STATEMENT OF

JAY HAKES

ADMINISTRATOR, ENERGY INFORMATION ADMINISTRATION

DEPARTMENT OF ENERGY

before the

ENERGY and NATURAL RESOURCES COMMITTEE

UNITED STATES SENATE

MARCH 25, 1999

Mr. Chairman and Members of the Committee:

I appreciate the opportunity to appear before you today to discuss the Energy Information Administration's (EIA) analysis of carbon emissions from energy and the potential impacts of the Kyoto Protocol.

EIA is an autonomous statistical and analytical agency within the Department of Energy. We are charged with providing objective, timely, and relevant data, analysis, and projections for the use of the Department, the Congress, and the public. We do not take positions on policy issues, but we do produce data and analysis reports that are meant to help policy makers decide energy policy. Because we have an element of statutory independence with respect to the analyses that we publish, our views are strictly those of EIA. We do not speak for the Department, nor for any particular point of view with respect to energy policy, and our views should not be construed as representing those of the Secretary of Energy or the Department's policy position. EIA's baseline projections on energy trends, however, are widely used by government agencies, the private sector, and academia for their own energy analyses.

Each year EIA publishes the Annual Energy Outlook, which provides projections and analysis of domestic energy consumption, supply, prices, and carbon emissions. These projections are not meant to be exact predictions of the future but represent a likely future, assuming known trends in demographics and technology improvements and also assuming current laws, regulations, and policies. In October 1998, EIA published the report Impacts of the Kyoto Protocol on U.S. Energy Markets and Economic Activity,⁽¹⁾ which is the focus of my testimony today. The report was done at the request of the House Committee on Science, which specified certain assumptions for the analysis.

Greenhouse Gas Emissions and the Kyoto Protocol

Carbon abatement is a highly complex issue, far more complicated than most other emissions reduction programs. Although comparisons are drawn between the sulfur dioxide (SO₂) reduction program for electricity generators and carbon reduction, there are several key differences. First, carbon emissions are an international issue. The U.S. climate would potentially be affected as much by carbon emissions around the globe as by emissions in the United States. Also, there are a vast number of entities that emit carbon--homes, factories, vehicles, commercial facilities, and agricultural sources--unlike the relatively few electricity generators covered by the SO₂ reduction program in the first phase. Finally, unlike SO₂, there are not cost-effective means at this time to remove and sequester carbon other than by natural processes, such as afforestation.

The Kyoto Protocol calls for the United States to reduce its total net emissions of six greenhouse gases, weighted for their global warming potential, by 7 percent relative to 1990 emissions levels. This reduction is to be achieved on average during the years 2008 to 2012. Much of the focus on emissions reduction is on the energy sector because energy use is the primary source of greenhouse gas emissions. In 1997, carbon dioxide emissions from the combustion of energy totaled 83 percent of all U.S. greenhouse gas emissions.⁽²⁾ Reducing carbon emissions below 1990 levels would be a challenging task, as they had already increased 10 percent by 1997 and are projected with current policies to rise by 2010 to 33 percent over 1990 levels.

Carbon emissions from energy can be reduced in several ways. First, there can be a shift from fossil to nonfossil fuels, such as nuclear power or renewable sources of energy. Second, energy use can shift from highly carbon-intensive fossil fuels to those with lower carbon intensity. For example, natural gas produces only about half the carbon emissions per unit of thermal output as coal. Also, energy consumers can use more energy-efficient technologies, thereby using less energy to achieve the same level of energy service. Finally, consumers can reduce the level of energy services, for example, by traveling less or lowering their demand for heating and cooling.

EIA's analysis assumed that a price mechanism would be used to encourage more rapid development and adoption of energy-efficient technologies, the use of less carbon-intensive fuels, and a reduction in energy demand. The price mechanism is applied to fossil fuels relative to their level of carbon content. Although electricity itself emits no carbon, the carbon price is applied to the fuels used to generate electricity and is passed to consumers through the price of electricity. This price mechanism may take the form of a carbon tax, a carbon permit trading system, or a carbon permit auction. In addition to price incentives, reductions in carbon emissions could be achieved by regulatory or voluntary programs.

Within the Kyoto Protocol, there are a number of ways for the United States to achieve the overall target apart from energy-related carbon reductions. The Protocol recognizes that different countries may have different levels of opportunity for emissions reductions and allows emissions trading among the Annex I countries. Joint implementation projects are also allowed among the Annex I countries, whereby a nation can earn emissions credits by investing in projects that reduce emissions or enhance emissions-absorbing sinks, such as forests, in other Annex I countries. The Protocol also establishes a Clean Development Mechanism, under which Annex I countries can earn credits for projects that reduce net emissions in non-Annex I countries. Apart from these international activities, domestic investment in carbon absorption activities, such as reforestation, or in reducing the emissions of the other greenhouse gases covered by the Protocol may also lower the required reduction in carbon emissions.

These flexibility measures in the Protocol offer opportunities to reduce the cost of complying with the Protocol, but complicate the analysis. Rules and guidelines for the international trading, joint implementation, and the Clean Development Mechanism are not specified in the Protocol and will be finalized at some future international meeting. Also, the actual opportunities for low-cost investment in emissions abatement in other countries cannot be known with certainty or whether other Annex I countries would be willing to sell emissions permits or would hold them for credit against future reductions. Finally, the role of sinks and other greenhouse gases in offsetting carbon reductions remains uncertain. Therefore, these items were addressed through alternative cases of energy-related carbon reductions.

In addition to these difficulties, there are a number of other uncertainties in analyzing the Protocol. Different energy analysts have different opinions about the price elasticity of energy--how quickly energy consumers will react to changes in energy prices by changing their patterns of energy use or by purchasing different energy-using equipment and also whether consumers change their behavior in anticipation of future price increases. Unknown future policies may raise or lower the costs of the impacts. It is also not possible to foresee with certainty how energy-using technologies will develop in the future. Finally, the entire issue of climate change and greenhouse emissions reductions is relatively new, and measurement systems and methods of gauging how individual consumers or countries will respond to an international effort of this scope and magnitude need to be further developed.

Analysis of the Kyoto Protocol

At the request of the Congressional committee, the EIA analysis was based upon the methodologies and assumptions in the Annual Energy Outlook 1998 (AEO98),⁽³⁾ with no changes in policy, regulatory actions, or funding for energy and environmental programs, since no specific policies had been advanced. The analysis was conducted using the National Energy Modeling System (NEMS), EIA's energy-economic model of domestic energy markets, which underlies the AEO98 projections.

In most of the energy-producing and consuming sectors, NEMS includes explicit treatment of individual technologies and their characteristics, such as capital and operating costs, date of commercial availability, efficiency, and other relevant characteristics. Because of this detailed representation of technology, NEMS captures the most significant factors that influence the turnover of energy-using equipment and the choice of new technologies and is appropriate for the analysis of the transitional impacts of policies designed to influence the choice of new technologies. NEMS also represents consumer choice through empirically-derived price elasticities and behavioral characteristics.

Because more energy-efficient and less-carbon intensive technologies can significantly reduce energy consumption and carbon emissions, the rate of technological progress and its penetration is one of the major factors and key uncertainties in determining the cost of carbon reductions. In its analysis, EIA incorporates ongoing trends of technological progress for both energy consumption and production, taking into account the characteristics of current technologies and those technologies assumed to be available and cost effective within the forecast horizon. In general, higher energy prices do not alter the characteristics or availability of energy-using technologies but encourage more rapid adoption of more efficient or advanced technologies because consumers would have more incentive to purchase them. However, the turnover rate of the capital stock--homes, appliances, and automobiles--can be slow, limiting the speed with which new, more-efficient technologies can capture a significant share of the market.

Carbon Reduction Cases

Because of the uncertainties concerning the final implementation of the Protocol, EIA's analysis included the reference case of what is expected with current policies and six additional cases with a range of reductions for energy-related carbon emissions in the United States. In each case, the United States achieves its target of reducing net greenhouse gas emissions by 7 percent; however, different means are used to reach the target. The cases in the analysis implicitly assume different levels of international trading, other international activities, forestry and agricultural sinks, and offsets from other greenhouse gases, with the remaining reduction taken in energy-related carbon reductions. Each of these cases is compared to a reference case that assumes no enforced carbon reductions in order to analyze the energy and economic impacts of achieving the reductions.

The reference case of the analysis is based upon the reference case from the Annual Energy Outlook 1998, in accordance with the Congressional request. By 2010, energy-related carbon emissions are projected to increase from 1,346 million metric tons in 1990 to 1,791 million metric tons, 33 percent above 1990 levels. The six carbon reduction cases range from reducing emissions to an average of 24 percent above 1990 levels (1990+24%) between 2008 and 2012 to reducing emissions to an average of 7 percent below 1990 levels (1990-7%) over the same period (Figure 1). The 1990+24% case assumes that international trading and other activities offset most (77 percent) of the required reductions in carbon emissions from energy; however, the 1990-7% case essentially assumes that the 7-percent target in the Kyoto Protocol must be met by energy-related carbon emissions with no net offsets from sinks, other greenhouse gases, or international activities. In this case, carbon emissions from energy are reduced approximately 30 percent from reference case levels in 2010.

In each of the cases, the target is achieved on average for the years in the first commitment period, 2008 through 2012. Although the rationale for the averaging is not explicitly stated in the Protocol, the fact sheet issued by the Department of State on January 15, 1998, indicates that this flexibility smooths short-term fluctuations in economic performance or weather. Because the Protocol does not specify targets beyond the first commitment period, the target is assumed to hold constant through 2020, the end of the forecast horizon. The target is assumed to be phased in over a three-year period, beginning in 2005 since the Protocol indicates that demonstrable progress toward reducing emissions must be shown by 2005. This allows energy markets to begin adjustments to meet the reduction targets.

Carbon Prices

In 2010, the carbon prices necessary to achieve the carbon emissions reduction targets range from $67 per metric ton (1996 dollars) in the 1990+24% case to $348 per metric ton in the 1990-7% case (Figure 2). In the three cases with the more severe reductions, the carbon price escalates more rapidly through 2010 in order to achieve the reductions in the commitment period then declines by 2020 as cumulative investments in more energy-efficient and lower-carbon equipment, particularly in the electricity generation sector, reduce the marginal cost of compliance in the later years of the forecast. The carbon prices represent the marginal cost of reducing carbon emissions to the specified level, reflecting the price the United States would be willing to pay in order to purchase carbon permits from other countries or to induce carbon reductions in other countries. In the absence of a complete analysis of international carbon markets, these carbon prices do not represent the international market-clearing price of carbon permits or the price at which other countries would be willing to offer permits.

Energy Intensity

Carbon fees raise the delivered prices of energy and lead to a decline in the overall intensity of energy use. Energy intensity, measured as primary energy consumed per dollar of gross domestic product (GDP), declines at an average annual rate of 1 percent between 2005 and 2010 in the reference case. In the carbon reduction cases, the rate of intensity improvement improves in the same period to between 1.6 percent a year in the 1990+24% case and 3.0 percent a year in the 1990-7% case (Figure 3).

Electricity Generation

In 2010, carbon reductions from electricity generation account for between 68 and 75 percent of the total carbon reductions due to lower electricity demand than in the reference case and the penetration of more efficient, less carbon-intensive generation technologies. Electricity generators are expected to respond more strongly to higher prices than end-use consumers because the industry has generally sought to minimize costs and factors future energy price increases into their investment decisions. In contrast, the end-use consumers are assumed to consider only current prices in making their investment decisions and consider factors other than price. Also, a number of more-efficient and lower-carbon technologies for electricity generation

become economically available due to the carbon price.

In the electricity generation sector, fuel switching accounts for most of the carbon reductions. Relative to the reference case, the delivered price of coal to generators in 2010 is higher by between 153 and nearly 800 percent in the carbon reduction cases. Coal-fired generation accounts for half of all generation in 2010 in the reference case, but its share drops to between 42 percent and 12 percent in the carbon reduction cases. To replace coal plants, generators build more natural gas plants, extend the life of existing nuclear plants, and, particularly in the more stringent reduction cases, dramatically increase the use of renewables as costs per megawatt decline with more penetration, especially biomass and wind energy systems. Improved generation efficiency and lower electricity sales also contribute to lower carbon emissions from generation. Across the carbon reduction cases, electricity sales in 2010 are reduced from between 4 and 17 percent relative to the reference case, as electricity prices increase between 20 and 86 percent above those in the reference case.

Share of Energy Fuels

The slate of energy fuels used in the United States is projected to change from that in the reference case (Figure 4). The use of both coal and petroleum is reduced, and there is a greater reliance on natural gas, renewable energy, and nuclear power. Although the consumption of petroleum declines relative to the reference case, it increases slightly as a share because most petroleum is used in the transportation sector in which there are fewer fuel substitutes available.

Coal

Because of the high carbon content of coal, total domestic coal consumption is significantly reduced in the carbon reduction cases, mostly for electricity generation but also in the industrial sector. Coal exports are also lower in the carbon reduction cases due to lower demand for coal in the Annex I nations, further reducing domestic coal production.

Natural Gas

Natural gas consumption is higher than in the reference case in 2010 by a range of 2 to 12 percent across the carbon reduction cases. Although the use of natural gas is lower in the end-use sectors due to demand reductions and efficiency improvements, this is more than offset by the increase in consumption for electricity generation. Although meeting the levels of production that may be required will be a challenge for the industry, sufficient natural gas resources are available, and the potential increases in both drilling and pipeline capacity are within levels achieved historically.

Renewable Energy

Consumption of renewable energy, which results in no net carbon emissions, is projected to increase by between 2 and 16 percent in 2010 and by between 9 and 70 percent in 2020. Most of this increase occurs in electricity generation, primarily with additions to wind energy systems and an increase in the use of biomass (wood, switch grass, and refuse), both of which significantly increase their share of electricity generation with higher carbon prices (Figure 5). Because additional renewable technologies become available and economic later in the forecast period, the share of renewable generation continues to increase through 2020, reaching as high as 22 percent in 2020, compared to 9 percent in the reference case.

Nuclear Power

In the reference case about half of the current nuclear plants are projected to retire by 2020. In accordance with the request, no new nuclear plants are assumed to be built in the carbon reduction cases, but extending the lifetimes of existing plants

becomes more economical with higher carbon prices. In more stringent reduction cases, most existing nuclear plants are life-extended through 2020.

Petroleum and Transportation Demand

In 2010, the average price of gasoline increases by between 11 and 53 percent across the carbon reduction cases, compared to the reference case (Figure 6). Although carbon emissions from transportation are reduced due to lower travel and the purchase of more efficient vehicles, the transportation sector accounts for the lowest reductions of all the end-use demand sectors. This is a result of the continued dominance of petroleum although alternative-fuel vehicles increase their market share. New car efficiency improves with higher carbon prices, but vehicle turnover rates slow the improvement of the fleet. Total light-duty fleet efficiency rises from 20.5 miles per gallon in 2010 to only between 20.7 and 21.7 miles per gallon. The impact of carbon prices on the economy also lowers light-duty vehicle and airline travel and freight requirements and

induces some efficiency improvements in the airline and freight sectors. Primarily due to lower demand in the transportation sector, petroleum consumption is reduced in all of the carbon reduction cases by between 2 and 13 percent in 2010 compared to the reference case. Because crude oil and petroleum product imports are reduced relative to the reference case, the dependency of the United States on imported petroleum is reduced from the reference case level of 59 percent to as little as 53 percent in 2010.

Residential, Commercial, and Industrial Demand

In both the residential and commercial sectors, higher energy prices encourage investments in more efficient equipment and building shells and reduce the demand for energy services. As a result, energy use per household and per square foot of commercial floorspace declines with higher carbon prices. Space heating, cooling, and ventilation account for the largest share of the demand reductions. More efficient lighting and office equipment and lower electricity demand for a variety of miscellaneous appliances, such as computers, televisions, VCRs, and telecommunications equipment also contribute to lower energy consumption. In the industrial sector, businesses replace productive capacity faster, invest in more efficient technology, and switch to less carbon-intensive fuels; however, total industrial output is also lower due to the impact of higher energy prices on the economy.

Macroeconomic Impacts

Apart from the impacts of the higher prices on energy markets, there are likely to be significant impacts on the macroeconomy. As energy costs rise due to the carbon prices, the rate of decline in energy consumption per dollar of GDP will accelerate. Other factors of production in the economy, including labor and capital, become relatively less expensive, and there will be some adjustments to substitute labor and capital for more expensive energy. Some economic potential is lost in that process. This will reduce the potential GDP for the United States, which is the long-run equilibrium path of the economy when all resources--labor, capital, and energy--are fully employed.

There are additional transitional costs that are likely to arise as energy price increases disrupt capital or employment markets. These short-run costs would impact the actual GDP but could be moderated by adjustments to Federal monetary and fiscal policies. The analysis assumes that a carbon permit trading system functions as an auction run by the Federal Government and that the revenues raised through the auction would be recycled back into the economy. Recycling of the funds would increase disposable income and encourage both consumption and investment, offsetting some adverse short-term effects on the economy. Two alternative fiscal policies were analyzed: one recycling the revenues through a lump sum rebate in the personal income tax and the other through the social security tax rates.

It is estimated that the loss in potential GDP will range from $13 billion to $72 billion (1992 dollars) in 2010. In an economy today of more than $7 trillion, which is expected to grow to more than $9.4 trillion in 2010, the percentage loss in output ranges from 0.1 percent to 0.8 percent in 2010. The loss in actual GDP is projected to range between $61 billion and $183 billion in 2010 if revenues are returned through a social security tax rebate and between $96 billion and $397 billion if they are recycled through personal income taxes. When viewed from the perspective of growth rates, the economy continues to grow, but at a slower rate between 2005 and 2010 (Figure 7). Although there is a slowing of economic growth initially, actual GDP returns to the potential path later in the forecast period, muting the economic impacts through 2020 (Figure 8). In effect, the economy adjusts to the emissions reductions and achieves a higher growth rate than in the reference case between 2010 and 2020.

The finding that economic growth slows only moderately in the transition period and slows only slightly when averaged to 2020 results from two factors. First, energy costs have become a smaller part of the overall economy than in the past, muting broader impacts of energy price increases. Second, some revenues from the higher costs of energy can be recycled back into the American economy, as opposed to, for instance, going to foreign oil producers. The continued growth of the economy and of personal disposable income during the period of carbon reductions is one of the reasons that energy prices reach the high levels in our projections. With growing personal income, energy consumers will be more willing to pay higher energy costs to maintain desired life styles.

1. Energy Information Administration, Impacts of the Kyoto Protocol on U.S. Energy Markets and Economic Activity, SR/OIAF-3 (Washington, DC, October 1998).