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Underlying Uncertainties

Before I begin my discussion of the economic literature, I would like first to acknowledge the uncertainties associated with estimating both the costs and benefits of reducing greenhouse gas emissions. To provide some perspective: as you all know, it is difficult to gauge exactly what impact the balanced budget agreement will have on the U.S. economy's growth rate, levels of employment, interest rates and consumption over the next five years. But with global climate change, it is orders of magnitude more difficult to gauge the effects on the economy: we are concerned with not just the next five years and not just the American economy, but, rather, we are dealing with economic and physical processes that operate globally and over decades, if not


Although a great many scientists believe that global climate change is already underway, the more serious potential damages associated with increasing concentrations of greenhouse gases are not predicted to occur for decades. This means that the benefits of climate protection are very difficult to quantify. And, while the potential costs of reducing greenhouse gas emissions may be more immediate, they too, as I will discuss below, are difficult to predict with any certainty. Many unanswered questions exist about the biophysical systems, potential thresholds, and economic impacts. In short, if anybody tells you that he or she has the definitive

answer as to the costs and benefits of particular climate change policies, I would suggest that you raise your collective eyebrows.

Lessons from the Economic Literature

Let me now turn to the economic literature and try to summarize what I think we know so

far about this difficult topic. Most economists have not addressed the benefits of climate protection, but rather have focused on the costs associated with alternative paths for reducing greenhouse gas emissions. The economic literature includes estimates using many different models to evaluate numerous alternative emission reduction strategies. In fact, because there are so many different models, economists initially faced difficulties in comparing results: they could not sort out the extent to which differences in results stemmed from differences in models and assumptions versus differences in baseline emission paths and policies. To solve this problem, thereby enabling meaningful comparisons, many economists have calibrated the various models by performing a standardized simulation. Specifically, they have assessed the consequences of stabilizing greenhouse gas emissions at 1990 levels by 2010 or 2020.

Within the Administration, a staff level working group -- the Interagency Analysis Team (LAT) -- has attempted to estimate some of the economic implications of climate change policies. They took the emissions scenario most often used in academic literature -- that is, stabilizing emissions at 1990 levels by 20 10


as the starting point for their own analysis. I would

emphasize that this scenario is not Administration policy; instead, it was picked to make comparisons with other models easier. The staff group employed 3 different models -- the DRI model, the Second Generation Model (SGM) and Markal-Macro model, all commonly available in the public sphere. In running these models, the staff adopted a common baseline and, to the maximum extent possible, similar economic assumptions. This modeling effort produced some

useful lessons, but as we found from the peer reviewers' comments, it also suffered from some serious shortcomings. Both the lessons and the shortcomings point to one clear conclusion: the effort to develop a model or set of models that can give us a definitive answer as to the economic impacts of a given climate change policy is futile. Rather, we are left with a set of parameters. and relationships that influence estimates of the impacts. In my view, it is more productive to employ a broad set of economic tools to analyze policy options than to seek to develop a single definitive model.

I understand that a draft of the staff analysis was given to the Subcommittee this morning, along with the reviewers' comments. I would be happy to answer any questions you may have about this modeling effort.

The Lessons. Modeling efforts both inside and outside the Administration clearly indicate that economic analysis can do no more than estimate a range of potential impacts from particular policies and highlight how outcomes depend on underlying assumptions about how the economy works and the ways in which policy is implemented. However, the economics literature on climate change does point to several important lessons:

How the economy works. First, the magnitude of the costs of reducing greenhouse gas emissions in the various models depends crucially on a number of key assumptions about how the economy works. For instance:

If firms in the economy can shift from high-carbon to low-carbon energy sources

quickly, the costs of climate protection will be lower.

If the economy has significant opportunities, even now, to employ energy-saving
technology at low costs, the costs of climate protection will be lower.

If technological change occurs at a rapid rate, or is highly responsive to increases
in the price of carbon emissions, the costs of climate protection will be reduced.
If the Federal Reserve pursues a monetary policy oriented toward keeping the
economy at full employment, transitional output costs will be lower.

In short, the greater the substitution possibilities and the faster the economy can adapt, the lower the costs.

How the plan is implemented. Second, costs depend critically on how emission reduction policies are implemented. It boils down to this: if we do it dumb, it could cost a lot, but if we do it smart, it will cost much less and indeed could produce net benefits in the long run. The over 2300 signatories of the economists' statement argued that any global climate change policy should be rely on market-based mechanisms. Such mechanisms allow for flexibility in both the timing and location of emission reductions, thereby minimizing the costs to the U.S. economy. The economists concluded that “there are policy options that would slow climate change without harming American living standards, and these measures may in fact improve U.S. productivity in the longer run."

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The speed at which emissions reductions are required can have large effects on the estimated costs. It is important to allow sufficient lead-time for orderly

investment in new equipment and technology. Alternatively, if emission

reduction requirements are too far off in the future, the incentives to adopt energy efficient technologies are weakened because people may not view the policy as credible.

A "cap and trade" system in which emission permits are issued and then traded among firms can substantially reduce the cost of meeting an emissions target by creating incentives for emissions to be reduced by those firms and in those

activities where costs are lowest.

International emission permit trading substantially lowers costs by applying the same cost-minimizing principle globally.

So-called "banking" and "borrowing" of permits increases flexibility and lowers costs by allowing firms to change the timing of their emission reductions.

Joint implementation, whereby US firms would receive credit for undertaking emission reductions in countries with low abatement costs, would also lower the domestic burden.

An additional aspect of implementation that profoundly affects the costs of reducing emissions concerns “revenue recycling.” In many model simulations, emissions are reduced by using various market mechanisms. For many of these scenarios, the Federal government realizes an increase in revenues. Economic growth can receive a

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