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FOREWORD

Nations that have signed the Global Climate Convention are negotiating commitments to stabilize and then reduce emissions of greenhouse gases, which will otherwise continue to build up in the atmosphere and alter global climate. An agreement with binding limitations is essential, since experience in the United States and many other countries over the past five years shows that the purely voluntary efforts pledged in Rio de Janeiro at the Earth Summit are insufficient.

Since the Framework Convention on Climate Change was concluded in 1992, global emissions have continued to rise despite increasing evidence that human activity is having a discernible effect on world climate. The most recent scientific assessment by the Intergovernmental Panel on Climate Change emphasized that the continued buildup of greenhouse gases could have long-lasting climatic effects, some of which would impose significant economic burdens on nations and vulnerable populations.

Before the United States commits itself to specific restrictions on carbon dioxide emissions and timetables for implementation, it is essential that the economic consequences be thoroughly understood. Limiting carbon dioxide emissions will mean significant changes in energy use and energy sources, probably changing energy costs substantially. Household budgets and business profits will be affected. These impacts may affect inflation, international trade, patterns of investment, and thus the macro-economy.

Whether the United States makes these changes unilaterally or in concert with other nations, whether it makes them in a cost-effective way using market-friendly policy instruments, and whether it implements them with adequate time and flexibility for economic adjustments to occur will all affect the macroeconomic impacts.

As the discussion of mandatory policies to reduce greenhouse gas emissions has accelerated, efforts to understand the economic implications of those policies have become intense. More than a dozen economic models have been used to generate simulations of different abatement targets and implementation policies. Not surprisingly, all this activity has produced little apparent consensus: economists derive markedly different predictions from their models about the likely impacts of achieving any specific abatement goal. Various interest groups have seized on particular predictions to support their own policy conclusions.

To sort out the resulting confusion, World Resources Institute vice president and senior economist Robert Repetto and his colleague Duncan Austin explain why different economic models reach different conclusionsbecause they start from different assumptions. This report, The Costs of Climate Protection: A Guide for the Perplexed, provides an overview of 16 leading economic simulation models. According to the report, under a reasonable set of common assumptions, models indicate that the macroeconomic impacts of stabilizing green

house gas emissions are likely to be modest and, if the environmental benefits are factored in, are likely to be beneficial. Repetto and Austin identify which assumptions are crucial. Their report will help readers form their own judgment about the likely impact of climate protection on the economy.

Building on the findings of earlier reports, including The Right Climate for Carbon Taxes: Creating Economic Incentives to Protect the Atmosphere; Green Fees: How a Tax Shift Can Work for the Economy and the Environment; and Breathing Easier: Taking Action on Climate Change, Air Pollution and Energy Insecurity, WRI continues to explore constructive ways

to resolve the climate problem without undermining economic prosperity. We are committed to working with the private and public sectors in the United States and abroad to achieve this goal.

We would like to thank the MacArthur Foundation, the W. Alton Jones Foundation, the Nathan Cummings Foundation, and the U.S. Environmental Protection Agency for providing generous financial support for the work underlying this report.

Jonathan Lash

President

World Resources Institute

INTRODUCTION

The latest international scientific assessment concludes that human activity is affecting the global climate (IPCC, 1996a). Population growth, rapid industrialization, increasing fossil fuel use, and continuing deforestation imply that without drastic action carbon dioxide concentrations in the atmosphere will double their preindustrial levels by about the year 2060 and eventually cause average global temperature to rise by IC-3.5C (IPCC, 1996a). The consequences of warming on this scale are hard to predict. Although some effects, such as rising sea levels and changing agricultural patterns, can be clearly foreseen, other effects, some potentially catastrophic, can only be guessed at. Nations have committed themselves to a precautionary approach designed to limit the accumulation of greenhouse gases.

Policies to prevent climate change focus mainly on carbon dioxide (CO2) emissions, the most important greenhouse gas. As a first step toward the ultimate goal of stabilizing concentrations, the industrialized nations that signed the Framework Convention on Climate Change voluntarily undertook to return their emissions of carbon dioxide and other greenhouse gases to 1990 levels by the year 2000. However, many countries, including the United States, will fail to meet this target.

In 1995, at the first Conference of Parties to the Convention (COP-1) in Berlin, signatories acknowledged that even if emissions were stabilized at 1990 levels, concentrations would continue to rise rapidly because CO2, once released, remains in the atmosphere for decades. The Berlin

Mandate calls for strengthened commitments from developed countries to reduce their emissions after 2000. Negotiations since COP-1 have led to various proposals, the most stringent calling for industrialized countries to reduce emissions to 20 percent below 1990 levels by 2005 (AOSIS, 1995). The United States Government has stated that it is prepared to accept legally binding commitments in future protocols in the hope that this will prompt other countries to adopt a similar stance. Agreement on future commitments will be embodied in a formal protocol to be signed at the third Conference of the Parties in Kyoto in December 1997.

If the United States and other nations do agree on binding limits on greenhouse gas emissions, they will need to adopt measures to reduce carbon emissions with the least adverse economic impacts. One of the most effective and efficient mechanisms is a carbon tax-a tax levied on all fossil fuels in proportion to their carbon

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contents. Raising the prices of fuels and energy-intensive products would discourage all fossil fuel uses in proportion to their carbon contents and encourage development of less carbon-intensive alternatives. A recent statement by leading economists points out that a tax mechanism would be much more efficient than a regulatory approach (Economists' Statement on Climate Change, 1997).

An alternative proposal under serious consideration in the United States is a tradable permits program, in which permits would be required in order to sell or use fossil fuels. By limiting the total number of permits, the regulatory authority could control carbon emissions. If the government allowed permits to be bought and sold, the program would create efficient incentives like those of a carbon tax. because the permit price in the marketplace would signal how much firms should reasonably spend on abatement measures. If the government initially distributed the permits through an auction, it could mitigate adverse economic impacts by using the revenues to reduce other taxes without increasing fiscal deficits. In this sense, auctioned-off tradable permits to sell or use fossil fuels have economic implications similar to those of a carbon tax. (In this report, statements about the effects of a carbon tax apply equally to the impacts of tradable carbon permits that are auctioned off.)

Though one argument for tradable permits is the perceived political

difficulty of proposing a change in the tax structure, the tradable permits approach also faces potential difficulties. It would be less efficient than a revenue-neutral tax and would encounter political opposition if valuable permits were given away to energy companies and utilities. Moreover, it would be difficult to include small fuel users in a tradable permits program, though their aggregate energy use is important, without creating administrative burdens much greater than those implied by raising energy taxes. Furthermore, if new scientific information necessitated further emissions reduction, canceling carbon permits that had been purchased in an auction or market transaction would be more difficult than raising a carbon tax.

Many interest groups claim that a carbon tax or any other efficient policy to reduce carbon emissions, such as a tradable permits policy. would impose high economic costs and reduce economic growth. For support, they point to simulations with economic models, some of which have suggested that stabilizing CO2 emissions at 1990 levels could require a tax of up to $430 per ton of carbon by 2030 and could impose total costs of up to 2.5 percent of annual gross domestic product (GDP) (Charles River Associates, 1997). Of course. other economic models predict that similar emissions reductions could be achieved with far smaller energy taxes and negligible, or even favorable, overall impacts on the economy (Gaskins and Weyant, 1993).

Despite the complexity of the models, only a handful of easily understandable assumptions are important in determining the simulation results.

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Which predictions should we believe— if any? Interested groups on different sides of the issues have their own preferred models (and modelers), and these tend to produce simulations supporting the policy positions of their respective sponsors. The underlying economic models may contain dozens of complicated equations that are nearly impenetrable to all but trained econometricians. How and why such models reach the predictions that they do is hard to comprehend. Yet, it matters greatly what the economic impacts of policies to reduce the long-term risks of global warming will be.

This report provides a guide for the perplexed—an explanation in simple terms of the key assumptions in the models being used to simulate the

economic effects of carbon taxes or similar policies to control carbon dioxide emissions. The report also provides a quantitative analysis of 16 widely used models, demonstrating how key assumptions affect the predicted economic impacts of reaching CO2 abatement targets. It turns out that despite the complexity of the models, only a handful of easily understandable assumptions are important in determining the simulation results. By showing the effect of these assumptions on the predicted economic costs, not just in one particular model but in all of them, this report can help readers to apply their own judgments about which models are more realistic and to reach their own conclusions about which economic predictions are more credible.

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