Congressional Budget Office
Director’s Blog

CBO has been doing a significant amount of analytical work on climate change, and I wrote an oped for today’s Washington Post on the topic.

The piece notes that the economic cost of emission reductions will depend on the degree to which flexibility is provided on when emission reductions can occur and what policymakers do with the valuable emission allowances created under a cap-and-trade program.

The first point — that timing flexibility matters — is based on the observation that, as the oped points out, changes in climate reflect the accumulation of greenhouse gases in the atmosphere over long periods. The environmental impact depends little on year-to-year fluctuations in emissions. By contrast, the economic cost of reducing emissions can vary a lot from year to year — because of factors such as weather, economic activity or the state of technology. Flexibility regarding the timing of emissions reductions matters because of this disconnect between the environmental dynamic, which depends on total emissions reductions over an extended period, and the economic dynamic.

The second point has been discussed at length in numerous CBO documents. For more on CBO’s climate work, see here.

CBO issued a letter today reviewing options to offset price increases experienced by low- and moderate-income households under a cap-and-trade program for carbon dioxide emissions.

• Under a cap-and-trade program for CO2 emissions, the government would set gradually tightening limits on emissions, issue rights (or allowances) corresponding to those limits, and then allow firms to trade the allowances among themselves. The net financial impact of such a program on low- and moderate-income households would depend in large part on how the value of emission allowances was allocated. By itself, a cap-and-trade program would lead to higher prices for energy and energy-intensive goods. Those price increases would impose a larger burden, relative to either income or household consumption, on low- and moderate-income households than on higher-income households.

• Lawmakers could choose to offset the price increases experienced by low- and moderate-income households by providing for the sale of some or all of the CO2 emission allowances and using the revenues to compensate such households.

• For example, if all allowances were sold and the proceeds used for an equal lump-sum rebate to each household, the rebate would be greater than the average increase in low-income households’ spending on energy-intensive goods. CBO’s letter discusses that and other options, including broad or targeted reductions in income tax rates, payroll or income tax rebates, an increase in the Earned Income Tax Credit, a supplement to Food Stamp benefits, increased funding for the Low Income Home Energy Assistance Program, and increased incentives for energy-saving investments by households. In addition, automatic cost-of-living increases for Social Security and Supplemental Security Income would provide partial protection for some households.

• Choosing among such options often involves a trade-off between providing targeted assistance to low- and moderate-income households and offsetting some of the adverse effects on overall economic activity from reducing carbon emissions.

Today CBO issued a cost estimate for an amended version of the Lieberman-Warner Climate Security Act of 2008.  The substitute amendment for S. 3036 (formerly S. 2191) would set an annual limit or cap on the volume of certain greenhouse gases (GHGs) emitted from electricity-generating facilities and from other activities involving industrial production and transportation.  Under this legislation, the Environmental Protection Agency (EPA) would establish three separate regulatory initiatives known as cap-and-trade programs— one covering most types of GHGs, one covering hydrofluorocarbons (HFCs), and a third program to cover the carbon emissions embodied in imported goods.

EPA would establish a quantity of allowances for each of calendar years 2012 through 2050 and would auction some of those allowances.  The proceeds would be used to finance various initiatives, such as developing renewable technologies, assisting in the education and training of workers, and providing energy assistance for low-income households.  EPA would distribute the remaining allowances at no charge, to states and other recipients, which could then sell, retire, or use them, or give them away.  Over the 40 years that the proposed cap-and-trade programs would be in effect, the number of allowances and emissions of the relevant gases would be reduced each year.

CBO estimates that enacting the legislation would increase revenues by about $902 billion over the 2009-2018 period, net of income and payroll tax offsets.  Over the next 10 years, we estimate that direct spending would total about $836 billion.  The additional revenues from enacting this legislation would exceed the new direct spending by an estimated $66 billion, thus decreasing future deficits (or increasing surpluses) by that amount over the next 10 years. Other spending could result from enactment of the bill, but it would be subject to future appropriation action. This estimate does not address such spending. In years after 2018, net revenues attributable to the legislation would exceed annual direct spending through 2050.

A detailed discussion of  the methodology that CBO uses for analyzing this type of legislation, including the budgetary treatment of the cap-and-trade program and a discussion of how tax offsets are applied to the revenues generated by allowances auctioned and given away are included in CBO’s April 10 cost estimate for S. 2191, the America’s Climate Security Act of 2007, as ordered reported by the Senate Committee on Environment and Public Works in December 2007.

 

I am testifying this morning on climate change before the Senate Committee on Energy and Natural Resources. Reducing greenhouse-gas emissions would provide benefits to society by helping to limit the damage associated with climate change, especially the risk of significant damage. The webcast of the hearing is posted here. The testimony focuses on ways to reduce the economic cost of achieving any given greenhouse gas emissions target. In particular:

• Market-oriented approaches to reducing carbon emissions, such as a cap-and-trade program, would reduce emissions more cheaply than would command-and-control approaches, such as regulations requiring across-the-board reductions by all firms. Those market-oriented approaches are relatively efficient because they create incentives and flexibility for emission reductions to occur where and how they are least expensive to accomplish.

• The cost of meeting an emission target with a cap-and-trade program could be reduced, potentially quite substantially, by providing firms flexibility in the timing of their efforts to reduce emissions. In its most inflexible form, a cap-and-trade program would require that a specified cap on emissions was met each year. That lack of flexibility would increase the cost of achieving any long-term goal because it would prevent firms from responding to year-to-year differences in conditions that affected costs for reducing emissions — such as fluctuations in economic activity, energy markets, the weather, and the technologies available for reducing emissions. In contrast, because of the long-term nature of climate change, the key issue from an environmental perspective involves the long-term emissions and concentration paths of greenhouse gases, not the year-to-year fluctuations in emissions. The most cost-effective cap-and-trade design would thus encourage firms to make greater reductions when the cost of doing so was low and would allow them leeway to lessen their efforts when the cost was high. Providing firms with such flexibility could also prevent large fluctuations in the price of allowances that could be disruptive to the economy.

• One option for allowing firms flexibility in determining when to reduce emissions while also achieving compliance with a cumulative emissions target would be through setting both a ceiling—typically referred to as a safety valve—and a floor on the allowance prices each year. The price ceiling would allow firms to exceed the annual target when the cost of cutting emissions was high, while the price floor would induce firms to cut emissions more than the annual target in low-cost years. The price ceiling and floor could be adjusted periodically to ensure that emission reductions were on track for achieving the long-run target; such a dynamic price system could substantially reduce the cost of a cumulative emissions target.

• Policymakers’ choices about whether to distribute the allowances without charge or to auction them — and if auctioned, how to use the proceeds — could also have a significant effect on the overall economic cost of capping emissions. Evidence suggests that the cost to the economy of a 15 percent cut in U.S. emissions (not counting any benefits from mitigating climate change) might be half as large if policymakers sold the allowances and used the revenue to lower current taxes on capital that discourage economic activity, rather than giving the allowances away to energy suppliers and energy-intensive firms or using the auction proceeds to reduce the costs that the policy could impose on low-income households. Using the allowances’ value to lower the total economic cost could, however, exacerbate the regressivity of the policy change.

CBO issued a study today examining possible future private investment in new nuclear power plants. The extent of such investment depends not only on possible charges for carbon dioxide (if the Congress adopts climate change legislation) but also on existing incentives provided for such plants in the Energy Policy Act (EPAct) of 2005.

The Energy Information Administration (EIA) projects that demand for electricity in the United States will increase by 20 percent by the end of the next decade. Most of the additional demand would likely be met by conventional fossil-fuel technologies without the incentives in EPAct or the prospects of a market price on carbon emissions.

• Carbon dioxide charges of about $45 per metric ton would probably make nuclear generation competitive with conventional fossil fuel technologies as a source of new capacity and could lead utilities to build new nuclear plants that would eventually replace existing coal power plants. At charges below that threshold, conventional gas technology would probably be a more economic source of baseload capacity than coal technology. Below about $5 per metric ton, conventional coal technology would probably be the lowest cost source of new capacity.
• EPAct incentives would probably make nuclear generation a competitive technology for limited additions to base-load capacity, even in the absence of carbon dioxide charges. However, because some of those incentives are backed by a fixed amount of funding, they would be diluted as the number of nuclear projects increased; consequently, CBO anticipates that only a few of the currently proposed plants would be built if utilities did not expect carbon dioxide charges to be imposed.
• Uncertainties about future construction costs or natural gas prices could deter investment in nuclear power. In particular, if construction costs for new nuclear power plants proved to be as high as the average cost of nuclear plants built in the 1970s and 1980s (adjusted for inflation), or if natural gas prices fell back to the levels seen in the 1990s, then new nuclear capacity would not be competitive, regardless of the incentives provided by EPAct. Such variations in construction or fuel costs would be less likely to deter investment in new nuclear capacity if investors anticipate a carbon dioxide charge, but those charges would probably have to exceed $80 per metric ton in order for nuclear technology to remain competitive under a scenario with high construction costs and low natural gas prices.

The study was written by Justin Falk of our Microeconomic Studies Division.

I am testifying this morning before the Senate Finance Committee on the implications of a cap-and-trade program for carbon dioxide emissions. The testimony is posted here. To view the hearing click here.

Global climate change is one of the nation’s most significant long-term policy challenges. Human activities are producing increasingly large quantities of greenhouse gases, particularly CO₂. The accumulation of those gases in the atmosphere is expected to have potentially serious and costly effects on regional climates throughout the world. The magnitude of such damage remains highly uncertain, but there is growing recognition of the risk that the damage may be extensive and perhaps even catastrophic.

The risk of potentially catastrophic damage associated with climate change can justify actions to reduce that possible harm in much the same way that the hazards we all face as individuals motivate us to buy insurance. Reducing greenhouse-gas emissions would help limit the degree of damage associated with climate change, especially the risk of significant damage. However, decreasing those emissions would also impose costs on the economy—in the case of CO₂, because much economic activity is based on fossil fuels, which release carbon in the form of carbon dioxide when they are burned. Most analyses suggest that a carefully designed program to begin lowering CO₂ emissions would produce greater benefits than costs.

One option for reducing emissions is to establish a “cap-and-trade” program. Under such a program, policymakers would set a limit on emissions and allow entities to buy and sell rights (referred to as allowances) to emit CO₂. In designing a cap-and-trade program to achieve emission reductions, policymakers would face a number of critical decisions, including whether to limit fluctuations in the price of allowances and whether to sell the allowances or give them away. If the government chose to sell them, decisions would also have to be made about whether to use the resulting revenue to offset other taxes, to assist workers or low-income households that might be adversely affected by the emission cap, to support other legislative priorities, or to reduce the deficit. My testimony makes the following key points about those issues:

• Market-oriented approaches to reducing carbon emissions (such as a cap-and-trade program or a carbon tax) are much more efficient than command-and-control approaches (such as regulations that require across-the-board reductions by all firms). The reason is that the market-oriented approaches create incentives and flexibility for emissions reductions to occur where and how they are least expensive to accomplish.
• Within the relatively efficient category of approaches that rely on the power of markets, a tax on emissions is generally more efficient than a cap-and-trade system. The reason is that although both a tax and a cap-and-trade system encourage firms to find the lowest-cost reductions at a particular point in time, a tax provides greater flexibility over time, allowing firms to achieve reductions when they are least expensive. In particular, a tax encourages firms to make greater reductions in emissions at times when the cost of doing so is low and allows them leeway to lessen their efforts when the cost is high. A cap-and-trade program can be designed to capture many of those time-related efficiencies by incorporating design features that prevent large fluctuations in the price of allowances (for example, a floor and a ceiling on allowance prices).
• A cap-and-trade program, like a tax on CO₂ emissions, could raise a significant amount of revenue because the value of the allowances created under such a program would probably be substantial. For example, in 2012, the value of the emission allowances that would be issued under S. 2191 would be roughly $145 billion, CBO estimates. As the cap that is included in that legislation became more stringent over time, the value of the allowances would grow. A key decision for policymakers is whether to sell emission allowances, thereby capturing their value in the form of federal revenue, or give them away.
• Under a cap-and-trade program, firms would not ultimately bear most of the costs of the allowances but instead would pass them along to their customers in the form of higher prices. Such price increases would stem from the restriction on emissions and would occur regardless of whether the government sold emission allowances or gave them away. Indeed, the price increases would be essential to the success of a cap-and-trade program because they would be the most important mechanism through which businesses and households would be encouraged to make investments and behavioral changes that reduced CO₂ emissions.
• Policymakers’ decisions about whether to sell or give away the allowances could significantly affect the overall economic cost of capping CO₂ emissions and the way gains and losses from such a program were distributed among U.S. households. A policy of giving away rather than selling a large share of the allowances could be more costly to the economy and impose disproportionately large burdens on low-income households.
  • Evidence suggests that the cost to the economy of a 15 percent cut in U.S. emissions (not counting any benefits from mitigating climate change) might be more than twice as large if policymakers gave allowances away than if they sold them and used the revenue to lower current taxes on capital that discourage economic activity.
  • In addition, providing allowances free of charge to energy producers and energy-intensive firms could create “windfall profits” for relatively high income shareholders of those companies, even though the emission cap would be likely to cause price increases that would disproportionately affect people at the lower end of the income scale. Further, allocating allowances without charge would not prevent the loss of jobs in affected industries because such firms would probably reduce their output in response to higher prices for carbon-intensive goods and services. Those job losses, in turn, would impose concentrated income losses in some households and communities. In contrast, if the government chose to sell emission allowances, it could use some of the revenue from those sales to offset the disproportionate economic burden that higher prices would impose on low-income households and to provide transitional assistance to dislocated workers.
• CBO has concluded that the federal budget should record the value of allowances that are given away by the government if the recipients of the allowances could readily convert them into cash. In particular, the budget should record the value of those allowances, when they are distributed, as both revenues and outlays. That procedure, which CBO has already applied in its estimates for S. 2191, underscores that giving away allowances is economically equivalent to auctioning the allowances and then dedicating the proceeds to the recipients.

CBO has issued a cost estimate of S. 2191, the America’s Climate Security Act of 2007, as ordered reported by the Senate Committee on Environment and Public Works in December 2007. We’ve also issued a cost estimate on a slightly amended version of the legislation that was transmitted to us on April 9, 2008.

The legislation would create a cap-and-trade system for carbon dioxide and other greenhouse gases. (Technically, there would be two separate cap-and-trade programs—a bigger one covering most types of greenhouse gases and a smaller one covering hydrofluorocarbons.) Some of the permits would be auctioned — through a new entity, the Climate Change Credit Corporation — and the remaining permits would be distributed at no charge to states and other recipients. Over the 40 years that the proposed cap-and-trade programs would be in effect, the number of allowances and emissions of the relevant gases would be reduced each year.

CBO estimates that enacting S. 2191 as it was ordered reported would increase revenues by about $1.2 trillion over the 2009-2018 period. Over that period, we estimate that direct spending from distributing those proceeds would also total about $1.2 trillion, but more than the revenues. The net effect of the original legislation (as ordered reported) would be to increase deficits (excluding any effects on future discretionary spending) by an estimated $15 billion over the next 10 years; the amended version would instead reduce future deficits (again excluding any effects on future discretionary spending) by roughly $80 billion over the next ten years. In addition, assuming appropriation of the necessary amounts, CBO estimates that implementing S. 2191 would increase discretionary spending by about $4 billion under the original legislation and about $80 billion under the amended version over the 2009-2018 period.

The estimates for the two versions of the bill differ because the amendment would increase the portion of allowances that would be auctioned, deposit some of the auction proceeds into a Climate Change Deficit Reduction Fund, and make spending from that fund subject to appropriation.

This complex legislation posed several scoring questions and challenges:

• The first involved how to treat the corporation it creates; the Climate Change Credit Corporation would be responsible for auctioning the allowances created by the federal government and for spending the resulting proceeds on various initiatives. How to treat the Corporation, though, seemed relatively straightforward: The Corporation would be part of the federal government, and the cash flows associated with auctioning the allowances and spending the proceeds should therefore be recorded in the federal budget.

• A second scoring question involved the emissions allowances that are given away at no charge. In CBO’s view, these should also be recorded in the budget as revenues and outlays. The government is essential to the existence of the allowances and is responsible for their readily realizable monetary value through its enforcement of the cap on emissions. The allowances would trade in a liquid secondary market since firms or households could buy and sell them, and thus they would be similar to cash. CBO estimates that the value of the market created by the major cap-and-trade program would be large, exceeding $100 billion in 2012. Therefore, CBO considers the distribution of such allowances at no charge to be functionally equivalent to distributing cash.

In our view, this scoring approach best illuminates the trade-offs between different policy choices. Distributing allowances at no charge to specific firms or individuals is, in effect, equivalent to collecting revenue from an auction of the allowances and then distributing the auction proceeds to those firms or individuals. In other words, the government could either raise $100 by selling allowances and then give that amount in cash to particular businesses and individuals, or it could simply give $100 worth of allowances to those businesses and individuals, who could immediately and easily transform the allowances into cash through the secondary market. Treating allowances that are issued at no charge as both a revenue and an outlay would mean that those two equivalent transactions were reflected in parallel ways in the scoring process.

In contrast, the proceeds associated with the allowances allocated for free to producers and importers under the smaller cap-and-trade program covering hydrofluorocarbons should not be recorded on the budget in CBO’s view, primarily because we expect that the market created for such allowances would be relatively small and illiquid. Based on information from industry representatives, CBO estimates that fewer than 30 entities would be considered covered entities under this program. And given our estimate of the price for consumption allowances, CBO expects that the size and value of the overall market created by the cap-and-trade program for hydrofluorarbons would be small—less than $2 billion annually in most years. Therefore, unlike the allowances for the other greenhouse gases, these allowances would not be sufficiently cash-like to merit inclusion in the federal budget, in CBO’s view.

• A third scoring challenge involved the technical process of estimating the permit price for the main cap-and-trade program, which would cover carbon dioxide and other greenhouse gases. Based on an analysis of the results of several economic models, our estimates suggest that under the legislation, the auction price of emission allowances for these greenhouse gases would rise from about $23 per metric ton of carbon dioxide equivalent (mt CO₂e) emissions in 2009 to about $44 per mt CO₂e in 2018. (In 2006 dollars, the auction price per mt CO₂e would rise from about $21 in 2009 to $35 in 2018.) Covered emissions of group I gases would decline by 7 percent in 2012 and by 17 percent in 2018 from base-case emissions (that is, those that would occur under current law); over the entire 2012-2050 period, they would decline by 42 percent from the base case.

• A final issue involved the longstanding methodology in the federal budget process to assume that overall economic activity (GDP) is held constant.  Under that assumption, higher amounts of indirect business charges reduce other income in the economy. (For example, if firms that must purchase allowances would be unable to pass those costs along, their profits would fall. More likely, some substantial portion would be passed along to others in the economy, such as consumers and employees, and other income would fall. Either way, the result would be lower taxable income in the economy, which would reduce federal revenues from income and payroll taxes.)  The tradition is to assume that 25 percent of any change in indirect business charges is offset by changes in income and payroll taxes (25 percent is an approximate marginal tax rate).  For this estimate, CBO did not apply the 25 percent reduction to all of the gross revenues, however, depending on how those revenues would be used:
  • To the extent that the revenues would be used in ways that would generate new taxable income, such uses would offset the loss of income and payroll taxes that would result from the initial purchase of allowances.  Therefore, CBO did not apply the 25 percent reduction to any revenues that would be used to make transfer payments to taxable entities without any conditions placed on the recipient regarding the use of those payments. While such transfer payments do not directly affect GDP because they are not made in exchange for goods or services, they are typically taxable. Thus, providing transfers to taxable entities generates additional federal revenue that would essentially offset the 25 percent reduction in revenue collections. Most of the estimated revenues from allowances given away under S. 2191 would be used for such purposes.
  • CBO also did not apply the 25 percent reduction in revenues to any allowances that would be given away under the bill and would not be immediately taxable to the individuals or businesses that receive them, but would generate taxable income when they were used or sold to others. Such allowances include those given away to facilities that generate electric power from fossil fuels and to facilities that produce or import petroleum-based fuel.
  • In contrast, we applied the 25 percent reduction to any revenues that would be spent by the government on goods and services (for example, on research and development activities) because such government spending would substitute for other economic activity (under the assumption that GDP is unchanged by the bill). As a result, revenue used in this way would not generate any new taxable income. All of the proceeds from the auction of allowances would be used for those purposes.

The two cost estimates provide much more information about the legislation and its projected effects.

Analyzing a complicated piece of legislation like this requires resources from across the agency. CBO has formed a climate change team, and more information about CBO’s activities on climate change can be found here. The cost estimates and the associated mandate statements were prepared by Mark Booth, Susanne S. Mehlman, Deborah Reis, Megan Carroll, Kathleen Gramp, Tyler Kruzich, Robert G. Shackleton Jr., Mark J. Lasky, Terry Dinan, Natalie Tawil, Neil Hood, and Amy Petz.

The Environmental Law Institute and Vanderbilt Law School are holding a conference on several important environmental topics this week. Terry Dinan of CBO and I are commenting on a climate change article written by Cass Sunstein. Our written comment is below.

Comment on “Of Montreal and Kyoto: A Tale of Two Protocols”

By

Peter R. Orszag and Terry M. Dinan

Congressional Budget Office

In “Of Montreal and Kyoto: A Tale of Two Protocols,” Cass Sunstein compares the political economy dynamics leading up to the signing and ratification of the Montreal Protocol (governing substances that deplete the ozone layer) and the Kyoto Protocol (governing substances that contribute to global warming). He observes that the United States was a strong and early supporter of the control of ozone-depleting substances but has generally opposed binding controls on greenhouse gases. In contrast, Britain was significantly more reluctant to agree to limits on ozone-depleting substances but has actively supported restrictions on greenhouse gases. Sunstein attributes that contrast to differences in the two nations’ perceptions of domestic benefits and costs from environmental action, and he concludes that the key to obtaining a global agreement on greenhouse gases will involve raising perceived benefits within the United States from such an agreement while reducing its perceived domestic costs. He suggests that motivating developing countries to agree to emission limits and achieving such reductions through an incentive-based global approach—such as a global tax on carbon dioxide (CO₂) emissions or a global cap-and-trade program—are the most promising approaches to altering U.S. perceptions of domestic benefits and costs.

It is undoubtedly correct that perceptions of domestic benefits and costs are important determinants of countries’ willingness to enter into international agreements (including those about limits on global pollutants).^[1] As we discuss in Section A below, however, if one accepts Professor Sunstein’s perspective and measures of the domestic benefits of greenhouse gas emissions reductions, his proposed approaches would be unlikely to motivate the United States to enter into such agreements. Specifically, those approaches would actually serve to increase costs to the United States while doing little to increase its perception of domestic benefits (based on the benefits measures that Professor Sunstein uses). While incentive-based approaches are likely to be important components of a cost-effective approach to reducing greenhouse gas emissions, we point out in Section B that Professor Sunstein does not give sufficient attention to the serious implementation challenges that would be associated with a global cap-and-trade program. Finally, we suggest in Section C that the measures of domestic benefits that Professor Sunstein presents do not adequately incorporate a primary motivation for agreeing to greenhouse gas restrictions: reducing the possibility that the buildup of those gases could lead to extremely large, potentially even catastrophic, damage that could not easily be allocated among countries.^[2]

A. Distribution of Costs and Benefits in a Global Emissions-Reductions Scheme

Any effort to make meaningful reductions in global emissions of greenhouse gases would have to involve the world’s five major emitters: the United States, China, the European Union (EU), Russia, and India (see Table 1). As Professor Sunstein points out, available estimates of the damage that the United States and China would incur (inadequately accounting for the uncertain possibility of catastrophic outcomes, as discussed below) as a result of a 2.5 ^oC increase in average global temperature may provide an insufficient incentive for either the United States or China to agree to incur significant costs to reduce emissions.^[3] Further, China may be less willing to shoulder even more modest costs given its low per capita income. Among those five top emitters, India is predicted to benefit the most from reduced warming, but like China, it has far fewer economic resources to devote to the problem than either the United States or the EU. Among the key players, the countries in the EU stand out as likely to benefit significantly from reduced warming (again, in expected value terms and without accounting for very uncertain but potentially very large damage), having sufficient per capita income so that reasonable levels of emission reductions would not pose undue hardship, and having contributed significantly to the stock of emissions in the past.

Sunstein observes that changing the dynamics of international negotiation would require a method of increasing perceived benefits and reducing perceived costs for some of the major emitters. He suggests that a global tax or cap-and-trade program might help achieve such an outcome. We agree that a global incentive-based approach would lower the aggregate cost of reducing emissions and could lead to greater total reductions. It would be much less likely, however, to alter the distribution of potential benefits (as indicated by the distribution of expected damage presented in Table 1), which is independent of where and how emission reductions occur.^[4]

Sunstein also suggests that major emitters with sufficient means could increase the benefits that China would receive from restricting emissions by paying it to undertake reductions, and that such payments could be built into a global cap-and-trade program through the allocation of allowances (that is, rights to emit).^[5] If China were given enough allowances to cover its anticipated growth in emissions, any reductions in its emissions relative to that baseline would free up allowances that it could sell at a profit. However, giving China enough allowances to provide it with unrestricted growth potential would mean that other major emitters, such as the United States, would need to receive far fewer allowances than their business-as-usual baseline. The result would, therefore, essentially transfer income from the United States to China—improving the benefit-to-cost ratio for China but worsening it for the United States.

B. Implementation Challenges of a Global Cap-and-Trade Program

Linking the cap-and-trade programs of various countries could help minimize the overall cost of reducing emissions but could also create significant concerns. Competitive forces would equalize the price of allowances among countries, a desirable outcome in that it is a necessary condition for global cost-minimization. However, countries would have to give up sovereignty over the price of allowances traded in their programs as well as control over the standards governing emissions reductions. Lax monitoring or enforcement by any one country would lessen the incentive to cut emissions in other participating countries and could undermine the integrity of the whole system. Including developing countries in a cap-and-trade program could increase the likelihood of that outcome since such nations may lack the institutional structures necessary for successful monitoring and enforcement.^[6]

A harmonized tax—implemented in different countries at an agreed-upon rate—could avoid one of the potential problems of a linked cap-and-trade program: lax monitoring and enforcement in one country would not undermine the integrity of the tax system in other countries.^[7] If such a tax were agreed to by developed countries, some of the revenue proceeds could be used to fund emission reductions in developing countries in ways that would depend less on the ability of the country to monitor and enforce an incentive-based policy.^[8] For example, China could agree to require new electricity-generating facilities to meet certain efficiency standards, which would be funded by proceeds from the tax on CO₂ emissions in developed countries.

A similar outcome could be achieved through a system of harmonized domestic cap-and-trade programs. In that case, countries could agree to: adopt equivalent domestic cap-and-trade programs (with similar expected allowance prices), sell a share of the allowances and use some of the auction proceeds to fund emission reductions in developing countries.^[9]

Either the harmonized tax and transfer—or the harmonized cap-and-trade and transfer—policy described above could reduce the problem of system integrity associated with a global cap-and-trade program, but neither would create a more favorable benefit-to-cost ratio for the United States, based on the distribution of expected damage (and, thus, potential benefits) presented in Table 1. Those measures do not, however, reflect the fundamental uncertainties associated with climate change and, as a result, may not adequately capture a primary motivation for limiting greenhouse gas emissions.

C. The Uncertain Possibility of Catastrophic Consequences

Estimating the damage that might result from unrestrained growth in emissions of greenhouse gases is complicated by several factors. Once emitted, greenhouse gases can linger for a very long time in the atmosphere (for example, each ton of CO₂ generates a rise in the average global temperature that peaks about 40 years after the CO₂ is emitted and then dissipates slowly, with a half-life of about 60 years), and the damage that they create could be irreversible.^[10] Further, analysts face profound uncertainties about baseline emissions, the physical processes leading to changes in the average global temperature, the resulting changes in regional climates, and ecological and human responses to changes in regional climates.^[11] Potential outcomes from unrestricted emissions include a much larger temperature increase than the 2.5 ^oC value on which the Table 1 damage estimates are based; a weakening of the Gulf Stream, resulting in a much colder climate in Europe; rapidly rising sea levels, with resulting land losses; and far more rapid warming than anticipated (making adaptation much more difficult) as a result of strong positive feedback effects, such as the release of large quantities of methane (a potent greenhouse gas) due to melting permafrost. Yet, scientists have been unable to determine what level of greenhouse gas buildup would trigger such outcomes, and the risk of them occurring is captured very imprecisely in the damage estimates presented in Table 1. Specifically, those highly uncertain, but potentially extremely large, losses are essentially translated into much smaller, but certain, losses.^[12]

Critics of the damage estimates presented in Table 1 suggest that alternative ways of incorporating the profound uncertainties associated with climate change (methods that better reflect the variation in possible outcomes around expected outcomes) would result in far higher potential damage estimates.^[13] In fact, some analysts suggest that reducing the risk of catastrophic outcomes is the primary motivation for restricting emissions.^[14] Further, if damage in individual regions grew to very large levels, the spillover effects to other regions could be large, making the allocation of catastrophic damage across different countries more difficult.^[15] If the uncertain possibility of extremely large losses was better accounted for and the potential for spillover effects was taken into account, the motivation for countries, such as the United States, to agree to emissions restrictions could be much greater than the damage estimates presented in Table 1.

Scientists will continue to work at improving their understanding of the conditions under which catastrophic outcomes might occur while analysts strive to develop better methods of incorporating uncertainty into analyses of the costs and benefits of restricting emissions. Meanwhile, policymakers must grapple with these uncertainties and understand the limitations of available damage estimates. Applying an insurance framework to policy decisions might be helpful; while imposing costs on the economy, restricting emissions could be viewed as a method of buying a reduction in the risk of triggering much larger losses than those presented in Table 1 (or of being in position to reduce emissions much more quickly should scientists judge that the concentration of emissions in the atmosphere was approaching a critical threshold that would trigger those very large losses). Adopting that insurance perspective could cause major emitters to revise their perceptions of domestic costs and benefits and provide a foundation for a global agreement.

TABLE 1. FACTORS AFFECTING COUNTRIES’ POTENTIAL WILLINGNESS AND ABILITY TO IMPLEMENT A CARBON DIOXIDE TAX OR CAP-AND-TRADE PROGRAM
	Contributions to GHG Emissions1 (Measured as a percentage of global emissions)					Governance Indicators3 (Country’s percentile rank)
Country	Current (in 2000)	Future (projected for 2030)	Historic 1850 to 2002	Damages from 2.5 oC Warming (as a % of GDP)1	Per Capita2 GNI	Government Effectiveness	Regulatory Quality	Rule of Law	Control of Corruption
United States	20.6	18.6	29.3	0.45	44,970	90th-100th	90th-100th	90th-100th	75th-90th
China	14.7	24.5	7.6	0.22	2,010	50th-75th	25th-50th	25th-50th	25th-50th
European Union	14.04	16.35	26.54	2.836	34,1497	75th-80th8	75th-80th8	75th-80th8	75th-80th8
Russia	5.7	n.a.9	8.1	-0.65	5,780	25th-50th	0-25th	0-25th	0-25th
India	5.6	5.0	2.2	4.93	820	50th-75th	25th-50th	50th-75th	50th-75th
1. Measures used as reported in Sunstein, supra note 1, at __. 2. Gross national income (GNI) converted to U.S. dollars using the World Bank Atlas method. See World Bank, World Development Indicators 2007 (2007). 3. Daniel Kaufmann, Aart Kraay, & Massimo Mastruzzi, Governance Matters VI: Governance Indicators for 1996-2006 (World Bank Pol’y Res. Working Paper No. 4280, 2007), available at http://ssrn.com/abstract=999979. 4. Includes countries in the EU with the exception of Romania and Bulgaria. 5. Includes all countries in Europe. 6. Includes all European countries in the Organisation for Economic Co-operation and Development (OECD). 7. Includes all countries in the European Monetary Union. 8. Reflects average of European countries in the OECD. 9. Included in future emissions for all countries in Europe.

^[1] This observation holds regardless of which level of government adopts the policy intervention. For a discussion of how the distribution of costs and benefits among states affects the likelihood of reaching an agreement on the control of tropospheric ozone, see Terry Dinan & Natalie Tawil, Solving Environmental Problems with Regional Decision-Making: A Case Study of Ground-Level Ozone, 56 Nat’l Tax J. 1 (March 2003). We also note that many analyses that consider emissions restrictions from a global perspective suggest that well-designed policy actions to slow climate change would produce larger benefits than costs.

^[2] While Professor Sunstein has written extensively about the role that concern about catastrophic outcomes plays in shaping climate policy, the expected value measures of damage that he presents here do not adequately represent those outcomes. See Cass R. Sunstein, Worst-Case Scenarios (2007).

^[3] In reality, the increase in the average global temperature resulting from unchecked emissions may be much larger than 2.5 ^oC. Further, preventing an increase of 2.5 ^oC may not feasible given the emissions that have already occurred. However, the pattern of relative damage across countries is likely to provide insight into the pattern of relative benefits for policies that restrict emissions.

^[4] A global incentive-based approach could affect the distribution of benefits only if it led to much larger emission reductions than would have occurred under non-linked programs. In that case, adopting a global approach could alter the types of damages that would be avoided and, as a result, the distribution of benefits.

^[5] Others have suggested a similar approach. See, e.g., Robert Stavins, Brookings Institution, A U.S. Cap-and-Trade System to Address Global Climate Change (2007), available at http://www.brookings.edu/papers/2007/10climate_stavins.aspx.

^[6] See Table 1 for a cross-country comparison of governance indicators.

^[7] In addition, countries would have a greater incentive to enforce a harmonized tax than a global cap-and-trade program. For a discussion of this point, see William D. Nordhaus, To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming, 1 Rev. Envtl. Econ. & Pol’y 26, 33 (Winter 2007).

^[8] See Joseph E. Aldy, Peter R. Orszag, & Joseph E. Stiglitz, Climate Change: An Agenda for Global Collective Action (paper prepared for the Pew Center on Global Climate Change Workshop on the Timing of Climate Change Policies, October 11–12, 2001), available at http://www.sbgo.com/Papers/Aldy-Orszag-Stiglitz_5.pdf; Joseph E. Aldy, Scott Barrett, and Robert N. Stavins, Thirteen Plus One: A Comparison of Global Climate Change Policy Architectures (Kennedy Sch. Gov’t Working Paper Series, Paper No. RWP03-012; FEEM Working Paper No. 64.2003, July 2003), available at http://ssrn.com/abstract=385000.

^[9] Assuring that emitters face similar incentives to reduce their emissions would be more difficult under a system of harmonized cap-and-trade programs than under a harmonized tax, however, because allowance prices would fluctuate with changes in underlying market conditions in individual countries.

^[10] See William A. Pizer, Combining Price and Quantity Controls to Mitigate Global Climate Change, 85 J. Pub. Econ. 416 (2002).

^[11] For an excellent discussion of how these factors, as well as uncertainty and irreversibility on the cost side, affect policymaking, see Robert S. Pindyck, Uncertainty in Environmental Economics, 1 Rev. Envtl. Econ. & Pol’y 45 (Winter 2007).

^[12] The potential for catastrophic losses of the type described above are represented as a single probability (derived from a survey of subjective probability estimates provided by experts) of a 25% loss in global income under a 2.5 ^oC increase in temperature. That aggregate loss was then distributed across countries on the basis of other damage estimates. See William D. Nordhaus & Joseph Boyer, Warming the World: Economic Models of Global Warming, 160-165 (2000).

^[13] See, e.g., Martin L. Weitzman, On Modeling and Interpreting the Economics of Catastrophic Climate Change (working paper, January 14, 2008), available at http://www.economics.harvard.edu/faculty/weitzman/papers_weitzman).

^[14] Robert Pindyck, Presentation at the International Monetary Fund (January 24, 2008).

^[15] Professor Sunstein raises a related point, referred to as “social amplification of risk,” in Worst-Case Scenarios. Sunstein, supra note 3, at 138.

As I have noted earlier, I will occasionally use this blog to clarify misinterpretations of our work. On that note, some recent blog postings seem to warrant a clarification of the main points in CBO’s study, Policy Options for Reducing CO₂ Emissions, regarding what policy analysis has to say about the trade-off among different policies to reduce carbon emissions.

CBO’s study evaluated a variety of incentive-based approaches—including taxes on carbon dioxide emissions and several variants of cap-and-trade programs—that policymakers might use to achieve long-term emission reduction targets. Key conclusions include:

• Policies that keep emission reductions on a downward trajectory—but allow firms’ emission reduction efforts to vary from year to year—can achieve equivalent benefits at significantly lower economic costs than policies that impose less flexible annual emission caps.
• Policies that allow emissions to vary from year to year do not necessarily imply weak long-term emission reduction targets. Flexible policies can be designed to achieve either modest or ambitious long-term targets. Indeed, flexibility from year to year in emission reductions reduces the cost of achieving a given long-term target and may therefore facilitate stricter long-term targets than would otherwise be feasible.
• A cap-and-trade program that included both a ceiling and a floor on the price of allowances or an emissions tax would be the most cost-effective policies.
• Allowing firms to bank or borrow emission allowances would be more efficient than less flexible cap-and-trade designs, but would offer less cost savings than other approaches.

The Value of Allowing Year-to-Year Flexibility in Emissions. Limiting future changes in the earth’s climate requires restricting the stock of carbon dioxide and other greenhouse gases in the atmosphere, but the year-to-year path of emissions reductions is relatively unimportant. For example, a policy that required firms to reduce emissions by 10 tons each year for 20 years would yield roughly the same ultimate environmental benefits as a policy that achieved the same 200 ton reduction in a 20-year period, but allowed firms to reduce their emissions by more than 10 tons in some years and less than 10 tons in other years. Yet flexibility with regard to the year-to-year path of emissions reductions can significantly reduce the economic costs involved, because in some years it can turn out to be substantially less expensive to reduce emissions than in others (for example, due to weather, conditions in energy markets, economic activity, and the availability of technologies at different points in time). As a result, flexible policies have the potential to achieve the same environmental benefits at a lower economic cost. (In contrast, an efficient approach to controlling a toxic pollutant might provide firms with little or no flexibility to shift emission reductions across time periods because variations in emissions at any given point in time can lead to large differences in environmental harm.)

How much can providing year-to-year flexibility in emission reductions reduce cost? Analysts conclude that providing flexibility in the year-to-year path of emissions would offer large cost savings by allowing firms to make greater cuts in emissions when costs are low and fewer when costs are high. Leading researchers have concluded that a rising tax (which would provide the most flexibility about how emission reductions could be allocated across time) would be roughly five times more efficient than a declining cap that did not offer any year-to-year flexibility. (As described below, flexible cap designs are possible that approach the efficiency of a tax. Either would be more efficient than an inflexible cap.) Researchers have found this conclusion to be robust even when they altered important assumptions, such as the form of cost uncertainty, the degree to which costs are correlated across time, and the period of time over which the choice of policy instrument could not be altered (1 year, 10 years, or 100 years).¹

Year-to-Year Emission Fluctuations and Tipping Points. Some analysts believe that studies concluding that flexible policies are more efficient than inflexible ones fail to account for the potential existence of “tipping points” (critical temperature increases beyond which there could be sharp increases in the damage from climate change). Examples of tipping points are temperature increases that might lead to the melting of the West Antarctic ice sheet—triggering a large rise in sea level—or a shut-down of an important circulation pattern in the Atlantic Ocean. This assertion, however, is unfounded. Specifically, researchers find that the potential existence of tipping points (also referred to as thresholds, or “kinks” in the damage function) will not justify an inflexible policy unless there is certainty about where the kink is located and the threshold is sufficiently near to current concentration levels that policymakers would want to virtually shut down emissions—regardless of the cost—to avoid, or delay, crossing it.² Although there is a genuine concern about the existence of tipping points, there is a great deal of uncertainty about what temperature increases will trigger them, as well as basic uncertainty about the relationship between annual emission flows and future temperature changes.³ In its most recent report, the Intergovernmental Panel on Climate Change concluded that there has been “little advance on…the proximity to thresholds and tipping points.” (p. 77) In addition, uncertainty about abrupt changes and the process that would lead up to them were featured in the report’s description of the two most important climate-science-related needs.⁴ Despite that uncertainty about the potential damage from climate change and the proximity of the current global temperature to tipping points, most analyses suggest that a carefully designed program to begin lowering emissions of carbon dioxide would produce greater benefits than costs. Reducing the risk of triggering large damages will require substantially reducing the flow of carbon dioxide into the atmosphere.

Allowing Year-to-Year Flexibility in Emission Reductions Need Not Imply Weak Policies. Taxes, inflexible caps, or flexible caps can all be designed to achieve either modest or ambitious multiyear emission reduction targets. Regardless of the target, however, the cost of achieving it will be far less if firms are given flexibility as to how reductions can fluctuate from year to year (while maintaining the necessary downward trend) than if they are not given such flexibility.

The Choice is Not Between Taxes and Inflexible Caps: Cap-and-Trade Programs Can Offer Varying Degrees of Flexibility. Policymakers can provide firms leeway in annual emission reductions in a variety of ways while ensuring that total emissions follow a desired long-term trajectory. Rising taxes are one method. Tax rates would need to be adjusted over time if they failed to induce the desired cumulative reduction in emissions over multiple years. Alternatively, a cap-and-trade program that included both a price floor and a price ceiling could achieve much of the efficiency advantages of a tax. The rate at which the cap declines—and that the price floor and ceiling increase—could be set to aim for a cumulative long-term emission reduction target. The policy could include provisions that would trigger a more rapid rise in the price floor and ceiling if it was failing to provide the desired cumulative emission reductions over a multiyear period. Finally, allowing firms to bank and borrow allowances can help reduce the cost of achieving a long-term emission reduction target relative to a system of inflexible annual caps. Those provisions, however, are unlikely to provide cost savings as substantial as those that might result from the alternative approaches.

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[1] For example, see Willam A. Pizer, “Combining Price and Quantity Controls to Mitigate Global Climate Change,” Journal of Public Economics 85 (2002) pp. 409-434; Richard G. Newell and William A. Pizer, “Regulating Stock Externalities Under Uncertainty” Journal of Environmental Economics and Management 45 (2003) pp. 416-432; Michael Hoel and Larry Karp, “Taxes and Quotas for a Stock Pollutant with Multiplicative Uncertainty,” Journal of Public Economics 83 (2001) pp. 91-114.

[2] See William A. Pizer, Climate Change Catastrophes, Resources for the Future Discussion Paper (May 2003); Willam A. Pizer, “Combining Price and Quantity Controls to Mitigate Global Climate Change,” Journal of Public Economics 85 (2002) pp. 409-434.

[3] For example, see Stephen H. Schneider and others, “An Overview of Dangerous Climate Change” in Avoiding Dangerous Climate Change, edited by Hans Joachim Schellnhuber and others, (Cambridge University Press, 2006).

[4] See Technical Summary of Working Group II of the Intergovernmental Panel on Climate Change, pp. 77-78, available at www.ipcc.ch.

CBO released a new report today on policy options for reducing carbon emissions.

Global climate change represents one of the nation’s most serious long-term problems. Rising concentrations of CO2 and other greenhouse gases are gradually warming the Earth’s climate, and some risk exists that the buildup of those gases could trigger abrupt changes and extreme damage. Substantially reducing emissions of those gases, however, could impose significant costs on the U.S. and global economies.

Minimizing the costs involved in reducing emissions would require a reliance on incentive-based policies that provide flexibility about where and how such reductions will take place, rather than more restrictive command-and-control style policies (such as technology standards).

In this study, CBO examined a variety of incentive-based policies for reducing CO2 emissions, including a tax and a cap-and-trade system:

• A tax would set an upper limit on the cost of emission reductions—firms would undertake reductions that cost less than the tax—but would leave the amount of emissions uncertain.
• An inflexible cap-and-trade program would set an upper limit on the amount of emissions but would leave the cost of reducing emissions uncertain.
• A flexible cap-and-trade program would maintain the structure of a cap-and-trade program, but would include features designed to limit the cost of meeting the cap. Specifically, a cap-and-trade program could include one or more of the following:
  • A price ceiling (often referred to as a safety-valve) and/or a price floor;
  • Provisions that permit firms to “bank” unused allowances in one year for use in a future year and/or “borrow” future allowances for use in an earlier year;
  • Provisions to make the cap less stringent if the price of allowances rises beyond an agreed upon amount. A “circuit breaker” would directly modify the cap. Alternatively, the government could indirectly modify the cap by changing the terms under which firms could use borrowed allowances.

The study examines the relative efficiency and administrative issues surrounding these approaches. It should be noted that other criteria could be of interest to policymakers in determining how best to address concerns about climate change. For example, economic efficiency addresses how well policies might function to minimize the cost of reducing emissions over a period of several decades; however, policymakers may choose to place more emphasis on providing certainty about the amount of emissions at specific points in time. Similarly, policymakers may also wish to focus on how different policy designs affect different segments of society.

The study finds that:

• A tax could achieve a long-term emission reduction target at a much smaller economic cost than an inflexible cap.
  • Provided that the tax was set equal to the expected benefit of reducing a ton of CO2, a tax could thus result in substantially greater net benefits (benefits minus costs) than a comparable cap-and-trade program.
  • The advantage of a tax stems from the long-term nature of climate change (which depends on the build-up of emissions over many decades, but is not sensitive to the amount of emissions in any given year) and the uncertain and variable nature of the cost of reducing emissions (which will vary from year to year based on the weather, conditions in energy markets, and the availability of new technologies).
  • An inflexible cap-and-trade program would provide more certainty about annual emissions than would a tax; however, that certainty would come at a cost: The cap would require too many reductions when the cost of achieving them was high and would mandate too few reductions when the cost was low.
• Flexible cap-and-trade programs could achieve some, but not all, of the efficiency-improving/cost-minimizing advantages of a tax:
  • Out of the flexible cap designs that CBO considered, a cap-and-trade program that included both a safety valve and either a price floor or banking provisions could offer the greatest potential to minimize the cost of meeting a given long-term target.
  • Including a circuit breaker, or altering the extent to which firms could use borrowed allowances, could help prevent the price of allowances from going higher than policymakers wanted. Either approach, however, would be less direct, and less effective than including a safety valve.
• Either a tax or a cap-and-trade program could be relatively easy to implement.
  • Some flexible design features, such as banking, borrowing or a safety valve, would be straightforward to implement.
  • In contrast, price volatility in the allowance market could make it difficult for the government to know when to implement a circuit breaker (or to change the terms associated with borrowing allowances).
• Minimizing the cost of reaching a global emissions target would entail undertaking the lowest-cost emission reductions regardless of where in the world they were located.
  • If coordinated among emitting countries, a tax would help minimize the cost of achieving any given target.
  • Linking the cap-and-trade programs of various countries could help minimize global costs, but could create some significant concerns:
    • Countries would give up sovereignty over the price of allowances traded in their programs.
    • Poor monitoring or enforcement in any one country could undermine the integrity of the allowances traded throughout the whole system.
    • Flexible design features, such as a safety valve, banking, or borrowing, would become available to all regulated entities in the linked system.
  • Major emitting countries could help minimize global cost of reducing emissions by establishing national cap-and-trade programs that each included a safety valve set at roughly the same level.

The report was written by Terry Dinan, who joined CBO in 1989.  She is a member of the Microeconomic Studies Division and serves as CBO’s Senior Advisor for Climate Policy.  She has written numerous CBO papers examining the effects of alternative policies for reducing carbon dioxide emissions as well as addressing other environmental issues, including CAFE standards, drinking water regulations, and the control of ground-level ozone.  She has published in a variety of journals, including the Journal of Environmental Economics and Management, the National Tax Journal, the Journal of Urban Economics, the Journal of Regulatory Economics and the Natural Resources Journal.  She served as an associate editor for the Journal of Environmental Economics and Management and was on the board of directors for the Association of Environmental and Resource Economists.  She has a Ph.D. in economics from Iowa State University.  Terry drives a Prius and rides her bike to work when her schedule permits.