Energy Prices

One of our two primary conclusions is that, using only free market forces (e.g., no new policies), it will take a substantial increase in the price of energy produced from fossil fuels to provide sufficient incentives for the needed changes to technologies in some sectors and consumer

Projected carbon prices in the six target cases, 1996-2020

choices in all markets to reduce carbon emissions from domestic energy use to required levels for the cases analyzed. The price increase could come from a variety of approaches including a cap that restricts the use of carbon-based fuels, an auction of carbon permits, or a carbon tax.

Using prices based on the carbon content of each fuel as the mechanism for pricing carbon emissions, EIA estimates that the resulting carbon price would range between $67 and $348 a metric ton (1996 dollars) in the year 2010 in the six cases analyzed. Obviously, the price increase falls most heavily on the most carbon intensive fuels, particularly coal. These price signals generally would be sufficient to produce the fuel switching, efficiency gains, and reductions in the demand for energy services needed to reach the Kyoto target. The price range narrows to $99 to $305 by 2020, as the passage of time allows adoption of more cost effective measures in the more stringent cases, and continued economic growth with increasing energy demand making adaptation more difficult for the least stringent cases.

Estimates of the cost per ton to reduce carbon emissions have little meaning for many people. As a result, it is important to look at the impacts of the prices energy users actually pay. The price of a gallon of gasoline, for instance would increase an estimated 14 to 66 cents in 2010 (from a projected level of $1.25 per gallon). The price of electricity would be more heavily impacted, rising an estimated 20 to 86 percent over the baseline price in 2010 (a projected 5.9 cents per kilowatthour). This would equate to a 4 to 62 percent increase over current (1996) levels.

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Motor gasoline price in the reference and
six target cases, 1990-2020

All economic studies have concluded that higher prices will be needed, but our estimates tend to be higher than most other analyses, particularly during the transition period of 2005-2012.

Embedded Capital Stock. Both the equipment that generates energy and the equipment that consumes it have long useful lives. The existing stock of this equipment serves to slow very rapid adoption of advanced energy technologies, since it is usually expensive to install new (usually more energy efficient) equipment before the old is scheduled for replacement. Much of the capital stock purchased in 1999, (for example, buildings), will likely still be in use in the year 2010. If the useful life of existing stock did not serve as a barrier to rapid penetration of more efficient technologies, the price signal needed to encourage rapid changes in the way Americans

NEMS provides the most detailed portrayal of the capital stock that generates and consumes energy among the various models used to assess the cost of restricting fossil fuel use. While these differences may not be significant for longer term studies, the existing stock is a critical issue for studies focusing on the period 2008-2012. With its broader coverage of the relevant capital stock, NEMS provides, in our opinion, a more realistic picture of the opportunities and challenges to rapid, inexpensive gains in energy efficiency.

Consumer Responses to Change in Energy Prices. Two major issues in assessing the impact of restrictions on carbon emissions are

whether energy users require large or a small price signals to adjust their patterns of
energy consumption, and

whether they change behavior in anticipation of future price signals.

If small price signals are sufficient to change behavior, the response is considered elastic; if large price changes are required to generate a behavior change, the response is considered inelastic. In the real world, there is a whole range of elasticities, but whatever they net out to be, they have a big impact on the estimated price change needed to reduce carbon emissions from energy use.

If energy users change behavior in advance of actual changes in energy prices, they exhibit "foresight." If not, there is no immediate effect from the announcement (as opposed to the implementation) of new policies. Foresight allows more gradual adaptation and lowers the estimated cost of carbon emissions during the period of peak impacts.

Energy prices have been extremely volatile over the last twenty-five years. As a result, we have had many opportunities to see how energy consumers react to rising and falling prices. It is generally acknowledged that responses to changes in energy prices tend to be inelastic compared to other commodities. Energy is such a basic part of doing business and of the quality of life that energy consumers are reluctant to reduce sharply their need for energy services, even in the face of rapidly escalating prices. In addition, the slow turnover of energy capital stock makes it difficult to respond quickly to higher prices with fuel switching or the use of more efficient equipment. While ELA projections do not assume that the future will always be like the past, we have not seen any reason to believe that consumer response to price changes will become more elastic than those observed historically. While large price increases in the 1976-1986 period resulted in both efficiency improvements and shifts in the mix of goods produced, and approximately a 30-percent reduction in energy intensity, the period between 1986-1996 had stable energy prices and exhibited virtually no improvement to energy intensity.

We have also looked closely at the issue of foresight. We allow the impacts of a price signal to begin in 2005 for end-use markets and the electric, gas pipeline, and refinery industries to anticipate the price signal in decisions before 2005. Other sectors do not exercise foresight in our model. On balance, we believe this allows a reasonable treatment of foresight. In some other models, foresight occurs across all sectors and has already begun to influence energy decisions. Other phase-in periods (shorter, longer, earlier, later) could affect the transitional costs and the associated carbon prices, particularly the peak carbon prices.

Prices for Carbon Will Be Set by Marginal Costs. A number of reports tell of reductions in carbon emissions that can be achieved at very low cost (for instance, encouraging reforestation or improving energy efficiency in developing countries). In some cases, these reductions are already contained in the projections for the United States in the base (no new policies) projections in ELA's Annual Energy Outlook reference case. As a result, they represent no additional progress in meeting Kyoto Protocol requirements. In other cases, the reports do reflect efforts that go beyond the base case in cutting emissions and the costs are very low.

Even if options are available that are low cost and represent additional effort beyond the AEO base case, these options may have relatively little bearing on the price of carbon in a competitive environment. It is the cost of the last ton reduced, wherever in the world that occurs, that will set the price in a competitive market for carbon emissions reductions.

Comparing Models. Comparison of models can be a daunting task and is covered in some detail in Chapter 7 of our report. One simpler alternative is to compare them on the relationship between consumer behavior and the retail price of gasoline. In the EIA case where carbon emissions are restricted to 9 percent above 1990 levels in 2010, the projected average efficiency of new cars rises above the 30.6 miles per gallon in the base case to 33.6. However, because new cars make up only a small percentage of the entire fleet, the increase in overall average fuel efficiency is much lower. In addition, projected miles driven is 4.9 percent lower than in the base case. These changes are achieved with a price signal of a 30-cent increase in the cost of a gallon of gasoline. Someone who believes the price signal would not need to be as great probably thinks the EIA model is not elastic enough. Someone who thinks the signal would need to be greater probably thinks the EIA model is too elastic.

Impacts on the Macro Economy

Impacts on the macro economy are typically represented by effects on the Gross Domestic Product (GDP). We have portrayed these impacts two ways -- effects brought about through changes in the quantity of energy consumed within the economy, represented by changes in the Potential GDP; and transitional effects brought about when energy prices also change, represented by changes in the Actual GDP. To further illustrate how the transitional effects can be influenced by fiscal policy, we have analyzed each carbon constraint under two revenue recycling schemes. Therefore, for each of the six carbon reduction cases, there are three estimates of the effect on the Gross Domestic Product. Each of these estimates is portrayed as effects on the overall size of the GDP and effects on the annual percentage growth rate. Our major findings are:

In 2010, ELA estimates that the Gross Domestic Product will be $13 to $397 billion
($1992) smaller than in the reference case depending on the severity of the carbon target
and amount of transition costs, (i.e., using both Potential and Actual Gross Domestic
Product). This represents a projected reduction of between 0.1 percent and 4.2 percent
from the level expected otherwise. Even with the greatest impacts, however, the
economy is 30 percent larger than in 1996.

The growth rate of the Gross Domestic Product during the transition period 2005-2010 is estimated to be 2.0 percent per year in ELA's reference case. In the Kyoto Protocol

impact cases examined, the projected growth rate either remains at 2.0 percent or falls as low as 1.2 percent.

Projected potential and actual GDP annual growth rates,

Looking further ahead to 2020, ELA estimates that the projected Gross Domestic Product (actual or potential) will be $23 to $83 billion ($1992) smaller than the reference case. This equates to a drop of 0.2 percent to 0.8 percent from the level otherwise expected. In the case with the greatest impacts, the projected economy is still 56 percent larger than in 1996.

Over the longer period 2005 to 2020, actual GDP grows 1.6 percent per year in the EIA reference case. Because the economy rebounds after the transition, the long-run growth rate is virtually unchanged in all the cases. The dynamic and flexible nature of the U.S. economy, combined with appropriate fiscal and monetary policy, can mitigate a fairly large energy price shock with little effect on overall long-term economic growth.