Political momentum is building in the effort to slow global warming. The scientific evidence is becoming stronger and public concern is mounting. For leaders in business—especially in industries, such as electric power, that yield large quantities of carbon dioxide and other “greenhouse gases”—the need to develop a strategy in the face of looming regulation will pose challenges greater than any faced in many decades. Tackling global warming is likely to transform the energy industry. It will create many risks for traditional companies as well as opportunities for firms that are politically and technologically best placed to shape the rules. •Although pressure for action by the federal government is mounting, the exact shape of a new federal policy is hardly clear. Some academics, myself included, think a carbon tax applied to the entire economy is best because it would signal the real cost of emissions and would generate revenues that could be used to offset other taxes that exert a drag on the economy. • Politically, however, that’s an unlikely outcome because the conventional wisdom in Washington is that the public abhors taxes. More probable is that the federal government will embrace a cap-and-trade system. The government would fix an “emissions budget,” and companies would be allowed to buy and sell permits so long as their emissions don’t exceed the budget. This approach has been successfully used since 1990 to control sulfur dioxide emissions. Europe already has such a system in place for greenhouse gases, and with that experience an international market could emerge that links the U.S., European, and other markets into a more global scheme. • Setting the cap is the easy part. Allocating the pollution permits and setting the rules of trade is politically much more difficult. The permits would be extremely valuable—worth perhaps tens or hundreds of billions of dollars—and not surprisingly there are many competing ideas on how the government should allocate them. The political process in Washington is only just now beginning to approach this most difficult issue. • Some of the global warming bills under consideration in Congress would give away emission credits for free to the existing emitters—as was done in 1990 when Congress amended the Clean Air Act and created the market for controlling emissions of sulfur dioxide, the leading cause of acid rain. Such allocation schemes actually reward the highest emitters, and this likely handout helps to explain why some of the nation’s largest emitters are now warming to the idea of regulation. They know that regulation is likely, and they hope that by embracing the process they can steer the rules—especially the rules about which firms get these valuable emission permits.

Economists have been rightly wary of this outcome. They generally prefer using auctions to award permits—as is done, for example, with cell phone licenses and other parts of the radio-magnetic spectrum. But auctions are politically troublesome because firms that contribute to the highest emissions—such as coal-fired utilities and also coal miners—are well organized politically and poised to block rules that trample their interests too severely. Some of the bills in Congress envision the use of auctions, and it may prove possible to utilize an auction for awarding some of the credits. Some European countries are using auctions to allocate a portion of the credits under their trading system, although most favor handouts that allow governments to reward politically favored industries.

Until the federal government acts, the vacuum in U.S. policy is being filled by a myriad of states and businesses that have stepped in to develop their own policies to limit emissions of greenhouse gases. Several states in the Northeast have formed the Regional Greenhouse Gas Initiative to stabilize CO2 emissions from power plants through a cap-and-trade system. Five states in the West are creating the Western Regional Climate Action Initiative, which could include a similar market. California has also committed itself to aggressive reduction of greenhouse gases.

In the private sector, a parade of major companies—ranging from GE (which makes efficient power generators and zeroemission wind turbines) to DuPont (which is creating new technologies for growing crops that can be turned into liquid fuels, replacing oil) to Duke Energy (which is a large coal-fired power generation company) and BP (which sells oil as well as lower-carbon natural gas and is also building a low-carbon electric power company)—are now calling for federal action. Many have already begun to invest in lowemission technologies so they are ready when binding rules eventually arrive.

For the electric power industry, this patchwork of rules creates special challenges. That’s because most of the industry is highly regulated, and decisions about building new plants—which are new commitments to emit greenhouse gases— require the consent of regulators. During the 1990s, utilities and other power producers built scores of gas-fired power plants. Gas turbines, as well as the gas to fire them, were inexpensive; gas projects and gas-fired electricity were easy for regulators to accept. Today, gas is much more expensive and utilities are shifting back to coal when they contemplate new plants. This shift, which is due to changes in fuel prices, is unfortunate because coal plants emit more than twice the carbon dioxide for each unit of electricity they generate when compared with gas.

Regulators are wary about approving these new coal plants in case they become white elephants as the nation curbs carbon. But they are even more wary of giving the green light to new-fangled coal plants that are much more expensive than conventional technology but could—if they work reliably—lead to much lower emissions. Determining which investments are “prudent” has never been more difficult. In the Energy Law class at Stanford Law School we look at the history of regulatory approvals for nuclear plants as a guide for how these risky projects might fare in the hands of regulators, and the lessons are sobering. Private utilities will have a hard time justifying these investments, even if regulators give them the green light, because they know that if the plants become financial millstones that their shareholders will get stuck with much of the loss. Indecision, however, is equally dangerous since the nation’s utilities could fail to keep up with rising demand for power. These issues have come to a head in the proposed takeover of the Texas utility TXU, which has abandoned most of its plans to build large, new coal plants partly due to concerns about the impact on global warming; what is less clear is what it will build instead.

One lesson that is becoming clear is that cap and trade, by itself, is not enough. The price of emission permits that is likely in a cap-and-trade system is unlikely to be high enough to encourage companies to invest in fundamentally different energy systems. In most of the country, the economic advantage of coal—when compared with alternatives such as low-carbon natural gas or zero-carbon nuclear power—will be especially hard to displace. Special policies—such as R&D incentives as well as subsidies for novel plants—will be needed to supplement the price signal and accelerate the pace of technological advancement in clean energy. Some of those incentives exist, but not on a scale that is commensurate with the challenge of global warming.

Secondly, our society will need to confront the carbon challenge while also addressing many other energy problems—not least of which is dependence of the oil markets on unstable supplies such as from the Middle East and West Africa. Some solutions to the oil problem could make global warming even worse—for example, synthesizing liquid fuels from coal, which would cause nearly double the emissions. Other solutions could make it easier to tackle the carbon problem, such as through greater use of electric cars and “pluggable” hybrid vehicles that run partly on gasoline and partly on batteries charged by electricity from the grid. Smart meters will make it feasible to move electric loads to the time of day when they are cheapest to serve. The shift to greater use of electricity can make it easier to manage the climate problem because power plants are large, stationary sources of emissions and thus easier to control than millions of vehicles plying the roads.

Effective solutions must be global. The European Union has taken the strongest lead in addressing the climate challenge; the United States, while behind, is now developing a coherent policy. Ultimately, such policies must also extend to all other economies, notably those in the rapidly developing world such as China and India. Some of the technological solutions developing in the advanced industrialized world—such as novel coal plants whose emissions are injected underground and safe from the atmosphere—are likely to find ready application in the coal-hungry developing world.

There is great opportunity in efforts to manage the carbon problem, but dangers also lurk. The broad goal of slowing global warming—which is now widely shared by the American public and business—could be implemented in a way that causes severe regulatory confusion. In a capital-intensive industry where time horizons are long—as they are, especially, in electric power—confusion and indecision can be extremely harmful.