National Center for Environmental Economics

In 1992, the United States and 185 other nations initiated global efforts to address human-induced climate change by negotiating the United Nations Framework Convention on Climate Change (UNFCCC). The Kyoto Protocol to the UNFCCC, an international agreement that specified binding emission reduction targets for 37 industrialized countries, was subsequently negotiated in 1997 and entered into force in February 2006. Kyoto Protocol commitments cover emissions for six species of greenhouse gas emissions (GHGs) –carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), all of which also occur naturally in the atmosphere and three man-made gases, hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulfur hexafluoride (SF6).

Although the United States did not ratify the Kyoto Protocol and is not subject to its emissions caps, a range of policy measures and voluntary actions have been implemented at the Federal, State, and local levels to address GHG emissions and to improve overall understanding of the sources and impacts of climate change on the U.S. economy, as well as the effectiveness of alternative approaches to cutting U.S. emissions.

In addition to producing an annual inventory of U.S. GHGs and sinks as required by the UNFCCC, the U.S. Environmental Protection Agency (EPA) has been engaged in a wide range of research into approaches aimed at curbing the United States’ contribution to global warming. Areas of investigation by NCEE include economic analyses of regulatory policy instruments such as emissions trading, estimation of greenhouse gas reduction benefits, the role of uncertainty, and the economics of geoengineering options that involve the application of technological solutions to climate change.

Regulating Emissions: Command-and-Control vs. Tradable Permits vs. Taxes

Since the 2007 Supreme Court ruling that concluded CO2 and other GHGs are pollutants, debate over policy approaches to addressing climate change has intensified in the United States.

A number of theoretical and empirical studies have shown important advantages of market-oriented policies over command-and-control approaches to controlling pollution (See US EPA 2000). Specific market-oriented approaches that are often discussed by economists as a way to reduce greenhouse gas emissions are:

• Tradable Permits: A tradable permits (a.k.a. cap-and-trade) program sets a specific goal or cap for total emissions and allocates the necessary number of pollution permits or allowances to firms within an area to meet that goal. Firms that are able to reduce their emissions more cost-effectively have an incentive to over-comply with their requirements and sell emission allowances to firms facing higher costs of compliance. Under this type of market-based approach, emission reductions are set by the cap, but the overall compliance costs may be uncertain [see Section 6 of EPA Economic Incentives Report, 2001 and Chapter 4 of EPA’s Guidelines for Economic Analysis].
• Emission Taxes: Like tradable permit systems, tax-based regulatory systems provide incentives for polluters to find cost-effective solutions to emissions control. Firms will either pay the tax or, if it is cheaper, they will reduce emissions to avoid the tax. In the case of emission taxes, the cost of compliance is known, but emission reductions may be uncertain [see Section 4 of EPA Economic Incentives report, 2001 and Chapter 4 of EPA’s Guidelines for Economic Analysis].

The primary regulatory advantage of a market-oriented approach is that it can achieve a particular emissions target at a lower social cost than a command-and-control approach due to the greater flexibility that it offers sources in determining how to reduce emissions. In other words, market-oriented approaches leave the method for reducing pollution to the emitter. As such, emitters have an incentive to find the least cost way of achieving the regulatory requirement. Command-and-control policies typically restrict emitter choices with regard to how they reduce pollution; in part, it is this inflexibility that leads to a higher cost of controlling pollution. Furthermore, market-oriented approaches create a single price for emissions - either through the tax on emissions or the price of an tradable right to emit - that is common to all polluters. Given this common price for emissions, the total abatement required by the policy is distributed across all emitters in such a way that the cost of reducing emissions is minimized.

By leaving the method of reducing pollution to the emitter, market-oriented approaches provide a greater incentive to develop new ways to reduce pollution than command-and-control approaches. Polluters not only have an incentive to find the least cost way of adhering to a standard, they also have an incentive to continually reduce emissions beyond what is needed to comply with the standard: For every unit of emissions they reduce under a market-oriented policy, they either have a lower tax burden or can sell a permit.

Market-oriented approaches are well-suited to controlling greenhouse gas emissions. Since greenhouse gas emissions are perfectly mixing and have a global effect, a unit of greenhouse gas emissions has the same effect on environmental quality regardless of where it occurs. Also, while policies can control the flow of emissions, what is of ultimate concern is the stock – the concentration of cumulative greenhouse gases in the atmosphere. In the short term, this means that damages per additional ton emitted into the atmosphere change little with the amount emitted. These two characteristics imply that it is less important to regulate the exact location and timing of emission reductions, which may be the focus of a command-and-control approach. Increased flexibility in how, what, and when sources reduce greenhouse gas emissions does not have much effect on the benefits from reducing them but can greatly influence the cost.

If certain sources are exempt from the policy, then some relatively low cost emission reductions might not occur, raising the overall cost of the policy. If sources of pollution are compartmentalized into different sector-specific or pollutant-specific approaches, each class of polluter may face a different price for their contribution to the environmental harm, and therefore trading opportunities that reduce pollution control costs will be unrealized (Burtraw and Evans, 2008). Pizer et. al (2006) have demonstrated that taking a non-integrated approach to control greenhouse gas emissions will likely result in higher costs. For example, they find that limiting a market-oriented GHG policy to the electricity and transportation sectors doubles the cost of achieving a five percent reduction in carbon emissions compared to when the industrial sector is also included. For any given GHG emissions goal within the U.S., a market-oriented approach likely would result in less leakage than a command-and-control approach to regulation because of the ability to keep the costs of regulation lower.

While carbon taxes and tradable permits systems can be designed to achieve the same expected reduction in emissions, they differ in important ways, including how costs are distributed across the economy. Economists have also considered hybrid instruments that combine aspects of taxes and a cap-and-trade system into a single mechanism. For instance, a cap-and-trade system may be combined with an economic safety valve that is triggered if permit costs are too high. The safety valve allows the emissions cap to be raised to relieve economic pressure. This allows for increased certainty in the cost of compliance. Also, a cap-and-trade that auctions allowances to polluters allows for the collection of revenue, which can be used to offset pre-existing tax distortions in the economy.

To date, tradable permit systems have been the most widely used method for regulating GHG emissions. The most comprehensive cap-and-trade scheme currently in operation is the European Union’s Emission Trading Scheme, which was initiated to help EU member states comply with their Kyoto Protocol targets. Several regional cap-and-trade systems are also under development in the United States, including the Regional Greenhouse Gas Initiative in the Northeast and the Western Climate Initiative in the Northwest.

Challenges in Estimating Costs and Benefits of Greenhouse Gas Policies

The long time horizon over which benefits and costs of climate change policy would accrue and the global relationships they involve raise challenges for estimation. The exact benefits and costs of virtually every environmental regulation is at least somewhat uncertain, because estimating benefits and costs involves projections of future economic activity and the future effects and costs of reducing the environmental harm. In almost every case, some of the future effects and costs are not entirely known or able to be quantified or monetized.

In the case of climate change, the uncertainty inherent in economic analyses of environmental regulations is magnified by the long-term and global scale of the problem. There are uncertainties regarding the pace and form of future technological innovation, economic growth, and thresholds for climate impacts. These difficulties in predicting the future can be addressed to some extent by evaluating alternative scenarios. In uncertain situations, EPA typically recommends that analysis consider a range of benefit and cost estimates, and the potential implications of non-monetized and non-quantified benefits.

Weitzman (2008) has raised the importance of accounting for low probability but high impact outcomes in economic analyses of climate change. In standard integrated economic assessment models of climate change policies, central or “best-guess” estimates typically are used for all input parameters. For example, the current central estimate for doubling the atmospheric concentration of carbon dioxide emissions is a temperature increase of around 3^oC. However, the actual value could turn out to be lower or much higher.

The basic rationale for excluding low-probability high-impact outcomes from assessments of climate change policies seems to be that the associated scientific uncertainty surrounding them is too large to provide a solid basis for policy decisions. However, a key point that follows from Weitzman’s research is that the “high-impact” component can potentially offset and even overwhelm the “low-probability” component. In general, it is the product of the probability and the impact that is important, rather than one or the other alone. A few recent studies have tried to account for uncertainty when evaluating climate change policy, but so far the results are mixed. (See Daigneault and Newbold (2008), Climate Response Uncertainty and the Unexpected Benefits of Greenhouse Gas Emissions Reductions.)

Geoengineering

In addition to examining methods to reduce GHG emissions and the benefits and costs of climate change, NCEE also studies the economics of technological approaches to addressing climate change, particularly atmospheric geoengineering. Geoengineering refers to the intentional modification of Earth’s environment to promote habitability. In relation to global temperature changes, atmospheric geoengineering focuses on technology to correct for Earth’s radiation imbalances. Atmospheric geoengineering is largely inspired by Earth’s climatic reactions to large volcanic eruptions, which spurt particles into the stratosphere at quantities large enough to cool Earth’s climate for several years.

Atmospheric geoengineering could provide benefits if technologies can be installed and operated more cheaply, more rapidly, and with less uncertainty than reducing emissions. Some concerns with the use of stratospheric geoengineering include possible unintended environmental effects on regional and seasonal climates, problems with the disposition of sulfate or other particles after they are injected into the stratosphere, and the unresolved issue of ocean acidification.

Reports Available from NCEE

Burtraw, Dallas and David A. Evans. 2008. "Tradable Rights to Emit Air Pollution." Forthcoming in Australian Journal of Agricultural and Resource Economics.

Carlin, Alan. 2008. "Why A Different Approach is Required If Global Climate Change Is to Be Controlled Efficiently or Even at All." Environmental Law and Policy Review, 32(3), 685-757.

Daigneault, Adam, and Steve Newbold (2008). “Climate Response Uncertainty and the Unexpected Benefits of Greenhouse Gas Emissions.” NCEE Working Paper Series.

U.S. Environmental Protection Agency, National Center for Environmental Economics, and National Center for Environmental Research, 2003. Market Mechanisms and Incentives: Applications to Environmental Policy. Session Three Proceedings: Carbon Trades and Taxes.

U.S. Environmental Protection Agency. 2001. The United States Experience with Economic Incentives for Protecting the Environment. Office of the Administrator, Section 6.16.

U.S Environmental Protection Agency. 2000. Guidelines for Preparing Economic Analyses. Office of the Administrator, Chapter 4.