Global Climate Change: Three Policy Perspectives III

CONTENTS FOR THIS SECTION

Economic Lens

Background
Application to Global Climate Change

Economic Lens

Background. Viewing environmental issues through an economic lens focuses attention on markets, price signals, and market imperfections. In this view, the recognition of environmental problems should lead to adjustments in market signals, changing producers' inputs and handling of wastes, as well as the composition and level of consumer demand, so as to maximize net social welfare. Cleaning the environment entails costs, which can be weighed against benefits.

The Government's role in this scenario is to ensure the correct market signals. To ensure correct signals, the government can:

• make consumers and producers aware of information on economic costs and benefits;
• adjust prices through taxes or fees; and
• affect supply through tradeable permits for products (as with leaded gasoline in the early 1980s) or for production-related emissions (as with sulfur dioxide emissions), or through other market-oriented devices.

With the correct signals, the marketplace can operate to find the optimal solution.

Economic considerations have been an explicit or implicit part of environmental policymaking since environmental quality became a federal issue in the 1960s. The use of economic mechanisms to implement environmental goals was debated in the 1960s and early 1970s, but usually rejected on various grounds.⁽²⁸⁾

Excluding economic considerations from environmental protection proved difficult, however. As laws began to be implemented, economic costs became increasingly consequential, although generally masked under "practical" or "feasibility" concerns, as achievement of some environmental standards within specified deadlines proved impossible. Automobile standards were delayed; ozone compliance was postponed; and other issues were litigated. Economic concepts began to re-emerge in the debate over the environment with the need to extend deadlines and to provide more flexibility to polluters to achieve mandated standards.

The preferred economic approach to environmental problems traditionally is the pollution tax. Economists observe that pollution imposes costs on society that are not incorporated in the price of the goods or services responsible for the pollution; these are called "external" costs. An ideal pollution tax "internalizes" these external costs by making the beneficiary of the polluting activity pay for the socially borne costs (polluter pays). As long as polluters find it cost-effective to reduce their emissions to avoid paying the tax, they would add pollution controls until further controls would have higher incremental costs than the tax. When the tax is set at the level at which the marginal costs of more control would equal the marginal benefits society gains by future reductions, society's net welfare is maximized.

Despite the theoretical benefits of the pollution tax methodology, it has received little practical use. Problems of implementation have loomed large, particularly because of a lack of data, especially on benefits. Estimates of the benefits of a specific environmental action can be uncertain and can vary by an order of magnitude. Uncertainties about pollution taxes have focused attention on using economic incentives to increase polluters' flexibility in achieving environmental standards based upon regulation. Unlike a tax that focuses on the price (demand) for a pollutant, these mechanisms focus on the quantity (supply) of the pollutant permitted. During the 1970s, four economic mechanisms were adopted to increase polluters' flexibility in meeting the various requirements of the Clean Air Act. These mechanisms were offsets, bubbling, banking, and netting.

• Offsets. The pending failure of many regions to meet the 1977 deadline for the National Ambient Air Quality Standards for ozone presented EPA with the prospect of imposing construction bans on new sources in the noncomplying areas. In 1976, EPA proposed to permit new pollution generating facilities that installed Best Available Control Technology to be sited in non-attainment areas if their emissions were offset with reductions from existing sources so that aggregate emissions in the area declined.
• Bubbling. In 1979, EPA proposed a bubbling program for existing polluting sources only. A bubbling program permits a facility with multiple pollution sources to treat them as a single source rather than individually. As long as the aggregate emissions of the specific pollutant meet the standard, the facility is in compliance.
• Banking. In 1979, as an adjunct to their offset and bubbling schemes, EPA promulgated regulations which included banking. Banking permits a facility to save any excess reductions it achieves for future use or sale. In this way, banking facilitates use of offsets and bubbles.
• Netting. The oldest (1974) mechanism is also the most successful. Netting permits an existing source under the Act to undergo a major modification without triggering the New Source Performance Standards provided the modification results in no aggregate increase in emissions.

Results from these tradeable permit systems are spotty. Netting has clearly been the most used and cost-effective mechanism with estimates of savings of between $0.5 and $12 billion. Other pollutants were added in the 1980s, including the successful lead trading program. That program indicated the feasibility of a market in "pollution rights" and the value of banking in stimulating trading. EPA estimated that the lead program "saved" refiners over $200 million over the life of the program. This success helped lead to the development of the sulfur dioxide (SO₂) trading scheme contained in the 1990 Clean Air Act.⁽²⁹⁾

While this lens is sometimes regarded as the private market's alternative to a regulatory command-and-control program, the interactions are more complex. The so-called "market for pollution rights" would not exist if not for a governmental role in altering what the market would do in lieu of governmental action. If governmental regulations did not restrict sulfur dioxide emissions, there would be no need for sulfur dioxide allowances. Government creates the market and defines the boundaries of acceptable market responses. Under the SO₂ trading program, facilities may buy allowances to meet necessary reductions instead of installing equipment to control pollution. The facilities may not exceed the National Ambient Air Quality Standard for SO₂ regardless of how may allowances their owners hold.

By allowing polluters to choose their lowest cost abatement actions, implementing environmental goals through market mechanisms represents a general elevation of economic "efficiency" as the sine qua non of decision-making. Pragmatically achieving this efficiency presumes substantially complete knowledge by producers and consumers of costs, abatement alternatives, and product substitutions as well as substantial flexibility in achieving compliance. The market approach simultaneously maintains the general principle of "polluter pays" as the underlying ethical rationale for the distribution of costs among parties. Through the market, the "polluter who pays" includes not only the producer, but also labor, stockholders, and the consumer (who demands the product and who pays somewhat more for the embedded costs to control pollution).

Those viewing environmental policy through the economic lens generally presume that governmental interference, whether through subsidies or regulation, should be minimal. In reality, the distribution of impacts through the market often leads to calls for political interventions that compromise efficiency and the "polluter pays" principle. The political process tends to weigh relevant differences between various groups affected by an environmental mandate, and special treatment may be deemed necessary to promote justice or fairness. For example, the new sulfur dioxide allowance system contains numerous "special" allocations of allowances to various groups that have argued for special consideration due to past, current, or future situations. These special allocations represent subsidies to these groups that a strict "polluter-pays" principle would not allow. This is not to say that such allocations are not justified on the grounds of justice or fairness, only that the "polluter-pays" principle is not a distributional principle that policymakers can treat independently of other concerns and criteria.

The economic lens reflects a traditional American belief in individual choice and private markets -- given the correct price signals, producers and consumers will adjust their behavior accordingly. This adjustment will be done in the most cost-efficient manner, and with a minimum of governmental involvement. Consumers' desires are seen as responsive to price. The issue then is for the price to reflect the costs of relevant externalities. With the right price, supply and demand will find the level that maximizes social welfare. Policymakers using the economic lens see consumers and producers adjusting their behaviors to the "new reality" of an environmental problem by responding to the price signals that take into account a particular environmental goal. But this approach creates clear winners and losers in terms of who will profit and who will pay the tab. As a result, policymakers adjust governmental intervention to achieve change at a pace and impact that are socially and politically acceptable.

Application to Global Climate Change. The economic lens focuses policymakers on market-based approaches to address global climate change; these include marketable permit (allowance) programs and various taxes, fees, and rebates,⁽³⁰⁾ as well as research and development, education, and market-related information. Current proposals for controlling carbon dioxide and other greenhouse gas emissions center on either marketable permits programs (loosely based on the current sulfur dioxide program) or on a carbon tax (the closest analogy is the Chlorofluorocarbon (CFC) tax although there are substantial differences between the two schemes).⁽³¹⁾

Current debate in the United States about implementing carbon reductions has focused on tradeable permits. A key element of the Administration's negotiating position at Kyoto was the inclusion of domestic and international emissions trading systems and international joint implementation programs to implement any emission reduction requirements. This support for trading programs has continued after the Kyoto conference. The Administration's FY1999 budget request calls on EPA, assisted by DOE, to analyze options for developing a domestic emission trading system. EPA would work with interested parties to begin building the institutional capacity to implement a tradeable permit program. In addition, one bill, S. 687, has been introduced by Senator Jeffords providing for substantial reductions in CO₂ emissions implemented through a nationwide tradeable permit program.⁽³²⁾

However, the generally acclaimed success of the sulfur dioxide program at its early stages may not translate easily to a marketable permit program for carbon dioxide. Fundamental differences exist: for example, the acid rain program involves over 2,000 new and existing electric generating facilities that contribute two-thirds of the country's sulfur dioxide and one-third of its nitrogen oxide emissions (the two primary precursors of acid rain). This concentration of sources makes the logistics of allowance trading administratively manageable and enforceable. However, carbon dioxide emission sources are not so concentrated. Although over 95 percent of the CO₂ generated from human activities comes from fossil fuel combustion, only about 33 percent comes from generating electricity. Transportation accounts for about 33 percent, direct residential and commercial use for about 12 percent, and direct industrial use for about 20 percent. Small dispersed sources in transportation, residential/commercial, and the industrial sectors are far more important in controlling CO₂ emissions than they are in controlling SO₂ emissions. This would create significant problems in administering and enforcing a tradeable permit program that attempts to be comprehensive or equitable. These concerns multiply as the global nature of the climate change issue is considered, along with other potential greenhouse gases, such as methane and nitrous oxide.

An alternative market-based mechanism to the tradeable permit system is carbon taxes -- generally conceived as a levy on natural gas, petroleum, and coal according to their carbon context, in the approximate ratio of 0.6 to 0.8 to 1.0, respectively. In the view of most economists, a carbon tax would be the most efficient approach to controlling CO₂ emissions.⁽³³⁾ With the millions of emitters involved in controlling CO₂, the advantages of a tax are self-evident. Imposed on an input basis, administrative burdens such as stack monitoring to determine compliance would be reduced. Also, a carbon tax would have the broad effect across the economy that some feel is necessary to achieve long-term reductions in emissions.

In other ways, a tax system merely changes the forum, rather than the substance of the policy debate. Because paying an emissions tax becomes an alternative to controlling emissions, the debate over the amount of reductions necessarily becomes a debate over the level of tax imposed. Those wanting large reductions quickly would want a high tax imposed over a short period of time. Those more concerned with the potential economic burden of a carbon tax would want a low tax imposed at a later time with possible exceptions for various events. Taxing emissions basically would remain an implementation strategy; policy determinations such as tax levels would require political/regulatory decisions. One argument for, or against, such a system would be that the tax would raise revenues. The disposition of these revenues would significantly affect the economic and distributional impacts of the tax.

Other tax schemes to address global climate change are also possible. For example, the European Community has discussed a hybrid carbon tax/energy tax to begin addressing CO₂ emissions. Fifty percent of the tax would be imposed on energy production (including nuclear power) except renewables; fifty percent of the tax would be based on carbon emissions. Another possible approach would be a Btu tax that would focus more on overall energy efficiency and have less impact on the coal industry. A modified version of this approach was embodied in the Administration's 1993 energy tax proposal.

The choice between a tradeable permit approach and a tax approach depends in part on one's sensitivity to the uncertainty in the benefits of reductions in greenhouse gases versus the uncertainty in the costs of the program. Those confident of the benefits to be received from reducing greenhouse gases tend to focus on the quantity of pollutants emitted and to argue for a specific, mandated emission level. For example, the Kyoto agreement mandates a specific allowable emission level based on a historical baseline (1990/1995, depending on the gas) for a specific compliance period (2008-2012). While a ceiling is placed on emissions, no ceiling is placed on control costs. Implementing such a reduction program through a market-based scheme, such as a tradeable permit program, would probably assure that the costs would be dealt with efficiently through the marketplace; however, those costs are not capped. This is the approach used under the current SO₂ control program. Preliminary results indicate that control costs under the SO₂ program are considerably less than they would have been under an alternative "command and control" scheme. However, there is no lid on the costs, which may rise in the future as the control requirements become more stringent.

Alternatively, a tax in effect places a ceiling on control costs, although the actual reductions achieved are subject to some uncertainty. For example, if a carbon tax of $100 a ton were levied, no polluter would pay more than $100 a ton to reduce carbon emissions. Thus, under worst-case conditions, the program costs would be $100 a ton. However, the actual reductions that such a tax might achieve would have to be estimated, based on economic simulations or actual monitoring. Reductions would not be guaranteed as any polluter could choose to pay the tax rather than to reduce emissions. Reductions could also vary over time as new technology or other events raise or lower the cost of reducing emissions.

A carbon tax or tradeable permit program would affect economic behavior in at least three ways: (1) effectively reduce real income through higher prices and therefore reduce overall consumption of goods (particularly in the short-term); (2) encourage manufacturers and consumers to substitute less carbon-intensive (or carbon free) energy sources for current carbon-intensive (i.e., fossil fuel) energy sources; and (3) encourage both research and development of innovative, less carbon intensive or more energy efficient technologies and their penetration into the marketplace. The ability and efficiency of the economy in making these adjustments over a specified period of time would largely determine the impact of a market-induced rise in the costs of energy generated from fossil fuels either through a carbon tax or a marketable permit program.

Depending on the reduction achieved and the model employed, annual gross domestic product (GDP) losses resulting from carbon control are estimated to range from less than one percent to more than four percent, with most falling into a range of one to three percent. If a carbon tax were chosen, that tax would generate revenues -- revenues sufficiently large to affect aggregate consumer demand. It is the contractionary pressure of these tax revenues that the Congressional Budget Office (CBO) cites as the major reason for a loss of two percent in U.S. GDP from a $100 per ton carbon tax phased in over 10 years.⁽³⁴⁾ How the Government chooses to deal with those tax revenues greatly would affect the impact of the carbon tax on the economy. The impact of a carbon tax on the economy would vary depending on a combination of policies beyond just the level of the tax.

The tax level necessary to achieve a given reduction is also subject to a wide range of estimates. The Stanford Energy Modeling Forum compared 13 models under a series of control scenarios with common assumptions (where possible), including one calling for carbon emissions stabilization at 1990 levels by the year 2000.⁽³⁵⁾ About half of the models studied estimated the carbon tax necessary to meet the stabilization target in the year 2000 to be about $30 per ton or less, while the other half estimated the necessary carbon tax to be about $100 or more.

With respect to a tradeable permit program, the Administration testified in March, 1998, that a carbon trading program among developed countries could reduce U.S. compliance costs under the Kyoto Agreement by an estimated 60-75% compared with a compliance strategy that allowed no trading. Full participation by developing countries in a trading program is estimated by the Administration to reduce U.S. compliance costs by an additional 55%.⁽³⁶⁾ Details on this analysis were released in July. Included in those details was an estimate that permit prices under Kyoto would be in the range of $14 to $23 per ton of carbon equivalent.⁽³⁷⁾

In response, the American Petroleum Institute funded a study to determine the assumptions underlying the Administration's conclusions.⁽³⁸⁾ The study, conducted by Charles River Associates (CRA), agreed with the Administration that full global trading, if achievable, would significantly reduce costs. CRA estimates a worst-case scenario (i.e., no trading at all) at $295 per metric ton in the year 2010. If trading is achievable only among developed countries, the international permit price would be about $120 per metric ton, if excess permits are offered by Russia ($171 per metric ton if not). If global trading is achievable, the permit price would be about $50 per ton. Using a different model, CRA reconstructs the Administration's analysis which suggests a no trading cost of $193 per ton, a developed country trading scenario cost of $23 per ton, and a global trading scenario cost of $14 per ton -- in line with the estimates released by the Administration. CRA states that the Administration analysis is internally consistent and compatible with mainstream economic analysis, but makes very optimistic assumptions about the economy's ability to reduce emissions at low cost and the potential flexibility the country would have to purchase permits internationally.⁽³⁹⁾

Because the problem of greenhouse gas emissions is seen in terms of internalizing a currently external cost, the economic lens implies that the marketplace is the most efficient means of controlling undesirable pollutants. The private sector can solve the problem if given sufficient incentive with minimal governmental interference. The Government's role primarily consists of providing a market-based signal to private industry about the external cost (e.g., emission taxes, tradeable permits, etc.). In reality, the Government's role is more involved. For taxes, this includes determining its level, any phasing-in period, escalation, and recycling of revenues received. For permits, this includes the total numbers of permits allowed, initial allocation formulas, any phasing in period, penalties, transaction procedures, and tax liability. While an economic approach would supplement the policy process in implementing a greenhouse gas reduction program, it would not be a substitute for basic policy decisions and oversight.

A limited or supporting governmental role is consistent with the overall perspective of the economic lens: private initiative, economic cost-effectiveness, concern about impact of environmental policy on economic policy, cost aversion, and reliance on market forces.

Footnotes

28. ^(back) Steven Kelman, What Price Incentives: Economists and the Environment (Boston: Auburn Publishing Co., 1981).

29. ^(back) CRS, Market-Based Environmental Management: Issues in Implementation, CRS Report 94-213, March 7, 1994, pp. 65-66.

30. ^(back) For a general discussion of market-based environmental management, see CRS, Market-Based Environmental Management: Issues in Implementation, CRS Report 94-213 ENR, March 7, 1994. For a specific discussion of market-based carbon control, see Larry Parker, Global Climate Change: Market-Based Strategies to Reduce Greenhouse Gases, CRS Issue Brief IB97057 [updated regularly].

31. ^(back) See Market-Based Environmental Management: Issues in Implementation, CRS Report 94-213, pp. 67-70, 72-75; and Global Climate Change: Market-Based Strategies to Reduce Greenhouse Gases, CRS Issue Brief IB97057.

32. ^(back) For a further discussion, see Global Climate Change: Market-Based Strategies to Reduce Greenhouse Gases, CRS Issue Brief IB97057.

33. ^(back) "It is an open and shut case that the most economic way to constrain carbon dioxide (CO₂) emissions is a flat-rate tax based on the carbon content of fuels -- across the board, no exceptions." David Cope, "Environment, Economics and Science," UK CEED Bulletin, No. 53 (Spring 1998), 18.

34. ^(back) Congressional Budget Office, Carbon Charges as a Response to Global Warming: The Effects of Taxing Fossil Fuels (August 1990), pp. 35-37.

35. ^(back) Energy Information Administration, Energy Modeling Forum Study 12--Global Climate Change: Energy Sector Impact of Greenhouse Gas Control Strategies. Response to request by the House Committee on Energy and Commerce (May 4, 1992).

36. ^(back) Council of Economic Advisors, Testimony of Dr. Janet Yellen, "The Economics of the Kyoto Protocol," Hearings before the Senate Committee on Agriculture, Nutrition, and Forestry, March 5, 1998.

37. ^(back) White House, The Kyoto Protocol and the President's Policies to Address Climate Change: Administration Economic Analysis (July 1998).

38. ^(back) Paul M. Bernstein and W. David Montgomery, "How Much Could Kyoto Really Cost? A Reconstruction and Reconciliation of Administration Estimates," Charles River Associates, June 1998.

39. ^(back) Charles River Associates, p. 18.

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