. They, and allies in the oil industry, have begun mounting an argument that cap-and-trade will recreate the economic conditions that led to the current market kerfuffle over collateralized debt obligations and credit default swaps in the mortgage market, as well as the collapse of Enron’s trading empire. The CO2 trading markets, they argue, will result in market-destroying chaos.

David Sokol, an electric industry generating veteran and chairman of MidAmerican Energy Holdings, a Warren Buffet utility, argued in a recent Washington Post op-ed, “If you liked what credit default swaps did to our economy, you’re going to love cap-and-trade. Just read Title VIII of the [Waxman-Markey] bill, which lets investment banks, hedge funds, and other speculators participate in the cap-and-trade market. They don’t have emissions to cut; they have commissions to make.”

This has become a standard argument against the cap-and-trade plan endorsed by many congressional Democrats and the Obama administration. At the most recent ELECTRIC POWER Conference, the consensus around the CEO Roundtable was that with cap-and-trade there will be market manipulation and a lack of a free and transparent market. Their clear, but not unanimous, preference was a carbon tax.

In the case of CO2 trading, Harvard’s Hogan said, the market looks far more transparent than the trading market for mortgages and mortgage-backed derivatives. Hogan predicted “pretty standardized contracts” for CO2 sales. “Carbon is carbon,” he said. “There isn’t much variance” likely in contract terms. Unlike mortgages, where terms were individualized and often quirky and the securitizing of the contracts was an attractive way to spread risks over a large number of diverse mortgages.

Supporters of a carbon cap-and-trade market cite the alleged successes of the U.S. SO2-trading regime. By most accounts, that market has worked remarkably well. Emissions have fallen by half, and there has been no market manipulation by players. Costs to generators have been minimal.

MIT’s Ellerman, a longtime expert on emissions trading mechanisms, said the development of derivative markets in the SO2 and the fledgling European carbon emissions trading market have been useful. The U.S. SO2 market, Ellerman said, has seen some trading of derivatives, such as forward contracts, options, and loan swaps. But these have been a small part of the overall market, which is not large and not highly developed. None of these derivatives are beyond conventional market phenomena, Ellerman told MANAGING POWER, or raise any concerns about market behavior.

As for those who say a carbon cap-and-trade market will spin out of control and mimic the market for such exotic instruments as mortgage credit default swaps, Ellerman said, “That’s scaremongering.” The proponents of this line of argument “do not understand markets” and are positioning their lack of understanding into opposition to what he believes is a sensible approach to CO2 reductions, Ellerman said.

Is a simple carbon tax preferable to a cap-and-trade regime? Not necessarily, argues Ellerman, although many economists prefer what they view as a simpler tax approach. Allocation of allowances by a public-policy procedure (through Congress and upfront political processes, such as cap-and-trade), Ellerman says, is more transparent than using the tax code to divvy up the allowances. The tax approach, he argues, is “subject to sub-rosa lobbying and lots of behind-the-scenes activity. I’d rather have it all done in public through congressionally mandated processes.”

Another view comes from former Reagan administration economic advisor Martin Feldstein, now a Harvard professor. He argues in The Washington Post against the Obama plan for allocating carbon allowances, from a different perspective. In an op-ed column, Feldstein straddles whether cap-and-trade or a carbon tax is a better policy instrument to deal with global warming. Instead, he focuses on costs of CO2 reduction and suggests that no policy is the best policy.

Positing whether an imputed $1,600-per-family annual cost of a cap-and-trade policy is worth “the very small resulting decline in global CO2,” Feldstein said he thinks not. “In my judgement,” Feldstein wrote, “the proposed cap-and-trade system would be a costly policy that would penalize Americans with little effect on global warming. The proposal to give away most of the permits only makes a bad idea worse. Taxpayers and legislators should keep these things in mind before enacting any cap-and-trade system.”

Feldstein argues that the U.S. should hold off on a CO2-reduction mechanism until China and India commit to greenhouse gas reductions. Many foreign policy experts predict that China and India will never agree to any reductions.

This debate is far from concluded. Stay tuned as the discussion continues in the House and Senate.

—Kennedy Maize is MANAGING POWER’s executive editor.