Climate Change

Testimony on Cap and Trade

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Appearing before the Senate Energy and Natural Resources Committee on May 20, CBO Director Peter Orszag explained how two key design decisions about a cap-and-trade system for carbon dioxide emissions would affect its cost: first, how flexible the system is in allowing businesses to adjust the timing of their emission reductions year to year and, second, how the value of this new commodity, an emission allowance, or the right to emit carbon dioxide, is used.

From the Director

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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 carbon dioxide, and their accumulation in the atmosphere is expected to affect regional climates throughout the world. Although the economic and social costs from climate change remain highly uncertain, there is some risk that they will turn out to be quite large. The associated risks could be reduced by policies that reduced emissions of greenhouse gases.

Efforts to limit greenhouse gas emissions are likely to yield long-term economic benefits by avoiding damages from climate change in the future, but they would also impose economic costs in the present, primarily by restricting the use of fossil fuels. Those costs would tend to be minimized by policies that provided broad incentives to reduce emissions, relying on markets to do so where it is most economically efficient. However, different incentive-based approaches can have substantially different effects both on economic efficiency and on equity (that is, on how the costs are distributed among businesses and individuals).

One approach would be to levy a gradually rising tax on sellers or consumers of fossil fuels in proportion to the carbon dioxide emitted in burning the fuels. Another approach would be to establish a "cap-and-trade" program, in which 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.

Either approach would create an incentive to reduce emissions at a lower cost than "command and control" style regulations that specify when, where, and possibly how, emission reductions must take place. However, not all incentive based policies will be equally cost-effective. Policies that allow individuals and firms leeway to cut emissions less in years when it is costly to do so (for example, due to an unusually cold winter or a disruption in energy markets) while motivating them to undertake greater reductions in relatively low-cost years can reduce the cost of meeting a long-term emissions target. A gradually rising tax-or a cap-and-trade program that includes a price floor and ceiling-would provide firms with such leeway. As a result, either of those policies would be likely to be more cost-effective than cap-and-trade programs that have less flexible annual caps.

On the basis of the various proposals currently under consideration, emission allowances (or emission tax revenues) might be worth between $50 billion and $300 billion per year (in 2007 dollars) by 2020. How policymakers decided to allocate allowances (or use the revenues) could strongly influence both the impact of the policy on the economy and on businesses and individuals. Given the potential magnitude of the allowance value and the liquidity of the secondary market for them, CBO has decided that allowances that are given away by the government should be reflected in the federal budgetary scoring process--specifically, the scoring should show, as both revenues and outlays, the value of any allowances created and distributed at no cost to the recipient.

CBO has a team of economists, budget analysts, and other policy specialists examining the economic and budgetary consequences of climate change. This Web page provides links to many of the agency's documents and activities on the topic.

2007 Director's Conference on Climate Change

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CBO Director Peter Orszag hosted the 2007 Director's Conference on Climate Change in November 2007. The conference featured leading researchers addressing key questions in the debate on climate change.