Adam Smith Would Smell a Rat

03/23/2009 07:17 pm ET | Updated May 25, 2011

Washington, D.C -- The father of free-market theory was very clear on one thing: Businesses don't like competition and will combine to squelch it whenever they can. Just such a combination has now emerged in America's public utility sector -- and the competition they are trying to shut down is the absolutely essential one of learning how to meet our energy needs without fossil fuels.

Members of the Edison Electric Institute -- i.e. the nation's big, private utilities -- have agreed among themselves that they will lobby hard to ensure that 40 percent of any carbon permits issues by the federal government should be given -- for free -- to them as a group. They have also agreed to divide this windfall (assuming they can lay their hands on it) among themselves using a formula in which half of the giveaway emission permits would go to high-carbon utilities relying on coal, like AEP, Southern and Duke, and half to the low-carbon utilities, such as PG&E and Florida Power & Light, that utilize more natural gas, renewables, and efficiency.

This proposed cartel is breathtaking in its audacity -- you could call it a conspiracy if it weren't so public and blatant. And, if successful, it will badly damage either the American economy or the global effort to curb climate change -- or both.

The biggest force on the other side is President Obama, whose administration has consistently called for a full carbon-permit auction where everyone who emits carbon dioxide would be treated equally. What's more, the dollars realized for awarding the right to emit CO2 to the atmosphere and oceans would be used for public purposes in a publicly accountable way. President Obama's director of the Office of Management and Budget, Peter Orszag, has pointed out that in Europe, where utilities were allocated (i.e. given) carbon permits, the result was huge profits for the utilities, large price increases for the customers, and no reduction in CO2 emissions. Orszag told the House Ways and Means Committee that free allocations would amount to billions in corporate welfare.

In response, utility executives claim that they will accept strings on their allocated permits so that they can't make windfall profits. They even claim that because their profits are regulated by state utility commissions, such strings really wouldn't be needed -- they would pass the value of the permits on to their customers, dollar for dollar.

But just as Bernie Madoff's promised rate of return was demonstrably impossible, the utilities' promise that giving them permits will benefit their customers, boost the economy, and curb global warming is simply fraudulent. Here's why:

Flaw #1: Giveaway permits virtually guarantee windfall profts.

First, remember how utilities are regulated. Typically they get an allowable and usually generous rate of return on their capital investment -- power plants, transmission lines, substations. They then "pass on" to their customers the cost of their fuel: coal, natural gas, uranium. So if you give Duke Energy permits that would have cost, say, $1 billion at auction, its various state utility regulators would need to lower the rates paid by Duke's customers by $1 billion. Otherwise, Duke would pocket a windfall profit. How likely is it that these commissions, which are mostly subject to enormous political pressure from the utilities, would do this? Not very.

But even if Duke and other high-carbon utilities don't get windfall profits, what happens to PG&E and other low-carbon utilities? They're actually going to get more permits than they need -- that's the unholy bargain that the utilities have cut among themselves. So their public utility commissions will be asked not only to make sure that rates don't go up but also to make sure that, when PG&E sells its permits, the profits will go to the ratepayers instead of to the shareholders. And even if this happens, it means that the big electricity users served by these low-carbon utilities will get windfalls -- the money the government gives away has to go to someone -- and there's no reason why big electricity users in California or Florida should profit from the carbon auction.

Flaw #2: Giving the utilities 40 percent of the permits ensures everyone else in the economy will have to pay more for permits.

This is simple supply and demand. If the utilities use the allocated permits as they have promised -- to keep rates low -- it means that the customers of the utilities that rely on high-carbon fuels will have little (or no) incentive to find ways to use electricity more efficiently. If utilities aren't paying for all of the carbon permits, then in effect they aren't paying what would otherwise be the full price on carbon -- so the high-carbon utility sector will continue emitting more than its share of carbon dioxide. What this means for the rest of us is that the remaining 60 percent of the permits, when sold at auction, will be more expensive -- because big electricity consumers in coal-reliant states won't be doing their part. Gasoline, natural gas used to heat homes, and all of the other uses of energy in the economy will cost more.

Flaw #3: Giving utilities 40 percent of the permits means we won't meet our carbon-reduction goals, even if Congress sets them.

The high-carbon utilities have made it clear that free permits are code for continuing to burn coal. American Electric Power (AEP) CEO Mike Morris, at the Dow-Jones ECO:nomics conference in Santa Barbara, at first claimed that the Sierra Club could put any conditions it wanted on how AEP used its free permits -- but then made it clear that he meant any conditions that allowed him to continue burning coal in unlimited quantities until carbon sequestration becomes economical -- which might be never.

Morris also made it clear that encouraging higher energy productivity wasn't part of his business plan. Asked about California's demonstration that, by encouraging energy productivity, energy usage can be cut 50 percent without raising utility bills, Morris declined. "I'm not for decoupling," he said. "I like earning a rate of return on my investments in generation."

And giving free permits to high-carbon utilities means that they would have little or no incentive to change their preference for a high-carbon, low-efficiency electricity model. AEP would never need to become more like PG&E, because it could make its customers whole with allocated permits.

But if coal-fired utilities continue to emit their current 2 billion tons of carbon dioxide, it will be impossible to meet the climate goals that scientists say are essential. (By 2050 total U.S. emissions from all sources cannot exceed 1.2 billion tons, so if coal utilities keep emitting 2 billion tons a year, the rest of the economy collides with climate goals long before that, regardless of what Congress decrees. You just can't make the least-efficient third of the carbon inventory off-limits.)

This is not only true in some extreme hypothetical situation. A study done last year for NRDC on the impact of the Warner-Lieberman "Climate Security Act" found that because of the free allowances awarded by that bill, plus subsidies for carbon sequestration, the bill would have mean "no significant changes in the amounts of coal" used for electricity generation. Indeed, the study reports that the EPA's analysis showed that, even with Warner-Lieberman, "most of the existing fleet of coal-fired power plants would continue to operate."

And Warner-Lieberman gave the utilities far fewer permits than they are asking for under the Edison Electric Institute's unholy pact!

So the cartel being formed by high- and low-carbon utilities to pursue of giveaway carbon permits is a formula for both economic and environmental catastrophe.

There are signs that this alliance is unstable and might fall apart. A letter AEP's Morris sent to Congress last week was viewed as undermining the agreement, and utility executives who originally opposed rewarding their high-carbon brethren, like New Jersey's Ralph Izzo, continue to say they don't like it.

"The logic there was if you really want to motivate people to act differently, then there's no finer way to do that than to motivate investors to act differently," Izzo said. "The thought was you issue credits based on what you want people to produce as opposed to what you don't want them to produce. I quite candidly still prefer that approach, but I realize it's not acceptable [to the rest of the utilities]."

Adam Smith feared that business's desire to avoid competition would hold such cartels together. Karl Marx argued that the cutthroat nature of capitalism meant that they would inevitably fall apart. But both understood that they were bad for the public. And this one is bad for the planet as well.