Cap and Trade: A Bad Trade-off for the Economy and Company Earnings*

By Wayne Winegarden
Saturday, April 21, 2007

Closing our eyes to the costs of global warming regulations will not make these costs disappear. And yet, the debate on global warming is progressing as if these costs do not exist. For instance, many leaders of the Corporate Social Responsibility (CSR) movement are calling for the United States to implement a carbon emissions cap on U.S. industries – or a "cap and trade" system. One example is the U.S. Climate Action Partnership (USCAP) – a coalition of environmental organizations and corporations including major corporate members such as GE, Alcoa, BP, Caterpillar, DuPont, Lehman Brothers, and PG&E.

The Kyoto Protocol is the benchmark for any U.S. based cap and trade regulations. The Federal Energy Information Agency (EIA) has already examined the cost from implementing the cap and trade regulations associated with the Kyoto Protocol in the United States. This study, conducted in 1998 during the Clinton-Gore Administration, concluded that the costs were substantial**.

If the U.S. were to commit to the Kyoto Treaty's goal of reducing carbon dioxide emissions to 7 percent below the 1990 level, several different types of adverse economic impacts would arise. Carbon based energy such as coal and petroleum is a less expensive energy alternative compared to most alternative energy sources***. Mandating that businesses reduce their carbon emissions requires these companies to invest in new technologies that reduce the amount of carbon emissions from current energy sources, or to invest in completely new energy sources (e.g. renewable energy) that emit less carbon. While this is the ultimate goal from an environmentalist perspective, these investments do not come without a cost. The regulation's costs are born by the companies' owners through lower profits, employees through lower wages, and/or customers through higher prices.

The EIA report found that one of the likely outcomes would in fact be higher energy costs. According to the report, a cap and trade system that reduces carbon emissions in the U.S. by 7 percent below the 1990 level raises gasoline prices by nearly 53 percent and raises energy prices by more than 86 percent.

The higher energy and regulatory costs are not benign to overall economic growth. One key ingredient for economic growth is growth in productivity – or the ability to create more output with the same amount of inputs. Cap and trade regulations increase the costs to produce the same amount of output, thereby lowering productivity. Simultaneously, the cap and trade regulations are increasing the costs to consumers, causing consumers to spend more money in order to acquire the same amount of goods. Both of these effects negatively impact overall economic growth.

The EIA report found that a cap and trade regulation would reduce total U.S. economic growth significantly; the precise impact depending on the assumptions. When the EIA evaluated the economic impact of a cap and trade regime, the agency assumed that the right to emit carbon dioxide would be auctioned off to the highest bidder, as opposed to being simply given away as many proposals now advocate. The actual economic impact varied depending upon what was done with the money raised from the auction.

Implementing the cap and trade proposal combined with a personal income tax rebate that partially offset the economic impacts was estimated to reduce economic growth by 4.2 percent according to the EIA study, which is $565 billion of 2006 GDP. Implementing the cap and trade proposal with a payroll tax rebate that partially offset the economic impacts was estimated to reduce economic growth by 1.9 percent, which is $256 billion of 2006 GDP. The economic impact was found to be widespread throughout the economy with nearly every industry experiencing significantly reduced economic growth including the construction, manufacturing, transportation and finance industries.

One last effect from the cap and trade regulations is its impact on inflation and the overall financial markets. The EIA found that initially the cap and trade regulations would lead to higher energy prices. Energy costs comprise a large portion of overall economic spending. Consequently, large increases in the cost of energy will have a large impact on inflationary measures such as the Consumer Price Index (CPI) and Producer Price Index (PPI). Higher energy prices would subsequently exert upward pressure on the overall price level.

Inflation erodes away the purchasing power of money in the future. Consequently, sharp increases in the price level raises concerns for banks, bondholders, and other lenders in the economy. In response to the more uncertain inflationary environment lenders will demand "inflation protection" in the form of higher interest rates. Of course, higher interest rates increase the costs for borrowing making it more expensive for businesses to expand and individuals to purchase houses, cars or other large durable goods. If these pressures are not handled correctly by the Federal Reserve, a difficult task, high and variable inflation, along with higher interest rates, could result. Overall credit and borrowing in the economy would be subsequently compromised, further reducing people's income and economic activity in the U.S.

From a business perspective, all of these trends are troubling. The initial impacts from the regulations raise the cost of doing business. As the costs from the regulations make their way through the economy, growth in overall demand slows. Furthermore, the price level effects could increase the operational costs of businesses through higher interest rates, reduce the demand for products from customers, and increase the possibility that the economy will be threatened by a run-up in inflation.

In total, the EIA under the Clinton-Gore Administration found that a cap and trade system imposes significant costs on the economy. From a business perspective, an economic environment of high-energy prices, low productivity growth, and slow economic growth is not an environment where companies thrive. This economic reality raises serious concerns regarding the policy recommendations of USCAP or other advocates of a carbon emissions cap and trade regulatory system. The large economic costs from any cap and trade regulations must be considered as the debates regarding the appropriate environmental regulation develops.

*Wayne H. Winegarden, Ph.D. is a partner with Arduin, Laffer & Moore Econometrics; a contributor to freeenterpriser.com; and a Lecturer in Economics at Marymount University.

**(1998) Impacts of the Kyoto Protocol on U.S. Energy Markets and Economic Activity. Energy Information Administration October (SR/OIAF/98-03).

***http://www.eia.doe.gov/fuelrenewable.html