Introduction Charles River Administration Assumptions Administration estimates of the cost of implementing the Kyoto Protocol are based on a number of important assumptions, including the ability to develop a global emissions trading system. Although the Protocol authorized emissions trading among Annex I (industrialized) countries, the nature of the emissions trading system and any limitations on the sale or use of purchased emissions permits were left to future negotiations. Moreover, the Protocol does not come into force until at least 55 countries--including Annex I countries responsible for 55% of 1990 carbon emissions--sign and ratify the Protocol. The United States has not yet signed the agreement, and the Clinton Administration has said that the agreement will not be submitted for Senate ratification unless there is meaningful participation by developing countries in a worldwide scheme to reduce greenhouse gas emissions. The Administration is also clearly counting on securing the cooperation of key developing and developed countries in an unrestricted, worldwide emissions trading system. This may be a difficult task. A global emissions trading regime has never existed before, so some countries, such as Japan, are naturally cautious. Other countries, in particular the European Union, have made policy statements that appear inconsistent with the U.S. position. The United States favors unrestricted emissions trading, advocates inclusion of developing countries in such a system, and supports the intentions of Russia to market its anticipated excess of emissions permits in a fashion that would allow global emissions totals to increase. The U.S. position is in line with what most analysts believe to be the minimum requirements for an economically efficient trading regime. The European Union has recommended limiting the amount of permits a country could purchase to meet its emissions reduction target. EU members also object to the sale of excess permits by Russia and other countries. Moreover, developing countries have made it clear that they have no intention of joining an emissions trading system under the Kyoto Protocol. Recent Testimony In March 4 testimony before the Senate Foreign Affairs Committee, Dr. Janet Yellen, chair of the President's Council of Economic Advisers, presented the Administration's views on the cost of implementing the Protocol if the United States achieves all of its goals in future negotiations. Her estimates assume that the United States will convince other countries to create a comprehensive, global, and unconstrained emissions trading system that includes developing nations. Dr. Yellen's estimates constitute, in a sense, the best-case analysis for the United States, and are considerably lower than those in other recent studies, including work underway at Charles River Associates (CRA). Understanding how responsible professionals can arrive at sharply different estimates of the same policy challenge is important. Fortunately, Dr. Yellen described in detail her assumptions regarding emissions trading, energy efficiency, and other cost-reducing factors. The differences between Dr. Yellen's analysis and other studies can be explained by honest and understandable Charles differences in these key assumptions. For example, in her testimony, Dr. Yellen said that fully implementing the Kyoto agreement would result in a direct cost to the 2010 U.S. economy of between $7 billion and $12 billion (19978). This figure represents about 0.1% of GDP in 2010, and would add between $70 and $110 annually in energy costs for the average American family. Dr. Yellen also estimated a price for carbon emissions permits of $14 to $23 per metric ton in 2010. Dr. Yellen's cost and carbon permit estimates are based on a set of extremely optimistic assumptions, including unrestricted global emissions trading and rapid replacement of coal with natural gas in electric utilities over the next 10 years. On the other hand, none of these estimates include credit for reductions in other greenhouse gases or credit for creating carbon "sinks" that might somewhat reduce costs in an extended analysis. Dr. Yellen also stated that her cost estimates were based on the Second Generation Model (SGM), developed by Pacific Northwest National Laboratories. Although the SGM is a highly respected integrated assessment model, it has severe limitations for use in analyzing near-term economic impacts. In particular, the model reports only direct costs in energy markets, leaving out impacts on other markets and sectors of the economy that are included in virtually every other economic model used to analyze climate change policies. In its favor, the SGM is well documented and open to scrutiny, so that it is possible to identify the specific assumptions behind the reported cost estimates, and so to reconcile the estimates from the SGM with estimates from other economic models. Thus, it is possible to use other models to derive an estimate of overall economic impacts consistent with the direct cost reported by SGM and by Dr. Yellen in her March 4 testimony. Adjustments to the CRA Model When we introduce all of Dr. Yellen's assumptions into the CRA model, we get the same estimates of permit prices and direct costs as a starting point. But these assumptions and resulting estimates are extremely optimistic. The first necessary correction is to identify the impact of the Protocol on the entire U.S. economy, not just the direct costs of energy. When this is done, estimates of GDP loss, in our model and virtually any other complete model of the economy, produce impacts that are significantly higher than the estimates of direct cost provided by Dr. Yellen. The second change involves estimating costs under different assumptions about fuel switching and under an emissions trading program consistent with the position of other countries. When these adjustments are made, U.S. costs to implement the Kyoto Protocol rise to ten times the amount Dr. Yellen estimates. In light of the current positions of other countries participating in the ongoing negotiations, this “adjusted" emissions trading scenario is at least as realistic as that assumed by Dr. Yellen. It assumes that developing countries do not participate in international trading; Russia is allowed to sell only permits generated by reducing emissions below baseline levels; and utilities are not able to replace all or almost all of their coal-fired powerplants with natural gas by 2010. Under these conditions, U.S costs would be about 1.1% of 2010 GDP, or Charles The outcome would be even more costly if Russia restricts its sale of permits to take advantage of its position as the sole seller under Annex B trading, or if the economy-wide price increases caused by higher energy prices result in a tightening of monetary policy and a further slowdown of the economy. If no internationally tradable permit system is implemented, the U.S. price of emissions permits would be $295 per metric ton under CRA's assumptions, and $203 per metric ton when Administration assumptions are used. Baseline Emissions The U.S. Energy Information Administration's (EIA) most recent forecast is that the United States will exceed the Kyoto limit of 7% below 1990 levels of carbon dioxide equivalent by 550 million metric tons of carbon in 2010. Table 1 reproduces EIA estimates of projected carbon emissions and Kyoto limits for the relevant global regions. Table 1 Carbon Emissions in the Annex I Countries, 1990 and 2010, Includes Non-Annex 1 Countries. IEO98 does not project emissions for separate countries within the EE/FSU region; however, Annex I countries in the EE/FSU region currently account for about 87 percent of the region's total emissions. Source: Energy Information Administration, International Energy Annual 1996 DOE/EIA-0219(96) (Washington, One of the subjects to be dealt with in future negotiations is how other greenhouse gas sources and sinks will be accounted for. Dr. Yellen cites Administration estimates to the effect that the Kyoto agreement will only require the U.S. to reduce its carbon dioxide emissions to 2 to 3% below 1990 levels when sinks are included in the baseline (see State Department briefing materials). However, in testimony before the House Subcommittee on National Economic Growth, Natural Resources, and Regulatory Affairs on May 19, 1998, Dr. Yellen stated that her calculations gave no credit for emissions reductions from sinks. Therefore, we take the ELA Charles Associates estimate of 550 million metric tons2 as the starting point for the calculations outlined in Dr. Yellen's testimony. Emissions Trading Among Developed Countries In her testimony, Dr. Yellen outlined two alternative international emissions trading programs and indicated these would reduce direct costs to the United States by 50% to 70%. These trading programs involve industrialized countries only. The first involved unlimited trading among all Annex B countries, including countries The second, referred to as the "Double Bubble” or “Umbrella Trading," assumes that the European Union will not engage in emissions trading with other Annex B countries, because of the prior establishment of an "EU Bubble" and allocation of the EU emissions limit among the EU members. The remainder of the Annex B countries would form a second bubble, trading only among themselves. The Administration estimates that this approach could cut direct costs by as much as another 40%, or up to 70% in total. Additional background is needed to fully understand the Administration's underlying assumptions. In particular, umbrella trading would lower permit prices because it gives the U.S. favored access to low-cost permits from the former Soviet Union. Russia and the Ukraine are important sources of emissions permits, because their emissions in 2010 are projected by the DOE to be about 200 million tons below their emissions in 1990 (see Table 1 above). The collapse of the economies of Russia and other formerly centrally planned economies, plus more rational use of energy as they abandon subsidized pricing and move to market prices, leads to a projected drop in their emissions with no additional effort or cost. The Administration assumes that Russia and the Ukraine will sell these excess emissions permits freely, and that the supply of excess permits will depress the international price. However, Russia also could bank the excess permits for their own later use, thus reducing the availability of permits during the 2008-2012 budget period, or restrict sales to gain a higher price. How much the supply of Russian permits will affect the international price of permits depends on the extent to which other Annex I countries bid up the price of Russian permits. In the Double Bubble option, with emissions trading limited to the non-EU countries, there are fewer countries bidding for Russian permits, and therefore the international price of permits is lower 2 The CEA accounts for other greenhouse gases, but since Dr. Yellen's testimony does not explicitly state how other gases are treated, 550 metric tons is a best guess of what her starting point must be. This assumption essentially treats the inclusion of other gases as neutral. Charles than in the full Annex I trading case. This is responsible for the higher range of reductions assumed by Dr. Yellen in the bubble trading case, an additional 40% over the full Annex I trading case. Emissions Trading With Developing Countries Introducing emissions trading with developing countries, if they were one day to come under the Kyoto Protocol, would reduce permit prices further. The Administration estimates an additional 55% reduction in cost, over and above that achievable with Annex I trading, from inclusion of all developing countries in a comprehensive global trading system. Summary Calculations Taking all of the Administration's reputed savings at face value, the total cost reduction (without double counting) of implementing the Kyoto Protocol could be as much as 77.5% to 86.5%. Annex I trading cuts costs by 50%. Extending that to the rest of the world results in an additional 55%, or 77.5% in all. And in the Double Bubble case, costs are reduced another 40%, or 86.5% in all. It is necessary to follow this train of reasoning backwards to reconstruct the Administration's presumed starting point, or estimate of permit prices and direct cost with no trading. According to discussions with CEA staff, the percentage cost savings in Dr. Yellen's testimony refer to reductions in cost, not permit prices. It is straightforward to estimate the costs that the Administration would have calculated for Annex I and no trading cases. This calculation is given in Table 2 below. Removing the 40% saving from umbrella trading increases cost from $7 billion in 2010 to $12 billion. Removing the 55% saving from global trading increases the cost to $27 billion, and removing the 50% saving from Annex I trading gives a starting point, for the cost to the United States with no international emissions trading, of $53 billion. In order to calculate the permit price, it is necessary to apply the formula used by the Administration to relate direct costs to permit prices. That formula is derived from the SGM, discussed below. Direct cost equals one-half the permit price times the reduction in emissions plus the permit price times the number of permits purchased internationally. Thus, in order to calculate the permit price, we need, in addition to our estimate of direct cost, an estimate of the amount of permits purchased overseas. This estimate is provided by the SGM. The results of these calculations are given in Table 2 below. A permit price of $193/metric ton is consistent with a direct cost of $53 billion and no international emissions trading. Permit prices for Annex I trading, global trading, and global trading with the "Double Bubble" are calculated using estimates of U.S. purchases of permits from the SGM. The results for permit prices under global trading fall within the range of prices reported by the Administration in March 4 testimony. All these prices and costs are in 1997 dollars, requiring an adjustment in results from the SGM and CRA models, which report costs in 1992 dollars. |