– 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.

– Paul Taylor is a Reuters columnist. The opinions expressed are his own –

Investors in clean energy are like motorists stuck at broken traffic lights. The public policy light is green but the price and credit lights are deep red.

Investment in wind, wave and solar power should be booming after the European Union last year adopted an ambitious goal to draw 20 percent of its energy from renewable sources by 2020 to help fight global warming, and U.S. President Barack Obama made green power a central plank of his government’s policy.

But the credit crunch, economic recession, the spectacular fall in oil prices since last July and a record low European carbon price have cooled investors’ ardour.

Consultants New Energy Finance forecast zero investment growth in climate-related companies this year, after a spectacular growth rate of 60 percent in 2006-7.

“The commercial lending market is holding back and until that can be addressed, it’s going to be a major constraint,” says Christopher Knowles of the European Investment Bank’s energy and environment department.

Yet to achieve the EU’s 2020 target, investment decisions need to be taken soon on long-term projects to build a smart electricity grid, giant offshore wind farms and networks to bring renewable energy to Europe’s industrial heartland.

How can the private investment logjam be broken?

One way could be to extend the public support system through which countries like Germany and Spain guarantee higher-than-market prices to generators of renewable energy.

The scheme provides secure revenue to green power producers, making their projects as safe investments as municipal bonds. But critics say it inflates the cost to consumers and taxpayers.

For example, the price guaranteed for photovoltaic energy is 20 times the cost of electricity from conventional power plants, said former International Energy Agency chief Claude Mandil.

CARBON FLOOR AND CEILING
Another idea is to put a floor under the carbon price by creating a carbon central bank that could withdraw emissions allowances from the market if the price fell below a certain level and issue extra permits if it rose above a fixed ceiling.

Mark Lewis, managing director of commodities research at Deutsche Bank, says carbon prices are artificially low because firms have been selling off emissions permits they received for free to raise short-term cash that they can no longer borrow.

“This sends the wrong price signal for investment and for changing consumer behaviour,” Lewis told an energy conference organised by the French Institute for International Relations.

Last week’s record low price of 9.5 euros ($12.17) a tonne makes it more economical to build new coal-fired power stations than to invest in renewable energy and smart infrastructure.

A carbon bank, like a monetary central bank, would be empowered to intervene if market forces were not achieving the desired policy objectives, and the mere threat of intervention might be enough to curb speculative peaks and troughs.

However, a reform of the EU’s Emissions Trading Scheme just adopted for the period 2013-2020 contains no such provision.

The United States, Australia and Japan can learn from the mistakes made in Europe, Lewis says, by insisting that industry buys carbon permits from the outset instead of getting them for free, and by creating a carbon bank.

The EU could then link its system into a global emissions market, involving initially the advanced industrial nations and eventually the emerging economies too.

Laying the foundations of an international cap-and-trade system that would create a global price for carbon would be a giant advance at the U.N. climate change conference in Copenhagen later this year.
EU Energy Commissioner Andris Piebalgs contends the best way to guarantee the necessary investments in Europe is through a 10-year infrastructure investment plan backed by public money from member states’ economic stimulus programmes.

In the short term, the European Commission plans to allocate 5 billion euros in unspent EU funds as seed money to promote cross-border energy interconnectors, an electricity supergrid and clean coal plants using carbon sequestration technology, as well as broadband telecoms networks.

But to Claude Turmes, a leading European Parliament member on climate issues, the money is too thinly spread to break the investment deadlock in renewable energy.

The Luxembourg Greens lawmaker says it would be better to use the money to leverage credit from the EU-owned European Investment Bank at subsidised interest rates to build the infrastructure backbone needed to transport renewable energy.