President Bush and other leaders of the Group of Eight pledged yesterday to try to reduce greenhouse gas emissions 50 percent by 2050. A key consideration in evaluating climate policies is the economic cost of cutting emissions. That cost could be reduced, perhaps by a lot, depending on two key questions about domestic climate policies: whether flexibility is provided when emissions are reduced and whether allowances to emit carbon are sold or given away.
The most common proposal for reducing carbon emissions involves a cap-and-trade program. Such programs provide flexibility regarding where and how firms reduce emissions. That’s a good start, but research suggests that businesses also need flexibility about when they reduce emissions if they are to minimize economic costs. Changes in climate reflect the accumulation of greenhouse gases in the atmosphere over long periods; the impact depends little on year-to-year fluctuations in emissions. By contrast, the economic cost of reducing emissions can vary a lot from year to year — because of factors such as weather, economic activity or the state of technology. Flexibility regarding the timing of emissions reductions matters because of this disconnect between the environmental dynamic, which depends on total emissions reductions over an extended period, and the economic dynamic.
Timing flexibility could be delivered in many ways. Some cap-and-trade proposals allow permits for emitting carbon to be shifted across years. Yet these «banking and borrowing provisions» are typically limited. Alternatively, setting a floor and a ceiling on allowance prices each year could provide flexibility without sacrificing the ultimate goal. Setting a minimum auction price for allowances would encourage more emissions reductions when the costs were low. A price ceiling, implemented by selling additional allowances at that ceiling price, would mean fewer reductions when costs were high. Regulators could periodically adjust the price floor and ceiling to ensure that emissions reductions were on track for achieving a long-term target. A carbon tax also would provide timing flexibility.
A second way to reduce costs under a cap-and-trade program involves the method for initially distributing emissions allowances. The key questions here are whether some or all of the allowances will be sold by the government or given away — and, if they are sold, how the revenue will be used.
Cap-and-trade programs create a new commodity: the right to emit carbon. With a constraint on total emissions, allowances would suddenly be highly valuable — likely to be worth more than $100 billion per year. Selling them would provide revenue to offset some of the costs of the program. For example, revenue could be used to lower existing taxes that dampen economic activity. Following this path, the cost to the U.S. economy of a 15 percent cut in emissions might be half as large as it would be if the allowances were given away.
Another possible use of revenue from auctioning allowances is to offset the effects that higher energy prices would have on low- and moderate-income households. Although such price increases encourage greater efficiency in reducing emissions, and are thus essential to the success of a cap-and-trade program, they would impose a disproportionate burden on low- and moderate-income households. The Congressional Budget Office has found that if the allowances were sold and the revenue used to provide equal rebates to every household, lower-income households could be financially better off because the rebate would be larger than the average increase in their spending on energy-intensive goods. Alternatively, the distributional consequences could be offset by increasing the earned-income tax credit or boosting food stamp benefits.
By contrast, granting allowances free to emitters would not be well suited to reducing either the macroeconomic costs or the distributional effects of a cap-and-trade program. Businesses would raise energy prices for their customers regardless of whether the allowances were auctioned or given away. Indeed, providing free permits to energy producers and energy-intensive firms would be equivalent to auctioning the permits and simply giving the proceeds to the firms. The result would be a lost opportunity to use the money to offset the costs of emissions reductions as well as the potential creation of regressive «windfall profits» for the relatively high-income shareholders of those companies.
Given that climate change is a global problem, effective solutions will require care toward not only these domestic design issues but in coordinating efforts with other major emitters. Whereas timing flexibility and the use of revenue from allowance sales can be legislated, such coordination is difficult to legislate — but may be easier to negotiate the more credible the U.S. effort, which in turn depends on avoiding excessive domestic costs. Giving firms flexibility about when they reduce emissions and devoting the revenue from selling allowances to reducing either the macroeconomic costs or the distributional consequences would not make it free to reduce the risks associated with global climate change, but such strategies could reduce the domestic economic costs substantially.
Peter R. Orszag, director of the Congressional Budget Office.