The “consensus” view du jour is that some sort of price on carbon is the silver bullet for tackling climate change and is embraced by eco-economists and environmentalists alike. I use the term eco-economists to describe the small but vocal group of economists that subscribe to the Stern Report findings, which has become the benchmark study just like the IPCC reports in regards to Global Warming, the “consensus” as it were. I say it is regressive policy and does not accomplish its sole stated purpose in either a Cap and Trade or Carbon Tax iterations. I am going to assume for a minute the ultimate goal is the reduction of CO2 emissions while maintaining a strong and at the least a stable economy. I believe that GHG emissions will reduce but not for the reasons assumed by the general public.

I will look at actual business level response to a price on carbon and the effect on the economy these responses will have. Now most eco-economists agree that these responses will occur, but the stance they take is that new low carbon industries will more than make up for the impacts by creating new areas of economic activity. While I agree some new growth will occur in certain established industries, there is no direct sustainable net benefit unless you artificially place a value on the potential consequences of business as usual scenarios on the economy in the form of climate change costs. I will argue that these costs will not be elevated above any past periods where climate related costs were incurred previously, that using this methodology you are adding a inflated estimate of impact on the economy that is completely irrelevant. Regardless of the new “consensus” the reality is that business level decisions are not driven by operational risks that are ill defined.

Business Response to Carbon Tax

There really is only one camp of thought as to the responses to adding an externality to business operations that would simply be a Carbon Tax. Businesses will react by simply passing on the tax burden through the chain down to the consumer. First let me state that businesses by far favour a Carbon Tax, because it is absolutely quantified, manageable and easily factored into operational cost structures. The eco-economists view is that this pass through will happen but it is the following that is in question; they then believe that market competition and consumer response to pricing increases will force players to reduce their tax exposure to lower consumer prices by reducing tax load and gaining a cost structure advantage. That is the theory.

The problem is that marginal operations, mostly in the small and medium sized manufacturing and transportation sectors, will simply be unable to shoulder the capital costs or financing charges related to the implementation of emission reduction measures. This means low margin operations will simply be forced to shut down because they will not be able to compete with larger players and imports who can run longer on smaller margins or losses, this will actually lead to a reduction of competition and the ability to increase margins for remaining players, the end result is a higher cost of goods and services and no real response to GHG emissions except for the loss of regional industry and jobs.

A side note about capital investments in equipment and GHG mitigation measures, for larger players they will weigh the cost of the tax against the cost of capital. If it is more cost effective to pass on the tax due to the rising cost of capital and a non-responsive business tax structure they will simply opt to add the costs and make no effort to mitigate. It also may be better to use capital to acquire market share though mergers and acquisitions, again reducing competition in the sector allowing for better margins, lower cost financing will be more available for these types of activities. The next point I would make is that equipment lifecycle and capital cost allowances may not be fully realized on existing equipment which will impact business decisions, so this cost would be added onto any decision involving more capital expenditures for GHG mitigation technologies.

ex. Buying an new car before the old one is paid for does what? The remaining cost of the old car loan is added to the new car loan, less trade in value. Now imagine that you cannot trade in your car, or the value of the trade-in is 25% of the remaining loan balance (SUV owners will know this pain) you add 75% of the old loan onto the entire full price of the new loan then your payments are considerably higher. The same is true when businesses purchase new or upgrade existing equipment. Higher capital costs in the form of loan repayments and financing means higher overhead which could be a burden far in excess of a Carbon Tax. Paying the tax may be the best solution the same as it could be for the car buyer to simply pay higher fuel costs on an SUV until it is paid for and then realize the savings in the form of outright vehicle ownership. The same situation holds true for people who own their SUV outright, it would not make any sense to take on a new payment for a financed vehicle because the cost would outweigh the operational costs of current vehicle.

The alternative response is to close manufacturing facilities and outsource production to foreign nations where the taxation regime is less strict depending on the type of raw material inputs and source of them. This is the worst possible response as it will cost the most jobs, but even with shipping costs the savings in operational costs outside of taxation would outweigh the expense. Many times the transportation costs are the factor that allows local industries to compete with imports and additional local operational costs would tip in the outsourcing direction, the main determination is the distribution channels available for the output products and the viability of the supply chain. The impact is uneven sector by sector and the response of consumer product manufacturing will effect the responses out through raw material input suppliers, without a market they may collapse and raw material transportation may replace a large portion of the refining sector.

Business Response to Cap and Trade

This is even a worse scenario for business, not only will they forced to make expenditures to produce emissions they could be placed into a double expense situation if the caps are reduced quickly and they need to expend capital on equipment and upgrades as no available certificates are on the market. This breeds uncertainty for the business operations and could lead to volatile consumer pricing as the availability and affordability would have businesses reacting annually to changes in the carbon market. This is the uncertainty that will stop industries from growing and expanding operations in the effected region.

As above you will see marginal players being acquired but not only for market share by larger entities but rather for their carbon allowances. This will reduce competition and give rise to low output operations continuing to operate under a larger corporation simply for their emission certificates. The cap will also completely arrest expansion and new players entering the marketplace, if there is no hope to acquire enough emission rights to start and grow a viable company investment capital will simply dry up in favour of better regions.

The response would for the most part mirror the Carbon Tax one, except the added volatility in operational costs could lead to market uncertainty and problems raising equity capital, with investors leaving regional equity markets in favour of foreign markets with more stabilized business models and could lead to huge swings in commodity prices as demands for raw materials migrates with the business.

Cost of Climate Change

This the main issue of contention in eco-economics that the cost of inaction is far too severe to warrant inaction. I do not advocate inaction, mainly because there is no way to halt the innovation of industry and action happens everyday. The main thing to consider is that the climate has been a function of business decisions from the first farmer until now, we are aware of it and we live and work in every climate on the planet. We know and understand that the best built building will be swept away in a natural disaster, that extreme conditions can affect a business. We know and we plan for it, the coming climate (no matter what it will be) will be a factor in every decision as it has been since man first learned to build. This risk will be considered, for example if sea levels do rise then developers will not build new structures as close to the coast and older structures will simply be taken down when the reach the end of their lifespan. There is no cost here except perhaps the devaluation of coastal real estate, not a huge concern for the broader economy.

To date there has been no appreciable costs associated to climate change, yet there is massive costs assigned to mitigation strategies such as biofuels. This is the real economic impact that the climate change issue has wrought, not some rising scale of destruction based on extremes of situation and spread out over centuries. What we do now can effect the future, it also can effect the present. Climate change taxes are not a hedge against future climate that can be calculated and quantified,  they are what they are; taxes and restrictions on innovation and economic freedom.

The End does not Justify the Means

In the end the only real reductions in GHG will be a result of loss of industry to other countries. The eco-economists think we would create new industry to replace the old one. There is no new industry to create that is sustainable in any sort of size that could replace the industrial losses. Businesses look for the best overall advantage and will simply choose to not invest in overly regulated and taxed regions. Most green tech is once to twice in a lifetime type of product and as such there may be initial demand but it will quickly wane and there are well established sectors to address all the energy conservation measures commonly referred to such as home solar, wind, insulation, and windows these will not grow substantially because they know growth will require more GHG emissions and the demand is not sustainable.

I find it ironic that we think our economy will strengthen when we will be restricting business growth and hampering investment, there is a difference between doing the “moral” choice and the economic choice. Businesses make economic decisions because they have to, the bottom line well is the bottom line and their employees and investors rely on them to make decisions that are best economically, not morally. I do not imply that business is immoral, but when economic viability butts up against moral social issues such as GHG emissions the economic decision is the only choice to make. I do think we can get where we want to be with less GHG by pursuing a path of regulating the ability of business to grow, innovate and produce. The end really does not justify the means in this case.

Written on December 2 2009 – Re-Posted

Ideology cannot be put aside in the name of cooperation, the very notion is so naive to be laughable except that it comes from the President of the United States, whose oratory skills and hypnotic rhetoric allows the media to spin his words into strands of shiny gold. “I welcome all ideas except ones that are not aligned with my ideology” is the translation of his actual meaning when speaking on behalf of his Investment and Recovery Plan when he says “do not come to the table with the same tired arguments and worn ideas that helped to create this crisis. Americans did not vote for the false theories of the past, and they didn’t vote for phony arguments and petty politics”. This is one of the many rhetoric vs reality items that I have come to expect from President Obama.

Now for posterity I postulate that if the Government had not interfered in the market we would be past this financial crisis already though sans a few financial entities and with some new banks filling the void, but we would still be in the midst of a recession. I say this because Government stepping in with the money broke the price discovery and the accountability tenants of Free Markets. The notion that self regulation failed is just wrong, what failed is the Government not allowing these institutes to fix or fail, the strongest regulator in the markets. The financial crisis did not cause the recession, high energy prices and inflation started it, that lead to loan defaults, which started impacting financial services, whose leverage amplified it, and the TARP spin and “Big Sell” emergency funding fueled it by pushing into the living rooms across America with dire predictions and unfounded claims of catastrophe. The Government trampled consumer confidence into the ground and stood in the rubble to point at everyone but themselves.

Now the Stimulus plan comes along with the President using the politics of fear to sell it. Just like the Bush Administration and the TARP program. So much for the Change we can Believe in.

Now we are told we must act and doing nothing is not an option. I say it would take more courage and political risk to do nothing, the correct course of action. I would even advance that reducing Government spending is a wiser course of action, because this level of spending and the way it is being spent is not retractable and is simply going to add to the unfunded liabilities of the US far into the future. The new reality is a smaller economy because that is unavoidable, people will not consume as much over the next decade, period. Credit will not be easy and people will need to save to buy, this is the new reality and the sooner that the Government embraces these facts the sooner things will improve. Perpetuating an artificial economy is not the right answer.

The stimulus is only a huge social assistance program that adds and extends many rewarding social programs, the bane of developed economies in a recession. Revenues drop as liabilities grow, this leads to massive budget deficits and even more lop-sided “progressive taxation” to re-distribute wealth. Out of 800 Billion only 60 Billion is stimulative, the rest is welfare in different forms, even the tax cuts are targeted as welfare to people not paying Federal Income Taxes. At the same time President Obama raises consumption taxes to pay for other social programs because that is the standard Democratic platform, such as the tobacco tax for healthcare bill, not realizing that revenue from consumption will be severely impacted in a recession when taxes are added, so that new program will require additional deficit funding to maintain.

Cutting spending is the priority to prepare for recovery, when people see Government making the tough calls and dealing with what they deal with, in this case real fiscal hardships, then they will dig in and get things moving, and that may not be through consumption but through innovation and inspiration.

Added January 6th 2010

Now after the elections of November 2010 the US seems to be heeding my call, I hope. I found this post unpublished in my WordPress Log and it’s message rather interesting as a time capsule from late 2009 so I am publishing it now because its insights seem even more salient given current conditions.

I do not know about you but I hate being put on hold, or “Ignore” as I call it, when you are trying to reach someone who is much too busy to be bothered with you. This seems to be the case with Global Warming and the Earth. Seems the planet is far too busy with real climate issues to be distracted by the AGW theory, much to the dismay of the climate faithful world-wide who are now simply falling back to the climate change argument that they set-up for just this purpose.

Recently in the journal Nature German climate scientists published new results of a coupled ocean-atmospheric model that now shows a decade out prediction, the result is cooler temperatures until at least 2015. This is similar to the last run that predicted cooler temperatures until 2009 followed by a 50/50 chance of renewed warming that came out in 2005. This re-modeling of the climate is starting to become situation normal for climate science, instead of admitting their original models are wrong they simply change the variables and re-run the simulations. They then claim that natural variability has masked the AGW signal, but it is still there under the empirical data. Like when the onions are under the baked potato on your steak dinner plate, they are there but you cannot see them. This begs the question of how cold would it be without the effects of global warming? ( or why you ate most of the steak sans onions before you moved the potato )

When Natural Variability Counts

During the run up to 2005, especially around 1999, just after the 1998  spike in temperatures I was told that natural variability does not detract from the global warming trend. This was in every Global Warming article and discussion regarding the temperature trends. Yet we have seen from 1999 – 2009 or ten years of stable and lowering temperatures, this has been chalked up to natural variability masking the warming signal, the same variability that has no effect on the trend, yet even if you use the 100 year trend this is not true because the last decade has affected the rate of increase to a lower trajectory. So when it helps with the trend upward it is not natural, but when it changes the trend downward it is natural? So either natural variability is far larger than we are lead to believe or some special climate science in regards to when you can include it as a factor is involved.

The Road Ahead

Since the faithful will not accept anything short of an Ice Age to discredit their AGW theory or catastrophic climate change predictions, which will be a result of AGW anyway for the first decade or so as the planet glaciates, we are left with still having to deal with them.

I just hope we can regain our senses before warming returns and 30 years pass until we reach the temperature level of today, when we will start arguing about that same 0.5C temperature increase again, you know the one we were so concerned about in the 1990′s and that started the whole Kyoto fiasco, then again in the 2000′s with the IPCC prominence and rise of Al Gore.

One can only dream.

If you have not noticed blogging has ground to a halt here on IlliquidAssets.net, this is due to a very heavy work schedule. I have been trying to keep my brain from exploding by using twitter to get out my musings in microblogs (love that term). (see sidebar)

I am getting things under control and will be resuming normal blogging by the end of June, so please be patient and also look through the archives for blogs you may have missed.

Follow me on Twitter @DarylT in the interim.

Thanks

Illiquid Assets