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COUNTING THE CHANGE: ACCOUNTING

FOR THE FISCAL IMPACTS OF

CONTROLLING CARBON EMISSIONS

HEARING

BEFORE THE

COMMITTEE ON THE BUDGET 

HOUSE OF REPRESENTATIVES

ONE HUNDRED TENTH CONGRESS

FIRST SESSION

HEARING HELD IN WASHINGTON, DC, NOVEMBER 1, 2007

Serial No. 110–24

Printed for the use of the Committee on the Budget

(

Available on the Internet: 

http://www.gpoaccess.gov/congress/house/budget/index.html 

(II)

COMMITTEE ON THE BUDGET 

JOHN M. SPRATT, JR., South Carolina, Chairman 

ROSA L. DELAURO, Connecticut, 

CHET EDWARDS, Texas 

JIM COOPER, Tennessee 

THOMAS H. ALLEN, Maine 

ALLYSON Y. SCHWARTZ, Pennsylvania 

MARCY KAPTUR, Ohio 

XAVIER BECERRA, California 

LLOYD DOGGETT, Texas 

EARL BLUMENAUER, Oregon 

MARION BERRY, Arkansas 

ALLEN BOYD, Florida 

JAMES P. MCGOVERN, Massachusetts 

NIKI TSONGAS, Massachusetts 

ROBERT E. ANDREWS, New Jersey 

ROBERT C. ‘‘BOBBY’’ SCOTT, Virginia 

BOB ETHERIDGE, North Carolina 

DARLENE HOOLEY, Oregon 

BRIAN BAIRD, Washington 

DENNIS MOORE, Kansas 

TIMOTHY H. BISHOP, New York 

GWEN MOORE, Wisconsin 

PAUL RYAN, Wisconsin, 

Ranking Minority Member 

J. GRESHAM BARRETT, South Carolina 

JO BONNER, Alabama 

SCOTT GARRETT, New Jersey 

MARIO DIAZ–BALART, Florida 

JEB HENSARLING, Texas 

DANIEL E. LUNGREN, California 

MICHAEL K. SIMPSON, Idaho 

PATRICK T. MCHENRY, North Carolina 

CONNIE MACK, Florida 

K. MICHAEL CONAWAY, Texas 

JOHN CAMPBELL, California 

PATRICK J. TIBERI, Ohio 

JON C. PORTER, Nevada 

RODNEY ALEXANDER, Louisiana 

ADRIAN SMITH, Nebraska 

[Vacancy] 

PROFESSIONAL STAFF

THOMAS S. KAHN, Staff Director and Chief Counsel 

PATRICK L. KNUDSEN, Acting Minority Chief of Staff 

(III)

C O N T E N T S

Page 

Hearing held in Washington, DC, November 1, 2007 ........................................... 1

Statement of: 

Hon. John M. Spratt, Jr., Chairman, House Committee on the Budget ..... 1

Hon. Paul Ryan, ranking minority member, House Committee on the 

Budget ............................................................................................................ 2

Hon. Norman D. Dicks, a Representative in Congress from the State 

of Washington, prepared statement of ........................................................ 3

Peter R. Orszag, Director, Congressional Budget Office ............................... 6

Prepared statement of ............................................................................... 9

David Doniger, Climate Center policy director, Natural Resources Defense Council ................................................................................................. 18

Prepared statement of ............................................................................... 21

Robert Greenstein, executive director, Center on Budget and Policy Priorities ................................................................................................................. 27

Prepared statement of ............................................................................... 29

Anne E. Smith, Ph.D., vice president, CRA International ............................ 35

Prepared statement of ............................................................................... 37

(1)

COUNTING THE CHANGE: ACCOUNTING

FOR THE FISCAL IMPACTS OF 

CONTROLLING CARBON EMISSIONS 

THURSDAY, NOVEMBER 1, 2007

HOUSE OF REPRESENTATIVES, 

COMMITTEE ON THE BUDGET, 

Washington, DC. 

The committee met, pursuant to call, at 12:04 p.m. in room 210, 

Cannon House Office Building, Hon. John Spratt [chairman of the 

committee] presiding. 

Present: Representatives Spratt, Doggett, Tsongas, Hooley, 

Moore of Kansas, Moore of Wisconsin, Ryan, Garrett, Lungren, 

Campell, and Smith. 

Chairman SPRATT. I will call the meeting to order and welcome 

our witnesses and other participants to the Budget Committee’s 

hearing on the fiscal considerations of controlling carbon emissions. 

Before going any further, let me announce and introduce our most 

recent addition, Niki Tsongas, recently elected from the Fifth District of Massachusetts, the widow of Paul Tsongas. And we are delighted to have you. 

The steering committee of our party has appointed her to this position. She hasn’t been confirmed yet on the House floor. Oh, she 

was. I beg your pardon. You are a full-fledged Member. We are 

glad to have you this morning to participate. 

The concentration of greenhouse gases, carbon dioxide in particular, has gradually increased in the atmosphere over the last 

century, and is widely believed to be contributing to the warming 

of our climate. In light of the damages of climate change, there is 

gathering momentum in the Congress for legislation that uses market-based mechanisms to limit and eventually to lower emissions 

of greenhouse gases resulting mainly from the burning of fossil 

fuels, coal, oil, and natural gas. 

In fact, the Senate Committee on Environment and Public Works 

is holding a subcommittee markup of the Lieberman-Warner bill on 

the subject today. 

As Congress considers systems for control of carbon emissions, 

this committee, the Budget Committee, needs to consider budgetary issues to be resolved in implementing any such system. Our 

consideration of these issues is not meant to impede implementation of controls, but it is an important part of working out what assistance should look like and include, if and when Congress adopts 

one. 

2

The most prominent option is a cap-and-trade program for carbon dioxide emissions. Cap-and-trade programs would establish an 

overall limit on greenhouse gas emissions, declining over time, but 

allowing producers to buy and sell allowances or permits as needed. By capping emissions, but allowing trading, a new and highly 

valuable commodity would be created: the right to emit CO2. How 

this commodity is allocated and treated in the budget is a vitally 

important topic for the Budget Committee to consider. 

Today’s topic is not only important, it is complex, and we are fortunate to have some lucid witnesses on the subject. My chief of 

staff took that word out and put ‘‘outstanding,’’ but I am putting 

‘‘lucid’’ here because we put great stock in that. We have asked you 

here to come and explain it to us from your different viewpoints. 

Dr. Peter Orszag, who is the Director of CBO, will lead; followed 

by David Doniger, Policy Director for the National Resources Defense Council; followed by Bob Greenstein, Executive Director of 

the Center on Budget and Policy Priorities; and, finally, Anne 

Smith, who is the Vice President of CRA International. 

Before turning to our witnesses for their testimony, let me ask 

Mr. Ryan, our Ranking Member, for any opening statement that he 

may wish to make. Mr. Ryan. 

Mr. RYAN. I thank you, Chairman. Before I make my opening 

statement, I simply want to recognize something that is pretty important here. Today is your birthday. I simply want to say happy 

birthday. 

Chairman SPRATT. Thank you, sir. I hope we couldn’t put that 

on the record. 

Mr. RYAN. I wasn’t going to say what birthday it is. 

Thanks for holding this hearing. There seems to be broad agreement that carbon dioxide and other greenhouse gases are accumulating in the Earth’s atmosphere. There also seems to be broad 

agreement that man is creating carbon dioxide emissions, primarily 

through the combustion of fossil fuels such as coal, oil, and natural 

gas. There is far less agreement, however, about what this may 

mean for the planet’s climate over time. 

While this is very clearly a worthy debate, the Budget Committee 

isn’t the place for weighing the science of global warming. We will 

leave that to the other committees with expertise over that issue. 

What this committee can and should do, though, is examine the 

economic and budgetary implications associated with different approaches to reducing carbon emissions. We all want to be good 

stewards of the planet. So if keeping our planet healthy means we 

must reduce carbon emissions, Congress and the public have got to 

recognize that there are going to be tradeoffs involved. 

First, any increases in regulations and costs imposed on energy 

producers will be passed on to consumers directly in the form of 

higher prices. And those with lower incomes will be hit the hardest. 

Second, the rise in energy costs will have a suppressing effect on 

economic growth. And without a strong and growing economy, our 

options for addressing environmental challenges in the future will 

become extremely limited. 

I note some have suggested Congress create yet another mandatory program to help consumers offset the higher energy prices that 

would result from regulating carbon emissions, but we already 

3

have an unsustainable rate of entitlement growth. We should not 

keep making promises we simply can’t keep. 

Finally, we also must recognize the international dimensions of 

this issue. According to the Congressional Research Service, the 

United States currently accounts for about 20 percent of global carbon emissions, and our share of emissions is expected to fall in the 

decade ahead as countries such as China and India continue their 

rapid growth. So in short, we are not going to fix anything simply 

through our actions alone. It must be a global worldwide effort. 

We should also start to look beyond the government mandates to 

reduce carbon emissions. We have got to look toward research and 

development from both the government and private sector. In 

short, I think we need to spend a little less time writing government mandates and a little more time advancing cleaner methods 

of producing energy America needs. And with that, Mr. Chairman, 

I thank you for holding this hearing. 

Chairman SPRATT. Thank you, Mr. Ryan. 

Chairman SPRATT. And just one housekeeping detail before we 

move on with the testimony. First of all, I ask unanimous consent 

that we include in the record for this hearing, testimony which has 

been submitted by Representative Norm Dicks of Washington. I 

also ask unanimous consent that all members be allowed to submit 

a statement at this time, at this point in the record. If there is no 

objection, it is so ordered. 

[The prepared statement of Mr. Dicks follows:]

PREPARED STATEMENT OF HON. NORMAN D. DICKS, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF WASHINGTON

Mister Chairman, Mister Ranking Member, and Members of the Budget Committee: thank you for holding this important hearing to examine impacts of proposals to address climate change, and for the opportunity to submit testimony for 

the record. 

I believe that climate change is the emerging issue of our time. Climate change 

could alter the face of our planet in ways we cannot yet fully comprehend, and I 

believe it is our responsibility not only to do as much as possible to halt or slow 

it, but also to do everything in our power to protect the earth’s living resources from 

its impacts so that future generations will be able to appreciate and benefit from 

them as we and past generations have done. While it is not the specific focus of this 

hearing today, as Chairman of the Interior, Environment and Related Agencies Appropriations Subcommittee, I wish to highlight for the Budget Committee the impending crisis faced by our federal natural resource management agencies as the 

impacts of climate change on our nation’s wildlife and ecosystems continue to grow. 

My testimony also recommends that the Budget Committee support dedicated funding from revenues that may be generated from comprehensive climate change legislation for a balanced program to support our federal natural resource management 

agencies in navigating this crisis. 

Our nation’s wildlife is one critically important resource that is particularly vulnerable to climate change, and it is also a resource that is a fundamental part of 

America’s history and character. Conservation of wildlife and wildlife habitat is a 

core value shared by all Americans. 

America’s wildlife is vital to our nation for many reasons. Wildlife conservation 

provides economic, social, educational, recreational, emotional and spiritual benefits. 

The economic value of hunting, fishing, and wildlife-associated recreation alone is 

estimated to contribute $100 billion annually to the U.S. economy. Wildlife habitat, 

including forests, grasslands, riparian lands, wetlands, rivers and other water bodies, is an essential component of the American landscape, and is protected and valued by federal, state, and local governments, tribes, private landowners, and conservation organizations. 

Unfortunately, it is becoming increasingly apparent that the effect of climate 

change on wildlife will be profound. Reports from the Intergovernmental Panel on 

Climate Change (IPCC) have made clear that global warming is occurring, that it 

4

is exacerbated by human activity, and that it will have devastating impacts on wildlife and wildlife habitat. Wildlife is already suffering from massive changes in habitat, particularly in the arctic, and shifts in ranges and timing of migration and 

breeding cycles. Continued global warming could lead to large-scale species 

extinctions. These impacts add to and compound the adverse effects wildlife and its 

habitat already suffer from land development, energy development, road construction, and other human activities, and from other threats such as invasive species 

and disease. 

A U.S. Geological Survey Study released in September points to one particularly 

tragic and unthinkable consequence—there will be no polar bears in Alaska within 

the next 50 years due to a drastic decline in Arctic sea ice by mid-century. And 

polar bears are not the only animal that relies on Arctic sea ice. We can expect that 

many other ice-reliant creatures will also be in jeopardy. 

According to the IPCC, global warming and associated sea level rise will continue 

for centuries due to the time-scales associated with climate processes and feedbacks, 

even if greenhouse gas concentrations are stabilized now or in the very near future. 

I believe that, as a nation, we must craft responses and mechanisms now to help 

wildlife navigate the looming bottleneck of complex threats caused by global warming, so that wildlife populations can survive to reap the benefits from reductions in 

greenhouse gas emissions undertaken now. 

As Chairman of the House Interior and Environment Appropriations Subcommittee, I have held hearings to assess the impacts of climate change on federally 

protected resources. Officials from federal agencies with responsibility for managing 

our national wildlife refuges, forests, parks, monuments, other public lands, and fish 

and wildlife already are seeing impacts from climate change out on the ground that 

make a compelling case for a national response. 

All of the Interior Department and Forest Service officials who testified expressed 

concern over the current and future impacts of global warming on the natural resources they are entrusted to protect and maintain for the American people. Their 

task is overwhelming. As Deputy Secretary of Interior, Lynn Scarlett, stated: ‘‘Perhaps no subject relevant to managers of public lands and waters is as complex and 

multi-faceted as climate change.’’

Spectacular American treasures are at risk. Everglades National Park lies entirely at or near sea level. Park Superintendent Dan Kimball told my subcommittee 

that if IPCC sea level rise projections of 7 to 23 inches hold true by century’s end, 

10% to 50% of Everglades National Park’s freshwater marsh would be impacted and 

transformed by salt water intrusion. 

Glacier National Park has lost 73% of its glaciers. Point Reyes National Seashore, 

one of 74 coastal national park units, has witnessed seal haul-outs and endangered 

bird nesting areas washed out by rising seas, changes to offshore krill populations 

that have devastated sea bird populations, and reductions in fog patterns affecting 

forest and scrub species dependent on fog moisture. 

Sam Hamilton, Regional Director of the Southeast Region of the U.S. Fish and 

Wildlife Service testified that there are more than 160 coastal national wildlife refuges threatened by sea level rise. Places like Pea Island National Wildlife Refuge 

on North Carolina’s Outer Banks are losing chunks of marsh and beach to the ocean 

every year. Hamilton also warned that the incredible biological diversity of U.S. 

coral reefs, including reefs within national wildlife refuges, has already been impacted by warming-induced coral bleaching events. Hamilton added: 

‘‘As wildlife managers, we have managed around and through weather patterns 

like drought, which occur annually and can last years. However, now we are beginning to face growing certainty that these recent observations are not part of an annual or even decadal change in weather pattern, but are potentially linked to a longterm change in the climate system itself. If so, the implications for wildlife and fisheries management are consequential.’’

The Bureau of Land Management (BLM) is very concerned that exotic, noxious 

weeds like cheatgrass and red brome, will benefit from higher concentrations of carbon dioxide and further out-compete native species in the Great Basin and other 

parts of the West. These weeds are largely responsible for the increase in damaging 

wildfires in sagebrush habitats. Combined with an increase in woody vegetation, 

also stimulated by global warming, the risk of wildfires will much magnified, impacting human population centers, wildlife, grazing, and other uses of the public 

lands. 

The BLM has also seen direct evidence of desertification as a result of an increase 

in the frequency and duration of drought. Reductions in water availability have directly affected plant and animal communities. According to Ron Huntsinger, the National Science Coordinator of the BLM, ‘‘The overall results of these changes are 

more fragile ecosystems, a greater susceptibility to the outbreak of attacks by 

5

parasites and diseases, increased vulnerability to wildlife fire and erosion, and an 

overall reduction in carrying capacity of the land.’’

These are just some of the impacts of global warming presented by federal agency 

officials to my subcommittee. These impacts have been documented first hand by 

our federal resource managers. 

Based on this overwhelming evidence, it is obvious that, to conserve our wildlife 

and ecosystems in the face of the far-reaching effects of global warming, there is 

a need for a coordinated, national response that includes a strategy based on sound 

scientific information to ensure that impacts on wildlife and ecosystems that span 

government jurisdictions are effectively addressed and to ensure that federal funds 

are provided and prudently committed. 

That is why I introduced the ‘‘Global Warming Wildlife Survival Act,’’ H.R. 2338. 

The bill takes a first step in ensuring that our nation is using all possible means 

to help America’s wildlife navigate the global warming bottleneck. 

I introduced this along with my friends and colleagues, Jay Inslee of Washington 

and Jim Saxton of New Jersey. I also am deeply grateful to my friend and colleague, 

the Chairman of the House Natural Resources Committee Nick Rahall of West Virginia and his staff for working with me to develop the ‘‘Survival Act’’ and for including it in his comprehensive legislation, the ‘‘Energy Policy Reform and Revitalization 

Act’’ that passed the House of Representatives as part of H.R. 3221, Speaker Pelosi’s 

‘‘New Direction for Energy Independence Act’’ just before the August recess. Senator 

Sheldon Whitehouse of Rhode Island recently introduced a similar version of the 

bill, S. 2204. 

The ‘‘Global Warming Wildlife Survival Act’’ has four elements: 

• First, it includes a Congressional declaration of national policy recognizing that 

global warming is having profound impacts on wildlife and its habitat and committing the federal government, in cooperation with partners, to use all practicable 

means to assist wildlife in adapting to and surviving the effects of global warming. • Second, the bill requires development of a national strategy for assisting wildlife impacted by global warming developed by the Secretary of the Interior, in consultation with other relevant federal agencies, state and local governments, tribes, 

and other partners. A committee of scientists is established to advise the Secretary 

in development of the National Strategy. The Secretaries of the Interior, Agriculture 

and Commerce are charged with implementing the National Strategy on federal 

lands and in conservation programs they administer. • Third, the bill will support improved science capacity for federal agencies to respond to global warming, including establishment of a National Global Warming 

and Wildlife Science Center in the United State Geological Survey, and enhanced 

science capacity in federal land management and wildlife agencies. • Finally, the bill directs strategic allocation of funding for implementation of the 

National Strategy and state and tribal actions to enhance wildlife resilience to global warming. The Act allocates federal funding to implement the National Strategy—

45% to federal land management agencies, 25% to federally-funded and implemented fish and wildlife programs, and 30% to states through the State and Tribal 

Wildlife Grants Program created by our subcommittee in the FY 2001 Interior appropriations bill as a mechanism to facilitate comprehensive wildlife conservation in 

each state and as an upstream solution to help conserve species before they decline 

to the point where they need Endangered Species Act protection. 

The ‘‘Survival Act’’ will help to ensure that the pressing needs faced by our natural resource management agencies and programs that help wildlife and wildlife 

habitat are addressed strategically, based on a foundation of sound scientific information, and that funding is allocated among the federal agencies and the states in 

the most efficient way possible. 

As Members of the Budget Committee, you surely can understand that, as an appropriator, and considering the pressures on the federal budget, I would call for a 

new program only if it were critically needed. In the face of the overwhelming evidence already before us showing significant impacts on wildlife borne out by observations of the federal natural resource agencies on the ground, it is apparent that 

we are behind the curve in addressing this crisis and that we must move quickly 

to start to deal with this now before it is too late. 

Also, as an appropriator, I believe that any new program must be carefully and 

solidly structured. And the ‘‘Survival Act’’ program meets that test by building on 

and better coordinating many existing federal, state and tribal conservation programs around the problem of climate change. The framework established in the 

‘‘Survival Act’’ is a strong one in which the components complement one another. 

Recently, two new reports have been released that underscore the need for the 

measures included in the ‘‘Survival Act.’’ A report released by the Government Accountability Office (GAO), ‘‘Climate Change: Agencies Should Develop Guidance for 

6

Addressing the Effects on Federal Land and Water Resources’’ evaluated how federal resources management agencies are dealing with the impacts of climate change 

and federal lands. The GAO found that the federal land and wildlife management 

agencies lack the capacity and guidance to effectively respond to the impacts of global warming on our federal lands and wildlife. On the heels of the GAO report, the 

National Academy of Sciences (NAS) released a report, ‘‘Evaluating Progress of the 

U.S. Climate Change Science Program: Methods and Preliminary Results.’’ The NAS 

report found that the government is failing to monitor global warming’s impacts at 

a regional level, which is the scale of study necessary to inform sound policy choices. 

The ‘‘Survival Act’’ directly responds to both the GAO and NAS findings by giving 

our natural resource managers the national policy direction and mandate, as well 

as the scientific capacity, to plan for, and respond to, global warming impacts on 

wildlife and its habitat. 

Of primary interest to the Budget Committee, it is my firm belief that there ultimately should be dedicated funding for the program established in the ‘‘Survival 

Act.’’ Today’s hearing examines proposals to address global warming that will likely 

generate new sources of funding for the federal government. Although the ‘‘Global 

Warming Wildlife Survival Act’’ as it currently stands merely authorizes funding to 

implement the provisions of the bill, I believe that a portion of any revenues that 

will be generated by upcoming climate change legislation should be specifically dedicated to implement the provisions of the ‘‘Global Warming Wildlife Survival Act’’ 

and I urge the Budget Committee to support me in ensuring this outcome. 

As the Chairman of the Interior and Environment Appropriations Subcommittee 

that has jurisdiction over our natural resource management agencies, I can say that 

my subcommittee allocation is already woefully stressed even to deal with the current pressing needs of the agencies and programs under its jurisdiction. Our federal 

land management agencies already have tremendous backlogs for operations and 

maintenance of our national wildlife refuges, parks, forests and other public lands. 

This situation has been greatly exacerbated by the past 6 years of Bush administration budgets and prior Congresses. Hundreds of important biologist positions have 

been cut, and the agencies’ budgets are far below what they have needed just to 

keep up with inflation. These programs have been starved to the point where they 

are on life support. It became apparent in the hearings on global warming held by 

the subcommittee that the land management agencies are already seeing broad 

changes from climate change out on the ground, but that they have few, if any, resources to deal with these changes. With these increasing impacts, our Subcommittee allocation and agency budgets will be stressed beyond the breaking point. 

I greatly appreciate the work of Chairman Spratt and the Budget Committee to provide increases for FY 2008 in Function 300, natural resources and environment 

funding, as a significant first step in addressing the current shortfalls. However, it 

will be crucial, if we are to help our nation’s wildlife and ecosystems navigate the 

global warming bottleneck, to infuse dedicated new funding into our efforts to address this crisis, and I ask the Budget Committee’s support in working with me to 

make this happen. 

Mr. Chairman and Members of the Committee, this is a great nation with a 

unique and irreplaceable natural heritage. Even though we face challenges today on 

many fronts both internationally and nationally, I believe we are a great enough 

nation not to allow our nation’s magnificent wildlife to fall to the ravages of climate 

change that we ourselves have created. I sincerely hope that by starting now we 

will be able to hold our wildlife losses to the absolute minimum, and that the lion’s 

share of our rich wildlife heritage will survive to benefit our grandchildren and future generations just as it has benefited us. Again, thank you for the opportunity 

to provide my views to the Committee.

Chairman SPRATT. Dr. Orszag, thank you for coming. You can 

proceed with your testimony. The floor is yours. 

STATEMENT OF PETER R. ORSZAG, DIRECTOR,

CONGRESSIONAL BUDGET OFFICE 

Mr. ORSZAG. Thank you very much, Mr. Chairman, Mr. Ryan, 

members of the committee. Global climate change is one of the Nation’s most significant long-term problems. The accumulation of 

greenhouse gases, especially carbon dioxide, will impose economic 

and social costs, including through rising sea levels, altering agricultural zones, and increasing the severity of storms and droughts. 

There is furthermore some risk those costs could be catastrophic. 

7

For example, if the thermohaline circulation stopped or if there 

were a breakdown of the west Antarctic ice sheet. 

In effect, we are conducting an experiment with potentially quite 

dangerous consequences and no backup plan. Mitigating those 

risks requires some reduction in carbon dioxide and other greenhouse gas emissions, which can be thought of as an insurance policy against the severe risks or the severe costs that could be entailed in the further accumulation of greenhouse gases in the atmosphere. 

Most analysis suggests that this insurance is worth purchasing; 

that is, a well-designed policy to reduce emissions would produce 

larger benefits than costs. There would, however, be costs as the 

economy adapted to lower emissions levels. Those costs would be 

much higher under a command-and-control type of approach in 

which there were, for example, technology standards that were imposed or other rigid approaches to reducing emissions. And they 

would be lower under an incentive-based approach in which the 

power of markets were used to seek out the lowest cost possible reductions. 

There are two basic incentive-based approaches to reducing emissions, a carbon tax and a cap-and-trade system. A tax is generally 

the more efficient approach for two reasons: 

First, it allows reductions to occur in the years in which they are 

cheapest to undertake. A reduction of a ton of emissions this year 

is not that much different for the climate ultimately than a reduction next year, but the cost of those reductions could vary significantly from year to year depending upon the weather, economic 

conditions, the development of technology, and other factors. A 

rigid cap each year does not allow you to undertake the emission 

reductions in the cheapest year. A tax does. In addition, a tax provides price certainty to households and to firms, and there can be 

benefits associated with that certainty. A cap-and-trade system, 

however, can be made relatively more efficient through various design features; for example including a safety valve that is a maximum price at which permits would be sold. The government would 

stand ready to sell permits at some price, and that would put a cap 

on the price risk or the potential cost of the permits. And also 

banking and borrowing, which would allow emissions to be basically shifted across years and help address that year-to-year variability that I mentioned before. 

Under cap-and-trade, the mechanism for taking emissions down 

to the cap level is an increase in the price for carbon-intensive 

goods and services. And it is very important to recognize that a 

price increase is absolutely essential to having the cap system 

work. That is the mechanism through which reductions occur, because when you price carbon-intensive goods more, there is shifting 

towards less carbon-intensive activities and production processes. 

The size of the price increase would depend on things including 

the technology available, but especially including the stringency of 

the cap. The more that you try to reduce emissions, the higher the 

price increase. It is also important to recognize that that price increase would occur regardless of whether the permits were sold to 

firms or households or were given away to them at no cost. 

8

It is sometimes thought that if you gave the permits away to 

firms, the ultimate price increases would not occur. And that is not 

likely to be correct. It is not what has occurred in the European 

Union where permits were allocated at no cost and there were price 

increases that varied from country to country. And it is not what 

we would expect to occur in the United States either. Those price 

increases by themselves are regressive, because low-income households consume a larger share of their income in the form of energy 

than higher-income households, so the price increases for carbonintensive goods and services impose a relatively larger burden on 

low-income households than higher-income households. But the 

overall distributional impact of the policy will depend not only on 

that effect, but also, very importantly, on how the value of the allowances themselves are allocated. 

We estimate that the allowances would be worth somewhere between $50 and $300 billion a year by the year 2020. And what policymakers decide to do with those allowances could have a very big 

effect on the overall distributional consequences of a cap-and-trade 

system. In particular, if the permits were allocated at no cost to 

firms, the firms would obtain that $50 to $300 billion. 

And just to put that in context, profits for U.S. producers of oil, gas and coal over the last 10 years have averaged less than $70 

billion a year. So relative to existing profits, those permits would 

be extraordinarily valuable. 

Furthermore, allocating the permits in that way would exacerbate the regressivity of the underlying policy because the shareholders in those firms tend to be disproportionately higher-income 

households. 

The alternative is to auction the permits, in which case the $50 to $300 billion a year could be used to reduce the deficit or used 

to reduce other taxes. This approach could attenuate the distributional effects if the money was used to cushion the blow, especially 

for the poor, and it could also potentially reduce the macroeconomic 

consequences if some of those funds were used to reduce other 

distortionary taxes, including the individual income tax marginal 

rates and corporate income tax marginal rates. In particular, because giving the permits away to producers would disproportionately benefit high-income households and would preclude the possibility of using the allowance value to reduce the macroeconomic 

costs, such a strategy would appear to rank low from both a distributional and efficiency perspective. 

The final part of my testimony addresses the scoring of cap-andtrade systems under our role as the Congressional Budget Office 

and the budget scoring process. This is an important topic, but has 

received little attention to date. If the permits were auctioned, it 

is fairly clear that the revenue collected would be scored as revenue. And then depending on what was done with those funds, 

there may or may not be an outlay associated with the activity. 

If the permits were given away, however, the scoring is less 

clear. There is a solid case to be made that given the depth and 

liquidity of the secondary market in these permits that giving a 

firm or a household permits worth a hundred dollars which they 

could immediately transform into cash is effectively equivalent to 

giving that firm or household $100 in cash. And therefore giving 

9

away a permit should be scored as an outlay and a corresponding 

revenue with no net effect on the budget deficit. 

That kind of treatment would put on equal footing two transactions that economists believe are equivalent. Selling the permits 

for a hundred dollars and then giving a hundred dollars to particular firms and households, or simply giving a hundred dollars’ 

worth of permits to those same firms or households, which they can 

then immediately and easily transform into cash. 

On the other hand, existing scoring—for example for the sulfur 

dioxide program—does not treat permits that are given away at no 

cost in this manner, and the Federal budget remains a primarily 

cash-based thing. And the transactions involved in giving away 

permits are not cash, they are just quasi-cash transactions. 

This scoring issue is something that CBO will be examining over 

the coming months as cap-and-trade proposals move through committee and we are forced to decide one way or the other how to 

score permits that are given away. 

Thank you very much, Mr. Chairman. 

Chairman SPRATT. Thank you, Dr. Orszag. 

[The prepared statement of Peter R. Orszag follows:]

PREPARED STATEMENT OF PETER R. ORSZAG, DIRECTOR,

CONGRESSIONAL BUDGET OFFICE

Mr. Chairman, Congressman Ryan, and Members of the Committee, thank you for 

the invitation to discuss issues related to reducing U.S. emissions of greenhouse 

gases, most prominently carbon dioxide (CO2). 

Global climate change is one of the nation’s most significant long-term policy challenges. Human activities are producing increasingly large quantities of greenhouse 

gases, particularly CO2. The accumulation of those gases in the atmosphere is expected to have potentially serious and costly effects on regional climates throughout 

the world. The magnitude of such damage remains highly uncertain. But there is 

growing recognition that some degree of risk exists for the damage to be large and 

perhaps even catastrophic. 

Reducing greenhouse-gas emissions would be beneficial in limiting the degree of 

damage associated with climate change, especially the risk of significant damage. 

However, decreasing those emissions would also impose costs on the economy—in 

the case of CO2, because much economic activity is based on fossil fuels, which release carbon in the form of carbon dioxide when they are burned. Most analyses 

suggest that a carefully designed program to begin lowering CO2 emissions would 

produce greater benefits than costs. 

The specific policy approach adopted to reduce emissions can have significant effects on the costs involved and on their distribution. In particular, an incentivebased approach for curbing CO2 emissions is substantially more economically efficient than alternative ‘‘command-and-control’’ policies, which might dictate specific 

technologies or set standards for particular products or producers. An incentivebased approach to lowering CO2 emissions could be implemented in two main ways: 

by regulating the price of those emissions (for example, by taxing emissions) or by 

adopting a market-based system to regulate the quantity of emissions (for example, 

by establishing a ‘‘cap-and-trade’’ program for them). Either approach would raise 

the price for consuming goods and services that result in CO2 emissions. Those 

price increases could provide an effective financial incentive for firms and households throughout the economy to take actions that would decrease emissions. 

My testimony makes the following key points about those issues: 

• The risk of potentially catastrophic damage from climate change can justify taking action to reduce that risk in much the same way that the hazards we all face 

as individuals motivate us to buy insurance. Some of society’s resources may best 

be devoted to addressing climate change even if the most severe risks ultimately do 

not materialize. 

• Although both a tax on emissions and a cap-and-trade system use the power 

of markets to achieve their desired results, a tax is generally the more efficient approach. The efficiency of a cap-and-trade program can be enhanced, how ever, 

through various design mechanisms, such as a ‘‘safety valve’’ that would allow addiVerDate 0ct 09 2002 12:51 Feb 13, 2008 Jkt 000000 PO 00000 Frm 00013 Fmt 6633 Sfmt 6621 J:\DOCS\HEARINGS\110TH\110-24\39491.TXT HBUD1 PsN: DICK
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tional emission allowances to be sold when the price of an allowance exceeded a 

specified level. 

• Under a cap-and-trade program, a key decision for policymakers is whether to 

sell emission allowances or to give them away. The value of those allowances would 

probably be substantial: Under the range of cap-and-trade policies now being considered by the Congress, the annual value of emission allowances would be roughly $50 

billion to $300 billion by 2020 (measured in 2006 dollars). More-stringent caps 

would result in higher total allowance values. 

• Policymakers’ decisions about how to allocate the allowances could have significant effects on the overall economic cost of capping CO2 emissions, as well as on 

the distribution of gains and losses among U.S. households. Giving allowances away 

to companies that supply fossil fuels or that use large quantities of fossil fuels in 

their production processes could create ‘‘windfall’’ profits for those firms. The reason 

is that the cap-and-trade program would still result in higher prices for consumers 

and households but would not impose additional costs on those firms. Even if the 

companies received allowances for free, they would still raise prices to their customers because the cost of using an emission allowance for production—rather than 

selling it to another firm—would be embodied in the prices that they would charge 

for their goods and services. The resulting price increases would disproportionately 

affect people at the lower end of the income scale. 

• If the government chose to sell emission allowances, it could use the revenue 

to offset the disproportionate economic burden that higher prices would impose on 

low-income households. Selling allowances could also significantly lessen the macroeconomic impact of a CO2 cap. Evidence suggests that the macroeconomic cost of 

a 15 percent cut in U.S. emissions (not counting any benefits from mitigating climate change) might be more than twice as large if policy-makers gave allowances 

away than if they sold the allowances and used the revenue to lower current taxes 

on labor or capital that discourage economic activity, such as income or payroll 

taxes. 

• The budgetary treatment of a federal cap-and-trade system for CO2 emissions 

is an important topic that has received relatively little attention. If the federal government sold emission allowances, the proceeds would clearly be scored as federal 

receipts. The appropriate treatment of allowances issued at no charge is less clear. 

There is a solid case to be made that even allowances that were given away by the 

government should be reflected in the budgetary scoring process—specifically, that 

the value of any allowances initially distributed at no cost to the recipients should 

be scored as both revenues and outlays, with no net effect on the budget deficit. A 

different perspective would suggest that issuing allowances at no charge should be 

viewed as a straightforward regulatory action, with no direct budgetary consequences. 

THE BENEFITS OF REDUCING GREENHOUSE-GAS EMISSIONS

Human activities—industry, transportation, power generation, and land use—

produce large quantities of greenhouse gases. Those gases are accumulating in the 

atmosphere more rapidly than natural processes can remove them. Atmospheric concentrations of CO2, for example, have risen from 280 parts per million in the 

preindustrial era to about 380 parts per million today. The result of that and other 

greenhouse-gas accumulation has been a gradual warming of the global climate: Average temperatures have already increased by about 0.8 C (1.4 F). 

Under a business-as-usual case, the total stock of greenhouse gases in the atmosphere would rise significantly, and estimates suggest that the global climate could 

warm by at least another 2 C to 6 C (4 F to 11 F) over the coming century. Such 

warming would impose economic and social costs—for example, by raising sea levels, 

altering agricultural zones, and increasing the severity of storms and droughts. At 

the higher end of the range of projections, the amount of warming to come would 

be at least as great as the amount that has occurred since the depths of the last 

ice age and could produce unexpected, rapid, and very costly changes in the Earth’s 

climate. Some experts think that the effects of climate change could be modest, especially if society is ingenious in adapting to the change. However, other experts are 

concerned that rising concentrations of greenhouse gases could produce much more 

severe consequences for the global and U.S. economies than have generally been 

projected—as well as other costs, such as mass species extinction, that are difficult 

to quantify in economic terms. 

Curbing greenhouse-gas emissions would help reduce not only the expected costs 

of future global climate change but also the chances of irreversible or potentially 

catastrophic damage. The Congressional Budget Office (CBO) has no basis to judge 

the scientific merits of the more extreme outcomes. But in general, the possibility 

11

of such extreme costs provides an economic motivation for additional action to moderate the growth of emissions—and, potentially, to reduce emissions to very low levels in the longer run. Individuals take actions, such as mitigating risky behavior or 

buying insurance, to reduce their harm from extreme events. Similarly, societies or 

governments do and should take actions to avoid catastrophic collective harm. The 

difficulty for policymakers is determining the appropriate cost to be paid today to 

reduce what may be a small risk of a potentially catastrophic event in the future.1

INCENTIVE-BASED APPROACHES TO REDUCING EMISSIONS

Any effort to limit CO2 emissions would have two principal effects: It would 

produce long-term economic benefits by avoiding some future climate-related damage, and it would impose immediate economic costs by reducing the use of fossil 

fuels. Most analyses suggest that a carefully designed program to begin lowering 

CO2 emissions would produce greater benefits than costs. 

Employing incentive-based policies to reduce CO2 emissions would be much more 

cost-effective than using more-restrictive command-and-control approaches (such as 

imposing technology standards on electricity generators). Command-andcontrol approaches rely on policymakers to determine where or how emissions should be cut. 

Incentive-based policies, by contrast, use the power of markets to identify the least 

expensive sources of emission reductions. Thus, they can better reflect technological 

advances, differences between industries or companies in the ability to make lowcost emission reductions, and changes in market conditions. 

The two main incentive-based approaches to reducing CO2 emissions are to tax 

such emissions or to establish a cap-and-trade program for them. Under a tax, a 

levy would be imposed on CO2 emissions or on the carbon content of goods (which 

is ultimately released in the form of CO2). Under a cap-and-trade program, policymakers would set a limit (the cap) on total emissions during some period and would 

require regulated entities to hold rights, or allowances, to the emissions permitted 

under that cap. After allowances were initially distributed, entities would be free 

to buy and sell them (the trade part of the program). Reducing emissions to the 

level required by the cap would be accomplished mainly by stemming demand for 

carbon-based energy through increasing its price.2 The size of the required price increase would depend on the extent to which emissions had to be reduced—larger 

reductions would require larger price increases to reduce demand sufficiently. 

EFFICIENCY ADVANTAGES OF A TAX ON CO2 EMISSIONS

Although both types of incentive-based approaches are significantly more efficient 

than command-and-control policies, studies typically find that over the next several 

decades, a well-designed tax would yield higher net benefits than a capand-trade approach. A tax creates relative certainty about the cost of emission reductions each 

year, because firms will undertake such reductions until the cost of decreasing emissions by another ton just equals the tax on an additional ton of emissions. A capand-trade program, by contrast, creates relative certainty about the quantity of 

emission reductions each year, because the cap limits total annual emissions. In 

terms of the impact on the climate, however, it does not matter greatly whether a 

given cut in emissions occurs in one year or the next.3 From that perspective, a tax 

has an important advantage: It allows emission reductions to take place in years 

when they are relatively cheap. Various factors can affect the cost of emission reductions from year to year, including the weather, the level of economic activity, and 

the availability of new low-carbon technologies (such as improvements in windpower technology). By shifting emission-reduction efforts into years when they are 

relatively less expensive, a tax can allow the same cumulative reduction to occur 

over many years at lower cost than can a cap-and-trade program with specified annual emission levels. In addition, by avoiding the potential volatility of allowance 

prices that might result from a rigid annual cap, a tax could be less disruptive for 

affected companies. 

The relative advantages of a tax and a cap-and-trade program could change over 

time, however. For example, because a cap creates relative certainty about the level 

of emissions, it could become more efficient than a tax if additional emissions were 

likely to trigger a sharp increase in damage, or if new technologies offered the opportunity to make extremely large cuts in emissions at a low and fairly constant 

cost. Analysts who have tried to define more precisely the conditions under which 

a cap would be more efficient than a tax have found those conditions to be quite 

narrow and not likely to be relevant in the near term. Specifically, scientists would 

need to have fairly precise knowledge about the level of an emissions threshold—

beyond which additional emissions would trigger a sharp increase in total global 

damage—and such a threshold would have to be sufficiently close that policymakers 

12

would want to make very large cuts in emissions each year to avoid crossing it.4

In the absence of those conditions, a tax offers a more efficient approach for reaching a multiyear emission-reduction target. 

ENHANCING THE EFFICIENCY OF A CAP-AND-TRADE SYSTEM

Although a tax is a more efficient policy in the near term, the efficiency of a 

capand-trade approach can be enhanced by various design features. In addition, 

some participants in the policy discussion believe that analytical comparisons of a 

tax and a cap-and-trade system ignore the idea that policymakers may be more inclined to set a tight cap than a correspondingly high tax.5

Policymakers could capture some of the efficiency advantages of a tax, while 

maintaining the structure of a cap-and-trade program, by adding features that 

would help keep the price of allowances in line with the anticipated benefits of emission cuts. For example, a price cap—typically referred to as a safety valve—and a 

price floor could keep the price of allowances from climbing too far above or falling 

too far below the anticipated benefits of emission reductions. The government could 

implement a safety valve by agreeing to sell as many allowances as firms wanted 

to buy at a specified price. (If the safety valve was triggered, emissions would exceed 

the level of the cap.) A price floor could be implemented if policymakers decided to 

sell a significant fraction of the allowances in an auction and set an auction reserve 

price. Alternatively, rather than setting a price floor, policymakers could allow firms 

to ‘‘bank’’ allowances when the cost of reducing emissions was low and to use those 

allowances in the future when costs were higher. Banking would keep the price of 

allowances from falling too low, provided that prices were expected to be higher in 

the future. 

The effects of a cap-and-trade system would also depend substantially on whether 

the allowances were sold or issued at no cost, as discussed below. 

THE DISTRIBUTIONAL CONSEQUENCES OF A CAP-AND-TRADE PROGRAM

By establishing a cap-and-trade program, policymakers would create a new commodity: the right to emit CO2. The emission allowances—each of which would represent the right to emit, say, one ton of CO2—would have substantial value. Based 

on a review of the existing literature and the range of CO2 policies now being debated, CBO estimates that the value of those allowances could total between $50 

billion and $300 billion annually (in 2006 dollars) by 2020. The actual value would 

depend on various factors, including the stringency of the cap (which would need 

to grow tighter over the years to keep CO2 from continuing to accumulate), the possibility of offsetting CO2 emissions through carbon sequestration or international allowance trading, and other features of the specific policy selected.6

Policymakers would need to decide how to allocate the allowances that would correspond to each year’s CO2 cap. One option would be to have the government capture their value by selling the allowances, as it does with licenses to use the electromagnetic spectrum. Another possibility would be to give the allowances to energy 

producers or some energy users at no charge. The European Union has used that 

second approach in its 2-year-old cap-and-trade program for CO2 emissions, and 

nearly all of the allowances issued under the 12-year-old U.S. cap-and-trade program for sulfur dioxide emissions (which contribute to acid rain) are distributed in 

that way. Policymakers’ decision about whether to sell the allowances or to give 

them away would have significant implications for the distribution of gains and 

losses among U.S. households and for the overall cost of the policy. 

The ultimate distributional impact of a cap-and-trade program would be the net 

effect of two distinct components: the distribution of the cost of the program (including the cost of paying for the allowances) and the distribution of the allowances’ 

value (because someone will pay for them, someone will benefit from their value). 

Market forces would determine who bore the costs of a cap-and-trade program, but 

policymakers would determine who received the allowance value. The ultimate effect 

could be either progressive or regressive. 

MARKET FORCES WOULD DETERMINE WHO BORE THE COSTS OF A CAP

Obtaining allowances—or taking steps to cut emissions to avoid the need for such 

allowances—would become a cost of doing business for firms that were subject to 

the CO2 cap. However, those firms would not ultimately bear most of the costs of 

the allowances. Instead, they would pass along most such costs to their customers 

(and their customers’ customers) in the form of higher prices. By attaching a cost 

to CO2 emissions, a cap-and-trade program would thus lead to price increases for 

energy and energy-intensive goods and services that contribute the most to those 

emissions. Such price increases stem from the restriction on emissions and would 

13

occur regardless of whether the government sold emission allowances or gave them 

away. Indeed, the price increases would be essential to the success of a capand-trade 

program because they would be the most important mechanism through which businesses and households were encouraged to make investments and behavioral 

changes that reduced CO2 emissions. 

The rise in prices for energy and energy-intensive goods and services would impose a larger burden, relative to income, on low-income households than on highincome households. For example, not incorporating any benefits to households from 

lessening climate change, CBO estimated that the price increases resulting from a 

15 percent cut in CO2 emissions would cost the average household in the lowest 

one-fifth of the income distribution about 3.3 percent of its income but the average 

household in the top quintile about 1.7 percent of its income (see Table 1).7

The higher prices that would result from a cap on CO2 emissions would reduce 

demand for energy and energy-intensive goods and services. Thus, those price increases would create losses for some current investors and workers in the sectors 

that produce such goods and services. Investors could see their stock values decline, 

and workers could face the risk of unemployment as jobs in those sectors were cut. 

Stock losses would tend to be widely dispersed among investors, because shareholders typically have diversified portfolios. In contrast, the costs borne by existing 

workers would probably be concentrated among relatively few households and, by 

extension, their communities. 

POLICYMAKERS WOULD DETERMINE WHO RECEIVED THE VALUE OF THE ALLOWANCES

Although the price increases triggered by a cap-and-trade program for CO2 emissions would be regressive, the policy’s ultimate distributional effect would depend 

on policymakers’ decisions about how to allocate the emission allowances. As noted 

above, those allowances would be worth tens or hundreds of billions of dollars per 

year. Who received that value would depend on how the allowances were distributed. 

Lawmakers could more than offset the price increases experienced by low-income 

households or the costs imposed on workers in particular sectors by providing for 

the sale of some or all of the allowances and using the revenue to pay compensation. 

For example, CBO examined the ultimate distributional effects of a cap-andtrade 

program that would reduce U.S. CO2 emissions by 15 percent and concluded that 


o1.eps
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lower-income households could be better off (even without including any benefits 

from reducing climate change) as a result of the policy if the government chose to 

sell the allowances and used the revenue to pay an equal lump-sum rebate to every 

household in the United States. In that case, the size of the rebate would be larger 

than the average increase in low-income households’ spending on energy and energy-intensive goods.8 Such a strategy would increase average income for households in the lowest income quintile by 1.8 percent (see the top panel of Figure 1). 

At the same time, average income for households in the top quintile would fall by 

0.7 percent, CBO estimates.

Conversely, giving all or most of the allowances to energy producers to offset the 

potential losses of investors in those industries—as was done in the cap-and-trade 

program for sulfur dioxide emissions—would exacerbate the regressivity of the price 


o2.eps
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increases. On average, the value of the CO2 allowances that producers would receive would more than compensate them for any decline in profits caused by a drop 

in the demand for energy and energy-intensive goods and services that cause emissions. As a result, the companies that received allowances could experience ‘‘windfall’’ profits, with the government regaining only part of that windfall through corporate income taxes. For example, one study suggested that if emissions were reduced by 23 percent and all of the allowances were distributed for free to producers 

in the oil, natural gas, and coal sectors, stock values would double for oil and gas 

producers and increase more than sevenfold for coal producers, compared with projected values in the absence of a cap.9 If emissions were instead reduced by 15 percent, as in the scenario discussed above, profits in those sectors would rise several 

fold. For example, in 2000, CBO examined the effects of reducing emissions from 

1998 levels and estimated that under a 15 percent cut, the value of allowances 

would be 10 times as large as coal, oil, and natural gas producers’ combined profits 

in 1998 and more than double their profits in 2006.10 Because the additional profits 

would not depend on how much a company produced, they would be unlikely to prevent the declines in production and resulting job losses that would stem from the 

price increases. 

In addition, those profits would accrue to shareholders, who are primarily from 

higher-income households, and would more than offset those households’ increased 

spending on energy and energy-intensive goods and services. Low-income households, by contrast, would benefit little if allowances were given to energy producers 

for free, and they would still bear a disproportionate burden from price increases. 

Thus, giving away allowances would be significantly regressive, making higher-income households better off as a result of the cap-and-trade policy while making 

lower-income households worse off (see the top panel of Figure 2, which, like Table 

1 and Figure 1, does not incorporate the benefits of reducing climate change). That 

regressive outcome could occur even if the government used its share of the allowance value—received through corporate income taxes on the windfall profits—to provide lump-sum rebates to households.

16

Giving away all of the allowances and using the government’s regained share of 

their value to reduce corporate tax rates would be particularly regressive. In that 

scenario (once again not including any benefits from reducing climate change), average household income would fall by 3.0 percent in the lowest quintile and rise by 

1.9 percent in the highest quintile. However, that approach would help lessen the 

macroeconomic cost of the cap on CO2 emissions. 

REDUCING THE OVERALL ECONOMIC IMPACT OF A CO2 CAP

The ways in which lawmakers could allocate the revenue from selling emission 

allowances would affect not only the distributional consequences but also the total 

economic cost of a cap-and-trade policy. For instance, the government could use the 

revenue from auctioning allowances to reduce existing taxes that tend to dampen 


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17

economic activity—primarily, taxes on labor, capital, or personal income. Research 

indicates that a CO2 cap would exacerbate the economic effects of such taxes: The 

higher prices caused by the cap would lower real (inflation-adjusted) wages and real 

returns on capital, which would be equivalent to raising marginal tax rates on those 

sources of income. Using the allowance value to reduce such taxes could help mitigate that adverse effect of the cap. Alternatively, policy-makers could choose to use 

the revenue from auctioning allowances to reduce the federal deficit. If that reduction lessened the need for future tax increases, the end result could be similar to 

dedicating the revenue to cutting existing taxes. 

The decision about whether or not to sell the allowances and use the proceeds in 

ways that would benefit the economy could have a significant impact. For example, 

researchers estimate that the efficiency cost of a 15 percent cut in emissions could 

be reduced by more than half if the government sold allowances and used the revenue to lower corporate income taxes, rather than devoting it to providing lump-sum 

rebates to households (see the bottom panel of Figure 1). The efficiency cost of a 

policy reflects the economic losses that occur because prices in the economy are distorted in ways that do not reflect the (nonenvironmental) resources used in their 

production. That cost includes decreases in the productive use of labor and capital 

as well as costs (both monetary and nonmonetary) associated with reducing emissions. To provide perspective on the magnitude of such efficiency costs, they are depicted as a share of gross domestic product. 

Giving the allowances away to producers, by contrast, would largely prevent the 

government from using the allowance value in ways that would lower the cap’s total 

cost to the economy. For example, as indicated in the bottom panels of Figures 1 

and 2, selling the allowances and using the revenue to reduce existing taxes that 

discourage economic activity would entail only about half the efficiency cost of giving 

the allowances away and devoting any revenue that the government regained 

(through the corporate income tax) to reducing those types of taxes. 

THE FEDERAL BUDGETARY TREATMENT OF A CAP-AND-TRADE PROGRAM

The budgetary treatment of a federal cap-and-trade program for carbon dioxide 

is an important topic, although it has received little attention. Auctioning off allowances would clearly generate receipts for the federal government, and those 

amounts would be recorded as revenues or as offsetting receipts (reductions in outlays) in the federal budget. For example, if the government conducted an auction 

of cap-and-trade allowances and received $100 for them, the $100 would be recorded 

in the federal budget as a receipt. 

The appropriate treatment of allowances issued at no charge is less clear, however. A solid case can be made that even allowances that are given away by the 

government should be reflected in the federal budgetary scoring process—specifically, the scoring should show, as both revenues and outlays, the value of any allowances distributed at no cost to the recipients. If the allowances given away by the 

government were worth $100, the budgetary scoring process would record the $100 

as both a revenue and an outlay.11 The net effect on the budget deficit or surplus 

would be zero, since the value of such allowances would increase revenues and outlays by the same amount. 

Several considerations motivate that type of approach to scoring CO2 allowances. 

The government is essential to the existence of the allowances and is responsible 

for their readily realizable monetary value through its enforcement of the cap on 

emissions. (The allowances would trade in a liquid secondary market, since firms 

or households could buy and sell them, and thus they would be similar to cash.) In 

addition, that type of scoring approach best illuminates the trade-offs between different policy choices. Distributing allowances at no charge to specific firms or individuals is, in effect, equivalent to collecting revenue from an auction of the allowances and then distributing the auction proceeds to those firms or individuals. In 

other words, the government could either raise $100 by selling allowances and then 

give that amount in cash to particular businesses and individuals, or it could simply 

give $100 worth of allowances to those businesses and individuals, who could immediately and easily transform the allowances into cash through the secondary market. Treating allowances that were issued at no charge as both a revenue and an 

outlay would mean that those two equivalent transactions were reflected in parallel 

ways in the scoring process. 

A different perspective would suggest that issuing allowances at no charge should 

be viewed as a straightforward regulatory act, with no direct budgetary consequences. That perspective stresses that the federal budget is primarily a cashbased concept, and granting allowances at no cost involves no cash transaction between the government and the private sector. That approach would be the same as 

18

the one now applied to the Environmental Protection Agency’s issuance of emission 

allowances for sulfur dioxide. 

As legislative proposals to create a cap-and-trade system for CO2 emissions are 

introduced in coming months, CBO will evaluate those approaches to scoring such 

proposals. 

ENDNOTES

1For more discussion of policy choices in the face of catastrophic costs, see Cass R. Sunstein, 

Worst-Case Scenarios (Cambridge, Mass.: Harvard University Press, 2007). 2 Emissions could also be reduced to some extent through ‘‘carbon sequestration’’—the capture 

and long-term storage of CO2 emissions underground (geological sequestration) or in vegetation 

or soil (biological sequestration). For more information, see Congressional Budget Office, The Potential for Carbon Sequestration in the United States (September 2007). 3 Although it is difficult to measure, the long-term cumulative nature of climate change implies that the benefit of emitting one less ton of CO2 in a given year—referred to as the marginal benefit—is roughly constant. In other words, the benefit in terms of averted climate damage from each additional ton of emissions reduced is roughly the same as the benefit from the 

previous ton of emissions reduced, and shifting the reductions from one year to another does 

not materially affect the ultimate impact on the climate. In contrast, the cost of emitting one 

less ton of CO2 in a given year—the marginal cost—tends to increase with successive emission 

reductions. The reason is that the least expensive reductions are made first and progressively 

more-expensive cuts would then have to be made to meet increasingly ambitious targets for 

emission reductions. 4See William A. Pizer, Climate Change Catastrophes, Discussion Paper 03-31 (Washington, 

D.C.: Resources for the Future, May 2003). 5Some analysts also suggest that a cap-and-trade program could be more politically acceptable 

than a tax because distributing the allowances for free could provide a method of directly compensating producers in the most affected industries. See Robert N. Stavins, AU.S.Cap-and-Trade 

System to Address Global Climate Change (Washington, D.C.: Brookings Institution, October 

2007). The revenues from a tax could be used in a similar fashion, however. 6For information about carbon sequestration, see footnote 2. 

7Those calculations are based on cash income, which excludes in-kind transfers and accrued 

but still unrealized income. CBO could have presented results based on alternative measures 

of income, such as adjusted family income, which adjusts for family size. Using that measure 

would alter the quantitative results slightly but would not affect the conclusions of the analysis 

in any qualitative way. The numbers are based on an analysis that CBO conducted using 1998 

data; see Congressional Budget Office, Who Gains and Who Pays Under Carbon Allowance 

Trading? The Distributional Effects of Alternative Policy Designs (June 2000). In an updated 

analysis, the qualitative findings would be unlikely to change, but the quantitative results could 

be significantly different because of various factors, including changes in the distribution of income and in marginal tax rates. 8One researcher has suggested that an environmental tax credit based on earnings could offer 

another means of reducing the regressive effects of the price increases that would result from 

a tax or cap on CO2 emissions. See Gilbert E. Metcalf, A Proposal for a U.S. Carbon Tax Swap 

(Washington, D.C.: Brookings Institution, October 2007). 9Lawrence H. Goulder, Mitigating the Adverse Impacts of CO2 Abatement Policies on EnergyIntensive Industries, Discussion Paper 02-22 (Washington, D.C.: Resources for the Future, 

March 2002), Table 3. 10Specifically, CBO estimated that the value of those allowances would total $155 billion (in 

2006 dollars). By comparison, profits for U.S. producers of oil, natural gas, and coal totaled $13.5 

billion in 1998 (in 2006 dollars). Those companies’ total profits were substantially higher in 

2006: $174 billion. 11The value of allowances that were given away could be estimated either from the prices 

of any allowances that were auctioned or from the prices at which allowances were subsequently 

bought and sold by firms.

Chairman SPRATT. Let me add to the housekeeping details, previously the typical stipulation that all of your statements will be 

made part of the record so that you can summarize them as you 

see fit. 

Now we will go next to Mr. Doniger. 

STATEMENT OF DAVID DONIGER, CLIMATE CENTER POLICY 

DIRECTOR, NATURAL RESOURCES DEFENSE COUNCIL 

Mr. DONIGER. I thank you very much, Mr. Chairman and Mr. 

Ryan, for the opportunity to testify. I am David Doniger. I am the 

Policy Director of the Climate Center at the Natural Resources Defense Council. I am here on behalf of our 1.2 million members and 

supporters across the country. 

19

A discussion about global warming, in my view, needs to start 

very briefly with some words on the urgency. And I wonder if I 

could have the slide shown. 

[Slide.] 

Mr. DONIGER. We are already suffering dangerous impacts from 

global warming. We used to think it was off in the future. It is 

upon us now. There is a strong consensus in the Intergovernmental 

Panel on Climate Change, that won a Nobel prize recently, that 

global warming is occurring, it is human-caused, it is within our 

power to control. The picture here shows the loss of Arctic ice at 

the summertime minimum since 1979. Forty percent of the Arctic 

ice has melted away this past year in comparison with 1979. 

As Peter mentioned, we have the danger that the Greenland ice 

sheet and the Antarctic ice sheet would melt, triggering over a 

longer period very, very large sea level rises, 21 feet from either 

one of those melting. 

We have the expectation of more wildfires like the ones that have 

been suffered in California. I am not here to say whether that was 

or was not definitively caused by global warming, but it is of the 

kind that we will see more of, because there will be stronger 

droughts occurring as a result of global warming. There will also 

be stronger hurricanes like of the kind we saw hit New Orleans in 

Hurricane Katrina. The Centers for Disease Control, when it isn’t 

being censored, acknowledges that there are public health impacts. 

I would point out as well that apart from the warming impact, 

the oceans are soaking up a great deal of carbon dioxide. This is 

increasing the acidity of the oceans. And scientists are now predicting that coral and shellfish may lose the ability to lay down 

shells as a result of the changing acidity of the oceans. 

In our view, we need to hold the future temperature increase—

we have already had about a degree Fahrenheit already occur this 

past century—we need to hold the future increase under two degrees more Fahrenheit in order to avoid the worst effects of global 

warming. And this will take a declining cap on the emissions imposed here in the U.S. by our industrial partners, and eventually 

as well by developing countries. 

In the U.S. we need a cap that would be reducing emissions by 

2020 on the order of 15 percent, and on the order of 80 percent by 

2050. That is the sort of specifications that Mr. Dingell—at least 

at the strong end of the range that he is talking about. There is 

a bill approaching that that was just marked up by Senators 

Lieberman and Warner in the subcommittee in the Senate this 

morning. 

My next point is that we can afford this, but it gets much harder 

if we delay. If I could have the second slide. 

[Slide.] 

Mr. DONIGER. The first point I would make before really referring to that slide is that estimates of the cost of these kinds of programs show that the actual effect on a growing gross domestic 

product is quite minimal. 

I will submit a study for the record that was just done by the 

Duke University Nicholas Institute that shows that by 2030 if we 

don’t have a program, we will have GDP growth on the order of 

112 percent. If we do have a declining cap like the Lieberman and 

20

Warner proposal, the growth would be 111.5 percent. And by 2050, 

238 percent growth expected. If you have a climate change program 

that might be 236.5 percent. Very small differences in our growth. 

But the longer we wait—and this is what this slide illustrates—the 

harder it is to meet these kinds of targets. Because you ramp-up 

the emissions to a higher point, and that means the ramp-down 

has to be much steeper in a shorter period of time. So a slow start 

means a crash finish. 

And that is why we think it is so important for Congress to act 

to pass this kind of legislation without further delay. A cap-andtrade program with complementary policies such as performance 

standards for efficiency and incentives to help achieve these standards and move new technologies is, we believe, the most efficient 

and effective way to meet carbon limits needed to curb this kind 

of serious impact. And I believe there are tools to smooth out the 

costs, to control the costs, such as banking and borrowing which 

Dr. Orszag mentioned. 

We are, however, opposed to including a safety valve. The fundamental problem with a safety valve, as that term has come to be 

used, is that it breaks the cap. You just keep bringing more allowances, and we don’t achieve the environmental protection objectives 

that are needed. 

One or two other points. The key thing is to look at these allowances, as Dr. Orszag has said, as a public asset, something that 

should be used for public purposes. Those can include promoting 

new technologies such as renewable energy and a faster deployment of efficiency, technologies to promote the faster takeup of carbon capture and storage by coal-burning facilities, to retool Detroit 

to help make vehicles that fit the profile we need for a carbon-constrained world, to have greener buildings and lower energy-consuming appliances, and to rebuild electricity companies’ demandside management programs to reduce energy. These are some of 

the technology-oriented uses that can be made of the value of the 

allowances. 

There is another dimension which I know Bob Greenstein will 

talk about in greater detail, but with our full support, that one 

needs to use a very large, probably the largest part of the value of 

these allowances to protect low- and moderate-income people who 

will be seeing the cost increases associated with the cap. 

There are vulnerable workers and communities in certain other 

industries which deserve to have some assistance. There is a need 

for spending to protect and restore ecosystems on land and in other 

coastal and ocean resources. 

My last point is, though, I would urge a distinction between ends 

and means, between the public purpose of the allowances and the 

tool of auctions. Auctions is a very good tool, but not the only tool 

available to achieve the public purposes that I have been describing. Some of these purposes can be achieved by having allowances 

go by formula towards certain objectives. 

For example, the Tax Code already includes production tax credits for wind energy, for example. That can also be funded, or similar things can be funded with a production allowance credit. Perhaps a certain number of allowances go to a coal-burning utility 

that stores the carbon safely geologically underground. A certain 

21

number of allowances would go to the makers of super-efficient vehicles or super-efficient appliances. These can be done by formula. 

They can also be done by raising the money through an auction 

and spending the money out by spending formulas. 

The key thing in using all these tools is the need for stability, 

for dedicated resources that are stably allocated for multiple years; 

because the investors, the marketplace, needs to have clarity not 

only coming from the cap, but clarity about how the allowances are 

going to be allocated so that smart investment decisions can be 

made. 

And to go back to the production tax credit example for a moment, the wind energy industry has suffered because the tax credit 

in that instance has come on again and off again several times. So 

you have booms and busts which are triggered by the presence or 

absence of that tax credit. Stability is important. And in that sense, 

direct allocation, directed spending, tax incentives on a multiyear 

basis are, in our view, preferred over using the annual appropriations process to achieve these purposes. 

I would be happy to answer questions. Thank you. 

Chairman SPRATT. Thank you, Mr. Doniger. 

[The prepared statement of David Doniger follows:]

PREPARED STATEMENT OF DAVID DONIGER, CLIMATE CENTER POLICY DIRECTOR, 

NATURAL RESOURCES DEFENSE COUNCIL

Thank you for the opportunity to testify today regarding the impacts of global 

warming legislation on the federal budget and the U.S. economy. My name is David 

Doniger. I am policy director of the Climate Center at the Natural Resources Defense Council (NRDC). NRDC is a national, nonprofit organization of scientists, lawyers and environmental specialists dedicated to protecting public health and the environment. Founded in 1970, NRDC has more than 1.2 million members and online 

activists nationwide, served from offices in New York, Washington, Los Angeles and 

San Francisco, Chicago and Beijing. 

Our discussion of the impacts of global warming legislation must begin with a reminder of why this legislation is so badly needed. Action to curb the pollution that 

is driving global warming has already been delayed too long. Every day we learn 

more about the ways in which global warming is already damaging our planet and 

its ability to sustain us. As described in a full page story in the October 22nd Washington Post, dramatic new satellite pictures show that summertime arctic ice has 

declined by 40 percent since 1979 (Figure 1). The UN Intergovernmental Panel on 

Climate Change found that 11 of the past 12 years are among the 12 hottest years 

on record. The Greenland and West Antarctic ice sheets are losing mass at accelerating rates. Rising sea surface temperatures correlate strongly with increases in 

the number of Category 4 and 5 hurricanes like Hurricane Katrina that devastated 

New Orleans. More wildfires like the disaster that just hit California, more heat 

waves, and more droughts and floods are predicted to occur as global warming continues unabated. Our own Centers for Disease Control—when not censored by the 

White House—calls global warming a threat to public health. Our oceans are warming and becoming more acidic, threatening the survival of corals and shellfish. Everywhere one looks, the impacts of a disrupted climate are confronting us. 

22

FIGURE 1

The reality of global warming is now a recognized fact throughout the world. Earlier this year, the United Nations Intergovernmental Panel on Climate Change 

(IPCC) concluded that warming of the earth is ‘‘unequivocal’’ and that with 90 percent certainty, humans are causing most of the observed warming. At about the 

same time, major businesses, including many of the world’s largest companies in diverse industry sectors, banded together with environmental organizations, including 

NRDC, under the umbrella of the U.S. Climate Action Partnership (USCAP) to call 

for mandatory legislation that would reduce emissions by 60-80 percent by 2050. In 

April, the United States Supreme Court ruled that greenhouse gases are air pollutants subject to control under the Clean Air Act. 

In the past year, stories about global warming have appeared on the covers of 

Time, Newsweek and Sports Illustrated. And recent polls show very high levels of 

concern about global warming. For instance, a recent opinion poll conducted by the 

Yale University Climate Center indicates that 62 percent of Americans believe that 

life on earth will continue without major disruptions, only if society takes immediate 

and drastic action to reduce global warming Finally, just this month, the Nobel 

Peace Prize was awarded jointly to Al Gore and to the IPCC for their work on global 

warming. Global warming has come of age as an issue of supreme importance. 

Climate scientists now warn that we must act now to begin making serious emission reductions if we are to avoid truly dangerous global warming pollution concentrations. Because carbon dioxide and some other global warming pollutants remain in the atmosphere for many decades, centuries, or even longer, the climate 

change impacts from pollution released today will continue throughout the 21st century and beyond. Failure to pursue significant reductions in global warming pollution now will make the job much harder in the future—both the job of stabilizing 

atmospheric pollution concentrations and the job of avoiding the worst impacts of 

a climate gone haywire. 

Since the start of the industrial revolution, carbon dioxide concentrations have 

risen from about 280 parts per million (ppm) to more than 380 ppm today, and global average temperatures have risen by more than one degree Fahrenheit over the 

last century. A growing body of scientific opinion has formed that we face extreme 

dangers if global average temperatures are allowed to increase by more than another 2 degrees Fahrenheit from today’s levels. We may be able to stay within this 

envelope if atmospheric concentrations of CO2 and other global warming gases are 

kept from exceeding 450 ppm CO2-equivalent and then rapidly reduced. However, 


don1.eps
23

this will require us to halt U.S. emissions growth within the next few years and 

then cut emissions by approximately 80% over the next 50 years. 

This goal is ambitious, but achievable. It can be done through an annual rate of 

emissions reductions that ramps up to about a 4% reduction per year. (See Figure 

2.) But if we delay and emissions continue to grow at or near the business-as-usual 

trajectory for another 10 years, the job will become much harder. In such a case, 

the annual emission reduction rate needed to stay on the 450 ppm path would double to 8% per year. In short, a slow start means a crash finish, with steeper and 

more disruptive cuts in emissions required for each year of delay. 

FIGURE 2

It is critical to recognize that continued investments in old technology will ‘‘lock 

in’’ high carbon emissions for many decades to come. This is particularly so for the 

next generation of coal-fired power plants. Power plant investments are large and 

long-lasting. A single plant costs around $2 billion and will operate for 60 years or 

more. If we decide to do it, the United States and other nations could build and operate new coal plants that return their CO2 to the ground instead of polluting the 

atmosphere. With every month of delay we lose a piece of that opportunity and commit ourselves to 60 years of emissions. The International Energy Agency (IEA) forecasts that more than 20 trillion dollars will be spent globally on new energy technologies between now and 2030. How this money is invested over the next decade, 

and whether we will have the proper policies in place to drive investment into cleaner technologies, which can produce energy from zero and low carbon sources, or that 

can capture and dispose of carbon emissions, will determine whether we can realistically avoid the worst effects of global warming. 

We have the solutions—cleaner energy sources, new vehicle technologies and industrial processes and enhanced energy efficiency. We just lack the policy framework to push business investments in the right direction and to get these solutions 

in the hands of consumers. 

Congress is beginning to respond. Many bills to cap and reduce global warming 

pollution have been introduced in the House and Senate this year. The strongest 

of these bills—H.R. 1590, sponsored by Rep. Henry Waxman and a bipartisan group 

of 142 other members, and S. 309, co-sponsored by Senators Bernie Sanders and 

Barbara Boxer and 19 other members—would reduce U.S. emissions 80 percent by 

2050. The committees of jurisdiction are also working hard on serious legislation. 

In the Senate, the Environment and Public Works Committee is taking up the bipartisan America’s Climate Security Act, S. 2191, co-sponsored by Senators Joseph 

Lieberman and John Warner, a cap-and-trade bill that would cut the global warmVerDate 0ct 09 2002 12:51 Feb 13, 2008 Jkt 000000 PO 00000 Frm 00027 Fmt 6633 Sfmt 6621 J:\DOCS\HEARINGS\110TH\110-24\39491.TXT HBUD1 PsN: DICK

don2.eps
24

1http://energycommerce.house.gov/Climate—Change/White—Paper.100307.pdf 

2 EPA, Analysis of The Climate Stewardship and Innovation Act of 2007, S. 280 in 110th Congress, July 16, 2007, http://www.epa.gov/climatechange/downloads/s280fullbrief.pdf 

ing pollution from three key sectors—electric power, transportation, and industry—

15 percent by 2020 and 70 percent by 2050, with additional policies to reduce emissions from other sources. Here in the House, Energy and Commerce Chairman John 

Dingell and Subcommittee Chairman Rick Boucher have started the legislative process by circulating a white paper on the scope of a cap-and-trade program to reduce 

U.S. global warming pollution 60-80 percent by 2050.1

NRDC believes a declining emissions cap and an emissions allowance trading system—combined with complementary policies such as performance and efficiency 

standards and incentives for new power plants, vehicles, appliances, buildings, and 

renewable sources of electricity and motor fuel—is the most environmentally effective and economically efficient approach to curbing global warming pollution. (I 

would note that a final energy bill containing the best of the House and Senate provisions would enact some of the most important of these performance and efficiency 

standards, including the House’s renewable electricity standard and the Senate’s 

CAFE standard, and would be a down-payment on global warming.) 

Under a cap-and-trade system, Congress creates a limited number of emissions 

‘‘allowances’’ in an amount equal to the intended emissions cap. The cap, and the 

number of allowances, declines each year. Each entity that Congress designates—

for example, power plants, oil refiners, major industries—must acquire and then 

turn in one allowance for each ton of CO2 (or the equivalent amount of another 

greenhouse gas) that it emits, or that will be emitted when its products (like gasoline or refrigerants) are burned or released to the atmosphere. Tradable allowances 

can also be bought or sold. A cap-and-trade system thereby harnesses the marketplace to achieve the necessary pollution reductions and meet the cap at the lowest 

cost. Firms with low pollution control costs will make the most reductions, and firms 

with highest costs will make the least. 

Analyzing a predecessor to the Lieberman-Warner bill, the Environmental Protection Agency found that reducing global warming pollution will have an imperceptible affect on economic output overall. If that bill were enacted, EPA found consumption of goods and services by U.S. households would increase 103% between 

2005 and 2030, which is virtually indistinguishable from the 105% increase projected without the legislation.2 Household consumption, of course, is not the same 

as welfare. It does not include the value we place on reducing the risk of catastrophic storms, preserving our favorite beaches and alpine meadows, and preventing polar bears and countless other species from being driven to extinction. 

Some have expressed the view that even these modest costs are too high, and that 

legislation should include a feature—often called a ‘‘safety-valve’’—to artificially 

limit the operation of the marketplace. The fundamental problem with the safety 

valve is that it breaks the cap without ever making up for the excess emissions. 

Simply put, the cap doesn’t decline as needed or, worse, keeps growing. In addition 

to breaking the U.S. cap, a safety valve also would prevent U.S. participation in 

international trading systems. If trading were allowed between the U.S. and other 

capped nations, a major distortion would occur. Firms in other countries (acting directly or through brokers) would seek to purchase the artificially lower-priced U.S. 

allowances. Their demand would almost immediately drive the U.S. allowance price 

to the safety valve level, triggering the ‘‘printing’’ of more American allowances. The 

net result would be to flood the world market with far more allowances—and far 

less emission reduction—than anticipated. 

Although NRDC believes that the primary and most effective cost containment device in any mandatory legislation will be the cap-and-trade system itself, NRDC also 

supports other means of providing flexibility. Banking has long been a feature of 

cap and trade systems. We also support provisions allowing firms to borrow allowances with appropriate interest and payback guarantees. Banking and borrowing 

can smooth out unpredictable year-to-year volatility. 

As members of this committee are aware, one must pay close attention to the equity of major national policies, as well as their efficiency. In this regard, a cap-andtrade system requires careful attention to how the emissions allowances are allocated, and for what purposes. Even though the overall economic cost of curbing global warming will be modest, the value of the pollution allowances created by a capand-trade law will be much higher: The best estimates of their value lie between 

$50 billion and $100 billion per year. 

NRDC believes these pollution allowances are a public trust and a public asset. 

They represent permission to use the atmosphere, which belongs to all of us, to dispose of global warming pollution. As such, they are not a private resource owned 

25

3 CBO, Trade-Offs in Allocating Allowances for CO2 Emission, April 25, 2007, p.5, http://

www.cbo.gov/ftpdocs/80xx/doc8027/04-25-Cap—Trade.pdf 

by historical emitters and such emitters do not have a permanent right to free allowances. The value of the allowances should be used for public purposes, including 

promoting clean energy solutions, protecting the poor and other consumers, ensuring 

a just transition for workers in affected industries, and preventing human and ecosystem impacts both here and abroad, especially where they can lead to conflicts 

and threats to security. 

If one looks back over the past few years of debate over global warming legislation, one can see a marked shift in thinking about allowance allocation. Five years 

ago, the common assumption was that all of the emissions allowances should simply 

be given away—grandfathered—to historical polluters. This is what was done with 

the much smaller pool of allowances for sulfur dioxide in the 1990 Clean Air Act 

amendments which established the cap-and-trade program to curb acid rain. The 

acid rain program has been extremely successful at meeting its environmental target at much lower cost than predicted. But the grandfathering approach to allowance allocation chosen in 1990 is not appropriate for a global warming program 

adopted now. 

Economic studies have established that in the case of global warming, 100 percent 

grandfathering would result in vastly enriching the regulated entities. The Congressional Budget Office has summarized this literature as follows: 

Researchers generally conclude that less than 15 percent of the allowance value 

would be necessary to offset net losses in stock values in both ‘‘upstream’’ industries 

(such as suppliers of coal, natural gas, and petroleum) and energy-intensive ‘‘downstream’’ industries (such as electricity generators, petroleum refiners, and metal and 

machinery manufacturers). The reason is that the cost of holding the allowances 

would generally be reflected in the prices that producers charged, regardless of 

whether those producers had to buy the allowances or were given them for free.3

It follows that if more than about 15 percent of the allowances are given away 

to polluters for free, there will be a large transfer of wealth to them at the expense 

of consumers. And as CBO further found the impact would be disproportionate for 

poor consumers, who have the least income and who must devote a larger percentage of their income than others for energy-related costs. 

These insights have been borne out in real experience. The European Union deserves great credit for moving forward with a cap-and-trade program for a large 

fraction of their emissions in 2005, even before their obligations under the Kyoto 

Protocol take effect in 2008. But they have made some start-up mistakes—an experience they are learning from and we should too. Specifically, they grandfathered 

100 percent of their allowances to electric power companies. Predictably, the electric 

companies raised electricity prices to reflect the value of those allowances, even 

though they received the allowances for free. From these price increases the firms 

reaped several billion dollars in windfall profits. 

In the other direction, a group of U.S. states in the northeast have established 

the ‘‘Regional Greenhouse Gas Initiative,’’ a cap-and-trade program for electric 

power in that region. All of these states so far have chosen to auction their allowances and use them for promoting energy efficiency and other public purposes. For 

example, Governor Spitzer announced last week that New York will auction 100 

percent of its CO2 allowances and use the proceeds from the auction to fund energy 

efficiency programs and renewable energy projects. 

As a result of these insights and experiences, there is more and more acceptance 

that the bulk of the allowances must go to public purposes, not private enrichment. 

Still, the battle is not yet entirely won. In this body, there are some who still speak 

of grandfathering nearly all of the allowances. And in the Senate, while the 

Lieberman-Warner bill eventually devotes most allowances to a variety of public 

purposes—promoting clean energy solutions, protecting the poor and other consumers, ensuring a just transition for workers in affected industries, and preventing 

human and ecosystem impacts both here and abroad, especially where they can lead 

to conflicts and threats to security—it still grandfathers too many allowances to 

power companies and industries at the outset and takes too long to phase out that 

grandfathering. We are working cooperatively with the sponsors and others to improve their bill. 

Note that in this discussion I generally have said ‘‘public purposes’’ rather than 

‘‘auction.’’ I put it this way in order to focus on the ends before the means. It is 

possible to directly and efficiently allocate allowances to achieve many of the public 

purposes to which they should be put. Here are some examples found in bills introduced either in this or prior Congresses: 

26

4http://www.pewtrusts.org/our—work.aspx?category=130. 

• Promoting renewable energy: Congress could write legislation that includes an 

appropriate formula for allocating bonus allowances to firms that produce electricity 

from wind or other renewables. The recipient would sell the allowances into the 

marketplace to realize their value. The incentive would function just like the current production tax credit for wind: the developer of a new wind farm would receive 

incentive revenue in proportion to its electricity output. • Encouraging Carbon Capture and Storage: Congress could include a bonus allowance formula to encourage power companies to adopt carbon capture and storage 

technology. As above, the power company would receive incentive revenue from selling the allowances in the marketplace. • Retooling the Auto Industry: To help domestic automakers retool and reposition 

for a changing market, Congress could establish an allowance allocation formula 

that functioned like a consumer rebate to encourage the purchase of low-emitting 

vehicles. • Greening Buildings, Equipment, and Appliances: Likewise, allowance formulae 

could be written to promote faster deployment of highly energy-efficient appliances 

and construction of highly energy-efficient buildings. • Demand-Side Management and Climate Rebates: Allowances also could be allocated to local electric and gas distribution utilities on condition that the proceeds 

from selling them into the marketplace are used to fund energy efficiency and rebate programs for their consumers. 

These same objectives could be achieved, of course, by auctioning the allowances 

and using the revenue to support tax credits, directed spending, or appropriations 

aimed at the same results. Direct allocation of allowances for these public purposes, 

however, has the advantage that it can be accomplished in a single piece of legislation. It can also create incentives that planners and investors will see as stable and 

predictable over multi-year periods. To achieve the same degree of stability and effectiveness through an auction approach, it would be critical to put the allowance 

revenue into a dedicated trust fund mechanism that is sheltered from the uncertainties introduced by annual appropriations. 

There are some public purposes, however, that can be more effectively and efficiently pursued through such measures as tax credits or programs administered by 

federal or state agencies. For example, as Robert Greenstein of the Center on Budget and Policy Priorities will elaborate, in order to protect low-income consumers 

from a disproportionate distributional impact, the most effective and efficient approach may be a combination of (1) raising the Earned Income Tax Credit, and (2) 

delivering climate rebates through the electronic benefits card already used to deliver benefits to poor Americans. Likewise, an efficient way to deliver a climate rebate to moderate-income consumers would be through an increase in the standard 

deduction for income taxes. 

Another example of an important public purpose is transition assistance for workers and communities that otherwise would be disproportionately affected by a climate program. Assistance programs provided through government agencies could be 

funded by statutorily directing a certain percentage of auction revenues. 

Likewise, programs to protect our nation’s health and our land and ocean resources, which are already suffering serious global warming impacts, could be funded with auction revenues. Indeed, a dedicated trust fund for the protection of ocean 

resources was a recommendation of the non partisan Pew Oceans Commission in 

2003.4

Whether the means to achieve these public purposes is direct allowance allocation 

or the use of auction revenues, it is important to put things on a stable footing. Allocation formulae, tax credits, and dedicated funding can provide such stability. These 

are preferable to year-to-year appropriations, which introduce more uncertainty. 

Whether one is thinking of technology investors or low-income beneficiaries, there 

is significant value in establishing stable and predictable incentives and benefits. 

Finally, while the resources that can be made available in a cap-and-trade program to fight global warming may seem significant, so are the public needs associated with the program—promoting new technology, protecting low- and moderateincome citizens, providing transition assistance for workers and communities, and 

addressing both domestic and international adaptation needs. Therefore, regardless 

of other chronic budget needs that could make a claim to these resources, it is critically important given the magnitude of the threat from global warming that the top 

priority for their use be the success of this program. 

Let me briefly mention a couple of additional issues in designing a national capand-trade system. Some contend we should do nothing until China and India agree 

to act. To the contrary, the best way to bring China and India on board is to take 

27

leadership. We are the world’s most powerful economy. We are responsible for more 

of the global warming pollution now in the atmosphere than any other country. We 

have the most technological know-how. The best way to get global action is to start 

acting at home, and to negotiate reciprocal action from other countries. 

We’ve done this before. Twenty years ago, in 1987, industrial nations took the 

lead in a binding treaty to phase-out ozone-depleting CFCs. In just three years, in 

1990, developing countries came on board. Led by China and India, they accepted 

binding limits on their own CFC production. Since then we’ve marched together—

developed and developing—ever since, and have already eliminated 95 percent of 

the ozone-depleting chemicals. Just this past September, China and India agree to 

a new round of mandatory cuts in ozone-depleting chemicals. What’s missing on 

global warming is our leadership. We are the only major industrial country that has 

refused to limit its own emissions. It’s time to act. 

At the same time, Congress can design legislation to encourage other nations to 

join in action to reduce greenhouse gas emissions, and to protect American businesses and workers from unfair competition if specific nations decline to cooperate. 

Under a proposal advanced by American Electric Power and the International 

Brotherhood of Electrical Workers, the United States legislation would instruct the 

President to negotiate for ‘‘comparable’’ emissions reductions from other emitting 

countries within 8 years of enactment. Countries failing to make such commitments 

would be required to submit greenhouse gas allowances for certain carbon intensive 

products. NRDC supports this provision, while bearing in mind that the U.S., as the 

world’s greatest contributor to the burden of global warming pollution already in the 

atmosphere, needs to show leadership in meeting the global warming challenge. 

Thank you for the opportunity to testify and I would be pleased to answer any 

questions that you may have.

Chairman SPRATT. And now Bob Greenstein. 

STATEMENT OF ROBERT GREENSTEIN, EXECUTIVE 

DIRECTOR, CENTER ON BUDGET AND POLICY PRIORITIES 

Mr. GREENSTEIN. Thank you, Mr. Chairman. My focus will be on 

the potential effects of climate change legislation on the Federal 

budget and the budgets of American families, especially those of 

modest means. 

Our analysis indicates that Congress can develop climate change 

policy that is environmentally sound, fiscally responsible, and that 

treats low-income families equitably. But to do so, the policy has 

to be well designed. Our analysis of these issues is summed up, to 

a significant degree, in four sets of numbers that I would now like 

to discuss. The first number is $750 to $950 a year. That is the average increase in energy-related costs for households in the poorest 

fifth of the population from a relatively modest reduction, 15 percent, in emissions. 

As Dr. Orszag noted, effective policies to reduce emissions work 

in part by raising prices for fossil fuel energy products. And that 

will raise prices to consumers for a wide array of items from heating fuel, to gasoline, electricity, food, mass transit, and various 

other products and services with energy inputs. 

As Dr. Orszag also noted, households—and I think Mr. Ryan also 

noted—households with limited incomes will be affected the most 

since they spend a larger share of their incomes on energy-related 

products than more affluent households do. And it should be noted 

that lower-income households also have less ability to afford investments that can reduce their energy consumption, like buying a 

new, more fuel-efficient car or replacing your heating and cooling 

system with a new one. 

This means that if climate change legislation is passed but nothing is done to protect people of modest means, many of them will 

slip into poverty. Those who are poor will become poorer, and the 

28

trend towards widening income inequality will be aggravated: $750 

to $950 a year is a particularly large number when you reflect on 

the fact that the average income of households in the bottom fifth 

of the population is a little more than $13,000 a year. 

Figure number two you have already heard from Peter Orszag, $50 billion to $300 billion a year, which is the Congressional Budget Office’s estimate of the resources potentially generated by climate change policies that could be used to assist low-income consumers and address a range of other climate change-related needs. 

In other words, this would be the amount that would be raised if 

the government auctioned off permits under a cap-and-trade system, because it is the expected value of the permits that would be 

created. 

Figure number three is approximately 14 percent. This is the 

share of the auction proceeds that we estimated would be needed 

to fully offset the increased energy costs faced by low-income consumers and provide some relief to moderate-income consumers as 

well. 

In my written testimony I set forth a series of principles—we 

elaborate on them more in our paper that is on our Web site—for 

how to effectively and efficiently, without new bureaucracies or big 

administrative costs, provide this kind of relief so that we would 

fully offset the impact on the poorest 20 percent of people and provide some relief to many hard-pressed families in the next 20 percent as well. We estimate that that could be done with 14 percent, 

that is one-seventh of the resources that would be generated by 

auctioning off all the permits in a cap-and-trade system. And because the resources would come from the revenues, the new system 

created, it would not increase the deficit or put any pressure on the 

budget. It would be part of the self-contained system that climate 

change legislation created. 

Of course, there are other legitimate claims that arise on the 

budget from climate change legislation as well. Beside the need to 

protect vulnerable population, these include basic research into alternative energy resources, as Mr. Doniger noted, assistance for 

workers and communities that depend upon the coal industry and 

other industries that will be most affected by the shift to a less carbon-intensive economy. 

In addition, I want to note, of particular interest to this committee I would think, higher energy prices will raise costs to Federal, State, and local governments. They consume energy-related 

products. For example, the single largest consumer of energy in the 

United States is the U.S. Department of Defense, not surprisingly. 

What that means is that if those costs are not offset, either the 

Federal deficit will rise or government services will have to be reduced or taxes raised. 

But this too can readily be addressed. If one auctions off the 

lion’s share of the permits, one can take the appropriate fraction 

of the permits, or the proceeds from an appropriate fraction of the 

permits, use them to offset these costs so that the net effect on the 

Federal Government is a deficit-neutral effect. 

My fourth and final number, and could you put up the blue slide 

at this point, the one called Well-Designed Climate—thank you 

very much. 

29

[Slide.] 

Mr. GREENSTEIN. My final number is also from the Congressional 

Budget Office. And this is 15 percent, actually, technically, a little 

less than 15 percent. This is the share of the potential resources 

from auctioning off permits that the Congressional Budget Office, 

based on a thorough review of the literature in the field, estimates 

is needed to compensate energy companies and other emitters for 

financial losses due to climate change. 

This indicates that about 85 percent of the permits could safely 

be auctioned, a quite sufficient amount to meet the legitimate 

budgetary needs and to avoid increases in poverty, increases in 

deficits to fund the necessary basic research into alternative energy 

sources and so forth. 

So the real bottom line here, as we see it, is the need to ensure 

that needed legislation to address global warming that uses a capand-trade system if it does, auctions off the bulk of the allowances, 

gives away those needed to make emitters whole, but auctions off 

the rest rather than giving away more than is needed to make 

emitters whole by giving too many of them away free to energy 

companies. 

Again, CBO’s estimate of the evidence is about 15 percent would 

be needed to make—offset the effects on energy companies. And I 

believe the term CBO has used is ‘‘windfall’’ gains for what would 

result if significantly more than that amount were given away free 

to the companies. 

I looked yesterday at a recent piece written by Greg Mankiw, the 

former Chairman of President Bush’s Council of Economic Advisors, one of the Nation’s most distinguished economists. Dr. 

Mankiw, in this piece, notes that if you had a cap-and-trade system 

that gave away to the energy companies more than was needed to 

offset their costs, what you basically would be doing would be to 

establish a very large program of—Dr. Mankiw’s term—‘‘corporate 

welfare.’’

I would also note, and I will be very brief here because Dr. 

Orszag already really covered this, that the main argument one 

sometimes hears for giving away more of the permits is the claim, 

well, if you give them away, prices to consumers won’t go up; but 

if you auction them off, they will. As Dr. Orszag has noted, that 

belief is simply not correct. It defies the basic laws of supply and 

demand. And I doubt that many, if any, economists, regardless of 

where they are on the political spectrum, would subscribe to that 

view. So in conclusion, well-designed climate change policy can generate sufficient resources to meet legitimate budgetary claims that 

arise from the policy. If we do a cap-and-trade policy, that means 

it is necessary to auction off most of the permits. If that is done, 

the proceeds can be used to avoid increasing poverty, increasing 

deficits or debt, and also allowing resources to fund alternative energy, shield coal mining communities, and the like. The key, again, 

making sure that we auction off the appropriate share of the permits rather than failing to meet budgetary needs, failing to meet 

the needs of low-income families, and erecting a new program of 

corporate welfare instead. 

Chairman SPRATT. Thank you, Mr. Greenstein. 

[The prepared statement of Robert Greenstein follows:]

30

1The Congressional Budget Office has provided a figure of $680 for the average increase in cost for the bottom 20 percent of households. It should be noted that the $680 figure is for the 

fifth of households with the lowest incomes, not the poorest fifth of the U.S. population. There 

is an important difference. If one simply ranks households by income, regardless of household 

size, then the bottom fifth of households disproportionately consists of one- and two-person 

households, and as a result, includes significantly less than one-fifth of the people in the United 

States. Moreover, the bottom fifth of households, if measured in this manner, includes many 

small households that are not poor (i.e., that are above the poverty line), while missing many 

larger households that are poor. (The poverty line is adjusted by household size.) The $680 figure for the bottom fifth of households is measured in this manner. CBO has also developed a 

standard methodology to address this household-size problem when dividing households into income quintiles (or income ‘‘fifths ’’) and uses that methodology in most of the work it conducts 

on income distribution issues. We use the CBO size-adjustment methodology here to allow us 

to examine the poorest fifth of the population, rather than the bottom fifth of households irrespective of household size. This produces a figure of $750 to $950 for the poorest fifth of the 

U.S. population. 

PREPARED STATEMENT OF ROBERT GREENSTEIN, EXECUTIVE DIRECTOR,

CENTER ON BUDGET AND POLICY PRIORITIES

Effective action to reduce greenhouse gas emissions is necessary to prevent costly 

and potentially catastrophic environmental and economic damages from climate 

change. The Center on Budget and Policy Priorities is not making recommendations 

about how much we need to reduce emissions; that is not our area of expertise and 

we leave those recommendations to experts in environmental policy. Instead, our 

focus is on how climate change legislation might affect 1) the budgets of American 

families, especially those of modest means; and 2) the federal budget. 

Our analysis indicates that Congress can develop climate change policy that is environmentally and economically sound and fiscally responsible, and that treats lowincome families equitably, avoiding increases in poverty and hardship. To achieve 

these objectives, however, the policy has to be well designed. This means the policy 

must generate sufficient budget resources to address the requirements and challenges of sound climate-change policy—including the resources needed to offset the 

direct impact of those policies on the federal budget—and must cushion the impact 

on vulnerable populations, especially people with low incomes. 

FOUR KEY NUMBERS ON CLIMATE POLICY, THE BUDGET, AND LOW-INCOME FAMILIES

Our analysis of the effects of climate-change policy on the federal budget and the 

budgets of low-income households can be summed up in four key sets of numbers. 

1. $750—$950 per year: the average increase in energy-related costs for the poorest 

fifth of the population from a modest (15 percent) emissions reduction 

Effective policies to reduce greenhouse-gas emissions work in part by raising the 

prices of fossil-fuel energy products to encourage energy efficiency and the substitution of clean energy sources for fossil fuel. This is essential to prevent extensive 

environmental and economic damage from climate change. However, it will raise 

costs to consumers for a wide array of products and services, from gasoline and electricity to food, mass transit, and other products or services with significant energy 

inputs. 

Households with limited incomes will be affected the most by those higher prices, 

since they spend a larger share of their incomes on energy-related products and 

services than more affluent households do. They also are less able to afford investments that can reduce their energy consumption, such as buying a more efficient 

car or a new heating and cooling system. If nothing is done to protect people of limited means, many more of them will slip into poverty, those who are poor will become poorer, and the trend toward widening income inequality will be aggravated. 

$750 to $950 per year is our estimate of how much, if left to fend for themselves, 

average families in the poorest 20 percent of the population would have to come up 

with to cover the increased costs arising from a 15 percent reduction in emissions.1

This is a group whose average income is only modestly over $13,000 a year, and 

our $750-$950 estimate already takes into account increases in cost of living adjustments that they may receive, such as through the annual Social Security COLA, as 

a result of higher energy costs. Moreover, the 15 percent reduction in emissions, 

which is what CBO uses in its analysis, is relatively modest by the standards of 

current proposals. It is 15 percent below business-as-usual levels (what emissions 

would be if there were no restrictions), not 15 percent below the 1990 or 2005 levels 

that are often used as benchmarks in legislative proposals. Those benchmarks themselves are well below business-as-usual levels. 

31

2. $50 billion to $300 billion per year: resources potentially generated by climatechange policies to help low-income consumers and to address other climatechange-related needs 

Fortunately, the same climate-change measures that generate higher energy-related costs can also generate substantial resources to cover those costs. CBO estimates that various recent proposals to limit greenhouse-gas emissions by establishing a cap-and-trade system would create a valuable resource—emission permits—that would be worth $50 billion to $300 billion per year by 2020, depending 

on the specifics of each proposal. That is how much revenue the government could 

expect to raise if it auctioned off all of the permits. It is also how much revenue 

the government could expect to raise if a carbon tax with a similar effect on limiting 

emissions were used instead of a cap-and-trade approach. 

3. Approximately 14 percent: share of auction proceeds or carbon tax revenues needed 

to fully offset the increased energy-related costs faced by low-income consumers 

The amount of revenue the government could raise by auctioning off all of the permits in a cap-and-trade system is far more than what would be needed to protect 

low-income consumers from higher energy-related prices arising from climatechange legislation. We estimate that a program designed according to the principles 

laid out later in this testimony, which would fully offset the impact on the poorest 

20 percent of people and also provide some relief to many hard-pressed working 

families in the next 20 percent, could be fully funded with approximately 14 percent 

of the resources that would be generated by auctioning off all the allowances in a 

cap-and-trade system, or by a carbon tax. 

The specific dollar amounts in our first two sets of numbers—$750 to $950 per 

year of added costs for low-income consumers and $50 to $300 billion per year of 

potential revenue are tied to specific emissions targets, but the 14 percent figure 

is not. When the emissions target is looser (and hence the emissions reduction is 

smaller)—as it would be in the early years of most proposals—the dollar amount 

of revenue that could be raised would be lower, but so too would be the increase 

in energy prices and the amount of added costs that households would face. As the 

cap tightens and larger emissions reductions are called for, the added costs to 

households increase, but so too does the potential revenue that would be available 

to offset those costs. In each case, the revenue needed to protect low-income consumers would be about 14 percent of the revenue that could be generated. 

4. Less than 15 percent: share of potential budget resources needed to fully compensate energy companies and other emitters for financial losses due to climatechange policies 

Although the resources that can be generated by sound climate-change policies 

are substantial, so too are the budget claims arising from those policies. Besides the 

need to protect vulnerable populations, those claims include basic research into alternative energy sources, assistance for workers and communities that depend on 

the coal industry and other industries most affected by the shift to a less carbonintensive economy, and other needs. In addition, higher energy prices will drive up 

the cost to federal, state, and local governments of providing many important services and benefits. Unless these costs are offset, government services will have to be 

reduced or taxes raised, or the federal deficit will rise. 

In a cap-and-trade system, making sure there are adequate budget resources requires that most of the emission allowances are auctioned off, not given away for 

free to energy companies and other emitters due to misconceptions about the financial losses they would incur. One misconception is that those losses would be very 

large. CBO’s review of the evidence, however, concludes that less than 15 percent 

of the total value of the allowances would be sufficient to offset the net financial 

losses of companies affected by policies to restrict emissions. More than that would 

simply create what CBO has called ‘‘windfall profits’’ for companies receiving the 

free allowances. 

A related misconception about cap-and-trade may also contribute to the belief that 

large numbers of emission allowances should be given away to energy companies 

and other industrial emitters. This is the mistaken belief that energy prices will not 

rise if the allowances are given away. That belief is not correct; it flies in the face 

of the basic law of supply and demand. A cap on emissions will limit the amount 

of energy produced from fossil fuels. Regardless of whether the government gives 

away or sells the allowances, market forces will raise the price of fossil-fuel energy 

to the point where the amount demanded will fall to equal the amount supplied. 

Either way, energy companies will be able to sell their products at the higher price. 

The increase in prices is the source of windfall profits for the companies that receive 

allowances for free but are able to charge the higher price. 

32

2Greg Mankiw, ‘‘Greg Mankiw’s Blog: Random Observations for Students of Economics,’’ August 2, 2007. 

There are legitimate policy issues around the choice between a carbon tax and a 

cap-and-trade mechanism. But we should not let misconceptions cloud the debate 

or create false choices. Here is how Harvard economist Greg Mankiw, who served 

as Chairman of President Bush’s Council of Economic Advisers, has characterized 

a cap-and-trade mechanism under which the allowances are given away: 

Economists recognize that a cap-and-trade system [in which the allowances are 

given away to emitters] is equivalent to a tax on carbon emissions with the tax revenue rebated to existing carbon emitters, such as energy companies. That is, Capand-trade [under which the allowances are given away to emitters] = Carbon tax 

+ Corporate welfare.2

AVOIDING REGRESSIVE OUTCOMES WHILE MEETING OTHER CLIMATE-RELATED BUDGET

PRIORITIES

The policies needed to reduce greenhouse-gas emissions would, by themselves, result in regressive changes in energy prices. But they also can generate substantial 

revenue that could be used to offset those regressive impacts. Our analysis, like that 

of CBO, shows that the potential revenue from auctioning off emission allowances 

under a cap-and-trade system could yield more than enough revenue to offset the 

losses likely to be experienced by low- and moderate-income families and by workers 

in the industries hit hardest by the adjustment to a less carbon-intensive economy. 

The revenue could be sufficient both to address these issues and to meet various 

other legitimate purposes arising from the legislation as well (see figure 1).

In contrast, giving away a substantial fraction of emission allowances to existing 

energy producers would do almost nothing to compensate low- and moderate-income 

families for their losses. A very large percentage of the benefits of such a giveaway 

would go to shareholders of the energy companies, most of whom have high incomes, 

while little revenue would be available to mitigate the effects on those least welloff. 

Addressing regressivity and adjustment costs would not be the only claims on the 

resources that could be generated by a cap-and-trade system or carbon tax. GovernVerDate 0ct 09 2002 12:51 Feb 13, 2008 Jkt 000000 PO 00000 Frm 00036 Fmt 6633 Sfmt 6621 J:\DOCS\HEARINGS\110TH\110-24\39491.TXT HBUD1 PsN: DICK

green.eps
33

ments at all levels would pay more for the energy and energy-related products that 

they consume directly. For example, the Defense Department is the single largest 

consumer of energy in the United States. In addition, there would be impacts on 

living costs and economic activity, which, while modest in the overall economy, could 

nevertheless trigger increases in automatic cost-of-living adjustments in Social Security and other benefit programs and some modest reductions in tax revenues. These 

issues can be addressed—and any increases in deficits and debt avoided—by using 

a share of the allowances to offset such tax and expenditure changes. (Note: action 

to reduce the damages from climate change should have positive effects on the budget over the longer run, by reducing government expenditures for such things as natural disasters, crop failures, and disease epidemics. In other words, in the absence 

of effective climate-change policies, natural events are likely to occur sooner or later 

that entail large federal costs and throw the budget farther out of whack.) 

In addition, although higher energy prices would create strong incentives for energy conservation and for investment in clean-energy technologies, there will be 

claims for additional subsidies to encourage a wide variety of activities in the name 

of combating climate change. In many cases (including various types of basic alternative energy research), such investments can be a valuable complement to the market incentives provided by a cap-and-trade system or carbon tax. Such spending will 

be wasteful, however, if it merely subsidizes activity that would take place anyway 

or that is not well focused on reducing greenhouse-gas emissions. 

Finally, economic analysis suggests that if there are instances where existing 

taxes have some disincentive effects that may dampen economic activity, receipts 

from cap-and-trade auctions or a carbon tax could be used to reduce those taxes. 

This, in turn, would lower any economic cost of restricting greenhouse-gas emissions. For example, CBO reports that the changes in economic activity required to 

achieve a 15 percent reduction in greenhouse-gas emissions would result in economic losses equivalent to roughly one-half of one percent of GDP in 2010 if the all 

the allowances were given away. If, however, all of the emission allowances were 

auctioned off and the proceeds were used to cut payroll taxes or corporate income 

taxes, that loss could be cut substantially. At the same time, CBO points out that 

using all of the auction proceeds exclusively to reduce net economic costs would 

itself come at a price, because those proceeds would not be available to address the 

regressive effects of increases in consumer costs or to make investments in basic research on clean technologies. 

It should be noted, that these calculations of net economic loss do not take into 

account the substantial benefits that may arise from avoiding environmental and 

economic damages from climate change. Economic costs of the magnitude that have 

been reasonably estimated appear to be a modest price to pay to achieve the important goal of reducing greenhouse-gas emissions. In a well-designed climate-change 

policy, these are necessary costs for achieving the benefits of reduced greenhousegas emissions. They do not ‘‘harm’’ the public any more than expenditures on antibiotics to fight a serious infection ‘‘harm’’ a patient. Moreover, these ‘‘side effects’’ 

in terms of economic performance are modest (analogous to losing a day or two of 

work a year due to the antibiotic treatment in order to avoid greater harm from 

failing to treat the infection). 

To return to the trade-off between reducing net economic costs and equitable 

treatment of families facing higher costs, CBO has found that using the proceeds 

from auctions exclusively for tax cuts would offset only a very modest fraction of 

the impact of higher energy costs on low-and moderate-income households, and that 

cutting corporate taxes would be highly regressive. With all of the auction receipts 

used for either a payroll tax cut or a reduction in corporate income taxes, the poorest 20 percent of households would have the largest net losses (as a share of income) 

while the richest 20 percent of households would end up with tax cuts that exceeded 

their increase in energy costs. (It also should be noted that analyses by CBO and 

others find that reducing long-term budget deficits would do substantially more to 

boost the economy over time than cutting taxes and have a far less regressive impact.) 

While there are tradeoffs between economic efficiency and fairness in the design 

of climate-change policy, one policy that fails to measure up on either ground is giving away a substantial fraction of the permits to existing emitters. As CBO has explained, 

Because giving allowances to energy producers would disproportionately benefit 

higher-income households and would preclude the possibility of using the allowance 

34

3 Congressional Budget Office, letter to Senator Jeff Bingaman, Chairman, Committee on Energy and Natural Resources, United States Senate, July 9, 2007, pp. 3-4. 

value to reduce taxes on capital and labor, such a strategy would appear to rate 

low from both a distributional and an efficiency perspective.3

If lawmakers capture the necessary revenue and make wise choices among competing claims in designing climate-change policy, they can achieve the economic and 

environmental benefits from reducing greenhouse-gas emissions while addressing 

the impact of higher prices on low-income consumers and other legitimate new 

claims on available resources. (It might even be possible to achieve some modest deficit reduction, which would be valuable at a time when, as this Committee well 

knows, the pressures on the federal budget will be increasing.) 

If, however, lawmakers give away too many emissions rights to existing emitters, 

as a number of the bills currently pending in Congress would do, they will fail to 

capture sufficient resources to meet these needs, while conferring windfall profits 

on energy companies and other emitters. This latter course would risk large increases in deficits and debt (already on course to reach unsustainable levels in future decades), significant increases in poverty and hardship, and a further widening 

of the gap between rich and poor. 

DESIGNING CLIMATE-CHANGE LEGISLATION THAT SHIELDS LOW-INCOME HOUSEHOLDS

FROM INCREASED POVERTY AND HARDSHIP

Making sure that sufficient resources are available to shield low-income households from increased poverty and hardship is crucial in the design of climate-change 

policies. But it is only the first step needed to avoid increases in poverty. It also 

is vital to use the resources made available for this purpose in a way that is effective in reaching low-income households, efficient (with low administrative costs), 

and consistent with energy conservation goals. At this early stage of the debate, no 

climate-change legislation introduced on Capitol Hill meets this goal, although there 

is a growing interest among a number of lawmakers in finding effective ways to protect low-income people from increased costs. 

To shield vulnerable households from higher energy costs in a manner that is 

both effective and efficient, we recommend that policymakers follow these six basic 

principles. 

1. Fully protect the most vulnerable households. Climate-change legislation 

should not make poor families poorer or push more people into poverty. To avoid 

that outcome, climate rebates should be designed to fully offset higher energy-related costs for low-income families. A good place to start is by fully protecting households in the bottom fifth of the income spectrum—those with average incomes of 

$13,000—or less than $27,000 for a family of three. Families at modestly higher income levels that struggle to make ends meet will need some help, as well, in coping 

with higher bills. 

2. Use mechanisms that reach all or nearly all low-income households. Some lowincome households work for low wages and could receive their climate rebate 

through the tax code, such as through an increase in the Earned Income Tax Credit. 

But others are elderly, unemployed (especially during recessions), or have serious 

disabilities. Climate rebates need to reach all of them. 

Fortunately, policymakers can tap existing mechanisms to reach the large number 

of low-income households that cannot be reached through a tax rebate mechanism 

because their incomes are so low they are not required to file a federal income tax 

return. For example, ‘‘climate-change rebates’’ could be provided through the electronic benefit transfer (EBT) systems that state human service agencies use to provide assistance to many poor people. Policymakers could fill any remaining gaps, 

and provide weatherization assistance, through some increases in the Low Income 

Home Energy Assistance Program. 

3. Minimize red tape. Funds set aside for low-income consumers should go to intended beneficiaries, not to administrative costs or profits. Accordingly, policymakers should provide assistance as much as possible through existing, proven delivery mechanisms rather than new public or private bureaucracies. 

4. Don’t focus solely on utility bills. For households in the bottom fifth of the population, higher home energy costs will account for less than half of the hit on their 

budgets from increased energy prices. And about 20 percent of the households in 

the bottom fifth have their utility bills reflected in their rent, so they pay for utilities only indirectly, through the rents their landlords charge. Policymakers should 

structure ‘‘climate-change rebates’’ so they can also help low-income families with 

these rent increases, as well as higher prices for gasoline and other products and 

services that are sensitive to energy costs. 

35

5. Adjust for family size. Larger households should receive more help than smaller 

households because they have higher expenses. Families with several children will 

generally consume more energy, and consequently face larger burdens from increased energy costs, than individuals living alone. Many other forms of assistance 

vary by household size; this one should as well. 

6. Adjust relief to reflect changing needs. Assistance for low-income consumers 

should be smaller in the beginning, when a cap-and-trade system or carbon tax is 

just phasing in and the impact on energy-related prices is less substantial, and larger when the system is fully in place. 

CONCLUSION

The economic and distributional effects of climate-change policy will generate 

major new claims on the federal budget, especially the need to offset the regressive 

impact of higher energy prices. But a well designed climate-change policy can also 

generate significant resources that can be used to avoid regressive outcomes and address other legitimate budgetary claims that arise from the new policy. Policymakers need to recognize the importance of generating adequate revenue and addressing fairness concerns to avoid ending up with a policy that increases poverty 

and further widens gaps between rich and poor, increases deficits and debt, or both.

Chairman SPRATT. Now, Dr. Smith. 

STATEMENT OF ANNE E. SMITH, Ph.D., VICE PRESIDENT,

CRA INTERNATIONAL 

Ms. SMITH. Mr. Chairman, members of the committee, thank you 

for inviting me to participate in today’s hearing. I am Anne Smith. 

I am a vice president at CRA International. My testimony today reflects my own research and opinions, and not any positions of my 

company, CRA. 

Today you have heard a lot about alternative methods for allocating allowances under cap-and-trade schemes. And allocations 

are extremely important, but they are also greatly misunderstood. 

For instance, many people seem to be saying that the very large 

value associated with the allowances can outweigh the costs of a 

carbon cap, and it cannot. Any policy that cuts carbon emissions 

will always impose a net cost on society. And there are only two 

ways that different types of allocation rules could even help reduce 

that net cost on society. And neither one is being seriously considered by the Congress at this moment. 

The first of these ways would be to use the auction revenues, 

rather than allocating some of the allowances, to reduce the drag 

on the economy that comes from income taxes. CBO has talked 

about this possibility. And I just want to emphasize that they made 

the statement, and it is true, that the benefit in the reduction on 

the drag on the economy that would come from this approach requires reducing marginal income tax rates, which is highly unpopular politically because it is regressive. If you don’t reduce the marginal income tax rates you don’t get the benefit in reducing the cost 

of the policy on the economy. So in contrast, giving tax rebates to 

households or increasing their tax deductions, that will not reduce 

the policy’s net societal costs, although it will change the distribution of the impacts of that policy. 

The second way in which allocation values could be used to reduce the net costs of a carbon policy would be to promote the invention of new, advanced low-carbon technologies. Most of the allocations proposed so far for supporting technology are just subsidies, 

deployment subsidies, for instance, and demonstration project funding. These do not improve the incentives for breakthrough techVerDate 0ct 09 2002 12:51 Feb 13, 2008 Jkt 000000 PO 00000 Frm 00039 Fmt 6633 Sfmt 6602 J:\DOCS\HEARINGS\110TH\110-24\39491.TXT HBUD1 PsN: DICK
36

nology research and development. And that is what is needed in 

order for those uses of allocations to cut the policy’s net costs. 

So the other types of allocation schemes that are being discussed 

will only change the distribution of the policy costs, and they will 

not reduce those costs. And it is important to recognize that the net 

cost of any of these hard-cap bills that are currently being discussed in the Congress are quite large. For example, I have estimated that the current set of bills for hard caps would generate the 

following impacts by 2020 compared to a case with no carbon limits: Net losses of between $1,000 and $1,500 per year in the average household’s real spending power. Net reductions of 2 to 4 million jobs. And reductions in the U.S. GDP of between $300 billion 

and $500 billion in 2020, which represents a drop of 1.5 percent to 

2.5 percent. Of course, that drop in GDP would cause a corresponding 1.5 percent to 2.5 percent drop in government revenues 

approximately. Keep in mind these costs keep rising after 2020. 

These economic impacts are substantial enough to warrant a serious discussion about how to meet the proposed emissions targets 

as cost-effectively as possible. 

Before discussing a couple of ways that we can do this, I would 

like to note a couple of other misunderstandings about allocations 

that I frequently hear and have heard today. First, assertions that 

businesses require no more than 15 percent of the allowances to 

compensate them for their profitability losses due to carbon cap are 

misleading. We have just seen that in Mr. Greenstein’s testimony. 

It also appears in some form similar to that in the CBO’s written 

statement. 

I am one of the three researchers whose analyses are cited in 

support of that 15 percent rule, and I disagree with this oversimplification. In my written statement I describe four specific reasons why the actual percentage that businesses would require 

under a real-world carbon cap would be larger than 15 percent, in 

some cases much larger. 

Another misunderstanding is the view that allocations can protect U.S. companies whose products compete in international markets. As carbon price levels rise, more and more of these types of 

businesses will cease production in the U.S. no matter what their 

allocation is. However, as they close their operations here in the 

U.S., their emissions will simply reappear in another country, one 

that doesn’t have a carbon cap of a similar magnitude. This is 

called ‘‘leakage.’’ And even fully compensating allocations to these 

companies cannot stop it. Short of global cooperation on emissions 

limits, the only way to stop leakage with a cap-and-trade would be 

through border tax adjustments, but these may not be legal under 

international trade agreements in a cap-and-trade application. If 

border tax adjustments are not put in place at the same time that 

a cap is imposed, in the same time period, the only alternative for 

minimizing this perverse leakage phenomenon would be to place a 

reasonable ceiling on the price of allowances. This is the idea of the 

safety valve that has been mentioned in other testimony today. 

An allowance price ceiling would have some important additional 

economic merits besides helping protect against unreasonable 

amounts of leakage. Prices in all cap-and-trade programs are notoVerDate 0ct 09 2002 12:51 Feb 13, 2008 Jkt 000000 PO 00000 Frm 00040 Fmt 6633 Sfmt 6602 J:\DOCS\HEARINGS\110TH\110-24\39491.TXT HBUD1 PsN: DICK
37

riously volatile, and volatility in carbon prices will translate into 

volatility in economic performance generally. 

Even the government should prefer to see stable allowance 

prices. For example, would large variability in any auction revenues that are going to be used to fund technology deployment programs be of any value when they need long-term stable funding? 

Mr. Doniger spoke of the need for projects like these to have stable funding. But if it is funded through auction revenues, this funding may not be stable at all if the prices that can be returned in 

those auctions are quite volatile. Even if the auction revenues were 

to be simply rebated to citizens, would either the government or 

the citizens prefer to have variability in the size of their rebate 

checks? 

So in closing, be aware that cap-and-trade schemes are not the 

only market-based policy option, as Dr. Orszag said at the beginning of his testimony. Other options, such as a carbon tax, may be 

more suitable to the challenge of reducing carbon to the proposed 

levels that we are looking at without excessive damages to our 

economy. 

Thank you for this time. I have a longer written statement that 

I request be submitted into the record. 

Chairman SPRATT. Thank you very much. As. 

[The prepared statement of Anne E. Smith follows:]

PREPARED STATEMENT OF ANNE E. SMITH, PH.D., VICE PRESIDENT,

CRA INTERNATIONAL

Mr. Chairman and Members of the Committee: Thank you for your invitation to 

participate in today’s hearing. I am Anne Smith, and I am a Vice President of CRA 

International. Starting with my Ph.D. thesis in economics at Stanford University, 

I have spent the past twenty-five years assessing the most cost-effective ways to design policies for managing environmental risks, including cap-and-trade systems. 

For the past fifteen years I have focused my attention on the design of policies to 

address climate change risks, and have prepared many analyses of the economic impact of climate polices. I thank you for the opportunity to share my findings and 

climate policy design insights with you. My written and oral testimonies reflect my 

own research and opinions, and do not represent any positions of my company, CRA 

International. 

The topic of today’s hearing is the fiscal impacts of controlling carbon emissions. 

Much of the discussion these impacts revolves around options for how the government can shift the economic burden of a cap-and-trade system on greenhouse gases 

through alternative formulas for allocating the capped allowances. When a marketbased approach to greenhouse gas emissions control is implemented, a very large 

amount of wealth in the form of the allowances will be created, even while the policy also forces net resource costs on society. No one should be surprised by the intensity of interest focused on how that wealth might be distributed because any single 

interest group could be made far wealthier under a carbon cap-and-trade program 

than not—if it can get the ‘‘right’’ kind of allocation assigned to it. Without denying 

the great importance of the allocations decisions, I would like to make a number 

of observations about the resource costs and economic impacts of such policies that 

policymaker’s should not lose sight of when contemplating greenhouse gas emissions 

legislation. 

MINIMIZING THE POLICY’S COST VERSUS SHARING ITS COST

The total value of allowance allocations will always be less than the total cost of 

a carbon cap: the policy will always have a net cost. 

The total resource cost of an emissions limit is the sum of the expenditures that 

emitters will make in order to physically reduce their emissions from what they 

would otherwise have been. Under a market-based system, a limit is placed on emissions, and regulated emitters are required to pay for every ton that they emit. If 

the policy is a cap-and-trade system without any free allocations, emitters do this 

by buying as many allowances as they emit in a year, and rendering those allowVerDate 0ct 09 2002 12:51 Feb 13, 2008 Jkt 000000 PO 00000 Frm 00041 Fmt 6633 Sfmt 6621 J:\DOCS\HEARINGS\110TH\110-24\39491.TXT HBUD1 PsN: DICK
38

ances to the government. Because there are not as many allowances as there would 

be emissions (at least in the aggregate), emitters also are forced to reduce their 

emissions. Thus, there are two expenditures that emitters incur: (1) they spend 

money to reduce emissions down to the level of the cap and (2) they pay for allowances to cover all of their emissions that remain after the controls have been applied. 

In aggregate over all emitters, the second component of total expenditures by 

emitters is simply the value of the allowance pool that is created by the government 

when it sets up a cap-and-trade system. Therefore, the entire wealth that government will have to allocate is only equal to the second component of the emitters’ 

costs. The government can give that entire value back to the companies by making 

a free allocation of 100% of the allowances to emitters, but that leaves companies 

still incurring the first cost component—the real resource cost associated with actually reducing emissions, which is the real net cost to society. 

The wealth associated with the allowances can be very large compared to the real 

resource costs of the cap. For example, if emissions without a cap are 100 tons and 

a 10% reduction is required by establishing a cap at 90 tons, the cost of controls 

(and hence the market value of the 90 tons of allowances) might be $20/ton of CO2. 

In that case, the real resource cost of reducing 10 tons of emissions would be less 

than $200 whereas the market value of the pool of 90 allowances would be $1800. 

However, even if the government gave all the allowances to the emitters, it would 

only reduce emitters’ expenditures from $2000 (i.e. the sum of $200 for emissions 

controls and $1800 to buy allowances for their remaining emissions) down to the 

net societal resource cost $200.1

The net resource cost is therefore an inescapable fact of an emissions limit via 

a cap-and-trade program that cannot be eliminated through any allocation formula 

that may be devised. All that an allocation scheme can do is alter the companies 

and individual consumers that end up bearing the burden of that resource cost. An 

excessive amount of focus on who will gain the value in the allocations can cause 

policymakers to lose sight of the fact that they are creating a new cost to society 

that should be evaluated in the context of overall societal budget priorities. 

The net cost of a carbon cap of the stringencies now being discussed in the Congress would be very substantial. 

A large number of proposals have circulated in recent months that entail hard 

caps on US greenhouse gas emissions reaching reductions of about 75%to 90% from 

projected ‘‘business as usual’’ emissions by 2050. These current hard cap proposals 

vary in their specific timing and stringency, but all of them would impose significant 

costs on the US economy even in the near term, if implemented. I have performed 

economic impact analyses of many different levels and types of emissions limits 

using CRA International’s general equilibrium model of the US economy called 

‘‘MRN-NEEM.’’ My analyses indicate that the current set of proposals in the Congress for hard caps on greenhouse gas emissions would impose real resource costs 

to the US economy of the following general magnitude: 

• Net losses in the average household’s real spending of $1000 to over $1500 per 

year by 2020. 

• Net reductions in jobs by 2020 of 2 million to 4 million. 

• Reductions in US gross domestic product (GDP) of $300 billion to $500 billion 

(i.e., a reduction of 1.5% to 2.5%) from a case with no carbon limits, by 2020. 

Needless to say, a drop in GDP implies a reduction in government revenues too—

also roughly on the order of 1.5% to 2.5% by 2020. The costs of these proposals are 

projected to increase continuously up to 2020, and are only somewhat lower in their 

very first year of implementation. Further, these costs are projected to continuously 

increase in the decades beyond 2020, because the reductions they require by 2020 

are small compared to those that would be mandated by 2050 in these Bills. 

These economic impacts are substantial enough that they warrant a very serious 

discussion about priorities for the spending of our society’s resources. There is no 

question that achieving significant reductions in greenhouse gas emissions will be 

very costly, and it is therefore important to strive to minimize those costs. That cannot be done by focusing solely on how to allocate allowances. The design of the program itself is what matters, which requires taking care to ensure the following attributes in a cap-and-trade system: 

• A cap that comprehensively covers all types of emissions sources. 

• A policy that protects against leakage of emissions to economically competing 

nations. 

• A supportive set of policies that provide effective incentives for research and development on breakthroughs in technologies that produce low-carbon energy. 

• A cap stringency that is timed to match the availability of new, low-carbon technologies. 

39

• A policy that offers businesses price certainty for planning major new investments in new technologies. • Provisions in the policy to limit the costs that it will impose on the economy 

overall if emissions reductions turn out to be more expensive to achieve than currently anticipated. • A policy that will deliver even larger emissions reductions if they turn out to 

be less expensive to achieve than currently anticipated. 

None of these attributes are easy to design into a greenhouse gas policy, and none 

of the hard cap proposals that are currently being discussed in the Congress have 

sufficiently addressed these needs. Their projected costs (described above) are thus 

probably unnecessarily high for achieving their stated emissions goals. I will discuss 

several of these points in more detail below, after a few more comments about allocations. 

There are very many claimants to the value associated with the allowance allocations. 

The costs of greenhouse gas reductions will directly increase the costs of companies that are emitters targeted by a regulation. These companies are thus the traditional and natural claimants on the allocations. However, in the case of greenhouse 

emissions limits, many of those emitters’ costs will be passed on to consumers. This 

will occur through multiple routes. Energy prices will increase. The costs of most 

goods and services will increase because they can only be produced by using energy. 

Some companies will be forced out of business, with attending consumer costs of 

making job transitions. Energy cost impacts will be regressive, and affect the poor 

disproportionately. All of these impacts create additional groups in society that also 

can make a valid claim for a share of the wealth associated with the allowance pool. 

Finally, in addition to the claims from industry, businesses, workers, and representatives of the socio-economically disadvantaged, government must also contend with 

its own needs. Government needs to support a massive increase in energy research 

and development. Government also needs to grapple with likely declines in its traditional tax revenues due to the costs, reduced profits and reduced household incomes 

that the policy imposes on its tax base. 

Clearly, policymakers face an unusually complex situation where almost every 

group in the economy has a reasonable claim for some share of the allowance value. 

This becomes an outright dilemma when one realizes that there will never be 

enough allowance value to cover all of the claims. When the net resource costs of 

the policy are so large, policymakers should focus should be on creating the most 

cost-effective policy possible; an emphasis on allocations rules does not further this 

goal. 

Alternative allocation formulas being proposed would not reduce the overall societal cost of a cap-and-trade policy. 

As I have described above, the value associated with the allowance pool that 

would be created under a cap-and-trade scheme is a ‘‘transferable’’ amount of 

wealth. By allocating that wealth in different ways, the cost burden of the policy 

can be adjusted across the many players in the economy. That is, the allocation formula just splits the same pie in different ways. If one group is handed a pie slice 

that is larger than its slice of resource costs, that group will be better off. But because the total pie of transferable wealth is smaller than the total pie of expenditures that emitters must incur, a larger allocation for one group inevitably means 

that another group will be less well off. Almost all of the alternative allocation formulas being discussed would merely alter how the pie is sliced, and not how large 

the pie is. 

There are only two alternative uses of the allowance value that would actually 

reduce the net economic burden of a greenhouse gas policy, and neither one receives 

very much attention in current bills in the Congress: 

1. It is often stated that giving away free allowances reduces the opportunity for 

the government to enhance economic activity by lowering the economic distortions 

of existing taxes. If the allowances could instead be auctioned and the new revenues 

to the US government used to reduce these existing ‘‘tax distortions,’’ then there 

would be a generalized benefit to the economy that could partially offset the newly 

imposed economic cost of the emissions reductions. However, not a single one of the 

many policy proposals that have been introduced in Congress has proposed to use 

the auction revenues in the manner necessary to gain this offsetting economic benefit. It requires specifically that the auction revenues be used to reduce the marginal tax rate on either the personal income tax or on corporate tax rates. Several 

analyses have found that this could reduce the net impact to the economy of a cap 

by as much as 50%.2 However, it is highly unpopular politically because of its expected regressive nature.3 (In fact, reduction of marginal payroll tax rates would 

have much less beneficial impact than reduction of marginal personal income tax 

40

rates, and even less than if the marginal corporate income tax rates are reduced, 

each of which would be increasingly regressive.) While economists agree that reduction of marginal income tax rates would be an excellent way to reduce the net economic impact of a policy, policymakers seem incapable of implementing the right 

form of tax rate reductions to claim policy cost reduction as a justification for auctioning a larger share of permits. Rebate checks to households, reductions in average tax rates, and other forms of tax reductions called ‘‘lump sum’’ do not accomplish any such policy cost reduction. 

2. It is widely accepted that another way to reduce the cost of a greenhouse gas 

cap would be to reduce the costs of, and to speed the time of commercial availability, 

of new and advanced low-carbon technologies. This might be accomplished through 

government policies that offer greater and more cost-effective incentives for targeted 

and successful research and development in energy technologies. Most of the recent 

carbon policy proposals attempt to direct some of the allowance value towards technology development, and this is a positive development. However, most of these proposals’ provisions are limited to subsidies and demonstration project funding. They 

still give insufficient attention to how to actually improve the incentives for both 

public and private researchers to effectively target their efforts towards new, breakthrough technologies. Far more effort needs to go into designing these research and 

development initiatives before one can argue that allocating a larger share of allowances or auction revenues to fund technology programs will have much effect in reducing the cost of the associated cap. 

CLARIFICATION OF SOME ISSUES REGARDING ALLOCATIONS TO EMITTERS

Assertions that emitting businesses require ‘‘less than 15%’’ of the allowances to 

compensate them for their losses due to a carbon cap costs are misleading, and incorrect in most cases. 

A common assertion within greenhouse policy circles is that only a small fraction 

of the total allowances need be given to emitters to offset their profit losses. The 

Congressional Budget Office (CBO) has characterized this ‘‘small fraction’’ as less 

than 15%.4 I am one of the researchers whose analyses are cited in support of CBO’s 

statement. I would like to identify several problems with that are associated with 

this type of oversimplifying summary statement.5

• Phase out of allocations over time. The small percentages of allowances that 

modeling studies find would offset sectoral average profitability losses are calculated 

assuming that the free allocation percentage will remain constant permanently (i.e., 

infinitely) into the future. In real application (and in all present policy proposals), 

the allocations are not permanent, but are phased out; yet the policy’s impacts only 

continue to increase over time. If an allocation is to be phased out over time, the 

percentage share that achieves the same degree of compensation is higher. For example, an 8% perpetual allocation would need to become a 54% allocation per year 

if it were to end after ten years.6 It would need to be in the range of 50% or more 

in the first year, if it were to be phased out gradually over 20 or more years. 

• Compensation estimated only for average sectoral impacts. The estimates of a 

percentage of allocation that would compensate ‘‘businesses’’ is actually based on a 

model that does not consider individual businesses, but only entire aggregate sectors, such as the ‘‘energy-intensive industries’’ sector or ‘‘the electricity generating’’ 

sector. There will, in fact, be both winners and losers in any large aggregated sector, 

and these models cannot distinguish between them. Instead, the share of allocation 

estimated to compensate the entire sector on average assumes the winning companies’ gains within a sector can be netted against the losses of the losing companies. 

This is like saying that profitability increases to wind farmers and nuclear generators due to a cap will be taken from them and given to coal generators. Then, any 

remaining net losses to coal generators would be compensated by free allocations to 

that sector. If one of the modeled sectors had an equal balance of winners and losers, the model would estimate a zero need for any allocations to that sector—clearly 

that would be insufficient to compensate companies facing profitability losses within 

that sector. In one case where the analysts were able estimate the allocations needed to compensate each individual business rather than the sectoral average, the 

analysis found that that actual compensation of every individual business would require a 33% allocation to that sector, even though the analysis indicated a 0% allocation need when estimated on the typical sectoral average basis.7

• Compensation estimates largely ignore how trade exposure reduces abilities to 

pass costs through to customers. One of the reasons that some businesses may be 

able to be compensated for their profit reductions under a carbon policy is that they 

can actually pass a large share of their cost on to the consumer. That is, impacts 

to their profits are not as large as their increased compliance expenditures. The 

41

economy-wide models that have been used to assess how many allocations are needed to compensate sectors are not detailed enough to address the degree to which 

different sectors are able to pass costs through in their product prices, and they tend 

to overstate the pass-though. In particular, if parts of some sectors are highly exposed to competition from international competitors, they have exceptionally little 

ability to raise prices, because they will lose market share to foreign producers. 

However, when aggregated with a variety of other types of businesses in a ‘‘sectoral 

model,’’ their actual vulnerability to cost increases is averaged away. The model will 

assume they can achieve an average degree of price pass-through, and thus understate the profitability impacts of the very highly trade-exposed within each sector. 

Those types of companies would require larger allocations than the modeling exercises have estimated. • Comprehensiveness of cap’s coverage. The modeling exercises have modeled 

idealized caps that would be applied uniformly to all emissions in the US. However, 

if a real-world cap were to only apply to about 50% of the emissions, while non-market policies and measures would be applied to the remaining sources, then the economic impacts of the policy would be the same or higher, but there would only be 

half as many allowances (and half as much allowance value) available to allocate. 

The amount of value needed to offset profitability impacts would be the same, but 

in this case, achieving that amount of compensation would require allocation of 

twice as large of a percentage of the allowance pool (because it is half as large). The 

bottom line is that as the comprehensiveness of the cap is lowered, the percentage 

of the allowances needed to achieve the same level of compensation rises. 

The above set of bullets points identify many limitations in the ability of models 

to address the question of fair compensation. The ideal solution would be to develop 

more disaggregated models to refine the estimates. Unfortunately, there are limits 

to what any models can do, due to lack of the necessary disaggregated data. In the 

end, there are no available analytical methods for determining allocations of allowances to individual companies throughout all sectors of the economy that would equitably mitigate the financial impacts of the policy. 

The available analyses do suggest that not all companies would require a 100% 

allocation in order to be compensated. However, any rule of thumb based on the 

quantitative results of these analyses (such as ‘‘less than 15% ’’) probably understates the true aggregate need when several of the real-world features of climate 

policies are taken into account. Such simplistic rules also clearly are not correct at 

the level of individual businesses, some of which will benefit without any allocation, 

and others of which may not be compensated even with a 100% allocation. 

Domestic companies whose products compete in international markets are likely 

to be driven out of business no matter what allocation they receive. 

A generous allocation could increase the shareholder value of a company that is 

unable to increase its prices due to competition in international markets (i.e., a 

‘‘trade exposed’’ industry). However, it will do this in a perverse way that policymakers need to be aware of. As the price of allowances rises, a company that cannot 

raise its product prices will experience falling margins. If that company is also 

granted free allocations, it can use them to offset some of the costs, and thus maintain profitability. However, this will only be true for a range of lower allowance 

prices. For every type of company that cannot pass costs through, there will be an 

allowance price level at which the company would be able to make more money by 

selling its allowance allocation than by using those allocations to continue to 

produce its usual product. When allowance prices reach that level, the company will 

cease production, and become a seller of allowances instead. The shareholders may 

be satisfied with their financial situation, and use the proceeds of their allowance 

sales to invest in some different business venture that can be profitable in the carbon-constrained world. However, from the vantage point of the US economy, there 

will be premature retirement of the existing productive assets in our trade-exposed 

sector, and reductions in the economic activities associated with those sectors. 

This is hardly fits the image that some may have of the notion of achieving compensating allocations for the businesses. Yes, the losses in profitability are offset for 

the affected shareholders, but this goes hand in hand with plant closures and loss 

of key economic sectors. Given that the cause of the closures is international competition, these lost US manufacturing activities would be replaced by foreign manufacturing: global emissions will not fall but the US economy will still pay the price. 

This perverse outcome of climate policy is called ‘‘leakage’’ because the policy is 

rendered ineffective environmentally when it causes emissions to ‘‘leak’’ across national borders. Emissions from any part of the globe have comparable impacts on 

climate risks, as they all first accumulate together in the global atmosphere to have 

their combined and joint effect on the global greenhouse effect. On the one hand, 

this offers important flexibility to reduce emissions anywhere in the globe that has 

42

cost-effective opportunities to do so, and not to confine domestic efforts to actions 

within US borders. On the other hand, it also means that any GHG cap we impose 

domestically, and its attending domestic reductions, may be undermined by offsetting emissions increases in nations that do not have comparable caps on their own 

economies. Large sums of money could be spent with no actual global environmental 

benefit. US economic output and jobs leak to other countries as well. 

Leakage has often been talked about in very general terms. Estimates of leakage 

due to a US domestic policy are suggested in the range of about 10-15%, meaning 

that for every 10 tons that is reduced in the US, 1 ton is just emitted elsewhere 

in the world. This may sound like a relatively small price to pay in order to get 

a net 9 tons of reduction from US action. The difficulty with this view, however, 

is that leakage is not a phenomenon that applies to every ton of emissions reduction. Instead, there may be almost no leakage associated with controls on emissions 

that are not trade-exposed (e.g., personal and commercial transportation, electricity 

generation, and services), but nearly 100% leakage associated with controls on emissions in sectors that are trade-exposed (e.g., many of the energy-intensive manufacturing processes such as cement, iron and steel, chemicals, transportation equipment manufacturing, textiles, etc.) Concentrated economic impacts on specific sectors that offer no benefit in terms of global emissions reduction make no sense as 

a matter of policy design. The possibility that the shareholders could be made whole 

is not a relevant argument to allow this to happen. 

The potential severity of the impacts to trade-exposed industries appears not yet 

fully appreciated by policy analysts or policymakers. Most of the attention on estimating climate policy impacts has been focused on transportation and electricity 

generation, which are among the least concerned with potential leakage. The potential plight of the trade-exposed industries has been mostly thought to be something 

that could be dealt with through compensating allocations. While that might solve 

the concerns of some of the shareholders of those businesses, policymakers should 

closely examine whether they are prepared to face the economic impacts of reduced 

exports, increased imports, and losses of domestic output of many important elements of the US manufacturing base. 

SOME OPTIONS FOR REDUCING NET ECONOMIC IMPACTS

I noted in the first section that there are a few attributes of a greenhouse gas 

policy that would be important to keeping the policy’s economic impacts in an acceptable and politically sustainable range. I believe that these require at least as 

much attention in designing a policy as the question of how to allocate allowances. 

This section provides some discussion of several of those attributes. 

Policymakers should focus on how to limit US emissions without creating leakage. 

As I noted in the last section of these comments, leakage is a serious concern for 

some portions of the economy, and not one that can be addressed satisfactorily with 

some free allocations to the trade-exposed sectors. There are two ways to mitigate 

leakage without exempting trade-exposed sectors from an emissions cap: 

1. The first is to impose domestic emissions limits only as part of a global agreement among all nations that compete with our products, or which might start to 

compete once a policy offers them a greater cost advantage than they have now. 

Clearly, the present policy proposals in the Congress would not accomplish this. 

2. The second is to find ways to remove the competitive advantages of competitors 

at our borders, through ‘‘border tax adjustments.’’ Border tax adjustments are allowed only under very special circumstances under the rules of the World Trade Organization. 

The legality of obtaining effective border tax adjustments in the case of a cap-andtrade system is quite questionable at present.8 While a proposal to do so has been 

circulated by American Electric Power and the International Brotherhood of Electrical Workers (the ‘‘AEP-IBEW’’ proposal), it appears to have dubious chances of 

success in limiting leakage due to a cap-and-trade proposal. The AEP-IBEW proposal contains quite a complex set of provisions, each aimed at addressing one of 

several hurdles that would be faced in order to achieve the ultimate goal of equalizing costs of imports at the US border in a WTO-compliant manner. Each element 

of the proposal would be open to legal challenge, leaving multiple potential ways 

that the approach could fail to provide the intended protection from leakage. Most 

critical in my mind, however, is that these many steps require time to accomplish. 

As embodied in the bill of Senators Bingaman and Specter, the imposition of leakage protection from the AEP-IBEW scheme might not be possible until 2020. Given 

that the cap in that policy would start in 2012, this would imply up to eight years 

during which US trade-exposed manufacturers would be facing competitive pressures, eroded ability to profitably continue in business, and experiencing leakage. 

43

Delays of this sort in obtaining that coverage are not acceptable for the businesses 

that face rapidly responding markets. 

The AEP-IBEW proposal for obtaining WTO-compliant leakage protection was 

crafted to work with a cap-and-trade form of proposal. Interestingly, the prospects 

of successfully and immediately implementing border tax adjustments are considered to be much greater in the case of a greenhouse gas tax than in the case of 

cap-and-trade.9 Those having a hand in creating a climate policy for the US should 

become much more familiar with the intricacies of WTO rules, and the likelihood 

of successfully creating immediate and durable protection from leakage under different types of greenhouse gas policy designs. This needs to be sorted out before and 

not after a greenhouse gas policy is enacted. 

In the absence of a clear mechanism for preventing leakage with a cap-and-trade 

system, the only alternative for keeping economic impacts within acceptable bounds 

is to place a ceiling on the cost of allowances. 

The higher the price of permits under the domestic cap, the more serious ‘‘leakage’’ is likely to be if there are no border tax adjustments in place. Thus, potential 

for leakage provides an important reason for directly ensuring that the price of permits that may occur under a domestic GHG cap-and-trade program will remain relatively low. The only way to design a domestic cap-and-trade program to address 

this international competitiveness risk is simply to keep the carbon price low 

enough that such losses remain within acceptable bounds. This, naturally, limits the 

amount of domestic emissions reductions that will be achieved as well. Until international competitiveness issues are resolved (either through coordinated action or 

a system of border tax adjustments) ambitions to make significant reductions 

through any domestic cap-and-trade program will be thwarted, or else highly disruptive to key parts of our economy. This also implies that any domestic cap-and-trade 

program that is implemented in advance of internationally coordinated efforts 

should be designed with clearly defined permit price caps. 

An allowance price ceiling has important additional merits for businesses and government. 

Prices in all previous and existing cap-and-trade programs have exhibited substantial volatility, and this can be expected of GHGs as well.10 Price volatility, however, is likely to have much greater generalized economic impacts with a CO2 cap 

than for caps on SO2 and NOx. CO2 is a chemical that is an essential product during the extraction of energy from any fossil fuel. As long as fossil fuels are a key 

element of our energy system (which they are now, and will remain for many years 

even under very stringent caps), any change in the price placed on GHG emissions 

will alter the cost of doing business throughout the economy. This is because all 

parts of the economy require use of energy to one degree or another. 

In contrast, under the Title IV SO2 cap, a fluctuating SO2 permit price would 

only affect emissions from coal-fired electricity generation. In deregulated electricity 

markets, coal-fired electricity does not always affect the wholesale price of electricity, and even significant fluctuations in SO2 permit prices might have almost no 

effect on electricity prices. Even in regulated electricity markets, the impact of the 

SO2 price on the cost of all electricity generation would be diluted by the unaffected 

costs of all other sources of generation before it reached customers. Also in contrast 

to an economy-wide GHG cap, no other sources of energy in the economy are affected at all by SO2 price changes. Finally, under the Title IV SO2 cap, price variations during the past year that range from $400/ton to $1500/ton (the range observed in the past year under Title IV) have a modest effect on the majority of coalfired units that are already either scrubbed or burning low-sulfur coal. Such units 

might see the cost adder due to its SO2 emissions vary between 7% and 26% of its 

base operating cost,11 and (as noted) the impact on consumer’s cost of electricity 

would be much smaller, if anything. 

Variation of CO2 prices such as that observed in the EU ETS market over the 

past two years (approximately $2/ton to $35/ton) would cause all coal-fired units to 

see additional costs varying between about 10% and 175% of their base operating 

costs. Further, even gas-fired units would experience absolute cost increases equal 

to about half those of the coal-fired units.12 Since gas-fired units do frequently set 

the wholesale market price of electricity, consumer electricity prices would also vary 

markedly with the price of GHG permits. Retrofits would not be available to attenuate these costs (at least, not until even higher permit price levels would be achieved 

and sustained at those levels.) At the same time, all other key energy demands in 

the economy (e.g., for transportation, industrial process heat, building heating and 

air conditioning, etc.) would also experience similar fluctuations with varying GHG 

permit prices. Clearly, the effect on the economy could be disruptive. 

These are not just theoretical calculations. The EU’s statistics bureau, Eurostat, 

reports that electricity prices rose significantly throughout the EU in 2005. HouseVerDate 0ct 09 2002 12:51 Feb 13, 2008 Jkt 000000 PO 00000 Frm 00047 Fmt 6633 Sfmt 6621 J:\DOCS\HEARINGS\110TH\110-24\39491.TXT HBUD1 PsN: DICK
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hold rates rose by 5% on average over all 25 EU countries, and industrial rates rose 

by 16% on average.13 The high prices of GHG permits under the EU ETS during 

that period is widely viewed as having contributed to this price increase, and indeed, wholesale electricity prices have fluctuated in step with the wide swings in 

ETS permit prices. It is not clear yet how or whether the wide variations in permit 

prices may begin to contribute to the variation in economic activity. However, it 

should also be noted that the EU ETS does not cover all sources of GHGs, or even 

a majority of sources of CO2 emissions in the EU. (This may dampen the impacts 

of CO2 permit price volatility on the EU economy, but is also a widely observed flaw 

in that cap-and-trade system’s potential to produce sufficient cuts in GHG emissions 

necessary for the EU to meet its GHG targets.) 

To sum up, price uncertainty and price volatility will impose impacts in the case 

of GHG emissions limits that are completely different in scale and scope from those 

under previous emissions trading programs. Their potential to increase variability 

in overall economic activity thus should be viewed as a core concern in designing 

a GHG cap-and-trade program. At the same time, the nature of climate change risks 

associated with GHG emissions is such that it is possible to design price-stability 

into a GHG cap-and-trade program without undermining its environmental effectiveness. In the case of a stock pollutant such as greenhouse gases, there is no need 

to absorb high costs in return for great specificity in achieving each year’s emissions 

cap.14 Economists widely agree that the cost to businesses of managing the price 

uncertainty of a hard cap is not worth the greater certainty on what greenhouse 

gas emissions will be from year to year. 

Businesses clearly prefer having reliable allowance price expectations, but even 

governments would probably prefer some stability in the year to year revenue 

streams from an auction. For example, would large variability and uncertainty in 

allowance auction revenues be of any use if those revenues are intended to fund important technology-related projects that have long-term funding needs? Even if the 

revenues would simply be rebated to citizens, would either the government or the 

citizens find any value in such uncertainty in the size of the rebate checks? 

There are various ways to provide much greater price certainty under a cap-andtrade program, although none have been used in any trading programs to date. One 

of the simplest concepts that has gained substantial attention for GHGs has been 

called a ‘‘safety valve.’’ Unfortunately, this term has begun to be used loosely (e.g., 

under the rules of the Regional Greenhouse Gas Initiative, and in California’s AB32 

program) for a variety of mechanisms that do not actually provide the price certainty originally intended. To be quite specific, the cap-and-trade program mechanism that provides the requisite price cap is one where the government offers to 

issue any number of additional permits to regulated companies at a pre-specified 

and fixed price per permit. This price is set low enough that it is not considered 

punitive, but rather as an assurance by the government that it would not consider 

control costs above that level to be desirable as a normal course of events.15 This 

is the mechanism that has been incorporated into the bill of Senators Bingaman and 

Specter. 

Because regulated entities know that they need not ever pay more for a permit 

than the established safety valve price, it functions as a price ceiling. No company 

would ever pay more to purchase a regular permit in the emissions market if it 

knows that it can always obtain sufficient permits at that price from the government, if necessary. Permit prices may fluctuate at levels below the safety valve 

price, but by judicious selection of an appropriate safety valve price, policy makers 

can ensure that these variations would not rise to a level that might be viewed as 

potentially harmful to the economy at large. If the safety valve price is hit on an 

occasional basis under a cap, then the goal of achieving long-term reductions in 

emissions is not harmed, given that the primary environmental risk of GHG emissions is a long-term, cumulative one. If the safety valve price is hit on a perpetual 

basis, this suggests an important need for policy makers to consider how we should 

address the evidence that meeting targets that are more difficult than hoped; however, this policy deliberation will be possible without the urgent need to throw 

‘‘band-aid’’ solutions onto the cap-and-trade program, and with concrete evidence of 

the degree of economic pain that is associated with the initially-established maximum permit price. A higher price might then be deemed acceptable, but if not, the 

safety valve will have helped us avoid the greater pain of learning that fact through 

a hard cap approach. 

Aversion to the idea of a price ceiling has been widespread among parties that 

prefer hard caps at any cost over a long-run policy that offers price certainty in exchange for some flexibility in year to year emissions outcomes. Recently, a proposal 

for a ‘‘Carbon Market Efficiency Board’’ (CMEB) was released that was supposed to 

offer an alternative to the price ceiling approach.16 This concept has since been inVerDate 0ct 09 2002 12:51 Feb 13, 2008 Jkt 000000 PO 00000 Frm 00048 Fmt 6633 Sfmt 6621 J:\DOCS\HEARINGS\110TH\110-24\39491.TXT HBUD1 PsN: DICK
45

corporated into the bill of Senators Lieberman and Warner. This CMEB proposal 

provides no cost certainty at all, and it explicitly states that it does not wish to diminish allowance price volatility: ‘‘The cost relieve measures are not intended to relieve brief price spikes that are part of normal, healthy market volatility.’’ 17 The 

proposal goes on to assert that ‘‘ ’volatility’ in price is expected and even desirable.’’ 18 As I have noted above, volatility creates unnecessary planning and management costs to businesses, and should be eliminated if possible without harming one’s 

objectives for reducing emissions within acceptable cost bounds. This is entirely possible in the case of a market that is entirely the result of regulation, such as an 

allowance market. The CMEB proposal does not meet the objectives of providing 

price certainty or policy cost containment. 

THINKING OUTSIDE OF THE CAP

Almost everybody considers it as a foregone conclusion that cap-and-trade is the 

only option for achieving cost-effective reductions in greenhouse gas emissions. However, in efforts to secure a greater share of the allowance values for non-industry 

interests, and in efforts to raise government funds for supporting research, and even 

in efforts to raise government revenues to reduce other taxes, there is growing pressure for a large share of the allowances to be auctioned. In the limit, however, an 

auction works just like a tax—except that the level of the tax is unknown in advance of passing the legislation, and will probably remain highly variable over time 

even after implementation of the legislation. This price uncertainty is not a helpful 

element to achieving reductions at lowest possible cost to the economy. 

If we find ourselves shifting into a world where auctions predominate, one must 

ask: why not simply apply a tax? All parties—public and private—would benefit 

from the much greater price certainty, reduced administrative and strategic planning effort. Often expressed concerns with manipulation of allowance markets (for 

both the auction and the secondary markets) would also be eliminated. Further, as 

CBO has demonstrated in one of its issue briefs, the tax approach can outperform 

either a hard cap or a cap with a price ceiling in terms of cost-benefit outcomes.19

Thus, it may be wise for policymakers to take time to consider more closely alternatives to the cap-and-trade approach for greenhouse gases. Cap-and-trade is not 

the only form of market-based policy option, and others may be more suitable for 

the challenge of reducing greenhouse gases to levels that are being proposed without 

excessive damages to our economy. 

With those central points in mind, I want to close by noting that even a highly 

effective and efficient market-based approach for GHGs will have a serious limitation that should not be forgotten. An adequate national climate policy must consist 

of more than a system of efficient GHG controls. Actual stabilization of climate 

change risks will require that GHGs be reduced to nearly zero levels. Although this 

goal may be possible to achieve at some point in the later part of this century, it 

can only be done through truly revolutionary technological progress and the resulting changes in the structure of how our energy systems. 

Hoffert et al. report that ‘‘the most effective way to reduce CO2 emissions with 

economic growth and equity is to develop revolutionary changes in the technology 

of energy production, distribution, storage and conversion.’’ 20 They identify an entire portfolio of technologies requiring intensive R&D, suggesting that the solution 

will lie in achieving advances in many categories of research. They conclude that 

developing a sufficient supply of technologies to enable near-zero carbon intensity 

on a global scale will require basic science and fundamental breakthroughs in multiple disciplines. Therefore, Herculean technological improvements beyond those 

that are already projected and accounted for in cost models appear to be the only 

hope for achieving meaningful reduction of climate change risks. By inference, no 

cap-and-trade system should be placed into law that does not simultaneously incorporate specific provisions that directly support a substantially enhanced focus on energy technology R&D. 

Placing a price on carbon emissions, as a cap-and-trade program would do, would 

affect the pattern of private sector R&D. However, this so-called ‘‘induced-innovation effect’’ would be small. Economic analysis shows that market forces produce a 

less than socially optimal quantity of R&D. Once a private sector innovator demonstrates the feasibility and profitability of a new technology, competitors are likely 

to imitate it. Copycats can escape the high fixed costs required to make the original 

discovery. Therefore, they may gain market share by undercutting the innovator’s 

prices. In that case, the initial developer may fail to realize much financial gain. 

Foreseeing this competitive outcome, firms avoid investment in many R&D projects 

that, at the level of society as a whole, would yield net benefits.21

46

The task of developing new carbon-free energy sources is likely to be especially 

incompatible with the private sector’s incentives. With no large emissions-free energy sources lying just over the technological horizon, successful innovation in this 

area will require unusually high risks and long lead times. As Hoffert et al. pointed 

out, developing the needed technologies will entail breakthroughs in basic science, 

placing much of the most essential R&D results beyond the boundaries of patent 

protection. These are precisely the conditions under which for-profit firms are least 

likely to rely on R&D as an approach to problem-solving. Thus, greenhouse gas caps 

on their own would insufficiently increase private sector R&D directed toward technological solutions to abatement. 

Market-based policies can very effectively stimulate incremental innovation and 

deployment into the market place of emerging new technologies. They cannot, however, stimulate the kinds of technological progress necessary to enable meaningful 

emissions reductions later on. Realistically, then, government must play an important role in creating the correct private sector incentives for climate-related R&D, 

as well as in providing direct funding to support such activity. This role must be 

built into any cap-and-trade policy, in order to avoid establishing an emissions policy that cannot fulfill expectations, and to avoid wasteful diversion of key resources 

for the requisite forms of R&D. 

Merely establishing cap and trade cannot meet the crucially important need for 

enhanced emphasis on basic research rather than additional subsidies for specific 

technologies that are already far along in the development process. It also does not 

clearly define government’s role or an appropriate division of labor or risk between 

the public and private sectors in the development of new technologies, whether as 

commercialization and incremental improvement of existing low-carbon technologies, 

or R&D for new, breakthrough technologies. Creating an effective R&D program will 

not be easy, but it ultimately has to happen if climate risks are to be reduced. The 

difficult decisions are how much to spend now, and how to design programs to stimulate R&D that avoid mistakes of the past. 

In conclusion, the current policy debate about how to impose near-term controls 

through cap-and-trade programs is encouraging policy makers to neglect much more 

important, more urgently needed actions for reducing climate change risks. The top 

priority for climate change policy should be a greatly expanded government-funded 

research and development (R&D) program, along with concerted efforts to reduce 

barriers to technology transfer to key developing countries. Neither of these will be 

easy to accomplish effectively, yet they are receiving minimal attention by policy 

makers. 

ENDNOTES

1 Emitting companies may be able to pass some of these two cost components on to their customers, and so directly-regulated companies could be given more compensation than the cost 

that their shareholders bear if all of the allowances were allocated to them alone. However, this 

only means that a part of the net cost has been spread to other, non-regulated parties, including 

consumers. They, in turn, would require their share of the allowance allocation to be compensated for the part of the cost that was passed to them. There is not enough value in the 

allowances to cover all costs to regulated companies if they cannot pass those costs on, and neither can that value cover all the incurred costs even if they are passed through to customers 

and spread throughout the entire economy. 2For a review of the literature and specific analytical examples, see A. E. Smith, M. T. Ross 

and W. D. Montgomery, Implications of Trading Implementation Design for Equity-Efficiency 

Trade-offs in Carbon Permit Allocations, Charles River Associates Working Paper, December 

2002. 3 Congressional Budget Office, Trade-offs in Allocating Allowances for CO2 Emissions, Economic and Budget Issue Brief, April 25, 2007, Figure 1. 4 Congressional Budget Office, op. cit., p. 5. 

5The points are further explained in my paper (Smith, Ross and Montgomery, op cit.). The 

CBO does acknowledge some of the following, but the caveats noted by CBO are not usually 

noticed, although they are extremely important to how this research is applied to actual policy 

design. 6Smith, Ross and Montgomery, op cit., p. 54. 

7 Congressional Budget Office, op. cit., p. 5, footnote 15. 

8 J. Pauwelyn, U.S. Federal Climate Policy and Competitiveness Concerns: The Limits and 

Options of International Trade Law, Nicholas Institute for Environmental Policy Solutions 

Working Paper NI WP 07-02, April 2007. 9 Ibid. 

10Some have argued that banking reduces price volatility. While it may reduce it, it certainly 

does not eliminate it. For example, the Title IV SO2 market has experienced high volatility over 

the past two years, even though it has a large bank already in place. During 2005, SO2 permit 

prices rose from about $600/ton to above $1600/ton, then plummeted to below $400/ton by the 

beginning of 2007. Additionally, banking offers little price stability at all during the start up 

of a new cap, simply because no bank yet exists, and this initial-period volatility can be very 

47

large if the first-period cap requires a substantial amount of reduction and/or has a relatively 

brief regulatory lead time. The experience of the first year in the NOx cap of the Ozone Transport Region of the northeastern U.S. is a classic example. 11 By ‘‘base’’ operating cost, I mean the cost of generating a unit of electricity before accounting for the emissions price. The majority of this cost is the cost of the fuel. 12 However, the percentage increase in the base operating cost would be much smaller (i.e., 

about 30% compared to 175%) because natural gas is so much more expensive than coal. 13 Eurostat, ‘‘News Release—July 14, 2006’’ (Revised version 93/2006), available at http:/

ec.europa.eu/eurostat 14 Richard G. Newell and William A. Pizer 2003, ‘‘Regulating Stock Externalities Under Uncertainty,’’ Journal of Environmental Economics and Management, Vol. 45, pp. 416-432. 15Outside of the U.S., further confusion about the notion of a ‘‘safety valve’’ has been created 

by application of this term to the traditional notion of a penalty for noncompliance. The EU ETS 

has a penalty for noncompliance that is (Euro) 40/ton CO2 in Phase I and will be (Euro) 100/

ton in Phase II, starting in 2008. This is often described as a price cap, but its very high level 

relative to the price at which the cap is expected to be met makes it extremely ineffective. Further, its role as a penalty rather than as an additional compliance mechanism clearly would undermine the willingness of companies to resort to its use for planning purposes. The same confusion of penalty and safety valve appeared in the proposal for an Australian emissions trading 

scheme released in 2007 by Australia’s National Emissions Trading Taskforce. The notion of a 

‘‘safety valve’’ should be clearly separated from the role of a noncompliance penalty, with the 

former being set at a price that is considered an acceptable level of policy implementation cost, 

and the latter being set at a much higher level that is considered ‘‘punitive’’ and not acceptable 

as an indicator of the cost of meeting the policy goals. 16 ‘‘Cost Containment for the Carbon Market: A Proposal,’’ developed in consultation with the 

Nicholas Institute of Environmental Policy Solutions, Duke University, July 24, 2007. Available: 

http://www.nicholas.duke.edu/institute/carboncosts/carboncosts.pdf. 17 Ibid., p. 3. 18 Ibid., p. 7. 19 Congressional Budget Office, Limiting Carbon Dioxide Emissions: Prices Versus Caps., Economic and Budget Issue Brief, March 15, 2005. 20M. I. Hoffert et al., ‘‘Advanced Technology Paths to Global Climate Stability: Energy for a 

Greenhouse Planet’’ Science, Vol. 298, Nov.1, 2002, p. 981. 21These points are developed in a more rigorous fashion in W. D. Montgomery and Anne E. 

Smith ‘‘Price, Quantity and Technology Strategies for Climate Change Policy,’’ in M. Schlesinger 

et al (eds.) Human-Induced Climate Change: An Interdisciplinary Assessment, Cambridge University Press, 2007.

Chairman SPRATT. I listened to the testimony of all of you. You 

seem to be attributing great dexterity to the invisible hand that 

moves through a very substantial market, the entirety of the 

United States. What mechanism would you employ to administer 

and facilitate the operation of this system we are talking about, a 

cap-and-trade system? It obviously can’t be turned over just to the 

marketplace, it has to have some kind of overseer and administrator, it seems to me, to be operative. We will start with Dr. 

Orszag. 

Mr. ORSZAG. Let me make two points about administration. The 

first is that you could impose a cap-and-trade system at different 

parts of the production process, if you will, either upstream—that 

is, you know, at the point of an oil or natural gas or a coal firm—

or downstream, in the form of the goods and services that are actually then bought by households. It is almost universally viewed by 

analysts that an upstream approach would be much more administratively efficient because you have to then monitor many fewer potential sources. So that is the first point. 

The second point is it is difficult to see how a system of—a capand-trade system could be effectively undertaken in the United 

States without at its heart the Federal Government playing an important role in monitoring and enforcement. And that actually then 

speaks to the scoring issue that I was mentioning. In addition to 

the allowances being very cash like, it is also the case that the Federal Government will have to be at the heart of enforcing and monitoring how the allowances are used and whether firms are exceeding their allowances and what have you. 

Chairman SPRATT. Mr. Doniger. 

48

Mr. DONIGER. Thank you, Mr. Chairman. 

If I could add, of all the kinds of pollution regulatory programs, 

the cap-and-trade system is the most economical to administer. Everything that Mr. Orszag said is true, but it is a much simpler system than traditional command-and-control systems. 

For example, the Environmental Protection Agency administers 

the acid rain cap-and-trade program, and I don’t remember the 

exact number, but it is with a couple of dozen employees as opposed to the more command-and-control portions of the clean air 

program, which involves hundreds of people. And the fundamental 

thing, as Dr. Orszag said, is that you have to have systems of monitoring emissions and reporting those emissions and then making 

sure that the submission of allowances is made by a company in 

the number which it owes. 

In the acid rain program there is almost perfect compliance. 

There is a system of monitors in the stacks of the major power 

plants in this country that gives hour-by-hour readings of four pollutants—excuse me, three pollutants, one of which is carbon dioxide. So we already have under the Clean Air Act all the data necessary to implement this program for the electric power industry. 

And there is equally good data on the amount of fuel that moves 

through refineries. 

Various other statistics are already out there and collected by 

government agencies from which you can either directly measure 

or infer the amount of CO2 that is released there, or will be released, when the fuel is burned by households or by cars or whatever. 

So the system is actually quite economical. It does depend on 

there being a penalty which is larger than the market price. So 

most of these bills have, as a rule of thumb, that the penalty for 

not submitting allowances is on the order of three times the price 

of an allowance. And that is why you get such ready compliance, 

because it always makes sense for a company to turn in the number of allowances it owes rather than——

Chairman SPRATT. Is this a self-certifying system, then? 

Mr. DONIGER. No, at least with the acid rain program and a couple of other programs of the same nature, companies file reports, 

there is a violation of law to mislead, there are extensive records 

which are kept which are quite good at preventing that kind of 

misleading. But you do need a government authority and the EPA 

or another agency which has the power and the resources to check 

and audit, and when it finds problems, go after violators. But it is 

a very economical system compared to many other kinds of pollution control systems. 

Chairman SPRATT. Mr. Greenstein, you have been around the 

government a long time. What NRDC is proposing is a slight increase over time, less in previous—I think it is up to 450 million 

ppm or whatever it is, and then it drops down by 80 percent over 

the next 50 years. Can that be accomplished, in your view, without 

some sort of strong oversight by the Federal Government? 

Mr. GREENSTEIN. I am not an expert on these aspects of environmental policy. My testimony really focuses on the areas we know: 

fiscal policy and distributional effects on low-income households. 

The only thing I would note on this front is that if the Congress 

49

enacts legislation that phases various things in over time, you 

probably want to design it in a way that minimizes the potential 

for future Congresses to undo the phasing in of the controls over 

time. 

Having said that, certainly both the economic price and the political difficulty of going in one fell swoop to the full degree of reduction in emissions one would like to achieve would make that impossible. I don’t think there is any alternative but to phase in the reductions in emissions over time. Given that there is no alternative 

to do that, I think it means one designs the legislation in a way 

to try to maximize the potential for the reductions to stay in place 

and to minimize the potential for future policymakers to undo them 

before the goal is reached. 

Chairman SPRATT. Dr. Smith, what do you propose for the oversight, administration, and implementation? 

Ms. SMITH. If you are going to have a cap-and-trade system, you 

definitely need to have sound monitoring and sound enforcement. 

I don’t think you need any sort of oversight board to interfere in 

the marketplace per se, and you definitely would not need that if 

you had a safety valve price. But I do want to comment that Mr. 

Doniger said that of all the types of emissions regulations that are 

possible, cap-and-trade is the easiest to administer. And this is 

simply not true. 

A carbon tax would be far simpler to administer. There would be 

no auctions. There would be no volatility to worry about. There 

would be far fewer worries about possible market manipulation 

that could occur. You would still need to have the enforcement and 

the monitoring, of course, but the issues would be much simpler. 

And the analogy to the SO2 market for a CO2 market is actually 

a very poor one. The SO2 market applied to a few thousand individual electricity-generating units, all of which were already highly 

overseen by regulators in the first place in a very uniform market. 

With CO2 we are looking at thousands of more sources, all sorts 

of sectors of the economy, encompassing other types of gases than 

CO2. And even CO2 sequestration activities, which are taking CO2 

out of the atmosphere, rather than emitting, all of these make for 

a far more complicated sort of marketplace to monitor and enforce. 

Chairman SPRATT. In your testimony, and this is my last question, but you do raise a difference between your viewpoint and Mr. 

Doniger’s and Dr. Orszag’s. That is, you question the assertion that 

emitting businesses would require less than 15 percent of the allowances to compensate for losses due to the carbon caps. You call 

these misleading, and maybe even suggest you have been miscited. 

Would you like to explain to us why you think the 15 percent is 

misleading? 

Ms. SMITH. Certainly. I will say that that literature does demonstrate that you don’t necessarily need to give 100 percent of the 

allocations to businesses in order to compensate their profitability 

losses. The 15 percent is the oversimplification, and the suggestion 

that it is a very small percent. For instance, the models that have 

produced that number have always assumed that the allocation 

would be a permanent, infinite horizon allocation, year over year, 

all the way into the future. As you probably are aware, most realworld applications of cap-and-trade for CO2 involve a phaseout of 

50

those allocations, perhaps as short as 10 years as one amendment 

over on the Senate side says today. With a phaseout like that, you 

are going to get less value from your allocations because you will 

get them over a shorter period of time. But you have to nevertheless achieve the same amount of compensation because the costs go 

on forever and they continue to rise. 

So if the allocation has to perform the compensation in a short 

period of time the percent will rise. It is just a very simple piece 

of algebra. And we saw, for instance, in our analysis that an 8 percent allocation, if it were to be a constant allocation just for 10 

years and then phase out, would require rising up to about 50 percent allocation in order to achieve the exact same amount of compensation to the exact same businesses with the exact same policy. 

So that is one important area. 

Another one is that the percent, whatever it is, 15 percent or 50 

percent, in the case of that other estimate, is based on the average 

of a sectoral impact. And there are many businesses in a sector. 

And these models work with very, very aggregated sectors. One 

sector is the entire electricity-generating sector, rather than all 

types of generators, some of which emit carbon and some don’t. Another is all of the energy-intensive sectors, which include many, 

many diverse types of manufacturing all into one because they all 

happen to use a lot of energy in their production processes. They 

have very different marketplaces. Some of them may benefit under 

a carbon market and some may lose. If you try to estimate what 

the impact would be to the sector on average, you may find that 

you need no compensation, zero percent. But in fact if you say, 

well, if you look behind those numbers you find that that has assumed that you have taken the profits from the winning companies, compensated the losing companies in the sector with those 

profits that they will never get their hands on, and then only say 

what do we need in addition to further offset the overall sectoral 

losses? 

So in one analysis we found a zero percent needed allocation to 

compensate a group of businesses. Actually, if you looked at the 

need to compensate each of the individual losers, without taking 

profits away from the winners, it translated into 30 percent allocations. So those are two very critical ones. 

Also the models are very poor at estimating whether certain companies can actually pass their costs through to customers. The 

models assume a good deal of price pass-through. And that is simply not the case for some kinds of businesses, particularly those 

that are exposed to trade competition from foreign imports or exports. If they can’t pass it through, they need a larger allocation 

to be made whole. Because part of the reason you don’t need to give 

a hundred percent of the allocation to businesses is because a lot 

of the business costs do get passed through to the consumer. And 

that will happen. 

As we said, prices of energy will go up, and it will get passed 

through in many cases to consumers as higher costs of goods and 

services. 

Chairman SPRATT. Dr. Orszag, would you like to respond briefly? 

Mr. ORSZAG. Sure. I would first note that the paper that talks 

about this from CBO was issued under my predecessor, Douglas 

51

Holtz-Eakin. I have reviewed that. I think that the depiction therein is entirely accurate. It does distinguish between net effects on 

the sector and compensating individual firms. And I don’t think 

there was anything misleading at all in CBO’s presentation. 

I would also note a deeper question, though, which is in many 

discussions of compensation for losses there is a level of aggregation that is undertaken. Mr. Greenstein, for example, talked about 

compensating low-income households. That was an average across 

all sorts of low-income households, some of whom will lose more 

and some of whom will lose less. If you compensate low-income 

households, on average, you are not going to hit each individual 

household exactly, nor do I think it is even possible for you to do 

so. So it is often the case in this kind of setting, that there is a 

level of aggregation done and an impossibility of reaching in and 

compensating each individual household or each individual firm for 

the effects imposed on them. If you tried to do that, I think you 

would wind up with a bigger administrative mess than administering the cap-and-trade program itself. 

Chairman SPRATT. Thank you very much. Now, Mr. Doniger, did 

you want to say something? 

Mr. DONIGER. Just one quick point. The whole premise that the 

company’s shareholders need to be compensated is based on an assumption that this program is coming and hitting them as a surprise. But we have known for a long time that global warming is 

a problem. And smart investors have known that there were risks 

associated in holding positions in companies with a lot of carbon 

exposure. I am not sure that it is—I am not saying that we oppose 

using a share of the allowance proceeds for some sort of transitional assistance to companies in the fossil fuel industry. I am not 

saying that NRDC completely opposes that. 

But I do think that it shouldn’t be taken as a given that they 

are owed this, because like everybody else, they have been on notice that global warming is a problem and legislation is coming. 

Chairman SPRATT. Thank you, sir. Mr. Ryan. 

Mr. GREENSTEIN. One quick point also, since I was also accused, 

my testimony along with Dr. Orszag’s, of being a little misleading 

here. As Dr. Orszag said, our estimate of a 14 percent of the allowances to offset the effects on low-income households, there would 

be winners and losers in that. If I tried to give you an estimate of 

how to do something you could administer that identified every single low-income household in the United States and made them 

whole, it would cost more, but that is not feasible. And it doesn’t 

occur to me that it has been the policy over time of the U.S. Government every time it institutes a new policy in any area to try to 

identify every individual firm in the United States that may be affected by a change in policy or regulation and fully compensate it. 

It is not feasible. 

The other point is it certainly is true that if you phase out the 

allocation of permits to energy companies after something like 10 

years, then your initial percentage would need to be higher than 

15 percent. The 15 percent figure that CBO talked about, and we 

are just citing their figure, is a steady-state figure. You can do 15 

percent in perpetuity or you can do a somewhat higher percentage 

52

initially and phase it down to zero over time. There is nothing misleading there. You just take your choice on how you do it. 

Chairman SPRATT. Mr. Ryan. 

Mr. RYAN. Thank you, Chairman. This is a good hearing and a 

good debate, and something we need to do a lot more of. Unfortunately, some of us are on Ways and Means, we are in the middle 

of a markup, we have amendments coming up, so we are going to 

be coming and going. I guess this debate shows you that, you know, 

modeling is a crude science still. And these sectors-wide, aggregatewide, economy-wide models are tough and crude and difficult to 

measure. 

And so when we put in place policies that are so prescriptive, it 

is really difficult to measure the outcomes. And so that is why I 

want to get into the debate about if we do cap-and-trade, and we 

don’t have a safety valve on leakage, then what are the consequences? If we do have a safety valve, then we still lose emissions, either way you go, because of foreign competition. 

It seems to me going down the cap-and-trade route, and if we 

take Mr. Doniger’s recommendation and don’t have any price protection, don’t have a safety valve, then you will have a lot of leakage, at which planetarily-wise you are going to have a reduction in 

your goals. But if you do have leakage protection, or you do allow 

leakage—I mean if you do allow a price ceiling, then you are going 

to have—you are going to reduce your goals either way. So the 

point is why don’t we have more discussion about a carbon tax instead of a cap-and-trade? If we are going to spend all of our time 

building a big mouse trap to try and reach the goal of cap-andtrade, isn’t a better, more efficient, less economically damaging 

route a tax? 

I think the Mankiw article that I think, Bob, you mentioned, 

which I agree, if you just take benefits out of the economy and give 

to a few, you are clearly giving something that is more valuable. 

Corporate welfare is probably a good way of describing it. But at 

the same time, think Greg also mentioned we maybe ought to look 

at a tax that is international. And therefore you can have global 

adjustments, border adjustments. 

So here is my quick question to everybody. And then, Peter, I 

have a scoring question I want to ask you, and then I will turn it 

over. Those of you who are advocating cap-and-trade, why is it that 

you think this is so much better than a tax if, given we have to 

do all of these things to try and police a cap-and-trade, would seem 

to me are going to escape us and we will not meet our goals? 

Mr. DONIGER. Could I take the first whack at that? 

Mr. RYAN. Sure. 

Mr. DONIGER. First of all, let me go back to the beginning. There 

is a distinction to be made between the volatility problem, prices 

going up and down year to year, and the long-term cost. The volatility problem, in my experience in talking with people from the industries, is the thing that really kills people. If their costs are predictable, they can adjust to them. 

So how do you avoid volatility? Well, the primary way to avoid 

volatility in a cap and trade program is with banking, which means 

that if prices are low in a year, you control more and you save up 

the allowances and borrowing. If costs are high, you can borrow 

53

from the future under an interest-based repayment. And that can 

have the capacity to smooth out this year-to-year volatility. 

If you had the ability during the spike in natural gas prices to 

have borrowed and used natural gas that wouldn’t be pumped from 

the ground until 2020, it would have dampened the price of 2006 

natural gas. 

You can do that with allowances because you can shift them in 

time. So I don’t think the volatility problem is as serious a problem 

or it has a cure without going to the safety valve. 

The second point I would make is that your question and Dr. 

Smith’s observation assumes a very long period in which the 

United States is doing its thing on global warming all by itself and 

other countries are not coming along. Well, first of all, except for 

Australia, the rest of the industrial world is already ahead of us 

and we would be joining them rather than leading them. 

Secondly, there are provisions in several of the bills to create 

more leverage for bargaining with key developing countries by proposing that there should be border pollution purchase requirements 

like a board of tax adjustment if after a number of years key countries don’t have comparable control requirements. 

As someone who has worked in the international negotiations as 

well as the domestic arena, I think the time actually has come 

where the developing countries are ready to respond if and when 

we lead. So it will come together in the next 5 to 10 years, and you 

won’t have that sort of thing. 

The last point on the tax, what the atmosphere sees is the number of tons that go into it. That is what causes global warming. So 

we need, in my opinion, a direct limit on the amount of pollution 

that goes into the atmosphere. When you use a tax approach, you 

are guessing at how much response there will be in terms of what 

pollution levels will go in. And it is not easy to write a tax. Everyone has their own different provisions and subprovisions and loopholes and this’s and that’s. It is not any less complicated than writing a cap and trade program, and you have to keep adjusting the 

amounts to get the results you want. 

Mr. RYAN. I would simply say, constructing a border adjustment 

regime on a cap and trade program that is WTO compliant I think 

would be a lot more difficult than if you did it on a tax. We did 

DSC and FSC and all of these iterations, and now ETI, and now 

where are we. We have had a hard time just with existing trade 

law and tax policy complying with WTO. I think there is a case to 

be made that this would be very difficult. Because we are worldwide and the rest of the countries are territorial our tax regimes 

are different. We would have a very hard time, I would think, constructing a WTO compliant border adjustability regime under a cap 

and trade program than if we did in our tax system. 

And I know you are not a tax guy, I think the other folks here 

are. But go ahead, Bob. 

And then one just quick question, Peter, I want to ask you about 

scoring. 

Mr. GREENSTEIN. It seems to me one way to think of this is think 

of three alternatives, carbon tax, cap and trade; the third alternative is doing nothing, sticking with what we have now. 

54

Now, clearly, by far the worst alternative is doing nothing. The 

difference between that and either cap and trade or a carbon tax 

is vastly greater than the difference between a carbon tax and a 

cap and trade. 

So I would agree with you that if we could either do a cap and 

trade or a carbon tax, I would prefer a carbon tax. My concern is 

that the political system I think would have a real—all of you and 

your colleagues—a much harder time enacting a carbon tax than 

a cap and trade system. I wish that weren’t true. That certainly is 

true today; maybe it won’t be true in a couple years. 

Mr. RYAN. Right. But politics aside, in theory in the policy vacuum you are saying the carbon tax is the better way to go than a 

cap and trade? 

Mr. GREENSTEIN. In a policy vacuum, I would prefer a carbon 

tax. But I have a very strong fear that if one tried to move it, those 

who advocated it would be immediately attacked as tax increasers 

and the whole thing would fall apart and we would end up with 

nothing. So in the ideal world with no politics, I would prefer a carbon tax. But I don’t want to let the perfect be the enemy of the 

good. 

Ms. SMITH. I first want to point out, banking is not a way to reduce volatility. There is an enormous amount of banking allowed 

and used in the SO2 cap, and yet we have seen huge volatility in 

that market. Just in the past couple years, prices rose in the space 

of 12 months from $400 per ton of SO2 up to $1,500 a ton, and 

then plummeted back down to the range of about $500 a ton. 

And you have hit it on the mark about the tax. For the WTO 

compliance, a tax allows a much easier and immediate, without 

delay, implementation of border tax adjustment that would be 

WTO compliant or very likely to much, more likely than anything 

that has been proposed around the cap and trade schemes. Taxes 

may be complicated to implement into law, to enact into law and 

write, but I think we are seeing that cap and trade is complicated 

to enact and write into law. Just have a look at the length of the 

Lieberman-Warner bill. But once you get it implemented, and it is 

pretty easy to know if it is a simple one or not. Once you get it 

implemented, then you have all the benefits of simplicity associated 

with the tax in addition to the international trade side of it. 

Mr. RYAN. Okay, Peter. Answer that question, then I will tack 

this out at the end. Your written testimony, you go into sort of 

scoring rules that you are going to put down. If we send you a bill, 

one that auctions how we score that, if we send a bill that does not 

auction, that gives the allowances away, how is that going to be 

scored? 

Mr. ORSZAG. Let me answer that question first. As my written 

testimony notes, if you auction the permits, that would be scored 

as a revenue. If you gave the permits away, there is a solid case 

to be made that that should be scored as a revenue and a corresponding outlay with no net effect on the deficit. That would be 

a departure from the way that the sulfur dioxide program, for example, was scored, and it would be a departure from the fact that 

the budget is primarily cash based. 

55

On the other hand, again, there is a very solid argument to be 

made that that would be the most insightful scoring to put equivalent transactions on an equal footing in the scoring process. 

Mr. RYAN. You can’t be a two-handed economist when you are 

CBO Director though. You will have to make a decision. 

Mr. ORSZAG. Within a very short period of time, we will have to 

make a decision. 

Mr. RYAN. And you have yet to do that? 

Mr. ORSZAG. We have not yet formally done that. Again, I would 

just say there is a solid case to be made for treating the permits 

that are given away as both a revenue and an outlay. 

Mr. RYAN. So no net effect? 

Mr. ORSZAG. No net effect on the budget. However, the benefit 

of that kind of approach is it would make it transparent what was 

happening. And in particular, again, repeating the equivalents, giving someone permits worth $100 that they can immediately turn 

around and sell for cash is effectively equivalent to selling the permits for $100 and then giving that person or firm $100 in cash. 

Scoring the permits that are given away as a revenue and an outlay would make those equivalent transactions equivalent in the 

scoring process. And for transparency and so that policymakers can 

evaluate the tradeoffs clearly, there is a solid case to be made for 

that kind of scoring. 

Mr. RYAN. Then, because I know you do tax as you dabble there, 

isn’t it easier for us to concoct a border adjustability regime that 

is WTO compliant based on a tax versus a cap and trade system? 

And give me your take on the efficiencies of achieving the end goal 

between the two. 

Mr. ORSZAG. First, as my testimony makes clear, a tax is generally more efficient than a cap and trade system. You can make 

a cap and trade system sort of approach the efficiency of a tax by 

changing its design features. So, banking and borrowing and then 

a safety valve, as you noted. And so, relatively speaking, a tax is 

more efficient, but a cap and trade can approach the efficiency of 

a tax with design features that I mentioned. 

On the border tax adjustments and WTO compatibility, I would 

say the area of adjustments in a cap and trade system at the border has ambiguities associated with it. Before I joined CBO, I had 

done some work in the area. And I would just say that is a particularly complicated area in which I wouldn’t want to make predictions about what exactly is or is not WTO compliant. 

Mr. RYAN. Thank you. 

Mr. SPRATT. Ms. Tsongas, welcome. Do you have any questions? 

Ms. TSONGAS. I don’t, but I have enjoyed your testimony. This is 

clearly an issue we have to face, and there is no time to waste. 

Mr. SPRATT. Mr. Smith. 

Mr. SMITH OF NEBRASKA. Thank you very much for your time 

here. I know that it gets to be a challenge balancing science and 

politics and economics, and I appreciate your efforts. 

In trying to read up on so much of this, it has been interesting 

to see, and especially for my district, a large producer of livestock. 

And I have read about the impacts of high corn prices, not only 

high corn prices on the prices in livestock, but across the food spectrum, if you will, around the world. 

56

Here are pluses and minuses along the way. But especially the 

criticisms of the livestock industry and relating to carbon, would 

situations be considered, Mr. Orszag, if you don’t mind; with a cap 

and trade system would the increased costs of food production be 

considered in this equation? 

Mr. ORSZAG. There would be a variety of effects that would be 

spread out across different sectors, and the agricultural sector in 

particular would experience effects. I would also note, the agricultural sector would be one of the sectors most affected by a change 

in climate, so you also need to weigh the costs and benefits. 

And beyond that, I would just point out that your example might 

be a particularly salient one to return to the scoring issue. Handing 

a farmer a permit worth $100 that the farmer then turns around 

and sells for cash of $100 is really similar to handing that farmer 

$100 in cash. 

So you are right to identify your district and the agricultural sector in particular as a key sector in climate change. It is often noted 

that methane emissions are tied to the agricultural sector, and that 

is one of the greenhouse gases. And there would be important effects that are part of all of these models that strive as best they 

can to identify potential impacts on particular sectors. 

Mr. SMITH OF NEBRASKA. Go ahead. 

Mr. DONIGER. May I add a couple points? First, that most cap 

and trade bills don’t suggest they would actually control the emissions from most agricultural activities. But the change in the markets for energy means that there will be even larger opportunities 

for farm-based energy production. And this is apart from allocation 

subsidies or other subsidies. It just becomes more valuable to make 

wind energy, to recover methane natural gas from the wastes of 

livestock production, to grow, we would hope, cellulosic products, 

not the corn but the stocks, switchgrasses and so on, and turn 

those into ethanol. So you get an increase in farm-related energy 

markets just from the imposition of a cap. And there can also be, 

inside the distribution of the allowances there can be incentives to 

make some of those technologies come forward faster. 

Mr. SMITH OF NEBRASKA. Dr. Smith. 

Ms. SMITH. I would like to also point out agriculture is one of the 

most energy intensive forms of manufacturing we have in the U.S. 

It is up there with other energy intense sectors. Cost of energy, 

when it rises, will raise the cost of farming. There is no question, 

though, that there may be some opportunities if the world is shifting towards biomass-based ethanol and use of land for forestry. 

There will be higher rises and changes in markets for land as well 

as change in markets for the crops off of the land, and I think it 

creates much uncertainty. There could be some upside for farmers, 

but it could also be a pretty disruptive time. At the same time, all 

the input prices are changing. 

Mr. SMITH OF NEBRASKA. I think you might have been reading 

a transcript of some conversations I had with constituents. I appreciate your bringing that up, because agricultural producers, their 

greatest concern right now is the cost of energy. And with the direct impact that a cap and trade system would probably have on 

the energy costs, it would even exacerbate the problem that I see. 

57

When we look at the larger issue, again, are we confident that 

those who would be most impacted across the border, whether it 

is individuals, whether it is companies, whether it is those on fixed 

income paying their utility bills, that we can truly address all 

those? I know that is an ambiguous question; but I am fearful that 

there might be some unintended consequences along the way. 

If Mr. Greenstein would respond. 

Mr. GREENSTEIN. Sort of following up on an earlier comment I 

made. If the question is, could we identify every individual firm or 

elderly person on a fixed income, or a farmer, and fully offset the 

impact, no, we can’t do it for each individual one. We have never 

done that for any big policy the governmenthas ever implemented. 

What we can do, though, is we can identify the priority needs. 

And if we auction off the lion’s share of the permits, the resources 

are there. One can design in an efficient manner how to provide 

the assistance in those areas. 

Now, clearly you are not going to be able to fully offset the impact on everyone. If you took every consumer at all income levels 

and fully offset the cost on all of them, you wouldn’t have money 

for basic research, or you might not have enough to go deeper in 

the coal mining communities. You make some choices. But the 

amount of revenue that can be raised, whether it be through auctioning permits or a carbon tax, as Mr. Ryan suggested, is sufficient that Congress could identify all the priority needs it needed 

to address, and it could on average fully address the needs in each 

of those areas, whether it be energy companies, people on fixed incomes, low income consumers, or the like. 

Mr. ORSZAG. Mr. Smith, let me just add that it is not possible 

to compensate each individual household or each individual firm 

precisely because there is an overall economic cost to acting. That 

overall economic cost means it is not—I don’t want to call it a fool’s 

quest, but it is not possible to compensate everyone for the effects 

because there is some net cost. However, that cost has to be 

weighed against the benefit of purchasing insurance against climate change, basically. 

And so attempts to fully compensate everyone for the economic 

costs involved are not going to succeed almost by definition, but the 

net cost that sort of will be there needs to be weighed against the 

benefit of reducing the risk of potentially catastrophic climate 

change. 

Ms. SMITH. I would like to add, I completely agree. There was a 

net cost that was my starting point. The different forms of allocations can maybe help find a way to smooth out where the impacts 

are, but there is no way to make everybody better off even if you 

get a fully smooth and equitable sort of distribution. 

But I also want to point out, yes, we need to try to weigh the 

costs against the benefits, and we need to look at the costs that I 

just reported in my statement. Those are the net costs after accounting for all the recycling of all the benefits associated with the 

revenues from the allocations. And so the net average cost to the 

household for the kinds of hard cap bills that we are looking at, 

without accounting for the uncertainty of volatilities, is in the 

range of $1,000 to $1,500 a year. That is what needs to be compared against the benefit from the climate. 

58

Mr. ORSZAG. So it is not net-net. 

Mr. SMITH OF NEBRASKA. Thank you, Mr. Chairman. I really 

want to thank the witnesses here today. This has been very interesting and I think a very productive debate. Thank you. 

Mr. SPRATT. Thank you, Mr. Smith. 

One final question of Ms. Smith. Would you take just a minute 

and explain to what extent that CRA’s analyses, your analyses take 

into account the economic benefits of imposing climate control, particularly with respect to avoiding environmental harm and even 

catastrophic consequences? 

Ms. SMITH. As I just said, those are the costs that need to be 

evaluated against the benefits. So they do not include the environmental benefits; instead, they provide you a sense of what you 

would be spending for different emissions targets. And then one 

can ask, what do we gain from those emission targets? 

I would just take a moment to mention that some of these catastrophic changes, if they are happening now, will not—the risk of 

them will not be changed by any of these carbon policies. We can 

change the amount of future warming that might occur with deep 

cuts on a global basis, but the kinds of changes we are talking 

about in those cap and trade programs that the U.S. is undertaking 

would not be able to avert any catastrophic losses that are already 

in the works. They don’t make enough change in the climate forecast. 

Mr. SPRATT. Mr. Doniger. 

Mr. DONIGER. Thank you, Congressman. First, what we are 

sketching out is the U.S. part of a balanced world program to cut 

back the global warming pollution not yet in the atmosphere. And 

the IPCC and many other analysts see increasingly dire future consequences as the temperature goes up. 

If we had it in our power, we would keep the temperature from 

going up at all, but there is some increase coming from the pollution already in the bank, already in the air, and from the activities 

that we need to turn around that won’t be turned around overnight. 

So the goal, at least from the environmental community, is to 

draw as much as we can a bright line against letting the temperature increase over where we are now go on a global average up another 2 degrees Fahrenheit or more than that. 

It is true, as Dr. Smith said, that there are impacts occurring 

now, and it is unfortunately true, that have resulted from the global warming pollution already in the atmosphere, changing the frequency of droughts and storms and some of the other bad events. 

Not every fire, not every hurricane obviously is caused by global 

warming, but you are changing the number of dots on the dice and 

changing the outcome as we roll the future climate dice. 

We have no alternative but to cut back emissions now in order 

to stave off the impacts we have not yet committed to. If we just 

keep letting it go, it just gets worse and worse. 

Mr. SPRATT. Mr. Greenstein? 

Mr. GREENSTEIN. I was just going to say we need numbers to 

help guide us in work, especially those of us who deal with the 

budgets. One problem we sometimes run into is for things that we 

do not have enough data to quantify, we run the risk of ignoring 

59

or acting like there is zero. In this case, the thing we can’t quantify 

is the economic damage, and you could—how you would average it 

per household of doing nothing. 

Now, think of the—let me be clear. I am not an expert on Hurricane Katrina. I don’t know to what degree that was climate change 

related. But for sake of illustration, suppose over the next 50 years 

there were a series of events like that that could have been averted 

if we took strong action to address climate change. The potential 

economic impacts of those would be very large. And if we knew the 

number we could quantify it per household. We can’t do it because 

we can’t possibly predict what that is. We can’t come up with a 

number. But it doesn’t mean the number is zero. And there is a 

very substantial chance that that number is substantially larger 

than all the numbers we are talking about here today of the potential effect per household because of what would be relatively modest impacts on the economy. 

Mr. SPRATT. Mr. Smith. 

Mr. SMITH OF NEBRASKA. I know you are not scientists, but we 

are trying to balance all of this right here. If those who would wish 

to state on a scale of 1 to 100 the certainty of reversing global 

warming with a cap and trade program. 

Mr. DONIGER. Let me take the first cut at this. The analysis by 

the IPCC scientists, the Intergovernment Panel on Climate 

Change, and by others is that the kind of emission reduction pathway that I am talking about, 15 percent reduction by 2020, 80 percent reduction in the U.S. by 2050. If matched by other developed 

countries, and there is a lot of those countries that are ahead of 

us, and if not exactly the same action but proportionate action is 

taken in moderating emissions growth in developing countries and 

ultimately to reduce it, that sketches out a budget, an atmospheric 

carbon budget that is consistent with avoiding the 2-degree increase or worse that I described. And that is the physics, that is 

the budget of the atmosphere that we are bringing to this economic 

budget hearing. 

Mr. SMITH OF NEBRASKA. Anyone else wishing to respond? 

Ms. SMITH. There is no question, if we were to stop the growth 

of the CO2 emissions and the other greenhouse gases going 

through the future and through this century, that we would reduce 

the amount of warming that will occur otherwise. But we are not 

going to reverse the warming that is occurring now without waiting 

another century or so. 

So there is a certain amount that is committed. It is not going 

to get reversed. Then the question is, with these expenditures, 

what will we do in the way of reducing further growth? There is 

a serious issue here where we don’t have developing countries involved and their emissions aren’t being reined in, and there is 

nothing on a hard cap in the U.S. that actually brings them into 

the fold. In fact, they have more and more incentive not to come 

into the fold as we put tighter and tighter caps on ourselves unilaterally because they gain competitive advantages over it. 

So the real issue is, can we get a globally coordinated reduction 

in those greenhouse gas emissions? And just putting a cap on the 

U.S. emissions and in bearing these costs in the near term isn’t 

going to accomplish that. 

60

That doesn’t mean that we shouldn’t try to take some action in 

the U.S. to start to put in effect a cost effective climate policy that 

will start to move us in the direction of getting towards zero emissions over the next century. And by ‘‘us,’’ I mean the whole globe. 

And that is the other point I have been making, is that these policies are more costly than they need to be in order to get us on that 

long-term, centuries long action to prevent more greenhouse gas increase than is desirable. 

Mr. ORSZAG. Could I just add one thought, which is I think too 

much of the discussion about future climate change has focused on 

the expected outcome, the range of say 2 to 6 degrees Celsius, for 

example, and too little on what economists call the tail, the small 

probability of really bad things happening. And I would think that 

more attention, even though they are extraordinarily difficult to 

quantify or even know what the risk is, more attention to that risk 

would be beneficial in evaluating the pros and cons of moving forward rather than just the sort of expected outcomes, because there 

is an important element of insurance here against that kind of catastrophic risk. 

Mr. SMITH OF NEBRASKA. Thank you. 

Mr. SPRATT. Thank you, Mr. Smith. 

Now, I believe that concludes the hearing. I have one final detail. 

Any members who did not have the opportunity to ask questions, 

I ask unanimous consent they be given 7 days to submit questions 

for the record. Without objection, so ordered. 

Thank you very much for your testimony and your lively presentation. We appreciate it, and we have learned a lot. Thank you. 

[Whereupon, at 1:30 p.m., the committee was adjourned.]

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