The House of Representatives’ passage of the American Clean Energy and Security Act by a narrow margin late Friday is a reminder of the emerging trend on the Hill, something which they perfected a long time ago in Prague, to throw out the window that which is not meant to be thrown out of windows. In this modern case it is basic lessons from economics—although a politician here and the
re would not actually be such a bad thing. More and more politicians are falling victim to the epidemic of selective thinking, applying and often bending economic wisdom where they see fit, and ignoring these time-tested principles when they reveal an “inconvenient truth.”
Before we hold Friday’s bill and the thinking of 219 members of the House led by Nancy Pelosi up to the light, let’s strip away the layers and examine the framework of the legislation. At the heart of the bill is the cap-and-trade legislation designed to limit greenhouse gas emissions by creating a carbon market through which producers could buy and sell permits to emit certain volumes of CO2. In accordance with the typical cap-and-trade schedule used around the globe, the regulation begins looser with fewer limits on producers, and with time begins to tighten, gradually decreasing permissible levels. The plan is to cut output by 3% in 2012 versus 2005 levels, 17% by 2020, and 83% by 2050.
As is usually the case, the political maneuvering involved in the creation of the bill has its byproducts. The House has created a cushion for producers through its inclusion of “offsets” as an equivalent to cutting emissions. An offset could include a foreign investment to plant or maintain forests, or domestic assistance to help firms or industries limit their own emissions. This is based on the idea that reduction of carbon emissions abroad will have the same benefit to the “global” climate as reductions here—essentially a concern with net emissions. Environmentalist critics are quick to point out that while offsets will lower emissions abroad, they will allow continued emissions at home, reducing coal-power generation only slightly during the initial phases. Without offsets, however, carbon costs to producers would skyrocket (89% according to the EPA).
Contradicting the claims of democrats to drive the creation of clean energy jobs, the offset allowance permits half of the offsets to come from overseas, with the option to grow to three quarters if the market for domestic offsets is too small. The offset could potentially be an incentive for a producer to invest three quarters of its carbon offset project overseas. It is also doubtful that U.S. companies will be able to initiate international offset projects in the time frame that the bill leaves open.
The counterpart to the cap-and-trade policy’s reduced emissions driven by higher “dirty” fuel costs is the subsequent creation of renewable energy demand and generation. However, an EPA report states that the bill would result in slightly less renewable energy generation capability by 2020 than if we continued without caps. This is due to (1) the requirement of more energy efficient buildings and appliances that would reduce energy demand, and (2) the fact that the offsets provision will prevent a significant increase in the cost of dirty fuels meant to drive the switch. In short, lower energy demand and a less than called for increase in fossil fuel costs will result in a stagnation or slight decline in renewable energy capacity (solar, wind, etc.), but a large growth in nuclear, renewables, and coal plants with carbon-capture systems.
While Democrats do concede that the bill will cost the average household $175 by 2020, this estimate by the CBO conveniently takes a one-year snapshot of the taxes of the bill before it gets up to full speed. In the year 2020, cap restrictions are still loose and offset opportunities still remain in place. However, as restrictions tighten and companies lose the opportunity to offset, the price of a permit will grow. The CBO estimate of $28 per ton of carbon in 2020 is far from the price it will reach when carbon emissions are facing a true cap. For instance, while the Heritage Foundation found the bill to cost $1,870 per family of four in 2020, it estimated an increase to $6,800 per by 2035 (WSJ, June 28). Regardless of the base figures, note the more than tripling. This isn’t even a progressive, steeply-terraced tripling that we have all come to know and love. Lower income Americans allocate a greater proportion of their income to energy costs (a regressive tax, then). Democrats have, of course, attempted to account for this by allocating 15% of the revenue from permit sales to offsetting of increased energy costs for low- and moderate-income homes (in other words, a redistribution of wealth).
The bill calls for the investment of approximately $190 billion to energy technologies and efficiency measures by 2025--$90B to energy-efficiency and renewable-energy technologies, $60B to carbon capture and sequestration, $20B to electric vehicles and other auto technologies, and $20B for basic scientific R&D. It also requires that new coal plants utilize carbon capture and sequestration, assuming the technology reaches effective levels, to capture 50% of all carbons emissions by 2025.
The real trouble comes from the long-term, broader effects of the growth in price of carbon permits as their supply shrinks—something that occurs after the CBO snapshot. As the government removes permits from the market, supply will shrink while faced with similar demand (since renewable and alternative energies will have not yet come into their own), resulting in higher price. When producers are forced to pay a higher price per ton of carbon, their costs of production reflect this, and they will price their goods accordingly. Whether these are intermediate goods that still must be incorporated into the final product for the consumer, or goods that are going directly to the consumer, companies will pass their higher costs along to the consumer unless they are in the business of going out of business. In the end, a higher cost somewhere in the chain of production will trickle all the way down to the end-user. You pay for higher gas prices at the pump, but also in your food, appliances, toys—anything that involved gas before it made it to your hands. When faced with higher prices, demand will fall, and supply will shift in to match demand. Less supply? Fewer jobs, greater unemployment. When faced with higher costs some firms may instead choose to move their production overseas—you get the picture. Across the board we will be left with a shrinking GDP, which certainly isn’t a cure to our current recession.
Looking at cap and trade from a basic economic perspective, it is a quantity constraint. With a predetermined fixed quantity that can be produced, movement in the market can only impact price—with a fixed supply curve, variation in demand will lead to variation in price. In a recent report, Arthur Laffer and Wayne Winegarden explained that the quantity restraint from a cap-and-trade system would lead to price volatility in the GHG allowance market, which has been the case in Europe. It is extremely difficult, especially for government,
which also happens to be subject to significant external influence, to correctly set a quantity constraint that will avoid inefficiencies. In the “chalkboard example,” we can accurately determine the demand curve, supply curve, and current level of production/emissions, thus devising the correct remedy for the market. In this case, as seen in the chart below from the Arduin, Laffer, & Moore report, a price constraint (floor), quantity constraint, and tax all have the same effect under perfect knowledge and understanding of the market.
Under the assumption that the market-determined level of output (and resulting GHG production) is incorrect because producers and consumers are not taking into account the cost of the externality of GHG emission, the government would implement a policy that would assist producers in recognizing the full cost of production taking into account the externality. Consumers then pay PED and producers receive PES.
However, in the real world, policymakers can only estimate what we knew in this example, and, therefore, can only create an approximate constraint. The demand curve will fluctuate or may have simply been different from an inaccurate government estimate used to implement the cap—this can be seen to the left. When this happens, prices move, and the volatility creates inefficiency that ripples throughout the economy—all the way down to you.
We need to learn from past experience—energy supply shocks will lead to a decline in the economy, a rise in unemployment, and a decline in the value of the stock market. Laffer and Winegarden point out that we have witnessed this during the oil supply shocks in 1974-75, 1979-81, and 1990-91.
Simple economic theory tells us that cap-and-trade regulations are detrimental to the economy and are not an effective way to address global warming concerns based on science that is yet to be proven—even the CBO saw it this way. It is certainly not the time to limit output, hindering American businesses and the overall economy, when we are attempting to climb out of a recession and compete with the economies of India and China whose producers face no obstacles. Ironically, economist Greg Mankiw points out, “…as a higher gas tax discourages oil consumption, the price of oil would fall in world markets” due to lower American demand. Lower oil prices would lead to an increase in consumption in China, India, and Brazil that may more than offset our own cutback, leading to a net increase in world carbon emissions. We should think about putting Introductory Economics up there with citizenship, age, and residence.
(Graphs from “The Adverse Economic Impacts of Cap-and-Trade Regulations”, written by Arthur Laffer and Wayne Winegarden, September 2007)
