Carbon Trading: With the presidential elections behind us, one thing that comes to mind as a virtual done-deal under the new Obama administration will be a Carbon Cap-and-Trade System. Sort of like the Obama tax cut for 95% of Americans, this one sounds better on the surface than it will likely turn out also. The essence of this system is the worst combination of a Federal tax along with a private enterprise implementation system.

Background: The real problem starts with a noble desire by governments (not just the US) to force businesses into reducing their carbon footprint. This is a result of a recognition that the real cost of energy (including all associated costs for clean-up, pollution, ...), is much higher than the price of delivered energy, or "price at the pump". How much higher is up for debate, but most estimates that I hear are at least 25% more and as high as 100% more. For some businesses, such as coal-fired power plants, this is a real problem, since they run quite efficiently to start with (at least in the US) and produce energy at very low costs which allows us to grow our economy and enjoy a great life style. Other businesses will finally be forced to take the easy steps to reduce their emissions, but those will quickly become increasingly difficult as the low-cost solutions are implemented and only higher cost solutions remain. The result of these cost increases will obviously be passed onto the consumer in the form of higher energy costs.

In its implementation, the Cap-and-Trade system will set an upper-bound limit on emissions at either their current level, or some previous years level - such as 1990's level. From that point forward, any excess in emissions will come with a price-tag in the form of either a purchased offset or a penalty. The real question will be how the system is implemented. If it is done as a tax, then it will have predictability, certainty and one level of cost. If it is implemented as a free-market system, it will obviously not have predictability, certainty and it will have at least two levels of cost as those involved in the exchange will extract their profit margin and the governments will continue to expect their energy tax windfalls.

Problem: The system that has been proposed is a combination of rewards and punishments. The rewards are permission to continue to operate at some historical level of gas emissions, and the punishment is effectively a tax on growth (or a penalty). To avoid the penalty, businesses must buy carbon credits, either from industries that were granted caps in excess of their current usage, or from others that reduce greenhouse gases through reforestation or other means of carbon sequestration. These credits will be traded on for-profit exchanges and herein lies the rub. Not that I'm a fan of taxes or government bureaucracy, but I'm afraid of government moving too fast and creating a huge financial disaster similar to the well intentioned housing bubble hang-over that we currently are in the middle of. In the past, newly deregulated markets such as electricity trading in California have been set up with rules envisioned with the best efforts of regulators, but with unforeseen loop-holes that were quickly taken advantage of by companies such as Enron, and others. The early days of electricity deregulation in California included a huge spike in electricity costs and almost caused collapse of the system, or at least the state government's ability to meet its budget.

Gaming the System: The first thing that comes to mind is an incredible new round of lobbying efforts to set emissions caps to artificially high levels, which would give existing industries head-room to meet their emissions targets. The next thing that will likely happen is for countries to try to protect their economic growth, by either claiming that the system doesn't apply to them, or by asking for credit for some unrelated activity. An example of this is China's recent claim that they should be given credit for their one-child-per-family rule, saying effectively that if they hadn't have implemented such a program previously, their population and carbon footprint would be much higher. These are just the games that will be played at the beginning of the program. An exchange-based program will add volatility to the system, thus making is more difficult for everyone. Utilities will have to move to adjustable rates, new businesses will become energy market forecasters, banks will have to discount cash-flows from financial forecasts due to energy cost uncertainties,... In essence, this uncertainty will make the system unworkable.

Solution: As hard as it is for me to say it - the best solution will likely be a federal-level tax that is administered by one of our existing taxing entities. This would have certainty, which would allow our financial system to continue to operate in a reasonable fashion. I would like to think that the proceeds of the tax would be directed to clean energy programs such as building utility-scale wind mills, or even nuclear plants. I'll hold my breath to wait and see on this one.