Congressional Budget Office
Director’s Blog

Human activities around the world—primarily fossil fuel use, forestry, and agriculture—are producing growing quantities of emissions of greenhouse gases, other gases, and particulates and are also greatly altering the Earth’s vegetative cover. A strong consensus has developed in the expert community that if allowed to continue unabated, the accumulation of those substances in the atmosphere and oceans, coupled with widespread changes in patterns of land use, will have extensive, highly uncertain, but potentially serious and costly impacts on regional climate and ocean conditions throughout the world.

Today CBO released a paper presenting an overview of the current understanding of the impacts of climate change in the United States. CBO cannot independently evaluate the relevant scientific research, so our paper draws from numerous published sources to summarize the current state of climate science and provides a conceptual framework for addressing climate change as an economic concern. The paper was reviewed by several knowledgeable external reviewers and, as with all CBO analysis, makes no recommendations.

The paper discusses potential impacts on the physical environment (temperature, precipitation, severe storms, ocean currents, climate oscillations. sea level, and ocean acidification); biological systems(ecosystems and biological diversity, agriculture, forestry, and fisheries); and the economy and human health (water supply, infrastructure, human health, and economic growth).

The paper emphasizes the wide range of uncertainty about the magnitude and timing of impacts and the implications of that uncertainty for the formulation of effective policy responses. Uncertainty arises from several sources, including limitations in current data, imperfect understanding of physical processes, and the inherent unpredictability of economic activity, technological innovation, and many aspects of the interacting components (land, air, water and ice, and life) that make up the Earth’s climate system.  This does not imply that nothing is known about future developments, but rather that projections of future changes in climate and of the resulting impacts should be considered in terms of ranges or probability distributions. For example, some recent research suggests that the median increase in average global temperature during the 21st century will be in the vicinity of 9° Fahrenheit if no actions are taken to reduce the growth of greenhouse-gas emissions. However, warming could be much less or much greater than that median level, depending on the growth of emissions and the response of the climate system to those emissions.

Given current uncertainties, crafting a policy response to climate change involves balancing two types of risks: the risks of limiting emissions to reach a temperature target and experiencing much more warming and much greater impacts than expected versus the risks of incurring costs to limit emissions when warming and its impacts would, in any event, have been less severe than anticipated. Climate policies thus have a strong element of risk management: Depending on the costs of doing so, society may find it economically sensible to invest in reducing the risk of the most severe possible impacts from climate change even if their likelihood is relatively remote. In particular, the potential for unexpectedly severe and even catastrophic outcomes, even if unlikely, would justify more stringent policies than would result from simply balancing the costs of reducing emissions against the benefits associated with the expected or most likely resulting degree of warming. At the same time, the uncertainties in the link between emissions and climate change mean that even rigid quantitative targets are not likely to achieve a specific warming target.  Uncertainties may thus justify flexible mechanisms even though they may simultaneously justify relatively stringent policies.

The report was written by Bob Shackleton.  He has been at CBO for the past 10 years and working on climate issues here and elsewhere for nearly 20 years.  Bob holds a Ph.D. in economics from the University of Maryland.  In addition to his interest in climate issues, he satisfies his intellectual curiosity through a wide variety of pursuits including publishing original scholarly research on the history of American dialects and studying quantum mechanics in his free time.  In short, he is a true geek . . .

The 111th Congress is taking up the issue of addressing the risks associated with climate change, a task that would entail the regulation of emissions of a variety of greenhouse gases from a variety of sources. The Environmental Protection Agency estimates that, in 2006, households and businesses in the United States emitted nearly 7.1 billion metric tons of carbon dioxide equivalent of greenhouse gases. Those emissions were partially offset by the net absorption of roughly 900 million metric tons of carbon dioxide  by the nation’s forests and soils.

Several different approaches, or combinations of approaches, could be used to manage emissions, including direct regulations, cap-and-trade restrictions, and taxes that would directly raise the price of emitting gases. A program based on such approaches could be used to regulate any or all of those emissions.

CBO has previously produced several estimates of the budgetary impact of policies designed to mitigate emissions of greenhouse gases and will produce additional estimates during the current Congress. To do so, CBO undertakes a detailed analysis of the specific provisions of the legislation. In particular, it must estimate the marginal, or incremental, cost of reducing emissions of a number of different greenhouse gases at various levels of mitigation and at different points in the future.

On Friday, CBO released a paper describing the methodology that it uses to estimate the costs of mitigating emissions. In preparing its estimates, CBO uses projections of mitigation costs that, by construction, are in the middle of the range of estimates produced by current state-of-the-art energy-economy models. CBO can use its approach to calculate the amount of emissions generated at a given price or tax, or to determine the price or tax required to achieve a given emissions target.

The methodology involves several steps. CBO first projects a base case that serves as a marker against which to measure the effects of the proposed policies; that base case encompasses projections of future greenhouse-gas emissions and future prices of fossil fuels, electricity, and other products and services closely associated with such emissions—all assuming no new federal policies to control those emissions.  For its base-case projections, CBO relies primarily on projections from the Energy Information Administration of the Department of Energy.

Then, CBO estimates how firms and households will respond to the proposed regulatory program. In the case of a cap-and-trade system, CBO determines how the proposals would affect the prices of emission allowances, and estimates how those allowance prices would filter through to prices of fuels and other emission-intensive products, affecting the aggregate demand for such goods and services.

CBO draws on a variety of sources to calculate how sensitive emissions are likely to be to changes in the allowance price. That sensitivity is, in effect, an elasticity of emissions with respect to the price. (An elasticity is a measure of the response of one variable to changes in another; for example, the elasticity of household demand for electricity measures how much an increase in the price of electricity would reduce households’ electricity consumption.) To develop its measures of price sensitivity, CBO applies six different models, available from government agencies, academic institutions, and other researchers, that represent the current state of the art.

CBO’s estimate implicitly includes the sensitivity of end-use energy demand to changes in allowance prices as well as the amount of substitution that might occur among energy sources. For example, rising prices for fossil fuels would lead electric utilities to substitute some sources for others, by using more natural gas or wind and using less coal to generate electricity, but would also lead households and firms to consume less electricity. Both types of responses are implicitly built into CBO’s estimates.

Over the past several years, spurred by both rising gasoline prices and long-standing subsidies for producing ethanol, the use of ethanol as a motor fuel in the United States has grown at an annual average rate of nearly 25 percent.  U.S. consumption of ethanol last year exceeded 9 billion gallons–a record high.  CBO released a paper today that discusses the relationship between ethanol, greenhouse-gas emissions, food prices, and federal spending on nutrition programs.

Most ethanol in the United States is produced from domestically grown corn, and the rapid rise in the fuel’s production and usage means that roughly one-quarter of all corn grown in the U.S. (nearly 3 billion bushels) is now used to produce ethanol. The demand for corn for ethanol production has exerted upward pressure on corn prices and on food prices in general. CBO estimates that the increased use of ethanol accounted for about 10 percent to 15 percent of the rise in food prices between April 2007 and April 2008.

In turn, increases in food prices will boost federal spending for mandatory nutrition programs such as the Supplemental Nutrition Assistance Program (SNAP, formerly known as Food Stamps) and the school lunch program by an estimated $600 million to $900 million in fiscal year 2009. The Special Supplemental Assistance Program for Women, Infants, and Children—better known as WIC—is a discretionary program that provides a specific basket of goods to recipients rather than a set cash benefit, so changes in food prices in 2008 had an immediate impact on costs for the program.  Under the assumption that the effects are much the same, increased production of ethanol would have added less than $75 million in fiscal year 2008 to the cost of serving the same number of WIC participants as in 2007.

Last year the use of ethanol reduced gasoline usage in the United States by about 4 percent and greenhouse-gas emissions from the transportation sector by less than 1 percent. The future impact of ethanol on greenhouse-gas emissions is unclear. Research suggests that in the short run, the production, distribution, and consumption of ethanol will create about 20 percent fewer greenhouse gas emissions than the equivalent processes for gasoline. In the long run, if increases in the production of ethanol led to a large amount of forests or grasslands being converted into new cropland, those changes in land use could more than offset any reduction in greenhouse-gas emissions—because forests and grasslands naturally absorb more carbon from the atmosphere than cropland absorbs. In the future, the use of cellulosic ethanol, which is made from wood, grasses, and agricultural plant wastes rather than corn, might reduce greenhouse-gas emissions more substantially, but current technologies for producing cellulosic ethanol are not yet commercially viable.

This morning I testified before the House Ways and Means Committee about the ways to reduce the economic cost of a cap-and-trade program for greenhouse-gas emissions by increasing firms’ flexibility in the timing of their emission reductions. Accumulating evidence about the pace and potential extent of global warming has heightened the interest of policymakers in cost-effective ways to achieve substantial reductions in emissions. Many analysts agree that that putting a price on carbon emissions—rather than dictating specific technologies or changes in behavior—would lead households and firms to reduce emissions where and how it was least costly to do so.

Allowing flexibility about when emissions were reduced would further lower costs, because changes in weather and fuel markets lead the cost of emissions reduction to vary from year-to-year. This flexibility in timing can be achieved without lowering the benefits of emissions reductions because climate change depends not on the amount of greenhouse gases released in a given year but on their buildup in the atmosphere over decades. Analysts have developed a number of options for increasing timing flexibility; this morning I made five key points about these options:

• First, permitting firms to “bank” allowances—to save allowances for use in the future—has helped lower compliance costs in existing cap-and-trade programs. However, existing cap-and-trade programs that use banking have still experienced substantial volatility in allowance prices.
• Second, permitting firms to borrow future allowances as well as to bank them could further lower compliance costs. Existing cap-and-trade programs typically preclude borrowing, in part because of concerns that firms that borrow allowances might be unable to pay them back later.
• Third, permitting firms to purchase allowances from a public “reserve pool”– composed of allowances that were borrowed from future years or that supplemented the initial supply—could partially substitute for borrowing by individual firms.  The effectiveness of the reserve pool in realizing cost savings would depend on the size of the pool and the threshold price at which firms could purchase the reserve allowances.
• Fourth, setting a floor and ceiling for the price of allowances would also lower firms’ compliance costs, but it would not ensure a particular level of emissions in the end.
• Finally, a “managed-price” approach would allow for substantial cost savings by eliminating short-term volatility in the price of allowances while accommodating longer-term shifts in prices that would be necessary to keep emissions within a long-term cap. In a managed-price arrangement, firms could purchase allowances from the government each year at a price specified by regulators; in this respect, the policy would be similar to a tax. However, the policy is like a cap-and-trade program in other key respects: Policymakers could choose to distribute some allowances to firms for free; they could allow firms to comply by purchasing “offsets,” or credits for emission reductions made in sectors not covered by the cap; and cumulative emissions over a period of several decades would be capped. To implement this approach, regulators would establish a path of rising prices for allowances with the goal of complying with the cumulative cap that legislators had set; that path would be adjusted periodically based on new information about emissions and future compliance costs.

In short: timing flexibility can be a useful tool in meeting emissions targets as efficiently as possible. The more flexibility that is granted regarding the timing of emissions reductions, the less short-term volatility in the price of emissions and the lower the cost of meeting any given emissions target.

Global climate change poses one of the nation’s most significant long-term policy challenges. While the potential damage from climate change is large, the potential cost of avoiding it is also large. Policymakers could help minimize that cost by using either a tax, or a well-designed cap and trade program, to motivate reductions in emissions. As many analysts have noted however, either a tax or a cap would cause prices of goods and services to increase, with larger increases for goods that entail greater emissions, such as home heating. Those price increases are essential to the success of the program, but they would represent a larger share of income for lower-income households than for higher-income households. Terry Dinan of our Microeconomic Studies Division discussed CBO’s analysis of the distributional consequences of cap-and-trade programs for CO2 emissions yesterday in a testimony before the Ways and Means Subcommittee on Income Security and Family Support.

I’ve highlighted some of the key points of Terry’s discussion below. To read her full testimony, click here.

• One approach that lawmakers could use to cushion the effects of those higher prices under a cap-and-trade program is to sell some allowances and give the revenue back to households. If, for example, the government sold all of the allowances and used the proceeds to provide the same lump-sum rebate to each household in the U.S., low-income households would actually be made better off under a cap-and-trade policy (though this rebate would not fully compensate higher-income households for their increased expenditures).
• If lawmakers wanted to use a more targeted approach for offsetting costs incurred by low-income households, they could choose from a variety of different strategies, including using existing transfer programs or providing rebates through the income tax system.  However, no single existing system would be likely to reach all such households.
• Delivering rebates through a combination of the income tax system and existing transfer programs would do a better job of reaching low-income households than would relying on either approach by itself. Using multiple systems to reach all households poses other challenges: it is not easy to coordinate among existing programs to avoid compensating the same household twice.
• In choosing among options for using proceeds from the sale of emissions allowances, potentially tens or hundreds of billions of dollars per year, policymakers could face a trade-off between providing targeted assistance to low- and moderate-income households and offsetting some of the adverse effects on the economic activity caused by the price increases.

Tonight I’m giving the Goldman Lecture in Economics at Wellesley College. (Here are the slides from my talk.)  The topic is climate change—starting with an overview of the problem and then discussing a range of possible approaches to reducing the risks involved.  As I’ve noted before with regard to health care, our political system doesn’t deal well with gradual, long-term problems. And climate change would definitely qualify as one of those gradual, long-term problems.  (More precisely, let’s hope climate change is a gradual long-term problem and doesn’t become a sudden crisis, as is possible given the potential nonlinearities involved.) 

Reducing the risks associated with climate change requires trading off up-front costs in exchange for long-term benefits.  Given the difficult political economy in such trade-offs, the Goldman lecture discusses ways of reducing the shorter-term economic cost of meeting whatever longer-term environmental objective we choose. 

CBO released a brief today on climate-change policy and CO2 emissions from passenger vehicles (for the PDF, click here).

Discussions about addressing climate change (e.g., through a cap-and-trade program or a carbon tax) often focus on the transportation sector. The brief argues, however, that most of the reduction in CO2 emissions would occur in other sectors (e.g., the electricity sector) and that the effects on vehicle emissions would be modest, especially in the shorter run.

To be sure, a cap-and-trade system or a carbon tax would raise the price of gasoline, encouraging consumers to drive less and to buy more fuel-efficient cars– but the magnitude of these effects would be relatively small. For example, CBO has estimated that a price of $28 per metric ton of CO2 in 2012 would lead to a reduction of about 10 percent in total U.S. emissions compared with a no-action scenario. Vehicle emissions, though, would remain relatively constant in the short run, and even over time they would decline only by around 2.5 percent — much less than the 10 percent reduction in overall emissions.

Several factors account for the relatively small influence that a price on CO2 emissions would have on passenger vehicles and driving behavior. First, a CO2 price of $28 per metric ton would raise gas prices by about 25 cents per gallon, far less of an increase than consumers have recently born with little behavioral result. (Between 2003 and 2007, gas prices increased from $1.50 to more than $3.00 per gallon. Vehicle miles driven, driving speeds, and the purchase of larger vehicles have all responded only modestly despite the dramatic increase in prices.) An increase in gas prices of 25 cents or so per gallon is unlikely to generate massive changes in driving behavior.

In addition, recent changes to corporate average fuel economy (CAFE) standards will require substantial gains in fuel economy over the next dozen years. Especially over the longer term, gas price increases are not likely to have a large effect beyond what CAFE standards will require.

Finally, cultural, historic, and geographic considerations drive the extent to which Americans have become dependent on automobile travel, and their choices tend towards larger and more powerful (and less fuel efficient) automobiles. While dramatic increases in gasoline prices (or shifts in cultural norms) might eventually influence these considerations, the magnitude of gas price increases under most legislation under consideration would likely have little effect.

The brief was written by David Austin of our Microeconomic Studies Division.

This morning I’m testifying on climate change before the Committee on Ways and Means in the House of Representatives.

Global climate change is one of the nation’s most significant long-term policy challenges. Reducing greenhouse-gas emissions would be beneficial in limiting the risks associated with climate change, especially the risk of potentially catastrophic damage. Reducing those emissions, however, would also impose costs on the economy.  Our political system arguably has difficulty addressing this type of issue, in which there are short-term costs required in order to reap expected long-term benefits.

As I’ve discussed in other recent testimonies (see here and here), policymakers designing a cap-and-trade program for greenhouse gas emissions face important decisions about how to allocate allowances: whether to sell or give them away, and if they are sold, how to use the revenue generated. In addition, policymakers would face decisions about the degree of flexibility offered to firms — especially the flexibility to reduce emissions in those years in which it is least expensive to do so.  These decisions can have substantial effects on the costs of meeting any given climate target.

Today’s testimony also includes a discussion of additional complexities that arise for energy-intensive U.S. industries facing foreign competition (the steel and aluminum industries, for example). Under stringent cap-and-trade policies, these industries would face increased import competition (and export competition in third countries) from countries with less stringent policies on greenhouse gas emissions, which could not only reduce domestic production in those industries but also undermine part of the environmental benefit from an emissions reduction scheme. In my testimony, I examine a few recent proposals intended to mitigate these concerns.

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.