15 January 2009

Economic Challenges for Climate Change Policy

By Toni Johnson, Council on Foreign Relations, January 15, 2009


A consensus continues to grow among world leaders that climate change poses a threat to the global economy. Incoming President Barak Obama and the Democratic majority in Congress say they are committed to enacting mandates to curb greenhouse gases. But a failed 2008 attempt by congressional Democrats to push through a bill underscores the uphill battle lawmakers face. Finding an approach that manages to cut greenhouse gases without doing serious harm to the U.S. economy, particularly given the global economic downturn, remains a top concern. Amid a slumping U.S. economy, any legislation that imposes higher energy costs will be particularly difficult to negotiate. However, many lawmakers say climate-change policy also holds economic opportunities, including creating jobs and employing new green technologies.

Taking the Plunge

Numerous reports and studies, notably the 2007 report of theIntergovernmental Panel on Climate Change, have concluded that climate change is real and is being driven primarily by the emissions of man-made greenhouse gases. A number of projections suggest it could have significant implications for the global economy. Nearly all of the signatories of the Kyoto Protocol, a UN framework for reducing greenhouse gases, have begun taking steps to meet the emissions caps set for them. The United States was a Kyoto signatory but never ratified the protocol, in part due to fears that it would reduce U.S. competitiveness with countries like China and India that are not subject to emissions caps. Officials in those countries have likewise expressed reservations that the imposition of emissions caps would reduce their competitiveness and harm their economies. President Bush in April 2008 called for stopping the domestic rise in greenhouse-gas emissions by 2025 through a “comprehensive blend of market incentives and regulations to reduce emissions by encouraging clean and efficient energy technologies.” But Bush declined to endorse the cap-and-trade approach favored by a number of lawmakers and warned that “bad legislation would impose tremendous costs on our economy and on American families without accomplishing important climate change goals.”

The Democratic-led Congress has begun looking at what policy changes the United States can make ahead of any international commitments. Although climate-change policy poses significant challenges, environmental advocates believe more significant harm to the economy would come through inaction. The 2006 Stern report sponsored by the British government forecasts global GDP losses of 5 percent to 20 percent unless significant action is taken to halt climate change. Environmental advocates say the longer the United States waits to begin making reductions, the steeper those reductions will need to be to make a difference. But it is unclear whether a law can be enacted under the Bush administration.

Weighing the Costs

Legislation taken up by the Senate (PDF) in June 2008 spawned vastly divergent analysis about how climate-change laws would affect the U.S. economy. The bill also sparked contentious debate between Republicans and Democrats about how much the bill would raise energy prices. Such concerns helped doom action on the bill this year but a version of it is expected to be reintroduced in 2009.

The Senate proposal would require a 19 percent greenhouse-gas emissions reduction below 2005 levels by 2020 and a more than 70 percent reduction below 2005 levels by 2050. The caps would be targeted at the electric power, transportation, manufacturing, and natural gas sectors, which account for about 87 percent of U.S. emissions. The bill also limits the number of emissions permits that can be given out each year, and the number of emissions offsets that can be employed.

The U.S. Environmental Protection Agency (EPA) estimates that in 2030 the law would cost between $238 billion and $983 billion (PDF) (1 percent to 4 percent) in gross domestic product (GDP) losses for that year. Industry advocates like the American Council for Capital Formation (ACCF) and the National Association of Manufacturers (NAM), put GDP losses in 2030 at more than $600 billion (PDF). By contrast, the Clean Air Task Force, an environmental advocate, says the law would precipitate less than $200 billion in GDP losses (PDF). These models must make assumptions about a number of unknowns, which accounts for the large disparity in estimates. Such unknowns include what will happen with international climate efforts, behaviors by consumers and industry, natural gas prices, and the viability of carbon capture and sequestration technology.

"You want to be careful not to design a cap-and-trade target so ambitious that it gives a shock to the economy." --Derik Broekhoff, a senior associate for the environmental think tank the World Resources Institute.

The EPA’s analysis shows that energy prices could rise as much as 44 percent by 2030 and gas prices about fifty cents a gallon in the same period. The ACCF/NAM report estimates gasoline could cost as much as two to three dollars more and household energy costs could rise as much as 129 percent by 2030. Meanwhile, the Clean Air Task Force projects cost increases of only ten cents a gallon for gasoline and three cents per kilowatt hour in electricity costs by 2030. Jeffrey R. Holmstead, a former senior EPA official and now an industry lawyer, says that even at the low end of the projections, climate-change policy is likely to be one of the largest government programs in U.S. history.

Cost by Design

A major problem for climate-change policy is how to set the price for emitting greenhouse gases. Most climate policy proposed by the U.S. Congress focuses on designing a cap-and-trade program. Under such a program, like the one in the European Union, the price of emissions would be market-based. Companies are allocated allowances limiting them to a certain amount of greenhouse-gas emissions each year. To meet these caps, they must reduce emissions but can also purchase offset credits from climate-friendly projects in lieu of internal emissions reductions.

Under the EU trading system, permit prices for emitting an equivalent ton of carbon dioxide have fluctuated significantly. Instead of cap-and-trade, economists generally favor a carbon tax, which they believe would provide price predictability with costs to the economy offset by lowering taxes in other areas. However, many experts think such a tax would be nearly impossible to get through Congress. Environmental experts also contend that while a tax would provide cost certainty, only a cap could provide certainty on minimum emissions reductions.

Peter R. Orszag, director of the Congressional Budget Office (CBO), told a congressional committee in November 2007 that decisions about how to allocate emissions permits (PDF) can have a significant economic impact. Permits can either be given away for free or sold, usually by auction. The Senate bill set for introduction in the summer of 2008 would auction 27 percent of permits in the first few years, rising to nearly 70 percent by 2030. The CBO estimates the bill would increase federal revenues by about $1.2 trillion in the first decade (PDF) from permit sales. The remainder of the permits would be given away to industries based on a formula in the bill.

Orszag says giving allowances away would allow companies to pass on the cost of an emissions permit without actually having paid for it themselves, thus creating windfall profits. A March 2008 report from Point Carbon, a consulting group, finds that this was true of utilities in the European Union (PDF), where permits were given away. But the National Rural Electric Cooperative Association, an energy industry advocate, says the electric utilities should be allocated some free permits to“avoid rate shocks” (PDF). Robert C. Baugh, head of the AFL-CIO’s energy task force, notes that companies also could horde permits (PDF), increasing price volatility. He suggests assigning time limits to permits to “create a more certain, less speculative environment.”

Offsetting Economic Harm

Industry and some experts are concerned about the possible negative economic impacts of setting a price on carbon. “You want to be careful not to design a cap-and-trade target so ambitious that it gives a shock to the economy,” says Derik Broekhoff, a senior associate for the environmental think tank the World Resources Institute. The National Rural Electric Cooperative Association says the Senate bill should include a measure that would cap allowance prices. William A. Pizer, senior fellow at Resources for the Future, a Washington-based environmental think tank, argued in a CFR.org Online Debate in June 2007 that a “safety valve,” allowing for the distribution of additional permits when permits reach a certain price, could provide the same stability as a tax. But Kenneth P. Green, resident scholar at the American Enterprise Institute, notes in the same debate that while the safety valve could work in theory “emission trading systems have been plagued by corruption and subversion that make such a perfect scheme highly unlikely.”

Lawmakers and industry worry that such greenhouse-gas caps in the United States will reduce the ability of U.S. companies to compete with foreign imports, leading U.S. companies to move to countries without greenhouse-gas restrictions. To address such concerns, the bill contains a proposal to tax imports from countries not making similar greenhouse-gas reductions of their own. The Senate’s bill would require importers of greenhouse-gas-intensive goods to begin purchasing permits about decade after enactment. Some environmental advocates even contend green tariffs could bring exported industries back to the United States.

"The most obvious economic benefit to capping greenhouse-gas emissions is mitigating the impact of climate change, which will have far-reaching implications for the U.S. and global economies, if projections prove right."

But creating such a tariff system would pose a number of hurdles. One is deciding how to measure how much greenhouse gas was emitted to produce a certain product. Gary Clyde Hufbauer, a Peterson Institute economist, says the likely outcome is a messy set of hybrid systemsthat differ from country to country. “Each country will favor a mixture of subsidies, border adjustments, and other [greenhouse gas] controls that foster its own producers, especially ‘national champions,’” he says. For members of the World Trade Organization (WTO), such tariffs are likely to face serious challenge in the WTO’s dispute settlement system. An evaluation by the Pew Center on Global Climate Change finds “unilateral border adjustment measures” (PDF) would not adequately address U.S. competitiveness or stimulate developing-country action on emissions reductions.

The New Green Economy

The most obvious economic benefit to capping greenhouse-gas emissions is mitigating the impact of climate change, which will have far-reaching implications for the U.S. and global economies, if projections prove right. A cap-and-trade system also offers potential economic benefits. Caps would provide incentives for energy saving and low-emissions technologies. Revenues from purchasing credits that offset emissions could be used to spur investment in green technologies that help the economy transition. Offset projects themselves count as new business opportunities. Projects under consideration by U.S. policymakers include reforestation, renewable energy projects, and methane capture from farms and landfills. A report on the benefits and challenges of offsets by the Congressional Research Service points out that offsets could help lower compliance costs (PDF) for regulated entities.

The development of green technologies will also create new jobs. In 2006, more than two million people globally were working in sectors related to renewable energy, according to a UN report. It projects that number could go as high as twenty million (PDF) by 2030. Broekhoff, of the World Resources Institute, says the bill will provide extra incentive for U.S. firms to maintain a competitive advantage in green technologies. But Holmstead, the former EPA official, says people who tout a net gain in jobs under climate-change policy are “economically illiterate.” He argues more jobs will be lost from climate-change policies than would be gained. The ACCF/NAM report found that as many as four million U.S. jobs could be lost by 2030.

Copyright 2009 by the Council on Foreign Relations. All Rights Reserved.

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