Cap and Trade - am economic tradeoff

July 9, 2009 Edition, Volume III

Inside Signature Update

Obama Administration Making Its Mark on the Markets
Cap and Trade Policies – an economic tradeoff


Obama Administration Making Its Mark on the Markets

The weakness in the equities markets over the past several weeks has more to do with policies announced by the Obama administration than on any other input. During a time in which the administration should be obsessively focused on the employment market and restoring America’s economic underpinnings, precious resources, including time, are being directed towards other facets of the administration’s wide ranging and sometimes idealistic agenda. This may well represent change, but it is not what the American people bargained for, and Obama’s numbers in the poles are telling an important story; one in three voters has lost confidence in the newly elected president’s ability to deftly deal with the economy and the employment markets. Not good… not good at all.

Too much of the rhetoric coming out of Washington has turned decidedly anti-business, not unlike it did prior to the market’s decline ending in a March low on the DOW at nearly 6,500 points. Following heavy handed dealings with the financial services and automobile industries, the administration has prematurely turned its attention to health care and energy. While most would agree that a re-engineering of these industries may ultimately be important, the tenor of the administration’s actions is damaging the markets as it is ill timed and taking important focus away from much needed attention to the labor markets and restoring confidence in the economy.

Ideally, there are numerous fronts that must be addressed, but doing so while the nation bleeds jobs is simply a waste of capital; economic and political. I’ll repeat CNBC’s Jim Cramer’s sentiment expressed Wednesday afternoon; I want Obama to succeed at restoring jobs and growth to the US economy, but right now he, his advisors, and key legislative representatives in the House and Senate are blowing it. It’s time for a change!


Cap and Trade Policies – an economic tradeoff

The Energy Bill recently passed by the US House of Representatives includes more than 1,200 pages of policy, amendments and ‘stuff’. ‘Stuff’ best describes most of it as 300 pages of amendments and special interest bequests were added to the bill just hours before its passing. At the heart of the bill is a plan to reduce greenhouse gas emissions to 17% below 2006 levels by 2020 through the use of a ‘cap and trade’ system in which companies would buy and sell pollution permits to meet emissions limits. Predictably, the Democrats are pleased with themselves for passing such a sweeping piece of legislation, the Republicans are outraged at the cost the public will bear, and most people just don’t care; but this is one we all need to care about.

When energy prices are high, politicians and the public clamor for greater energy efficiency, but once prices subside, the noise goes away and little improvement is made. Let’s face it, there’s a high cost to changing energy policy and there’s a cost of not changing as well; we just get confused over which cost we’re willing to bear when the short-term pricing moves up and down at the gas pump or on our monthly utility statements. Most would agree that we must reduce, or even eliminate our nation’s dependence on foreign oil or fossil fuels altogether; that’s an ambitious goal, but few of us honestly see a prosperous future without such changes.

This is a difficult time to consider stepping up to pay for such a major overhaul of our energy policy and it is taking important capital away from the more important need for job creation. Regardless, we’ll soon need to bite the bullet, and in keeping with the theme of an ‘Economic Reset’, at some point we’ll need to simply set our sights on the future and run. There’s more than a little naïveté in that statement, but the public and our political representatives have oft times shown a lack of willingness to address this issue when it may be more advantageous to do so, and many would suggest that we’re running out of time. The Obama administration sees the current situation as an opportunity and may be making a run at it as they work towards several major policy initiatives, including healthcare reform. Change is costly and may cause a myriad of other difficulties; prudent change on the other hand, complemented or offset by cost reductions in other areas, has a chance of success. Does the current administration, with effective control of the house and senate, have the strength and courage to trim other waste in order to make room for the expense of forward-thinking initiatives? Likely not, but we can always hope.

There is a current and future cost to higher levels of pollution. Whether you subscribe to ‘global warming’ theories or you simply don’t appreciate viewing dense haze, breathing in polluted air, or enduring another ‘smog alert’; it’s difficult to ignore the reality. While we have substantially more fuel-efficient transportation systems, energy production and manufacturing processes than at any time in the past 100 years, we also have many more people to support and we use far more energy per person than ever before. That’s a trend that’s simply not going to reverse itself; it would be economic suicide were we to attempt such an exchange.

As other less developed nations move towards an improved quality of life the problem will simply exacerbate itself. Jared Diamond, the author of Collapse, makes an interesting point as he suggests that ‘the larger danger that we face is not just of a two-fold increase in population, but of a much larger increase in human impact if the Third World’s population succeeds in attaining a First World standard’. With lifestyle changes in many emerging economies, it is becoming ever more incumbent on us to decrease our ecological footprint, both personally and as a society, before we risk being suffocated by it as others attain our standard of living.

There are numerous ways of curtailing greenhouse gases, we have the technology and understand how to deploy it, but the problem lies more in how to motivate firms and consumers to choose efficiency over lower-cost alternatives. While a ‘cap and trade’ system has numerous pitfalls, it may represent an efficient way to affect a shift in production and consumption.

‘Cap and trade’ refers to the issuance of pollution permits to businesses allowing certain levels of specific pollutants from that business at a cost that reasonably must be viewed as a pollution tax. Firms that re-engineer their manufacturing processes sufficiently to emit less pollution than their permit allows may sell the excess (unused) pollution capacity to firms that emit pollutants beyond the limits of their permits. The trading of these permits is likely to create additional revenues for very efficient firms and increase costs for firms that are less efficient, but such additional costs may be less than the fines a firm may have to pay if it emits pollutants in excess of allowable levels based on current standards. The current system of pollution standards provides incentives for firms to avoid being fined by not emitting more pollution than allowed, but doesn’t offer real incentive for a firm to become more efficient than imposed standards would dictate. A ‘cap and trade’ system has the ability to reward very efficient firms, while at the same time keeping less efficient firms from paying heavy fines and penalties to federal, state and municipal bodies. The taxing authorities which now depend on collecting such fines, and as such are less likely to assist a firm in creating more efficient processes, would receive the bulk of their revenues from the cost of the permits up front rather than through a process of monitoring, fining and collecting from offending firms.

In terms of an economic model designed to offer incentives and create surplus, a ‘cap and trade’ system may be preferable to most others. However, it is costly, and the cost will undoubtedly be passed onto consumers. As a result, consumer demand for a given product at a higher price point will decline and the result may be fewer jobs. It is also likely that less-expensive substitutes may gain market share. Some firms will simply choose to bypass the system and move higher polluting manufacturing processes to other countries with lower costs or standards – again resulting in domestic unemployment. These are two of the main points of contention many have with the proposed system, and at a time when job creation should be first and foremost on the minds of our nation's policy makers, a 'cap and trade' system may not be all that expedient.

We already have major US firms that have moved their manufacturing processes offshore to gain cost advantages; sometimes to avoid high union labor and benefit costs, other times to seek out lower costs of land and rents, and to find lower emissions costs or to be allowed to continue to use higher polluting, lower cost manufacturing processes. While we can surmise that imposing a cost to purchase pollution permits may be enough to push some firms to look to other markets for producing goods it may also attract firms from other markets with efficient processes that may find themselves profiting from the secondary market sale of their unused credits. Other firms may find that the cost of permitting may be lower than the cost of fines and penalties. Yet other firms may choose to re-engineer and may find greater profitability by doing so - both in terms of lower costs and higher revenues - such has been the case of many US corporations thus far.

If there is to be a marketplace for the trading of permits, rest assured that a regulatory environment will develop to govern it – in the mean time the trading of permits may be a breeding ground for abuse and unfair practices.

Those nations that have succeeded in encouraging ‘green’ concepts for businesses and consumers have done so at great political and economic costs, but with the attending benefits such investments may offer. Curitiba, Brazil is a prime example of a city transformed by courageous elected leaders determined to provide a higher quality of life for their constituents. After 20 plus years of re-engineering, Curitiba is considered the most livable major city on the planet and much of the rest of Brazil is now following suit; as are many other major metropolitan areas in other countries. Innovative practices not unlike the proposed ‘cap and trade’ system have set Curitiba apart as their efforts have transformed the regional economy.

The current energy bill may never make it through the US Senate in the Fall; the very fact that the energy issue is being raised in tough economic times speaks of our interest in improving our national energy structure and will ultimately bode well for our economy and society. If we are to maintain our position as the world’s economic leader, we will have to take bold action to do so – this may be just one example of more to come.






Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management and CEO of Signature Management, LLC