10 climate stavins

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HAMILTONTHE

PROJECT

Advancing Opportunity,

Prosperity and Growth

The Brookings Institution

A U.S. Cap-and-TradeSystem to AddressGlobal Climate Change

D I S C U S S I O N P A P E R 2 0 0 7 - 1 3 O C T O B E R 2 0 0 7

Robert N. Stavins


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The Haiton Project sees to advance Aericas proise o

opportunit, prosperit, and groth. The Projects econoic

strateg reects a judgent that ong-ter prosperit is best

achieved b aing econoic groth broad-based, b

enhancing individua econoic securit, and b ebracing a

roe or eective governent in aing needed pubic

investents. Our strategstriing dierent ro the

theories driving econoic poic in recent earscas or fsca

discipine and or increased pubic investent in e groth-

enhancing areas. The Project i put orard innovative

poic ideas ro eading econoic thiners throughout the

United Statesideas based on experience and evidence, not

ideoog and doctrineto introduce ne, soeties

controversia, poic options into the nationa debate ith

the goa o iproving our countrs econoic poic.

The Project is naed ater Aexander Haiton, the

nations frst treasur secretar, ho aid the oundation

or the odern Aerican econo. Consistent ith the

guiding principes o the Project, Haiton stood or sound

fsca poic, beieved that broad-based opportunit or

advanceent oud drive Aerican econoic groth, and

recognied that prudent aids and encourageents on the

part o governent are necessar to enhance and guide

aret orces.

HAMILTONTH E

PROJECT


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The Brookings Institution

OCTOBER 2007

HAMILTONTHE

PROJECT

A U.S. Cap-and-Trade System to

Address Global Climate Change

Robert N. StavinsHarvard University

National Bureau o Economic Research

This discussion paper is a proposal rom the author. As emphasized in The Hamilton Projects

oriinal stratey paper, the Project is desined in part to provide a orum or leadin thiners

rom across the nation to put orard innovative and potentially important economic policy ideas

that share the Projects broad oals o promotin economic roth, broad-based participation in

roth, and economic security. The authors are invited to express their on ideas in discussion

papers, hether or not the Projects sta or advisory council aree ith the specic proposals.

This discussion paper is oered in that spirit.


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A U.S. CAp-And-TrAde SySTem To AddreSS GlobAl ClimATe ChAnGe

2 THE HAMILTON PROJECT|

THE BROOkINgS INSTITUTION

Copyriht 2007 The Brooins Institution

Astact

The need or a domestic U.S. policy that seriously addresses climate change is increas-

ingly apparent. A cap-and-trade system is the best approach in the short to medium term.

Besides providing certainty about emissions levels, cap-and-trade oers an easy means o

compensating or the inevitably unequal burdens imposed by climate policy; it is straight-orward to harmonize with other countries climate policies; it avoids the current political

aversion in the United States to taxes; and it has a history o successul adoption in this

country. The paper proposes a specic cap-and-trade system with several key eatures

including: an upstream cap on CO2 emissions with gradual inclusion o other greenhouse

gases; a gradual downward trajectory o emissions ceilings over time to minimize dis-

ruption and allow rms and households time to adapt; and mechanisms to reduce cost

uncertainty. Initially, hal o the programs allowances would be allocated through auc-

tioning and hal through ree distribution, primarily to those entities most burdened by

the policy. This should help limit potential inequities while bolstering political support.

The share distributed or ree would phase out over twenty-ve years. The auctioned

allowances would generate revenue that could be used or a variety o worthwhile publicpurposes. The system would provide or linkage with international emissions reduction

credit arrangements, harmonization over time with eective cap-and-trade systems in

other countries, and appropriate linkage with other actions taken abroad that maintains a

level playing eld between imports and import-competing domestic products.


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www.HAMILTONPROJECT.ORg|

OCTOBER 2007

Ctts

I. Introduction 5

II. A Comprehensive Cap-and-Trade System or greenhouse gases 14

III. Economic Assessment o the Proposal 1

IV. Comparison o the Cap-and-Trade Proposal ith Alternative Proposals 48

V. Responses to Common Objections 54

VI. Summary and Conclusions 57

Reerences 60
http://www.hamiltonproject.org/http://www.hamiltonproject.org/


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OCTOBER 2007 5

The megadisaster lm The Day Ater Tomor-

row, about the apocalyptic consequences othe greenhouse eect, had less scientic basis

than The Wizard o Oz, but the reality is disturb-

ing enough. There is now a near consensus that

anthropogenic emissions o greenhouse gases are

very likely to change the earths climate in ways

than many people will regret.

The basic story has been explained many times, but

it merits repeating. Two trace constituents o the

atmosphere, carbon dioxide (CO2) and water vapor,

create a thermal blanket or the planet much as glasson a greenhouse traps the suns energy within. It

is a good thing, too: without greenhouse warming,

the earth would be ar too cold to be livable. But

the balance between too much and too little green-

house eect is remarkably delicate. Massive quanti-

ties o CO2 are produced rom the combustion o

ossil uelscoal, petroleum, and natural gasand

deorestation. Meanwhile the direct warming e-

ects o CO2 and other greenhouse gasesmeth-

ane, nitrous oxide, and halocarbonsare indirectly

amplied because the warming increases the evap-oration o water, raising atmospheric water vapor

concentrations (Intergovernmental Panel on Cli-

mate Change 2007a).

Average global surace temperatures have risen by

about 1.25 degrees Fahrenheit over the past 150

years, with most o the increase occurring since

1970. This ts the predictions o modern com-

puter models o climate change that also take ac-

count o increases in atmospheric dust (dust cools

the earth by refecting sunlight) and variations inthe suns energy output. Changes in temperatures

in the middle o continents and at high latitudes

have been two to our times greater than the aver-

age global changealso as predicted.

Warmer days and nights (which would surely be

welcome in some places) are only part o the story.

The most important consequences o greenhouse

gas concentrations are likely to be changes in pat-terns o precipitation and runo, the melting o gla-

ciers and sea ice, increases in sea levels, and changes

in storm requency and intensity (Intergovernmen-

tal Panel on Climate Change 2007b). That is why it

is important to view the problem as global climate

change rather than global warming alone.

But moving rom predictions o average global tem-

perature change to predictions o regional climate

impacts is dicult. The best computer models can-

not yet produce reliable estimates o these impacts.What is obvious, however, is that emissions in one

country aect the climate in every other. Hence the

undamental logic o a global pact on emissions,

such as the one hammered out in Kyoto, Japan, in

December 1997.

Four years ater Kyoto, the Bush administration an-

nounced that it would not submit the Kyoto Pro-

tocol, initialed by the Clinton White House, to the

U.S. Senate or ratication. O course, the Clinton

administration also chose not to submit the agree-ment to the Senate, and it is very unlikely that Al

Gore or John Kerry, had either been elected presi-

dent, would have done so. Even beore the Kyoto

conerence, the Senate had resolved, by a vote o

95-0 in the Byrd-Hagel resolution, that it would

not approve a climate control pact along the lines

o the Kyoto accord.

Many analystsparticularly economistshave

been highly critical o the Kyoto Protocol, noting

that, because o specic deciencies, it will accom-plish little, and that at a relatively high cost (Aldy,

Barrett, and Stavins 2003). Others have been more

supportive, noting that Kyoto is essentially the only

game in town. But both sides agree that wheth-

er that rst step was good or bad, a second step is

required. Indeed, as some nations prepare or the

Kyoto Protocols rst commitment period (2008-

i. ituct


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12), the international policy community as a whole

has begun to search or a better global policy archi-

tecture or the second (Aldy and Stavins 2007).

In the meantime the impetus or a meaningul U.S.

climate policy is growing. Scientic evidence hasincreased (Intergovernmental Panel on Climate

Change 2007a, 2007b), public concern has been

magnied, and many people perceive what they

believe to be evidence o climate change in prog-

ress. Such concern is reinorced by the aggressive

positions o key advocacy groups, which are no lon-

ger limited on this issue to the usual environmental

interest groups; religious lobbies, or example, have

also been vocal. All this has been refected in greatly

heightened attention by the news media. The re-

sult is that a large and growing share o the U.S.population now believe that government action is

warranted (Bannon et al. 2007).1

In the absence o a responsive ederal policy, re-

gions, states, and even cities have moved orward

with their own proposals to reduce emissions o

CO2 and other greenhouse gases. Ten northeastern

states, or example, have developed a cap-and-trade

program under their Regional Greenhouse Gas

Initiative (RGGI), and Caliornias Assembly Bill 32

may do likewise or the nations largest state. Partlyin response to ears o a ractured set o regional

policies, an increasing number o large corpora-

tionssometimes acting individually, other times

in coalition with environmental advocacy groups

have announced their support or serious national

action.2 Building on this initiative is the April 2007

U.S. Supreme Court decision that the administra-tion has the legislative authority to regulate CO2

emissions,3 as well as ongoing demands rom Euro-

pean allies and other nations that the United States

reestablish its international credibility in this realm

by enacting a meaningul domestic climate policy.

Indeed, in June 2005 the Senate balanced its dis-

tinctly negative view o the Kyoto Protocol with an

aggressive sense-o-the-Senate resolution, adopted

by unanimous consent, regarding domestic climate

policy.4

Thus momentum is clearly building toward enact-

ment o a domestic climate change policy. But there

should be no mistake about it: meaningul action to

address global climate change will be costly. This is

a key inconvenient truth that must be recognized

when policymakers construct and evaluate propos-

als, because the details o such a policys design will

greatly aect its ability to achieve its goals, its costs,

and the distribution o those costs. Even a well-de-

signed policy will ultimately impose annual costs on

the order o tens and perhaps hundreds o billionso dollars.5 That certainly does not mean that action

1. Not surprisingly, the public ocus in this domain is on the goals o public policy, not on the specic means. When asked, the general publicappears to be predisposed to conventional regulatory approaches; but when conronted with a possible trade-o between the promisedbenets and the perceived cost o conventional regulation, public enthusiasm or cost-eective, market-based policy instruments increases(Bannon et al.2007).

2. The U.S. Climate Action Partnership issued a call or action in January 2007, recommending the prompt enactment o nationallegislation in the United States to slow, stop, and reverse the growth o greenhouse gas emissions over the shortest time reasonablyachievable (2007, p. 2). The partnership consists o some o the largest U.S. companies with a stake in climate policy, rom a diverse seto sectors: electricity (Duke Energy, Exelon, FPL Group, NRG Energy, PG&E, and PNM Resources); oil and gas (BP, ConocoPhillips,and Shell); motor vehicles (Caterpillar, Daimler-Chrysler, Ford, GM, and John Deere); aluminum (Alcan and Alcoa); chemicals (DuPontand Dow); insurance (AIG and Marsh); mining (Rio Tinto); and manuacturing (Boston Scientic, General Electric, Johnson & Johnson,Pepsico, Siemens, and Xerox). The coalition is rounded out by six environmental organizations: Environmental Deense, the National

Wildlie Federation, the Natural Resources Deense Council, the Nature Conservancy, the Pew Center on Global Climate Change, andthe World Resources Institute.

3. Massachusetts et al. v. Environmental Protection Agencyet al., no. 05-1120, argued November 29, 2006, decided April 2, 2007.4. The resolution states: Congress should enact a comprehensive and eective national program o mandatory, market-based limits and

incentives on emissions o greenhouse gases that slow, stop, and reverse the growth o such emissions at a rate and in a manner that (1)will not signicantly harm the United States economy; and (2) will encourage comparable action by other nations that are major tradingpartners and key contributors to global emissions. The proposal set orth in this paper is consistent with that resolution.

5. By comparison, the cost (in 2001 dollars) o all U.S. Environmental Protection Agency regulations enacted rom 1996 to 2006 is estimatedat $25 billion to $28 billion annually (U.S. Oce o Management and Budget 2007), and a number o historical studies have estimated theannual cost o all environmental regulation in the United States to be on the order o 1 to 2 percent o GDP (Jae et al. 1995; Morgen-stern, Pizer, and Shih 2001).


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OCTOBER 2007 7

should not be taken, but it does mean that the costs

should be recognized i eective and sensible poli-

cies are to be designed and implemented.

It is important to identiy an appropriate policy

instrument at the outset, to avoid creating con-stituencies that will later resist change (Repetto

2007). Once a policy architecture is put in place,

it can be exceptionally dicult to change. For ex-

ample, any policy o signicant scope, once imple-

mented, leads to institutional investments in both

the public and the private sectors. And as people

learn how to operate within the policy, status quo

bias sets in. Some sectors and interests will benet

rom any policy, and these groups will resist sub-

sequent reorm. Thus the stakes associated with

policy design are signicant. A poorly designedpolicy could impose unnecessarily high costs or

unintended distributional consequences while pro-

viding little public benet, and could detract rom

the development o and commitment to a more

eective long-run policy. In the case o climate

change, choosing an inerior approach could be

exceptionally costly: the dierence between a cost-

eective approach and an inerior one could be as

great as $150 billion annually (1 percent o todays

GDP), or $1.8 trillion over a decade (Repetto

2007). And because o the unique characteristicso the climate change problem, simply relying on

existing and amiliar policy models will not lead to

the best solutions.

Atatv pc istuts truc Gus Gas esss

There is general consensus among economists and

policy analysts that a market-based policy instru-

ment targeting CO2 emissionsand potentially

some non-CO2 greenhouse gas emissionsshouldbe a central element o any domestic climate pol-

icy.6 Two alternative market-based instrumentsa

cap-and-trade system and a carbon taxhave been

advocated. Although there are trade-os between

them, this paper will argue that the better approach

and the one more likely to be adopted in the short

to medium term in the United States is a cap-and-

trade system.

The environmental eectiveness o a domesticcap-and-trade system or climate change can be

maximized and its costs and risks minimized by

inclusion o several specic eatures. The system

should target all ossil uel-related CO2 emissions

through an economy-wide cap on those emissions.

The cap should be imposed upstream, that is, on

ossil uels at the point o extraction, processing, or

distribution, not at the point o combustion. The

system should set a trajectory o caps over time that

begin modestly and gradually become more strin-

gent, establishing a long-run price signal to encour-age investment in emission-reducing technology. It

should adopt mechanisms to protect against cost

uncertainty. And it should include linkages with the

climate policy actions o other countries. Impor-

tantly, by providing politicians with the option to

mitigate economic impacts through the distribution

o emissions allowances, this approach can estab-

lish consensus or a policy that achieves meaningul

reductions. It is or these reasons and others that

cap-and-trade systems have been used increasingly

in the United States to address an array o environ-mental problems, or example to phase out the use

o lead in gasoline, limit emissions o sulur diox-

ide (SO2) and nitrous oxides (NOX), and phase out

chlorofuorocarbons (CFCs; Stavins 2003; see also

the online appendix atwww.hamiltonproject.org).

Cap-and-trade should not be conused with emis-

sions reduction credits or other credit-based pro-

grams, in which those reporting emissions reduc-

tions receive credits that others either may or must

buy to oset obligations under some other policy.Credit-based programs have oten been considered

as a means o encouraging emissions reductions

rom activities outside the scope o a cap-and-trade

system, emissions tax, or standards-based policy. But

6. This perspective is embodied in international assessments o national policy instruments as well (Intergovernmental Panel on ClimateChange 2007c).
http://www.hamiltonproject.org/http://www.hamiltonproject.org/http://www.hamiltonproject.org/http://www.hamiltonproject.org/


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an important limitation o credit-based programs is

that they typically require measurementor, more

likely, estimationo emissions reductions, which,

unlike emissions themselves, cannot be directly ob-

served. Hence these programs generally ace di-

culties in establishing that reported reductionswould not have occurred in the absence o the pro-

gram. This is the so-called baseline or addition-

ality problem: how to compare actual outcomes

with an unobserved and undamentally unobserv-

able hypothetical. Despite this obstacle, cost sav-

ings still may be achieved through the selective use

o credit-based programs targeting certain activi-

ties. As discussed later, these include various types

o carbon-saving land management that otherwise

would be too costly or ineasible to integrate into a

cap-and-trade (or a tax) system.

The alternative to a cap-and-trade system most re-

quently considered by policymakers is the use o

command-and-control standards, such as energy

eciency or emissions perormance standards,

which require rms and consumers to take particu-

lar actions that directly or indirectly reduce emis-

sions. The costs o standards are oten largely invis-

ible except to those directly aected by them. But

in act, those costs would be signicantly greater

than under sound market-based policies, becausestandards oer rms and consumers ar less fex-

ibility in reducing emissions, and they cannot target

many low-cost emissions reduction opportunities.

Moreover, the eectiveness o standards in achiev-

ing nationwide emissions targets is highly uncer-

tain, in part because they could cover only a raction

o those emissions, leaving many sources unregu-

lated. In contrast, market-based policies can cover

all sources o ossil uel-related CO2 emissions, and

unlike other alternatives, a cap-and-trade system

can essentially guarantee achievement o emissionstargets or sources covered by the cap.

T Fcus Ca-a-Ta

A cap-and-trade system places a cap, or ceiling, on

the aggregate emissions o a group o regulated

sources by creating a limited number o tradable

emissions allowances or a given period and requir-ing rms to surrender a quantity o allowances equal

to their emissions during that period.7 The system

imposes no particular limits on emissions rom any

given rm or source. A rm may emit as much as it

chooses, as long as it obtains sucient allowances

to do so. The government may initially distribute

the allowances or ree or sell them at auction. In ei-

ther case, the need to surrender valuable allowances

to cover any emissions and the opportunity to trade

those allowances establishes a price on emissions.

In turn, this price provides rms with an incentiveto reduce their emissions that infuences all o their

production and investment decisions.

Because allowances are tradable, the ultimate dis-

tribution o emissions reduction eorts necessary

to keep emissions within the cap is determined by

market orces. Those sources that nd it cheaper

to reduce their emissions than to continue emit-

ting and pay or allowances will do so, and those

that nd it cheaper to purchase allowances will do

so. Through the trading o allowances, the priceadjusts until emissions are brought down to the

level o the cap. Firms ability to trade emissions

allowances creates a market in which allowances

migrate toward their highest-valued use, covering

those emissions that are the most costly to reduce.

A well-designed cap-and-trade system thus mini-

mizes the costs o achieving any given emissions

target. Overall, a cap-and-trade system provides

certainty regarding emissions rom the regulated

sources as a group, because aggregate emissions

rom all regulated entities cannot exceed the totalnumber o allowances.8

7. This description is o what is called a downstream cap-and-trade system or CO2, which regulates the sources that emit CO2 by burningossil uels. This paper proposes an upstream system, as dened above, because o its economy-wide coverage.

8. The trade-o or such emissions certainty is uncertainty regarding the policys costs, as regulated sources will meet the cap regardless ocost. In contrast, a carbon tax provides greater certainty over program costs but does not guarantee achievement o a specic emissionstarget. Later in this paper, the trade-o between cost uncertainty and emissions uncertainty is examined, and specic means o reducing acap-and-trade systems cost uncertainty are identied.


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OCTOBER 2007

The cost o achieving signicant greenhouse gas

emissions reductions in uture years will depend

critically on the availability and cost o low- or

nonemitting technologies. A cap-and-trade system

that establishes caps extending decades into the

uture generates price signals that provide incen-tives or rms to invest in the development and

deployment o such technologies, thereby low-

ering the uture cost o reducing emissions. To

create these incentives, a cap-and-trade system

must provide credible commitments to meeting

long-run emissions targets.9 I a lack o credibility

makes the payo rom investments in the new

technologies highly uncertain, these investments

will lag (Montgomery and Smith 2007). On the

other hand, policymakers also need to maintain

fexibility to adjust long-term targets as new in-ormation is obtained regarding the benets and

costs o mitigating climate change. Managing this

trade-o between the credibility o long-run tar-

gets and fexibility is important or the success o

any climate policy.

Even a credible long-run cap-and-trade system may

provide insucient incentives or investment in

technology development i it does not address cer-

tain well-known market ailures, in particular those

associated with investments that create knowledgewith a public good nature (Jae et al. 2005, Newell

2007). A cap-and-trade system alone will not en-

courage the socially desirable level o investment

in research, development, and deployment o new

technologies that could reduce uture emissions re-

duction costs. Additional policies may be necessary

to increase government unding or incentives or

private unding o such research.10

Acats Ca-a-Ta

mcass

Over the past two decades, tradable permit systems

or pollution control have been adopted with in-

creasing requency in the United States (Tieten-

berg 1997) as well as other parts o the world. As

explained above, tradable permit programs are o

two basic types, credit programs and cap-and-trade

systems. The ocus o this brie review is on appli-

cations o the cap-and-trade approach.11 The pro-grams described below are examined in more detail

in the online appendix to this paper.

pvus Us Ca-a-Ta Ssts

lca a rga A put

The rst important example o an environmen-

tal trading program in the United States was the

phasedown o leaded gasoline in the 1980s. Al-

though not strictly a cap-and-trade system, the

phasedown included eatures, such as trading and

banking o environmental credits, that brought itcloser than other credit programs to the cap-and-

trade model and resulted in signicant cost savings.

The program was successul in meeting its environ-

mental targets, and the system was cost-eective,

with estimated cost savings o about $250 million

a year (Stavins 2003). Also, the program provided

measurable incentives or the diusion o cost-sav-

ing technology (Kerr and Newell 2000).

A cap-and-trade system was also used in the United

States to help comply with the Montreal Protocol,an international agreement aimed at slowing the

rate o stratospheric ozone depletion. The proto-

col called or reductions in the use o CFCs and

halons, the primary chemical groups thought to

lead to depletion. The timetable or the phaseout

o CFCs was later accelerated, and the system ap-

pears to have been relatively cost-eective.

The most important application in the United

States to date o a market-based instrument or

environmental protection is arguably the cap-and-trade system that regulates SO2 emissions,

the primary precursor o acid rain. The program,

established under the U.S. Clean Air Act Amend-

9. Although no legislation can guarantee that uture commitments will be met, legislated targets increase credibility by increasing the politi-cal costs to legislators o altering uture requirements.

10. See, or example, National Commission on Energy Policy (2007b). Such complementary policies are examined later in this paper.11. This section draws, in part, on Stavins (2003).


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ments o 1990, is intended to reduce SO2 and NOX

emissions by 10 million tons and 2 million tons,

respectively, rom 1980 levels. A robust market in

SO2 allowances emerged under the program, re-

sulting in cost savings on the order o $1 billion an-

nually compared with some command-and-controlalternatives (Carlson et al. 2000). The program has

also had a signicant environmental impact: SO2

emissions rom the electric power sector decreased

rom 15.7 million tons in 1990 to 10.2 million tons

in 2005 (U.S. Environmental Protection Agency

2005).

In 1994 Caliornias South Coast Air Quality Man-

agement District launched a cap-and-trade pro-

gram to reduce NOX and SO2 emissions in the Los

Angeles area. This program, called the RegionalClean Air Incentives Market (RECLAIM), set an

aggregate cap on NOX and SO2 emissions or all

signicant sources, with an ambitious goal o re-

ducing aggregate emissions 70 percent by 2003.

Trading under the RECLAIM program was re-

stricted in several ways, with positive and negative

consequences. But despite problems, RECLAIM

has generated environmental benets, with NOX

emissions in the regulated area alling by 60 percent

and SO2 emissions by 50 percent. The program has

also reduced compliance costs or regulated acili-ties, with the best available analysis suggesting cost

savings o 42 percent, amounting to $58 million an-

nually (Anderson 1997).

Finally, in 1999, under U.S. Environmental Pro-

tection Agency guidance, twelve northeastern

states and the District o Columbia implement-

ed a regional NOX cap-and-trade system to re-

duce compliance costs associated with the Ozone

Transport Commissions (OTC) regulations under

the 1990 amendments to the Clean Air Act. Emis-sions caps or two zones rom 1999-2003 were set

at 35 percent and 45 percent o 1990 emissions.

Compliance cost savings o 40 to 47 percent have

been estimated or the period, compared with

a base case o continued command-and-control

regulation without trading or banking (Farrell et

al. 1999).

Gus Gas Ca-a-Ta Ssts

Although cap-and-trade has proved to be a cost-e-

ective means to control conventional air pollutants,

it has a very limited history as a method o reducing

CO2 emissions. Several ambitious programs are in

the planning stages or have been launched.

First, the Kyoto Protocol, the international agree-

ment signed in Japan in 1997, includes a provision

or an international cap-and-trade system among

countries, as well as two systems o project-level

osets. The protocols provisions have set the stage

or the member states o the European Union to

address their commitments using a regional cap-

and-trade system. This system, the European

Union Emissions Trading Scheme (EU ETS) or

CO2 allowances, is by ar the largest active cap-and-trade program in the world. It has operated or

two years with considerable success, despite some

initialand predictableproblems. The 11,500

emissions sources regulated by the downstream

program include large sources such as oil rener-

ies, combustion installations, coke ovens, cement

actories, and errous metal, glass and ceramics, and

pulp and paper producers, but the program does

not cover sources in the transportation, commer-

cial, or residential sectors. Although the rst phase,

a pilot program rom 2005 to 2007, allows tradingonly in CO2, the second phase, 2008-12, potentially

broadens the program to include other greenhouse

gases. In its rst two years o operation, the EU

ETS has produced a unctioning CO2 allowanc-

es market, with weekly trading volumes ranging

between 5 million and 15 million tons, and with

spikes in trading activity accompanying major price

changes. Apart rom identiying some problems

with the programs design and early implementa-

tion (discussed in the online appendix), it is much

too soon to provide a denitive assessment o thesystems perormance.

In the United States, RGGI, a program among

ten northeastern states, will be implemented in

2009 and begin to cut emissions in 2015. RGGI

is a downstream cap-and-trade program intended

to limit CO2 emissions rom electric power sec-


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OCTOBER 2007 11

tor sources. Beginning in 2015 the emissions cap

will decrease by 2.5 percent each year until 2019,

when it will be 10 percent below current emissions,

or about 35 percent below the business-as-usual

(BAU) estimate, and 13 percent below 1990 emis-

sions levels. Because RGGI limits emissions romthe power sector only, incremental monitoring

costs are low, as U.S. power plants are already re-

quired to report their hourly CO2 emissions to the

ederal government, under provisions o the SO2

allowance trading program. The program requires

participating states to auction at least 25 percent o

their allowances; the remainder may also be auc-

tioned or distributed ree. It is obviously not yet

possible to assess the systems perormance, but sev-

eral problems with its design are examined in the

online appendix.

Finally, under Caliornias Global Warming So-

lutions Act (Assembly Bill 32), signed into law in

2006, the state will begin in 2012 to reduce emis-

sions to 1990 levels by 2020, and may employ a cap-

and-trade approach. Although the act does not re-

quire the use o market-based instruments, it does

allow or them, with restrictions: they must not

result in increased emissions o criteria air pollut-

ants or toxics, they must maximize environmental

and economic benets in Caliornia, and they musttake localized economic and environmental justice

concerns into account. This mixed set o objectives

may interere with the development o a sound

policy mechanism. The Governors Market Advi-

sory Committee has recommended a cap-and-trade

program, with a gradual phase-in o caps covering

most sectors o the economy, and an allowance dis-

tribution system that uses both ree distribution

and auctions, with a shit toward more auctions in

later years.

Cta pc Asssst

Three criteria stand out as particularly important

or the assessment o a domestic climate change

policy: environmental eectiveness, cost-eective-

ness, and distributional equity.12

evta ectvss

The rst criterion any proposed climate policy

must meet is environmental eectiveness: Can the

proposed instrument achieve its intended targets?

This will depend, in the case o a standards-based

approach, on the technical ability o policymakers to

design and the administrative ability o governments

to implement standards that are suciently diverse

to address all o the sources o CO2 emissions in a

modern economy. In the case o a tax, it will dependon the ability o political systems to impose taxes that

are suciently high to achieve meaningul emissions

reductions (or limits on global greenhouse gas con-

centrations, or limits on temperature changes).

The evaluation must also consider how certain it is

that the proposed policy will achieve its emissions

or other targets. Dierent policy designs may be

expected to achieve identical targets, but with di-

erent degrees o certainty. A cap-and-trade system

can achieve emissions targets with high certaintybecause guaranteed emissions levels are built into

the policy. With a carbon tax or technology stan-

dards, on the other hand, actual emissions are di-

cult to predict because o current and uture un-

certainty about uture energy prices or how quickly

new technologies will be adopted. Such policies

may aim to achieve particular emissions targets,

but actual emissions may either exceed or all below

those targets, depending on actors beyond policy-

makers control.

12. Eciency is ordinarily a key criterion or assessing public policies but is less useul when comparing alternative domestic policy instru-ments to address climate change. The eciency criterion requires a comparison o benets and costs, but given the global commonsnature o climate change, a strict accounting o the direct benets o any U.S. policy to the United States will produce benets that aresmall relative to costs. Clearly, the benets o a U.S. policy can only be considered in the context o a global system. Later in this paper themarginal cost (allowance price) o the proposed policy is compared with previous estimates o the marginal benets o globally ecientpolicies. In the short term, the cap-and-trade system, like any other meaningul domestic climate policy, may best be viewed as a step to-ward establishing U.S. credibility or negotiations on post-Kyoto international climate agreements. At the same time, another argument inavor o a cap-and-trade (or a carbon tax) policy is political: the likelihood o some national climate policy being enacted is increasing, andit is preerable that such a policy be implemented cost-eectively rather than through more costly conventional regulatory approaches.


14/68


15/68



OCTOBER 2007 1

require rapid changes in capital stock, markets, and

consumer choices. Finally, policies may also create

negative costs(or co-benefts) by reducing the cost o

complying with other environmental regulations,

such as those targeting SO2 and NOX emissions, or

by bringing about other non-climate-related ben-ets, including increased energy security.

dstuta equt

The economic impacts o any climate policy will be

broadly elt but will vary across regions, industries,

and households. The ultimate distribution will de-

pend not only on the costs imposed by the policy,

but also on resulting shits in the supply o and de-

mand or aected goods and services, and associated

changes in market prices. Firms directly regulated

by a climate policy typically experience two impacts:direct regulatory costs that reduce their prot mar-

gins, and changes in demand or their products. A

policys initial burden on directly regulated rms

may be partially oset as the introduction o direct

regulatory costs leads to increases in those rms

product prices, or reductions in prices o some in-

puts, or both. As a result o these price changes,

other rms not directly regulated by climate policy

will also experience changes in prots and demand.

The extent to which rms acing the direct or indi-

rect costs o a climate policy pass those costs on totheir consumers (or back to their suppliers) depends

on the characteristics o the markets in which they

compete, including the industrys cost structure and

consumers price responsiveness.

Any comprehensive climate policy will adversely a-

ect many rms, but some may experience windall

prots. For example, rms making less carbon-in-

tensive products may enjoy windall prots i a cli-

mate policy increases market prices or their prod-

ucts more than it increases their own costs. Thusevaluation o a climate policys distributional im-

plications requires identiying its ultimate burdens,

ater all adjustments in market prices, rather than

just its initial impacts on costs.

Although discussion oten ocuses on the impact

o climate policies on rms, all economic impacts

are ultimately borne by households in their roles

as consumers, investors, and workers. As produc-

ers pass through their increased costs, consumers

experience increased prices o energy and nonen-

ergy goods and may reduce their consumption. As

a policy positively or negatively aects the prot-ability o rms, investors experience changes in

the value o investments in those rms. Finally,

workers may experience changes in employment

and wages.

The benets (that is, the avoided damages) o cli-

mate policy are also unevenly distributed. Alterna-

tive policy instruments are very unlikely to result

in dierent geographic distributions o climate im-

pacts, because greenhouse gases mix uniormly in

the atmosphere. On the other hand, emissions onon-greenhouse gas pollutants that are correlated

with emissions o CO2 may have local impacts and

be sensitive to the choice o policy instrument.

ogazat t pa

Section II o this paper proposes a comprehensive

U.S. CO2 cap-and-trade system and describes its

key elements: a gradual trajectory o emissions re-

ductions; tradable allowances; upstream regulation

with economy-wide eects; mechanisms to reducecost uncertainty; allowance allocations that com-

bine auctions with ree distribution, with auctions

becoming more important over time; availability

o osets or underground and biological carbon

sequestration; supremacy over state and regional

systems; and linkage with international emissions

reduction credit and cap-and-trade systems and cli-

mate policies in other countries.

Section III provides an economic assessment o the

proposal, including an analysis o aggregate costsand distributional impacts. Section IV compares

the proposal with alternative approaches to the

same policy goal, with particular attention to com-

mand-and-control regulation and carbon taxes.

Section V examines some common objections to

the proposed policy and provides responses. Sec-

tion VI concludes.


16/68




The United States can launch a scientically

sound, economically rational, and politicallyeasible approach to reducing its greenhouse

gas emissions by adopting an upstream, economy-

wide CO2 cap-and-trade system that implements

a gradual trajectory o emissions reductions over

time. The approach proposed here also includes

mechanisms to reduce cost uncertainty, such as

multiyear compliance periods, provisions or bank-

ing and borrowing, and possibly a cost containment

mechanism to protect against extreme price volatil-

ity.15

Allowances under the system would be allocated

through a combination o ree distribution and

open auction. This is intended to balance, on the

one hand, the legitimate concerns o those who will

be particularly burdened by this (or any) climate

policy with, on the other hand, the opportunity to

achieve important public purposes with unds gen-

erated by the auctions. The share o ree allowances

would decrease over time as the private sector ad-

justs to the carbon constraints, with all allowances

being auctioned ater twenty-ve years.

Osets would be made available or both under-

ground and biological carbon sequestration, to

achieve short-term cost-eectiveness and create

long-term incentives or appropriate technologi-

cal change. The cap-and-trade system would be a

ederal program, with supremacy over all U.S. re-

gional, state, and local systems, to avoid duplication,

double counting, and conficting requirements. It

would also provide or harmonization over time

with emissions reduction credit and cap-and-tradesystems in other nations, as well as related interna-

tional systems.

maj Tug nt excusv Fcus

Co2

This proposal ocuses on reductions o ossil uel-

related CO2 emissions, which accounted or nearly

85 percent o the 7.1 billion metric tons o U.S.

greenhouse gas emissions in 2005.16 CO2 emissions

arise rom a broad range o activities involving the

use o dierent uels in many dierent economic

sectors (Figure 1). In addition, biological seques-

tration and reductions in non-CO2 greenhouse gas

emissions can contribute substantially to minimiz-

ing the cost o limiting total greenhouse gas con-centrations (Reilly, Jacoby, and Prinn 2003; Stavins

and Richards 2005). Some non-CO2 emissions

might be addressed under the same ramework as

or CO2 in a multigas cap-and-trade system.17 But

challenges associated with measuring and moni-

toring other non-CO2 emissions and biological

sequestration may require separate programs tai-

lored to their specic characteristics, as described

later.

Gaua icasg Tajct esss ructs v T

Because climate change is a long-term problem,

policies can be somewhat fexible regarding when

emissions reductions actually occur. Policies that

take advantage o this when fexibility, or exam-

ple by setting annual emissions targets that gradu-

ally increase in stringency, can avoid many o the

costs associated with taking stringent action too

quickly, without sacricing environmental benets

(Wigley, Richels, and Edmonds 1996). Prematureretirement o existing capital stock can be avoided,

as can many production and siting bottlenecks.

ii. A Csv Ca-a-Ta Sst Gus Gass

15. For a review o alternative designs or a national cap-and-trade system, see Cambridge Energy Research Associates (2006).16. This gure measures greenhouse gases in CO2-equivalent terms; that is, quantities o greenhouse gases other than CO2 are converted to

quantities o CO2 o the same radiative orcing potential over their average duration in the atmosphere.17. Because landll methane emissions are already monitored, and monitoring o industrial (as opposed to agricultural) non-CO 2 greenhouse

gases would not be dicult, regulation o these sources might be integrated with CO 2 policies (Reilly, Jacoby, and Prinn 2003).


17/68



OCTOBER 2007 15

Gradually phased-in targets also provide time toincorporate advanced technologies into long-lived

investments (Goulder 2004; Jae, Newell, and

Stavins 1999).18 Thus, or any given cumulative

emissions target or associated atmospheric con-

centration objective, a climate policys cost can be

reduced by gradually phasing in eorts to reduce

emissions.

The long-term nature o the climate problem and

the need or technological change to bring about

lower-cost emissions reductions also make it es-sential that the caps be instituted gradually over a

long period. The development and eventual adop-

tion o new low-carbon and other relevant tech-

nologies will depend on the predictability o uture

carbon prices, which themselves will be aected bythe caps constraints. Thereore the cap-and-trade

policy should incorporate medium- to long-term

targets, not just short-term targets.

It would be a mistake, however, to think that when

fexibility is a reason to allow delay in enacting a

mandatory policy. On the contrary, the earlier a

mandatory policy is established, the more fexibility

there will be to set emissions targets that gradually

depart rom BAU levels while still achieving a long-

run objective or atmospheric concentration. Thelonger it takes to establish a mandatory policy, the

more stringent the near-term emissions targets will

need to be to achieve a given long-run concentra-

tion objective.

FiGUre 1

U.S. Gus Gas esss, 2005

18. In addition, given the time value o money (the opportunity cost o capital), environmentally neutral delays in the timing o emissionsreduction investments can be socially advantageous.

PetroleumCO

2 2,614CoalCO

2 2,142

NaturalGasCO2 1,178RenewablesCO

2 12

IndustrialP

rocessesCO2

105

Methane

612

Nitrou

sOxid

e367

Othe

rgase

s160

(Million Metric Tons Carbon Dioxide Equivalent)

U.S. Territories 59

International Bunkers 101

CO2Energy

Subtotal5,945

CO2Unadjusted

Total6,051

Direct Fuel Uses3,570

Power SectorConversion

to Electricity2,375

Industrial Processes105

Methane, Nitrous Oxide,Other Gases

1,139

Greenhouse

Gases

2005 Total

7,147

Coal 1,944Natural Gas 319Petroleum 100Renewables 12

CO21,2

66

Non-CO2

18

Residenti

al

1,284

CO2 1,061

Non-CO2 240

Commercial

1,301

CO2 1,804Non-CO2 757

Industrial

2,562

CO2 1,877Non-CO

2 123Transportation2,000

Source: U.S. Energy Information Administration (2006).


18/68




Gradually phasing in the stringency o emissions

targets may also reduce the near-term burden o

a climate policy, and with it both the costs and the

challenges associated with gaining political consen-

sus. On the other hand, a policy that shits reduc-

tion eorts too ar into the uture may not be cred-ible, thus weakening incentives or investments in

advanced technologies.

Several alternative types o policy-target trajecto-

ries are possible, including trajectories or emis-

sions caps, emissions reduction targets, global con-

centration targets, and allowance prices. Given the

long-term nature o the problem, the best measure

o policy stringency may be the sum o national

emissions permitted over some extended period.

As explained later, i banking and borrowing o al-lowances are allowed, then only the sum o capped

national emissions over time matters, not the spe-

cic trajectory, because trading o allowances will

generate the cost-minimizing trajectory.O course,

i there is too much delay in bringing down emis-

sions, then the timing o emissions reductions can

aect total damages, even i cumulative emissions

are the same.

How should the appropriate sum o capped nation-

al emissions be identied? The classic economicapproach is to choose targets that maximize the

dierence between expected benets and expected

costs, but such an approach is simply not ea-

sible in this context, or several reasons. Reliable

inormation about anticipated damageseven in

biophysical, let alone economic termsis lack-

ing. In any case such a calculation could be made

only at the global, not the national, level given

that the problem aects the global commons. Fi-

nally, it is increasingly clear that an analysis that

merely compares expected benets with expected

costs is inadequate, since it is the small risks o

catastrophic damages that are at the heart o the

problem (Weitzman 2007).

The cost assessment presented later in this paper

adopts and assesses a pair o trajectories or 2012-50

to establish a reasonable range o possibilities or

illustrative purposes. The less ambitious trajectory

involves stabilizing CO2 emissions at their 2008

level over 2012-50, as predicted by Paltsev and oth-

ers (2007a, 2007b). This trajectory, in terms o its

cumulative cap, lies within the range dened by the

2004 and 2007 recommendations o the National

Commission on Energy Policy (2004, 2007b). The

more ambitious trajectory, also dened over 2012-50, would reduce CO2 emissions to 50 percent be-

low their 1990 level. This trajectory, dened by its

cumulative cap, is consistent with the lower end

o the range proposed by the U.S. Climate Action

Partnership (2007).

This illustrative pair o cap trajectories has sever-

al signicant attributes. First, both are consistent

with the requently cited global goal o stabilizing

atmospheric concentrations o CO2 at between 450

and 550 parts per million (ppm), i all nations wereto take commensurate actions.19 Second, the caps

gradually become more stringent over an extended

period, thus reducing costs by avoiding the necessi-

ty o premature retirement o existing capital stock,

by reducing vulnerability to siting bottlenecks and

other risks that arise with rapid capital stock transi-

tions, and by ensuring that rms have the opportu-

nity to incorporate appropriate advanced technol-

ogy in their long-lived capital investments.20

19. Commensurate action is dened in the analysis as other countries taking action that is globally cost-eective, or example by employingcap-and-trade systems with the same allowance price or equivalent carbon taxes (Paltsev et al. 2007a, including Table 12, page 57).

20. An alternative to the type o caps recommended here, which are denominated in tons o CO 2 emissions, is the use o intensity-basedtargets, where emissions intensity is specied by the ratio o emissions to economic activity. Any aggregate output index could serve asthe denominator, but a target based on CO2 emissions per dollar o GDP has been requently proposed. Under such a GDP-indexed cap,allowable emissions in each year would be equal to the intensity cap multiplied by GDP. The Bush administrations climate policy includesemissions intensity targets o this type (Pizer 2005a). Intensity-based caps are not inherently more or less stringent than absolute caps:given a GDP orecast, an intensity-based cap can be designed to yield the same expected emissions level as any absolute cap. An intensity-based cap does introduce uncertainty regarding emissions levels, but at the same time it reduces cost uncertainty. However, intensity-basedtargets would create problems or linking with cap-and-trade systems in other nations. Total emissions under linked systems may eitherincrease or decrease i one or both systems employ an intensity-based rather than an absolute cap. It should be noted that the correlation


19/68



OCTOBER 2007 17

Usta pt rguat aec-W Sc Cvag

Any cap-and-trade system or CO2 must dene theset o emissions sources that are capped (the scope

o coverage) and the point in the ossil uel supply

chain at which that cap is enorced (the point o reg-

ulation). To achieve economy-wide coverage, the

point o regulation should be upstream, collecting

allowances according to the carbon content o uels

at the point o their extraction, import, processing,

or distribution.21 The rst sellers o extracted ossil

uels would be required to hold allowances: or coal,

at the mine shipping terminus; or petroleum, at the

renery gate; or natural gas, at the rst distributionpoint; and or imports, at the point o importation.

Such a cap would eectively cover all sources o CO2

emissions throughout the economy (Table 1).22

Any upstream program should include a credit

mechanism, to address both the small portion o

ossil uels that are not combusted and the use o

between GDP and emissions varies substantially across countries, ranging rom 0.70 or the United States to only 0.10 or France (Newelland Pizer 2006). Where the relationship between GDP and emissions is weak, an intensity-based cap may exacerbate fuctuations in emis-sions reduction eorts by overadjusting emissions targets in response to economic fuctuations. More broadly, an intensity target need not

take the orm o a simple ratio, and more sensible outcomes would be associated with slightly more complex ormulas (Aldy 2004).21. Regulation at the point o transportation or distribution is sometimes reerred to as midstream regulation. A downstream program im-

poses allowance requirements at the point o emissions, or example at electric power plants or actories. An upstream point o regulationhas been used in the past where ultimate emissions are directly related to upstream production activity. For example, an upstream point oregulation was used to phase out automobile lead emissions by limiting the quantity o lead that reneries could use in gasoline. Similarly,emissions o ozone-depleting substances were phased out through limits on their production rather than on their use. It should be notedthat an upstream approach is not ully comprehensive unless provisions are made to address process emissions rom natural gas andcrude oil extraction.

22. The electric power and transportation sectors account or over 70 percent o total CO 2 emissions; when the industrial sector is included,these three sectors account or nearly 90 percent o emissions. But electric power sector emissions result rom electricity use by all othersectors. The last column o Table 1 includes indirect emissions rom electricity use in reporting each o the other sectors emissions.

TAble 1

Co2 esss eg Csut Sct a Fu T, 2005Millions o metric tons except here stated otherisea

Scts ct sss

Sct Ca onatua

gasA uts

Scts ctsss assa tta a scts

(ct)

Sctsctsss

ctct us

Scts cta ctsss

Scts ct

a ctsss assa tta a scts

(ct)

Residential 1 105 262 68 6.2 886 1,254 21.1

Commercial 8 55 166 20 . 821 1,051 17.7

Transportation 0 1,22 2 1,5 2. 5 1,5 2.

Industrial 185 41 400 1,020b 17.1 66 1,682 28.

Electricity 1,44 100 1 2,75c . NA NA NA

All sectors 2,18 2,614 1,178 5,45 5,45

All sectors asshare o total(percent) 6.0 44.0 1.8 100.0 100.0

Source: U.S. Enery Inormation Administration (2006).

a. Emission totals dier rom those in ure 1 because ure 1 includes CO2 emissions rom industrial processes and because o minor dierences in measurement, such

as treatment o emissions rom U.S. territories.

b. Includes emissions rom net coe imports not accounted or in the rst three columns.

c. Includes emissions rom eothermal and aste-to-enery eneration not accounted or in the rst three columns.


20/68




postcombustion emissions reduction technologies,

such as carbon capture and sequestration (CCS). It

should also include a credit-based arrangement or

ossil uel exports so that exporters are not placed

at a competitive disadvantage relative to oreign

suppliers that do not ace allowance requirements.Emissions reductions rom CCS technologies can

be readily measured. Also, unlike some credit-

based programs, a program or CCS runs no risk

o granting credits or ctitious emissions reduc-

tions: because emissions sources have no incen-

tive to install CCS equipment in the absence o

a climate policy, emissions reductions achieved by

CCS are clearly additional. CCS technologies are

expected to play a signicant role in achieving

long-run emissions reduction goals; thereore such

a credit mechanism is an essential component oan upstream cap.

Although the point o regulation determines which

entities are ultimately required to hold allowances,

this decision can be made independently o the

initial allowance allocation decision. The point

o regulation does not dictate or in any way limit

who may receive allowances i allowances are dis-

tributed or ree. The point-o-regulation deci-

sion also has no direct eect on either the costs o

emissions reduction or the distribution o resultingeconomic burdens.23 A cap has the same impact on

the eective cost o uel or downstream users re-

gardless o the point o regulation. With upstream

regulation, the allowance cost is included in the uel

price. Since all suppliers ace the same additional

allowance cost, all will include it in the prices they

set or downstream customers. With downstream

regulation, the downstream customer pays or the

allowances and the uel separately. In either case

the downstream customer ultimately aces the same

additional cost associated with emissions rom itsuel use.

This has two important implications. First, the

distribution o costs between upstream and down-

stream rms is unaected by the point-o-regula-

tion decision. Second, rms and consumers will

undertake the same emissions reduction eorts

and thereby incur the same emissions reductioncostsin either case, because they ace the same

carbon price signal.

Some conusion has emerged regarding these

points, with some observers suggesting that an up-

stream program will dilute the carbon price signal,

because only part o the allowance costs will be

passed through to downstream emitters. In par-

ticular, higher uel prices will reduce demand, lead-

ing producers to moderate their price increases and

absorb some o the allowance costs themselves.This argument is valid but not unique to upstream

systems. With a downstream point o regulation,

ossil uel would in eect become more expensive,

because emissions sources would be required to sur-

render valuable allowances. This would reduce their

demand and lead to the same osetting eect on

uel prices. Similarly, some critics nd an upstream

point o regulation counterintuitive, since it does

not control emissions per se. In act, an upstream

approach gets at the problem more directly: it caps

the amount o carbon coming into the system.

evta ectvss

An economy-wide cap provides the greatest cer-

tainty o achieving a given national emissions tar-

get. Limiting the scope o coverage to a subset o

emissions sources leads to emissions uncertainty

through two channels. First, exogenous changes

in emissions rom unregulated sources can cause

national emissions to deviate rom expected lev-

els, even i emissions rom regulated sources meet

the target.24 Second, a limited scope o coveragecan cause leakage, in which market adjustments

23. This point was established decades ago in the context o tax policy (Musgrave and Musgrave 1980). However, there are a ew exceptions.For example, the point o regulation will aect the distribution o administrative costs between upstream and downstream entities, al-though, again, these costs would be small relative to the overall cost o a well-designed cap-and-trade system.

24. For example, the EU ETS covers CO2 emissions rom acilities accounting or about 45 percent o EU greenhouse gas emissions. As aresult, the European Unions ability to meet its Kyoto Protocol target is threatened by signicant growth in transportation sector emis-sions, which are not covered by the ETS (European Environment Agency 2006; see also the online appendix).


21/68



OCTOBER 2007 1

resulting rom the regulation lead to increased

emissions rom unregulated sources outside the

cap that partially oset reductions under the cap.

For example, a cap that includes emissions by the

electric power sector (and thereby aects electric-

ity prices) but excludes emissions rom natural gasor heating oil use in commercial and residential

buildings may encourage substitution o unregu-

lated natural gas or oil heating or electric heating

in new buildings. As a result, increased emissions

rom natural gas and oil heating will oset some

o the reductions achieved in the electric power

sector.

Some stakeholders have argued or a downstream

point o regulation or at least some emissions

sources.25 I downstream regulation o some acili-ties is allowed, broad coverage o emissions will

require a hybrid point-o-regulation approach, in

which some sources are regulated upstream and

others downstream. As commonly proposed, such

a hybrid approach would involve upstream pro-

ducers surrendering allowances or some but not

all o the uel they sell, depending on whether or

not the uel is sold to sources subject instead to

downstream regulation. This approach has two

signicant problems. First, a hybrid system may

ail to provide complete coverage. Some emis-sions sources may all through the cracks, covered

by neither downstream nor upstream regulation.

Second, there would need to be two classes o

uel in the market, one or which allowances have

been surrendered, and one intended or use by

acilities subject to downstream regulation. This

would increase administrative complexity and the

potential or noncompliance.26

Cst ectvss

The aggregate costs o emissions reductions un-

dertaken to meet a cap are directly aected by the

scope o coverage. Emissions reduction programs

are subject to economies o scope: costs decline

more than proportionately as the programs scopeincreases. An upstream point o regulation makes

economy-wide coverage easible, thus exploiting

these economies.

Three actors contribute to these lower costs. First,

a broader cap expands the pool o low-cost emis-

sions reduction opportunities that can contribute to

meeting a national target. Even i a sector may con-

tribute only a small portion o reductions, includ-

ing that sector under the cap can yield signicant

cost savings by displacing the highest-cost reduc-tions that would otherwise be necessary in other

sectors. For example, it has been estimated that the

cost o achieving a 5 percent reduction in U.S. CO2

emissions could be cut in hal under an economy-

wide cap compared with a cap limited to the electric

power sector (Pizer et al.2006).

Second, an economy-wide cap provides important

fexibility to achieve emissions targets given uncer-

tainties in emissions reduction costs across sectors.

By drawing rom a broader, more diverse set oemissions reduction opportunities, an economy-

wide cap reduces the risk o unexpectedly high

costs, much as investing in a mutual und reduces

investment risk through diversication.

Third, an economy-wide cap creates incentives or

innovation in all sectors o the economy. Such in-

novation increases each sectors potential to con-

25. See, or example, the debates surrounding the development o a cap-and-trade program to implement Caliornias AB 32 (Market Advisory

Committee 2007; Stavins 2007).26. An alternative approach that may address the objectives o downstream proponents while reducing administrative complexity would be to

adopt a pure upstream cap-and-trade system as proposed here, but allow certain downstream sourcessuch as electric power generatorsusing CCSto choose downstream regulation. This would be an alternative to the credits or CCS proposed elsewhere in this paper.Under this optional downstream regulation, sources would be granted allowances refecting their uel consumption to oset the eect oupstream regulation on their uel costs, but would be required to surrender allowances or their emissions. Since any sources subject todownstream regulation need to be monitored in any event, this approach would be ar less administratively complex than requiring up-stream sources to determine their allowance requirements or uel supplied based on the identity o the end consumer. To the extent thatthere are real benets o downstream regulation, such an approach could capture some o these benets without sacricing the completecoverage achieved by pure upstream regulation, while minimizing the administrative complexity that usually comes with a hybrid point-o-regulation system.


22/68




tribute cost-eective emissions reductions in uture

years, and the resulting long-run cost savings rom

starting with a broad scope o coverage may ar ex-

ceed any short-term gains. In theory, a policy that

proposes to eventually expand an initially narrow

scope o coverage might create broad incentivesor innovation. But achieving that subsequent ex-

pansion would be dicult in practice, given that

the adjustments that sectors ace upon joining the

cap will only become greater over time as the caps

stringency increases. Thus political obstacles to

expanding the cap may grow over time as the cap

becomes more stringent.

The point-o-regulation decision is a primary de-

terminant o a cap-and-trade systems administra-

tive costs through its eect on the number o sourc-es that must be regulated. As that number increases,

the administrative costs to regulators and rms rise.

The point o regulation should be chosen to acili-

tate regulation and minimize the administrative

costs o a desired scope o coverage.27

An upstream point o regulation makes an econ-

omy-wide cap-and-trade system administratively

easible: nearly all U.S. CO2 emissions could be

capped with regulation o just 2,000 upstream enti-

ties (Bluestein 2005). It would be administrativelyineasible to implement an economy-wide cap-and-

trade (or carbon tax) system through downstream

regulation, as this would require regulation o hun-

dreds o millions o commercial establishments,

homes, and vehicles. An upstream program also

eliminates the regulatory need or acility-level

greenhouse gas emissions inventories, which would

be essential or monitoring and enorcing a down-

stream cap-and-trade system. The ossil uel sales

o the 2,000 entities to be regulated under the up-

stream cap-and-trade system are already monitoredand reported to the government or tax and other

purposes (Table 2). Because monitoring is o little

use without enorcement, meaningul and credible

penalties are also important, such as ees set at up

to ten times marginal abatement costs, plus the

requirement or rms to make up the dierence.

Such provisions have resulted in virtually 100 per-

cent compliance in the case o the SO2 allowance

trading program (Stavins 1998).

dstuta Csqucs

An economy-wide emissions cap spreads the cost

burden o emissions reductions across all sectors.

In contrast, limiting the scope o coverage both

increases the overall cost (as discussed above) and

concentrates the burden among certain sectors, re-

gions, and income groups.

Limiting the scope o coverage may also have unin-

tended consequences. For example, limiting cover-age to the electric power sector would lead to greater

electricity rate impacts and more regional variation

in those impacts than would be anticipated under

an economy-wide cap. In addition, excluding direct

emissions rom residential and commercial build-

ings would alter regional variation in household im-

pacts because o regional dierences in household

use o electricity, heating oil, and natural gas.

ets t Ca-a-Ta Sst

tat ruc Cst Uctat

A cap-and-trade system minimizes the cost o

meeting an emissions target, but emissions reduc-

tion costs can be greater than anticipated. This risk

arises because, without mechanisms (described be-

low) that control costs, regulated sources will have

to meet the emissions cap regardless o the cost.

This cost uncertainty is one argument oered in

avor o a carbon tax, which largely eliminates cost

uncertainty (but introduces uncertainty about the

quantity o emissions reduction) by setting thecarbon price at a predetermined level. But policy-

makers can protect against cost uncertainty under

a cap-and-trade system, while largely maintaining

27. The size o the regulated sources also aects aggregate administrative costs. The EU ETS, a downstream scheme, covers approximately11,000 sources, 90 percent o which account or less than 10 percent o total emissions (Ellerman, Buchner, and Carraro 2007). Thequestionable x apparently being devised in that case is a set o less demanding monitoring and verication requirements or smallersources.


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OCTOBER 2007 21

certainty over emissions, by adopting a ew key de-

sign elements: provision or banking and borrow-

ing o allowances, and possible inclusion o a cost

containment mechanism.

T natu Cst Uctat

Cost uncertainties can arise in an emissions reduc-

tion scheme rom numerous actors: many advanced

technologies expected to contribute signicantly to

achieving emissions reductions have highly uncer-

tain costs, or their commercial easibility has not yetbeen demonstrated; peoples willingness to adopt

less emissions-intensive and energy-intensive tech-

nologies is not well understood; and unanticipated

events, including uture exogenous changes in en-

ergy prices or GDP growth, as well as uture politi-

cal decisions, could signicantly aect the cost o

meeting emissions reductions targets.

Concern about cost uncertainty in the context o cap-

and-trade systems derives rom the possibility o un-

expected, signicant cost increases. The experiencewith the southern Caliornia RECLAIM cap-and-

trade system or NOX emissions is a requently cited

example. RECLAIM had no automatic mechanism

or relaxing emissions caps in the ace o unexpect-

edly high costs, and in 2000 allowance prices spiked

to more than twenty times their historical levels

(Pizer 2005b).28 Cost uncertainty may increase the

long-run cost o emissions caps, because uncertainty

about uture allowance prices may deter rms rom

undertaking socially desirable but capital-intensive

emissions reduction investments, orcing greater

reliance on less capital-intensive but more costly

measures. Firms acing investments in irreversible

(sunk) costs require greater returns as uncertaintyabout costs or revenue increases (Dixit and Pin-

dyck 1994). Furthermore, although the populations

directly aected by allowance price spikes may be

relatively small, the higher prices pass through to

aect the prices o goods and services that are more

broadly consumed, such as electricity prices in the

case o RECLAIM or gasoline prices in the case o

an economy-wide cap on CO2 emissions.

pvs Awac bakg a

bwg Allowance banking and borrowing can mitigate

some o the undesirable consequences o cost un-

certainty by giving rms the fexibility to shit the

28. Because electric power generators were part o this cap-and-trade system, these price spikes worsened the developing West Coast electric-ity market crisis (Joskow 2001). Such unexpectedly high costs, even i only temporary, may jeopardize commitments to long-run policygoals. The RECLAIM program, or example, returned electric power generators to standards-based regulation in response to the eco-nomic disruptions that occurred (Harrison 2003; see also the online appendix).

TAble 2

Atatv pts rguat a U.S. Ca-a-Ta Sst

Fss u catg

pt guat Ca o natua gas

Upstream Minin and imports

(500 companies)

Production ells and

imports (750 companies)

Production ells and imports

(750 companies)

Midstream Rail, bare, and trucin

(not addressed)

Renin (200 reneries) Pipelines and processin

(200 pipelines, or 1,250 localdistribution companies and500 liquied natural as

plants)

Donstream Electric poer plants

(500 plants)

Mobile sources, industrial

boilers, and electric poerplants (millions o sources)

Industrial boilers, commercial

and residential urnaces, andelectric poer plants (millionso sources)

Source: Cambride Enery Research Associates (2006).


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timing o emissions reductions in the ace o unex-

pectedly high or low costs.29 I the cost o achieving

targets is unexpectedly and temporarily high, rms

can use banked or borrowed allowances instead o

undertaking costly reductions. Banking o allow-

ancesundertaking extra emissions reductions ear-lier, so that more allowances are available or use

laterhas added greatly to the cost-eectiveness o

previous cap-and-trade systems (Stavins 2003), but

banking provides little protection when costs remain

high or so long that the banked allowances ace ex-

haustion. This problem may be particularly acute in

a caps early years, when relatively ew allowances

have been banked. Borrowing o allowances rom

uture years allocations can be a particularly useul

orm o cost protection in these early years.

Banking oers this cost protection while still guar-

anteeing achievement o long-run cumulative emis-

sions targets. Although banking may shit some

emissions out in time, rom when allowances are

banked to when they are used, cumulative emis-

sions at any point can never exceed the number o

allowances issued up to that point.

Credible mechanisms need to be established to en-

sure that borrowed allowances are repaid through

uture emissions reductions. For example, rmscould be allowed to borrow rom their own uture

supplies, while entering into a contractualpos-

sibly bondedagreement with the government to

repay the borrowed emissions at a subsequent date.

Or the government could allocate allowances rom

a uture year to be used this year, decreasing the

rms uture allocation by the same amount.

pvs a Ss Cst Ctat

mcas

Ultimately the most robust cost control eature o acap-and-trade program is a broad and fuid market

in allowances. With such a market, osetsdis-

cussed elsewherecan play a key role in keeping

costs down. Another issue is cost uncertainty linked

with short-term allowance price volatility. Banking

and borrowing can be exceptionally important in

reducing long-term cost uncertainty, but the pos-sibility o dramatic short-term allowance price

volatility may call or inclusion o a sensible cost-

containment mechanism. Such a mechanism could

allow capped sources to purchase additional allow-

ances at a predetermined price, set suciently high

(say, rom twice to ten times the expected level o

allowance prices, not 10 or 20 percent above) to

make it unlikely to have any eect unless allowance

prices exhibit truly drastic spikes. The resulting

revenue would be dedicated exclusivelyto nanc-

ing emissions reductions by uncapped sources, suchas o non-CO2 greenhouse gases, or to buy back

allowances in uture years. This is very dierent

rom standard proposals or a saety valve, both

because the environmental integrity o the program

(the cap) is maintained by using the revenue or the

specic uses just mentioned, and because the high

predetermined price has no eect unless there are

drastic price spikes.

The predetermined trigger price or the cost-

containment mechanism would place a ceiling onallowance prices and hence on abatement costs,

because rms will not undertake emissions reduc-

tions more costly than the trigger price (Jacoby

and Ellerman 2002).30 To be eective as an insur-

ance mechanism, the trigger price should be set

at the maximum incremental emissions reduction

cost that society is willing to bear. At this level

the mechanism would be triggered only when

costs are unexpectedly and unacceptably high. O

course, a cost-containment mechanism that is set

too high would provide no insurance against ex-cessive costs.

29. All existing cap-and-trade programs have implicit provision or banking and borrowing within the length o their compliance periods: oneyear in the case o the SO2 allowance trading program, and ve years in the case o the Kyoto Protocols commitment periods.

30. An alternative that would maintain and possibly exceed long-run emissions targets is a complementary allowance price foor, acilitated bya government promise topurchase allowances at a specied price. A price foor ensures achievement o all emissions reduction opportuni-ties below a given cost, which may exceed the amount o reductions necessary to meet the cap. The need or a price foor may decrease,however, with banking.


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OCTOBER 2007 2

Importantly, because revenue rom the trigger price

mechanism would be used to nance emissions re-

ductions by uncapped sources or to buy back allow-

ances in uture years, the cost-containment mecha-

nism would reduce cost uncertainty and increase

cost-eectiveness, whilesimultaneously maintain-ing environmental eectiveness.

Acat Awacs

The cap-and-trade system would create a new com-

modity, a CO2 allowance, which would have value

because o its scarcity: only as many allowances

would be issued as is consistent with the emissions

target. The government could distribute allow-

ances or ree or auction them. This proposal rec-

ommends an allowance allocation mechanism thatcombines auctions with ree distribution, with auc-

tions becoming more important over time.

The aggregate value o allowances in a nationwide

system would be substantial. Indeed, i all allow-

ances are auctioned, annual auction receipts would

amount to a signicant share o ederal revenue.31

For rms needing to buy auctioned allowances, total

allowance costs would signicantly exceed the cost

o emissions reductions that would meet a modest

cap. The reason is that under an economy-wideemissions cap that reduces nationwide emissions by

5 percent, or example, regulated rms would incur

costs associated with reducing those emissions but

would have to purchase allowances or the remain-

ing 95 percent o their emissions.

The magnitude o these rm-level costs indicates

that the choice o allocation method (auctioning

versusree distribution) and the use o auction reve-

nue can have important distributional implications.

By contrast, the allocation choice does not aect

the achievement o the emissions targets, andasemphasized abovethe allocation issue is inde-

pendent o the point o regulation. Indeed, since

alternative points o regulation lead to the same

ultimate distribution o economic burdens, there is

no economic rationale or tying allocation choices

to the point o regulation. For example, under an

upstream cap, it would be possible to distribute al-

lowances or ree to downstream energy-intensive

industries that are aected by the cap even though

they are not directly regulated by it. This is one

approach to compensating those industries or theimpact o a climate policy, since they could then

sell the allowances to rms directly regulated under

the cap.

T Cc btw Auct a F

dstut: ova Cst Ccs

Beyond the distributional consequences o alloca-

tion decisions, the choice o whether allowances

will be auctioned or distributed or ree can aect

the programs overall cost. Generally speaking, the

choice between auctioning and allocating allowanc-es or ree does not infuence rms production and

emissions reduction decisions.32 Firms ace the same

emissions cost regardless o the allocation method.

Even when it uses an allowance that it received or

ree, a rm loses the opportunity to sell that allow-

ance and thus incurs an opportunity cost.

31. Under the economy-wide program proposed here, annual auction revenue (i all allowances were auctioned) would exceed $100 billion,compared with ederal net tax revenue in scal year 2006 o $351 billion rom the corporation income tax, $994 billion rom the individualincome tax, and $810 billion rom employment taxes (U.S. Energy Inormation Administration 2006b).

32. Two exceptions are allocations to regulated utilities (discussed below) and updating allocations. I allowances are reely allocated, the

allocation should be on the basis o some historical measure or measures, not on the basis o measures that rms can infuence. Updatingallocations, which involve periodically adjusting allocations over time to refect changes in rms operations, violate this principle. For ex-ample, an output-based updating allocation ties the quantity o allowances that a rm receives to its output. This distorts rms pricing andproduction decisions in ways that can introduce unintended consequences and can signicantly increase the cost o meeting an emissionstarget. Selective use o updating allocations has nevertheless been recommended by some to preserve industry competitiveness and reduceemissions leakage in sec

10 climate stavins

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