No. 102 - Greenhouse Gas Control: Implications for Agriculture (Part 4)

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One way to pay farmers to increase the amount of carbon stored in their soil is through government grants. On June 6, 2003, the U.S. Department of Agriculture said it would begin taking greenhouse gas management practices into account when evaluating farmers’ applications for conservation grants and subsidies.<48> State programs to date have also tended to focus on grants for demonstration projects and education.

Grants and subsidies for conservation tillage or tree planting may be worthy of support for their other environmental benefits, but not as a way to postpone or mitigate global warming. The subsidies required to make sequestration a major component of greenhouse gas control efforts would exceed the budgetary capacity of either the federal or state governments.

An alternative to government grants is to allow farmers to participate in a carbon emissions trading program. Under this plan, farmers would receive credits for the carbon they sequester, and emitters would be allowed to purchase such credits in lieu of reducing their emissions. This is what Senator Joe Lieberman (D-New York) had in mind when he said,

[S]equestration projects can produce environmental benefits beyond the benefit to the climate, including reduced deforestation and more sustainable agricultural practices. Such projects also bring a needed infusion of money into the farm economy--not through subsidies, but through the sale of a new ‘crop,’ sequestered carbon dioxide.<49>

In January 2003, the Chicago Climate Exchange was launched as a four-year pilot project to allow companies to buy and sell credits for reducing emissions of six greenhouse gases.<50> There is also a sizeable academic literature on emissions trading.<51> But there are problems when this seemingly “market-based” remedy is used to control greenhouse gas emissions.

Operational Problems

Some operational problems immediately become apparent. Farmers who earn emission credits for sequestering carbon and subsequently sell them may be contractually locking themselves into a land management plan for extended periods or even in perpetuity. Otherwise, one can imagine endless ways for farmers to “game the system” by starting and stopping various conservation practices, essentially storing, releasing, and recapturing the same carbon dioxide over and over again. What sort of complex regulatory regime would be necessary to prevent this sort of conduct?

What happens when a land management plan adopted to earn emission credits proves to be unprofitable? Must farmers face bankruptcy rather than change to a different crop or cultivation method? Do the requirements of the land management plan adhere to the property forever, obligating heirs and future buyers? Finally, what happens if drought, flooding, or some other natural disaster results in less carbon being sequestered than originally planned? “When their ability to sequester is wiped out, would they have to pay that money back?”<52>

In November and December 2002, the U.S. Department of Energy held a series of workshops in Washington DC, Chicago, San Francisco, and Houston to collect information about how the department’s Voluntary Greenhouse Gas Reporting System should be modified to implement directives issued by President George W. Bush. Participants in the Chicago workshop, held December 5-6, were decidedly leery of DOE’s desire to make the reporting program more attractive. The discussion below is based partly on testimony and conversations at that meeting.<53>

Identifying Sources, Verifying Reductions

A greenhouse gas emissions trading system would require the identification of emission sources, and for each the establishment of baseline emissions for some year, such as 1990. That is not as easy as it sounds. The ubiquitous nature of carbon dioxide makes it impossible to trace the gas to specific sources. The range of possible sources is much wider with respect to greenhouse gases than, say, sulfur dioxide. Moreover, there are six primary greenhouse gases, and it is not clear how the trading of these gases might work.

Not only must a greenhouse gas trading scheme allow for the trading of multiple greenhouse gases, it must also recognize corporate entities often have more than one source of emissions. There are notional gains to be achieved simply from averaging sources within an entity, making the calculation of a true “net” reduction extremely controversial. Achieving such gains does not require a full-blown emissions trading market with all of the attendant transaction costs. It is instructive to note that throughout its history (since 1995), the much simpler Title IV trading of sulfur dioxide has mainly involved divisions within electric utilities trading with each other, rather than intercompany trades.

Participants in the DOE’s Chicago workshop discussed at length how emissions would be measured. Emissions might be measured as absolute levels; as estimates derived from energy fuel consumption; on the basis of intensity (emissions per unit of economic output, perhaps per dollar of GDP), as is mentioned in the Presidential initiative; as project-specific emissions; or entity-wide. The number of measurement options available makes it more difficult to set baselines and measure subsequent compliance.

Verification would be especially difficult for sequestration projects. The effect of growing plants and trees to absorb carbon dioxide is theoretical at best. It is impossible to estimate the impact of a sequestration project on ambient carbon dioxide concentration levels, since CO2 is ubiquitous and doesn’t vary from place to place. Land-use changes are not uncommon, and each change presumably increases or decreases the ability of the land to store carbon. Would the effect on carbon storage of every land-use change have to be estimated, reported, and then made legal by the purchase or sale of permits? Would a farmer get credit for not clearing land of trees?

Questions arose about how the emission reports submitted by entities participating in a trading scheme would be verified. Participants at the Chicago workshop thought a signed statement from the entity’s technical manager would suffice, but it is not clear such an arrangement would or should satisfy government officials, in light of recent accounting scandals. Should a company’s CEO be required to certify the results?

Under the new Sarbanes-Oxley corporate accountability law, CEOs of publicly traded companies may be required to personally endorse emission reports regardless of what the emissions trading program says. Given the very complex, highly variable, and perhaps even subjective nature of these estimates, how many CEOs will be willing to take the risk of being second-guessed by auditors and regulators?

Because of the inherent difficulty of arranging a data reporting system for unconventional emission reduction projects (which is what biological carbon sequestration would be), it would not be surprising to see such projects disappear from any trading program after it is established. Such has been the case for California’s RECLAIM system, as the next section describes.

The Case of Old Auto Scrapping

In 1990 the Union Oil Company (Unocal) established an innovative program to offset emissions from its refinery in Southern California. The idea was to reduce emissions, mainly oxides of nitrogen, by scrapping automobiles that were manufactured before emission standards were established. Pre-1982 passenger cars and light-duty trucks were the targets of the scrapping program. It was estimated at the time that these vehicles were responsible for one-tenth of the region’s mobile source air pollution.

The initial results of the project were so successful that in 1992 it was awarded the Presidential Environmental Conservation Challenge Award. At the time of the award, the President’s Council on Environmental Quality deemed the program “an unprecedented effort to improve air quality in the Los Angeles Air Basin by scrapping heavily polluting pre-1971 cars. In four months, the company purchased and crushed for recycling 8,376 old cars. SCRAP reduced air pollution by 13 million pounds per year at a cost of 50 cents per pound.”

In October 1993, the South Coast Air Quality Management District (SCAQMD) established the Regional Clean Air Incentives Market (RECLAIM). This governmentally designed market began trading in 1994 and was primarily intended to facilitate trading among stationary sources of oxides of nitrogen and sulfur dioxide. However, it also included the Unocal program, despite the fact that it used mobile source reductions to offset stationary source emissions.

By 1995 the scrapping program had removed more than 1,500 vehicles from the Southern California roads and eliminated more than two million pounds of potential air pollution. In that year Unocal formed Eco-Scrap, Inc. to help other businesses in Southern California offset their emissions from the old vehicle buy-back programs.<54> In 1996 Eco-Scrap received the first Air Quality Investment Program award from SCAQMD and Economic Leadership Award in the Area of Innovation from California’s governor. The tally at the end of 1997 was 17,000 high-polluting vehicles and a reduction of approximately 19 million pounds of emissions.<55>

In 1998, SCAQMD significantly tightened restrictions on the program. It required that “pollution reduced by scrapping must exceed the emission reductions that would otherwise be obtained by installing controls” at the stationary plants. A review by the District revealed 83 percent of the credits from auto scrapping were being used in lieu of employee ridesharing, not to offset plant emissions. In order to reduce this unanticipated activity, the District ordered additional tests. Each auto scrapped must be inspected to make sure the engine, drive-train, and all other vehicle equipment are present and generally in working order. Moreover, vehicles must have a valid Smog Check certificate and be held before scrapping for three days to allow for additional inspections by the District.<56>

The old auto scrapping program was mortally wounded by the regulatory overreaching of the SCAQMD. While there was an attempt by the Air Resources Board to revive a two-year pilot program for the scrapping of an additional 1,000 older automobiles in the South Coast Air Basin, it never took off. One reason was “no emission credits will be created or made available for purchase, sale or trade.” Apparently, even the Air Resources Board’s regard for the RECLAIM trading program is minimal.<57>

Failed Emissions Trading Programs

The demise of the old auto scrapping program alerts us to the fact that emissions trading markets are not as efficient as their proponents claim. Sometimes, they fail completely. The New Jersey Open Market for Emission Trading (OMET), established in 1996, was a voluntary system that promised credit for early reductions of oxides of nitrogen, volatile organic compounds, and greenhouse gases. During the program’s life there were only two instances where greenhouse gas credits were generated.<58>

OMET was terminated by EPA in 2002 at the request of the New Jersey Department of Environmental Protection.<59> The stated reasons for termination were “serious questions ... raised about the effectiveness of the OMET program’s credit validation process and about its impact on potential enforcement actions.”

In an August 2002 letter to EPA, Bradley Campbell, commissioner of the New Jersey Department of Environmental Protection, blamed “the prior Administration” for poor design and implementation of the program. More likely, however, changes imposed by the NJDEP in 2000 and by EPA when it approved the proposal in 2001 spooked the participants, including the market makers.<60> Campbell’s letter says, “I understand that the EPA may be contemplating its own enforcement actions against credit users,” a clear warning to any businessperson thinking about participating in a state emissions trading program.

More evidence of failure can be seen by observing California’s RECLAIM system in action since 2000.<61> In early 2000, before the electricity crisis began in California, permits for NOx were selling in the range of $1 to $2 per pound.<62> By June prices were almost $10 per pound, and they reached $35 per pound in late August. In May 2001, SCAQMD intervened in the market by separating power plants from other RECLAIM participants and imposing a flat fee of $7.50 per pound of NOx emissions, with the proceeds going toward the reduction of emissions from other sources. Instead of being able to buy permits, power plants were required to install “Best Available Retrofit Control Technology.”<63>

In June 2003 the SCAQMD decided that the power plants could rejoin RECLAIM at the beginning of 2004. It also reported, with some apparent pride, that the pollution controls installed in the last two years at power plants in lieu of the suspended RECLAIM trading credits will reduce emissions an estimated 90 percent.<64>

Markets aren’t really markets if a government agency can at any time decide to suspend trading, destroy the value of existing permits (without compensation to their owners), and replace the trading system with command-and-control regulations. They can’t be said to “work” if they are periodically suspended by government administrators who prefer fees--where they can pocket the proceeds--over permit trading, where the gains are exchanged among the emission sources. Shutting down RECLAIM paved the way for the subsequent failure of the electricity market in California, when government agencies at the state and federal levels intervened to “fix” yet another flawed government-created market.

Even the national trading system for sulfur dioxide and oxides of nitrogen, allowed under the Clean Air Act Amendments of 1990, is no shining example of success. The volume of trading and price of permits are well below levels originally predicted by the program’s advocates or thought by some experts to be sufficient to explain the emission reductions that have occurred.<65> Most trades are made among divisions within a single company, not between companies, because the companies don’t trust regulators to enforce the contracts. Intercompany trading declined by about 40 percent in 2002, following the Enron fiasco and the collapse of some energy and trading companies.<66>

Why do programs that sound good in theory fail in practice? Experience has revealed emissions trading programs generally suffer from four shortfalls.

Denial of Property Rights Status to Emission Permits

In a normal market, intervention by the government that has the effect of substantially reducing the value of private property is constrained by the Fifth Amendment of the Constitution, which prevents the government from taking property without just compensation. However, there is a specific provision in the RECLAIM system that relieves the District from any liability for damages resulting from government action:

RTCs [RECLAIM Trading Credits] are not property within the meaning of the state and federal constitutions. The [South Coast Air Quality Management] District reserves the right to limit, suspend or terminate any RTCs, or the authorization to emit ...<67>

Similar language appears in Section 405(f) of the Clean Air Act Amendments of 1990:

An allowance allocated under this title is a limited authorization to emit sulfur dioxide in accordance with the provisions of this title. Such allowance does not constitute a property right. Nothing in this title or in any other provision of law shall be construed to limit the authority of the United States to terminate or limit such authorization.

These provisions were not idle threats. In April 2002, a change in the rules for trading sulfur dioxide allowances in Philadelphia--where 80 percent of the modest trading was taking place--all but dried up the market. As reported previously, during the electricity crisis of 2001 and 2002, the South Coast Air Quality Management District suspended the trading of RECLAIM credits among electric utilities and replaced trading with monetary penalties for emissions.

By reducing the costs to government agencies arising from changes to the trading program, such regulatory language encourages changes that undermine the workability of the program. Potential participants become wary of joining the emissions trading system. It also ought to be a warning to those tempted to join a voluntary system of emissions reduction or even a reporting system.

Regulatory Bias Toward Command-and-Control Rules

The brutal reality is that a bureaucracy cannot handle the spontaneous innovations that arise from ordinary market transactions. Free markets turn subjective values and local knowledge into objective data--prices--which in turn influence the behavior of buyers and sellers. The immense amount of information mobilized by a market is beyond the ability of a single planner to grasp, let alone manage.

The institutional requirements for solving the information problem--decentralization of authority, ease of entry and exit by traders, secure property rights, and contracts reliably enforced--are opposite the structure and nature of political institutions. Bureaucracies require all important aspects of exchanges be determined in advance or by official amendment imposed subsequently by a regulatory agency, since that is how accountability for outcomes is determined. Discretionary authority at the level of direct interaction with customers is antithetical to the bureaucratic model, while opportunities for top-down political interference to reward campaign donors and allies and punish others are de rigeur.

The bureaucratic attitude is particularly deadly for activities like sequestration, where no natural market could exist between the traders, and in cases where innovation is crucial. Bureaucratic bias favors capital-intensive compliance strategies such as BACT (best available control technology) mandates rather than market-based approaches such as emissions trading--another lesson from the RECLAIM experience. According to John Blaney, writing in Public Utilities Fortnightly about research produced by Douglas Bohi and Dallas Burtraw at Resources for the Future:

Bohi and Burtraw observed that at the same time that cost-of-service regulation biased compliance strategies toward capital-intensive solutions, these same regulations discouraged reliance on emissions trading to achieve compliance. For example, in some states, regulations removed the upside potential from trading excess allowances at prices higher than the cost of acquisition, because the revenue gain from such a trade was treated as a reduction in cost-of-service. In addition, in some states buying or selling allowances could have led to a prudence audit if and when allowance prices subsequently moved in an adverse direction relative to the earlier trade. Furthermore, power companies in some states had disincentives to locking in allowances ahead of time because they may not have been able to pass on costs, as they could with fuel costs, until the acquired allowances were actually used.<68>

Emissions trading cannot work if it is layered on top of BACT and other regulations that discourage risk-taking and innovation. Yet those who urge carbon emissions trading (and a role for farmers in such schemes) simply assume away these real-world complications. They presume government agencies will act in ways that are contrary to the incentives they face and to all experience. Advocates of emissions trading are seldom heard calling for the repeal of BACT and other existing regulations, which emissions trading ought to be a substitute for, not an addition to. These are crippling defects in the emissions trading concept.

Regulators Cannot Detect or Prevent Fraud

Bureaucracies are also not adept at policing trading systems for fraud. Whereas markets are self-enforcing--each firm has incentives to disclose fraud by their competitors and avoid engaging in commerce with them, and consumers are self-interested in avoiding firms that fail to deliver what they promise--bureaucracies rely on a top-down application of police authority, which can be influenced by bribery or careerism and often cannot penetrate the privacy of board rooms or decipher complex financial transactions.<69>

Fred Smith, president of the Competitive Enterprise Institute, and a dozen other public policy experts recently warned of this problem in an open letter to President Bush: “Transferable credits increase the risk of future Enron-type scandals. Firms might ‘earn’ credits by not producing things, outsourcing production, shifting facilities overseas, or ‘avoiding’ hypothetical future emissions. A market in such dubious assets will be fertile soil for creative accounting.”<70>

The recent corporate accounting scandals and the electricity trading crisis in California are vivid examples of regulators failing to prevent financial and accounting fraud. Once again, RECLAIM can provide an example from the emissions trading field. In 2002, one of the principal traders of RECLAIM trading credits, Automated Credit Exchange (ACE), headed by former Cal-Tech economist Anne Sholtz, was charged by several clients for failure to deliver credits and reneging on an agreement to refund payments.

In April 2002 a U.S. District Court Judge issued a $4.3 million judgment against ACE on behalf of InterGen, a Massachusetts-based power producer. The SCAQMD has also charged that ACE “knowingly made [a] false statement” regarding 106,050 emission credits for Chevron. The trading firm filed for Chapter 11 protection in May 2002. This resolution of the matter is hardly reassuring to other traders, yet RECLAIM and indeed all over-the-counter trading systems lack clearing organizations that would guarantee delivery of credits. Such organizations do not emerge in the absence of secure private property rights.

Problems with policing the farm insurance program suggest enforcement of a sequestration program could be especially difficult. The Office of the Inspector General was recently quoted saying crop insurance “continues to suffer from errors and abuses that are largely unreported by insurance companies, and it continues to incur dollar losses from improper payments that frequently go undetected.”<71> The Agriculture Department’s Risk Management Agency, tasked with managing the crop insurance program, employs only 100 people to check for fraud in a program that involves more than 200 million acres of cropland. This does not bode well for any greenhouse gas sequestration program in the agricultural sector.

Changing Political Priorities

Although President Bush has directed the Secretary of Energy to reform the greenhouse gas reporting system to make it more attractive to greenhouse gas emitters, the directive brings with it no guarantees. It can be superceded at any time, by a subsequent directive from Bush himself or by a new President. Congress also has the authority to substantially change rules established by the administration.

How confident should farmers be that a carbon emissions trading program that included biological carbon sequestration would remain in place, without substantial changes in the rules, long enough to recoup up-front investments in new equipment or land uses? Not very.

Opposition to allowing farmers to participate in a carbon emissions trading system will come from inside the agricultural community from fruit and vegetable producers and cattle and dairy farmers who have fewer opportunities to sequester carbon and may actually have to pay their neighbors for their emissions. Cattle ranchers and dairy farmers will find themselves at a disadvantage when competing with corn and soybean growers for land, labor, and capital, and so will lobby to hobble or sabotage the sequestration program with rules and regulations.

Liberal environmentalists also will lobby to undermine the program, since sequestration does not advance the movement’s anti-corporation and anti-technology agenda. Greenpeace and the World Wildlife Fund, for example, oppose allowing sequestration to be an option under the Kyoto Protocol, saying it “could accelerate the destruction of old-growth native forest around the world” and alleging “the economics of the developing carbon sequestration market is becoming an additional driver for clearing native forests.”<72>

It is easy to see how the same argument could be used against farmers and foresters in the U.S. “Not only are sinks projects a questionable method of addressing climate change,” according to Greenpeace and WWF, “but they may also lead to negative environmental outcomes.”<73>

NOTES TO PART 4

1 Joseph Bast is president of The Heartland Institute in Chicago; Dennis T. Avery, an agricultural economist, directs the Center for Global Food Issues at the Hudson Institute in Indianapolis; Alex Avery, a biologist, is Director of Research and Education at the Center for Global Food Issues; James L. Johnston is a senior fellow in regulatory affairs for The Heartland Institute and retired senior economist for Amoco; John Skorburg and Terry Francl are economists at the American Farm Bureau Federation. The authors would like to thank Carlos Stagnaro and David E. Wojick for their comments on early drafts of the manuscript. Any errors that remain are strictly the responsibility of the authors.

48 Associated Press, "Farmers to Get Incentives to Cut Greenhouse Gases," June 7, 2003.

49 Sen. Joe Lieberman, Testimony to the Senate Commerce Committee on "Harnessing America's Innovation Economy to Combat Climate Change," January 8, 2003.

50 Julie Deardorff, "Big Business to Buy, Sell Greenhouse Gas Credits," Chicago Tribune, January 17, 2003.

51 See, for example, Richard K. Kosobud and Jennifer M. Zimmerman, eds., Market-Based Approaches to Environmental Policy (New York, NY: Van Nostrand Reinhold, 1997); James Johnston, "Emission Trading for Global Warming," Regulation, Vol. 21, #4, 1998; A. Denny Ellerman, Paul L. Joskow, and David Harrison, Jr., "Emissions Trading in the U.S.: Experience, Lessons, and Considerations for Greenhouse Gases," Pew Center on Global Climate Change, May 15, 2003.

52 "Agriculture's role discussed in carbon trading," American Farm Bureau Federation, June 19, 2000, quoting John Doggett, former senior director of government relations for the American Farm Bureau Federation.

53 Jim Johnston, "Report on DOE Workshop on the Voluntary Greenhouse Gas Reporting System," December 5, 2002, http://www.heartland.org/Article.cfm?artId=11382.54 See http://www.unocal.com/responsibility/95hesrpt/scrap.htm.

55 See http://www.unocal.com/uclnews/97news/120597.htm.

56 See http://www.aqmd.gov/monthly/jul98.htm.l

57 See http://www.arb.ca.gov/newsrel/nr103098.htm.

58 http://yosemite.epa.gov/aa/programs.nsf/1431a1843ac
7c8928525651c00502358/94f592795045b281 8525651-c00506e0a?OpenDocument.

59 http://www.epa.gov/fedrgstr/EPA-AIR/2002/October/Day-18/a26440.htm.

60 http://www.state.nj.us/dep/aqm/ometp2ad.htm.

61 For background on this program, see Jim Johnston, "Pollution Trading in La La Land," Regulation, Vol. 17, No. 3 (1994), pages 44-54.

62 Paul L. Joskow and Edward Kahn, "A Quantitative Analysis of Pricing Behavior in California's Wholesale Electricity Market During Summer 2000," The Energy Journal, Vol. 23, No. 4 (2000), pages 14, 15.

63 http://www.aqmd.gov/news1/Governing_Board/2001/Bs5_11_01.
htm#RECLAIM, and http://www.aqmd.gov/hb/010535a.htm.

64 http://www.aqmd.gov/news1/Governing_Board/2003/bs6_06_03.htm.

65 Jim Johnston, "We Told You So," Regulation Vol. 18, No. 3 (1995). http://www.cato.org/pubs/regulation/reg18n3j.html.

66 John Blaney, "Emissions: Where are the Traders?" Public Utilities Fortnightly, June 15, 2003, page 34.

67 Regional Clean Air Incentives Market, Volume I, October 1993, pages 3-19.

68 John Blaney, supra note 66, page 35.

69 Mancur Olson, Power & Prosperity (New York, NY: Basic Books, 2000), chapter 6, pages 101-110.

70 Reprinted in Environment & Climate News, January 2003.

71 Scott Kilman, "Abuses Plague Program to Insure Farmers' Crops," Wall Street Journal, May 5, 2003, page 1.

72 "The Clearcut Case: How the Kyoto Protocol Could Become a Driver for Deforestation," news release, November 9, 2000, http://archive.greenpeace.org/~climate/sinksmedia/.

73 Ibid.

© 2003 The Heartland Institute. Permission is granted to quote from this Heartland Policy Study, provided appropriate credit is given. Nothing in this Heartland Policy Study should be construed as reflecting the views of The Heartland Institute, nor as an attempt to aid or hinder the passage of legislation. Questions? Contact The Heartland Institute, 19 South LaSalle Street #903, Chicago, IL 60603; phone 312/377-4000; fax 312/377-5000; email think@heartland.org; Web http://www.heartland.org.