Report of James L. Johnston
on the proceedings of the
Department of Energy’s
Voluntary Greenhouse Gas Reporting System
1605(b) workshop held
December 5-6, 2002
On February 14, 2002 President George W. Bush proposed a climate change initiative focused on sequestration and reducing greenhouse gas (GHG) intensity in energy production and consumption. The President’s proposal departed dramatically from the approach taken by the Kyoto Protocol, where the objective is to reduce the absolute level of greenhouse gases back to a level below the base year of 1990. By contrast, the President’s objective is to encourage voluntary greenhouse gas reductions while at the same time avoiding serious harm to the economy.
As a first step toward implementing the President’s plan, the Department of Energy has been directed to improve the present greenhouse gas reporting system established under Section 1605(b) of the Energy Policy Act of 1992. Firms registering emission reductions will supposedly not be “penalized under a future climate policy.” Moreover, “transferable credits [will be given] to companies that can show real emissions reductions.” Sequestration efforts will also be given credit, both domestically and internationally, according to the directive.
On November 18-19, 2002, a workshop was held in Washington, DC to collect information about how the existing Voluntary Greenhouse Gas Reporting System should be modified to implement the President’s initiative. Three subsequent workshops were held in December in Chicago, San Francisco, and Houston.
I attended the Chicago meeting and submit the following report on those proceedings.
The underlying model for emission reduction is the identification of emission sources, and for each the establishment of baseline emissions for some year, like 1990. This is not as easy as it sounds. Among the questions to be addressed is whether or not the corporate entity is a U.S. citizen. Next there is the question of what defines each entity? Equity ownership seems to be the guide here, except when there is a partnership or joint venture and the ownership is fractionalized. Operational control is also a complication when there is, for example, a power pool. The types of corporate structures are even more varied for electric utilities because of recent mergers and divestitures.
The range of possible emission sources is much wider with respect to greenhouse gases than, say, sulfur dioxide. There are six primary greenhouse gases. It is not clear how the trading of these gases might exchange with one another.
The Title IV trading of sulfur dioxide under the Clean Air Amendments of 1990 was supposed to include the exchange of nitrogen oxides. The trading arrangement was never developed, however, and NOx emissions remain governed by what is essentially command-and-control regulation. This is not to say the SO2 trading system is free of regulation. It is, in fact, highly regulated, with best available control technology required for many emission sources. Essentially, the Title IV system is a command and control system with a trading scheme grafted on top.
The RECLAIM trading system adopted by the South Coast Air Quality Management District in California involves several types of emissions. The primary ones are sulfur dioxide and oxides of nitrogen and of the two, NOx dominates. The simultaneous trading of six kinds of emissions has never been tested.
Corporate entities often have more than one source of emissions. Consequently, there are gains to be achieved simply from averaging sources within an entity. Achieving such gains does not require a full-blown emissions trading market with all of the attendant transaction costs. It should be noted that throughout the history of the much simpler Title IV, trading of sulfur dioxide has mainly involved each electric utility trading with itself.
Participants in the DOE’s Chicago workshop discussed at length how emissions would be measured. Possibilities include project-specific emissions; or entity-wide; absolute levels; as estimates derived from energy fuel consumption; or on the basis of intensity (emissions per unit of economic activity), as is mentioned in the Presidential initiative. The number of measurement options available severely complicates the setting of baselines and the subsequent compliance.
It was pointedly observed at the workshop that what is being proposed is a trading of assignments, not actual emission reductions. Participants worried there might be a great deal of political input into the assignment of base period allowances. The sulfur dioxide trading program suffered from extensive political manipulation and that could happen again with the proposed trading of greenhouse gas reductions.
Considerable discussion at the Chicago workshop made obvious the difficulties of establishing a GHG trading program. Beyond the explicit design difficulties raised at the workshop, the implicit market design is extremely complicated, perhaps fatally so.
Voluntary exchange is by nature open-ended. Without this openness, the possibilities for entrepreneurial innovation are quite limited. Successful trading systems are not constrained by detailed regulation. Indeed, markets are substitutes for regulation. Yet the rules determining sources and how emissions are to be measured will be enormously complex, effectively replacing markets with bureaucracies. It raises the possibility that transaction costs might actually be less for a command-and-control system.
History is a useful guide here. The oil futures and options markets emerged in an order that matched the timing of price deregulation. Natural gas contracts were initiated after deregulation of wellhead prices in 1985. The trading of currencies started in Chicago after the system of fixed exchange rates was abandoned in the early 1970s. It seems implausible in light of this history that functioning markets would emerge after the imposition of new regulations.
The record for trading schemes is not good with respect to energy conservation and emission reduction. The South Coast Air Quality Management District in California had an existing program, operated as a joint venture by oil companies, of retiring old automobiles from the highways and roads. It had won an award for its innovative approach to reducing pollutants, especially oxides of nitrogen. At the time the RECLAIM system was being established, opposition arose toward the auto-scrapping project. Antique car collectors were concerned about losing a source of spare parts for their restorations. The oil companies arranged a 48-hour period after accepting an auto when the collectors could cannibalize the vehicles for parts. That was acceptable to most parties. Nevertheless, the District decided to impose a limit on the number of cars that could be scrapped, and subsequent restrictions eliminated the viability of the project entirely.
Participants in the Chicago workshop discussed the challenges posed by the need to develop credible baseline data and verify emission reductions on an ongoing basis. The ubiquitous nature of carbon dioxide makes it very difficult to associate emissions with any specific source. By contrast, the sources of pollutants like sulfur dioxide and oxides of nitrogen are comparatively easier to identify, precisely because they are pollutants. SO2 and NOx have measurable effects on human health and are distinct enough to be separately identified from the surrounding environment.
The verification problem is especially difficult with sequestration projects. The effect of growing plants and trees to absorb CO2 is estimated on a macro scale using computer models. Calculating local effects may not be feasible. Moreover, since CO2 moves across the North American continent with prevailing winds, it is difficult to estimate what the CO2 levels would have been in the absence of sequestration projects. That difficulty also presents itself for other projects that involve emission reductions, like car pools for employees and other energy conservation efforts.
Establishing an emissions baseline is an especially thorny question with respect to electricity generated by nuclear energy. Virtually no emissions of any type are coincident with nuclear-powered generators. But that has always been the case, even before any base year like 1990. Would Congress allow emissions credit for nuclear-powered electricity capacity already in existence before a base year? Or would Congress allow credit only for the incremental amount displaced after the trading program was put into place? A precedent can be found in the CAAA of 1990, where the savings in sulfur dioxide emissions were denied to nuclear power plants.
The inherent difficulty in arranging a data reporting system for GHG emission reduction projects suggests they defy the conventions established for existing emissions trading systems. If such projects are nevertheless created, it would not be surprising to see them disappear from the trading program once it is established, or soon after, as happened with auto scrapping in California.
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 satisfy government officials. Nor is it obvious what alternatives to self-reporting would be acceptable, but Arthur Anderson and vote counters in Florida are definitely not on the list.
Data gathering for greenhouse gas reductions would be more extensive and more widely applicable than any other data-gathering effort with the possible exception of income tax reporting. Enforcement will therefore be hugely expensive. It is worth noting that some experts believe the cost of compliance and enforcement of the income tax exceeds the revenue the tax collects.
Several participants indicated data gathering for greenhouse gas emissions ought to be coordinated with other federal data collection efforts. The suggestion probably reflects frustration with the pervasiveness of current data-gathering requirements more than any realistic hope that greenhouse gas measurement can be made to fit in with other efforts. Moreover, any combined or “streamlined” data-gathering effort would mean many agencies would likely review the reported data. This has already raised serious concerns under the Toxic Release Inventory (TRI) program, where public release of emissions data has caused competitive and security concerns, as well as giving environmental groups raw data with which to frighten an ill-informed public.
Another question that complicates the monitoring of a GHG trading scheme involves entitlement to the credits. Who should receive them: the seller of energy, or the buyer? Congress might make this decision, or the trading parties might work out the arrangements through contracting among themselves.
Either arrangement would be complicated and potentially costly. Government decisions on such a wide scale would be time-consuming and subject to delays. Standing contracts would have to be renegotiated where they exist. But not all relationships are covered by contract. Some are regulated by state agencies, and some are internal to a corporate structure, especially for vertically integrated firms that operate internationally. Formalizing all of these myriad arrangements would be neither cheap nor easy.
Even if the many complexities of emissions verification, baseline establishment, data quality, and entitlement to the credits could be worked out, the ultimate measure of compliance with the national goal would not be derived from this extensive effort. Another calculus, called the “macro goal,” will be used. Apparently, sensors placed in some yet-to-be-determined pattern will measure the degree of overall national compliance. That determination, in turn, will in all likelihood affect the goals for individual emission sources. The future would seem to involve ever-changing targets and emission assignments for participants.
President Bush has directed the Secretary of Energy to recommend reforms to the greenhouse gas reporting system that (a) ensure that businesses and individuals registering reductions are not penalized under a future climate policy and (b) give transferable credits to companies that can show real emission reductions.
What is notable, first of all, is that sequestration projects are not included is this guarantee, if it can be called that. Companies in forestry, agriculture, and outdoor recreation in particular would be wise to hold off betting large sums on such a long shot.
More importantly, a later directive can supercede the President’s directive by the present office holder or by a subsequent office holder. Congress also has the authority to substantially change rules established by the Administration.
The record of governments that currently supervise emission-trading schemes is not encouraging in this respect. Indeed, in the CAAA of 1990 and the RECLAIM system for the Southern California Air Basin (SCAB) have explicit provisions allowing subsequent changes or outright elimination of emissions trading.
This is achieved by denying the allowances and credits property rights status. Since the allowances and credits are not property, reducing their value by changing the rules is not a “takings” under the Fifth Amendment of the Constitution. Thus, the governments are not required to offer compensation to the injured parties. In both of these trading schemes, the government agency explicitly reserves the right to change or eliminate the system entirely.
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. [Clean Air Act Amendments of 1990, 405(f)]
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 … [Regional Clean Air Incentives Market, Volume I, October 1993, page 3-19]
It was later discovered that these reservations 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. During the electricity crisis of 2000 and 2001, the South Coast Air Quality Management District suspended the trading of RECLAIM credits among electric utilities and replaced trading with monetary penalties for NOx emissions.
It is worth mentioning that the failed electricity market in California was also designed by statute. All trading was confined to the spot market. Lost were the long-term contractual arrangements where consumers paid an options premium for price stability and the proceeds of the premium were used by suppliers to install extra capacity in generation and transmission.
During normal times, spot prices are usually lower than contract prices. But during a crisis spot prices rise sharply higher than contract prices previously negotiated. The political establishment in California suspended the trading of electricity and successfully lobbied the Federal Energy Regulatory Commission to roll back allowable prices. This effectively destroyed the electricity market in California and seriously impaired the trading of electricity in other parts of the country.
At the Chicago workshop it was pointed out the government had a severe credibility problem because of the trading suspensions. One workshop participant suggested the interim regime proposed by the President’s directive be guaranteed in writing by the President and/or by the Secretary of Energy. After all, he noted, a written guarantee is being required from firms to verify the accuracy of their emissions reporting.
The DOE representatives’ response to this suggestion was very instructive. It was pointed out that a written guarantee would not bind the next President or even the next secretary of energy. The only reasonable conclusion one can draw is that the no-penalty promise will not be kept.
What Is a Company to Do?
The Chicago workshop made clear the many flaws associated with a system of voluntarily reporting greenhouse gas emissions. It has all the dangers of self-incrimination: providing the government [not to mention competitors and environmental groups] with information that could be used to reward allies and punish adversaries. In the present anticapitalist environment, where private-sector firms are viewed with considerable hostility, political rewards and punishments are very real possibilities. It is obviously tempting for emitting entities to avoid participation in such a program.
On the other hand, being absent from the political arena leaves firms vulnerable to disadvantages built into the trading regime by competitors, as was done when the federal government and several states mounted an antitrust suit against Microsoft. Moreover, firms that refuse to participate may lose a public relations advantage available to those who voluntarily decrease emissions. However, as one private-sector participant at the Chicago workshop observed, public relations might justify participation in the reporting phase, but it is not a sufficient rationale for taking part in a flawed trading system.
It was also pointed out at the workshop that alternatives exist to emissions trading schemes. Many firms, for example, might simply accumulate emissions credits not to trade, but to bank the credits for application against future growth.
Moreover, other proposals for greenhouse gas emissions trading are being proposed in Congress and by some think tanks, like Resources for the Future. One Congressional proposal would reduce the allowable sulfur dioxide emissions by three-quarters and devalue the banked allowances by a similar amount.
Another proposal by a government-funded think tank would substitute a tax for emissions trading. The think tank analysts believe it possible to construct a tax that would achieve results similar to those of a trading system. This devotion to taxes ranks in the same class as Gollum’s obsession with the Ring in J.R.R. Tolkien’s Hobbit.
For a firm facing such dangers from government-funded schemes for reducing greenhouse gases, it would seem prudent to support financially analysts and free-market institutions not committed to government solutions. It would be sensible as well to promote more scientific inquiry into global warming theory. Contrary to the claims of the political establishment, the science is far from settled.
Jim Johnston is an economist retired from Amoco. He is a Senior Fellow member of the Board of Directors of The Heartland Institute.