As promised during last year’s Presidential campaign, the start of the Obama administration has seen aggressive action on climate change policy. More is yet to come. What does this mean for manufacturers? The short answer is: higher costs. But why this is, and what companies can do to prepare for it, takes some explanation.

The Clean Air Act Conundrum

The idea that action is necessary to address climate change was resisted by the Bush Administration but is embraced by President Obama and his team. But no good legal vehicle exists to do so. At first blush, it would seem that the Clean Air Act, the nation’s principal air pollution control law, would fit the bill. In fact though, it does not, especially as to “stationary sources”—that is, factories and farms.

The reason is that the regulatory scheme embodied in the Clean Air Act focuses on technological fixes for particular sources of particular pollutants in particular areas, on an emission-source-by-emission-source basis. The act’s basic tool is to authorize the U.S. Environmental Protection Agency (EPA) to develop and define technological fixes, and (except for vehicles) for states then to implement them. This is workable for pollutants like lead and sulfur dioxide. Those chemicals’ release and impact is local or regional, and their sources are readily identifiable.

The man-made emissions that combine to threaten climate change present a different problem. They come from all over the world and mix in the atmosphere. Emissions in China affect conditions in the United States. Moreover, some fairly small and unusual sources can contribute potentially significant quantities of greenhouse gases (GHG). For example, industrial-size cattle feed lots are a significant source of GHG—the methane emitted by cow flatulence. Start thinking about the best-available technology to impose on the cattle and you see the problem.

The Clean Air Act’s fit is marginally better for vehicles than stationary sources, however. Recognizing this, a decade ago environmental activists petitioned EPA to make a finding that GHG emissions constituted an “endangerment” to public health or welfare. If such a finding were made, new regulations on vehicles—the source of about a quarter of GHG emissions—would be required.

The statutory problem, however, is that the endangerment standard that triggers mobile source regulation also appears in Clean Air Act provisions that deal with stationary sources. Therefore, a finding that mobile sources “endanger” could trigger similar conclusions as to stationary sources, which in turn could trigger a very considerable expansion of the scope of existing regulatory programs. This would most likely result in tightened emission permits for every company already regulated and new permit requirements for small factories, farms, apartment buildings and possibly even single-family homes.

The Bush administration tried mightily to sidestep the need to make an endangerment finding. But it was eventually told by the Supreme Court, in a 2007 decision, that the decision had to be made. Even then, the administration stretched out the process, leaving the task to its successor.

Enter “Market Solutions”

In recent decades, both Democratic and Republican administrations have championed “market-based” solutions to environmental regulatory problems. Increase the cost of polluting, the theory goes, and industry will find the most efficient ways to reduce it. Government need not mandate the right technology.

In practice, this comes down to one of two things. The first is easy: impose a carbon tax on emissions, thus increasing the cost to pollute and incentivizing emitters to emit less. The second is more complicated: set a maximum target for total GHG emission in the United States (i.e., a cap), requiring emitters to pay for a permit to emit and then letting those permits be “traded” among companies. In this way, those who can limit their emissions most inexpensively will do so, and will sell their “credits” to others. This has come to be known, not surprisingly, as cap-and-trade.

Obviously, imposing the tax is the more straightforward option and minimizes transaction costs. Former Vice President Al Gore, for one, historically has favored this solution.

But at least some of the cost imposed by a tax on emissions will be passed on to customers. Most obviously, because electric utilities and refineries are emitters of almost half of the GHG in the United States, a tax increases electricity and fuel oil costs. Various groups therefore clamor for protection: advocates for the poor, municipalities and manufacturers—especially those in energy-intensive industries like steel that face international trade competition—to name just a few. And these claims are legitimate.

So politicians must decide whom to subsidize. This would translate to thousands more pages in the Internal Revenue Code.

The cap-and-trade alternative has the same impacts, but offers politicians and interest groups four other attractions (at least to politicians). First, and perhaps most important to the politicians, it avoids the horrible word “tax.” Second, the idea of tradable credits sets mouths on Wall Street watering, as yet a new market and, perhaps, set of packagable assets appears. (Admittedly, this attraction is considerably weaker than it was 18 months ago, but hope springs eternal.) Third, and probably most important to many environmental activists, tradeable credits mean a new bureaucracy to supervise—a jobs program for policy wonks. Fourth, a ready form of subsidy is inherent in the system: some credits can be given away to worthy recipients, who can then avoid the need to pay for credits to support their own emissions or, if they are not emitters, sell them to “polluters” who do need them.

Unfortunately, however, neither of these approaches is embodied in most of the Clean Air Act. Whatever hope there was that the law could be stretched to allow it died when, in a July 2009 decision, the U.S. Court of Appeals for the D.C. Circuit—widely understood to be just a half-step below the Supreme Court—ruled that efforts to stretch that law to embody a cap-and-trade program for sulfur dioxide emissions were unlawful.

The Result: New Legislation

Faced with these facts, virtually all who believe some sort of governmental action is merited favor new legislation. The debate is about the details: whose costs will be increased and who will be protected from those cost increases. And, for the four reasons stated above, only cap-and-trade is seriously on the table.

Prepared by EPA in late April 2009, it does not reflect all the options on the table, only two embodied in the dominant pending House legislation, the Waxman-Markey American Clean Energy and Security Act (H.R. 2454) that was reported out of the House Energy and Commerce Committee in May.

It predicts electricity cost increases of about 10% by 2010 over a “reference case” (i.e., no legislation) and 40% by 2050. (Both figures are in constant dollars.) Natural gas prices would increase by similar amounts.

Early versions of the Waxman-Markey bill assumed a good number of credits would be given away to ameliorate these cost increases, or that funds from government sales of credits would be provided directly to impacted industries, but did not say who would get them. That was decided, as committee mark-up approached, on the basis of policy and political concerns.

The bill that emerged gave energy-intensive manufacturers 15% of the total available allowances available every year through at least 2025—a considerable sum, given that each 1% is expected to be worth about $225 million per year in the early years.

To protect consumers from higher costs, it gave utilities between 35 and 43% of the allowances, over a similar period, but phasing out by 2030. Similarly, natural gas local distribution companies would receive 9% of the allowances and it gave financial support to various other interests: for example, 3% to manufacturers of plug-in hybrid vehicles and their components.

Some day, if the bill is passed, someone in the EPA or the Department of Energy will decide how those credits get distributed.

Most Manufacturers Escape Direct Cap-and-Trade Burdens

The good news for the manufacturing community is that—except as to the energy-intensive subsector (steel, etc.), it is not the source of a large percentage of CO2 emissions, and thus therefore generally does not have to own credits to stay in business.

Looking at total GHG emissions, vehicles account for about 26%; electricity generation 32%; energy-intensive manufacturing (steel, etc.) 5%; feedlots and agriculture 6%; and residential and commercial heating 21%. This leaves only 10% of emissions allocable to all other uses, and virtually everyone involved is inclined to draw the line for permit requirements somewhere above that last category.

That does not mean the cost impacts will not be felt by manufacturing. For this reason, the focus now is on how to shape the scheme to minimize the injury on manufacturers, and there is a lot more to be done if manufacturers are to be protected. Some manufacturing sectors have better arguments to make than others.

Those who are involved in reclamation or using reclaimed products, for example, have a natural claim for support—their work saves the energy that must be used to produce virgin products. Those who face severe foreign competition are another—since all recognize that China, Brazil and other low-cost competitors are unlikely to impose on their factories anything like the burdens the United States will adopt.

In truth, however, creative advocates for just about any other industry sub-group should be able to come up with a reasonable rationale.

Thoughtful manufacturing managements already are making investments in anticipation of these cost increases. A good example is Crown Battery Co., which is a privately held, 445-employee operation in Ohio.

In March, Crown installed a windcube generator on the roof of a new plant in Port Clinton, OH. The first of its type in the country, the unit is expected to generate 15 to 20% of the factory’s substantial electricity needs.

So how big will the overall cost of climate change legislation to manufacturers be? The next 18 months will tell. Unless your industry comes up with a good claim for attention or you invest in energy-saving technology, you can be confident your energy and other input costs will be going up dramatically.

This article appeared in Manufacturing Today.