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The accumulation of greenhouse gases in the atmosphere could cause costly changes in regional climates throughout the world and has led policymakers and analysts to consider policies to restrict emissions of those gases. One option for reducing emissions in a cost-effective manner would be to establish a cap-and-trade program for those gases. Such a program would limit the number of tons of greenhouse gases emitted by setting gradually tightening annual caps, which, when added together, would set a cumulative cap over the duration of the policy. The government could distribute allowances, which would be rights to emit those gases, by selling them, possibly through an auction, or giving them away. Then firms could trade allowances, “bank” unused allowances for future use, or “borrow” allowances allocated for future years in order to reduce the cumulative cost of complying with the caps.

The price of allowances would vary on the basis of current conditions, such as the weather and the economy, and firms’ expectations about factors affecting their compliance costs over the duration of the policy. Unexpectedly high (or low) allowance prices would make the cost of meeting the caps much higher (or lower) than policymakers had expected, which could alter the tradeoff between costs and benefits that policymakers had anticipated when they selected the caps. Because they cannot know in advance how high or low allowance prices would be in any given year, policymakers might consider including mechanisms in a cap-and-trade program that would help limit the range of potential allowance prices.

Today CBO released a study—prepared at the request of the Chairman of the Senate Committee on Energy and Natural Resources—that examines the potential effects of certain mechanisms that would help manage allowance prices, and thus the cost of complying with a cap-and-trade program, by altering the number of allowances available to firms at various prices. CBO examined the effects of three such mechanisms: a price ceiling, an allowance reserve, and a price floor. Actual experience in managing allowance prices through the approaches that CBO examined is quite limited, and they could have effects other than those identified here.

A Price Ceiling

Policymakers could set an upper limit, or ceiling, on allowance prices by allowing firms to buy an unlimited number of allowances, in addition to those permitted under the cumulative cap, at a specified “ceiling price.” Such a policy would have the following consequences:

• It would provide an upper limit on allowance prices but not on emissions, meaning emissions could exceed the cap.
• The higher the ceiling price was set above the projected path of allowance prices, the less likely it would be that firms would buy additional allowances, and if they did buy them, the fewer they would buy. As a result, a higher ceiling would generally lead to fewer additional emissions than would arise under a lower ceiling.
• Provided that firms were able to shift allowances from one year to another—that is, bank and borrow allowances—a ceiling could dampen the price of allowances, even when their market price was below the ceiling price.
• If the ceiling lowered allowance prices, it would diminish firms’ incentives to invest in equipment that reduced emissions and in efforts to develop new lower-cost technologies for reducing emissions. That decrease in investment would lower firms’ spending for emissions reductions in the near term but could increase it in the future, when their compliance costs rose.

An Allowance Reserve

Alternatively, policymakers could offer to sell firms a limited number of allowances at or above a given price. Such an “allowance reserve” would have the following effects:

• It would impose an upper limit on emissions—which might be different from the cumulative cap—but would not set an upper limit on the price of allowances.
• A reserve created by adding to the number of allowances supplied under the cap would allow a limited loosening of the cap when costs were high. Such a reserve would tend to increase emissions and lower allowance prices relative to a policy with the same cap but no reserve.
• A reserve created by withholding allowances that would otherwise be distributed under the cap could increase firms’ compliance costs but allow fewer emissions than those under a program with the same cap but no reserve.
• The effect of a reserve on emissions and allowance prices might be greater but would be less certain if regulators could restock the reserve by using offset credits, which reflect reductions in domestic or overseas emissions that would not otherwise be subject to the cap.
• If the federal government used auctions to sell the reserve allowances it created, it would capture their full value. Alternatively, if the reserve allowances were distributed by offering firms options to purchase them at a fixed price, the government and firms would share the allowances’ value.

A Price Floor

Another approach, a price floor, would set a lower limit on the price of all traded allowances. With a “hard” price floor, the simplest form of such an approach, the government would be required to purchase an unlimited number of allowances at a predetermined price. Broadly speaking, including a price floor in a cap-and-trade program would tend to boost allowance prices in the near term but would probably not result in fewer emissions over the duration of the policy if firms were permitted to bank allowances. CBO’s analysis also indicates the following:

• The further below the projected path of allowance prices that the floor price was set, the less likely it would be that the floor would become binding—that is, prevent any further decline in prices.
• At a time when it was binding, a price floor would increase firms’ compliance costs, relative to a policy with the same cap and no price floor, because it would require firms to reduce emissions more than they otherwise would.
• To the extent that a price floor increased the price of allowances, it would strengthen firms’ incentives to invest in emissions-reducing equipment and to develop new lower-cost technologies for reducing emissions. Those investments would boost firms’ spending in the near term but decrease their compliance costs (and lower allowance prices) in the future.
• If firms could shift allowances from one period to another (by banking and borrowing allowances), a price floor would probably not result in cumulative emissions over the life of the policy (typically several decades) that were less than the amount permitted under the policy’s cap. Instead, it would shift reductions forward in time.
• Policymakers could try to set a lower limit on the price of allowances by establishing a minimum bid price for the allowances sold in a government-run auction. But that bid price would establish a floor for prices in the secondary market only if the demand for allowances was great enough that firms would want to buy at least some of the allowances being auctioned.

This study was prepared by Terry Dinan of CBO’s Microeconomic Studies Division.

The federal government supports the use of biofuels—transportation fuel produced usually from renewable plant matter, such as corn—in the pursuit of national energy, environmental, and agricultural policy goals. Tax credits encourage the production and sale of biofuels in the United States, while federal mandates specify minimum amounts and types of biofuel usage each year through 2022. Tax credits effectively lower the private costs of producing biofuels relative to the costs of producing their substitutes, gasoline and diesel fuel. Together, the credits and mandates increase domestic supplies of energy and reduce U.S. emissions of greenhouse gases, albeit at a cost to taxpayers and consumers. For example, in fiscal year 2009, the biofuel tax credits reduced federal excise tax collections by about $6 billion below what they would have been if the credits had not been in effect.

Roughly 11 billion gallons of biofuels were produced and sold in the United States in 2009, and ethanol produced from corn accounted for nearly all of that total. Blenders of transportation fuels receive a tax credit of 45 cents for each gallon of ethanol that is combined with gasoline and sold. Although the credit is provided to blenders, most of it ultimately flows to producers of ethanol and to corn farmers—in the form of higher prices received for their products.

Most of the rest of the biofuel sold in the United States consists of biodiesel, which is made largely from soybean oil but is also produced from animal fats and recycled plant oils. Until recently, the producers of such biodiesel received a tax credit of $1 per gallon. Although that credit expired in December 2009, CBO included it in the analysis to provide information about the value of the credit should policymakers decide to reinstate it. In the future, cellulosic ethanol—made from plant wastes such as corn stalks—could account for a significant share of domestic production of biofuels. Its producers are eligible for a tax credit of $1.01 per gallon if it is produced and blended with gasoline; even with that credit, however, cellulosic ethanol is not commercially viable today and is produced in very limited quantities.

In a study prepared at the request of the Chairman of the Subcommittee on Energy, Natural Resources, and Infrastructure of the Senate Committee on Finance, CBO assesses the incentives provided by the biofuel tax credits for producing different types of biofuels and analyzes whether they favor one type of biofuel over others. In addition, we estimate the cost to U.S. taxpayers of reducing the use of petroleum fuels and emissions of greenhouse gases through those tax credits; we also analyze the interaction of the credits and the biofuel mandates. CBO’s main conclusions are the following:

• The incentives that the tax credits provide to producers of biofuels differ among the fuels. After adjustments for the different energy contents of the various biofuels and the petroleum fuel used to produce them, producers of ethanol made from corn or other similar feedstocks receive 73 cents to provide an amount of biofuel with the energy equivalent to that in one gallon of gasoline. On a similar basis, producers of cellulosic ethanol receive $1.62, and producers of biodiesel would receive $1.08 (if that credit were extended).
• The costs to taxpayers of reducing consumption of petroleum fuels differ by biofuel. Such costs depend on the size of the tax credit for each fuel, the changes in federal revenues that result from the difference in the excise taxes collected on sales of gasoline and sales of biofuels, and the amount of biofuels that would have been produced if the credits had not been available. The costs to taxpayers of using a biofuel to reduce gasoline consumption by one gallon are $1.78 for ethanol and $3.00 for cellulosic ethanol. The cost of reducing an equivalent amount of diesel fuel (that is, a quantity having the same amount of energy as a gallon of gasoline) using biodiesel is $2.55, based on the tax policy in place through last year.
• Similarly, the costs to taxpayers of reducing greenhouse gas emissions through the biofuel tax credits vary by fuel: about $750 per metric ton of CO₂e (that is, per metric ton of greenhouse gases measured in terms of an equivalent amount of carbon dioxide) for ethanol, about $275 per metric ton of CO₂e for cellulosic ethanol, and about $300 per metric ton of CO₂e for biodiesel. Those estimates do not reflect any emissions of carbon dioxide that occur when production of biofuels causes forests or grasslands to be converted to farmland for growing the fuels’ feedstocks (the raw material for making the fuel). If those emissions were taken into account, such changes in land use would raise the cost of reducing emissions and change the relative costs of reducing emissions through the use of different biofuels—in some cases, by a substantial amount.

Federal biofuel mandates require vendors of motor fuels to produce or blend specified minimum volumes of the different fuels with gasoline and diesel fuel; the annual targets are scheduled to rise through 2022. In the past, those requirements have not directly increased the quantity of biofuels sold in the United States because the combination of underlying economic conditions and the biofuel tax credits has caused the use of biofuels to exceed the mandated quantities. In the future, the scheduled rise in mandated volumes would require the production of biofuels in amounts that are probably beyond what the market would produce even if the effects of the tax credits were included.

The report was written by Ron Gecan of CBO’s Microeconomic Studies Division and Rob Johansson, formerly of CBO.

This afternoon I spoke at a Brookings conference on climate and energy policy. CBO has done a great deal of work in this area, applying the research done by outside experts as well as our own analysis and modeling to help the Congress understand the likely budgetary and economic effects of alternative policy approaches and specific legislative proposals being considered. In my comments today I focused on one particular issue—efforts to reduce emissions of greenhouse gases—and what CBO sees as the lessons of economic analysis for those efforts. (These slides capture the key points that I made today; all of CBO’s work on climate change is available here and relevant links are noted throughout this blog post.) CBO’s analysis focuses on how economic principles would apply to emission-reduction efforts, but following its standard practice, CBO does not make recommendations regarding specific policies. 

Lesson #1: To reduce greenhouse-gas emissions at the lowest social cost, the government should put a price on emissions.

Putting a price on emissions—for example, by taxing them or creating a cap-and-trade system—would create incentives for conservation, substitution in production, and technological innovation—the changes needed to reduce emissions. In addition, a price-based approach would allow firms and households to reduce emissions in the lowest-cost way. However, achieving cost-effective emission reductions would probably require other policies as well, because price signals do not always work effectively and because government has a key role to play in funding basic research and in other areas.

Lesson #2: To reduce greenhouse-gas emissions at the lowest social cost, the price should rise gradually over time and should avoid unnecessary volatility.

Gradual reductions in emissions are important because it takes time for research to be conducted and technology to be designed, tested, refined, and disseminated widely; time for patterns of production and consumption to change; and time for business and household capital to wear out and be replaced with different sorts of capital. Unnecessary volatility in the price of emissions would make a given amount of emissions reduction more costly, because it would force too many reductions when the cost of cutting emissions was relatively high and motivate too few when the cost was relatively low.

Lesson #3: To reduce greenhouse-gas emissions at the lowest social cost, the scope of emissions that are priced should be as broad as possible.

Market-based methods of reducing emissions would be most cost-effective if the largest number of producers and consumers are involved. That does not mean that everyone needs to be under exactly the same system or face exactly the same price: As long as the prices faced by different producers and consumers were similar, the outcome would be fairly efficient. This issue arises in several contexts in climate policy—in designing one system for the entire economy or different systems for different parts of the economy, in considering approaches for international coordination, and in addressing so-called “offsets” (reductions in emissions from activities not subject to limits).

Lesson #4: An efficient system for reducing greenhouse gas emissions would probably lower overall GDP, employment, and households’ purchasing power by a modest amount relative to what would occur otherwise (and leaving aside the economic effects of slowing climate change).

Although estimates are very uncertain, most experts project that the long-term loss in gross domestic product (GDP) from a policy like the American Clean Energy and Security Act of 2009 (ACESA) would be a few percent, which is roughly equal to normal growth in GDP over just a few years. Employment would probably also fall slightly as production shifted away from industries related to the production of carbon-based energy and energy-intensive goods and services, and toward the production of alternative and lower-emission energy sources, goods that use energy more efficiently, and non-energy-intensive goods and services; workers would follow those shifts in demand, but that would take time and entail costs. The reduction in households’ purchasing power would occur because resources would be devoted to achieving a goal not included in measured income. CBO estimated that the loss in purchasing power from the primary cap-and-trade program that would be established by ACESA would rise from about 0.1 percent of GDP in 2015 to about 0.8 percent of GDP in 2050.

Lesson #5: The details of policies to reduce greenhouse gas emissions would have significant effects on how workers in different industries and households at different income levels would be affected by those policies.

Policies can be designed to cushion the effects on certain industries. Of course, the protection of those firms and workers would have costs, because the resources that would be given away through those channels would not be available to be given to other people. A policy that reduced emissions would affect households at different income levels differently, depending crucially on how the revenues collected under the policy were returned to households. The amount of revenue involved could be large: CBO estimated that the value of allowances under ACESA would total nearly $900 billion during the next decade.

Human activities around the world are producing increasingly larger quantities of greenhouse gases, particularly carbon dioxide resulting from the use of fossil fuels and from deforestation. Adopting policies aimed at reducing emissions of green house gases would shift the demand for goods and services away from fossil fuels and products that require substantial amounts of those fuels to make or to use and toward alternative forms of energy and products that require lesser amounts of fossil fuels. Employment patterns would shift to mirror those changes in demand. Changes in employment in specific industries would reflect the amounts of greenhouse gases they emit (through production and use of their output) and the difficulty of reducing their emissions of those gases.

In a brief released this afternoon, CBO has analyzed the research on the effects that policies to reduce green house gases would have on employment and concluded that total employment during the next few decades would be slightly lower than would be the case in the absence of such policies. In particular, job losses in the industries that shrink would lower employment more than job gains in other industries would increase employment, thereby raising the overall unemployment rate. Eventually, however, most workers who lost jobs would find new ones. In the absence of policies to reduce emissions of greenhouse gases, changes to the climate also might affect employment; however, this brief does not address such changes because that effect would probably arise after the next few decades, and it has not been studied as carefully by researchers.

Various industries would be affected differently by policies to reduce greenhouse gas emissions:

• Coal mining would probably see the largest percentage decline in employment. Among fossil fuels—coal, petroleum, and natural gas—coal, when it is burned, produces more greenhouse gases per unit of energy than do the others. Moreover, coal is widely used to generate electricity, and electric utilities have some ability to substitute other sources of energy for coal. A mitigating factor for the coal mining industry could be the development of technologies to capture and store emissions of coal-fired power plants.
• Employment in oil and gas extraction and natural gas utilities would also be expected to decline as those fuels became more expensive and the demand for them declined. In percentage terms, the decline would be smaller than that in coal mining, though. Because oil is widely traded on international markets, continued demand for it in other countries that did not implement emission-reduction policies would lessen some of the effects of the decline in domestic demand. Because the use of natural gas to generate electricity produces smaller quantities of greenhouse gases than does the use of coal, demand would probably shift from coal to natural gas in some instances, offsetting some or all of the reduction in demand for natural gas that would otherwise occur.
• Mining (for materials other than coal), construction, and the industries that produce metals, nonmetallic mineral products (such as glass), chemicals, and transportation services—all of which use relatively large amounts of energy directly or indirectly—would probably also experience reductions in employment, although the percentage declines would be relatively small.
• Over time, employment would increase in industries and sectors (such as services) whose products are less emission-intensive to produce and result in fewer emissions when used. Employment also would increase in industries that manufacture equipment for the production of energy using low-emission technologies such as nuclear, solar, and wind power.

This brief was prepared by Bruce Arnold of CBO’s Microeconomic Studies Division, with contributions from Molly Dahl of CBO’s Health and Human Resources Division.

This morning CBO released a letter responding to a request from Representative Christopher Smith for additional information on the costs that H.R. 2454, the American Clean Energy and Security Act of 2009 (as passed by the House of Representatives), would impose on households as a result of the legislation’s primary cap-and-trade program, which would regulate greenhouse gas emissions. The legislation would set annual limits, or caps, on total emissions between 2012 and 2050 and would require regulated entities—including producers and importers of petroleum-based liquids, natural gas distributers, and large electricity generators—to hold rights, or allowances, to emit greenhouse gases. After allowances were initially distributed, entities would be free to buy and sell them (the trade part of the program). Regulated entities could comply with the policy by reducing their emissions, holding allowances for greenhouse gases that they emitted, and/or acquiring “offset credits” (referred to here as offsets) for greenhouse gases that they emitted.

This letter supplements CBO’s previous work by providing estimates of the loss in purchasing power that households would experience in each year between 2012 and 2050. Previously, CBO estimated the average loss in purchasing power that households would experience between 2012 and 2050; CBO also examined how that loss would vary across households with different levels of income in 2020 and 2050.

A rough indication of the direct effect on households of the primary cap-and-trade program is the resulting loss in their purchasing power. That loss equals the costs of complying with the policy minus the compensation that would be received as a result of the policy. Households would bear compliance costs and receive compensation in their various roles as consumers, workers, shareholders, taxpayers, and recipients of government services, so accounting for the net effect of the act on purchasing power is not straightforward.

Compliance costs include the cost of purchasing allowances and offsets and the cost of reducing emissions. Although those costs would initially be borne by businesses, they would generally pass them along to households in the form of higher prices for goods and services. Compensation comprises the receipt of allowances at no cost, the receipt of proceeds from the sale of allowances (including the benefits received from government programs funded by the sale of allowances), and the profits earned from producing offsets. Much of that compensation would initially be received by businesses or governments but would be passed along to households.

The loss in a household’s purchasing power would be modest as a share of gross domestic product (GDP) in all years between 2012 and 2050, but it would rise over that period as the cap became more stringent and more resources were dedicated to cutting emissions. The loss would equal about 0.1 percent of GDP in 2012, about 0.5 percent in 2030, and about 0.8 percent in 2050, CBO estimates; the average loss per year over the entire 2012–2050 period would be about 0.4 percent. Measured in terms of 2010 income, the average loss per household would be $90 in 2012, $550 in 2030, and $930 in 2050; it would average about $460 per year over the 2012–2050 period.

As awareness of global climate change has expanded over past decades, Congresses and Administrations have committed several billion dollars annually to studying climate change and reducing emissions of greenhouse gases, most notably carbon dioxide. Most of that spending is done by the Department of Energy (DOE) and by the National Aeronautics and Space Administration, although a dozen other federal agencies also participate. The effort has included funding science and technology, creating tax preferences, and assisting other countries in their attempts to curtail greenhouse-gas emissions. In a study released this afternoon, CBO examines the government’s commitment of resources to those purposes. The study presents information on current spending and analyzes recent patterns and trends in spending.

From 1998 through 2009, appropriations for agencies’ work related to climate change totaled about $99 billion (in 2009 dollars); more than a third of that sum—$35.7 billion by CBO’s estimation—was provided in the American Recovery and Reinvestment Act of 2009 (see the figure below). During that period, the nation’s commitment to climate-related technology development increased significantly, as has the forgone revenue attributable to tax preferences. Funding for climate science and international assistance, by contrast, stayed roughly constant.

Federal Climate Change Funding, by Category

(Budget authority in billions of 2009 dollars)

Growth in reported funding for climate programs occurred in three ways over the past decade. First, funding increased for some programs whose basic mission was maintained throughout the period. Second, as different Administrations reconsidered what constituted a climate change program, some programs, most notably those in DOE for the development of nuclear power, were included in the tabulation without a change in mission. Third, the focus of some programs has shifted to emphasize climate change. DOE’s program for research and development (R&D) on energy supplied from fossil fuels, for example, evolved from research on converting coal into liquid fuels to finding ways to cut emissions from coal-fired power plants.

There are several rationales for these federal activities. A leading argument in favor of federal support for climate science and technology R&D holds that because private developers of scientific and technical innovations do not capture all of the benefits from their discoveries and inventions, private investment is lower than would be justified by the magnitude of its benefit to society. A different rationale arises from the fact that the prices for fossil fuels and for carbon emission do not fully reflect environmental and social costs. Some activities in the climate change budget can be viewed as compensating for the lower energy prices. Although some or all of the conceptual justifications could apply to many types of policies, they do not indicate that any particular federal program should be undertaken.

CBO assessed the effect of technology programs for R&D, technology demonstration, energy efficiency, infrastructure investment, and tax preferences—areas in which there has been a significant recent commitment of resources. Previous analyses have shown that some programs in the climate change budget, although not all, have provided economic benefits to society that exceed the federal government’s investment.

This study was prepared by Philip Webre of CBO’s Microeconomic Studies Division.

Yesterday CBO released a cost estimate for S. 1733, the Clean Energy Jobs and American Power Act, which was ordered reported by the Senate Committee on Environment and Public Works on November 5, 2009.  This legislation would make a number of changes in energy and environmental policies largely aimed at reducing emissions of gases that contribute to global warming. The bill would limit or cap the quantity of certain greenhouse gases (GHGs) emitted from facilities that generate electricity and from other industrial activities beginning in 2012.

Under the bill, the Environmental Protection Agency (EPA) would establish two separate regulatory initiatives known as cap-and-trade programs—one covering emissions of most types of GHGs and one covering hydrofluorocarbons (HFCs). EPA would issue allowances to emit those gases under the cap-and-trade programs. Some of those allowances would be auctioned by the federal government, and the remainder would be distributed at no charge. The legislation also would authorize the establishment of a Carbon Storage Research Corporation to support research and development of carbon capture and sequestration (CCS) technology. Funding for the corporation would largely be derived from assessments on utilities enforced by the federal government.

CBO and the staff of the Joint Committee on Taxation estimate that over the 2010-2019 period enacting this legislation would:

• Increase federal revenues by about $854 billion; and
• Increase direct spending by about $833 billion.

In total, those changes would reduce budget deficits (or increase future surpluses) by about $21 billion over the 2010-2019 period. In years after 2019, direct spending would be less than the net revenues attributable to the legislation in each of the 10 year periods following 2019. Therefore, CBO estimates that enacting S. 1733 would not increase the deficit in any of the four 10-year periods following 2019.

The legislation also would authorize appropriations for various programs to be operated by EPA, the Department of Energy (DOE), and other agencies. If those funds were appropriated, CBO estimates that implementing S. 1733 would increase discretionary spending by about $29 billion over the 2010-2019 period. Most of that funding would stem from spending auction proceeds associated with the HFC cap-and-trade program.

Differences Between S. 1733 and H.R. 2454, the American Clean Energy and Security Act of 2009

S. 1733 is similar to H.R. 2454, which was passed by the House, but there are some significant differences that result in lower estimates of revenues and direct spending under S. 1733. Specifically, several energy-related provisions in H.R. 2454 that CBO estimated would increase direct spending (such as the renewable-electricity standard and the establishment of a Clean Energy Deployment Administration) are not included in S. 1733. Also contributing to lower spending under the Senate bill are the different amounts of proceeds from allowance auctions that are not spent. (See CBO’s cost estimate for H.R. 2454 as passed by the House on June 26.  CBO and JCT estimate that over the 2010-2019 period, the House bill would increase federal revenues by about $873 billion and increase direct spending by about $864 billion, reducing budget deficits over that period by about $9 billion.)

In addition, differences between the two versions of the legislation would result in higher allowance prices under S. 1733.  CBO estimates that prices for emission allowances would be about 15 percent higher under S. 1733 than under H.R. 2454, as passed by the House, because S. 1733:

• Contains a more stringent emissions cap in 2014 and between 2017 and 2029;
• Contains different allocations for distributing emission allowances and auction revenues; and
• Places greater restrictions on the amount of international offsets that can be used towards an entity’s compliance obligation.

CBO’s Work on Climate Change

CBO has done extensive work on issues surrounding climate change.  Earlier this month, CBO’s Assistant Director for Microeconomic Studies, Joseph Kile, testified on the use of agricultural offsets as part of a cap-and-trade program for reducing greenhouse gases. Last month, CBO released a brief about the economic costs of reducing greenhouse-gas emissions in the United States.  That brief highlighted more than a dozen of CBO’s cost estimates and publications related to the issues of climate change and legislative proposals to reduce greenhouse gases. 

Today CBO’s Assistant Director for Microeconomic Studies, Joseph Kile, testified before the House Agriculture Committee’s Subcommittee on Conservation, Credit, Energy, and Research on the use of agricultural offsets as part of a cap-and-trade program for reducing greenhouse gases. Discussions about reducing greenhouse gases often focus on limiting the use of fossil fuels to generate electricity or power cars and trucks, yet a variety of other actions—including changing methods of farming and lessening deforestation—could also reduce the concentration of greenhouse gases in the atmosphere. Those activities, which would not be subject to limits on emissions under a cap-and-trade program, would have the potential to “offset” the burden of reducing emissions and reduce the net cost of achieving the environmental objective. This testimony draws upon CBO’s August 2009 brief on the use of offsets as well as our analysis of H.R. 2454, the American Clean Energy and Security Act of 2009, which was passed by the House of Representatives.

H.R. 2454 would set an annual limit, or cap, on greenhouse-gas emissions for each year between 2012 and 2050 and would distribute “allowances,” or rights to produce those emissions. After the allowances were distributed, regulated entities—those that generate electricity or refine petroleum products, for example—would be free to trade them, so entities that could reduce their emissions at lower costs would sell allowances to others facing higher costs.

The provisions of H.R. 2454 reflect the fact that a variety of other actions such as changing agricultural practices can also reduce the concentration of greenhouse gases in the atmosphere. Those actions have the potential to lessen the extent to which more costly actions would have to be undertaken to meet a chosen target for total greenhouse-gas emissions. Under the bill, regulated entities would be allowed to use offsets in lieu of reducing their emissions or purchasing allowances. Yet the difficulty of verifying offsets raises concerns about whether the specified overall limit on emissions would actually be met. Such concerns may be especially acute when, as under H.R. 2454, allowable offsets include actions taken outside the United States.

The testimony makes the following key points:

• Researchers have concluded that a cap-and-trade program that allowed for offsets—such as those that might be generated by changes in agricultural practices and forestry—could reduce greenhouse gases more cheaply than a cap-and-trade program that did not include offsets, but instead relied on reducing the consumption of fossil fuels. 
• Because of concerns that the use of offsets could undermine the environmental goals of a cap-and-trade program, four challenges would have to be addressed if offsets are to play a meaningful role in reducing the concentration of greenhouse gases in the atmosphere. In particular, offsets would have to bring about reductions in greenhouse gases that (1) would not have otherwise occurred; (2) could be quantified; (3) were permanent rather than merely a delay in the release of greenhouse gases into the atmosphere; and (4) accounted for “leakage,” that is, higher emissions elsewhere or in different sectors of the economy as a result of the activities producing the offsets. 
• On the basis of data from the Environmental Protection Agency, CBO expects that, under the provisions of H.R. 2454, most offsets would be generated by changes in forestry and agricultural practices. Of the offsets from those sectors, fewer than half would be produced domestically in most years, and only about 10 percent of the domestically produced offsets would be from changes in agricultural practices. The remaining offsets from those sectors would come from international sources and would be more evenly split between agriculture and forestry. 
• CBO estimates that the savings generated by offsets under H.R. 2454 would be substantial—reducing the price of allowances and the net cost of the program to the economy by about 70 percent. By CBO’s estimates, regulated entities would use offsets for about 45 percent of the total emission reductions that they would be required to make over the 2012-2050 period covered by the policy.  
• Any assessment of the use of offsets is subject to many uncertainties, which are inherent in the models used, about such things as the types of activities that would be eligible to generate offsets and the amount of offsets supplied by those activities, the prospects for concluding agreements with other nations to allow the use of international offsets, and the cost of ensuring that activities generating offsets actually reduce greenhouse gases.

The consumption of fossil fuels and deforestation are producing increasingly large quantities of greenhouse gases, particularly carbon dioxide (CO₂). Most experts expect that the accumulation of such gases in the atmosphere will result in a variety of environmental changes over time Although the magnitude and consequences of such developments are highly uncertain, researchers generally conclude that a continued increase in atmospheric concentrations of greenhouse gases would have serious and costly effects.

Reducing emissions, through a cap-and-trade program or regulations for example, would impose a burden on the economy by lessening the use of fossil fuels and altering patterns of land use. Today CBO released a brief discussing the economic costs of reducing greenhouse-gas emissions in the United States, describing the main determinants of costs, how analysts estimate those costs, and the magnitude of estimated costs. The brief also illustrates the uncertainty surrounding such estimates using studies of a recent legislative proposal, H.R. 2454, the American Clean Energy and Security Act of 2009.

What Determines the Costs of Reducing Emissions?

The costs of reducing emissions would depend on several factors: the growth of emissions in the absence of policy changes; the types of policies used to restrict emissions and the magnitude of the reductions achieved by those policies; the extent to which producers and consumers could moderate emission-intensive activities without reducing their material well-being; and the policies pursued by other countries.

Emissions in the Absence of Policy Changes.Experts generally expect that, in the absence of policy changes to reduce them, domestic greenhouse-gas emissions will grow substantially in the next few decades. (See CBO’s 2009 publication, Potential Impacts of Climate Change in the United States.) However, long-term trends in emissions are notoriously difficult to project because they will be influenced by population and income growth, by advances in technology, and by the availability and price of fossil fuels. The more rapidly that emissions are projected to grow without policy changes, the greater the changes that would be required and the greater the mitigation costs that would be incurred to keep emissions below any specific level.

Types of Policies Adopted. A basic choice facing policymakers is whether to adopt conventional regulatory approaches, such as setting standards for machinery, equipment, and appliances, or to employ market-based approaches, such as imposing taxes on emissions or establishing cap-and trade programs (which, over a period of time, restrict the quantity of emissions that can be produced through the allocation of allowances to emit CO₂). Experts generally conclude that market-based approaches would reduce emissions to a specified level at significantly lower cost than conventional regulations. Whereas conventional regulatory approaches impose specific requirements that may not be the least costly means of reducing emissions, market-based approaches would provide much more latitude for firms and households to determine the most cost-effective means of accomplishing that goal.

Policymakers face many other critical decisions. Specifically, they must choose which types of emissions to control, and when and how much to reduce them. Further, if policymakers decided to adopt market mechanisms to control emissions, they would face decisions about which type of mechanism to use (a carbon tax vs. a cap-and-trade system, for example), as well as how to allocate allowances in a cap-and-trade program or how to use the revenues generated by taxes on emissions. For a more detailed discussion of the issues facing policymakers in designing a plan to reduce CO₂ emissions, see the following CBO publications:

• Policy Options for Reducing CO₂ Emissions (February 2008)
• How Regulatory Standards Can Affect a Cap-and-Trade Program for Greenhouse Gases (September 2009)
• Uncertainty in Analyzing Climate Change: Policy Implication (January 2005)
• The Use of Offsets to Reduce Greenhouse Gases (August 2009)
• Trade-Offs in Allocating Allowances for CO₂ Emissions (April 2007)
• Limiting Carbon Dioxide Emissions: Prices Versus Caps (March 2005)
• Flexibility in the Timing of Emission Reductions Under a Cap-and-Trade Program (March 2009)

The Response of the Economy. By gradually increasing the prices of fossil fuels and other goods and services associated with greenhouse-gas emissions, market-based policies would induce firms and households to change their practices-in the short run, by driving slightly less, adjusting thermostats, and switching fuels in the power sector; and in the long run, by buying more-efficient vehicles and equipment, for example. Rising costs of emission-intensive activities would tend to dampen overall economic activity by reducing the productive capacity of existing capital and labor, by reducing households’ income (which, in turn, would tend to reduce consumption and saving), and by reducing real (inflation-adjusted) wages. The more easily that producers and consumers can respond to price changes by altering their production techniques and behavior and by bringing low-emission fuels and technologies to market, the lower the costs of reducing emissions would be. (See CBO’s 2003 study, Economics of Climate Change: A Primer.)

Efforts by Other Countries. The stringency of other nations’ efforts to reduce emissions could strongly influence the costs of reducing them in the United States. As long as a significant percentage of the world’s economy did not restrict greenhouse-gas emissions, a portion of any reductions achieved in the United States would probably be offset by increases in emissions elsewhere. Such “leakage” could be avoided if most countries restricted emissions at the same time. Even so, the policies used in other countries would influence costs in the United States.

How Large Are Estimated Costs?

In recent years, a few legislative proposals for long-term emission reductions have been analyzed using several different models, providing an opportunity to compare cost estimates and to understand the sources of differences in estimates. Most recently, several groups have released estimates of the economic impact of H.R. 2454, the American Clean Energy and Security Act of 2009. That bill would create two cap-and-trade programs for greenhouse-gas emissions-a large one applying to CO₂and most other greenhouse gases, and a much smaller one applying to hydrofluorocarbons-and would make further significant changes in climate and energy policy.

Some of the findings of the leading models are similar. In nearly all of the reported scenarios, changes in the demand for energy and reductions in overall energy use are modest through 2025. However, the projected allowance prices vary substantially.

The aggregate employment effects of H.R. 2454 are likely to be modest over the long term. However, the legislation would cause a significant, although gradual, shift in the composition of employment over time, with potentially substantial adverse effects for some workers, families, and communities. Production and employment would shift away from industries related to the production of carbon-based energy and energy-intensive goods and services and toward the production of alternative and lower-emission energy sources.

All of the models reporting macroeconomic impacts project that the emission reductions required by H.R. 2454 would slightly dampen the growth of GDP over the long term. Quantitative estimates of the losses in GDP and consumption vary among studies, depending in large part on differences in assumptions about the availability of offsets (reduced availability of offsets increases the emission reductions required in the energy sector and thus increases economic costs) and differences in assumptions about the sensitivity of energy use to changes in prices (reduced sensitivity increases the price hikes required to reach emission targets and thus increases economic costs).

For a more detailed discussion, see CBO’s analysis of H.R. 2454 in the following cost estimates and publications:

• Cost estimate for H.R. 2454, as ordered reported by the House Committee on Energy and Commerce (June 2009)
• Cost estimate for H.R. 2454, as amended and reported by the House Committee on Rules (June 2009)
• The Estimated Costs to Households from the Cap-and-Trade Provisions of H.R. 2454 (June 2009)
• The Economic Effects of Legislation to Reduce Greenhouse-Gas Emissions (September 2009)

This issue brief was prepared by Robert Shackleton of CBO’s Macroecononic Analysis Division.

Today I testified about the economic effects of legislation aimed at reducing emissions of greenhouse gases, drawing on a report that CBO released a few weeks ago.

Global climate change poses one of the nation’s most significant long-term policy challenges. A strong consensus has developed in the expert community that, if allowed to continue unabated, the accumulation of greenhouse gases in the atmosphere will have extensive, highly uncertain, but potentially serious and costly impacts on regional climates throughout the world. Moreover, the risk of abrupt and even catastrophic changes in climate cannot be ruled out.

Reducing the extent of climate change would entail substantial reductions in U.S. emissions and in emissions from other countries over the coming decades. Achieving such reductions in this country would probably involve some combination of three broad changes: transforming the U.S. economy from one that runs on carbon-dioxide-emitting fossil fuels to one that increasingly relies on nuclear and renewable fuels; accomplishing substantial improvements in energy efficiency; and implementing the large-scale capture and storage of carbon dioxide emissions.

My testimony emphasized several points:

• The economic impact would depend importantly on the design of the policy. Decisions about whether to reduce greenhouse gases primarily through market-based systems (such as taxes or a cap-and-trade program) or primarily through traditional regulatory approaches that specify performance or technology standards would influence the total costs of reducing emissions and the distribution of those costs. The costs would also depend on the stringency of the policy; whether other countries imposed similar policies; the amount of flexibility about when, where, and how emissions would be reduced; and the allocation of allowances if a cap-and-trade system was used.
• Reducing the risk of climate change would come at some cost to the economy. For example, CBO concludes that the cap-and-trade provisions of H.R. 2454, the American Clean Energy and Security Act of 2009, would reduce GDP below what it would otherwise have been—by roughly ¼ to ¾ percent in 2020 and by between 1 and 3½ percent in 2050. By way of comparison, CBO projects that real (that is, inflation-adjusted) GDP will be roughly two and a half times as large in 2050 as it is today, so those changes would be comparatively modest. In the models that CBO reviewed, the long-run cost to households would be smaller than the changes in GDP because consumption falls by less than GDP and because households benefit from more time spent in nonmarket activities. Moreover, these measures of potential costs do not include any benefits of averting climate change.
• Climate legislation would cause permanent shifts in production and employment away from industries that produce carbon-based energy and energy-intensive goods and services and toward industries that produce alternative energy sources and less-energy-intensive goods and services. While those shifts were occurring, total employment would probably be reduced a little compared with what it would have been without such a policy, because labor markets would most likely not adjust as quickly as would the composition of demand for different outputs.
• CBO has estimated the loss in purchasing power that would result from the primary cap-and-trade program in H.R. 2454, incorporating both the higher prices that households would face and the compensation they would receive (primarily through the allocation of allowances or the proceeds from their sale). CBO’s measure omits some channels of influence on households’ well-being that cannot be readily quantified, and it appears that the measure probably understates the true burden to a small degree. As estimated, the loss in purchasing power would be modest and would rise over time as the cap became more stringent, accounting for 0.2 percent of after-tax income in 2020 and 1.2 percent in 2050. Households in the lowest fifth of households when arrayed by income would see gains in purchasing power in both 2020 and 2050, because the compensation they would receive would exceed the costs they would bear. However, households in the middle fifth would see net losses in purchasing power amounting to 0.6 percent of after-tax income in 2020 and 1.1 percent in 2050.