Secretary Chu Advised on "Prudent Development" of Oil and Gas

A news item concerning last week's release of the National Petroleum Council's "Prudent Development" report referred to a recommendation supporting a national tax on carbon. That caught my attention. Given the NPC's makeup, a consensus on such a controversial issue would be surprising. The actual text of the report proved somewhat less dramatic on the climate policy front, but no less worthwhile for its comprehensive assessment of the abundance of North American hydrocarbon resources, as well as the development approach "necessary for public trust, protection of health, safety and the environment, and access to resources." The report doesn't just focus on macro concerns about climate change and other environmental issues, but also on timely details such as the methane emissions, water and land-use impacts involved in shale gas production and other resource development.

For those not familiar with the NPC, the organization is charged with advising the Secretary of Energy on matters relating to oil and gas, though in practice it looks at a much broader array of energy issues. In 2007 I helped with the renewable energy analysis in the group's previous study, entitled "Hard Truths." The current study is one of two requested of the NPC by Secretary Chu; the other will look at future transportation fuels and is due out in the first half of next year. What makes these reports unusual is that they incorporate the views of academics, government officials, non-governmental organizations, and the legal and financial sectors, along with those of the energy industry. In the current study, just under half the participants represented oil and gas companies, while the Emissions and Carbon Regulation Subgroup included members from the National Resources Defense Council and US EPA, and the Environment and Regulatory Subgroup was chaired by someone from the Environmental Defense Fund. I think we'd all benefit from more such "strange bedfellows" collaborations.

The report's specific recommendation on carbon pricing as a mechanism for addressing greenhouse gas emissions appears in the Executive Summary and originates in an entire chapter on "Carbon and Other Emissions in the End-Use Sectors." Although it's much more generic than the Fuelfix article indicated, it's still noteworthy. It deals with the need to internalize emissions costs into fuel and technology choices, with a carbon tax mentioned as just one option among a range of measures for establishing an explicit or implicit price on carbon. It states,

"As Congress, the Administration, and relevant agencies consider energy policies, they should recognize that the most effective and efficient method to further reduce GHG emissions would be a mechanism for putting a price on carbon emissions that is national, economy-wide, market-based, visible, predictable, transparent, applicable to all sources of emissions, and part of an effective global framework."

It goes on to address non-market mechanisms such as performance standards and clean energy standards, and how a policy on carbon should be phased in. While individual oil and gas companies have supported cap and trade or a carbon tax either individually or within multi-industry groups, I can't recall such a broad cross-section of this industry going along with the idea of carbon pricing, even in this non-specific manner.

The timing of this is interesting. It's hard to envision a comprehensive climate bill passing the Congress between now and the November 2012 election, or even being introduced on anything other than a symbolic basis. The pork-laden monstrosity of the Waxman-Markey bill succeeded only in making cap and trade toxic, and I can't imagine a worse environment for introducing any kind of new tax--a price on carbon is clearly a tax--even if the concept behind cap and trade has a solid bipartisan pedigree. Short of the miraculous materialization of a carbon tax as a compromise revenue solution from the deficit-fighting Supercommittee, carbon pricing in the US looks dead until 2013 and possibly well beyond. I'm also starting to see more comments along the lines of this one from the blog of the Information Technology and Innovation Foundation suggesting that policies promoting innovation might be a lot more important in addressing climate change than any level of carbon pricing that could realistically be implemented here.

So whether you regard this recommendation by the NPC as an attempt to restart a stalled debate on carbon pricing, or merely a tardy entry in a formerly crowded field, I think it also signals that the energy industry isn't oblivious to the fact that its emissions--including the lion's share associated with end-user consumption of their products--must eventually be dealt with. Chances are, that will await a return to economic health and stability, when US consumers, voters and taxpayers might be expected to prove more willing to incur the sacrifices this will entail. The report also includes a good perspective on the considerable North American resource upside that could be unleashed with different policies than the ones now in place, and that might just hasten the arrival of more favorable economic conditions for carbon policy.

Read More

Chicago's Climate Exchange Shuts Down

I see that the Chicago Climate Exchange (CCX) will be winding down its CO2 trading operations by the end of the year and laying off staff. This is only surprising considering that the parent company of the CCX was acquired just this summer by the Intercontinental Exchange, though mainly for its successful European emissions trading market. In case you were wondering how long the odds against enacting cap & trade legislation in the US have become, the demise of the CCX is a signpost you can't ignore. If the symbolism of a popular Democratic governor using the Waxman-Markey climate bill for target practice during his recent successful bid for the US Senate wasn't clear enough, it looks like his bullet may have also hit the CCX.

I recall a meeting with one of the founders of CCX at Texaco's corporate headquarters in New York prior to my leaving the company at the end of 2001. At that time, Texaco's management was coming around to the idea that sooner or later emissions of CO2 and other greenhouse gases would carry a price, for the first time in human history. Cap & trade offered a proven way to discover that price, based on the pioneering experience of US markets for sulfur dioxide, a cause of acid rain, and nitrogen oxides. The principles of emissions trading had been embedded in the Kyoto Protocol, largely thanks to the efforts of the US delegation, and European countries were setting up the precursors of the EU Emissions Trading System to manage mandatory carbon reductions. Such developments still appeared to be somewhere over the horizon in the US, which never ratified Kyoto, but they seemed likely to find their way here, eventually. One of the main selling points of the CCX, which was based on voluntary emission reduction commitments by member companies, was that it would provide valuable early experience in a formal market for emissions reductions, giving participants a leg up when such trading was required by law. This argument didn't persuade my former employer, but a number of other companies signed up.

If this scenario now seems like a quaint strand of alternate history--a "what if?" that never materialized--that perspective is quite recent. The prospects for CCX and wider emissions trading looked reasonable for a long time. The value of the CCX contract peaked in mid-2008, when it had become apparent that the ultimate presidential nominees of both major US political parties would be candidates who supported cap & trade, with the Republican even having previously co-authored Senate legislation on the subject. After a severe dip during the worst of the financial crisis, the contract recovered to around $2/ton after the new administration took office, but then swooned again as the Waxman-Markey bill, with its heavily skewed version of cap & trade, neared passage. As the likelihood of parallel Senate action on climate legislation receded, it never really recovered.

In its editorial on the termination of the Chicago Climate Exchange, the Wall Street Journal suggested that the market has delivered its verdict and the idea of national-level cap & trade is now dead in the US. Perhaps, but it certainly doesn't signal an end to all CO2 trading here. Aside from the state and regional programs to which the Journal alluded, companies with global operations subject to emissions caps in other countries will still be active participants in non-US emissions markets, and firms that remain committed to voluntary reductions in the US may continue to trade with each other, via brokers, or with over-the-counter market makers.

For that matter, I can't help wondering whether cap & trade is truly as dead as a Monty Python parrot or just resting. I'm reluctant to let go of an idea I've supported for a long time, but I also still see significant advantages for cap & trade over other means of putting a price on greenhouse gas emissions. Although the idea of carbon pricing may have gone out of fashion in the US, major tax reform for the purpose of deficit reduction could make it much more difficult to provide the monetary incentives for renewable energy technologies that we do today. Without those subsidies or a price on CO2, renewables will have a hard time competing with fossil fuels. And if our only other choices for emissions reduction were mandates or the command-and-control approach for which the EPA is now gearing up, then cap & trade and the emissions trading that makes it work might no longer look quite so appalling to their critics. In that case, the companies that participated in the CCX during the last seven years might not have wasted their time, after all.

FYI, I'll be participating in a webinar on the sustainability aspects of natural gas next Monday at The Energy Collective . To sign up follow this link. In the meantime, I wish my US readers a very enjoyable Thanksgiving. New postings will resume next week.

Read More

Energy Implications of Tax Reform

I've been thinking about the implications for energy of a major deficit reduction effort along the lines suggested by the co-chairs of the President's fiscal responsibility and reform commission. Our present approach to providing incentives for various energy sources and technologies, new and old, is embedded in a tax code and taxation philosophy that might not survive the upheaval required to bring the US deficit and resulting federal debt back into a manageable range. This goes far beyond the comparatively minor question of extending expiring grants and tax credits that I discussed the other day; under the most stringent of the proposals from Mr. Bowles and Senator Simpson, such things wouldn't even exist. It's not clear how the Administration or Congress would promote favored energy technologies and strategies without these well-established but costly tools.

Start with renewable energy. We currently promote renewable fuels and electricity generation with a combination of mandates--policies such as the federal Renewable Fuels Standard (RFS) and state Renewable Portfolio Standards--and subsidy payments. Until last year's stimulus bill established the Treasury renewable energy grants, for which eligibility is due to expire in a few weeks, most of those subsidy payments have come in the form of reductions in federal taxes, via either an investment tax credit (ITC) based on the cost of a project or a production tax credit (PTC) for actual energy generated. Both of these measures, which have had a checkered history of expirations and extensions, fall into the broad category of "tax expenditures". The Zero Option proposed by Messrs. Bowles and Simpson would permanently eliminate over $1 trillion of such tax expenditures, in exchange for much lower tax rates.

Even if the renewable energy tax credits were reloaded into a streamlined tax code under the "Wyden-Gregg-style" reform presented as Option 2 from the co-chairs, the value of those credits would be reduced--or at least rendered harder to extract--because the corporate tax rate would be reduced from the current 35% to 26%. That means that a higher proportion of companies would likely not pay large enough taxes to take full advantage of the renewable energy tax credits--or have as much appetite for others' credits via "tax equity" swaps. Compounding that, the likelihood of enacting cash grants to get around this restriction would probably be much lower in an environment in which entire herds of sacred cows were being slaughtered in the cause of averting a looming national deficit and debt crisis.

In the absence of such tax credits, renewable energy developers and manufacturers would be forced to rely even more on state-level mandates or a proposed federal renewable electricity standard. The first test of such a mandates-only approach might come in a few weeks, if the ethanol blenders' credit is allowed to expire, while the annual RFS mandate continues to ratchet up. Or companies might simply conclude that without generous tax subsidies for renewable energy deployment here, their best opportunities would be found in markets that are growing much faster than ours, based on actual energy demand, rather than better incentives. Developing Asia comes to mind. That shift might not be the worst outcome, in terms of both the US trade deficit and global emissions reductions.

Conventional energy firms wouldn't escape unscathed, either. They stand to lose significant tax expenditures as well, in the form of oil & gas depletion allowances, the Section 199 manufacturing deduction, and other benefits. However, the oil and gas industry has been paying an effective corporate tax rate above 40% even after all these credits and deductions. A drop to 26% might more than offset the loss of the other benefits, while more importantly bridging the competitive gap between US firms and foreign competitors that operate under lower tax rates and a territorial tax system, rather than being taxed on worldwide earnings, as US companies are today. Bowles/Simpson also proposed increasing the federal gasoline tax by 15¢ per gallon to restore the Highway Trust Fund to solvency. That's a worthy goal, but as I've pointed out previously the Highway fund faces complex challenges as the US car fleet becomes steadily more fuel efficient and increasingly moves away from liquid fuels taxed at the pump. Raising the gas tax is a stop-gap measure, at best, on the way to a different means of collecting road taxes.

With regard to climate policy, tax reform that eliminated tax credits or reduced their value would also tend to nudge the debate back in the direction of putting an explicit price on carbon, either via cap & trade or with an outright tax. Might that prospect suddenly look more attractive as an adjunct to a fairer and simpler income tax system, than it seemed when it would have come as a further complication to an already enormously convoluted tax system that is widely viewed as unfair by both liberals and conservatives? My guess is not, without something else that motivates us to tackle climate change on a much more urgent basis.

Now let's come back to reality. The proposals of the commission's co-chairs have already received a frosty reception or outright hostility from both sides of the aisle, and they haven't yet gotten the buy-in of the rest of their team; the final report requires the consent of 14 of the 18 members. Their ideas must also compete with a growing number of deficit-reduction alternatives, including a widely-reported plan from another bi-partisan group, plus at least one solo proposal from another member of the President's commission. The chances are low for any of these proposals to gain enough traction to be enacted without first being significantly watered down. However, it is starting to look just as risky to assume that the present tax system--and its cornucopia of energy incentives--will continue unchanged indefinitely. A quick glance at the US debt clock ought to make that abundantly clear.

Read More

Is Gasoline Too Cheap?

It's an article of faith among many observers of the oil industry that gasoline is too cheap in the US. Environmentalists and economists point to various externalities that aren't included in the price consumers pay, while carmakers and alternative energy developers need a (much) higher price to make advanced vehicle technologies and substitute fuels competitive without subsidies. When someone asks, "Too low compared to what?" the response usually draws a comparison to prices in Europe and elsewhere. Yet while perusing a clever historical price comparison tool on the Energy Information Agency's website, I was struck by how high today's gas prices are, when adjusted for inflation, compared to those that prevailed for most of my life--other than during energy crises. That's surely a factor in current weak US gasoline demand, which has been running slightly below last year's, and a full 3% less than the record levels of 2007.

In the course of searching for a standard table of historical gasoline prices, I recently ran across a handy new feature (or merely one I hadn't seen before) of the EIA's Short-Term Energy Outlook report. It allows the public to compare the nominal and real prices for crude oil, gasoline and other fuels, and electricity, over a flexible interval adjusted with a slider control. The first thing I noticed was that although today's price for West Texas Intermediate crude oil of $76 per barrel seems pretty low compared to its $145/bbl high in July 2008, it's actually higher than the inflation-adjusted price for most of the period from 1973-2006, with the exception of the aftermath of the second 1970s oil shock. Now, the Consumer Price Index might not be the most appropriate measure of inflation for crude oil, as I've described in some detail before, but it is perfectly reasonable to apply it to gasoline prices.

On that basis, this week's national average of $2.72 per gallon--$0.17/gal. more than one year ago--is higher than the $0.53/gal. average (equivalent to $2.32/gal. today) for 1974, following the Arab Oil Embargo that helped trigger a severe global recession. It's higher than the $1.17/gal. average ($2.37/gal.) for 1985, before a flood of new production from the North Slope, North Sea and elsewhere broke OPEC's pricing power for more than a decade. It's even higher the $1.35/gal ($2.20) that we paid in the final lead-up to the first Gulf War in late 1990. In fact, it's almost a full dollar higher than the $1.75/gal. inflation-adjusted average for 1986-2005.

When gas prices dipped below $2.00/gal. in late 2008 and early 2009, that provided a significant stimulus to an economy suffering from the combination of a recession and financial crisis. At today's level, however, not only are gas prices not stimulating the economy, but they must be a significant drag on it. Our consumer psychology may be anchored for the time being on $4 as the gauge of what constitutes a high gas price, but compared to the prices that were in effect when our current patterns of mobility and employment were set and the vast majority of the US vehicle fleet was purchased, $2.70 seems more than sufficiently high to inflict economic pain.

Don't get me wrong. I understand full well that a realistic assessment of the cost of greenhouse gas emissions would add at least another $0.10-0.20/gal. to gas prices, and that the current level of US motor fuel taxes is inadequate to pay for the proper maintenance of our highway infrastructure, let alone all the other transportation priorities we'd like to pursue. Other economies have adjusted to much higher gas prices, though these do not prevent the European Union from being a larger net oil importer, in aggregate, than the US is. If OPEC can keep crude oil above $70/bbl when global demand is slack, it's anyone's guess how high it will go when the global economy is actually growing strongly, again. Yet while higher gas prices may well be in our future for many reasons, we should recognize that today's prices remain at oil-crisis levels, and the view of them as "too low" is very much in the eye of the beholder.

Read More

What's the Alternative to KGL?

Although I haven't yet seen the latest discussion draft of the "tri-partisan" energy and climate proposal of Senators Kerry, Graham and Lieberman (KGL), I've been thinking about its rumored provisions for a while. These apparently include a cap & trade system for the electricity sector, eventually expanding to include most industries, and a "carbon fee" on petroleum fuels that would be linked to the cap & trade market, along with measures to increase domestic energy production from a wide range of sources, including oil. It occurs to me that the most important question about the resulting legislation may not concern its actual contents, but what we ought to compare it to.

For all the remaining uncertainty about the risks of climate change, which this week's Economist details, the US regulatory baseline for it has already moved beyond doing nothing. Having issued its Endangerment Finding, the EPA is gearing up to regulate greenhouse gas emissions from both stationary and mobile sources. Almost any other approach to these emissions would be preferable, since regulating point sources ignores the fundamental differences between CO2 and the traditional pollutants like the oxides of nitrogen or sulfur they've been dealing with for decades. If we fail to capitalize on the helpful reality that all GHG emissions anywhere are essentially equivalent in their effect on the climate, we likely won't tackle the cheapest reductions first, and that could cost us a fortune. Yet even without some form of national greenhouse gas legislation or regulations, these emissions are already being regulated at the state level through efforts such as California's A.B. 32 and the Regional Greenhouse Gas Initiative. In that context, whatever one's assessment of the underlying science, we all have a stake in Congress passing the most practical and cost-effective greenhouse gas legislation possible. Sadly, the blatant favoritism and profligate spending of the Waxman-Markey bill that passed the House last spring disqualify it on both of these criteria.

One of the biggest challenges for KGL is ensuring that their bill doesn't end up as a bloated monstrosity like Waxman-Markey. You don't need 1,000 or more pages to define a cap & trade regime or a carbon tax, or to set up "cap & dividend", under which most of the money collected from selling emissions permits would flow back to taxpayers. (That approach has its own problems.) You do need hundreds or thousands of pages, however, to accommodate all the pork and giveaways that seem to be necessary to get any major legislation passed these days, one vote at a time. Careful scrutiny of the text of the Waxman-Markey bill suggests that there is not a majority of this Congress--or perhaps of any actual Congress we're likely to get--that sees the necessity of crafting a clear response to climate change as trumping the need to score goodies for their districts and favorite causes or constituencies. Messrs. K, G and L have their work cut out for them, finding enough support for their proposal through its primary provisions, rather than accreting dozens or hundreds of tit-for-tat favors.

Perhaps the key to a successful bi/tri-partisan bill could be found in its approach to the uses of the enormous revenues it would generate. The healthcare bill that passed the House last weekend only achieved deficit neutrality by taking a huge bite out of the revenues and savings that might otherwise have gone to bringing Medicare or Social Security back into balance, and that's not a partisan talking point. If we are indeed facing an entitlements crisis on the scale that many expect, and some form of consumption tax is on the horizon as the only viable revenue alternative to a return to the bad old days of confiscatory taxation on upper-income Americans who already pay 86% of all the federal income tax collected, then energy might be a good place to start. A fee of 25 cents per gallon--roughly equivalent to $25/ton of CO2 emitted--on gasoline, diesel and jet fuel would collect on the order of a half-trillion dollars over 10 years.

If KGL do go down the path of a carbon fee on petroleum, the biggest mistake they could make would be to follow the advice of the economists and experts who advise collecting it as far "upstream" as possible. Taxing refineries is a sure recipe for offshoring one of the few remaining basic manufacturing industries in this country that has managed to remain globally competitive, even if it has fallen on hard times recently. Likewise, taxing US oil & gas exploration and production would make them uncompetitive with foreign sources free from such burdens. Instead, since most of the emissions from the petroleum value chain occur during consumption, rather than production, the best place to apply a carbon fee--can't call it a tax--is at the gas pump. This would subject domestic and imported fuels to the same cost without having to go through gyrations to manage "leakage", only to find out later that they violate international trade rules. Best of all, the government already has the mechanism in place to collect such a fee without adding another expensive bureaucracy: Simply tack it onto the federal fuel excise tax and post the amount on every fuel dispenser whenever it changes.

In a perfect world, we'd establish a price on carbon using a simple and transparent cap & trade mechanism and return every penny collected to the public, in order to minimize the burden on the economy while shifting it in the direction of greater energy efficiency and lower emissions. In the last several years it has become abundantly clear that we don't live in that world, if we ever did. I still favor cap & trade as an efficient mechanism for price discovery, but not if its implementation comes with as much baggage as Waxman-Markey carried. I will eagerly await the details of the KGL proposal to see whether they can navigate the narrow gap between an effective, efficient approach to GHG management and the political forces seeking to feast on the bonanza it represents.

Read More

US Refineries Under Cap & Trade

A new study confirms my previous suspicions that the allocation of free emission allowances in the Waxman-Markey climate bill would disproportionately disadvantage the US oil sector, with serious consequences for our energy security. In particular, it quantifies the impact on the refining sector, which was chosen by the bill's authors as the focal point for collecting the "tax" on all carbon emissions from the use of petroleum products. In the view of EnSys Energy Systems, Inc., based on their model of global downstream petroleum markets, US refineries would run much less crude oil and be able to invest much less in modernization. As a result, US imports of refined products would grow significantly, despite lower overall consumption, and employment in the US refining sector would fall, while the reductions in greenhouse gas emissions from domestic refineries would be largely offset by increases abroad. Such an outcome would benefit neither the global climate nor US national security.

When I examined the preliminary version of Waxman-Markey in early June, I concluded that because it doled out so many free emission allowances to the electricity sector, its main effect for at least the first two decades would be to function as a tax on the petroleum sector, though without the clarity and transparency of a gasoline tax. Those allocations didn't change materially during negotiations, with the final House bill offering roughly 2% of emission allowances to refineries that would be saddled with the responsibility for between 33% and 44% of all US GHG emissions, depending on how you slice them. Compare that to the electricity sector, which accounts for 39% of emissions but would get at least 35% of the free allowances.

Rather than going through the details of the EnSys study, which was commissioned by API, I'd like to approach this by considering how an evenly-distributed cap & trade system (or carbon tax) should reasonably be expected to affect the oil industry, which after all accounts for a major share of US emissions. You'd hardly expect it to get off scot-free. However, it's a fact that most emissions in the petroleum value chain occur when refined fuel is burned, rather than during production (extraction) or refining. The Ensys study puts the refining contribution at less than 10% of all emissions from well to wheels. Although refiners ought to see their operating costs rise under cap & trade, giving them further incentives to increase their already impressive efficiency of roughly 90% (energy out vs. energy in), the impact should properly be relatively modest. The bulk of the impact from cap & trade should manifest in the form of higher end-user prices for gasoline, diesel and jet fuel, putting commensurate pressure on consumers to use less. The outcome of that reduction would fall on the marginal suppliers of refined products to the US market: foreign refiners that sent us over 3 million barrels per day last year. EnSys concludes that Waxman-Markey would have entirely the opposite result, enriching foreign refiners at the expense of the employees and owners of US facilities.

I wouldn't be surprised if the EnSys study were greeted with the customary skepticism of a finding that supports the interests of the constituency that paid for it. API and its member companies have much at stake in this debate. But if you doubt the likelihood of the scenario it describes, you need only review the regulatory history of the US refining industry and the long-term trend of our refined product imports, which have increased at double the rate of our crude oil imports. Between 1993 and 2007--before the recession axed them--net US refined product imports (after subtracting out exports) grew by a compound average rate of roughly 6% per year, compared to an average increase of 3% per year for net crude imports over the same period. This coincided with increasingly strict regulations on permits for new facilities and on refinery emissions of criteria pollutants, along with ever-tougher rules on gasoline and diesel fuel specifications, culminating in the current reformulated gasoline and ultra-low-sulfur diesel specs. With the exception of a couple of years of stellar margins late in that interval, returns on refinery investments were very poor, and the major oil companies were steadily shedding refining capacity as a bad bet. Today, even the independent refining companies that created profitable businesses by purchasing these assets at a fraction of their replacement cost are suffering from low profits.

If anything, the economic impact on the US refining industry from regulating carbon emissions could be even worse than this recent history, since it hinges on the basic chemistry of combustion itself, rather than the removal of impurities that constitute only a small percentage of their feedstock inputs, even for the highest-sulfur crudes. That could happen even with an even-handed approach to cap & trade or a carbon tax, but it would be a certainty under a system that appears designed mainly to shield utilities and their customers at the expense of the entire existing transportation fuel system. The principal means of reducing GHGs from the latter is through cuts in consumption, not more efficient refining, and even our recent low level of product imports offers the opportunity to cut our emissions from petroleum products by roughly 7% with a minimal effect on US refineries. Instead, Waxman-Markey would effectively offshore many of those refineries--and their emissions. In a world transfixed by market failures, that would constitute a regulatory failure of the first magnitude.

Read More

How Much Per Gallon?

A book I recently received from a publisher makes an interesting contrast with last Friday's posting on how many cars our current oil production might eventually support. Its title of "$20 Per Gallon" demands attention, though the book proves to be less of an argument for how we might get there than for what things might be like if--the author would say when--we did. Rather than providing detailed arguments for the imminent arrival of Peak Oil, Mr. Steiner essentially accepts that premise and builds on it to offer a set of scenarios describing life in the US at gasoline prices escalating steadily in $2 increments between $4 and $20 per gallon. It makes for an entertaining and sobering set of "what ifs?" Unfortunately, despite a brief author's note dated from February of this year, the book is something of a victim of the collapse of oil prices late last year. While its premise might have been accepted eagerly and unquestioningly last summer, the world looks a bit different today. The challenges he describes appear somewhat less urgent, particularly after oil's recent surge past $70 per barrel was cut short when it turned out that all that talk of "green shoots" might have been a bit premature.

In a sense "$20 Per Gallon" seems like two books, one quite interesting and the other seriously flawed, at least as a document about our energy future. The interesting part lies in the author's exploration of what successively higher energy prices might mean for different aspects of the US economy and lifestyle. True to its subtitle, it's hardly a tale of uniform woe, unless you have the misfortune of working in one of the sectors he concludes is doomed, including anything connected to commercial air travel as we now know it. He points out the environmental, health and safety benefits that might ensue from our responses to progressively dearer petroleum-derived products. Many of these benefits sound quite appealing, though I would propose that they are neither as inevitable nor as neatly tied to oil use as Mr. Steiner suggests. The book is also filled with anecdotes accumulated from his travels researching its subject. I particularly liked his description of the airplane graveyard and his rides in various energy-efficient UPS trucks. If you come to this book already convinced that we are on the precipice of Peak Oil, I suspect you would find most of this not just entertaining, but riveting.

The book is less likely to appeal to anyone who is skeptical about the inevitability of Mr. Steiner's scenario assumptions. Start with his structural choice of using gasoline prices as a proxy for underlying oil prices, despite the fact that petroleum product markets experience supply and demand fluctuations that differ--sometimes markedly--from oil's. This choice also ignores the enormous influence of taxes and other government policies on gas prices. You don't need $300/bbl oil to reach $8 gasoline, as European drivers can attest. Last week the price of the average gallon of gas in the US fell to $2.46/gal., compared to the equivalent of $6.40/gal. in the UK and $6.77/gal. in Germany. The difference is almost entirely due to taxes. Despite this, daily life in those countries is not so far beyond the pale of recent American experience as to frighten small children. The implications of a world of high fuel prices resulting from the combination of moderate oil prices and high taxation look quite different from those arising from oil prices above last summer's peak of $145/bbl.

There's an even bigger issue lurking under the surface, and it relates to the author's conviction that in the long run oil prices can only go higher--much higher--due to Peak Oil. There's at least some truth to that, and I've posted periodically on the enormous difficulties involved in attempting to increase oil production in the face of constraints on access to resources--internationally and domestically--along with high interest rates, scarce capital, chronic project delays, and the inexorable depletion of mature oil fields. But oil prices are determined by more than supply, and while he eagerly describes all of the ways in which we would have to adjust our habits to a world of higher and higher gasoline prices, I don't get the sense that Mr. Steiner has considered the ways in which these responses would tend to retard the steady price advances he describes. We have only to look at the impact that a demand reduction of less than 4% since late 2007 has had on oil prices in the last 12 months. That responsiveness to lower demand is as inherent in a commodity with a steeply-sloped short-run supply curve as were the high prices that accompanied the steadily increasing demand we saw earlier. This behavior reflects two sides of the same coin.

The complexities of the various feedback mechanisms involved would also make some of the positive outcomes that Mr. Steiner sees more uncertain. Consider the drop in traffic fatalities that he posits as a consequence of higher gas prices. While you would generally expect people to drive less if gasoline were much more expensive, that response would probably be less pronounced in the long run than in the short run, because of the other ways in which consumers would react. $4 gasoline is painful if your current automobile gets 20 mpg. However, once you've traded it in on a 50 mpg hybrid, your cost per mile--and thus your monthly fuel bill--is lower even at $6/gal. than it was before at $3.

In addition to these concerns, I noticed a few basic errors and misleading comparisons along the way. Compared to the above, they are nit-picks, but anyone who reads the book ought to bear them in mind. First, Mr. Steiner suggests a pretty dramatic impact from high gasoline prices on all the plastics we consume, without delving deeply enough to determine that most of the ethylene- and propylene-derivative plastics in North America--including Saran Wrap--aren't sourced from oil but from the liquids produced with natural gas. That's a crucial distinction, with vast new gas resources available and with the prices of oil and gas having diverged rather dramatically, at least for now. He also makes several numerical comparisons between the response to last year's oil price spike and the aftermath of the oil crisis of the 1970s without taking into account the 42% increase in US population since 1974.

I have to believe that Mr. Steiner would have written a somewhat different book, had he begun the project this year rather than last. I don't doubt that some of the outcomes he describes are waiting on the sidelines until the economy climbs out of its current trough, even if oil prices don't quite reach the stratospheric heights he expects. For example, it wouldn't take the oil-price equivalent of $8/gal. to trigger a radical restructuring of the airline business, after what's it's been through. At the same time, though, I doubt we've seen the last oil price cycle, and the relationship between the prices of oil and alternative energy sources remains complex and dynamic. In some respects proposals such as cap & trade or a carbon tax are intended to evoke some of the same responses that Mr. Steiner imagines, but on a gradual basis and without having to pay an external supplier for the privilege of motivating us. I suggest reading "$20 Per Barrel" in that spirit, rather than as a firm prediction of the inevitable future of our oil-based world.

Read More

A Funny Thing Happened on the Way To Cap and Trade

How much of an unappetizing jumble can you put into a dog's breakfast, before the dog refuses to eat it? That is the question that the authors of the Waxman-Markey "climate bill" appear intent on testing, before it goes to an expected vote of the entire House of Representatives tomorrow. Aside from addressing truly momentous, economy-altering matters--a cap & trade system for greenhouse gas emissions and a national renewable electricity standard to promote green power even more than cap & trade would, anyway--this bill includes more than its share of tenuously-related add-ons, some of which might be nearly as significant as the provisions that have garnered the headlines. Nor has last week's Congressional Budget Office analysis settled all the questions about the bill's likely cost to the public, except to raise suspicions that if it truly amounted to only $175 per household per year, there wouldn't be so much fuss about it.

Let's start with those costs, before we come back to the miscellaneous provisions that begin on page 808 of 1092. The CBO examined the cap & trade provisions of Waxman-Markey and its issuance of free emissions permits to various sectors and groups. They then allocated the costs among all American households by quintile of income. That's an important detail, because of the bill's provisions for rebates and other assistance to lower-income families, the lowest-earning of which would actually come out ahead in their analysis. For the rest of us, I believe the key figures to focus on are not the estimated $235-340 per year "net cost", but the range of $555-1,380 per year in expected "gross costs" before "direct relief to households"--which if you read the bill doesn't look very direct at all. It consists mainly of those free emissions permit allocations that go to utilities and various other industries and groups, not consumers.

The other aspect of the CBO analysis to focus on is its assumptions, explicit and implicit. The key explicit one is the emissions permit price of $28/ton of CO2 from which these costs were derived. While it's certainly possible that permit prices might be that low in 2020--the equivalent of $0.25 on a gallon of gasoline or roughly $0.03/kWh on coal-fired electricity--in the long run they would likely rise much higher, in order to cover the cost of deeper, more difficult reductions in industrial and transportation emissions. The CBO's big, implicit assumption relates to the impact of cap & trade on the economy as a whole, which footnote 3 indicates is excluded, along with the impact of the bill's many other provisions. If cap & trade slows growth, as seems very likely, incomes would be lower and jobs less plentiful than otherwise--even if "green jobs" grew--and other taxes would need to increase to service the debt and cover growing entitlement costs. When you factor in these uncertainties, the probability that cap & trade would cost American families no more than a couple of hundred bucks a year looks low.

The other day I described the severe mismatch between actual US emissions and the sectors chosen in Waxman-Markey to receive the lion's share of free emission permits. The bill would also establish an "Emission Allowance Rebate Program" to help energy-intensive industries engaged in international trade. Remarkably, however, it states, "The petroleum refining sector shall not be an eligible industrial sector." So US refineries, which under this bill would be responsible for both their own emissions and those from the subsequent use of their products--in our cars, for example--could not seek relief for the permit costs associated with products they export to the Caribbean and other markets, while other industries could. That would hamper not only refinery profitability, but also their ability to produce a suitable mix of products for domestic consumption. Last year US refineries exported 1.8 million barrels per day of products to balance their operations and meet stringent US fuel specifications. Raising the cost of those exports would ultimately result in fewer US refineries and more petroleum product imports. That would make US fuel prices more volatile, while increasing the average Waxman-Markey premium at the pump, over and above the direct cost of emissions permits.

Now let's consider what else has been included in this bill. Among the surprises I found in its last few hundred pages was another $4 billion of funding for the cash-for-clunkers program I discussed last Friday, along with its extension until next April 1st. Another provision would give the Secretary of Transportation broad powers under an "Open Fuel Standard" to require auto makers to produce large volumes of flexible fuel vehicles--a key enabler for increasing the country's biofuel production above the amount that can safely be blended into ordinary gasoline. According to yesterday's Washington Post, it would also establish and fund a new multi-billion-dollar federal agency, the Clean Energy Deployment Administration, in apparent competition with the Department of Energy.

Moving further afield, Waxman-Markey would also impose sweeping new rules on energy commodity markets to allow the Commodity Futures Trading Commission to regulate derivatives and swaps and limit speculation. The CFTC would decide what constituted a "bona fide hedge" and what didn't, setting limits on how many contracts a non-hedging entity could hold--not just in the US but also on foreign exchanges dealing with US-based commodities. It would also control energy commodity speculation by index funds. And while these measures at least have a connection to energy, that certainly does not hold for Section 355, which would place strict limits on who could buy a credit default swap, and under what circumstances.

I hope you haven't concluded from the above that I am a wide-eyed idealist who is easily shocked by the way the world really works. This is not a case of liking an idea only in its most abstract form. Although I have long supported cap & trade as the best approach for reducing emissions, I always expected a certain amount of horse-trading to get there--and note that the Senate has yet to weigh in on this bill. Unfortunately, the central cap & trade provisions of Waxman-Markey have been sufficiently distorted to cast serious doubt on their likely efficacy in managing our actual emissions, while issues as important as the regulation of energy markets and credit default swaps surely warrant separate legislation that would expose these proposals to the scrutiny and transparency they deserve. This might be the way laws are made these days, but the insertion of a grab-bag of disparate provisions into a bill of this magnitude represents an act of legislative mischief. In the context of the similar process that shaped last year's version of cap & trade, the Boxer-Lieberman-Warner Bill, I have begun to wonder if it's even possible for cap & trade to be implemented effectively under our political system, or whether a simpler carbon tax might be less prone to this sort of excessive creativity.

Read More

The Non-Tax Tax

When President Obama campaigned in 2007 and 2008, cap & trade was the centerpiece of his strategy on climate change. The latest iteration of cap & trade legislation is being developed by the House Energy and Commerce Committee, within the broader Waxman-Markey Bill. After numerous hearings and comments, the revised bill is expected to be released later this week and put to a committee vote by Memorial Day. In the process, its approach to cap & trade has apparently evolved from an assumption that 100% of the emissions permits would be auctioned, to the current expectation that a large fraction of them would be allocated for some period at no cost to current emitters, particularly in the electric power sector. In some quarters, the potential impact of this change on the federal deficit is being viewed with alarm and treated as tantamount to a tax cut--never mind that the tax being reduced does not yet exist. For that matter, many politicians can't even agree on whether cap & trade constitutes a tax. I'm sympathetic, because while it has many of the same effects and features of a tax, it differs in at least one important respect: the revenue it raises is incidental to achieving its primary purpose.

One key feature of taxation shared by cap & trade is its potential to transfer large sums of money from taxpayers to the government. In that respect, cap & trade fits many people's definition of a tax. Since it would fall heaviest on consumers and productive industries, both of which are reeling from the effects of the current recession, I've argued for deferring its collection until economic growth has resumed. Even then, the more of its proceeds are recycled back to taxpayers in the form of relief on other taxes or simple rebates, the better the chances that it would not undermine a fragile recovery. Granting free allowances to current emitters--a form of temporary grandfathering--merely reduces the amount that would need to be recycled, as well as the risk that large portions would be diverted to other purposes. Although conventional wisdom has it that a similar allocation to the power sector and other industries in the first phase of the European Emissions Trading Scheme resulted in a windfall for utilities, the same result is far from certain here, because the structure of our power sector is different. But whether the value of these permits is captured by industry, government, or no one at all is ultimately immaterial to the real purpose of cap & trade, which is to put a tangible price on the marginal unit of carbon emitted. That's what will alter investment decisions and consumer behavior.

This is where cap & trade differs most from its first cousin, the simple carbon tax. A carbon tax would apply the same price--set by the government--to every ton of CO2 and other greenhouse gases (GHG). Since the US emitted 7.2 billion tons of GHG in 2007, the most recent year for which we have data, a carbon tax wouldn't have to be very high to raise a lot of money--but it also couldn't be so low that it didn't influence behavior. A tax of $20/metric ton of CO2-equivalent would add on average about $0.22 per gallon of gasoline and $0.012/kWh of electricity, while raising nearly $150 billion per year. If it took $100/ton to achieve the desired emissions reductions, that revenue could swell to over $700 billion per year--almost enough to close the budget gap, but also enough to be a serious drag on the economy. Cap & trade could deliver the same marginal cost of carbon, but with a significantly smaller net burden on the economy, by allocating a portion of the allowances at no cost.

The key to making that work would be to ensure that the total number of allowances auctioned and allocated each year created a shortage in the market; that's why you do this, anyway, as a means of shrinking emissions year after year. That shortage is what gives the allowances their value. If you issued exactly as many allowances as the tons of GHG we expected to emit next year, their value would be zero. But you also need to make sure that you don't grandfather so many emissions that no one needs to buy or sell allowances. If everyone can meet the target themselves, allowances would become worthless. So the trick is to give out just enough free allowances--reducing this allocation annually--to avoid creating a shock analogous to an oil price spike, but not so many to any participant or sector that they can opt out of trading and deprive the aftermarket of the liquidity it needs to function properly.

The problem today is that we already have a federal budget built upon the assumption of a certain level of revenue ($646 billion over the next 10 years) from the auctioning of emissions permits from a new system, the enactment of which remains uncertain. Once that revenue is in the budget, even if it has never been collected before, anything that reduces it risks throwing the whole edifice into disarray. This bit of aggressive planning has empowered two powerful constituencies: those who see cap & trade as a massive, and thus undesirable new tax, and those who see any weakening of it as a threat to fiscal stability. I will be watching with great interest as these groups grapple with cap & trade in the weeks ahead.

Read More

Cap & Trade: No Free Lunch

One thing I still miss about living in the New York metro area is receiving the Times on my front doorstep every morning. So instead of pouncing on Tom Friedman's latest column the morning it's published, I often don't see it for a couple of days, until I run across it on the Internet. The net effect is to raise the bar for Friedman remarks on which I feel compelled to comment, because they're usually superseded by other, more interesting topics on which to blog. Unfortunately, the theme of Mr. Friedman's column of last Saturday is likely to be with us for some time, working its way insidiously into our assessment of energy and climate policy. Cutting through its convoluted logic, it suggests that we can significantly increase the price of energy to send a signal concerning greenhouse gas emissions but somehow end up spending less on energy and becoming richer in the process. While I continue to support the basic idea of a cap & trade system for managing our emissions, touting it to the public as a free lunch seems likely to set us up for a future backlash not unlike the one the financial industry is now experiencing, after we learned that the cheap credit we've enjoyed came with a steep hidden price.

In his script for a hypothetical speech by President Obama, Mr. Friedman sets out his thesis this way: "Yes, the cost of gasoline or kilowatt hours will rise in the short term. But in the long term, your actual bills and expenses will go down because your car, appliances and factory will become steadily more productive and give you more power for less energy." This exaggeration of the basic principle that higher energy prices stimulate greater energy efficiency incorporates several basic fallacies, the most important of which is that while higher prices affect all consumers and businesses more or less immediately--some businesses may have hedged their energy purchases for a time--their capital stock of energy-consuming devices turns over slowly. It also ignores the diminishing returns to higher fuel economy. Someone buying a new, more efficient car might offset most or all of the fuel price increase via higher fuel economy, but the other 93% of car owners are stuck with higher bills for at least another year. The only means by which the remainder of the population can manage this higher expense is through reduced consumption, if not of energy then of other goods and services. We saw that effect on steroids last year, and we are still living with the hangover from it. But even the consumer who bought the frugal car might be worse off, if it cost much more than the model he would have bought otherwise. In effect, he traded some wealth for lower expenses.

The impact on businesses looks similar. While business investment is hardly a zero-sum game, higher investment in energy efficiency would come at least in part at the expense of other kinds of investment, perhaps in new computer equipment or staff hiring or training. Higher prices on energy thus promote improvements in energy productivity at the expense of other kinds of productivity. Although this certainly reduces expenses, it would take some time to reduce them in absolute, rather than merely relative terms, and without increasing top-line revenue. That might sound equivalent in terms of its impact on profits, but it often isn't. Expense improvements tend to get competed away in the marketplace, and are thus often not sustainable sources of earnings. So while business investment in energy efficiency might ultimately shield consumers from higher prices for finished goods and services, it seems unlikely to do much for corporate profits or stock valuations.

Mr. Friedman's assertion ultimately rests on an energy analogy to the experience of the electronics industry. If there is a Moore's Law for energy, it has yet to be discerned, let alone quantified. In the early phases of any new technology, "experience curve" effects can emulate Moore's Law-style improvements for a while. Then, as cumulative output grows the rate of change slows dramatically. Last year's DOE study on the feasibility of obtaining 20% of our electricity generation from wind energy included some interesting observations on cost. While the cost of new wind power fell dramatically between the 1980s and 2000, in classic experience-curve fashion, that decline appears to have bottomed out in 2002 and actually reversed somewhat since then. Moreover, when wind capacity is pushed further along its supply curve, the cost of incremental capacity is expected to go up, as prime wind locations are exhausted and new development is forced into more expensive regimes, in coastal waters or further from markets. Creating a bigger market for energy efficiency won't necessarily drive the cost of efficiency dramatically lower than it is now, or will be once the wave of efficiency investments triggered by $100 oil and $10 natural gas rolls through.

Like Mr. Friedman, I believe we should put a price on emissions of greenhouse gases--if not this year then fairly soon--in order to promote efficiency and the adoption of cleaner technologies over time. However, we shouldn't imagine this will be easy or cheap, let alone something that will create mountains of new wealth out of, literally, thin air. Haven't we all just been through something like that, to our regret? We can't suddenly start collecting fees on behalf of an environmental service--storing our waste carbon in the atmosphere--that has been free since the dawn of time and expect that this won't impose a burden on someone. More precisely, it represents a different kind of wealth transfer than the one we all complained about last year--sending our money to OPEC--in which those who use energy (most of which is still derived from fossil fuels) will send money to those who use less of it and to those who are developing new ways of producing and using it with fewer emissions--and of course to those administering these programs. That should benefit investors in green technology, but someone else will get the bill.

Read More

Time to Choose

Last week's finding by the US Environmental Protection Agency that greenhouse gas emissions "threaten the public health and welfare of current and future generations" should not have come as a surprise. It has been virtually inevitable since the Supreme Court decision in Massachusetts v. EPA two years ago, and it was rendered imminent by the election last November of Barack Obama, who made responding to climate change a centerpiece of his presidential campaign. Whatever you might believe about the risks of climate change, we no longer have a choice between addressing them or ignoring them. Representative Edward Markey (D-Mass.), who chairs the Select Committee on Energy Security and Global Warming, responded to the finding by saying, "It is now a choice between regulation and legislation." I don't think that's quite accurate, particularly since his own proposed climate legislation includes many strong regulatory features. Instead, I believe the choice lies between relying primarily on an explicit price for emissions to nudge consumers and businesses away from emissions-intensive activities, and employing a more prescriptive approach using mandates, "standards", and air pollution-style rules on smokestacks and tailpipes. Long-time readers won't need to infer my position on this matter from the way I've described that choice.

I've argued the case for cap & trade numerous times on this blog and in front of various audiences, corporate and public. I've also expressed my misgivings about the imposition of a strict cap & trade system in the middle of a recession, particularly if the government intends to use the revenues from cap & trade to fund a dog's breakfast of non-energy programs, rather than returning the bulk of it to taxpayers. I've even suggested that under some circumstances a simple carbon tax might be preferable to cap & trade, since both serve the purpose of establishing a price for emissions, to which our market economy must respond by shrinking emissions-intensive sectors and growing low-emissions ones, including the renewable energy sector with its vaunted "green jobs." I've spent less time, however, examining the regulatory approach, perhaps because I regarded it as self-evidently inferior, particularly if it looks more constraining than the version of cap & trade that might accompany it. It is abundantly clear that many others do not share that view.

The main appeal of the regulatory path is that it would build on long experience in managing other environmental impacts--including many from energy systems--under existing federal and state air and water quality regulations, the federal Renewable Fuel Standard (RFS), and numerous state-level renewable electricity standards (RPSs) and other regulations. But these programs also illustrate some of the severest drawbacks of this approach, in the complexity and overlapping nature of these rules. Regulating emissions that are not incidental to, but rather a fundamental consequence of the use of our principal energy sources would add further layers of complexity without subtracting any, as cap & trade might eventually be expected to. We already have trading in Renewable Energy Certificates (RECs) for state RPS compliance, Renewable Identification Numbers for compliance with the federal RFS, and sulfur and nitrogen credits for compliance with the Clean Air Act's rules for criteria pollutants. And because the GHG emissions from motor vehicles are determined largely by how much fuel they consume, efforts at regulating tailpipe emissions become de facto fuel economy regulations, in conflict with the federal Corporate Average Fuel Economy regs. (This is the matter on which California eagerly awaits a waiver from the administration to pursue its legislated Low-Carbon Fuel Standard.) With all due respect to the dedicated professionals at the EPA, anyone contemplating leaving the regulation of greenhouse gas emissions to that agency should be required to pass a test demonstrating that they understand the EPA's notice implementing the RFS for 2009, which involves the comparatively much simpler task of setting the required ethanol percentage in gasoline for the year.

We are now at the point that I have long feared we would be, if we mislabeled carbon dioxide as a pollutant. While the consequences of excess CO2 and other naturally-occurring greenhouse gases certainly live up to the terms the EPA has applied in its finding, unleashing a pollution mentality to solve climate change will be counter-productive and unnecessarily expensive, when dealing with a phenomenon for which a ton of CO2 emitted, captured or avoided in Boston is exactly equivalent in its climate impact to a ton emitted, captured or avoided in Beijing. We would have been much better served if the Supreme Court had paraphrased the Hitchhikers Guide to the Galaxy and found that CO2 was "almost, but not quite, entirely unlike" pollution, yet here we are.

By next year's Earth Day, the 40th anniversary of the first one, I expect that we will have made our choice between these competing approaches. We see signs of this in the apparent determination of the administration to arrive at the Copenhagen climate conference this December having taken concrete steps here, and in the competing cap & trade bills making their way through the Congress. I can understand that opponents of strict legislation on climate change might regard the EPA's endangerment finding as a high-stakes game of chicken. But whether it serves as an implicit threat or merely an insurance policy against protracted legislative delay, it--rather than inaction--represents the new baseline. Anyone who has been sitting on the fence must now decide which approach is likely to be more effective in dealing with the US contribution to global warming, while simultaneously doing less harm to our economy. After long and careful scrutiny of the options, and after spending a career in an industry that has already been regulated to the gills, I find pricing emissions by far the most attractive solution. This is anything but a trivial decision, though it is one that must be made, and soon, before the default option becomes as inevitable as the endangerment finding was.

Read More

Taxing Carbon

While many observers were focused on the most obvious first represented by yesterday's presidential inauguration, I was thinking about another one: Barack Obama is the first US President elected on a platform that included putting a price on our emissions of carbon dioxide and other greenhouse gases to the atmosphere. Although the likelihood of that happening this year has receded somewhat, due to the weak economy, it would be just as momentous in a year or two. Either way, it's not a long interval in which to decide the best way to go about altering a practice that humanity has taken for granted since the discovery of fire. There are some very strong views on each side of the carbon tax vs. cap & trade dilemma.

Last week, the CEO of ExxonMobil made news when he came out in favor of a carbon tax, though in fairness, while Mr. Tillerson's remarks at the Woodrow Wilson Center in Washington, DC reflected a clear preference for a carbon tax over cap & trade, they fell short of advocating the immediate implementation of either. But however one chooses to parse his comments, the concerns he raised about cap and trade are entirely legitimate and must be addressed forthrightly in the political debate on limiting emissions of greenhouse gases (GHGs). One concern in particular seems likely to carry much more weight now than it would have a year or two ago:

"It is important to remember that a cap-and-trade system requires a new market infrastructure for traders to trade emissions allowances. This new 'Wall Street' of emissions brokers will take the emphasis away from the goal of reducing carbon emissions and focus its attention on trading on price volatility. For businesses and consumers, these market gatekeepers and resultant price swings add cost and they create uncertainty."

The idea of setting up a new market that will benefit traders and speculators is bound to raise some hackles, when these are widely viewed as having contributed to last summer's oil-price spike and to the larger financial crisis. If it weren't for one crucial shortcoming of a carbon tax, I would find Mr. Tillerson's arguments for its simplicity and predictability quite compelling, and the other justifications for cap & trade might be reduced to mere quibbles. To see why, let's consider the practical aspects of implementing either approach.

The ultimate goal of either cap & trade or a carbon tax is to reduce GHG emissions, in order to limit the extent of global warming and consequent changes in the earth's environment. These cuts are intended to begin gradually but quickly gather momentum to deliver substantial cumulative reductions in emissions within a few decades. Both cap & trade and a carbon tax would lend themselves to being carefully phased in, and either one could be rendered revenue-neutral, to minimize the undesired economic effects of a policy designed to alter our consumption patterns in fundamental ways, at least with regard to energy-intensive goods and services. In either system, vulnerable consumers and industries with few alternatives could be protected or given more time to adapt. And while cap & trade creates a strong incentive for companies and sectors with the lowest costs for reducing emissions to maximize their cuts and trade the resulting surplus with others who face higher costs, a carbon tax could be modified to allow some trading around the edges, capturing at least part of that benefit for the economy. The biggest distinction may also be the most basic: how is the price of emissions set in the first place?

In effect, the choice between a carbon tax and cap & trade boils down to a choice between the cost of CO2 being set by committee, or by markets. Whatever else disappointed investors might think about them, markets excel at price discovery. While I have little doubt that a blue-ribbon panel of economists, scientists and engineers could come up with a reasonable estimate of the level of carbon taxation required to reduce emissions by the desired amount, I have much more confidence in the logic of setting the desired level of emissions reduction in each year, and then allowing the price to emerge from the interaction of those whose livelihoods depend on meeting these limits, in real time. That preference is rooted in the risks of each approach.

If our hypothetical Carbon Price Committee sets the carbon tax too low, emissions will exceed the goal and they can ratchet the tax higher in the next period. However, if they set it too high, we'll beat the emissions targets, but the economy will shift too rapidly, and jobs and output in energy-intensive sectors will be shed faster than new, "green" jobs and products can be created. The result might look a lot like what we're experiencing today. Cap & trade has its own risks, though they tend to focus more on the effectiveness and efficiency of the program than on its consequences for the economy. Mr. Tillerson is right to identify problems of "verification and accountability," though there is already a large and growing body of experience in managing these issues, from the EU Emissions Trading System and from voluntary emissions trading--and the statutory SOx and NOx trading--that has been going on in the US for more than a decade.

In the final analysis, the decision to put a price on greenhouse gas emissions matters more than how it is implemented. At the same time, the latter choice will determine how effectively those reductions are achieved, and at what cost to the rest of the economy, where most of us will continue to earn our livelihoods and save for our future needs. I hope that the new administration will weigh these considerations carefully, in consultation with the Congress and all affected stakeholders, including our international trading partners, who could be affected in many ways by the result. The idea of a carbon tax deserves a fair hearing alongside cap & trade, once our leaders agree on the timing of limiting our emissions.

Read More

A Gasoline Floor Price for Hybrid Cars

The coverage of this year's Detroit Car Show has focused on hybrids and electric vehicles, with a number of high-profile launches, including the debut of the third generation Toyota Prius. However, as convinced as I am that electric-drive cars represent the future of the car industry and will make important contributions to reducing greenhouse gas emissions and oil imports, the collapse of oil prices has erected a substantial barrier to the rapid market penetration of these technologies. Nor can the answer be simply ratcheting up the nation's Corporate Average Fuel Economy (CAFE) standard, as the New York Times recently suggested. We need a practical way to bridge the gap between consumers' growing interest in electrified vehicles and the economic deterrent posed by the added cost of these complex systems. Rather than taxing fuel itself, as has been widely suggested, we should consider a new hybrid car tax credit based on the price of fuel.

Despite growing interest in hybrids, these vehicles accounted for only 2.4% of the 13.2 million light-duty vehicles sold in the US last year. Although its 2008 sales of around 160,000 units made the Prius the 15th most popular model in the US last year, it did not even make it into the top 20 for December, thanks to slumping gasoline prices and the credit crunch. For that matter, the December monthly figures showed trucks, including SUVs, outselling cars again at 53% vs. 47% of the market, essentially back to their average for 2007. For all of 2008 cars outsold trucks by 51% to 49%, though that included those summer months of $4 gas when you couldn't have given a big SUV away. Perhaps the most encouraging news in this data is that sales of "cross-over" SUVs declined much less than other light trucks to become the largest segment of that market. (Moving someone from a 15 mpg SUV to a 22 mpg crossover saves more gallons of gas than converting a Camry owner to a Prius driver.)

The lackluster hybrid sales at the end of the year shouldn't surprise anyone. Consider the Saturn VUE crossover SUV. The sticker for the hybrid version is $4,880 higher than the base model with the same 4-cylinder engine. Boosting fuel economy from an EPA-estimated combined 22 mpg to 28 mpg saves 117 gallons of gas per year, based on 12,000 miles of annual driving. Yet even if gas were still $4 per gallon, it would take 10.4 years of fuel savings to pay out the hybrid premium. With gas at $1.78/gal., that stretches to 23 years. If the savings at the pump aren't sufficient to justifying spending an extra $5k on the hybrid, a buyer must bet that the combination of higher resale value and lower maintenance costs would close the gap.

How could the government induce more consumers to buy hybrids, even when fuel costs are too low to justify the extra investment? One option is to raise the CAFE standard beyond the 35 mpg target that the industry must meet by 2020. That might force manufacturers to produce more hybrids, bringing their cost down, and sell fewer non-hybrids, which would tighten the market, reducing the effective premium from both ends. The Congress would like to impose that outcome, in any case, as a condition of financial assistance to Detroit. Unfortunately, such a command-and-control approach risks creating another disconnect between car companies and consumers, and the modest fines by which CAFE has been enforced may end up looking more attractive to Detroit than the distortions an unrealistic fuel economy standard could create in their already-strained sales channels.

Another solution would be a big increase in the gasoline tax, or a floor-price tax on gas, to boost pump prices to a level that would ensure high demand for very fuel-efficient cars. As I noted the other day, however, the gas tax looks like a much less effective way to reduce greenhouse gas emissions than a tax on carbon or emissions cap-and-trade that would create a similar disincentive for CO2. Nor does raising the gas tax during a major recession--even if a large portion of the revenue could be returned to taxpayers--look like smart economic policy, when the recent drop in fuel prices is among the few forms of relief actually reaching consumers and smaller businesses.

Perhaps the answer lies in inverting the proposition offered in those car ads we saw when gas prices were rising steadily--the ones that promised your first few years of fill-ups at some low fixed price. To make hybrids more attractive, we could replace the current, expiring hybrid tax credits with a new, fully-refundable tax credit--one that the government pays even if it exceeds your income tax liability for the year--that would create an effective gasoline floor price of $4, but only for the purchasers of hybrid cars. The amount of the credit would be set by the difference between $4 per gallon and the national average pump price for each year, applied to the EPA fuel economy rating of the hybrid purchased. This could easily be made technology-neutral by extending it to any car exceeding the actual new-vehicle CAFE for the previous year, which for the 2008 model year averaged 31.2 mpg for cars and 23.4 for trucks. Even with this modification, the bulk of the subsidy would still flow to the models that save the most fuel.

For example, if we calculated the credit on 10,000 miles of annual usage, a buyer of the new 37 mpg Ford Fusion Hybrid would receive a credit of $600 for 2009, if gasoline remained at last week's average of $1.78/gal for the entire year. Of course, that would be in addition to roughly $260 of actual fuel savings, compared to the 24 mpg non-hybrid Fusion. If gas prices averaged $3 in 2010, this taxpayer's credit would drop to $270, while fuel savings rose to $440. Once gas was back over $4, the tax credit would go to zero.

It sounds complicated, though in practice it would merely be a hedge contract on the price of fuel--in the opposite direction from the ones typically offered to heating oil customers--conferring the equivalent of a set of annual put options on gasoline at $4. It probably would not be any more difficult to implement than a floor-price tax for all gasoline sold, even if the latter were politically feasible or economically desirable. It would also have the benefit of a built-in phaseout, as overall fleet fuel economy increases and future gas prices rise.

Perhaps someone can think of a simpler way to reduce the uncertainty of hybrid car buyers about future fuel prices than by issuing federal gasoline floor price tax credits. What we can't do is merely to hope that gas prices will recover enough to make hybrids and other advanced technology vehicles attractive on their own merits, or to assume that consumers will remain so stunned by last summer's high gas prices that they will buy the most efficient cars possible, even if they don't promise a financial return. This discussion will turn distinctly non-theoretical as soon as the government considers another round of financial assistance for a Detroit that it insists must build as many hybrids as possible.

Read More

A Taxing Opportunity

While watching the scenery from Amtrak's Acela on my way back from a meeting in New York yesterday, I made my first sighting of $1.99 per gallon gasoline, posted on the polesign of a station in Delaware. With wholesale gasoline trading on the New York Mercantile Exchange for $1.138 per gallon at yesterday's close--nearly $7 per barrel below the closing price for light sweet crude oil--most of the country could shortly be paying less than $2/gal. for unleaded regular, for the first time in more than three years. An op-ed in yesterday's Washington Post started me thinking about gasoline taxes, again, and I agree that the current gas price collapse provides a uniquely opportune time for a symbolic increase in the federal gasoline tax, which has not been raised since 1993.

Raising taxes in a recession isn't terribly sound economics in general, but gasoline in 2008 presents an unusual case. As I noted in Monday's posting, the decline in prices from their summer peak to last week's $2.22/gal. average puts roughly $260 billion per year back in the pockets of US consumers, at a time when that ought to be quite helpful. However, it's equally clear that low gasoline prices will complicate the task of selling more efficient cars to an American public that is already buying fewer cars than at any time since the recession of the early 1990s. Moreover, with gasoline demand running at least 3% below last year's at this time, and with prices now a dollar per gallon lower than they were a year ago, and below their annual averages for 2005, 2006 and 2007, state and municipal tax revenues from sales taxes on gasoline will also fall well below expectations. That puts further pressure on state and local budgets already stressed by falling home values and rising unemployment, and it could force cuts in infrastructure projects that many economists suggest we need more of, just now, not less.

This needn't conflict with the necessity to put a price on our emissions of greenhouse gases, effectively taxing fuels on their inherent carbon content. My preference has been for cap & trade, but a simple carbon tax would do much the same thing. Every $10 per ton imposed on CO2 emissions would raise gasoline prices by roughly 10 cents per gallon, anyway, so I'd resist calls for the "big honking tax on gasoline" that Mr. Sloan's op-ed suggests. But with gas prices dropping by more than a dime per week since September, a 10 cent gas tax hike would scarcely be noticed, leaving that $260 billion effective stimulus I mentioned earlier untouched. It could also be shared with the states, with half of the roughly $14 billion per year it would raise going to fund federal infrastructure projects, and the other half allocated to backstop state-financed road and bridge work.

Ten cents a gallon might not sound like much, though the 4.3 cent increase in 1993 cost another first-year President a good deal of political capital. By itself, it wouldn't change the way Americans drive or buy cars. Nor would it be sufficient to nudge consumers towards diesel cars, when diesel fuel has carried an average premium of $0.50/gal. over unleaded regular this year, and currently sells for $0.73/gal. more. However, it would indicate the willingness of the government to intervene in gasoline pricing, when appropriate, in a manner that doesn't impede the market's ability to balance supply and demand, as price controls or a floor price mechanism would. And unlike raising income taxes when salaries and consumer spending are falling, a period of falling gasoline prices is precisely the right moment to raise the federal motor fuel tax, even if just by a little.

Read More