– John Kemp is a Reuters columnist. The views expressed are his own –

Resounding defeats for Democratic Party gubernatorial candidates in Virginia and New Jersey on November 3 have killed any lingering hope Congress will enact climate change legislation this year, and may doom the prospect of passing a cap-and-trade bill this side of the 2010 mid-term elections.

Prospects for eventually passing legislation may now depend on winning Republican support with nuclear loan guarantees and more offshore drilling.

While the president remains personally popular, with high approval ratings, and does not need to face the voters again for another three years, 16 Democratic senators and 256 Democratic members of the House of Representatives will be on the ballot in November 2010.

The Virginia and New Jersey off-cycle elections are often idiosyncratic. But crushing defeats for Democrats at the top of the ticket in both states are already sparking a bout of soul-searching over the lessons that need to be learned if the party is to retain firm control of both houses of Congress next year.

What worries many Democrats is that turnout among the young voters who helped propel them to victory last year fell away sharply, self-identified independents broke heavily for the Republican candidates; and voters overwhelmingly cited the economy and jobs rather than healthcare or climate change as their major concern in exit polls.

Democrats face the classic dilemma for any party after a defeat — press ahead trying to enact a difficult agenda or pull back, re-focus on simpler and less controversial measures.

The White House insists both defeats were due to local factors (a poor candidate in Virginia, a souring economy in New Jersey) and will not change the president’s determination to press ahead with an ambitious domestic agenda centered on healthcare reform and climate change.

But the party’s congressional wing is divided. Liberals (mostly from safe seats at little risk next year) argue the administration and party should press ahead; voters will rally behind a record of accomplishment next year. Moderates and conservatives (mostly from swing seats or those carried by John McCain in 2008 or George W Bush in 2004) as well as those from heavy industrial states are pressing to scale-back and refocus on cutting unemployment.

In this context, it seems unlikely the administration can find the 60 predominantly Democratic votes it needs to pass a climate bill on the floor of the Senate; hammer out a compromise between the differing House and Senate versions in conference; then secure simple majorities in both houses to pass the agreed bill into law.

Even before this week’s election results, the prospects for passing climate change legislation this year were dimming rapidly. But the arithmetic, already challenging, has now become very tricky as the administration loses momentum.

60-VOTE DOUBT IN SENATE

In the Senate, only two Democrats are up for re-election in Republican-leaning states carried by John McCain (North Dakota’s Byron Dorgan and Arkansas’s Blanche Lincoln).

Both have already taken a cautious approach to climate legislation. Both broke ranks with the majority of their colleagues earlier this year to vote for a Republican amendment preventing the budget reconciliation process being used to push through cap-and-trade on a 51-vote straight majority rather than the 60-vote super-majority normally needed to end a filibuster.

But the party remains ambivalent over cap-and-trade, split between liberals from coastal states who want a commitment to tough emissions reduction objectives, and senators representing industrial areas or conservative states anxious about supporting anything that could be portrayed as a costly, job-killing energy tax by their opponents at election time.

In theory, the Democratic Party (together with its independent allies) has the 60 votes needed to push a climate bill through despite almost uniform Republican opposition. In practice, the party broke 26-31 in favor of the Republican amendment to the budget resolution earlier this year, in what many saw as a straw poll on cap-and-trade.

Some Democrats have fallen into line since then, and the administration may be able to pick up one or two Republican votes such as South Carolina’s Lindsey Graham with the promise of loan guarantees and other government help for the nuclear power industry.

With several Democrats harbouring concerns, though, there are not yet 60 votes for an ambitious climate bill.

The bill will not be openly defeated on the Senate floor. If it dies or gets delayed it will be in the cloakroom. Majority Leader Harry Reid will not bring it up for a vote unless and until 60 firm votes are in his pocket. So Democrats with doubts will be able to delay the bill indefinitely by holding out and asking for more concessions, without having to come out explicitly against it.

RISK OF REVERSAL IN HOUSE

The arithmetic looks as daunting in the House of Representatives. While the lower chamber has already approved its own climate bill (HR 2454) legislators will have to vote again to pass the consolidated version if and when it is agreed in conference.

There is nothing to stop congressmen changing their minds. As the election draws closer and the already bitter partisanship in the chamber intensifies, some of the bill’s earlier supporters may withdraw.

The original bill passed only by the narrowest of margins (219-212), with 44 Democrats voting “No.”

A total of 84 Democrats represent Republican-leaning districts carried by John McCain or George W Bush in 2004. It will take only a handful of further defections to sink the measure if it returns from conference.

If the consolidated bill has been toughened in line with the Senate version (S 1733), congressmen will have a ready-made excuse to claim it has gone too far.

Parties controlling the White House usually lose seats at the mid-term elections, so pressure on Democrats in Republican-leaning areas will be immense.

The party’s heavy losses in Virginia and New Jersey this week will make them very cautious.

CROWDED AGENDA, LOSING MOMENTUM

Arguably, the president has tried to push through too many ambitious reform proposals and stretched his political capital too thinly.

At the best of times, it would be difficult to get either healthcare reform or climate change through Congress when the president’s majority is an uneasy coalition of liberals and centrists. But when the president is having to deal with a recession, financial regulation, and whether to increase the military commitment to Afghanistan, it has proved impossible to rally support for them both at the same time.

Hopes that healthcare and climate change legislation could be rammed through early in the year, long before the mid-term elections, while the Republican Party was still consumed by infighting after losing heavily in 2008, have evaporated.

Climate change has become a second-order priority. The political capital needed to assemble winning coalitions for a bill in both chambers is being deployed elsewhere.

The best option for the administration may be seeking to broaden its coalition, buying more Republican support through a combination of nuclear financing guarantees and greater access to offshore drilling.

But if an agreed climate bill does not go through before the year end, its prospects next year, when legislators will be fixated on the looming elections, are no better.

The man who will almost certainly become Japan's next prime minister, Yukio Hatoyama, is promising to cut the nation's greenhouse gas emissions by 25 percent from 1990 levels by 2020.

That is a far more ambitious target that can be found in the legislation currently making its way through Congress. The cap-and-trade bill passed by the House of Representatives would trim U.S. emissions by 17 percent from 2005 levels. That translates to around a 6 percent cut from 1990 levels.

But even that lesser reduction seems unlikely to happen anytime soon. Climate change legislation faces a tough road in the Senate, and it may get pushed back to 2010 or beyond.

Cap and trade is, like healthcare reform, in trouble, and for many of the same reasons:

- There doesn't seem to be an acute crisis. Polls show that the vast majority of Americans are satisfied with their healthcare. Reasons for complacency can also be found in recent developments in climate change. A new NASA study notes global temperature increases have stalled out this decade, likely because of decreasing solar irradiance.

Obviously some dire event, such as a terrible swine flu season or a brutal spike in temperatures, could refocus public attention and concern. But for now there doesn't seem to be an emergency to motivate either voters or lawmakers.

- Most people won't see an immediate benefit. Proposed changes in the U.S. healthcare system wouldn't immediately change the current insurance coverage of most Americans, despite new government spending and higher taxes. Likewise, cutting carbon emissions will likely incur big costs today with any tangible benefits coming later this century. During a recession, neither provides the sort of cost-benefit analysis that strapped Americans are likely to find compelling.

- Both plans seem off point. If you asked Americans what was the biggest problem facing America, polls show, the most common answer would probably be unemployment rather than healthcare or the environment. And that is one problem, at least as gauged by the unemployment rate, seemingly getting worse rather than better.

To quote the man who jumped from a burning airplane with no parachute, "First things first!" Americans seem to agree.

Given a possible weak economic recovery and worker anxiety about jobs, neither a strong cap-and-trade climate change bill, nor a carbon tax bill, may happen anytime soon.

Instead, a better option might be more government-funded research into technological fixes. The Bjorn Lomborg-led Copenhagen Consensus recently released a list of proposals -- such as marine cloud whitening and carbon storage -- that could give more bang for the buck than new regulation and taxes.

If politics is the art of the possible, new green technology may be all that environmentalists can realistically expect from America.

– John Kemp is a Reuters columnist. The views expressed are his own –

President Barack Obama’s first budget puts climate change at the heart of the administration’s long-term economic plan. But despite the clear theoretical advantages of a simple carbon tax, he seems set to follow the EU and California in opting for a cap-and-trade system.

The budget plan commits the administration to work with Congress on an economy-wide emissions reductions program, based around cap-and-trade.

It also anticipates almost $650 billion in revenues over 10 years from selling these yet-to-be-agreed pollution permits, and proceeds to spend it on investment in clean technologies ($120 billion) and rebates for vulnerable families, businesses and communities ($525.7 billion).

In a sense the budget is a “wish list”. While federal law requires the president to submit a unified budget, there is no obligation for Congress to consider it line by line, or even use it as a starting point in the annual tax-writing and spending process.

Prudently, the administration has been careful not to rely on permit auction revenues it may never be able to collect. The projections do not anticipate spending any money raised from the permit program
until October 2012.

Revenues from permit sales have also been earmarked to fund clean technology and new tax offsets. If auctions do not occur, or raise less money than expected, these spending commitments can be cancelled without affecting the rest of the budget.

Nonetheless, by putting a cap-and-trade into the budget document, and anticipating how the revenues could be spent, Obama has given a strong personal commitment to seeking comprehensive climate change legislation this year.

Legislation will need to be sent to Congress within the next few months to stand any chance of being enacted in time for regulators to draw up scheme details and arrange an auction before the end of 2012.

TAXES OR CAPS

The budget confirms the president’s campaign commitment to achieve reductions via cap-and-trade rather than a carbon tax.

Most commentators agree it is cheaper to reduce carbon emissions through an “incentive-based” system (establishing a market price for greenhouse gas emissions) rather than old-fashioned “command-and-control” administrative regulations.

But there is much less agreement about whether to implement incentives through a carbon tax or cap-and-trade scheme.

The non-partisan Congressional Budget Office (CBO) published a comprehensive assessment of the alternatives last year, and concluded that in most cases a straightforward carbon tax would achieve the same emissions reductions at lower cost (read pdf).

In an analytical sense, carbon taxes and fixed caps are very similar. Both raise energy prices and discourage consumption of goods and services made by burning fossil fuels in favor of less energy-intensive items made with cleaner ones.

The principal difference lies in a trade-off between two types of uncertainty: uncertainty about the quantity of emissions reduction versus uncertainty about the cost.

A carbon tax establishes a single, transparent and certain price for burning fossil fuels, and therefore the ultimate cost of emissions reduction.

Households and firms have an incentive to take steps which increase energy efficiency and reduce fossil fuel use if the cost is less than the tax rate, but not if the costs exceed it. If the rate is set at a level which reflects the benefits to society of avoiding potentially catastrophic climate change, a tax would encourage households and firms to take only those mitigation actions which yield a net benefit.

The great advantage of a tax is that it gives households and firms certainty about how much reduction will cost. It also ensures there is no compulsion to undertake very expensive mitigation strategies for which costs far outweigh benefits.

But the disadvantage, especially in the eyes of climate-change activists, is there is no guarantee it will reduce emissions by a specified volume in any given year. Over a multi-year period, this is less of a problem. The rate can be varied if the volume of emissions reduction turns out to be smaller or greater than originally anticipated. Presumably it would also rise over time to force progressive improvements.

Cap-and-trade has the virtue of creating greater certainty about the volume of emissions reductions — but the disadvantage of huge uncertainty over the cost for households and businesses.

In a binding cap-and-trade system, permit prices can rise to any level to ensure the cap is achieved, even if the marginal cost of reductions proves very high, and far outweighs the benefits.

Massive volatility in permit prices is a major drawback of the cap-and trade-system.

Experience with other pollution trading programs in the United States such as California’s RECLAIM nitrous oxide program, as well as the EU’s Emissions Trading Scheme (ETS), suggests permit prices would be far more volatile than equities, making long-term planning very difficult.

The problem, as CBO notes, is that “the cost of cutting emissions by a given amount could vary from year to year depending such factors as the weather, the level of economic activity, and the availability of low carbon technologies”.

In fact, cap-and-trade risks exacerbating the already high volatility in energy prices. Trading programs are dangerously “pro-cyclical”. In a cold winter or a hot summer, when air conditioners are on full, rising fuel consumption pushes up the price of energy directly. But in a cap-and-trade system, it would also send the cost of permits soaring, pushing up the price of fuel even further.

In the 2000 heatwave, California power generators’ demand for extra trading credits under the state’s RECLAIM program sent the cost of permits up ten-fold from $4,000 per tonne to almost $45,000, contributing to high wholesale electricity prices during the period and the state’s energy crisis.

Conversely, in a downturn, slumping consumption would depress the cost of permits, and risks removing any incentive to invest in energy efficient technologies such as hybrid cars. Permit prices in the EU’s ETS have fallen from 30 euros per tonne last summer to a low of just 8 euros earlier this month, largely removing efficiency incentives.

Trading schemes can be designed to limit the acceptable range of prices. By auctioning permits rather than giving them away free, the scheme administrator can set a minimum price floor. The administrator can avert sharp spikes by setting a price ceiling and offering to auction an unlimited number of permits at that price to satisfy excess demand.

Some schemes try to limit short-term volatility by allowing surplus permits to be carried forward (”banking”) to meet demand in future years (when caps are likely to be tighter); or brought forward from the future to the present (”borrowing”) to relieve temporary shortages.

At the limit, if the price cap is brought low enough, and the floor is raised sufficiently, the trading scheme is identical to a tax.

Most real trading schemes allow far more volatility than this. The EU’s ETS is progressively moving to an auction system, but imposes no real upward limit on volatility. California’s proposed Western Climate Initiative (WCI) would auction allowances, and set a minimum reserve price for them to help establish an effective floor, but again there is no upper limit.

Despite clear economic drawbacks compared with a simple carbon tax, the obvious attraction of cap-and-trade is political. It avoids the need for the government to set an explicit and unpopular price on carbon dioxide emissions; policymakers can hide behind a price determined by the inscrutable magic of the market.

In practice, by picking a quantitative level of emissions, federal regulators will also be setting a price, albeit indirectly and one subject to enormous volatility. But advocates of trading hope the lower transparency will reduce its political visibility and make it easier to implement.