Figure ES.5: Economic Impact in 2010

U.S. Kyolo target, domestic strategy with and without market and fiscal reforms

no tax shifts

Carbon permit price (597/C)

When tax shifts are also included, GDP losses from substitution effects are eliminated entirely. Depending on the extent and effectiveness of tax shifts (we model 50 to 150 percent offset of substitution losses), U.S. economic output in 2010 increases by an amount that ranges from less than 10 to more than $90 billion per year (again including environmental co-benefits of about $20 billion).

For the midpoint level of effectiveness (100 percent offset), tax shifts just compensate for the GDP impacts of the carbon charge. What remains, then, are the reductions in the total cost of energy services from market reforms (simply referred to as net energy bill savings), plus the environmental co-benefits of reduced carbon emissions. With a carbon charge of roughly $140/tC, net savings from market reforms are lower than they would be in the absence of carbon charges, but the cobenefits of avoided pollution compensate much of this effect. The total economic gain is about $50 billion/yr, equivalent to about half a percent of projected GDP in 2010.

EXTENDING THE TIME HORIZON TO 2020

The extension of the above analysis to 2020 is of great importance for the U.S. policy debate and the U.N. negotiations in that it indicates whether emission reductions can be profitably maintained or even increased over the following decade as economic growth continues to push the reference forecasts beyond current emissions levels.

Using the CEF results for 2020, we examine a domestic least-cost strategy, again consisting of permit trading, market reforms, and tax shifts. We analyze two alternative emission reduction targets. In the first case, it is assumed that the U.S. Kyoto target for 2010 (i.e.,1990 emission levels minus 7 percent) will be maintained in the subsequent decade. In the second case, the target is increased to the minus 20 percent level originally proposed at Kyoto by the Alliance of Small Island States (AOSIS), a group of countries most vulnerable to sea level rise.

As expected, the U.S. energy system in 2020 is more responsive to both market reforms and carbon charges. The Kyoto target is reached at $65/tC-roughly half the charge required in 2010. Expanding emission reductions to minus 20 percent of 1990 levels requires only a modest further increase in the carbon price, to $77/tC. Net economic benefits are roughly $120-125 billion/yr in 2020, equivalent to 0.9 percent of projected GDP. This is more than double the economic gains achieved with the same strategy in 2010. When the year 2020 emission reduction target is extended from minus 7 to minus 20 percent of 1990 levels, net economic gains are somewhat lower but still of the same order of magnitude as for the Kyoto target. The higher carbon charge necessary in 2020 to achieve the minus 20 percent target

does lead to reduced net savings in energy service bills. However, this effect is partially offset by larger environmental co-benefits.

The more than doubling of net benefits between 2010 and 2020 is explained by three factors: (a) money-saving productivity investments are far from saturation in 2010, and are continuing to penetrate the capital stock in the period between 2010 and 2020; (b) capital stock turnover in many important categories of energy-using equipment, and thus the penetration rate of demand-side efficiency programs, is inherently faster than economic growth, on account of short (10-20 year) equipment lifetimes; and (c) the costs of advanced low-carbon technologies decline at an accelerated pace, due to learning curve effects and R&D impacts.

Examining the CEF scenarios for the entire period from now until 2020, it is evident that a domestic no-regrets strategy of permit auctions, tax shifts, and market reforms already becomes significantly profitable within the first couple of years of implementation. From there, it grows more lucrative year by year as the capital stock turns over.

These findings call for a revision of conventional wisdom, which presumes an economic advantage from postponing most emission reductions to later years. Larger emissions reductions do become easier to achieve in later years, as more time is allowed for the adjustment process in the economy. However, because growing levels of emissions reductions below the baseline become profitable even in the early years, foregoing the early reductions implied in the Kyoto target would amount to a significant opportunity cost for U.S. consumers and firms.

INTERNATIONAL IMPLEMENTATION

The positive economic picture found so far further improves when a domestic least-cost strategy is integrated with the Kyoto flexibility mechanisms. Here, we analyze the limiting case of unrestrained global emissions trading. Other scenarios with only a supplementary role for trading are discussed in the subsequent section. Figure ES. 6 compares the international trading case of the EMF-16 analysis with the results for the CEF/Kyoto strategy combining international flexibility with domestic no-regrets action.

As a point of reference, the chart begins with the domestic worst-case policy based on a carbon tax without tax shifts or market reforms. When global trading is incorporated into this policy case, the carbon price drops by more than 80 percent from $230/tC to about $40/tC. Total mitigation costs decline by two thirds or more.

Fiqure BS.6: Economic Impact in 2010

U.S. Kyoto torget, domestic permil trading versus global trading versus integrated least-co

While global trading can reduce U.S. mitigation costs by significant percentages, it alone cannot prevent economic losses. By contrast, domestic market and fiscal re

forms can produce net benefits on their own. If these gains are enhanced by international allowance trading, the carbon price drops from about $40/tC to $11/tC, due in part to feedback effects of U.S. domestic no-regrets policies on the international allowance market.

Our analysis shows that a fully integrated 'flexibility with no regrets' strategy yields economic benefits of $57 billion/yr in 2010. Figure ES. 7 shows the individual components of this aggregate result. The graph also shows that tax shifts are of lesser importance in the context of an international strategy: economic substitution losses are diminished on account of the much lower carbon price.

The main results of our review are summarized in Figure ES. 8. These results support several conclusions. The first conclusion is that with an integrated leastcost policy mix, the U.S. can meet targets such as those set forth in the Kyoto Protocol at a net economic gain ranging from about 0.5 percent of GDP in 2010 to about 1 percent of GDP in 2020. Insofar as some of the total benefits are from avoided environmental damages (in areas other than climate change), not all of these economic gains may show up in the country's GDP accounts, but they are economic gains nonetheless.

Figure ES.&: Economic impacts of an integrated least-cost strategy for reducing
U.S. carbon emissions in 2010 and 2020

The second conclusion is that postponing carbon mitigation in the U.S., or reducing abatement efforts to less than the U.S. target under the Kyoto Protocol, brings with it significant lost opportunities for the U.S. economy. Such lost opportunities are of the order of $50-60 billion per year in 2010, and about $120 billion per year by 2020.

The full opportunity cost of inaction is measured by the sum of foregone annual economic gains in the period between now and 2020. By the end of the first Kyoto commitment period in 2012, U.S. consumers and businesses would forego cumulative economic gains of about $250 billion (net present value of growing annual gains, discounted to the year 2001 at a 5 percent real discount rate, constant 1997 dollars). For the entire period until 2020, this figure rises to more than $600 billion. The third conclusion is that positive net economic impacts are centrally driven by productivity-enhancing market reforms. A focus on international rather than domestic strategies is misplaced, because GDP losses from carbon charges can be minimized through either domestic tax shifts or international trading. The implication of this finding for the U.N. FCCC negotiations is further discussed below.

HOW IMPORTANT IS EMISSIONS TRADING?

Our analysis shows that the economic significance of international allowance trading has been exaggerated. To measure the significance of trading, the appropriate point of reference is the 'no trading' case examined in the EMF-16 assessments, in which the only policy is a domestic permit trading system or carbon tax. The mean of the EMF-16 estimates of the impact of the U.S. Kyoto target for this policy case is a GDP loss of about $110 billion/yr in 2010.

Relative to our average derived from the EMF-16 global trading case, the domestic least-cost approach of the CEF/Kyoto scenario improves economic results by eliminating all GDP losses and generating a net benefit instead. The economic improvement is roughly $(110+50) = $160 billion/yr in 2010. This figure is far larger than what is achieved in the EMF-16 'global trading' case, which reduces mitigation costs by only about $75 billion (Figure ES. 9).

Fiqure ES.9: Reductions in U.S. mitigation costs from domestic market and fiscal reforms
and global allowance trading relative to domestic permit trading only, year 2010

80

60

40

20

EMF-16 w/ global trading

CEF/Kyoto-domestic w/ tax offset

CEF/Kyoto w/ trading - tax offact

100%

100%

When the CEF/Kyoto scenario is expanded to incorporate international trading, results improve further to about $170 billion/yr, or by roughly $10 billion/yr. It is this marginal improvement of $10 billion/yr relative to the domestic gain of $160 billion/yr that measures the marginal significance of international trading.

These proportions indicate that trading adds no more than a roughly 5 percent improvement. About 95 percent of theoretically feasible abatement cost reductions can be achieved through domestic market and fiscal reforms alone. While a $10 billion absolute gain could certainly be worth pursuing, the purported major significance of international trading turns out to be an artifact of incomplete modeling analyses of domestic policy options.

Not only that, a one-sided reliance on international trading would be expensive for U.S. consumers and firms. Figure ES. 9 implies that in the absence of domestic market and fiscal reforms, global allowance trading as assumed in the EMF-16 scenario would saddle the U.S. economy with opportunity costs of roughly $(160–75) $85 billion/yr in 2010.

=

Rather than obtaining emission reductions at negative net cost from domestic action, U.S. energy users would end up paying for investments abroad that provide carbon reductions at a positive cost. The fact that this cost burden would be lower than in the absence of trading does not change the fact that exclusive reliance on trading (i.e., a lack of domestic action) would result in a sizable economic penalty.

HOW ROBUST ARE THESE FINDINGS?

A sensitivity analysis of our results shows that international trading can provide a certain amount of insurance against domestic policy failures, as well as against the large variation in GDP estimates from current economic models. This effect is illustrated in Figure ES. 10, which shows high/low sensitivity ranges for the domestic and international CEF/Kyoto least-cost strategies. Our sensitivity tests include both a fourfold variation in predictions from economic models (highest versus lowest GDP loss for a given carbon price); a range of ancillary benefit estimates; and variations in tax shift offsets and no-regrets emission reductions by plus or minus a third.