> 
 

CBOTESTIMONY

Statement of Peter R. OrszagDirector

Implications of aCap-and-Trade Program forCarbon Dioxide Emissions

before the Committee on Finance United States Senate

April 24, 2008
*This document is embargoed until it is deliveredat 10:00 a.m. (EDT) on Thursday, April 24, 2008. The contents may not be published, transmitted,or otherwise communicated by any print,broadcast, or electronic media before that time.*       
Chairman Baucus, Senator Grassley, and Members of the Committee, thank you for the invitation to discuss the implications of cap-and-trade programs that are designed to reduce 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 of the risk that the damage may be extensive and perhaps even catastrophic. 

The risk of potentially catastrophic damage associated with climate change can justify actions to reduce that possible harm in much the same way that the hazards we all face as individuals motivate us to buy insurance. Reducing greenhouse-gas emissions would help limit 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.

One option for reducing emissions is to establish a "cap-and-trade" program. Under such a program, policymakers would set a limit on emissions and allow entities to buy and sell rights (referred to as allowances) to emit CO2.In designing a cap-and-trade program to achieve emission reductions, policymakers would face a number of critical decisions, including whether to limit fluctuations in the price of allowances and whether to sell the allowances or give them away. If the government chose to sell them, decisions would also have to be made about whether to use the resulting revenue to offset other taxes, to assist workers or low-income households that might be adversely affected by the emission cap, to support other legislative priorities, or to reduce the deficit. My testimony makes the following key points about those issues: 

■

Market-oriented approaches to reducing carbon emissions (such as a cap-and-trade program or a carbon tax) are much more efficient than command-and-control approaches (such as regulations that require across-the-board reductions by all firms). The reason is that the market-oriented approaches create incentives and flexibility for emissions reductions to occur where and how they are least expensive to accomplish. 

■

Within the relatively efficient category of approaches that rely on the power of markets, a tax on emissions is generally more efficient than a cap-and-trade system. The reason is that although both a tax and a cap-and-trade system encourage firms to find the lowest-cost reductions at a particular point in time, a tax provides greater flexibility over time, allowing firms to achieve reductions when they are least expensive. In particular, a tax encourages firms to make greater reductions in emissions at times when the cost of doing so is low and allows them leeway to lessen their efforts when the cost is high. A cap-and-trade program can be designed to capture many of those time-related efficiencies by incorporating design features that prevent large fluctuations in the price of allowances (for example, a floor and a ceiling on allowance prices). 

■

A cap-and-trade program, like a tax on CO2 emissions, could raise a significant amount of revenue because the value of the allowances created under such a program would probably be substantial. For example, in 2012, the value of the emission allowances that would be issued under S. 2191 would be roughly $145 billion, CBO estimates. As the cap that is included in that legislation became more stringent over time, the value of the allowances would grow. A key decision for policymakers is whether to sell emission allowances, thereby capturing their value in the form of federal revenue, or give them away. 

■

Under a cap-and-trade program, firms would *not* ultimately bear most of the costs of the allowances but instead would pass them along to their customers in the form of higher prices. Such price increases would stem from the restriction on emissions and would 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 cap-and-trade program because they would be the most important mechanism through which businesses and households would be encouraged to make investments and behavioral changes that reduced CO2 emissions.

■

Policymakers’ decisions about whether to sell or give away the allowances could significantly affect the overall economic cost of capping CO2 emissions and the way gains and losses from such a program were distributed among U.S. households. A policy of giving away rather than selling a large share of the allowances could be more costly to the economy and impose disproportionately large burdens on low-income households. 

•	

Evidence suggests that the cost to the economy 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 policymakers gave allowances away than if they sold them and used the revenue to lower current taxes on capital that discourage economic activity. 

•	

In addition, providing allowances free of charge to energy producers and energy-intensive firms could create "windfall profits" for relatively high-income shareholders of those companies, even though the emission cap would be likely to cause price increases that would disproportionately affect people at the lower end of the income scale. Further, allocating allowances without charge would not prevent the loss of jobs in affected industries because such firms would probably reduce their output in response to higher prices for carbon-intensive goods and services. Those job losses, in turn, would impose concentrated income losses in some households and communities. In contrast, if the government chose to sell emission allowances, it could use some of the revenue from those sales to offset the disproportionate economic burden that higher prices would impose on low-income households and to provide transitional assistance to dislocated workers.

■

CBO has concluded that the federal budget should record the value of allowances that are given away by the government if the recipients of the allowances could readily convert them into cash. In particular, the budget should record the value of those allowances, when they are distributed, as both revenues and outlays. That procedure, which CBO has already applied in its estimates for S. 2191, underscores that giving away allowances is economically equivalent to auctioning the allowances and then dedicating the proceeds to the recipients. 

Flexibility in the Timing of Emission Reductions

Incentive-based approaches, which create financial incentives for firms and households to cut their greenhouse-gas emissions, are a lower-cost approach to reducing emissions than more restrictive command-and-control approaches, which would mandate how much such entities could emit or what emission-reduction technologies they should use. The lower cost of incentive-based approaches stems from the flexibility they provide as to where and how emission reductions are to be achieved. Either a tax or a cap-and-trade program would offer such flexibility at a given point in time:

■

Under a tax, policymakers would levy a fee for each ton of CO2 emitted or for each ton of carbon contained in fossil fuels. The tax would motivate entities to cut back on their emissions if the cost of doing so was less than the cost of paying the tax. As a result, the tax would place an upper limit on the cost of reducing emissions, but the total amount of CO2 that would be emitted in any given year would be uncertain. 

■

Under a cap-and-trade program, policymakers would set a limit on total emissions during some period and would require regulated entities to hold rights, or allowances, to the emissions permitted under that cap. (Each allowance would entitle companies to emit one ton of CO2 or to have one ton of carbon in the fuel that they sold.) After the allowances for a given period were distributed, entities would be free to buy and sell the allowances. The trading aspect of the program could lead to substantial cost savings relative to command-and-control approaches: Firms that were able to reduce emissions most cheaply could profit from selling allowances to firms that had relatively high abatement costs. 

Cap-and-trade programs can vary substantially in the amount of leeway that they provide regulated entities in the timing of emission reductions. Designs that allow for more timing flexibility are generally more cost-effective. 

Potential Savings in Costs as a Result of Timing Flexibility 

In its most inflexible form, a cap-and-trade program would require that a specified cap on emissions be met each year. That lack of flexibility would boost the cost of achieving any long-term goal because it would prevent firms from responding to year-to-year differences in conditions that affected emission reduction costs, such as fluctuations in economic activity, energy markets, the weather (for example, an exceptionally cold winter would increase the demand for energy and make meeting a cap more expensive), and the technologies available for reducing emissions. In contrast, the benefits of meeting inflexible annual emission targets are unlikely to be significantly different from the benefits of achieving the same long-term reductions but allowing firms to reduce their emissions by more than a given target in some years and by less in others. That insensitivity of benefits to patterns of annual emissions is a result of the long-term nature of climate change. Limiting global temperature increases would entail making substantial reductions in the amount of greenhouse gases that accumulate in the atmosphere over the next several decades. However, the benefits of doing so are largely independent of the annual pattern of those reductions.1

Available research suggests that a tax on CO2 emissions (which would provide firms with maximum flexibility in how they undertook emission reductions over time and could keep the cost of reductions in line with anticipated benefits) could achieve a long-term target at roughly one-fifth the cost of the most inflexible type of cap-and-trade program (that is, one with no leeway in the timing of emission reductions). No existing policy proposals envision such an inflexible cap, however. Among recent proposals for a cap-and-trade program, the amount of timing flexibility that firms are allowed would vary depending on the program’s specific design features. 

Design Features That Provide Firms with Timing Flexibility 

When combined, some design features could allow a cap-and-trade program to achieve many of the advantages in efficiency associated with a tax on emissions. One simple way of evaluating how close a cap-and-trade system would come to the efficiency of a carbon tax is to consider how much the price of allowances would fluctuate over time; the less fluctuation, the closer the cap-and-trade system would come to achieving the timing flexibility that is central to the efficiency of a tax. Minimizing price fluctuations requires measures to limit both unintended price increases and unintended price declines.

Keeping Costs from Climbing Too High. Setting a ceiling—typically referred to as a safety valve—on the price of allowances could make a cap-and-trade program more efficient than an inflexible cap. Such a policy could prevent the cost of reducing emissions from exceeding either the best available estimate of the environmental benefits that would result from those reductions or the cost that policymakers consider acceptable. The government could maintain a price ceiling by selling companies as many allowances as they would like to buy at the safety-valve price. 

Alternatively, policymakers could allow companies to defer emission reductions to later years by allowing them to "borrow" future allowances for use in an earlier year. Borrowing allowances from future years would tend to reduce allowance prices in the current year but then raise prices in the future (because borrowing would allow smaller reductions now but require greater reductions later). Firms would want to borrow allowances only if they expected the price of allowances in the future to be sufficiently below the current price as to make deferring reductions profitable. That is, borrowing could help deal with temporary spikes in allowance prices but not circumstances in which allowance prices were expected to remain high over the long term. As a result, borrowing is likely to be less effective than a price ceiling in preventing higher-than-anticipated allowance prices.

Keeping Costs from Falling Too Low. Policymakers could prevent the price of allowances from falling too low by setting a price floor. If the government chose to auction a significant share of the allowances, it could specify a so-called reserve price and withhold allowances from the auction as needed to maintain that price. The efficiency advantage that a price floor offers stems from the fact that it can prevent the cost of emission reductions from falling below the benefits that they were expected to produce—or below the level of effort that policymakers intend that emitters should maintain.

Alternatively, policymakers could help keep the price of allowances from falling too low by allowing companies to exceed their required emission reductions in low-cost years in order to "bank" allowances for use in future high-cost years. The additional emission reductions motivated by banking in low-cost years would put upward pressure on the price of allowances in those years. Similar to borrowing, banking would be most effective in addressing short-term lows in allowance prices rather than in circumstances in which allowance prices were expected to remain low over the long term. As a result, banking is likely to be less effective than a price floor in preventing lower-than-anticipated allowance prices.

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

In 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. On the basis of a review of the existing literature and the range of CO2 policies now being debated, CBO estimated that by 2020, the value of thoseallowances could total between $50 billion and $300 billion annually (in 2006 dollars). 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 that was selected.2 On April 10, 2008, CBO estimated that the value of the allowances created under S. 2191 would be roughly $145 billion once the proposed program took effect in 2012; in subsequent years, the aggregate value of the allowances would be even greater. (See Box 1 for a short description of CBO’s cost estimate for S. 2191.)

Box 1. 

CBO’s Cost Estimate for S. 2191
On April 10, 2008, the Congressional Budget Office (CBO) issued a cost estimate for S. 2191, the America’s Climate Security Act of 2007, as ordered reported by the Senate Committee on Environment and Public Works in December 2007. CBO also issued a cost estimate for a slightly amended version of the legislation that was transmitted by the committee on April 9. The legislation would create a cap-and-trade system for carbon dioxide and other greenhouse gases. (The bill actually calls for two separate cap-and-trade programs—a bigger one covering most types of greenhouse gases and a smaller one covering hydrofluorocarbons.) Some of the emission allowances would be auctioned—through a new entity, the Climate Change Credit Corporation; the remaining allowances would be distributed at no charge to states and other recipients. Over the roughly 40 years that the proposed cap-and-trade programs would be in effect, the number of allowances—and thus the emissions of relevant gases—would be reduced each year.    				On the basis of an analysis of the results of several economic models, CBO estimates that if the legislation was enacted, the auction price of emission allowances for those gases would rise from about $23 per metric ton of carbon-dioxide-equivalent (mt CO2e) emissions in 2009 to about $44 per mt CO2e in 2018.1 (In 2006 dollars, the auction price per metric ton of CO2e would rise from about $21 in 2009 to $35 in 2018.) Measured relative to base-case emissions (that is, those that would occur under current law), emissions of the main greenhouse gases covered by the programs would decline by 7 percent in 2012 and by 17 percent in 2018; over the 2012–2050 period, emissions would decline by a total of 42 percent relative to the base case.     					Enacting S. 2191 as it was ordered reported would increase revenues by about $1.19 trillion over the 2009–2018 period, CBO estimates. Direct spending from distributing those proceeds would total about $1.21 trillion over the period. The net effect of the original legislation (as ordered reported) would be to increase the deficit (excluding any effects on future discretionary spending) by an estimated $15 billion over the next 10 years. The effect of the amended version, in contrast, would be to reduce the deficit (again excluding any effects on future discretionary spending) by roughly $80 billion over the same period. In addition, if policymakers appropriated the amounts necessary to implement S. 2191, discretionary spending would increase over the 2009–2018 period, CBO estimates, by about $4 billion under the original legislation and by about $80 billion under the amended version.     					The cost estimates for the two versions of the bill differ because the amendment would increase the proportion of allowances that would be auctioned, deposit some of the auction proceeds in a Climate Change Deficit Reduction Fund, and make spending from that fund subject to appropriation.