Costs are uncertain in magnitude, but unavoidable

There have been a number of suggestions that costs of the kind I have described can be eliminated either by avoiding carbon taxes and price increases for energy, or by adopting a "technology strategy". Other policy instruments will not lower costs, but rather are likely to raise them. A technology strategy has great promise in the long run, but studies suggesting that it could eliminate (or even substantially reduce) costs by 2010 are seriously flawed.

Choice of policy instruments

There are a number of different ways in which these emission reductions could be accomplished. Carbon taxes, tradable permits, and regulatory interventions into energy markets are the three broad options available to Congress to implement a binding commitment to cap emissions at some level. All of them entail significant economic costs.

News releases from Monday's White House Conference quote the President as promising that there will be no taxes or increases in the price of oil and coal. This is not possible. Reductions of 20% in carbon dioxide emissions cannot be achieved without imposing costs, and the way in which these costs have to be transmitted to the public in order to cause them to change their behavior is through energy prices. The only question is whether the energy price changes are overt or concealed.

To see this, consider the following example: The Administration has suggested that its preferred method of implementing an emissions limit would be through a “cap and trade” system, similar to the one pioneered in the sulfur emission trading program created by the Clean Air Act Amendments. Carbon emissions permits would somehow be issued, and the price of a carbon emission permit would be set in an emissions trading market. This price would equal the marginal cost of reducing emissions to the required level. However, such a permit would be functionally identical to a carbon tax. However, this permit price would have to be equivalent in size and incidence to a carbon tax.

Our studies estimate that the price of emission permits would have to reach $150 - $200 per ton to induce sufficient fuel switching and energy conservation to reduce emissions by 20% in 2010. These tradable permits would increase the cost of energy to businesses and households in exactly the same amount as a carbon tax achieving the same aggregate emission reduction.

Once it is understood that the effect of an emission cap with tradable permits is to increase the price of fossil fuels in exactly the same amount as a carbon tax designed to achieve the same emission limit, the impossibility of promising no increase in energy prices becomes clear. Carbon taxes and emission caps directly increase the price of oil, natural gas and coal. Because energy is used in the production of every good and service in the economy, carbon taxes or permit prices would be incorporated in the prices of other goods, depending on the amount and type of energy used in their production.

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It is also possible that rather than adopting uniform, market based policies like carbon taxes or emission caps with trading, the Administration would propose a series of regulatory interventions to change and limit energy use. This is, in fact, the path that we have taken in the past in environmental policy. Regulatory programs conceal costs, and serve to obscure accountability for decisions by burying them in a variety of administrative processes and different pieces of legislation. But they do not avoid the real economic costs of emission limits. Instead, regulatory programs result in economic costs larger than those of either carbon taxes or emission caps.

Indeed, part of the research we are completing is an estimate of the relative cost-effectiveness of regulatory versus market measures in reducing carbon dioxide emissions from personal motor vehicles. We find that regulatory measures, such as CAFE standards, impose costs on consumers that are roughly five times as high per pound of carbon dioxide emissions avoided than do market measures such as "cap and trade" or carbon taxes. These costs are hidden rather than visible. But they exist.

In short, regulatory programs make costs of reducing emissions larger, not smaller. Estimates of carbon dioxide reduction costs based upon the use of market measures already incorporate the maximum cost savings that more flexible regulatory approaches could ever hope to achieve.

Analogies to the sulfur emissions trading program have been used to argue that emission trading will produce technological progress that will lower costs below the levels we estimate. It is always possible that market forces will stimulate unexpected innovations. But there is no foundation for the conclusion that the experience of sulfur trading programs proves that must happen. Independent evaluations of sulfur emission trading, by the Massachusetts Institute of Technology (MIT) and Resources for the Future (RFF), conclude that most of the cost savings have come from relaxing previous regulatory restrictions on the kinds of emission control technologies that could be used by utilities. Trades have been limited, and most cost savings have come from utilities taking advantage of additional flexibility to design cost-effective emission reduction strategies within their own systems.

It is also contended that in the past economic models overestimated the costs of controlling sulfur emissions through a trading program, and that therefore economic models will also overestimate costs of controlling carbon emissions if emission trading is adopted. As one of the originators of the idea of emission trading, I am happy to see it praised. But these claims are not true. There were some basic economic errors in the initial estimates by a consulting firm, as pointed out by Robert Hahn of the American Enterprise Institute. The RFF and MIT studies conclude that remaining differences between predicted and actual costs are largely accounted for by changes in the coal market, in particular the failure of predicted increases in the cost of low sulfur coal to materialize. Reductions in coal prices have been attributed to increasing productivity in mining coal and to deregulation of railroads, and resulting drops in freight rates, not to emission trading. It was also found that blending coals was cheaper and a wider range of coals could be used in existing boilers than originally believed. But the obstacle to fuel switching was an provision of the Clean Air Act designed to protect the high sulfur coal industry, the removal of which had nothing

There is no analogy in climate change that I can see to any of these influences on the costs of sulfur trading. If anything, the history of the sulfur trading program provides another example of how much higher costs can be when regulatory programs are used rather than market incentives. This is a lesson built into all economic models that assume the use of the most efficient policy instruments, and is the reason why I conclude that the most important risk is that costs will be higher than we estimate because of the use of inefficient policies.

Technology and meeting targets at no cost

Five national laboratories recently released a report claiming that carbon emissions could be reduced to 1990 levels by 2010 at no cost through adoption of technologies that are cost-effective but not currently chosen in the marketplace. The report is similar to earlier efforts by the National Academy of Sciences, the Office of Technology Assessment, and a number of environmental advocacy groups. These studies are all seriously flawed by their concentration on simple engineering estimates and lack of attention to evidence of how choices are made in the marketplace.

If there truly are measures that can reduce energy use or carbon emissions and save money at the same time, those measures will be adopted by the market economy. Unless some market imperfection prevents businesses or consumers from seeing correct prices for energy, there is no reason to believe that markets will not adopt all cost-effective energy saving technologies. With deregulation of oil and natural gas prices and restructuring of the electric power industry, there is no more reason to believe that there are systematic imperfections in the energy market than in the housing market or market for computers. It is for this reason that we, and most other economists who have approached the issue, conclude that all cost-effective measures to reduce energy use will be adopted in the baseline. Any reduction in emissions below the baseline will cost something. On this, I have no uncertainty.

How, then, can the five laboratories conclude that emissions can be returned to 1990 levels at no cost? The most general answer is that there are hidden costs, not recognized by the kinds of bottom up studies of which this is the most recent example. These can include differences in attributes that consumers value (such as downsizing and reducing acceleration improve new car fuel economy), reliability risks (particularly important to businesses where a small failure can idle entire production processes), or need for costly infrastructure for delivery or maintenance. All these are hidden costs.

It is only possible to reduce emissions at no cost if two conditions are satisfied:

Market imperfections exist and significantly interfere with price signals for improved energy efficiency

Specific policies to remove those imperfections are designed and can be implemented at a sufficiently low cost

For a more complete discussion of the limitations of the bottom up approach, see Mark Jaccard and W. David Montgomery, "Costs of reducing greenhouse gas emissions in the USA and Canada," Energy Policy, Vol. 24, Nos.

The report from the 5 laboratories contains no analysis of the market imperfections that might lead to a failure to adopt cost-effective technologies, and is completely lacking in any specifics on the policy measures that would be required to bring about the emission reductions it claims.

The report does talk about "something equivalent to a $50 per ton carbon tax" being required to limit emissions in 2010 to 1990 levels. That is a clear indication that measures with a net cost will be required. The report counterbalances these costs by assuming 100% penetration of the assumed cost-effective technologies, and making highly optimistic assumptions about what technological options can be made available. The report even states this in Chapter 5, with a candor not repeated in the Executive Summary: “...because the outcomes postulated in the high efficiency/low-carbon scenario require technological breakthroughs, they require a certain degree of luck to be achieved by 2010." If these options really were available and so cheap, they would be included already in any well-constructed baseline like that of EIA.

To reduce carbon emissions, the US must burn smaller quantities of fossil fuels (oil, gas, and coal). This means that industries must reallocate their resources in order to produce goods. That is, to produce the same output as before, they must use smaller quantities of fossil fuels and consequently greater amounts of non-energy goods such as capital and labor. By constraining the economy from using the quantity of energy that it desires, regulators will limit industries' production choices. Furthermore, to meet the emissions targets, consumers must also burn less fossil fuel derived energy. They can do this by doing a number of things, for example, driving more fuel-efficient vehicles, or taking fewer trips. But in all of these activities the consumers are undertaking an activity that they would not choose under an environment where regulators are not restricting consumers' choices. Therefore, consumers experience a loss in their welfare.

Future research

There are a large number of questions that still need to be addressed to understand what the impacts of an agreement on emission limits in Kyoto might be. In discussing research needs, I will draw on our own experience in trying to model the impacts of climate change policies, and on the research presented by others in the IPCC workshops in which we have been invited to participate. The highest priority needs to be given to questions about how international trade and national economic interests of the 160 or so signatories to the Framework Convention are likely to be affected by proposals currently under consideration. We can learn lessons from this from the other multilateral trade negotiations that have taken place since the Second World War. The recently-completed Uruguay Round was the eighth and broadest such negotiation, and is credited with major benefits for both industrial and developing countries. In our analysis of the international implications of emission limits, we find that the changes being proposed in the Framework Convention could reduce economic welfare in both the industrial and developing countries by amounts comparable to the gains of the Uruguay Round.

Negotiations under the Framework Convention are in fact multilateral trade negotiations, and their possible implications for global trade need far closer examination. Climate negotiations involve economic stakes every bit as high as the Uruguay Round. The Uruguay Round took 8

years and intense analytical effort to hammer out. The changes in the Framework Convention will be agreed to after just over two years of negotiation, almost none of which has paid any attention to their international economic consequences.

In particular, developing countries need to better understand the impacts of changes in trade relationships on them. Industrial countries have a responsibility to understand how their national economies and key industries will be affected by the trade distortions emissions will create. More research is also needed on the possible implications of efforts to exempt energy-intensive sectors from emission reduction requirements, and the effects of efforts to implement tariffs or other trade restrictions to offset those distortions. Most economists familiar with international trade would probably agree that distorting trade through unilateral emission limits and then compensating by erecting tariff barriers would be a major setback in the progress we have seen since the Second World War in trade liberalization.

Similar issues arise about how introduction of an international trading of emission rights would affect other trade patterns. Recent research reported in the Oslo IPCC meeting in August suggested that there could be large, unintended spillover effects of introducing emission trading. These spillover effects could change the prices of other goods exchanged in international trade in unexpected ways. Some analysts found that introducing emission trading would reduce costs for the United States, and others found that it would increase costs.

It is also necessary to understand better how emission trading would affect capital flows. If, for example, Russia (an Annex 1 country) is allocated emission rights equal to its 1990 emissions, it is likely to become a major seller of rights without taking any further action to reduce emissions, since the universal expectation is that its current course will take Russia to emissions far below 1990 levels in 2010. One group, ABARE, estimates that Russia would be receiving payments for emission rights equal to about 10% of its GDP by 2010. Emission trading is not a magical instrument for making costs disappear. It is a major change in the economic environment that can have wide-ranging economic effects not yet fully understood.

Without greater understanding of these possible fundamental changes in trade relationships among countries, negotiators do not have the information they need to protect their national interests in the negotiating process. No other multilateral trade negotiation has proceeded to this stage so quickly, or with so little attention to its economic consequences. That is the key area for research.

If a commitment could be made at Kyoto to a reasonable process for initiating R&D and involving developing countries - without specific emission reduction targets-- a whole new menu of important research topics emerge. The most important research projects, I believe, are on how to design policies that will stimulate effective private sector R&D into the range of possibilities for reducing carbon emissions in the absence of near term emission limits. These could include public-private partnerships modeled on the Partnership for a New Generation Vehicle, or other mechanisms in which public funding is used to change the direction of private research without "picking winners." These studies should not try to select technologies and guess at what their cost and energy savings would be, as past studies have done. Rather, the focus should be on