The U.S. farmer is a key stakeholder in the current debate surrounding climate legislation. Would a cap-and-trade regime be a farmer's friend or foe?

In our assessment, there are two key components to the cap-and-trade math as it pertains to agricultural producers. Where these two ultimately net out will determine the answer to our question.

The first is the degree to which a carbon regime serves to increase energy costs. By placing a limit on U.S. greenhouse gas (GHG) emissions and forcing GHG emitters to purchase offsets in order to comply with cap limits, the government would effectively tax energy consumption, which would drive up prices. A potential knock-on effect is that energy consumers may shift to lower GHG-emitting energy sources like natural gas. Natural gas is a key agricultural input, so a potential spike in both its price and demand could send a ripple effect through everything from fertilizer prices to grain drying costs.

The second piece of the equation is the degree to which U.S. agricultural producers will be able to benefit from this framework. This will depend in large part on the quantity and price of carbon offset credits which they themselves are able to generate. This, in turn, will largely be a factor of the types of practices and investments that ultimately qualify for offset credits and the supply and demand for credits in the market. Practices like no-till farming, which leaves soil undisturbed and keeps carbon trapped, would qualify for offset credits. However,calculating the appropriate amounts seems to us to be an imprecise science at best.

So where will this math net out? While answers vary widely, the one certainty is that there is a great deal of uncertainty surrounding the net effect a climate bill might have on the farm.

In the cap-and-trade corner, there is the EPA (amongst others), which has recently released a study estimating the net annualized benefit of a U.S. carbon cap to the agriculture sector at an extremely wide range of $1.2-$18.8 billion. The cornerstone of the EPA's argument is that revenue generated by monetizing carbon offsets would more than offset any incremental increase in energy and other costs that would result from a carbon cap. Under this scenario, farmers would be net beneficiaries of climate legislation.

In the anti-cap-and-trade corner are organizations like the American Farm Bureau (AFB), which hang their counter-argument on the notion that a carbon cap would drive energy and food prices skyward. The AFB argues that higher prices would, in part, result from a reduction in planted acreage, as crops give way to trees on more productive land as part of a possible offset program. The AFB argues that consumers would wind up bearing the brunt of the costs associated with the currently proposed legislation, and that American farmers would come up short relative to their foreign peers operating outside a carbon regime.

Skeptical farm-level stakeholders also cite the uncertainty surrounding the ultimate financial benefit that might be realized through monetizing offsets. This does not surprise us, given that the contours of offset-generating practices and investments remain shrouded in shades of grey. An additional layer of uncertainty surrounds the ultimate price and associated price volatility of carbon offsets. Generous government grants of carbon offsets to power generators (which are being doled out in part to dampen the effect of higher energy prices being passed along to the consumer) and blurry definitions of offset-qualifying activities create the potential for an oversupplied offset market, which could serve to drive down prices and the financial benefit that farmers would realize. This concern could be mitigated by Senate legislation proposing a price collar of $10-$28 per ton for offsets, a measure that has the backing of the Department of Energy.

As with any political issue, where you stand on cap-and-trade depends on where you sit. Still, we think there's one point all sides agree on: There exists a wide range of potential outcomes surrounding climate change legislation, and its impact on agricultural producers in the U.S. and input makers that supply them.

So how might all of this affect the firms in our agriculture industry coverage universe? In a best case scenario, where carbon offsets create a lucrative new revenue stream for U.S. farmers (at $18.8 billion, the top end of the EPA's estimate of the potential benefits of a cap-and-trade regime represents about a third of the USDA's $54 billion forecast for 2009 farm income), we think that a rising tide could lift all ships, as farmers reinvest their newfound windfall in their operations.

However, we think that the most likely outcome is less rosy. Higher energy costs resulting from a cap-and-trade regime would place upward pressure on the prices of key farm inputs like diesel and fertilizer. We think that this scenario would be most detrimental to U.S. nitrogen fertilizer producers, whose cash production costs are joined at the hip with natural gas prices. Higher energy prices would drive up production costs and fertilizer prices, and attract import competition for North American firms like Terra (NYSE:TRA - News) and CF Industries (NYSE:CF - News). At the same time, higher fertilizer and fuel costs, along with the potential for an increased incentive to adopt no-till practices, could be a boon for seed producers like Monsanto (NYSE:MON - News) and DuPont (NYSE:DD - News). These firms both have corn seed products in their pipelines that make more efficient use of nitrogen fertilizer, and currently offer herbicide resistant seed varieties that facilitate no-till farming practices.