Total Blindness to Unintended Consequences

Greenbiz.com has made a commendable and manful effort to wade through a dense thicket of data obfuscation. They have poured over all 40 pages of a recent study of how the current Cap’N Trade bill, volleyed about Congress, would impact the profitability of S&P 500 corporations. The study, itself, is a little too boring to read to the kids, but it marks a nice effort to merge financial investigation and fabulist storytelling.

The report, “Carbon Risks and Opportunities in the S&P 500,” was put together by the not-for-profit Investor Responsibility Research Center Institute and Trucost, a global provider of environmental data and analysis.

Regrettably Greenbiz got taken for a ride and doesn’t see too many problems with Cap’N Trade. They tell us to relax, the PMT is chump-change and we can always refinance the ARM before the rate adjusts. If you believe in fairy-tales, here’s what Peter Pan got off his handy-dandy Excel Spreadsheet.

The analysis found out that direct greenhouse gas emissions from companies in the S&P 500 in 2007 added up to about 2,173 million tons of carbon dioxide equivalents, more than all the emissions from cars, trucks, buses and aircraft in the United States. Total emissions, including emissions from first-level suppliers, totaled 4,307 million tons of carbon dioxide equivalents.

If a market price of $28.24 were applied to each metric ton of emissions, Trucost’s estimate of the carbon market price in 2012, that would bring carbon costs to more than $92.8 billion, more than 1 percent of revenue from the companies.

This is probably what would show up if you bumped the numbers from the EPA, the corporate reports and the disciples of Ronald Coase who were attempting to price CO2 as a pollutant regulated in an auction market. The math is no doubt solid, the initial, top-level assumptions not so bad.

Greenbiz was then good enough to delve into some particulars. These particulars are what rail the analysis. In particular, electrical utilities get a disproportionate hammering and immediately see their G&A costs go through the roof. Battle damage assessment to power utilities follows below.

If the 34 utilities in the S&P 500 had to pay for their emissions, their earnings would slide 45 percent. But in looking at risks to individual companies, the financial implications vary widely, from causing earnings to fall anywhere from less than 1 percent to 117 percent.

This immediately causes significant problems with the initial figures for S&P 500 profitability. The figures quoted above only tell me what industries in the S&P 500 pay to acquire the permits.

It does nothing to address the cost cascade that occurs when utilities are forced to spread large-scale increases in G&A, over a static allocation base, as they do their cost accounting. The impact of this increase will force power utilities to do one of two things. They can raise rates, or they can shut down.

This puts local regulators under a significant moral hazard. Utilities can’t just charge my business an extra $1.00 per Kw/H. This has to be approved by a rates commission, in session for a public meeting. No one will want to give the Utilities rate relief. Nor will they let the utilities suspend the actual production of electricity absent an impending Chapter 11 or Chapter 7 action.

This will defer essential maintenance to transmission lines, prevent installation of better, more environmentally sound technologies. It will also create a major speculation and arbitrage opportunity for Son of Enron, or any other firm who feels like acquiring and then wheeling people’s access Kilowatt Hours. That worked so well for America the last time.

Thus, in the long run, S&P 500 firms in sectors outside power generation will lose far more than just 1% from Cap’N Trade. They all do business with utilities. If the utilities go under, they pay more to purchase from an increasingly Oligopolistic market.

If the utilities succeed in suing for regulatory relief, these other S&P 500 firms are the aforementioned allocation base that eats a nice G&A cram-down. If they have to buy from a power-broker firm, they should hire Gray Davis as a consultant and ask him how that worked out for his career as Governor of California.

As they sardonically write on Wall Street blogs, “it can only end in tears.” Indeed. And the people who put together impact analysis are required to accurately reflect the magnitude of sorrow.

This analysis cited by Greenbiz fails that standard. It is incomplete. The modelers producing this study are like a lackadaisical aerospace engineer who pretends the atmosphere is hydrostatic and has no adiabatic lapse rate when he solves a set of Navier-Stokes Equations under conditions where such assumptions don’t legitimately apply. Too many variables have been left out of an intricate system; with hair-trigger sensitivity.

Just as a lazy solution to the admittedly ugly Navier-Stokes Equations does nothing to help a pilot fly safely, the lack of second order analysis from Investor Responsibility Research Center Institute and Trucost undermines the usability of their product. It simply doesn’t solve for enough unknowns to really satisfy all the equations that govern how much money S&P 500 firms will lose under Cap’N Trade. Like the straw-man idiots in a Nassim Taleb self-congratulatory tract, this model has no cognizance that Black Swans really do exist.

Yes, Virginia, there are unintended consequences that propagate massively from major regulatory initiatives. This doesn’t, in and of itself, imply major regulation should never be undertaken. However, these second-order knock-on effects have to be accounted for and accurately and honestly presented in the cost-benefit analysis.

Now that a chastened and embarrassed Henry Waxman has no doubt hurriedly sat down and actually read the Cap’N Trade legislation he intends to champion, he will obviously see the wisdom of this. He’ll run out and make the CBO do this process the right way. Never.

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