Gasoline consumption can be reduced in many ways--through technological improvements in the design of vehicles as well as through a variety of behavioral changes on the part of motorists. For example, manufacturers could increase the fuel economy of new vehicles or produce vehicles that use alternative fuels, such as ethanol. Consumers could purchase relatively fuel-efficient vehicles and hasten the retirement of older, less efficient ones. They could shift some of their driving to the most efficient car they own, reduce the number of miles they drive (such as by carpooling, using public transportation, or forgoing long trips), maintain their vehicles better, or drive more slowly.

Each of those gas-saving activities would impose costs on the producer or consumer who undertook it. People can be expected to make such changes voluntarily when the benefits to them would outweigh the costs. For example, drivers would choose more-fuel-efficient vehicles if they anticipated that their gasoline savings would be greater than the disadvantages that might be associated with such vehicles (say, a higher price or less horsepower). Likewise, manufacturers would voluntarily improve the fuel economy of their vehicles if they expected that doing so would boost their profits.

If the federal government raised the gasoline tax, tightened CAFE standards, or created a cap-and-trade program, it would generate further gasoline savings by inducing producers and consumers to undertake such activities to a greater degree than they would otherwise.⁽¹⁾ In all three cases, the costs to producers would take the form of lower profits, and the costs to consumers would take the form of reductions in their well-being, because of both monetary costs (such as price increases) and nonmonetary costs (such as reduced satisfaction from driving a less-powerful vehicle or inconvenience associated with carpooling).

The three policy options would differ in which parties they would affect directly and indirectly. Raising the tax would have a direct impact on consumers of gasoline because it would increase the amount they could save by reducing their gasoline use. It would affect automakers and gasoline producers indirectly by raising consumers' demand for fuel economy in new vehicles and lowering their demand for gasoline. A cap-and-trade program, in contrast, would affect gasoline producers and importers directly by requiring them to hold emission allowances. It would have an indirect effect on gasoline consumers (who would face higher prices) and on automobile producers (who would see greater demand for fuel economy). Raising CAFE standards, unlike the other two policies, would have a direct impact on automakers by requiring them to meet more-stringent fuel economy standards. It would affect car buyers indirectly through changes in the vehicle characteristics that manufacturers offered and the prices they charged. Higher CAFE standards would also affect gasoline producers indirectly by lessening the demand for gasoline.

Some proponents argue that raising CAFE standards would not impose any costs. They contend that automakers have low-cost ways to improve fuel economy, that the gasoline savings from those technologies would make consumers better off, and that without increases in CAFE standards, producers would fail to make use of those technologies. Their argument rests on the assumption either that consumers lack information about vehicles' fuel efficiency (in other words, they do not know what is best for them) or that producers lack an incentive to respond to consumers' preferences for fuel efficiency. (That issue is discussed in detail later in this study; see Box 2.)

Most economists do not believe that either assumption is valid. Vehicles' current level of fuel efficiency most likely reflects consumers' trade-offs between fuel economy and other characteristics that drivers want, such as vehicle size, horsepower, and safety. The same technologies that can be used to boost fuel economy can be used to hold fuel economy constant while increasing vehicles' weight, size, or power. Thus, the fact that producers have done the latter rather than the former in recent years suggests that they have responded to buyers' preferences by targeting available technologies toward other features that consumers desire. Raising CAFE standards would impose costs on both consumers and automobile producers by forcing improvements in fuel economy that car buyers may not want.

Society would be best off if the costs of a policy to decrease gasoline consumption were weighed against the benefits of the decrease. In an ideal world, policymakers would encourage reductions in gasoline use up to the point at which the incremental cost--the cost of reducing an additional gallon of gasoline--that those reductions would impose on producers and consumers equaled the incremental benefit that would result (from fewer carbon emissions and less energy consumption). However, quantifying the benefits and costs of such reductions to determine that ideal point is a difficult task and one that is beyond the scope of this analysis.

A less demanding criterion is to make policy changes that are "cost-effective"--in other words, that keep the decline in producers' profits and consumers' welfare to a minimum for any given level of gasoline savings. The incremental cost of a gasoline-saving activity will rise as the level of that activity grows. (For example, if automakers sought higher and higher levels of fuel economy, the cost of making an additional improvement in fuel economy would increase.) Because producers and consumers have so many methods to reduce gasoline use, which can be combined in various ways or traded off for each other, policies would be most cost-effective if they gave people the flexibility to pursue as many of those methods as possible, up to the point at which each method reached the same incremental cost. (For instance, the total cost of decreasing gasoline consumption could be lessened by relying more heavily on reduced driving and less heavily on improvements in fuel efficiency if the incremental cost for the former activity was lower than for the latter.) By contrast, policies that put all of their eggs in a few baskets--by encouraging some gas-saving activities but not others--would not produce the most cost-effective reductions in gasoline use.
 

The Cost-Effectiveness of Raising CAFE Standards

Increasing the stringency of CAFE standards would most likely reduce gasoline consumption, but it would not do so in a cost-effective way. The reason is that CAFE standards do not directly encourage either producers or consumers to decrease gasoline use, so they do not offer the flexibility or the incentives for gasoline reductions to occur at the lowest possible cost. That lack of cost-effectiveness springs in part from shortcomings in the current design of CAFE standards, which would allow automakers to comply with higher standards in ways that would not increase the average fuel economy of their vehicles. It also springs from problems that are intrinsic to any policy that regulates fuel economy instead of providing a direct incentive to reduce gasoline consumption.

Automakers' Compliance Strategies
Raising CAFE standards gives manufacturers a strong incentive to increase the average fuel economy of the vehicles they sell (because otherwise they must pay a fine). Automakers could use five different strategies, individually or in combination, to comply with higher standards.

First, and most obvious, they could improve the fuel economy of some or all of the vehicles they sell through technological changes. One general way to boost a vehicle's fuel economy is to increase the overall efficiency of its power train (the mechanism that transfers power from the engine to the axles) in order to reduce energy losses. Another way is to decrease the amount of energy needed to propel the vehicle, by altering its weight, aerodynamics, rolling resistance, or the power drain on the engine from components such as the cooling fan and the air-conditioning compressor.⁽²⁾

Second, manufacturers could give consumers financial incentives to buy their more-fuel-efficient vehicles. That strategy, called mix shifting, involves subsidizing (through lower prices) the sale of more-fuel-efficient vehicles and charging a premium (through higher prices) for less-fuel-efficient ones. Because there are separate standards for cars and light trucks, mix shifting could occur within each category but not between categories. Some studies have shown that mix shifting is more expensive than technology improvements and that although some mix shifting takes place, automakers have relied mainly on technological changes to comply with CAFE standards.⁽³⁾

Third, manufacturers could alter the domestic content of their vehicles. Because they must comply with separate (though identical) standards for their domestic and imported fleets, automakers cannot use relatively fuel-efficient imports to offset less efficient domestically produced vehicles. (Imported cars are typically more fuel efficient than domestic ones because they also cater to foreign markets, where consumers often face higher gasoline prices than in the United States.) By altering the amount of their vehicles' value that is produced in the United States or Canada so that domestic cars can be reclassified as imports, automakers could use the higher fuel economy of their imported fleet to offset the lower fuel economy of what would otherwise be domestic vehicles. One researcher has concluded that such a strategy could lower manufacturers' compliance costs significantly, but the extent to which they have used it is unknown.⁽⁴⁾

Fourth, automakers could alter the design of cars so that they would be reclassified as trucks and thus face a lower CAFE standard. Anecdotal evidence of that practice exists (for example, Chrysler's PT Cruiser, which can carry just four passengers and cannot tow a trailer, qualifies as a truck because it has a removable backseat). However, the extent of that practice is unknown.⁽⁵⁾

Policymakers established a lower CAFE standard for light trucks because when the standards were created, light trucks were primarily work and cargo vehicles that needed extra power, different gearing, and less aerodynamic designs to perform their work-related functions. At that time, they accounted for about 20 percent of new vehicles sold. Today, light trucks constitute nearly half of new vehicles sold, and many of them are used almost exclusively for personal transport rather than for work or cargo.⁽⁶⁾

Fifth, manufacturers could make "flex-fuel" vehicles--which can operate on ethanol as well as gasoline--as part of their compliance strategy. The government assumes that such vehicles will be operated on gasoline only half of the time, and it counts only miles per gallon of gasoline for compliance purposes. For example, a vehicle that got 20 miles per gallon when running solely on gasoline would be classified as a vehicle with a fuel efficiency of 33 MPG if it was also capable of running on ethanol.⁽⁷⁾

Problems with the Current Design of CAFE Standards
Raising CAFE standards would fall short of the cost-effectiveness ideal in part because of the current design of those standards. As noted above, automakers can comply with them in ways that do not lead to lower gasoline use. Altering the manufacture or design of vehicles so they count as imported rather than domestic or as light trucks rather than cars neither raises the overall fuel economy of passenger vehicles nor reduces gasoline consumption. Producing flex-fuel cars can also achieve CAFE compliance without decreasing gasoline use if those cars are not actually run on ethanol, as seems to be the case.⁽⁸⁾ The lower the price of gasoline--and hence the less that buyers want relatively fuel-efficient cars--the more incentive manufacturers have to find ways of complying with CAFE standards that do not involve altering the fuel economy of their vehicles and do not lead to lower gasoline consumption.

In addition, manufacturers can avoid CAFE constraints altogether by producing vehicles that exceed 8,500 pounds. For example, the Ford Excursion, which is used as a passenger vehicle, weighs more than 8,500 pounds and thus is not subject to any CAFE limit.

If higher standards caused car prices to increase more than light-truck prices, some consumers might switch from buying cars to buying light trucks that use more gasoline.⁽⁹⁾ Such switching would not put manufacturers out of compliance but would lead to greater gasoline consumption.

Another problem with the standards' current design is that since each manufacturer must meet CAFE standards for its own fleet, the incremental cost of further improvements in fuel economy will differ among automakers. The total cost of improving fuel economy would be lower if manufacturers with relatively high compliance costs were allowed to undercomply, so long as manufacturers with relatively low costs overcomplied by the same amount (as measured in gasoline consumption).⁽¹⁰⁾

Those shortcomings of the CAFE program could be reduced by making various design modifications to the current standards. (For more details, see Box 1)
 

Box 1. Making CAFE Standards More Cost-Effective by Improving Their Design The same level of fuel efficiency that corporate average fuel economy (CAFE) standards require today might be achieved at a lower cost if the current CAFE program was restructured. That program includes distinct standards for cars and light trucks, requires automakers to comply separately for domestic and imported cars, and makes each company meet the standards individually rather than measuring compliance at the industry level. All three of those features limit manufacturers' behavior without reducing gasoline consumption. Easing those constraints could potentially lower the costs of complying with the current CAFE standards. Setting a Single Standard for All Vehicles Reducing gasoline consumption imposes some monetary and nonmonetary costs on producers and consumers; the issue is how best to minimize those costs. With most automakers required to meet several standards (for domestic cars, foreign cars, and light trucks), total costs will generally not be kept to a minimum. The reason is that the costs of complying with separate standards tend to be unequal at the margin (the point at which a final expenditure, price change, or weight reduction just brings a firm into compliance). Inequalities in marginal compliance costs indicate that the total cost of the CAFE program can be reduced without lowering overall fuel economy. Any given level of fuel efficiency could be achieved more cheaply by allowing manufacturers to undercomply where their marginal costs were highest, as long as they overcomplied by an equivalent amount (in terms of gasoline savings) where their costs were lower. For instance, it may be cheaper for an automaker to save "one more gallon" of gasoline by raising the average mileage of its light trucks somewhat than by raising the average mileage of its domestic cars slightly. Likewise, a firm might be able to increase average mileage more cheaply for its imported vehicles than for its domestic fleet. If a unified standard applied to all of an automaker's light-duty passenger vehicles--including light trucks and domestic and imported cars--companies would be free to take advantage of such cost-saving trade-offs. Moreover, if it was appropriately designed, a unified standard would eliminate manufacturers' incentives to use unproductive compliance methods. In other words, firms could not reduce compliance costs by designing cars that could be classified as trucks or by altering production practices so that cars were classified as imported instead of domestic. Further, a unified standard would not give consumers an incentive to switch from cars to trucks, since trucks would no longer be subject to less-stringent fuel economy requirements. Making the transition to a single standard for all vehicles could pose difficulties, however. A unified standard that reflected the current average fuel economy of all new light-duty vehicles sold would benefit manufacturers that sell mainly cars and penalize firms that sell mainly trucks. For example, the existing car and truck standards (27.5 and 20.7 miles per gallon, respectively) and the roughly 50/50 mix of current car and truck sales imply a unified standard of 24.1 MPG. An automaker that produced 75 percent trucks and 25 percent cars and just met the separate car and truck standards would have an average mileage rating of 22.4 MPG for its total fleet. That firm would be out of compliance under the unified standard, even though it had been in compliance with the separate standards. In contrast, a company that produced 75 percent cars and 25 percent trucks and also just met the separate standards would have a combined fleet average of 25.8 MPG, which would exceed the unified standard. One way around that problem would be to set a separate unified standard for each manufacturer--one that reflected the current requirements for cars and trucks as well as the manufacturer's existing mix of car and truck sales. Such a standard would not alter automakers' compliance status. (In the above example, the first company would be required to meet a unified standard of 22.4 MPG, and the second company would have to meet a unified standard of 25.8 MPG.) But that design would "grandfather" lower standards for manufacturers that now produce a relatively large share of trucks. Alternatively, each automaker's standard could be adjusted annually to reflect that year's mix of car and truck sales. However, such an adjustment would not eliminate companies' incentives to use one unproductive compliance method. Specifically, manufacturers would be able to lower their overall compliance requirements by making vehicles that could be classified as light trucks rather than as passenger cars. Setting a Standard for the Industry as a Whole Under a unified standard for cars and trucks, cost differences would still generally exist among automakers because of differences in the average size and performance attributes of their vehicles and in their manufacturing costs. One way to reduce total costs would be to lessen differences in compliance costs among companies. That could be accomplished through fuel economy credit trading.1 Under such a trading system, the government would set a fuel economy standard for the entire auto industry. Manufacturers that exceeded the standard would generate credits, which they could sell to firms that fell below the standard. (The credits would be measured in gallons of gasoline saved.) Each company's compliance would be based on the fuel economy of the vehicles it sold in a given year, plus the number of fuel economy credits it held. Automakers with lower marginal compliance costs could raise their average MPG ratings above the required level in order to generate credits to sell. Other companies could buy those credits to make up a shortfall in their fleets' mileage ratings.2 It would be cheaper for high-cost firms to buy credits than to achieve the standard directly. (That is roughly the same principle that underlies cap-and-trade programs, in which sources of pollution trade emission allowances.) Letting overcomplying firms sell fuel economy credits to undercomplying firms could minimize total costs to producers and consumers. However, if the industrywide standard was a unified one covering both cars and trucks, credit trading would transfer wealth within the auto industry from companies that now sell a majority of trucks (and would need to buy credits under the unified standard) to companies that now sell a majority of cars (and would have excess credits to sell under the new standard). Of course, credit trading could be implemented either with or without a unified standard for all vehicles. The potential for credit trading to reduce total compliance costs would depend on how much those costs would vary among automakers in the absence of trading. The greater that variation, the greater the possible savings from trading. Further, credit trading would minimize compliance costs only if the market for credits was competitive--that is, if no buyer or seller could influence the price of credits. More research is needed to determine the extent to which credit trading could actually lower the overall cost of meeting CAFE standards. The Congressional Budget Office is currently analyzing that issue. 1.  Such trading was recommended in National Research Council, Effectiveness and Impact of Corporate Average Fuel Economy (CAFE) Standards (Washington, D.C.: National Academy of Sciences, 2002). 2.  Because some manufacturers already achieve greater fuel economy than the current standards require, credit trading could increase gasoline consumption if the standards themselves were not also raised. The reason is that sales of credits by overcomplying firms allow the buyers of the credits to undercomply by an equivalent amount. That would let some companies expand their sales of less-fuel-efficient vehicles. Alternatively, standards could be tightened enough to leave total gasoline consumption unchanged.

Problems with Targeting Fuel Economy
Even if the previous shortcomings were addressed, raising CAFE standards would not be cost-effective for at least two reasons, which are intrinsic to any policy that targets fuel economy. First, those standards do not give people an incentive to change their driving habits in ways that would reduce gasoline use. Instead, CAFE-induced improvements in the fuel efficiency of new vehicles would lower the cost of driving those vehicles and could cause their owners to drive more. Researchers generally assume that a 10 percent decline in the fuel-related costs of driving leads to about a 2 percent increase in the number of vehicle miles driven.⁽¹¹⁾

Second, an increase in CAFE standards could cause some drivers to delay buying new vehicles and instead operate their older, less-fuel-efficient ones longer. Such delays would tend to occur if manufacturers complied with higher CAFE standards by making technological changes that raised car prices. Although all old vehicles would be retired eventually, delaying new-car purchases would postpone the full realization of the fuel-saving benefits associated with technology improvements.⁽¹²⁾
 

The Cost-Effectiveness of Raising the Gasoline Tax

A well-designed increase in the federal tax on gasoline would give consumers a direct incentive to reduce gasoline consumption. As a result, it would encourage them to undertake all of the activities that could lead to lower gasoline use. Consumers would have an incentive to drive less, to rely more heavily on the most fuel-efficient car they owned, to retire gas-guzzling vehicles earlier, and to buy more-fuel-efficient vehicles. In general, people engage in each of those activities up to the point at which the cost of the activity equals the savings in gasoline spending that it brings about. A higher gasoline tax would encourage consumers to undertake more of each of those activities by increasing the value of their gasoline savings. Thus, it could lead to a cost-effective reduction in gasoline consumption.

Moreover, an increase in the gasoline tax would not create incentives for manufacturers to make unproductive design changes that would raise their fleets' MPG ratings by reclassifying vehicles without reducing gasoline use. With a gasoline-tax hike, sales of more-fuel-efficient vehicles would increase (relative to sales of less-fuel-efficient ones) and the fuel economy of vehicles would improve because of changes in consumer demand, not because manufacturers had to meet regulatory requirements.

To be most cost-effective, an increase in the gasoline tax would need to be well designed in at least two ways. First, it would have to cover all uses of gasoline that could be reduced at a cost lower than the tax. As noted in Chapter 1, gasoline purchased by state or local governments or for off-road commercial uses is exempt from the tax. The extent to which such exemptions would reduce the cost-effectiveness of a rise in the gasoline tax would depend on the potential for gas-saving changes in the exempted sectors. If that potential was low (in other words, gasoline consumption in those sectors would not change under the tax), then exempting the sectors would not significantly limit the cost-effectiveness of the tax increase.

Second, a significant rise in the gasoline tax would have to be matched by an equivalent rise in the tax on diesel fuel. Otherwise, drivers might shift to diesel-powered vehicles, lessening the effectiveness of the gasoline-tax increase. (Currently, less than 1 percent of new automobiles sold in the United States are powered by diesel fuel.)⁽¹³⁾

Further, a tax increase would be most effective at reducing gasoline consumption if it was perceived as permanent and was adjusted to keep pace with inflation. If people expected that a rise in the gasoline tax would be removed or would fall over time because of inflation, they would have less reason to buy more-fuel-efficient vehicles.

Some advocates of CAFE standards have argued that failures in the automobile market would prevent an increase in the gasoline tax from leading to improvements in the fuel economy of vehicles (see Box 2). However, most analysts agree that a gasoline-tax increase could be effective in boosting fuel efficiency.
 

Box 2. Is the Market for Fuel Economy in New Vehicles Efficient? An increase in the gasoline tax would lead to the production of more-fuel-efficient vehicles only if it caused consumers to attach a higher value to fuel economy and if producers responded to the rise in demand for more-efficient vehicles. Some advocates of corporate average fuel economy (CAFE) standards argue that a regulatory approach is necessary because the market for fuel economy is not efficient--that is, consumers and producers would not respond in those ways to a rise in the gasoline tax.1 Some proponents of CAFE standards maintain that although fuel economy is displayed on the labels of new vehicles (in the form of miles per gallon for highway and city driving), consumers lack the information to precisely determine their individual savings from greater fuel economy. Those savings depend on the amount of highway versus city driving they will do, their projections of future gasoline prices, and the discount rate (the interest rate used to determine the present value of future benefits and costs) that they select. Although few consumers may make those calculations, the fuel economy information on labels does let them assess the relative fuel economy of vehicles. Without making actual calculations, consumers who expect higher gasoline prices in the future and who are concerned about operating costs (perhaps because they drive a great deal or have tight budgets) will tend to value fuel economy more than consumers who drive less, have larger budgets, or expect lower gasoline prices in the future. There is little reason to believe that a tax increase that significantly raised gasoline prices would not increase the value that consumers attach to fuel economy. Another problem with the automobile market, according to CAFE advocates, is that buyers cannot be expected to take the time and effort to balance their preference for fuel economy against the numerous other features they may care about, such as size, reliability, style, and performance. That does not mean, however, that fuel economy does not affect vehicle choice. Fuel economy, like cargo space or performance, is one of multiple features that influence a buyer's preference for one vehicle over another. Consumers would need to make trade-offs among the relative importance of those features, but in cases in which other features were the same, they would prefer a vehicle with higher fuel economy. If a gasoline-tax increase caused consumers to prefer more fuel economy, producers would have an incentive to take that preference into account when redesigning models. Finally, some proponents of CAFE standards argue that producers would be reluctant to make design changes that would boost fuel economy, because if they made a design mistake, they could lose a significant share of the market for a single vehicle model. Conversely, producers could gain market share by choosing designs that better reflected consumers' preferences for all features, including fuel economy. There is little reason to believe that automakers would be more reluctant to meet consumers' demand for fuel economy than for any other feature. 1.  This description of potential failures in the market for fuel economy is based on David L. Greene, Why CAFE Worked (Oak Ridge, Tenn.: Oak Ridge National Laboratory, November 1997), pp. 3-4.

In addition, studies have found that consumers respond to higher gasoline prices by reducing their gasoline consumption, particularly in the long run. (For more details of those studies, see Box 3.) In the short run, consumers may respond to higher prices mainly by driving less (for example, by carpooling or using public transportation) or by switching some of their driving to the most fuel-efficient vehicle they own. In the long run, consumers can make more-drastic changes to reduce their gasoline use. For instance, they can trade in their vehicles for models with greater fuel economy or choose to live closer to their work.
 

Box 3. The Effect of Price Changes on Gasoline Consumption Consumers' responsiveness to price changes is measured in the form of a "price elasticity." That elasticity indicates the extent to which a 1 percent increase in price would affect the demand for a good or service (measured as a percentage change in the quantity sold). Empirical estimates of price elasticities for gasoline vary greatly, in part because they are sensitive to the type of model used to estimate them. A 1991 survey analyzed 97 price-elasticity estimates for gasoline.1 It defined 18 different categories of models and estimated the average short-run and long-run price elasticity for the types of models most appropriate for measuring those elasticities. The authors found an average short-run elasticity of -0.26 and an average long-run elasticity of -0.86.2 Based on those estimates, a 15-cent increase in the tax on gasoline (or a 10 percent increase in price, assuming a price of $1.50 per gallon) would cause a 2.6 percent decrease in the amount of gasoline used by passenger vehicles in the short run and an 8.6 percent decrease in the long run. An equivalent decline in gasoline consumption would result from increasing the stringency of corporate average fuel economy standards by roughly 10 percent.3 Consumers' responsiveness to changes in gasoline prices could alter over time because of numerous factors, such as changes in average income, options for public transit, and the availability of technologies for improving fuel economy. Some (though not all) more-recent studies have estimated lower long-run price elasticities. Based on a review of those studies, the Department of Energy suggests a long-run price elasticity of -0.38--implying that a 15-cent rise in the gasoline tax would eventually cause a 3.8 percent decline in the amount of gasoline used by passenger vehicles.4 Measuring price elasticities is a difficult task, however, and the elasticities discussed here should be viewed only as rough estimates. 1.  Carol Dahl and Thomas Sterner, "Analyzing Gasoline Demand Elasticities: A Survey," Energy Economics (July 1991). 2.  Seven different categories of models were found to be appropriate for measuring short-run and long-run elasticities. The average elasticity estimates for the categories considered appropriate for measuring the short-run price elasticity ranged from -0.22 to -0.31. The average estimates for categories appropriate for long-run elasticities ranged from -0.80 to -1.01. 3.  That estimate assumes that a 10 percent increase in fuel economy would result in a 2 percent increase in vehicle miles traveled. It also assumes that the increase in CAFE stringency would not cause consumers to switch from cars to trucks and would not cause manufacturers to shift vehicle production from domestic cars to light trucks and imported cars. 4.  Department of Energy, Office of Policy and International Affairs, Policies and Measures for Reducing Energy Related Greenhouse Gas Emissions: Lessons From Recent Literature, DOE/PO-0047 (July 1996).

 

The Cost-Effectiveness of Creating a Cap-and-Trade Program

Like a tax increase, a cap-and-trade program for gasoline-related carbon emissions would reduce gasoline consumption in a cost-effective way. Companies would have to buy emission allowances in order to continue producing or importing gasoline, which most likely would lead to higher prices at the pump. By raising the price of gasoline, a cap-and-trade program would give people an incentive to engage in all possible gas-saving activities, including buying more-fuel-efficient vehicles as well as changing their driving habits.

If the main objective of the cap-and-trade program was to decrease carbon emissions, the same level of emission reductions could be achieved at a lower cost by extending the program as broadly as possible--in other words, by making it apply to all sources of carbon emissions throughout the economy, not just the combustion of gasoline. Under one type of broad program (an "upstream" program), all producers and importers of oil, coal, and natural gas would be required to hold allowances based on the carbon content of their fuel--that is, the carbon emitted when the fuel is burned.⁽¹⁴⁾

The cap on carbon emissions would limit the production of carbon-based fossil fuels and would cause the price of those fuels to rise--with price increases reflecting each fuel's allowance requirements and, hence, its carbon content.⁽¹⁵⁾ Those price increases would raise companies' and consumers' costs, encouraging them to decrease their use of fossil fuels and energy-intensive goods and services. As a result, households and businesses throughout the economy would have an incentive to reduce all forms of carbon consumption and thus carbon emissions. (For example, utilities, which account for 38 percent of U.S. carbon emissions, would have an incentive to rely less on coal, which is the most carbon-intensive fossil fuel.) In short, an upstream cap-and-trade program would create an economywide incentive to decrease carbon emissions and would ensure that reductions were made at the lowest possible cost.

In contrast, a cap-and-trade program that covered only producers and importers of gasoline would confine incentives for cutting carbon emissions to the gasoline-consuming sector--which accounts for just 20 percent of U.S. carbon emissions. Such a system would not encourage potentially lower-cost reductions that might have been made outside that sector.

Similarly, raising the gasoline tax would reduce carbon emissions from gasoline consumption but would not encourage reductions in other sectors. Alternatively, levying a tax on the carbon content of all fossil fuels--much like enacting an upstream cap-and-trade program--would create an incentive for carbon reductions throughout the economy.