This chapter summarizes the energy market results of the carbon reduction and sensitivity cases evaluating the effects of the Kyoto Protocol in the National Energy Modeling System (NEMS). The first set of cases examine the impacts of six carbon emissions reduction targets, relative to a reference case without the Kyoto Protocol, as described in Chapter 1. The remaining cases examine the sensitivity of those results to variations in key assumptions-the macroeconomic growth rate, the rate of technological progress, and the role of nuclear power. More detailed analyses of the energy market results are presented in Chapters 3, 4, and 5. The macroeconomic results are described in Chapter 6. Although the results of the carbon reduction cases are consistent with the assumptions made, the projected impacts are subject to considerable uncertainty-particularly with the more stringent carbon reduction targets-because the cases reflect significant changes in energy markets.

Carbon Reduction Cases

Carbon Prices

Under the Kyoto Protocol, the United States is committed to reducing greenhouse gas emissions to 7 percent below 1990 levels in the period 2008 through 2012. The reduction in energy-related carbon emissions that the United States must achieve to comply with the greenhouse gas reduction target in the Protocol depends on the level of emissions offsets credited for sinks, reductions in other greenhouse gases, international permit trading, joint implementation, and the Clean Development Mechanism (CDM). A set of six cases examines a range of carbon emissions reduction targets, ranging from 7 percent below 1990 levels, an average of 1,250 million metric tons during the period 2008 to 2012, to 24 percent above 1990 levels, or an average of 1,670 million metric tons. The most stringent case assumes that the target of reducing greenhouse gases to 7 percent below 1990 levels is the domestic goal for energy-related carbon emissions, with no offsets from sinks, offsets, international trade, the CDM, or compensating changes in other greenhouse gases.

The six carbon reduction cases are compared against a reference case similar to the one published in the Annual Energy Outlook 1998 (AEO98) (Figure 1). The Protocol indicates that the greenhouse gas reductions must be

In order to reduce carbon emissions, demand for energy services must be reduced, more efficient energyconsuming technologies used, or less carbon-intensive fuels consumed. Thus, to constrain the overall level of carbon emissions to a given target, a price on carbon emissions is included in the delivered price of fuels. The carbon price is equivalent to the cost of a carbon permit under a market-based program within the United States to regulate the overall level of carbon emissions. In such a program, the purchase of fossil fuels would require the exchange of carbon permits, and a market for carbon permits would operate to allocate the overall supply of permits among US. energy consumers. More restrictive carbon targets would lead to higher market-clearing prices for carbon.

In analyzing the carbon emissions reduction targets, the carbon prices are incorporated as an added cost of consuming energy; that is, as an increase in the delivered price of energy. The added cost is in direct proportion to the carbon permit price and the carbon content of the fuel consumed. As a result, energy consumers face higher energy costs-both for the fossil fuels they consume directly, such as gasoline, and for the indirect use of fossil energy used to generate electricity. The higher energy costs also affect the cost of producing goods and services throughout the economy and, as a result, have macroeconomic effects beyond the impacts on the energy sector.

As indicated in Figure 1, some carbon reductions occur before 2005, based on anticipatory behavior, primarily as a result of forward-looking capacity planning decisions assumed in the electricity industry. For the electricity industry, where fossil fuel purchases are a predominant operating cost, planners are assumed to incorporate future fuel costs in their economic evaluation of generating plant alternatives. As a result, some capacity choices reflected in the reference case before 2005 are altered in the carbon reduction cases based on carbon prices beginning in 2005, thus lowering carbon emissions before the assumed start of carbon permit trading.

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Table 2 presents a summary of the key results in 2010 and 2020 for the reference case, the 24-percent-above1990 (1990+24%) case, the 9-percent-above-1990 (1990+9%) case, and the 3-percent-below-1990 (1990-3%) case. Tables of the complete results for all the carbon reduction cases are included in Appendix B.

Figure 2 depicts the estimated carbon prices, in constant 1996 dollars, necessary to achieve the carbon emissions reduction targets. Generally, the highest permit price occurs early on in the commitment period. The carbon price declines over time as cumulative investments in more energy-efficient and lower-carbon equipment, particularly in the electricity generation industry, tend to reduce the marginal cost of compliance in later years.

For most of the cases, the trend of carbon prices includes some relatively minor year-to-year fluctuations. Also, particularly in the more stringent reduction cases, the carbon price generally peaks in 2008, the first year of the commitment period, because of the 3-year phase-in period. A longer adjustment period might reduce the price; however, early reductions do not count toward the required reductions in the commitment period. In some cases, 1- to 2-year declines in prices occur as

1995 2000 Source: Office of Integrated Analysis and Forecasting, National Energy Modeling System runs KYBASE.D080398A, FD24ABV.D0803968, FD1998 D0803988, FOOBABY DO803988, F01800 D0803988, FD038LW.D0803888 and FD07BLW.D0803988

electricity generators complete construction of lowcarbon replacement plants. The new plants allow generators to shift from coal to lower-carbon energy sources, reducing their need to purchase carbon permits and holding down carbon prices. Because the additions of replacement capacity occur in discrete amounts, the year-to-year changes in carbon prices can be somewhat uneven. The short-term fluctuations in projected carbon prices are consistent with, but probably understate, the degree of short-term price movements that would be expected in a market for carbon permits.

The carbon prices from 2008 to 2012 average $159 per metric ton in the 1990+9% case, which represents a carbon reduction averaging 325 million metric tons a year relative to the reference case (Figure 3). In the more stringent 1990-3% case, the average carbon price from 2008 to 2012 is $290 per metric ton, achieving an average annual carbon reduction during that period of 485 million metric tons. In the 1990+24% case, carbon prices average $65 per metric ton in the compliance period, with average carbon reductions of 122 million metric

tons.

Carbon prices decline in most of the cases after 2012, despite continued growth in the demand for energy as the carbon target is held constant. While increased energy demand would be expected to exert upward pressure on carbon prices over time. downward pressure results from the cumulative effect of investments to improve energy efficiency and switch to lower-carbon energy sources. These long-lived

With the carbon prices included in the delivered cost of energy, the prices under the various carbon targets rise significantly above the reference case. Figures 4, 5, and 6 show the average delivered prices of coal, natural gas, petroleum, and electricity in the 1990+24%, the 1990+9% and the 1990-3% cases, respectively. In percentage terms, coal prices are most affected by the carbon prices. with the delivered price of coal in the 1990+9% case increasing 346 to 368 percent above the reference case price in the 2008 to 2012 period (Figure 7). Natural gas prices in the 1990+9% case increase 64 to 74 percent above the reference case prices, and oil prices Increase by 25 to 29 percent. Electricity prices, reflecting the higher costs of fossil fuels used for generation, as well as the incremental cost of additional plant investments to reduce carbon emissions by replacing coal-fired plants, increase to 47 to 50 percent above the reference case level.

Compared with the changes in coal and natural gas prices, the average increase in electricity prices is relatively low. Larger amounts of electricity would be generated from renewable and nuclear power, for which fuel costs are unaffected by carbon prices. In addition, cost-of-service electricity pricing is assumed for most of the country, so that fuel costs would be only a partial determinant of electricity prices. Nonfuel operating and

maintenance costs and capital equipment costs have a larger role in setting electricity prices under cost-ofservice pricing. In regions where electricity prices are assumed to be set competitively on the basis of marginal costs (California, New York, and New England), carbon prices would have a more significant influence on electricity prices, particularly when coal-fired plants are the marginal generators. On the other hand, those regions are less dependent on coal than are many other areas of the country.

The pattern of projected delivered energy prices matches the trend for carbon prices, especially in the more restrictive carbon reduction cases. In these cases, the carbon prices become a dominant component of the delivered cost of fossil energy; however, market forces continue to play a role in energy prices, especially for petroleum products. The reduced demand for oil under the various carbon reduction targets tends to reduce world oil prices. World oil prices are projected to fall as demand is reduced in the United States and in other developed countries that are committed to reducing emissions under the Kyoto Protocol. In 2010, world oil prices are projected to be about $20.00 per barrel in the 1990+24% case, $18.70 in the 1990+9% case, and $17.80 in the 1990-3% case, as compared with $20.80 per barrel in the reference case. With lower world oil prices, the change in delivered petroleum product prices with the various carbon prices is not as high as for natural gas prices, despite the higher carbon content of petroleum. In contrast to petroleum, coal prices are unlikely to be moderated by competitive forces. Much of the demand for coal by electricity generators is eliminated in the carbon reduction cases, particularly with the more stringent targets. Coal consumption for other uses, including Industrial steam coal and metallurgical coal, is also reduced but on a smaller percentage basis than for electricity generation. Although coal produced for export is also lower in the carbon reduction cases due to lower demand in the Annex I nations, the change is relatively small in comparison with the reductions in production for domestic use. Coal exports, projected at 113 million short tons in 2010 in the reference case, are 89 million short tons in 2010 in the 1990+24% and 1990+9% cases and 76 million short tons in the 1990-3% case. Because the industrial and export coal markets are served prlmarily by eastern coal producers, eastern production declines less in the carbon reduction cases than does production from western mines, which primarily serve the electricity generation market. Thus, while regional minemouth prices generally decline in the carbon reduction cases relative to the reference case, the national

Source: Office of Integrated Analysis and Forecasting, National Energy Modeling System nun FD00ABV.D0803088

average minemouth price increases because of the shift in share to the higher-priced coal mined in the East. Western coal production is also discouraged by higher rail transportation costs and reduced incentive for the development of new mines.

Natural gas demand is higher in the carbon reduction cases relative to the reference case primarily because of higher use in the electricity generation sector, offsetting reductions in the end-use demand sectors. As a result, the average wellhead price of natural gas, excluding any carbon price, is higher relative to the reference case in all the carbon reduction cases. The higher wellhead prices are an indication that greater reliance on natural gas under the Kyoto Protocol could benefit some domestic energy producers.

To meet the required carbon emissions reductions, the mix of energy fuels consumed would change dramatically from that projected in the reference case (Figure 8). Relative price changes cause a reduction in coal and petroleum use, coupled with greater reliance on natural gas, renewable energy, and nuclear power (see Figures 9 through 13). Coal, with its high carbon content and relatively low end-use efficiency, is severely curtailed in the more stringent cases, replaced by more use of natural gas, renewable fuels, and nuclear power in electricity generation. Coal's share of generation is reduced from 52 percent in 1996 to 42 percent, 26 percent, and 15 percent in 2010 in the 1990+24%, 1990+9%, and 1990-3% cases. By 2020, coal is nearly