Julv 18, 2001

Macroeconomic Effects of Caps on CO2 Emissions Are Significant. A wide range of economic models predict that capping U.S. carbon dioxide (CO2) emissions at the Kyoto target (7 percent below 1990 levels) would reduce U.S. GDP and slow wage growth significantly, worsen the distribution of income, and reduce growth in living standards. Proposed future reductions of 60 percent below 1990 levels by 2050 have not been modeled, but would have extremely serious consequences for all economies dependent on fossil fuels.

U.S. Budget Surplus Is Reduced Sharply. Slower economic growth means that federal tax receipts would be reduced. If implementation of the Kyoto Protocol reduces annual GDP by 3 percent per year, for example, the projected budget surplus in 2010 falls from $471 billion to only $315 billion. ■ International Emissions Trading Issues Are Major. Major obstacles to trading include securing developing country participation, allocating CO2 emission rights, and distributing the resulting rev

enue.

European Union Unable to Meet Targets. Even though several EU members continue to support ratification of the Kyoto Protocol, a number of recent

studies document that the EU will not be able to achieve its targets; in fact by 2010 the EU countries will be 10 to 25 percent above their targets. ■Science of Climate Change Needs to Be Better Understood Before Costly Policies Are Implemented. Despite the United States' intensive investment in climate change science, numerous gaps remain in our knowledge, including conflict between global atmospheric and "surface" temperature measurement, and uncertainty about the amount of carbon sequestered in the oceans and soil and about the feedbacks in the climate system that determine the magnitude and rate of temperature increase. ■Conclusion. A U.S. strategy for a productive climate policy providing energy security should include: fixing the U.S. tax code; expanding nuclear energy; expanding bilateral cooperation with developing countries; expanding incentives for use of landfill methane and biomass including ethanol from cellulose; implementing a multi-year plan for improvement of coal technology: removing regulatory barriers; avoiding caps on CO2 emissions by U.S. industry; and avoiding setting targets for global CO2 concentrations in the range of 550 ppm in the next 75-100 years.

INTRODUCTION

My name is Margo Thoming and I am pleased to present this testimony to the Senate Governmental Affairs Committee.

The American Council for Capital Formation represents a broad cross-section of the American business community, including the manufacturing and financial sectors, Fortune 500 companies and smaller firms, investors, and associations from all sectors of the economy. Our distinguished board of directors includes cabinet members of prior Republican and Democratic administrations, former members of Congress, prominent business leaders, and public finance and environmental policy experts.

The ACCF is now celebrating its 28th year of leadership in advocating tax, regulatory, environmental, and trade policies to increase U.S. economic growth and environmental quality.

We commend Chairman Lieberman, Senators Byrd and Stevens and the Senate Governmental Affairs Committee for their focus on the role of technology in addressing climate mitigation. In our view, tax incentives should be a key component in the push to develop new technology. Given the ACCFs extensive studies on the impact of tax policy on investment, my testimony will develop an aspect of what should become the foundation for an integrated approach to climate change policy. We believe that progress on technology proposals such as those in S. 1008, the Climate Change Strategy and Technology Act of 2001, is vitally important.

My testimony begins with a review of the macroeconomic consequences of near-term CO2 emission caps. It includes information from a number of analyses sponsored by the ACCF Center for Policy Research, the public policy research affiliate of the American Council for Capital Formation. These studies describe the economic costs of near-term caps on U.S. carbon emissions and the impact of emissions limits on the growth of the capital stock, as well as suggest tax incentives to encourage voluntary efforts such as the purchase of energy-efficient equipment and sequestration initiatives to reduce CO2 emissions both in the United States and abroad. (Summaries of the Center's climate policy studies are available on our Web site, www.accf.org. I also discuss issues related to long-term options for reducing CO2 concentrations. Finally, strategies for a cost-effective, long-term approach to CO2 stabilization are presented.

MACROECONOMICS EFFECTS OF CAPPING CO2 EMISSIONS

The Kyoto Protocol to the United Nations Framework Convention on Climate Change, which was negotiated in December 1997, calls for industrial economies such as the United States, Canada, Europe, and Japan (termed Annex B countries) to reduce their collective emissions of six greenhouse gases by an average of 5.2 percent from 1990 levels by 2008-2012. The U.S. target under the Protocol, which was rejected by the Bush Administration in March, is a 7 percent reduction from 1990 levels (or 1,251 million metric tons); this amounts to a projected 536 million metric ton cutback in carbon emissions relative to the projected amount in 2010, growing to a 728 million metric ton cutback by 2020 (see Figure 1). In 1999, U.S. emissions were 1,527 million metric tons, or 22 percent above the Kyoto target. By 2010, the U.S. Department of Energy's Energy Information Administration (EIA) projects that emissions will be 43 percent above the target, and the gap will grow to 58 percent by 2020. (In 2010, carbon emissions from the transportation and utility sectors alone are projected to be 1,300 million metric tons (see Figure 1). It is also worth noting that Mr. Tim Wirth, the former Clinton Administration climate policy negotiator, testified in 1997 that carbon emissions would need to be cut by up to 10 times the Kyoto targets (a 70 percent reduction). The United Kingdom has assumed it must reduce its emissions by 60 percent by 2050.

The emissions cap would, in effect, ration the use of energy in the United States and require very large taxes, either directly or indirectly through the purchase of "permits," to restrain the demand for energy. The "multi-pollutant" approach would have the same effect. Research conducted over the past decade for the ACCF Center for Policy Research by top climate policy scholars concludes that the cost of reducing carbon emissions in the near term would impose a heavy burden on U.S. households, industry, and agriculture by reducing economic growth.

IMPACT ON GDP

Many climate policy experts believe that the emission reductions called for in the Kyoto agreement have potentially serious consequences for all Americans. Predicting the economic impact of reducing carbon

emissions depends upon how an econom ic forecasting model handles several factors, including how rapidly industry and consumers respond to higher energy prices by substituting less carbon-intensive production methods and reducing the consumption of carbon-intensive goods and services. Other factors that can affect a model's results are the rate of technological change, the projected baseline greenhouse gas emissions, the amount of emissions trading, and use of carbon sinks and sequestration.

The rate of technological improvement for energ production and consumption assumed by most models under their baseline forecasts is fairly rapid. For example, the ELA's reference case assumes continued improvements in new and existing buildings, transportation, coal production, exploration for oil and gas, and electricity generation technologies. In fact, total energy intensity (defined as the ratio of primary energy consumption

per dollar of GDF) declines at an average

rate of 1.1 percent annually between 1998

and 2020. The faster the rate of econom

ic growth, the faster energy intensity

declines in the EIA reference cases due to the more rapid turnover of the capital stock.

Recent model results show that as carbon emissions are capped or constrained, economic growth slows due to lost output as new energy taxes are imposed and prices rise for carbon-intensive goodsgoods that must be produced using less carbon and/or more expensive processes. In addition, the capital stock accumulates more slowly, reflecting the premature obsolescerce of capital equipment due to the sharp energy price increases required to meet the car. bon emission reductions mandated under the Protocol. It takes from 20 to 30 years to "turn over" or replace the encze U.S. capital stock. Thus, meeting the Protocol's 2008-2012 timetable for emission reductions would mean either continuing to utilize plant and equipment designed to use much lower-cost (pre-Kyoto) fue's, or replacing the capital stock much more rapidly than its owners had planned.

The wide range of model results by climate policy experts such as Senior Vice President Mary H. Novak of WEFA, Inc.. Professor Alan S. Manne of Stanford University, Dr. Richard Richels of EPRI, Dr. W. David

Montgomery of Charles River Associates (CRA), Dr. Joyce Brinner of Standard & Poor's DRI (DRI), Dr. Brian S. Fisher of the Australian Bureau of Agricultural and Resource Economics (ABARE), and others, show that complying with the Kyoto Protocol would reduce U.S. GDP by a range of 1 percent to 4 percent annually (see Figure 2). This translates into annual losses of $100 billion to almost $400 billion (in inflation-adjusted dollars) in U.S. GDP each year compared to the baseline forecast for energy use. These studies, as well as the EIA report released in October 1998, stand in sharp contrast to the optimistic projections contained in the Clinton Administration's economic analysis prepared by the Council of Economic Advisers and released in July 1998.

Starting earlier to reduce carbon emissions (in 2000 rather than 2005) only worsens the overall impact, according to an EIA report released in July 1999. The EIA results show that the discounted present value of U.S. GDP falls by $1,430 billion 1992 dollars over the 2000-2020 period compared to $1,285 billion under the 2005 start date.

ECONOMIC IMPACT OF ADDITIONAL REDUCTIONS BEYOND THE KYOTO TARGET

The economic costs of the Kyoto Protocol described above do not reflect the additional economic impact of emission reductions beyond the Kyoto target. Kyoto supporters contemplate substantial future carbon emission reductions well below 1990 levels. At least one model has analyzed this scenario. A study using the Charles River Associates model (MSMRT) shows that the cost of going beyond the carbon emission reductions required by the Kyoto Protocol is high. For example, a target of 21 percent below 1990 emission levels (or three times the Kyoto target) would reduce U.S. GDP by 2.4 percent annually in 2020 with Annex B emission trading and by 3.0 percent with domestic abatement alone.

IMPACT ON THE FEDERAL BUDGET SURPLUS

One way of assessing the impact of the Kyoto Protocol is to examine how slower economic growth would affect projected U.S. federal tax receipts and federal budget surpluses. Policymakers need to consider the potentially large negative impact of the Protocol on GDP growth and federal budget receipts, particularly since both the Administration and Congress are already chipping away at the federal budget surpluses to finance spending initiatives and tax cuts for fiscal year 2001 and beyond. Using a simple calculation based on the relationship of increases in GDP to federal tax receipts, if GDP is 3 percent lower annually, the on-budget surplus in 2010 would decline by $156 billion dollars, from $471 billion to $315 billion (see Figure 3). If, as the EIA model predicts, the Kyoto Protocol reduces GDP by 4 percent in 2010, the budget surplus drops to only $261 billion dollars.

IMPORTANCE OF INTERNATIONAL EMISSIONS TRADING

Numerous studies show that a major determinant of the cost of curbing emissions is whether the United States can purchase permits from abroad where emissions can be reduced at a lower cost than in the United

States. In the absence of an unfettered international trading system, the United States would be forced to curb its own carbon emissions by about 30 percent within 10 years. Due to population growth and increas es in output, the gap between projected emissions and the Kyoto target will continue to grow (see Figure 1). Neither this growing gap nor the impact of additional reductions beyond the Kyoto targets have been addressed by Kyoto advocates.

IMPACT ON WAGE GROWTH AND
CONSUMERS

U.S. consumers suffer declines in wage growth and the distribution of income worsens der carbon stabilization policies. Wesleyan Univers: Professor Gary Yohe estimates that reducing emissions to 1990 levels (the Clinton Administration's pre-Kroto target) would reduce wage growth by 5 percent to 10 percent per year, and the lowest quintile of the population would see its share of the economic "pie” shrink by about 10 percent. Texas A&M University Professor John Moroney estimates that U.S. living standards would fall by 15 percent under the Kyoto Protocol compared to the base case energy forecast.

U.S. households also face much higher prices for energy under near-term reductions. A range of esti