Over the weekend a New York Times editorial critical of the energy industry for trying to stir up opposition to the Waxman-Markey climate bill prompted some further thought on the potential impact of the legislation on gasoline prices. The Times appears to accept the government's analysis suggesting that the increase would amount to no more than 20 cents per gallon by 2020, though this conventional wisdom collides with common sense, since such a low price on carbon seems unlikely to stimulate sufficient conservation and investments in efficiency to deliver on a steadily-shrinking national emissions cap. In particular, the Times seems unfazed by the way the bill's allocation of free emission allowances is stacked against the oil industry, suggesting that it, of all industries, can surely afford the extra burden. Yet it's precisely that distortion that I believe could throw all of the official estimates of future permit prices--and thus gas prices--into a cocked hat, when you consider the possible dynamics of a market established along these lines.

Let's start by stating the obvious: I don't have a detailed computer model of the energy markets and US economy to query on the likely outcome from the cap & trade system that would be instituted under Waxman-Markey, though I could probably come up with some drastically-undervalued credit default swaps for anyone who believes in the infallibility of such models. My assessment relies instead on logic and the experience of a career that included a long stint in energy commodity trading, including futures, options and derivatives. Based on that experience, I believe the crucial starting point for any attempt to understand how a new market might function is supply and demand: who has the commodity in question and who needs it.

Begin with demand. The Department of Energy's recent "flash estimate" of US CO2 emissions indicates that the electricity sector accounts for 41% of emissions, followed by transportation with 33%, and the non-electricity-related emissions of the industrial sector a distant third at around 17%. These three segments thus account for 91% of our CO2 emissions, by far the largest component of our greenhouse gas output. Under cap & trade, every ton of those emissions would have to be matched with a corresponding emission allowance, or the emitter would be liable for penalties at a multiple of the going price for allowances. Anyone who is given fewer allowances than their current emissions must thus either reduce their emissions directly or purchase allowances from others. But who are the likely sellers? A closing reading of the bill provides strong hints.

Under President Obama's original concept of cap & trade, in which 100% of emission allowances would have been auctioned by the government to the emitters that needed them, all sectors of the economy would have been in the same position of needing to cover their entire shortfall in the market. The government would have been the primary seller, though as the market evolved, companies that found cheap ways to reduce their own emissions would have ended up reselling allowances they had bought earlier, at a profit. Under Waxman-Markey, by my tally roughly 60% of the emission allowances would be handed out to emitters such as utilities, refiners and other industrial firms. Another 30% or so would be doled out in lieu of cash to fund efforts such as renewable energy R&D and deployment, climate adaptation and assistance to low-income consumers. Something less than 10% would be auctioned by the government itself to fund deficit reduction and other initiatives.

So on a given day, who would be selling and who would be buying? Consider the utilities and merchant power generators. As generous as the bill's authors were to this sector, it would still be short allowances from day 1, with a gap between actual emissions and free allowances equal to roughly 4% of US emissions. Non-energy industrial firms probably wouldn't be selling, either, at least unless the price got high enough to stimulate the big investments in energy efficiency that haven't risen to the top of their capital budget priorities so far. Initially, they would need to acquire allowances equal to around 5% of all emissions. And that brings us to refiners, who under Waxman-Markey would be responsible for their own emissions plus all of the emissions from the end-use of their products by non-regulated consumers, yet would receive only a 2% allocation of free allowances. Depending on how upstream production and oil imports are counted, the gap that refiners would need to cover could amount to more than 31% of all US emissions, or 3/4ths of the allowances given to non-emitting entities or auctioned directly by the government. At the same time, they have only modest scope for further reductions in their own emissions, considering that they are already 90% energy-efficient, on average. Who would be likely to have the advantage in such a situation? It sure looks like a "sellers' market" to me.

I don't doubt that refiners could probably scoop up some relatively cheap allowances from groups that get handed these tickets and don't quite know what to do with them, though market sophistication--and for-fee advice on such matters--might spread quickly. But refiners wouldn't just need to sweep up the stragglers, here. They'd require the entire allowance streams of many of the legislation's chosen beneficiaries for years to come, nor could they risk coming up massively short in any year. To me that suggests an average acquisition price for allowances that could rise well above the notional $15-$20/ton expounded by the EPA and DOE, considering that the effective price ceiling provided by brute-force CO2 reductions such as carbon capture and sequestration is probably north of $50/ton, equating to 50 cents per gallon of gasoline. While an increase that high might not be the likeliest outcome, it is at least plausible, and it would be added not to current gas prices, which have been depressed by the recession, but to those that would prevail after the legislation went into effect, when the economy--and perhaps even fuel demand--was presumably growing again. It doesn't take a leap of imagination to combine these factors to get to the $4 per gallon that the Times appears to dismiss.

From the last sentence of the editorial, I have to conclude that the Times doesn't understand the rationale for cap & trade nearly as well as they think they do. The point of this approach and any well-structured legislation implementing it is not to wean the US off of petroleum, but to reduce our emissions of the greenhouse gases implicated in climate change. While that certainly implies lower emissions from the oil sector, and thus lower consumption, it is perverse and counter-productive to shelter higher-emitting sectors that have greater flexibility for reducing emissions. The Congress may have judged that consumers would complain more about higher electricity bills than about increases at the gas pump, which could always be blamed on other factors--and on a singularly unpopular industry. But in creating such a wide disparity of demand for allowances among business sectors, they risk driving the price of those allowances much higher than otherwise, imposing an unnecessary drag on the economy. Even if their protests are motivated by self-interest, the oil industry and oil consumers are right to point this out.

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