The role of developing countries is another area of uncertainty for international activities. In July 1997, the Senate unanimously passed the Byrd-Hagel resolution, sponsored by Senators Robert Byrd of West Virginia and Chuck Hagel of Nebraska, resolving "that the United States should not be a signatory to any protocol to, or other agreement regarding, the United Nations Framework Convention on Climate Change... which would mandate new commitments to limit or reduce greenhouse gas emissions for the Annex I Parties, unless the protocol or other agreement also mandates new specific scheduled commitments . . . for Developing Country Parties within the same compliance period or would result in serious harm to the economy of the United States." President Clinton has declared on several occasions that he will not submit the Protocol for ratification without pledges of meaningful participation by developing countries. While participation by developing countries may be key to the acceptance of the Protocol, development of specific guidelines and rules for the international programs has been deferred, including the means to establish baseline projections and to monitor and verify emissions reductions.

There is also a possibility that investments to reduce carbon emissions in developing countries could be limited. First, such bilateral ventures may be viewed as substitutes for or additions to foreign aid, a political concern to both the United States and developing countries. Also, it is possible that the continuing discussions about the Implementation of the Protocol will raise the topic of trade limits-restrictions on the amount of reductions that any one country can satisfy through international programs. The Protocol states that such activities are to be supplemental to domestic actions. In the views of some countries, there is a potential problem with certain nations undertaking little internal action.

Because the potential impacts of forestry and agricultural sinks, offsets from other greenhouse gases, international trading, and other international activities are uncertain, a single target for the required reductions in energy-related carbon emissions in the United States cannot be developed at present. This analysis includes a number of cases, as requested by the Committee, assuming different levels of reductions in energy-related carbon emissions, in order to develop the energy and economic impacts of achieving those reductions. By establishing this range of carbon reductions, the analysis allows others to perform their own analyses of the impacts of sinks, offsets, and international programs, derive their own targets for energy-related carbon emissions, and use one of the EIA target cases to assess the energy and economic impacts of the carbon reductions in that case.

In addition to a reference case, six targets for reductions in energy-related carbon emissions are considered.

Reference Case (33 Percent Above 1990 Levels). This case represents the reference projections of energy markets and carbon emissions without any enforced reductions and is presented as a compari son for the energy market impacts in the reduction cases. Although this reference case is based on the reference case from AEO98, as specified by the Com mittee, there are small differences between this case and AEO98. Some modifications were made in order to permit additional flexibility in NEMS in response to higher energy prices or to include certain analyses previously done offline directly within the modeling framework, such as nuclear plant life extension and generating plant retirements. Also, some assump tions were modified to reflect more recent assess ments of technological improvements and costs. Significant changes to NEMS and its assumptions relative to AEO98 are noted in Appendix A. As a result of these modifications, the projections of car bon emissions in the reference case for this analysis are slightly lower than those in the AEO98 reference case-1.791 million metric tons in 2010 compared with 1,803 million metric tons. The carbon emissions projections in the reference case, as well as in all the carbon reduction cases, include ELA's estimate of the impacts of CCAP.

• 24 Percent Above 1990 Levels (1990+24%). This case assumes that carbon emissions can increase to an average of 1,670 million metric tons in the commit ment period 2008 to 2012, 24 percent above the 1990 levels, but 122 million metric tons below the average emissions in the reference case during that period.

⚫ 14 Percent Above 1990 Levels (1990+14%). This case assumes that carbon emissions in the commitment period average 1,539 million metric tons, which is approximately the level estimated for 1998 in AE098 and is 14 percent above 1990 levels. This requires the average annual carbon emissions between 2008 and 2012 to be reduced by 253 million metric tons.

⚫9 Percent Above 1990 Levels (1990+9%). This case assumes that energy-related carbon emissions can reach an average of 1,467 million metric tons in the commitment period, 9 percent above 1990 levels, an average reduction of 325 million metric tons from the reference case projection.

• Stabilization at 1990 Levels (1990). This case assumes that carbon emissions are stabilized approximately at the 1990 level of 1,346 million met ric tons, averaging 1,345 million metric tons during

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the commitment period, a reduction of 447 million metric tons from the reference case.

• 3 Percent Below 1990 Levels (1990-3%). This case assumes that energy-related carbon emissions are reduced to an average of 1,307 million metric tons in the commitment period. A reduction of 485 million metric tons from the reference case level is required. • 7 Percent Below 1990 Levels (1990-7%). In this case, energy-related carbon emissions are reduced to an average of 1,250 million metric tons in the commitment period, a reduction of 542 million metric tons from the reference case projection. This case essentially assumes that energy-related carbon emissions must meet the 7-percent target in the Kyoto Protocol with no net offsets from sinks, other greenhouse gases, or international activities.

Reductions in both the 1990-3% and 1990-7% cases would likely come from domestic actions only. The reductions in the other carbon reduction cases imply some international trade in carbon permits, CDM activity, or joint implementation projects, but this analysis does not address the shares that might result from international and domestic actions.

In each of the carbon reduction cases, the target is achieved on average for each of the years in the first commitment period, 2008 through 2012, in accordance with the Kyoto Protocol. The Protocol provides the flexibility for the target to be achieved on average over the 5year commitment period, to accommodate short-term fluctuations that might occur, such as severe weather or unanticipated economic growth. Because the Protocol does not specify any targets beyond the first commitment period, the target is assumed to hold constant from 2013 through 2020, the end of the NEMS forecast horizon. This assumption may be optimistic in that the possibility of further reductions has been advocated.

The target is assumed to be phased in over a 3-year period, beginning in 2005; that is, one-fourth of the reduction is imposed in 2005, one-half in 2006, and three-fourths in 2007. This analytical simplification allows energy markets to begin adjustments to meet the reduction targets in the absence of complete foresight, although a longer or delayed phase-in may lower the adjustment cost. Phase-in is also consistent with the requirement in the Protocol that countries achieve demonstrable progress toward the reductions by 2005; however, reductions prior to the commitment period are not credited against the required reductions.

Given the scope and potential costs of compliance with the reduction targets of the Protocol, there is a possibility that consumers might react differently-either taking more immediate action or waiting. Consumers could begin to modify their energy decisions even before the

3-year phase-in period, either in anticipation of future price increases or because of a national commitment to reduce greenhouse gases. On the other hand, it is possible that consumers could delay actions either until or beyond energy price changes, taking a cautionary approach to the magnitude and duration of price increases or even anticipating a reversal of policy.

Although each of the six reduction cases is modeled using NEMS, the analysis in this report focuses on three of the cases, the 1990+24%, 1990+9%, and 1990-3% cases. Three cases are chosen in order to keep the subsequent presentation and discussion of the results manageable. particularly since many of the basic trends are the same across the reduction cases, varying only in the magnitude of the impact. Where there are specific trends to note in any of the other cases, they are included in the appropriate section of this report. The full results of each of the cases are presented in Appendix B, and results across all cases are presented graphically, where practical. Any of the reduction targets may be plausible; however, it is likely that some mitigation of the 7-percent target will be achieved through a combination of offsets from forestry and agriculture, reductions in other greenhouse gases, international trading, and other flexible international mechanisms.

Carbon Prices

Each of the carbon reduction targets is achieved by assuming that a carbon price is applied to the cost of energy, which could result from a carbon emissions permit system. The carbon price is applied to each of the energy fuels at its point of final consumption relative to its carbon content. Imported energy products receive the same carbon price at the point of consumption, but no carbon price is levied on other imported products. Of the fossil fuels, coal has the highest carbon content. Natural gas produces about half the carbon emissions of coal per unit of energy content. Average emissions from petroleum products are between those for coal and natural gas. Nuclear generation and renewable fuels produce no net carbon emissions. As an example, the carbon emissions factors and energy costs for a hypothetical carbon price of $100 dollars per metric ton are shown in Table 1.

Electricity produces no carbon emissions at the point of use; however, its generation currently produces about 35 percent of the total carbon emissions in the United States. The carbon price is applied to the fuels used to generate electricity, and the higher prices are reflected in the delivered price of electricity.

Placing a value on the carbon released during the combustion of fossil fuels affects energy consumption and emissions in three ways. First, consumers may reduce the demand for energy services by driving less, reducing the use of appliances, or shifting to less energy-intensive

goods and services, as examples. Second, more energy. efficient equipment may be chosen, reducing the amount of energy required to meet the demand for energy services. Finally, there may be a shift to noncarbon or less carbon-intensive fuels, reducing the carbon released per unit of energy consumed.

In the energy market analysis in this report, the carbon prices represent the marginal cost of reducing carbon emissions to the specified level or, conversely, the value of consuming the last metric ton of carbon. Although there may be a number of easy, low-cost options for reducing energy use and emissions, higher levels of reductions will require more expensive investment and changes in patterns of energy demand. The projected carbon prices reflect the price that the United States would be willing to pay to achieve a given emissions reduction target. The energy market analysis does not address the international implications of achieving a particular target at the projected carbon price. In the absence of modeling international trade of emissions permits, the energy market analysis makes no link between the U.S. carbon price and the international market-clearing price of permits, or the price at which other countries would be willing to offer permits for sale in the United States.

Carbon prices, or similar mechanisms, are used by most analysts in assessing the implementation and impacts of the Kyoto Protocol or other emissions reduction targets, such as carbon stabilization. Carbon prices are used because they effect all three ways of reducing emissions-demand reduction, improved efficiency. and fuel switching-and may be the most efficient mechanism. Estimates of the carbon price necessary to achieve reductions vary widely. Lower estimates are suggested by those who assume that there are a number of low-cost options to reduce energy use or to shift to low-carbon or noncarbon fuels that are readily available and will be quickly adopted with higher energy prices. Higher estimates are suggested by analysts who think that the effective price of carbon-intensive fuels will have to be raised significantly to encourage changes in consumer choices and the development of additional alternative technologies.

The projected energy market costs in this study repr sent only the marginal cost of reducing energy-relan: carbon emissions and do not reflect other costs the could occur as a result of business cycle fluctuation capital constraints, or implementation of emission reductions through less efficient mechanisms. No cost are included for damage or adaption to potential climat change. In addition, no benefits for avoided damage of other ancillary benefits are included, unlike some analy ses that represent the net cost of emissions reductions net of benefits.

Macroeconomic Analysis

EIA analyzes the macroeconomic impacts of the carbon reduction cases using the Data Resources, Inc. DRE Macroeconomic Model of the U.S. Economy. The D Model is a representation of the U.S. economy with detailed output, price, and financial sectors, incorporsi ing gradual adjustment of the economy to policy changes. Macroeconomic models focus on adjuster processes of the economy associated with changing mar ket conditions, including economic policies. Real-world economic behavior involves adapting to changes in car ditions of supply and demand, which can lead to disiecations and less than optimal use of resources in the short run. Short-run movements in actual income are

portrayed against projected long-run levels of potential

output.

The linkage between the DRI macroeconomic model and NEMS is a set of energy variables. Twenty-seven energy variables in the DRI macroeconomic model are directly related to similar NEMS variables by ensuring that the DRI variables show the same percentage change from the baseline as the NEMS variables. These energy vari ables include energy prices, energy production, and energy consumption by different end uses, and the revenue from auctioned carbon permits. Energy prices include world oil prices; residential heating oil, electricity, and natural gas prices; transportation fuel prices for both diesel and gasoline; residual fuel oil prices, average refined oil price; wellhead natural gas price; and industrial coal and electricity prices. Coal, natural gas, and crude oil production from NEMS is used in the DRI

macroeconomic model as well as the end-use demand for oil, natural gas, electricity, and coal.

Energy prices and end-use demands for fuels are the key energy inputs, along with the level of auctioned carbon revenues, because energy prices affect inflation, and the end-use fuel demand represents energy in the DRI aggregate production function, which describes the supply potential of the economy. The amount of auctioned carbon revenue dictates how much energy consumers can expect to receive as rebated revenue, which in turn affects disposable income. Changes in the values of these variables relative to the reference case would have major impacts on the macroeconomy.

When a system is developed for the trading of carbon permits within the United States, a number of initial decisions must be made: How many permits will be available? Will they be freely allocated or sold by competitive auction? If they are allocated, how will the initial allocations be made? If they are sold, what will be done with the revenues? How many permits will be bought in international markets? If the permits are traded in a free market, holders of permits who can reduce carbon emissions at a cost below the permit price will sell their permits, and those with higher costs of reduction will buy permits, resulting in a transfer of funds between private parties. If the permits are sold by competitive auction, there will be a transfer of funds from emitters of carbon to the Federal treasury. This analysis makes the explicit assumption that the permits will be sold in a competitive auction run by the Federal Government 19

The macroeconomic analysis in Chapter 6 considers the flow of funds overseas that would be represented by international purchases of carbon permits, explicitly assuming that the carbon price determined in the NEMS model is the international price at which permits would be traded. Although the U.S. target established by the Protocol is a 7-percent reduction in greenhouse gas emissions relative to 1990 levels, the method of accounting for sinks and the flexibility to use 1995 as the base year for the synthetic greenhouse gasses may mean that the reduction would be no more than 3 percent below 1990 levels, according to the U.S. State Department. The differences between the reduction level in the 1990-3% case and the reductions in the cases with higher levels of energy-related carbon emissions are assumed to be met by permits purchased in the international market at the carbon price calculated for each case.

Many analyses of carbon mitigation have used a class of models that are characterized as computable general equilibrium (CGE) models. The CGE structure focuses on the interconnectedness of the economy and calculates the equilibrium of the economy in the long term, abstracting from the short-run adjustment processes. Most often the time horizon of these models is much longer-20, 50, or 100 years into the future. In contrast, the DRI macroeconomic model used in this analysis focuses on the adjustment of the economy over time, allowing for dislocations within the economy that yield less than optimal levels of economic activity. While climate change can arguably be considered a long-run phenomenon, the policies and measures to induce change may take effect in a near-term horizon.

Chapter 7 gives a more detailed comparison of the similarities and differences in the alternative model structures and results. Models of both types can contribute to the assessment of the possible impacts on the economy of greenhouse gas reduction. However, past analyses of the issue using CGE and macroeconomic models have often disagreed with each other over the concepts of the full employment GDP of the CGE models and the actual GDP measure presented in the macroeconomic models. Potential GDP is a concept calculated within the DRI Model but rarely presented as an output measure. The discussion in Chapter 6 considers the alternative views and introduces the concept of potential GDP into the discussion of the economic impacts of the Protocol.

International Energy Markets

The focus of the analysis is U.S. energy markets; however, changes in international markets may have a significant influence on the United States. In particular, crude oil and petroleum products constitute an international market, and the world price of oil has a strong impact on consumption and production of oil in the United States. Conversely, U.S. demand for and production of oil affects the world price of oil. The feedback of U.S. oil markets on international markets is represented within the NEMS framework. World oil prices are determined by means of a price reaction function, assuming that the Organization of Petroleum Exporting Countries will expand oil production capacity to meet world oil demand.

For this analysis, it is assumed the other Annex I countries will reduce their consumption of oil in order to help meet their reduction targets. Each country is assumed to

reduce its oil demand by the same percent that the United States reduces oil demand from the reference case level. Oil consumption in non-Annex ! countries is assumed to respond to changes in the world price of oil with no additional reactions as a result of carbon reduc tion policies.

Coal exports are a significant portion of US coal production, with exports going to both Annex I and nonAnnex I countries. Because Annex I countries must reduce carbon emissions, it is assumed that coal production and imports in Western Europe and coal imports in Japan would be reduced and that coal consumption in those countries would be reduced by more than their emissions reductions in the Protocol. In the target cases where U.S. carbon emissions are allowed to rise above 1990 levels in 2010, US. steam coal exports to Europe in 2010 are assumed to be lower by 16 million tons, and exports to Asia are 4 million tons lower than in the reference case. In the more stringent target cases, exports to Europe and Asia are 26 and 7 million tons lower, respectively, in 2010.

As a result of the Kyoto Protocol, energy prices in the Annex I countries may be higher than in the non-Annex I countries, which do not have emissions reduction targets in the Protocol. As a result, it is possible that more energy-intensive industries could shift from those countries with higher energy costs. Energy-intensive industries also may face reduced demand as consumers shift their consumption patterns to less energy-intensive goods and services. Consequently, the composition of U.S. industrial output is likely to change toward the less energy-intensive industries. Because this analysis does not cover international energy markets, international trade, or the international activities of the Protocol, a complete analysis of potential changes in U.S. industrial output is not possible (for discussion, see the box on *Industrial Composition" in Chapter 3).

Sensitivity Cases

A number of factors combine to determine the NEMS projections of energy consumption and carbon emissions. Typically, AEO explores a wide range of cases that vary the reference case assumptions on economic growth, world oil markets, technology improvement, and potential regulatory changes. In this analysis, a variety of sensitivity cases are used to examine the factors that have the most significant impacts on energy demand and carbon emissions. With the exception of the nuclear power sensitivity case, all the sensitivity cases are analyzed relative to the 1990+9% case.

Low and High Economic Growth

These cases analyze the effects of different assumptions about U.S. economic growth. The AEO98 reference case

assumes that the output of the Nation's econoEN. DER ured by GDP, will increase by an avena fi year between 1996 and 2000. The same assumpoor s used in all the carbon reduction cases a sma although there is a feedback within the NEXồ he work that alters the baseline economic assumptes sa result of changes in energy prices. Therefore, a es sions reductions become more stringent and the resul ing carbon prices become higher, there wi reduction in economic growth.

In order to reflect the uncertainty in potential economi growth, AE098 included high and low econont growth cases. The same alternative assumptions an used in this analysis. The high economic growth as includes higher population, labor force, and labor preductivity, resulting in higher industrial output lower inflation, and lower interest rates. As a result, the GOP increases at an average rate of 2.4 percent a year through 2020. The opposite assumptions in the low econorar growth case lead to an average annual growth rate di percent.

Low and High Technology

These sensitivity cases examine the effects of assump tions about the development and penetration of energy consuming technologies on the analysis results. The reerence cases in this analysis and in AEO98 include continued improvement in technologies for both energ consumption and production-for example, improve ments in building shell efficiencies for both new and existing buildings; efficiency improvements for new appliances: productivity improvements for coal production; and improvements in the exploration and devicoment costs, finding rates, and success rates for oil and gas production. Additional technology improvements in the end-use demand sectors and in the electricity generation sector could reduce energy consumption and energy-related carbon emissions below their projected levels in the reference case. Conversely, slower improve ment than that assumed in the reference could raise both consumption and emissions.

AEO98 presented alternative cases that varied key assumptions concerning technology improvement and penetration in the end-use demand and electricity generation sectors. This analysis uses the same low technology assumptions for a low technology sensitivity, in the residential and commercial sectors, it is assumed that all future equipment purchases will be made only from the equipment available in 1998 and that building shell eff ciencies will be frozen at 1998 levels. Similarly, in the transportation sector, efficiencies for new equipment are fixed at 1998 levels for all travel modes. In the industria sector, plant and equipment efficiencies are fixed at 1998 levels. No new advanced generation technologies are assumed to be available during the projection period.