Impacts on the Rall Industry (Continued)

the continued profitability of the Union Pacific, and of the Nation's major railroads in general. Even if these issues are successfully resolved over the next few years, the adoption of carbon emissions restrictions would inevita bly result in a reduction in domestic coal traffic handled by the railroads.

As suggested by the results of the carbon reduction cases. the reductions in coal traffic range from moderate to severe, depending on the case. In all cases, western coal, particularly subbituminous coal from the Powder River Basin, would be most severely restricted, because of its dependence on long-distance rail transportation to reach its markets in locations up to 2,000 miles away and its high ratio of carbon to energy content. As shown in the table, the Burlington Northern and Union Pacific systems have a fairly high dependence on coal freight revenue; therefore, the loss of revenue associated with carbon *Association of American Rallroads, Freight Commodity Statistics.

reduction measures could create significant financial problems for those firms. Lignite production in Texas, Louisiana, and North Dakota would also be severely reduced by carbon emissions restrictions, but the effect on rall revenues would be minor. Because of its inherently low heat content, lignite is predominantly consumed at or close to the place of mining.

Although the projected losses of coal production in the individual carbon reduction cases are proportionately and absolutely less for Appalachian coalfields than for the Powder River Basin, the two eastern rail systems (CSX and Norfolk Southern) are also highly dependent on coal revenue. In the more severe carbon reduction cases. Appalachian coal production could be reduced by onethird to one-half, with potentially serious financial conse quences for these carriers.

Objectives of the
Macroeconomic Analysis

Because energy resources are used to produce most goods and services, higher energy prices can affect the economy's production potential. Since the energy crisis of the 1970s, economic research has led to a better understanding of the potential adverse economic consequences of rising real energy costs, in terms of both longrun equilibrium costs and short-run adjustment costs. Long-run equilibrium costs are associated with reducing reliance on energy in favor of other factors of production-including labor and capital, which become relatively cheaper as energy costs rise. Short-run adjustment costs, or business cycle costs, can arise when price increases disrupt capital or employment markets. Longrun costs are considered unavoidable. Short-run costs might be avoidable if price changes can be accurately anticipated or if appropriate compensatory monetary and fiscal policies can be implemented.

This chapter assesses possible impacts on the economy associated with attaining the alternative carbon mitigation targets presented earlier in this report, focusing on three target cases-the 3-percent-below-1990 (1990-3%), the 9-percent-above-1990 (1990+9%), and the 24percent-above-1990 (1990+24%) cases-and comparing them with a reference case that does not include the Kyoto Protocol. In evaluating these alternative targets, three key questions are posed:

• What would be the unavoidable minimum impact on the economy?

• With rising energy prices and inflation, what cyclical reactions could the economy face, and how would the Federal Reserve Board implement accommodating monetary policy?

• What would be the impact of fiscal policy on economic output and inflation?

EIA used the Data Resources, Inc. (DRI) model of the U.S. economy to assess these issues." The DRI model is a representation of the U.S. economy with detailed output, price, and financial sectors incorporating both long-term and short-term properties. In the DRI model, the concept of potential GDP reflects the trajectory of the long-term growth potential of the economy at full employment, while actual GDP is a measure of the transition effects as the economy adjusts to its long-run path. Energy end-use demands and prices for fuels are the key energy inputs to the DRI model.79 In addition, for this analysis, assumptions were made about the domestic flow of funds that would result from a U.S. system of carbon permits sold by the Federal Government, and about the international flow of funds that would result from international trading of permits. These assumptions were based on the results of the energy market analyses described in the preceding chapters of this report.

This chapter first presents a discussion of the U.S. permit system and the potential role of international trading of permits. A summary of the macroeconomic effects is presented next, focusing on the definition and measurement of potential GDP, actual GDP, and the value of the purchased international permits as key elements. The chapter then discusses in detail two topics. The first addresses the unavoidable loss to the economy that would result from a reduction in available energy resources. The unavoidable loss has two components: the loss in potential GDP and the value of the purchased international permits. The chapter concludes with a discussion of the possible transitional impacts on the aggregate economy that might occur as energy prices increase in response to carbon emission constraints. The critical roles of monetary and fiscal policy are highlighted. Two fiscal policies are considered as alternative methods of returning carbon permit revenues to the economy: through a lump sum personal income tax rebate and through a social security tax rebate that would pass funds back to both employers and employees.

78 The version of the model used is US97A95.

The U.S.Permit System and
International Trading of Permits

Two key features shape the discussion in this chapterfirst, the characterization of the carbon permit trading system as an auction run by the Federal Government; and second, the international trading of carbon permits. Both of these issues have important implications for the assessment of the potential macroeconomic impacts of carbon mitigation policies.

The U.S. Permit System

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.

80

This analysis makes the explicit assumption that carbon permits will be sold in a competitive auction run by the Federal Government. To illustrate the importance of recycling the funds back to the economy, two fiscal policy approaches are considered: first, returning collected revenues to consumer through personal income tax rebates and, second, lowering the social security tax rate as it applies to both employers and employees. The two policies are meant only to be representative of a set of possible fiscal policies that might accompany an initial carbon mitigation policy.

International Trading of Permits

In the energy market assessments described earlier in this report, the projected carbon prices reflect the price the United States would be willing to pay to achieve a given emissions reduction target. The more stringent the carbon target, the higher the carbon price. The energy market analysis in this report 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 energ market assessment makes no link between the US car bon 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.

The macroeconomic analysis in this chapter depart from the above interpretation in order to facilitate an evaluation of the role of the purchase of permits in an international market. The analysis first assumes that the U.S. State Department's assessment of the accounting of carbon-absorbing sinks and offsets from reductions in other greenhouse gases will reduce the binding US emissions target to 3 percent below the 1990 level af emissions. Then, if the United States is to meet a target that is less stringent, the difference in emissions is assumed to be made up through the purchase of permits on the international market. Moreover, the United States is assumed to purchase international permits at the mar ginal abatement cost in the United States. Thus, the domes tic carbon price would be the same as the international permit price under the alternative targets considered li unrestricted international trading among Annex I coun tries is allowed, the international carbon price could fall below the levels projected here for domestic permits. Y this were to occur, to achieve equilibrium in an uncon strained market for carbon permits, the domestic carbon price would fall to the international carbon price.

The above assumptions imply that different international supplies of permits would be available in the alternative cases considered. This is an important simplifying assumption, and the value placed on the overseas transfer of funds to purchase international permits is subject to considerable uncertainty. However, this element must be considered a key factor in performing any assessment of the impacts on the economy, and therefore it is explicitly factored into the analysis. Table 25 shows the assumed carbon reductions, carbon prices, and number and value of carbon emission permits purchased on the international market in the 1990-3%, 1990+9%, and 1990+24% cases.

Summary of

Macroeconomic Impacts

In the long run, higher energy costs would reduce the use of energy by shifting production toward less energy intensive sectors, by replacing energy with labor and

capital in specific production processes, and by encouraging energy conservation. Although reflecting a more efficient use of higher-cost energy, this gradual reduction in energy use would tend to lower the productivity of other factors in the production process. The derivation of the long-run equilibrium path of the economy can be characterized as representing the "potential" output of the economy when all resources-labor, capital, and energy-are fully employed. As such, potential gross domestic product (GDP) in the DRI model is equivalent to the full employment concept calculated in a number of other models that focus on long-run growth while abstracting from business cycle behavior.

The ultimate impacts of carbon mitigation policies on the economy will be determined by complex interactions between elements of aggregate supply and demand, in conjunction with monetary and fiscal policy decisions. As such, cyclical impacts on the economy are bound to be characterized by uncertainty, possibly significant. Raising energy prices and, as a result, downstream prices in the rest of the economy could introduce cyclical behavior in the economy, resulting in employment and output losses in the short run. The measurement of losses in actual output for the economy, or actual GDP, incorporates the transitional cost to the aggregate economy as it adjusts to its long-run path. Resources may be less than fully employed, and the economy may move in a cyclical fashion as the initial cause of the disturbance-the increase in energy prices-plays out over time.

The possible impacts on the economy are summarized in Table 26, which shows average changes from the reference case projections over the period from 2008

through 2012 in the three carbon reduction analysis cases. The loss of potential GDP measures the loss in productive capacity of the economy directly attributable to the reduction in energy resources available to the economy. It represents part of the long-run, unavoidable impact on the economy. The macroeconomic adjustment cost reflects frictions in the economy that may result from the higher prices of the carbon mitigation policy. It recognizes the possibility that cyclical adjustments may occur in the short run. The loss in actual GDP for the economy is the sum of the loss in potential and the adjustment cost. The purchase of international permits represents a claim on the productive capacity of domestic U.S. resources. Essentially, as funds flow abroad, other countries have an increased claim on U.S. goods and services. The total cost to the economy is represented by the loss in actual GDP plus the purchase of international permits (Figure 110). These costs need to be put in perspective relative to the size of the economy, which is projected to average $9,425 billion between 2008 and 2012 in the reference case.

Another way to view the macroeconomic effects is by looking at the effects of the carbon reduction cases on the growth rate of the economy, both during the period of implementation and during the early part of the commitment period, from 2005 through 2010, and then over the entire period from 2005 through 2020 (Figures 111 and 112). In all instances, the economy continues to grow, but growth is slower than projected in the reference case. In the reference case, potential and actual GDP grow at 2.0 percent per year from 2005 through 2010. In the 1990+9% case, the growth rate in potential GDP slows to 1.9 percent per year, and the growth rate in actual GDP slows to 1.6 percent per year when the