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WORLD RESOURCES INSTITUTE

THE COSTS OF CLIMATE PROTECTION:A GUIDE FOR THE PERPLEXED

ROBERT REPETTO AND DUNCAN AUSTIN


THE COSTS OF CLIMATE PROTECTION:A GUIDE FOR THE PERPLEXED

ROBERT REPETTODUNCAN AUSTIN

CLIMATE PROTECTION INITIATIVE

Carollyne Hutter

Acting Publications Director

Hyacinth Billings

Production Manager

Designed by:

Lomangino Studio Inc., Washington, DC

Each World Resources Institute Report represents a timely, scholarly treatment of a subject of public concern.

WRI takes responsibility for choosing the study topics and guaranteeing its authors and researchers freedom of inquiry.

It also solicits and responds to the guidance of advisory panels and expert reviewers.

Unless otherwise stated, however, all the interpretation and findings set forth in WRI publications are those of the authors.

Copyright © 1997 World Resources Institute. All rights reserved.

ISBN 1-56973-222-1

Library of Congress Catalog Card No. 97-60932

Printed in the United States of America on Recycled Paper.

CONTENTS

ACKNOWLEDGMENTS v

FOREWORD v n

INTRODUCTION l

1. MODELS, ASSUMPTIONS AND CONCLUSIONS 5

2. HOW THE MODELS' ASSUMPTIONS DETERMINEWHAT ECONOMIC IMPACTS THEY PREDICT 11

3. MORE DETAIL ON THE KEY ASSUMPTIONS 17

A. The Scope for Reducing Energy Inefficiencies 17

B. Substitution Effects is

C. Technological Change and Energy Efficiency Improvement 19

D. Backstop Energy Sources 19

E. The Time Path for Stabilizing CO2 Concentrations 21

F. The Possibility of International Joint Implementation 23

G. How Revenues Are Recycled Into the Economy 23

H. Avoiding the Costs of Climate Change 26

I. Avoiding Other Environmental Damages 2 8

4. TRADE AND EQUITY ISSUES 3 1

A. Trade Issues 31

B. Distributional Effects 32

1. Distributional Effects On Households 32

2. Distributional Effects By Sector and Region 33

5. CONCLUSIONS AND RECOMMENDATIONS 35

REFERENCES 3 8

ANNEX 42

ADDITIONAL REFERENCES 4 6

ABOUT THE AUTHORS 4 8

BOARD OF DIRECTORS 49

WORLD RESOURCES INSTITUTE 5 0

WORLD RESOURCES INSTITUTE CLIMATE PROTECTION INITIATIVE 5 1

T H E C O S T S O F C L I M A T E P R O T E C T I O N / W O R L D R E S O U R C E S I N S T I T U T E I I I

ACKNOWLEDGMENTS

The authors wish to thank many peo-ple who helped with the researchunderlying this report but not to sug-gest that they bear any responsibilityfor its contents. Richard Goettle,Richard Richels, Hugh Pitcher, JaeEdmonds, Robert Shackleton, MikeShelby, and John Weyant wereextremely helpful with data and tech-nical suggestions. We thank JohnReilly, Tom Walton, Alan Miller, andan anonymous external reviewer foruseful criticisms and comments on anearlier draft of the report. Similarly,we thank WRI colleagues Paul Faeth,Jim Mackenzie, Walt Reid, JonathanLash, and Liz Cook for their com-ments. Valuable assistance at variousstages from Marca Hagenstad, TheresaBradley, Maggie Powell, HyacinthBillings, Carollyne Hutter, BethBehrendt, and Beth Harvey is greatlyappreciated.

R.R.D.A.

THE COSTS OF CLIMATE PROTECTION/WORLD RESOURCES INSTITUTE V

FOREWORD

Nations that have signed the GlobalClimate Convention are negotiatingcommitments to stabilize and thenreduce emissions of greenhouse gases,which will otherwise continue to buildup in the atmosphere and alter globalclimate. An agreement with bindinglimitations is essential, since experi-ence in the United States and manyother countries over the past five yearsshows that the purely voluntary effortspledged in Rio de Janeiro at the EarthSummit are insufficient.

Since the Framework Convention onClimate Change was concluded in1992, global emissions have continuedto rise despite increasing evidence thathuman activity is having a discernibleeffect on world climate. The mostrecent scientific assessment by theIntergovernmental Panel on ClimateChange emphasized that the continuedbuildup of greenhouse gases couldhave long-lasting climatic effects, someof which would impose significant eco-nomic burdens on nations and vulnera-ble populations.

Before the United States commitsitself to specific restrictions on carbondioxide emissions and timetables forimplementation, it is essential that theeconomic consequences be thoroughlyunderstood. Limiting carbon dioxideemissions will mean significantchanges in energy use and energysources, probably changing energycosts substantially. Household budgetsand business profits will be affected.These impacts may affect inflation,international trade, patterns of invest-ment, and thus the macro-economy.

Whether the United States makesthese changes unilaterally or in concertwith other nations, whether it makesthem in a cost-effective way using mar-ket-friendly policy instruments, andwhether it implements them with ade-quate time and flexibility for economicadjustments to occur will all affect themacroeconomic impacts.

As the discussion of mandatory policiesto reduce greenhouse gas emissionshas accelerated, efforts to understandthe economic implications of thosepolicies have become intense. Morethan a dozen economic models havebeen used to generate simulations ofdifferent abatement targets and imple-mentation policies. Not surprisingly, allthis activity has produced little appar-ent consensus: economists derivemarkedly different predictions fromtheir models about the likely impactsof achieving any specific abatementgoal. Various interest groups haveseized on particular predictions to sup-port their own policy conclusions.

To sort out the resulting confusion,World Resources Institute vicepresident and senior economist RobertRepetto and his colleague DuncanAustin explain why different economicmodels reach different conclusions—because they start from differentassumptions. This report, The Costs ofClimate Protection: A Guide for thePerplexed, provides an overview of 16leading economic simulation models.According to the report, under a rea-sonable set of common assumptions,models indicate that the macroeco-nomic impacts of stabilizing green-

TI-IE C O S T S O F C L I M A T E P R O T E C T I O N / W O R L D R E S O U R C E S I N S T I T U T E V I I

house gas emissions are likely to bemodest and, if the environmental ben-efits are factored in, are likely to bebeneficial. Repetto and Austin identifywhich assumptions are crucial. Theirreport will help readers form their ownjudgment about the likely impact ofclimate protection on the economy.

Building on the findings of earlierreports, including The Right Climatefor Carbon Taxes: Creating EconomicIncentives to Protect the Atmosphere;Green Fees: How a Tax Shift CanWork for the Economy and theEnvironment; and Breathing Easier:Taking Action on Climate Change, AirPollution and Energy Insecurity, WRIcontinues to explore constructive ways

to resolve the climate problem withoutundermining economic prosperity. Weare committed to working with the pri-vate and public sectors in the UnitedStates and abroad to achieve this goal.

We would like to thank the MacArthurFoundation, the W. Alton JonesFoundation, the Nathan CummingsFoundation, and the U.S. Environ-mental Protection Agency for provid-ing generous financial support for thework underlying this report.

Jonathan LashPresidentWorld Resources Institute

V I I I WORLD RESOURCES INSTITUTE /THE COSTS OF CLIMATE PROTECTION

INTRODUCTION

The latest international scientificassessment concludes that humanactivity is affecting the global climate(IPCC, 1996a). Population growth,rapid industrialization, increasing fossilfuel use, and continuing deforestationimply that without drastic action car-bon dioxide concentrations in theatmosphere will double their pre-industrial levels by about the year 2060and eventually cause average globaltemperature to rise by 1C-3.5C (IPCC,1996a). The consequences of warmingon this scale are hard to predict.Although some effects, such as risingsea levels and changing agriculturalpatterns, can be clearly foreseen, othereffects, some potentially catastrophic,can only be guessed at. Nations havecommitted themselves to a precaution-ary approach designed to limit theaccumulation of greenhouse gases.

Policies to prevent climate changefocus mainly on carbon dioxide (CO2)emissions, the most important green-house gas. As a first step toward theultimate goal of stabilizing concentra-tions, the industrialized nations thatsigned the Framework Convention onClimate Change voluntarily undertookto return their emissions of carbondioxide and other greenhouse gases to1990 levels by the year 2000. However,many countries, including the UnitedStates, will fail to meet this target.

In 1995, at the first Conference ofParties to the Convention (COP-1) inBerlin, signatories acknowledged thateven if emissions were stabilized at1990 levels, concentrations wouldcontinue to rise rapidly because CO2,once released, remains in the atmos-phere for decades. The BerlinMandate calls for strengthened com-mitments from developed countries toreduce their emissions after 2000.Negotiations since COP-1 have led tovarious proposals, the most stringentcalling for industrialized countries toreduce emissions to 20 percent below1990 levels by 2005 (AOSIS, 1995).The United States Government hasstated that it is prepared to acceptlegally binding commitments in futureprotocols in the hope that this willprompt other countries to adopt a sim-ilar stance. Agreement on future com-mitments will be embodied in a formalprotocol to be signed at the thirdConference of the Parties in Kyoto inDecember 1997.

If the United States and other nationsdo agree on binding limits on green-house gas emissions, they will need toadopt measures to reduce carbonemissions with the least adverseeconomic impacts. One of the mosteffective and efficient mechanisms is acarbon tax—a tax levied on all fossilfuels in proportion to their carbon

One of the most effective and efficient mechanisms toreduce carbon emissions is a carbon tax—a tax leviedon all fossil fuels in proportion to their carbon contents.

THE COSTS OF CLIMATE PROTECTION/WORLD RESOURCES INSTITUTE 1

contents. Raising the prices of fuelsand energy-intensive products woulddiscourage all fossil fuel uses inproportion to their carbon contentsand encourage development of lesscarbon-intensive alternatives. A recentstatement by leading economists pointsout that a tax mechanism would bemuch more efficient than a regulatoryapproach (Economists' Statement onClimate Change, 1997).

An alternative proposal under seriousconsideration in the United States is atradable permits program, in whichpermits would be required in order tosell or use fossil fuels. By limiting thetotal number of permits, the regula-tory authority could control carbonemissions. If the government allowedpermits to be bought and sold, theprogram would create efficient incen-tives like those of a carbon tax,because the permit price in the mar-ketplace would signal how much firmsshould reasonably spend on abate-ment measures. If the governmentinitially distributed the permitsthrough an auction, it could mitigateadverse economic impacts by usingthe revenues to reduce other taxeswithout increasing fiscal deficits. Inthis sense, auctioned-off tradable per-mits to sell or use fossil fuels haveeconomic implications similar to thoseof a carbon tax. (In this report, state-ments about the effects of a carbontax apply equally to the impacts oftradable carbon permits that are auc-tioned off.)

Though one argument for tradablepermits is the perceived political

difficulty of proposing a change in thetax structure, the tradable permitsapproach also faces potential difficul-ties. It would be less efficient than arevenue-neutral tax and wouldencounter political opposition ifvaluable permits were given away toenergy companies and utilities.Moreover, it would be difficult toinclude small fuel users in a tradablepermits program, though their aggre-gate energy use is important, withoutcreating administrative burdens muchgreater than those implied by raisingenergy taxes. Furthermore, if new sci-entific information necessitated fur-ther emissions reduction, cancelingcarbon permits that had been pur-chased in an auction or market trans-action would be more difficult thanraising a carbon tax.

Many interest groups claim that acarbon tax or any other efficientpolicy to reduce carbon emissions,such as a tradable permits policy,would impose high economic costsand reduce economic growth. Forsupport, they point to simulationswith economic models, some of whichhave suggested that stabilizing CO2emissions at 1990 levels could requirea tax of up to $430 per ton of carbonby 2030 and could impose total costsof up to 2.5 percent of annual grossdomestic product (GDP) (CharlesRiver Associates, 1997). Of course,other economic models predict thatsimilar emissions reductions could beachieved with far smaller energy taxesand negligible, or even favorable,overall impacts on the economy(Gaskins and Weyant, 1993).

Despite the complexity of the models, only a handfulof easily understandable assumptions are importantin determining the simulation results.

WORLD RESOURCES INSTITUTE /THE COSTS OF CLIMATE PROTECTION

Which predictions should we believe—if any? Interested groups on differentsides of the issues have their ownpreferred models (and modelers), andthese tend to produce simulationssupporting the policy positions of theirrespective sponsors. The underlyingeconomic models may contain dozensof complicated equations that arenearly impenetrable to all but trainedeconometricians. How and why suchmodels reach the predictions that theydo is hard to comprehend. Yet, it mat-ters greatly what the economic impactsof policies to reduce the long-termrisks of global warming will be.

This report provides a guide for theperplexed—an explanation in simpleterms of the key assumptions in themodels being used to simulate the

economic effects of carbon taxes orsimilar policies to control carbondioxide emissions. The report alsoprovides a quantitative analysis of 16widely used models, demonstratinghow key assumptions affect the pre-dicted economic impacts of reachingCO2 abatement targets. It turns outthat despite the complexity of themodels, only a handful of easily under-standable assumptions are important indetermining the simulation results.By showing the effect of these assump-tions on the predicted economic costs,not just in one particular model but inall of them, this report can help read-ers to apply their own judgments aboutwhich models are more realistic and toreach their own conclusions aboutwhich economic predictions are morecredible.


An economic model is no more than acoherent set of assumptions about thestructure and functioning of the econ-omy. A model is used to predict theconsequences of some change, often apolicy change like the imposition of acarbon tax. Naturally, the predictiondepends entirely on the assumptionsimbedded in the model—how could itbe otherwise? Many of the assump-tions of an economic model are simpli-fications, adopted to make the modeleasier to analyze or to compute.Modelers hope that in making thesesimplifying assumptions the baby is notdisappearing along with the bathwater,but, alas, that is not always so. Manyare based on empirical studies, oftenquite sophisticated, of particular rela-tionships in the economy, and themodeler hopes not only that the rela-tionship has been described accuratelybut also that it will continue in thefuture as it was in the past.

Many people are critical of theassumptions economists make butnone more so than economists them-selves. Typically, economic modeling ofimportant issues is subjected to wide-spread and intense scrutiny within theeconomics profession, and unrealisticassumptions tend to be identified,

improved, or discarded. Just as climatescientists and modelers over the pastdecade have criticized and improvedthe atmospheric models linking green-house gas emissions to changes in cli-mate, so have economists improvedthe modeling of the economic impactsof a carbon tax. There has been pro-longed economic debate and signifi-cant intellectual progress in makingthe models used for economic simula-tion more realistic. This report reflectssome of that intellectual history.

Two kinds of assumptions in the mod-els are critical: those that largely deter-mine the predicted economic costs ofabating carbon emissions and thoserelating to the economic benefits fromforestalling environmental impactsfrom fossil fuel emissions. Withrespect to the costs of limiting carbonemissions, the key assumptions are

1. the extent to which substitutionamong energy sources, energy tech-nologies, products, and productionmethods is possible;

2. the extent to which market and pol-icy distortions create opportunitiesfor low-cost (or no-cost) improve-ments in energy efficiency;

Just as climate scientists and modelers over the pastdecade have criticized and improved the atmosphericmodels linking greenhouse gas emissions to changesin climate, so have economists improved the modelingof the economic impacts of a carbon tax.


B O X 1 T H E M A I N K I N D S O F E C O N O M I C S I M U L A T I O N M O D E L S

Predictions of the economic impacts of climate protectionpolicies have been made on the basis of two main kinds ofeconomic analyses, commonly referred to as 'top-down' and'bottom-up' models. Top-down models are aggregate mod-els of the whole economy that represent the sale ol goodsand services by producers to households and the reciprocalflow of labor and investment funds from households toindustries. Models used for policy simulations also describethe role of government in imposing taxes, transferringincome, and purchasing goods and services. Computablegeneral equilibrium (CGE) models depict the formation ofmarket-clearing prices in the process of matching thedemand lor goods and services from users to their supplvby producers. Demand and supply conditions in such mod-els are based on assumptions that consumers and producersallocate their resources to maximize their welfare or profits,respectively. However, demand and supplv conditions aretvpically based on statistically estimated relationshipsobserved in the past. Optimizing models derive their pre-dictions by explicitly maximizing some assumed mathemati-cal formula representing household welfare as a function ofpresent and future consumption. Such general equilibriummodels assume that households and industries will eventu-ally respond efficiently to any policy change, though somemodels describe irreversible investment decisions andimperfect foresight regarding future prices that serve todelay the adjustment process.

In contrast, macroeconomic models predict economicbehavior from statistically estimated relationships amongeconomic variables in the past. Although such relationshipsare developed from accepted economic theory, macro mod-els do not derive the predicted response to a policy shiftfrom an explicit assumption that firms and householdsrespond efficient!} or with accurate foresight. Because theyarc estimated from actual macroeconomic behavior, theycan reflect the short-term adjustment costs in response toan unexpected economic policy change, including businesscycles, inflation, and unemployment. Macro and CGE mod-els can be complementary in predicting short-run and long-run responses to a policy change. Moreover, modelers havelearned to combine features of both (Hourcade andRobinson, 1996; Shackleton et al., 1992).

Top-down models used to analyze climate policies em-phasize interactions between the energy sector and the restof the economy. A tax-induced change in the priceof carbon fuels directly affects demand and supply for- ener-gy, and indirectly affects other markets for commodities,labor, and capital. Therefore, consumer prices, incomes,savings, and labor supply are also affected, resulting in new-levels of GDP, investment, and future growth. These can allbe compared to baseline projections. More detailed analy-ses offer insights into distributional incidence on particularindustries and income groups. When key assumptions arestandardized among models, the range of their predictionsnarrows (Gaskins and Weyant, 1993).

Bottom-up analyses examine the technological options forenergy savings and fuel-switching that are available in indi-vidual sectors of the economy, such as housing, transporta-tion, and industry. Information on the costs of these optionsin individual sectors is then aggregated to calculate theoverall cost of achieving a reduction in CO2 emissions. Incontrast to top-down models, iir which the scope for tech-nological substitution is extrapolated from past experience,bottom-up analyses estimate possibilities by consideringexplicitly the actual technologies that firms could profitablyadopt at various energy price levels. Bottom-up analysestend to be more optimistic about the scope lorcost-effective energy savings.

To some extent, this optimism comes from overlookingimportant barriers to implementation, such as managementand retraining time, risk-aversion toward unproven tech-nologies, capital constraints, household preferences, or lackof information (Boero et ah, J991). Top-down models basedon past rates of substitution and technological changeimplicitly incorporate such effects. Moreover, bottom-upanalyses do not deal as adequately with overall macroeco-nomic constraints on capital availability or- market demandas top-down models do. Despite these limitations, bottom-up analyses have highlighted energy inefficiencies and tech-nological opportunities. Some top-down climate modelshave adopted features of bottom-up analyses by incorporat-ing detailed descriptions of technological options for energysupplv, conversion, and use.

6 WORLD RESOURCES INSTITUTE /THE COSTS OF CLIMATE PROTECTION

Assumptions about the use of revenues generatedfrom carbon taxes or from auctioning off carbonpermits are crucial.

3. the likely rate of technologicalinnovation and the responsivenessof such change to price signals;

4. the availability and likely futurecost of non-fossil, backstop energysources;

5. the potential for international 'jointimplementation' of emissionsreductions; and

6. the possibility that carbon tax rev-enues would be recycled throughthe reduction of economically bur-densome tax rates.

Top-down models that assume limitedsubstitution, slow technological changethat does not respond to price signals,limited, expensive, or no availability ofnon-fossil energy sources, and theabsence of international cooperation inachieving emissions reductions at leastcost unfailingly predict that the eco-nomic costs of achieving any given car-bon abatement target will be high. Atthe other extreme, bottom-up analysesthat embody optimistic assumptionsabout the potential availability andrapidity of cost-effective, energy-savingtechnological improvements, and thatneglect capital and other resource con-straints can be counted on to predictlow abatement costs.

In addition, assumptions about the useof revenues generated from carbontaxes or from auctioning off carbonpermits are crucial. These revenuescan be used to offset reductions in rev-enues if rates are cut on other taxesthat are economically burdensome,

without raising fiscal deficits. Manyexisting taxes on incomes, profits, andpayrolls discourage savings, work,or investment by lowering after-taxreturns to those activities. Economicstudies suggest that lowering marginaltax rates for such existing forms oftaxation and making up the revenuethrough a carbon tax would lessen theeconomic impacts of achieving a car-bon abatement target. However, manyearly economic modeling simulationsassumed that revenues from a carbontax would not be used in this way butsomehow returned in arbitrary "lump-sum" distributions to households, withno effect on incentives to work, save,or invest.

The final set of key assumptions con-cerns the environmental damages acarbon tax would avoid. Though avert-ing these potential damages is therationale for a carbon tax, most eco-nomic models are not constructed inways that can take these damages intoaccount. However, some models havefactored in two types of savings:

1. avoiding the economic damagesfrom climate change (the 'climatebenefits'); and

2. reducing other air pollution dam-ages associated with the burning ofcoal and other fossil fuels (the 'non-climate benefits').

The impact of climate change on theU.S. economy is a matter of greatuncertainty, with predictions rangingfrom potential disasters—floods, hurri-canes, droughts, and pestilence—to


Though averting potential environmental damages isthe rationale for a carbon tax, most economic modelsare not constructed in ways that can take thesedamages into account.

potentially mild or even benign effects.Attempts at comprehensive assessmenthave projected that, on balance, cli-mate change will impose net economiccosts over the next century, rising withthe extent and rapidity of the change inclimate (IPCC, 1996b; Nordhaus, 1993;Cline, 1992). Some assessments haveassumed a degree of risk-aversion thatgives more emphasis to low-probabilitybut severely damaging outcomes.

Few models have dealt with the poten-tial environmental side-benefits of acarbon tax that would make coal andpetroleum fuels more expensive anddiscourage their consumption. Sincebaseline projections predict that with-out a carbon tax coal burning in powerplants and gasoline consumption inmotor vehicles will increase in comingdecades, air quality might deteriorate,harming human health and necessitat-ing higher medical expenditures. Acarbon tax would reduce these risks.Whether or not models take such envi-ronmental side-benefits into accountsubstantially affects the economicimpacts they predict.

As the next section will demonstrate,the divergent assumptions built into

economic models in these key areaslargely explain why their predictionsregarding the economic costs of reduc-ing emissions differ so widely. Under areasonable standardized set of assump-tions, most economic models wouldpredict that the macroeconomieimpacts of a carbon tax designed tostabilize carbon emissions would besmall and potentially favorable.

Aside from the macroeconomieimpacts, other considerations enterthe debate over climate protectionpolicies: notably, their distributionalimpacts and their effects on our inter-national competitive position. As dis-cussed in the final section of thisreport, the disproportionate impact ofa carbon tax on low-income householdsnow appears to be less than firstthought and could be easily offset byother tax reductions or cost-of-livingadjustments in social security andother transfer programs. By contrast,the disproportionate impacts on cer-tain industries, particularly the coalmining industry and coal-carrying rail-way lines, would undoubtedly be sub-stantial. To put this in context, thebaseline projections against whichthese effects are evaluated predict sub-

Under a reasonable standardized set of assumptions,most economic models would predict that themacroeconomie impacts of a carbon tax designed tostabilize carbon emissions would be small andpotentially favorable.

WORLD RESOURCES INSTITUTE /THE COSTS OF CLIMATE PROTECTION

stantial expansion in coal mining in thewestern United States. The effects of acarbon tax designed to stabilize emis-sions at something like current levelswould be largely to reduce the indus-try's rate of growth.

Concerns regarding the effects of car-bon abatement policies on the interna-tional position of the U.S. economyhave also weakened in force because ofrecent developments. The key issues,closely interrelated, are

1. whether reduced energy demand inthe United States would help holddown world oil prices, improvingour terms of trade;

2. whether higher domestic energyprices would stimulate energy-intensive industries in other coun-tries to expand more rapidly; and

3. whether other countries would alsoadopt similar policies to restrictgreenhouse gases, following theU.S. lead.

The United States is a sufficientlylarge importer of petroleum productsthat its demand affects world prices.Baseline projections imply that in theabsence of a carbon tax petroleumconsumption would continue to out-grow production capacity in non-OPEC regions, so that OPEC wouldsupply an increasing share of the world

oil market. By 2015, OPEC's sharewould exceed its peak two-thirds sharein 1974, when it was able to raise ener-gy prices sharply (U.S. EIA, 1996). AU.S. carbon tax that reduced U.S.energy demand could forestall increas-es in these prices and shift some of theeconomic impact on to foreign oil pro-ducers.

If, however, the United States aloneimposed a significant carbon tax, inter-national trade and investment in someenergy-intensive industries might shiftsufficiently to expand carbon emissionselsewhere and reduce U.S. productionof those products. This now seemsunlikely. Differential environmentalpolicies appear to have a weak impacton trade and investment flows, if any(Repetto, 1995). Moreover, many non-OECD countries, including India,China, Mexico, and the republics ofthe former Soviet Union, have alreadyraised energy prices unilaterally forpurely economic reasons. MajorOECD countries are likely to followsuit in instituting climate protectionpolicies if the United States takes thelead. A few European countries havealready enacted modest carbon taxes;others are seriously considering replac-ing some labor taxes with environmen-tal taxes (OECD, 1997; Carraro andSiniscalco, 1996). The greater likeli-hood of coordinated internationalaction means that adverse trade effectscan be avoided.

THE COSTS OF CLIMATE PROTECTION/WORLD RESOURCES INSTITUTE

To clarify how key modeling assump-tions affect the predicted economicimpacts of a carbon tax, we haveassembled 162 different predictionsfrom 16 of the most reputable andwidely used economic models. Each ofthe models differs in its basic featuresand for each model, different simula-tion "runs" reflect either different poli-cy assumptions (e.g., about the dispo-sition of tax revenues) or differentabatement targets and carbon tax rates.Each simulation "run" generates a pre-dicted economic impact—measuredhere as the percentage change in GDPin some future year—and a corre-sponding percentage change in carbondioxide emissions in the same year.Both variables are measured with ref-erence to a baseline scenario, particu-lar to each model, predicting whatwould happen in that year if no carbontax or equivalent policy were adopted.

This measure of economic impact—future year GDP—is not ideal but wasadopted because it is predicted in allmodels. If the predicted economicadjustment involves an initial slumpfrom which the economy then recov-ers, a better measure would be the(discounted) loss of income and con-sumption over the entire period, butsuch a measure is not available in allmodels. More fundamentally, GDP is ameasure of economic activity, not eco-nomic wellbeing: for one thing, it doesnot measure the nonmarket value ofenvironmental quality.

The collection of model "runs"—plot-ted in Figure 1—shows how variablethe predicted economic impacts are.

For example, a carbon tax that inducesa 35 percent reduction in CO2 emis-sions could be expected to raise GDPover its projected baseline level bymore than 1.5 percent or to reduceGDP by about 3 percent, dependingon the economic models and modelingassumptions used. The majority of pre-dictions suggest that abating CO2 emis-sions will reduce economic activity andthat eliminating a greater percentageof emissions will lower GDP morethan proportionately. However, this ap-parent consensus does not imply thatthis prediction is likely to be accurate,but only that most modeling exerciseshave employed similar assumptions.

For each of these 162 modeling pre-dictions, we have listed the mainassumptions underlying the predic-tions. Some of these revolve aroundthe basic features of the model; othersrefer to the policy options assumedfor the specific simulation. Our listincludes most of the key assumptionsdiscussed in the previous section. Ofthe structural features of the models,the salient distinctions are:

1. Is the model of the CGE type,which assumes that the economyadjusts efficiently in the long-run,or is it a macro-model that assumesthe economy suffers persistenttransitional inefficiencies?

2. How much scope for inter-fueland product substitution does themodel assume, as indicated bythe number of different energysources and industrial sectors inthe model?1

This is just one indicator ofpotential substitution; the other,not so easily measured, is theease with which one product canbe replaced by another inresponse to changes in relativecosts.

THE COSTS OF CLIMATE PROTECTION/WORLD RESOURCES INSTITUTE 1 1

3. Does the model assume that oneor more backstop non-fossil energysources are available at someconstant cost ?

4. How many years does the modelassume to be available to achievethe specified CO2 reduction target,expressed as a percentage reductionfrom projected baseline emissionsin the final year?

5. Does the model assume thatreducing CO2 emissions wouldavoid some economic costs fromclimate change, or that no suchcosts exist?

6. Does the model assume that reduc-ing fossil fuel combustion wouldavoid some damages from air pollu-tion, or not?

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The salient policy assumptions thatdifferentiate the model predictions are:

7. Does the model assume that carbontax revenues are returned to theeconomy through the reduction of adistorting tax rate, or throughlump-sum rebates?

8. Does the model assume that jointimplementation options are avail-able, or not?

To show how these assumptions affectthe predicted economic impacts, weexpressed these assumptions either asbinary variables (yes = 1; no = 0) ornumerical variables and used statisticaltechniques to relate the assumptions to

quadratically related to the per-centage change in carbon emis-sions, both measured relative tothe baseline projection.

the data points portrayed in Figure 1. 2 Specifically, we assumed that theDoing this Shows how the assumptions Percentage change in GDP was

affect the predicted impacts, not in anyone model but across all 16 models in162 different simulations. As suggestedby these data points, we assumed thatthe economic impact of each additionalone percent reduction in carbon emis-sions would be greater, the greater thepercentage reduction.2 We alsoassumed (consistent with the definitionof the baseline projection) that impos-ing no carbon tax would not affect theeconomy's baseline trajectory, so thatany statistical function would includethe zero point in Figure 1.

Surprisingly, these eight assumptions(along with the size of the CO2


3 This was established by estimat-ing a linear multiple regressionmodel that incorporates vari-ables representing the eightassumptions, taking the percent-age change in GDP as the vari-able to be "explained". (Theestimated regression equationcan be found in the Annex.) Analternative regression analysisthat included only the reductionin carbon emissions as anexplanatory variable and exclud-ed all the variables representingmodel assumptions explainedonly about half as much of thevariation in predictions.

4 The variable representing thepresence or absence of a back-stop energy source was specifiedto affect the curvature of thecost curve, since backstopsources become relevant only athigher energy prices and thenlimit the rate of cost increase.

emissions reduction) account forfully 80 percent of the variation inpredicted economic impacts.3 This isremarkable because it implies that allthe other modeling assumptions—hundreds of assumed parametervalues and relationships—are compara-tively unimportant. Together, theyaccount for only 20 percent of thedifferences among predicted impacts.Only a handful of basic assumptionsreally matters.

This is good news. People don't haveto be Ph.D economists to understandthe debate over the economic impactsof climate policy. Rather, people canuse their own judgment and commonsense to decide which of these basicassumptions are more realistic.Having decided that, they can thendetermine for themselves which pre-dictions are more credible and whatthe economic impacts of a carbon taxor a climate stabilization policy arelikely to be.

To illustrate, we have used the statisti-cal relationship between predictionsand assumptions to plot several costcurves in Figure 2. Each cost curverepresents a different set of modelingassumptions selected from those listedabove, starting from a set of "worstcase" assumptions and then successive-ly replacing them, one-by-one, withmore favorable assumptions until a setof "best-case" assumptions is arrivedat. In the statistical analysis underlyingthese curves, the slope of the curveconnecting GDP change to emissionsreduction was allowed to shift with

each of the eight assumptions, but theyear for achieving the abatement tar-get was held constant.4

The worst case assumptions are that:

1. there is no non-carbon backstopenergy source;

2. the economy does not respond effi-ciently to policy changes, even inthe long-run;

3. the scope for inter-fuel and productsubstitution is minimal;

4. there is no possibility of jointimplementation;

5. revenues are returned throughlump-sum rebates;

6. there are no averted damages fromair pollution; and

7. there are no averted damages fromclimate change.

Under these assumptions, many ofwhich are obviously unrealistic, theadverse economic impacts of acarbon tax or equivalent policy wouldbe severe, reaching 6 percent ofend-year GDP for a 50 percentreduction in projected baselineemissions by 2020. (See the bottom-most curve in Figure 2.)

Scanning Figure 2 from the bottom upreveals the effects on predicted eco-nomic impact of changing these worst-case assumptions one-by-one. For

Surprisingly, these eight assumptions (along with thesize of the CO2 emissions reduetion) aceount for fully80 percent of the variation in predicted economicimpacts.


Under all the best-ease assumptions, a reduction inCO2 emissions by 2020 would result in a substantialimprovement in GDP relative to its business-as-usualpath.

example, assuming that backstop ener-gy sources exist improves the predictedeconomic impact substantially—byabout one percent of GDP for a 50percent emissions reduction. In Figure2, what is notable about the predictedimpacts on the U.S. economy is thatchanging only five worst-case assump-tions—by assuming backstop energysources, efficient long-run adjustmentin the economy, greater substitutionpossibilities, joint implementation, andrecycling of carbon tax revenues byreducing other burdensome tax rates—dramatically alters the predicted eco-nomic impacts. Instead of a six percentloss of GDP by 2020, there would bemodest positive impact on GDP rela-tive to the business-as-usual scenario.

Judging from all these simulationsusing a wide variety of economic mod-els, the doomsday prediction of heavyeconomic losses if carbon emissionsare reduced is implausible. It is morereasonable to predict that with sensibleeconomic policies and internationalcooperation, carbon dioxide emissionscan be reduced with minimal impactson the economy.

Going further, Figure 2 indicates that ifreducing fossil fuel combustion avoidseconomic damages from climate changeor air pollution, then the overall eco-nomic impacts could be favorable.5 Thetop-most curve in Figure 2 indicatesthat under all the best-case assumptions,a reduction in CO2 emissions by 2020would result in a substantial improve-ment in GDP relative to its business-as-usual path.6 Of course, there is some

degree of emissions reduction beyondwhich the incremental abatement costsexceed the value of the environmentaldamages that more pollution would cre-ate. This turning point is not adequatelyreflected in Figure 2, which should notbe interpreted to suggest that if somecarbon abatement is good, more is nec-essarily better. Figure 2 does imply,however, that models that take the envi-ronmental benefits of carbon taxes intoaccount predict substantially morefavorable economic impacts than mod-els that ignore such benefits.

One target that has been analyzedextensively by the InteragencyAnalytical Team in preparation for theCOP-3 meeting in Kyoto in December1997 is a freeze on carbon emissions at1990 levels by 2010 and stabilization ofemissions thereafter. For the UnitedStates, it has been estimated that thistarget implies about a 26 percent reduc-tion below projected baseline emissionsin 2020, if the baseline is calculated onthe basis of policies now in place (U.S.EIA, 1996). Figure 3 uses the same sta-tistical analysis to show in detail therange of predicted long-run economicimpacts if this target is attained.7 Underunfavorable assumptions, GDP wouldbe 2.4 percent lower in 2020 than underbaseline conditions; under favorableassumptions, GDP would be 2.4 percenthigher. Figure 3 also quantifies the rela-tive importance of several modelingassumptions in creating this range ofpredictions.

Four assumptions stand out in termsof magnitude:

5 This prediction is consistentwith the interpretation of a car-bon tax as a corrective tax thatreduces a market failure—namely, the unintended effect ofcarbon emissions on the globalclimate. Economists agree that,if set at the proper rate, a tax tocorrect a market failure shouldimprove an economy's produc-tivity.

6 When air pollution damages areassumed, an expanded measureof GDP in which environmentaldamages are recorded is the rele-vant indicator of economicimpact.

This analysis cannot encompassshort-run transitional impactspredicted by some macroeco-nomic forecasting models.


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3. Joint Implementation

4. Revenues recycled effectively

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6. Climate change damages averted

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• whether the economy will adaptefficiently;

• whether international joint imple-mentation will be achieved;

• whether carbon tax or permit auc-tion revenues will be recycled byreducing other taxes; and

• whether there will be economicbenefits from abating pollution.

Most economists believe that the U.S.market economy, with high mobility ofcapital and labor, can adapt efficientlyto moderate the impacts of policy

changes. There is general agreementthat a carbon tax that discouraged coaluse in electricity generation wouldhave the effect of reducing air pollu-tion, even with current air pollutionregulations in place. Whether to userevenue-raising policy instruments tolimit emissions and how to dispose ofresulting revenues are decisions thatthe U.S. government must make.Finally, international cooperation injoint implementation of carbon reduc-tion targets is a possibility subject tonegotiation. Under reasonable assump-tions, the predicted economic impactof stabilizing emissions at 1990 levelswould be neutral or even favorable.


MORE DETAIL ON THE KEY ASSUMPTIONS

The preceding analysis looked broadlyat the key assumptions that turn out todetermine very largely the predictedeconomic impacts of climate protec-tion policies. These broad distinctionsamong the modeling assumptions ex-plain most of the differences amongpredictions. Nonetheless, other aspectsof the key assumptions, which couldnot be adequately built into the pre-ceding analysis need to be recognizedand understood. This section addressessuch issues.

A. THE SCOPE FOR REDUCINGENERGY INEFFICIENCIES

Top-down models typically assume thatall cost-effective improvements in en-ergy efficiency have already been real-ized, an assumption contradicted byactual experience (DeCanio, 1993). Forexample, large companies that joinedthe Environmental Protection Agency'svoluntary Green Lights Program toreduce their energy use found numer-ous opportunities to save both energyand money in their ongoing operations.

Bottom-up studies have found ineffi-ciencies in energy use that could beremedied through building improve-ment measures, such as better insula-tion and low-energy lighting; through

technological advances in transportefficiency; or through conversion ofindustrial processes. Assessmentsbased on engineering studies suggestthat from 20 to 25 percent of existingcarbon emissions could be eliminatedat an overall cost savings and thatsubstantial further cutbacks could bemade at relatively low cost (IPCC,1996b; National Academy of Sciences,1991; Office of TechnologyAssessment, 1991).

Some of these inefficiencies undoubt-edly persist because of energy marketimperfections, such as the divergencein incentives between tenants andlandlords, builders and home pur-chasers; because of energy subsidies;or because of suboptimal decision-making within organizations. However,some reported savings opportunitiesmight be illusory if the managementcosts of locating and implementingenergy investments were overlooked orthe differences in product and servicecharacteristics of various energy-conversion technologies were ignored.Energy service companies, whichseek to find and implement energy-saving opportunities on a contractualbasis, have not found unlimited busi-ness opportunities at current lowenergy prices.

Top-down models typically assume that all cost-effective improvements in energy efficiency havealready been realized, an assumption contradictedby actual experience.


Top-down models typically assumeaway energy subsidies that may encour-age excessive fuel use and must befinanced through higher levels of eco-nomically burdensome taxes. Energysubsidies, though not as prevalent inthe United States as in some othercountries, still include favorable tax andcredit treatment for energy producers,below-market provision of power frompublic sector installations, and federallysponsored research and development.Two recent studies quantify annual fed-eral energy subsidies at between $4.9-$14.1bn and $21-$36bn respectively(Alliance to Save Energy, 1993; U.S.EIA, 1992). Some of these subsidies,such as federally subsidized hydropow-er, actually reduce carbon emissions byreplacing fossil fuels with hydroelec-tricity. Others, such as tax breaks forindependent oil drillers, have no effecton U.S. oil consumption or carbonemissions, but merely replace foreignproduced oil with domestically pro-duced oil. Nonetheless, a study on theeffects of removing U.S. energy subsi-dies concluded that significant reduc-tions in CO2 emissions could beachieved at no cost to the economy(Shelby et al, 1995).

B. SUBSTITUTION EFFECTS

A carbon tax will raise the price of fuelsin proportion to their carbon content,increasing coal prices more than oil orgas prices and having little direct effecton hydro or nuclear power costs. Higherfuel prices will induce firms and house-holds to seek ways to mitigate the costincreases. In particular, they will tend to

• substitute less carbon-intensive fos-sil fuels, such as gas, for carbon-intensive fossil fuels, such as coal(intra-fossil fuel substitution);

• substitute non-fossil energy sourcesfor fossil fuels (non-fossil fuel sub-stitution);

• substitute other factors of produc-tion (materials, labor and capital)for energy; and

• substitute less energy-intensivegoods for energy-intensive goods(Cline, 1992).

The easier these substitutions are, thelower the overall burden of reducingCO2 emissions. In addition, all suchsubstitutions become easier as the timefor adjustment increases. For example,in the short-term, a firm's productiontechnique will be constrained by itsexisting equipment, but as new equip-ment and processes are brought online, energy use can be reduced morereadily. Similarly, consumers need timeto replace durable goods and fully adaptpurchasing habits to altered prices.

Economic models differ in the degreeto which they represent these substi-tution possibilities. Highly aggregatedmodels, which might have only a singleproducing sector (i.e., a sector produc-ing a composite commodity calledGDP), cannot incorporate the possi-bility of substituting one product foranother. Similarly, models that recog-nize only two primary fuel sourcescannot adequately represent inter-fuelsubstitution possibilities. More disag-gregated models, such as the Markal-Macro model, which recognizes 11 pri-mary fuel sources and dozens of fuelconversion technologies, are potential-ly better able to deal with such substi-tution possibilities (U.S. DOE, 1996).

However, this potential may or maynot be realized. Despite being more orless disaggregated, models differ in theassumed ease of substitution amongproducts and technologies in responseto cost changes. Some models assumeonly one technology available to pro-duce a given output, with no scope forsubstituting other inputs for energy.Others assume technologies will switch


in response to small changes in relativeinput price. Some models assume thatonce an investment is made, it cannotbe altered until its useful lifetime isfinished. Still other models assume thatcapital and labor can be shifted cost-lessly and instantaneously from one useto another. Clearly, models can eitheroverstate or understate the range andease of possible substitutions. It isdifficult for modelers to get it right.

C. TECHNOLOGICAL CHANGEAND ENERGY EFFICIENCYIMPROVEMENT

Redesigning existing products andprocesses and introducing new onescan also save energy, but the oversim-plified assumptions about technologi-cal change in most aggregated modelsare unrealistic. Most models assume asteady annual percentage improvementin energy efficiency, constant across allindustries and over time. This percent-age rate of improvement, captured bya variable entitled 'autonomous energyefficiency improvement' (AEEI),strongly influences projected energyconsumption and emissions, with orwithout a carbon tax. Though it hasbeen difficult to reach consensus on aproper value for this parameter,8 itseffect is critical: assuming an annualrate of improvement in energy efficien-cy of 1 percent rather than 0.5 percentcan cut projected 2100 emissions levelsby half, markedly affecting the project-ed costs of meeting a CO2 emissionstarget (Gaskins and Weyant, 1993).The higher the AEEI, the lower theprojected baseline emissions will bewithout any carbon tax and the lowerthe additional emissions reduction thatwill be required to meet any target.

For example, one model predicts thatthe present value of the cost of reducingemissions to 20 percent below 1990levels drops from $1 trillion to a negligi-ble level as AEEI rises from 0.5 percentto 1.5 percent (Manne and Richels,1990a). With these assumptions, most ofthe fall in emissions comes from energyefficiency improvements that occur withor without a carbon tax.

More critical than the assumed valuefor AEEI, though, is the assumptionthat the pace of energy efficiency im-provements is independent of energyprice changes and policies. Techno-logical changes do react to marketincentives provided either by regula-tion or by energy prices. Deregulationof electricity markets in the UnitedStates has already accelerated marketpenetration by high-efficiency, low-cost generating technologies. In gener-al, the phenomenon of "induced tech-nological change" is well-recognized(Binswanger and Ruttan, 1978). Econ-omists have shown that rising energyprices induce more rapid rates ofenergy-saving innovation (Newell etal., 1996; Grubb et al, 1995). Recentmodeling analysis in which higherenergy prices are assumed to stimulateenergy-saving technological changepredict lower economic costs of meet-ing given carbon abatement targets(Goulder and Schneider, 1996).9

D. RACKSTOP ENERGYSOURCES

Non-fossil energy sources do exist:hydroelectricity, nuclear power, windand solar energy, and biomass, to namethe most significant. As the prices offossil fuels rise, these and other alter-

8 The Clinton administration'sInteragency Analytical Team,convened in early 1997 to exam-ine the economic impacts of car-bon abatement policies throughmodeling exercises, settled on avalue of 1 percent per year.

9 If induced technological changeis assumed and abatement costsfall in response to a carbon tax,more abatement will occur andtotal (as opposed to per unit)abatement costs will be higherthan if technological change isnot induced. Then, since totalemissions will be lower, the pre-dicted economic impact willdepend on whether the econom-ic damages from climate changeare taken into account.

Economists have shown that rising energy pricesinduce more rapid rates of energy-saving innovation.


^ ^ ^ ^ ^ ^ ^ | C O S T O F E L E C T R I C P O W E R G E N E R A T I O N I N T H E U N I T E D S T A T E S ,

Technology

Natural Gas

Coal

Wind

Solar Thermal

Nuclear

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1985

10-13

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13-26

10-21

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1994

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5-7

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1985, 1994, 2000

2000

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5-62

native energy sources become moreattractive. Though too expensive to bewidely used today, technological im-provements may eventually bring thecosts of alternative energy sourcesdown below the costs of fossil fuels inmany applications if carbon taxes orcomparable policies raise fossil fuelprices. As Table 1 shows, wind anddirect solar energy have become morenearly competitive with coal and naturalgas sources over the past two decades.Hence, at some point, if carbon emis-sions are restricted, non-carbon 'back-stop' technologies may begin to replaceconventional fuels as major energysources. The concept of a backstoptechnology was popularized during theoil crises of the 1970s. It refers to analternative energy source available invirtually unlimited quantities at someprice. One example is solar energy.

Modelers have treated non-fossil energysources in various ways, making dif-ferent assumptions about their avail-ability, initial cost, and subsequent costchanges. Some models, which haveexcluded backstop technologies, over-state the economic impacts of a carbontax because the economy was assumedto rely indefinitely on conventionalfuels even after their costs were higherthan the costs at which alternative

energy sources would be profitable.Accordingly, the carbon tax would haveto continue to rise indefinitely to holdcarbon emissions constant despite eco-nomic growth (Dean and Hoeller,1992).

Other models have recognized non-fossil energy sources, but assume thattheir availability is limited so that theirprices will rise when used in greatervolumes. This assumption is reasonablefor sources such as hydroelectricityfrom dams, since the number of suit-able dam sites is limited, but it maynot be appropriate for solar energy.Hence, although the early Edmonds-Reilly model predicted an unexcep-tional tax of $351 per ton of carbon toreduce emissions by 45 percent in2020, by 2095 the predicted tax for an88 percent cut below the baseline pro-jection was $2,754 per ton, reducingannual GDP by an estimated 8.8 per-cent (Barns et al., 1992; Dean andHoeller, 1992).

Other models assume that backstopenergy sources will be available at non-increasing prices, making the key issuehow high that price is assumed to be.Models that assume a very high price(e.g., one equivalent to six times today'saverage fossil fuel prices) make the


Merely stabilizing the emissions rate would allowconcentrations to continue rising for centuries.

availability of non-fossil energy sourcesvirtually irrelevant because it wouldbe uneconomic to use them until thedistant future, if at all (Charles RiverAssociates, 1997). Models that assumea more reasonable price predict thatstabilizing CO2 concentrations willcost much less. For example, theGLOBAL 2100 model assumes thatnon-fossil backstop energy sourceswill become available at future pricesas low as twice current electricityprices. In this model, the estimatedcarbon tax falls from $354 per ton in2020 to $208 by 2050 and remains atthat level (Manne, 1992). As a result,the model predicts gross costs of only3.1 percent of GDP, instead of 8.8 per-cent, for the same 88 percent reduc-tion in projected baseline emissions(Dean and Hoeller, 1992).

Furthermore, were it assumed that thecosts of alternative energy sourceswould decline over time with techno-logical improvements and economiesfrom large-scale production—just asfossil energy costs have done—thenthe predicted costs of stabilizing CO2concentrations would also decline overtime. Most models, however, fail tomake this plausible assumption aboutthe future costs of non-fossil energysources, even though their costs havefallen substantially in past decades.

E. THE TIME PATH FORSTABILIZING CO2

CONCENTRATIONS

Ultimately, the goal of climate policymust be to stabilize the atmosphericconcentration of carbon dioxide andother greenhouse gases rather than

the rate of CO2 emissions. These twoobjectives differ substantially becauseemissions remain aloft in the atmos-phere for substantial periods of time.Merely stabilizing the emissions ratewould allow concentrations to continuerising for centuries. However, sincenational and international policy com-mitments have been framed in termsof emissions, modelers have adoptedthe same perspective. Recent analysisshows that adopting an explicit long-term target for atmospheric concentra-tions and then choosing policies toachieve the most efficient time pathfor emissions reductions to meet thetarget could significantly lower theeconomic impact (Wigley et al., 1996).

A target for atmospheric concentra-tions of CO2 is like a 'carbon budget'that limits total CO2 emissions within aspecified period of years. Under somecircumstances, it might be cheaper touse up more of the budget early on,postponing cutbacks until later(Richels and Sturm, 1996). Becausethe capital stock is durable andbecause so much equipment andbuilding will ultimately have to bechanged, adjustment is a costlyprocess. If the time allowed for transi-tion to a lower emissions path isincreased to allow capital stock to bereplaced as it wears out, overall abate-ment costs could be reduced. Also, asresearch and development yields newsuperior energy-savings technologies,more low-cost substitutes should beavailable in later years. Finally, post-poning costs reduces them because,with a positive return on investment,fewer resources need to be set asidetoday to meet future costs.


With these assumptions, some modelshave suggested that it may be morecost-effective to allow emissions torise for some decades before restrict-ing them significantly below 1990 lev-els. According to one analysis of thecost-effective pattern of emissionsreductions for the period 2000 to2050, flexibility in the timing of globalreductions could lower overall costs bymore than 35 percent, compared to aless flexible program that achieved thesame atmospheric concentration(Richels et al., 1996). Annual GDPlosses would be higher towards theend of the period but would be morethan offset by considerably smallerlosses in earlier years.

Under other assumptions, however,the least-cost approach would be toavoid the buildup of emissions andconsequent steep decline later in theperiod by instituting carbon taxesearlier on. The key is adopting policiesto encourage early development ofenergy-efficient and low-carbon tech-nologies and to discourage long-livedinvestments in carbon-intensive energyfacilities. According to one recentassessment,

The window of opportunity forreducing cost implies a need forimmediate and continuing actionto develop new low-carbon tech-

nologies and to begin shifting long-lived investment decisions towardalternatives that lower carbon emis-sions. Absent these actions, therapid future emissions reductionsincluded in the delayed emissionsscenario may be more costly thanmore evenly paced, and earlier,

reductions (Jaccard andMontgomery, 1996).

Some models assume that policy-makers can take advantage of theirconstituents' foresightedness bysimply announcing their intention tolimit emissions later in the periodwithout taking any such measuresimmediately. These models assumethat businesses and households willimmediately revise their research andinvestment strategies in response tosuch an announcement to minimizetheir exposure to expected futureenergy price increases. Under theseassumptions, the economy can startenjoying the benefits of redirectedR&D expenditures and investmentswithout incurring the costs of higherenergy carbon taxes.

More realistically, investors may doubtwhether a government that declines toinstitute carbon taxes or equivalentpolicies to meet its international com-mitments today will be certain to doso ten or more years into the future.Skeptical investors may adopt a wait-and-see attitude. Should that bethe case, equipment and buildingsembodying high-carbon technologieswill continue to accumulate, makingthe sharp future reductions needed tostay within a carbon budget all themore expensive. To quell such doubts,sending a credible policy signal byinstituting a small but unmistakablepolicy measure right at the start wouldbe less costly in the long run. A carbontax that is introduced at a low level andrises—perhaps significantly—in futureyears would make sense.

Sending a credible policy signal by instituting a smallbut unmistakable policy measure right at the startwould be less costly in the long run.


International joint implementation of CO2 emissionsreductions would allow a utility in Nonvay to achievean emissions reduction by contracting to pay a factoryin Poland to install more fuel-efficient furnaces.

F. THE POSSIBILITY OFINTERNATIONAL JOINTIMPLEMENTATION

The U.S. Environmental ProtectionAgency has long recognized that allow-ing emissions sources to contract witheach other to implement requiredemissions reductions can substantiallyreduce the costs of achieving any over-all abatement target. When able toenter into such transactions, a facilitythat could reduce emissions only atgreat cost can compensate anotherfacility with less expensive abatementpossibilities to make the cuts for it.This is called "joint implementation."If the emissions from both facilitiescontribute equally to the ambient pol-lution problem, joint implementationof an abatement target—or voluntaryemissions trading, as it's also called—can be advantageous to both partiesand save money. Emissions trading hasbeen used in the United States toreduce the costs of cutting lead, hydro-carbon, and sulfur oxide emissions.The United States has been a leader indeveloping this policy approach.

International joint implementation ofCO2 emissions reductions would allowa utility in Norway to achieve an emis-sions reduction by contracting to paya factory in Poland to install morefuel-efficient furnaces. It would allowa major multinational company toachieve a targeted emissions reductionby energy-saving measures at any of itsfacilities around the world. Since CO2has the same effect on climate whereverit is released, finding the lowest-cost

abatement possibilities is cost-effec-tive. Making such trades voluntarywould ensure that both parties to thetransaction gain from it.

So far, joint implementation of CO2abatement has been tried only in ex-perimental pilot programs: U.S. utili-ties have financed reforestation pro-grams in Central America to captureCO2 from the atmosphere, for exam-ple. Joint implementation cannot beused more widely until countries haveset binding emissions reduction targets(Zollinger and Dower, 1996). But, get-ting countries to agree on the baselinesthat should apply to each, from whichemissions reductions will be measured,is a formidable task. Moreover, moni-toring and verification of emissions re-ductions, along with some mechanismto enforce contractual obligations, willbe essential if joint implementation isto work. Nonetheless, such implemen-tation offers a promising opportunityto lower CO2 abatement costs and theeconomic impacts of protecting theclimate. Models focussed only on theU.S. economy generally assume thispossibility away. Efforts to model otherparts of the world along with the Uni-ted States have explored the potentialsavings from joint implementation andhave found them to be substantial.10

G. HOW REVENUES ARERECYCLED INTO THEECONOMY

A carbon tax would generate signifi-cant tax revenues—up to $300bn peryear by 2020 for a policy that holds

10 International emissions tradingcan be modeled as if all coun-tries set the same carbon taxrate, so that cost-effective emis-sions reductions are advanta-geous to undertake in whatevercountry they arise.

THE COSTS OF CLIMATE PROTECTION/ WORLD RESOURCES INSTITUTE 2 3

carbon emissions to 80 percent of their1990 levels (Gaskins and Weyant,1993). Starting from a position of fiscalbalance, some mechanism for recyclingthese revenues into the economy isneeded to prevent a general deflation-ary impact. Assuming that revenueswould not be fully recycled was one ofthe reasons for an early pessimisticconclusion that a carbon tax of $100per ton phased in over 10 years wouldreduce GDP by 2 percent annually andcut projected baseline emissions byonly a small amount (CBO, 1990).

Economic modelers then began assum-ing that revenues would be returned inthe form of lump-sum rebates. (Alump-sum tax or rebate is one in whichthe amount transferred is completelyindependent of all taxpayer behavior.Increasing the personal exemption inthe income tax would be an example ofa lump-sum rebate.) By assumingneutral lump-sum recycling, modelerstried to separate the economic impactsarising from climate abatement policyfrom those arising from other tax cuts(Gaskins and Weyant, 1993).

However, the baseline projectionsfrom which economic impacts are esti-mated implicitly or explicitly recognizethat the U.S. economy's tax structurereduces private incomes by far morethan a dollar for every dollar of tax rev-enue collected. The disincentiveeffects of taxes on payrolls, incomes,and profits either reduces work, invest-ment, and savings or diverts them intoless productive forms to reduce tax lia-bilities. Economists pointed out longago that using carbon tax revenues to

reduce existing taxes that penalizework, savings, and investment wouldlower the net cost of reducing emis-sions (Terkla, 1984). Indeed, this tax-shifting opportunity is one of the prin-cipal reasons for favoring a carbon tax(or carbon permits that are auctionedoff) over alternative climate policyinstruments.

Taxes on labor earnings drive a 'wedge'between the price paid by firms forlabor and the wage received by theemployee. As a consequence, fewerworkers are employed at a lower realwage rate, and the economy suffersaccordingly (MaCurdy et al., 1990;Triest, 1990; Browning, 1976).Similarly, taxes on investment earningsreduce the amounts saved, resulting inlower rates of capital investment andeconomic growth. Empirical work sug-gests that these efficiency losses maybe large: for every dollar of revenueraised from taxes on labor earnings,private income might ultimately fall by$1.10 to $1.25; and, per dollar of rev-enue from taxes on investment earn-ings, income might fall by $1.50 to$1.95 (Nordhaus, 1993; Fullerton,1991; Jorgenson and Yun, 1990;Ballard, Shoven and Whalley, 1985).

The use of carbon tax revenues toreduce existing tax rates benefits soci-ety not only by correcting a marketfailure in energy use but also by reduc-ing the costs of other distorting taxes, aso-called "double dividend" (Repettoet al., 1992). If the efficiency benefitfrom reducing existing taxes on laborand capital is incorporated into theanalysis, the projected net economic

Using carbon tax revenues to reduce existing taxesthat penalize work, savings, and investment wouldlower the net cost of reducing emissions.


^ ^ ^ ^ ^ ^ ^ H GDP LOSS (1990-2010)

Recycling Option

Lump Sum Tax Cuts

Personal Income Tax Cuts

Corporate Income Tax Cuts

Payroll Tax Cuts

Employee Only

Employer Only

Investment Tax Credit

U N D E R A L T E R N A T I V E R E C Y C L I N G O P T I O N S

DRI LINK

(Percentage change in

-0.58

-0.560.40

-0.58

0.19

1.55

- 0 . 4 6

-0.53

-0.11

-0.53

-0.25

1.67

Source: Shackleton et

Model

DGEMdiscounted constant

-0.62

- 0 . 1 6

0 . 6 0

al. (1992) .

Goulder

price GDP)

-0.24-0.16-0.17-0.18

0.00

impacts of a carbon tax are substantiallymore favorable than they appear to bewhen lump-sum revenue recycling isassumed (Goulder, 1995).

One analysis of this issue compared sixrevenue-recycling options, using fourdifferent models (Shackleton et al.,1992). Despite modeling differences aclear hierarchy of recycling optionsemerges, with lump-sum rebatesamong the least attractive. As Table 2shows, using revenues to lower corpo-rate income tax and payroll taxesinstead of giving lump-sum rebates sig-nificantly reduces the adverse econom-ic impacts of a carbon tax. Not surpris-ingly, the analysis reveals that recyclingrevenues by reducing taxes on capitalinvestment earnings and therebyencouraging capital formation reducesthe economic impacts more than low-ering taxes on consumption. In twomodels, recycling revenues by intro-ducing an investment tax credit leadsto net gains in GDP and consumption.(In a third model, the same recyclingmechanism exactly offsets the costsof mitigation.) More recent studiessupport these findings (McKibbin andWilcoxen, 1996; Goulder, 1995;Jorgenson et al., 1995).

Models suggesting that the substitutionof a carbon tax for other taxes couldprovide net economic benefits,irrespective of the environmentalgains, prompted some economists topropose a stronger form of the doubledividend hypothesis, claiming that acarbon tax could be justified evenapart from environmental benefits.This has led to a debate about whetherthe revenue recycling effect alone issufficient to justify the levying of acarbon tax (Goulder, 1995; Parry, 1995;Bovenberg and de Mooij, 1994). Thisis obviously not always true. If theenvironmental benefits and the welfaregain from correcting a market failureare ignored, a tax on fuels distortsenergy markets just like any excise taxdoes. It may be more or less distor-tionary than another tax already beinglevied, depending on the size of energymarkets, the price sensitivity of energydemands, the structure of pre-existingenergy taxes, and other conditions.Though Table 2 shows particular taxsubstitutions that suggest a strongdouble dividend, economists doubtwhether a strong double dividendwould generally be available. The keyissue is how an energy tax wouldinteract with existing taxes on capital

THE COSTS OF CLIMATE PROTECTION /WORLD RESOURCES INSTITUTE 2 5

B O X 2 T A X I N T E R A C T I O N S A N D T H E D O U B L E D I V I D E N D D E B A T E

Several economists have pointed out that when distortingtaxes on labor and capital income already exist in an econo-my, the effects of replacing some of these taxes with a car-bon tax are complicated. A carbon tax, which raises theprices of energy and energy-intensive goods, would raiseconsumers' cost of living and,vvith wage and salary levelsunchanged,would lower real wages. In this respect, a car-bon tax would have much the same effect as ;\ direct tax onlabor incomes. By lowering the real rewards from working,both kinds of tax would distort labor markets and reducelabor supply. Substituting one for another miglit not reducethe labor market distortion. Indeed, because a carbon tax—with a narrower tax base—would require a higher tax ralethan a direct payroll tax to raise the same revenue, a rev-enue-neutral tax shift might even reduce labor supplv fur-ther. Using this reasoning, these economists have ques-tioned the likelihood of a strong double dividend and theextent of a weak double dividend.

However, this argument rests on special assumptions. Itassumes unrealistically that a carbon tax would be borneentirely by working consumers, not at all by owners of coalmines, stockholders in energy- companies, or foreign oilsheikhs. Clearly, this assumption is not shared by these par-ties themselves, as they vigorously oppose the imposition ofa carbon tax or any equivalent policy. To the extent that acarbon tax would not reduce the real value of labor incomesbut would fall instead on earnings from capital and proper-ty or on foreign suppliers, it would not have the effect ofreducing labor supply.

More importantly, this line of reasoning ignores the effectsof environmental damages on the cost of living. A carbontax would raise energy prices but reduce COa emissions andother pollutants stemming from fossil fuel combustion: sul-fur and nitrogen oxides, hydrocarbons and other smog pre-cursors, particulates, and carbon monoxide. Cutting back

emissions of these pollutants would decrease medicalexpenses and the number of work days lost to sickness. Forexample, a recent comprehensive study estimated thatimproved air quality under the Clean Air Act has resultedin striking health benefits to the American population,including 80,000 fewer heart attacks in 1990, 10,000 fewerstrokes, 15,000 fewer cases of respiratory illness, 13,000fewer cases of hypertension, and a long list of other healthbenefits (U.S. EPA, 1996). These improvements are muchmore than an additional fuel tax would generate, but makethe point that health benefits from reducing air pollutionare substantial. Improved health and reduced health expen-ditures stemming from a carbon tax would offset the tax'smodest negative impact on incentives to work.

Similarly, all assessments of the risks from climate changeemphasize that global warming may raise production costsin affected industries. Increased evapotranspiration mayreduce crop yields and water availabililv, raisingagricultural production costs. Higher temperatures mayraise air conditioning and cooling costs (though loweringheating bills). Rising sea levels may increase coastal flood-ing and storm damages. Warmer climates may increase therange of agricultural pests and disease vectors. Productionlosses from a doubling of CO2 concentrations are estimatedat 1 or 2 percent of GDP (Fankhauser, 1995; Tol, 1995;Cline, 1992). Again, these estimated damages arc largerthan those that a modest carbon tax would eliminate, butmake the point that forestalling climate change wouldreduce many production costs. Therefore, though a carbontax would raise energy costs it would lower costs in a rangeof other industries, with uncertain effects on the overallcost of living. On balance, taking both costs and benefitsinto account, the interaction of a carbon tax or equivalentpolicy with pre-existing taxes is as likelv to magnify thedouble dividend as to shrink it.

and labor. (See Box 2.) Nonetheless,models that ignore the potentialgains from substituting a market-correcting tax for a market-distortingtax are excessively pessimisticabout the economic impacts of acarbon tax.

H. AVOIDING THE COSTS OFCLIMATE CHANGE

Most models used to simulate theeconomic impacts of carbon taxes havebeen adaptations of existing modelsdesigned for energy planning or for


Heat waves, severe storms, and other extreme weatherepisodes may become more frequent as averagetemperature and precipitation increase.

general macroeconomic forecasting,and were not able to incorporate thebenefits of preventing climate change,or equivalently, the costs of doingnothing. Instead, they have simplymeasured the economic impacts ofmeeting emissions abatement targets,implicitly assuming in the baselineprojections that climate change wouldhave no effect on the economy.

Granted, predicting the physicaleffects of global warming is difficultenough, let alone estimating the effecton human welfare. Climate change islikely to have many economic effects,some favorable and others not, espe-cially on agriculture, fishing, forestry,recreation, flood control, water supply,and other industries dependent on nat-ural resources. Other impacts willoccur not through market mechanismsbut through ecological changes, alteredrates of human morbidity and mortali-ty, heat-related distress and discom-fort, and migration (IPCC, 1996b).

Several studies have estimated dam-ages from a doubling of CO2 concen-trations midway through the next cen-tury. n Available estimates rely onquestionable simplifying assumptionsand are little more than best guesses,expressed as wide ranges. Estimatesfor the U.S. economy range from1.0 to 1.5 percent of GDP annually(Fankhauser, 1995; Tol, 1995; Cline,1992; Nordhaus, 1991). Titus (1992)predicts annual damages of 2.5 percentof GDP, largely because he assumesthat CO2 doubling will lead to highertemperatures than other researchersdo. Damages for the global economy

as a whole are closer to 2 percent ofworld GDP annually and up to 9 per-cent of national GDP for some devel-oping countries (Fankhauser, 1995; Tol,1995; Fankhauser and Pearce, 1994).

These estimates might be too pes-simistic (Fankhauser and Tol, EnergyPolicy, 1996). They do not adequatelyreflect the possibility that adaptationsto gradual climate change, such aschanged agricultural practices, may beavailable to forestall damages at rela-tively low cost (Mendelsohn, 1996;Adams et al., 1994; Nordhaus, 1994).They may give too little weight topotential cost savings from climatechange, such as reduced heating costs(Rosenthal et al., 1995). And they maynot adequately reflect changing scien-tific perceptions of likely ecologicalchanges, such as lowered predictionsof sea level rise (Yohe et al., 1996).

On the other hand, these estimatesrefer only to CO2 doubling, whenmuch higher concentration levels arelikely in the more distant future. Evenif emissions are successfully stabilizedand held at 1990 levels, concentrationswill double by 2100 and increasesubsequently thereafter (IPCC,1996a). Moreover, if emissionscontinue rising, concentrations couldexceed 700 ppmv by the end of thenext century, and damages mayincrease more than proportionately(IPCC 1996a; Cline, 1992).

In addition, estimates typically arebased on increases in averagetemperature and precipitation, butheat waves, severe storms, and other

11 'Doubling' refers to CO2 con-centrations of 560 ppmv (partsper million by volume), twicethe pre-industrial level of 280ppmv that forms the standardbenchmark. IPCC (1996a) esti-mates the temperature risefrom doubling at 1-3.5C with a'best guess' of 2.5C—the figureadopted by most researchers.


extreme weather episodes maybecome more frequent as averagetemperature and precipitationincrease. Omitting these extremesprobably understates the impacts ofclimate change, since gradual changesin average temperature and rainfallhave much less effect than theoccasional extreme event does. Theultimate manifestation of this is theunlikely possibility of catastrophicevents such as the disintegration ofthe West Antarctic ice sheet, theredirection of the Gulf Stream, thespread of disease vectors intounresistant populations, or the possi-bility of a 'runaway' greenhouse effect,where positive feedbacks overwhelmnegative ones (IPCC, 1996b).Potential catastrophes seem morelikely the longer the time frame underconsideration and cannot be assigneda zero probability.

Uncertain though they are, thereare costs associated with doing noth-ing in the face of rising greenhousegas concentrations. These are typicallynot reflected in the baseline projec-tions of most models. Therefore, thenet economic impacts of carbon taxestend to be overstated. The few modelsthat do take expected damages fromclimate change into account predictthat a carbon tax set at an appropriaterate, with revenues recycled efficient-ly back into the economy, actuallyimproves economic welfare(Nordhaus and Young, 1996;Jorgenson et al., 1995; Nordhaus,1994, 1993).

I. AVOIDING OTHERENVIRONMENTAL DAMAGES

By discouraging coal and other fossilfuel consumption, a carbon tax wouldreduce emissions of such air pollutantsas carbon monoxide, sulfur and nitro-gen oxides, and toxic trace pollutantsin exhaust gases. Though most of thesepollutants are already regulated, thisusually takes the form of a maximumrate of emissions per million BTUs.Thus, despite regulations, reducing thenumber of BTUs generated by fossilfuel combustion would lower emis-sions. This would almost immediatelyreduce damages to health, visibility,materials, and crops.

A simple approach to assessing non-cli-mate benefits is to calculate the tax-induced reduction in fossil fuel con-sumption and use emissions profilesfor individual fuels to estimate overallemissions reductions (Scheraga andLeary, 1993). This approach suggeststhat a carbon tax set to keep CO2 emis-sions at their 1990 levels by the year2000 would reduce various atmospher-ic emissions below projected baselinesby 1 to 7 percent. EPA estimates thatthe economic savings in the year 2000from the resulting pollution abatementwould be between $300 million and $3billion.

Other studies in Europe and theUnited States estimate that the non-climate benefits of a carbon tax wouldprobably be as large or larger than thebenefits of avoiding climate change(Ekins, 1995; Jorgenson et al., 1995).

Studies in Europe and the United States estimatethat the non-climate benefits of a carbon tax wouldprobably be as large or larger than the benefits ofavoiding climate change.


These estimated economic savingsfrom reduced air pollution damagesmay be sufficiently large to offset from30 to 100 percent of carbon abatementcosts (IPCC, 1996b).

Large as these sums are, this approachunderestimates damages over timebecause it ignores the fact that in base-line projections, in the absence of car-bon taxes, rising population and eco-nomic growth would increase exposureto air pollution while increased fuelconsumption would reduce air quality.Current environmental standards typi-cally limit emissions on a per-BTUbasis for stationary sources and on aper-mile basis for vehicles. As theeconomy grows, trying to maintainenvironmental quality by making eachmile traveled or BTU generated lesspolluting can become increasinglycostly. At some point, fuel taxes thatprovide incentives to conserve energyand limit the amount of drivingbecome cost-effective adjuncts to suchregulations (Eskeland and Devarajan,1996).

One of the few models to incorporatethe savings from reducing pollutiondamages estimates how much reduc-tion in CO2 emissions could be had for"free" under a "no regrets" policy—apolicy under which net abatementcosts are exactly offset by non-climatebenefits. When firms are assumed tobe able to substitute labor and capitalfor energy, a reduction of nearly 50percent of baseline emissions can beattained with no loss in economic wel-fare (Boyd, Krutilla and Viscusi, 1995).

Despite these impressive magnitudes,most models of carbon abatement poli-cies have ignored the potential savingsin pollution damages, and the remain-ing few have incorporated them rathercrudely. More recent and comprehen-sive research on the benefits of air pol-lution control is now available to beincorporated into climate models (U.S.EPA, 1996). Other benefits from lowerenergy consumption, such as reducedroad congestion and fewer environ-mental impacts from fuel mining,refining, and transport, could also betaken into account.


TRADE AND EQUITY ISSUES

A. TRADE ISSUES

Concerns about adverse internationaltrade consequences are strong amongbusinessmen who fear that if theUnited States unilaterally adopted acarbon tax its energy-intensive indus-tries almost certainly would becomeless competitive in international trade.International shifts in the location ofproduction, so-called 'leakage' effects,would mean that cuts in domesticemissions would be partially offsetby increases in emissions abroad asenergy-intensive industries expandedoverseas (Barrett, 1994; Gaskins andWeyant, 1993). For these reasons, acarbon tax adopted unilaterally wouldbe more costly to the U.S. economyand less effective in reducing globalemissions than one adopted by manycountries acting together.

Empirical research into the magnitudeof leakage effects is somewhat incon-clusive. The penalty for acting unilat-erally would be greater for small econ-omies than for large economies likethat of the United States. Studies ofunilateral emissions reduction policiesin OECD countries predict leakagerates of between 3.5 and 70 percent12

(Manne, 1993; Oliveira-Martins et al.,1992; Pezzey, 1992; Rutherford, 1992).Studies in the United States suggestthat cost differences created by inter-national differences in environmentalpolicies have minor impacts on tradeand investment flows (Repetto, 1995).

There would also be international tradegains, however. Given the size of theU.S. market, a tax-induced fall in U.S.

energy consumption would help re-strain world fuel prices, improving ourterms of trade as a net oil-importingeconomy. Baseline projections suggestthat in the absence of higher energytaxes, fossil fuel consumption in theUnited States and the rest of the worldwill continue to grow substantially incoming decades. One implication,given the already declining oil produc-tion in this country, is that OPEC willsupply an increasing share of world pe-troleum markets, and the United Stateswill become increasingly dependenton imports from OPEC producers.OPEC's world market share mightreach 72 percent by 2015, more than in1974 when its supply restrictions preci-pitated the first "oil shock" (U.S. El A,1996). A carbon tax would mitigatethese energy security and trade risks.

If the United States adopted a carbontax unilaterally, the risks of climatechange faced by other countries wouldfall, reducing their incentive to act(Barrett, 1994). However, increasinginternational coordination within theFramework Convention on ClimateChange means that unilateral action isunlikely. European countries have stat-ed their willingness to adopt a carbontax if major trading partners—theUnited States in particular—do thesame (Commission of the EuropeanCommunities, 1992). Sweden and Nor-way already have signaled willingnessby adopting small taxes. Developingcountries are clearly unwilling to com-mit themselves to action unless indus-trial countries that have emitted mostof the carbon dioxide to date take thelead. Nonetheless, substantial economic

12 The leakage rate is measured asthe increase in emissions out-side the tax region over theemissions reduction within theregion.


reforms and restructuring of energymarkets have taken place in developingand transitional economies, for purelyeconomic reasons. Energy subsidieshave been reduced, subsidies to ener-gy-intensive industries have fallen, andinstitutional changes have opened theenergy sector to improved technologyand greater efficiency. These signifi-cant changes have already reducedCO2 emissions in these countries wellbelow their projected levels (Reid andGoldemberg, 1997). Though undertak-en for strictly economic reasons, thesepolicy changes in other countries havegreatly reduced the risks of unilateralU.S. action.

B. DISTRIBUTIONAL EFFECTS

Even if the macroeconomic economicimpacts of a carbon tax were small orpositive, some household, regional andsectoral groups might be adverselyaffected, if they are highly dependenton fossil fuels and have limited abilityto adjust to price changes. These dis-tributional considerations are impor-tant policy issues: a carbon tax pro-gram may be considered undesirableif costs are felt disproportionately bylow-income groups or specific industrysectors, even if predicted overall eco-nomic burdens are small.

1. DISTRIBUTIONAL EFFECTS ONHOUSEHOLDS

It is commonly reckoned that a carbontax would be regressive, hitting lower-income households proportionatelyharder than those better off. To illus-trate, a $100 per ton carbon tax insti-tuted in 1990 would have created a

burden amounting to 10.1 percent ofincome for the lowest decile of house-holds arrayed by household incomebut only 1.5 percent for the top decile(Poterba, 1991). However, whenhouseholds are arrayed by expenditureinstead of income the carbon tax ismuch less regressive, accounting for3.7 percent to 2.3 percent of totalexpenditures for the bottom and topdeciles respectively. Household expen-diture is a better indicator of long-term ability to pay—and hence a betterbase against which to judge distribu-tional effects—because it is more sta-ble over time than household income.Short-term fluctuations in income aretypically cushioned by borrowing oradding to savings. At any time, therewill be many households whose in-comes are temporarily and abnormallyinflated or depressed.

At best, such calculations provide im-perfect guides: they reflect only thedirect effect of higher energy prices onexpenditures, omitting the fact thatgoods whose production relies onfuel—everything from cars to food-stuffs—will exhibit price rises too. ACanadian study that accounted fordirect and indirect effects by assessingthe carbon-intensity of the completeset of purchases made by different in-come or expenditure groups found thata $100 carbon tax would only be mildlyregressive even for households groupedby income. The burden was 2.9 percentfor the bottom income quintile and 1.8percent for the top quintile (Hamiltonand Cameron, 1994).

However, since the long-run distribu-tional impact will also depend on

European countries have stated their willingnessto adopt a carbon tax if major trading partners—the United States in particular—do the same.

3 2 WORLD RESOURCES INSTITUTE / THE COSTS OF CLIMATE PROTECTION

The energy industry generally, and the coal miningindustiy particularly, will experience the greatestimpacts from a carbon tax.

changes in employment, wages, andasset prices, only overall economicmodels can make comprehensive esti-mates. An analysis using a generalequilibrium model traced the welfareimpacts of a carbon tax on 16,128 sep-arate household groups categorized byfamily size, age and sex of householdhead, race, region, type of residence,and wealth. The model predicted that,on the whole, the distributional effectsof a carbon tax would be modest, rang-ing from mildly progressive to mildlyregressive, depending on underlyingassumptions (Jorgenson et al., 1992).

Of course, the overall distributionaleffect of a carbon tax would depend onthe use of the revenues. Expanding theearned-income tax credit would bene-fit low-income households; reducingcapital gains taxes would benefit therich. There are trade-offs betweenequity and efficiency concerns.Efficiency gains seem greatest if taxeson investment income are reduced;equity objectives are better served iftaxes on labor earnings are reduced. Acombination of the two—using therevenues to cut both capital and labortaxes—would balance these objectives.

Moreover, the distributional impacts ofa carbon tax should be judged againstthe impacts of a business-as-usual poli-cy. A number of studies predict thatglobal warming would lead to higherfood prices. Since food is as much anecessity as energy is, a business-as-usual policy might also be regressive(Scheraga et al., 1993). Similarly, sincepoorer households typically inhabitareas of lower environmental quality

and are generally in poorer health,they benefit disproportionately froman improvement in air quality (Yin,1993). However, they may value theserelatively large benefits absolutely lessthan the smaller benefits felt by betteroff households (Harrison andRubinfeld, 1978). All in all, the effectsof a carbon tax on the distribution ofincome and expenditures amonghouseholds would probably be small;and effects on vulnerable groups couldrather readily be offset by cost-of-liv-ing adjustments in government trans-fer programs and by other policyinstruments.

2. DISTRIBUTIONAL EFFECTS BYSECTOR AND REGION

The energy industry generally, and thecoal mining industry particularly, willexperience the greatest impacts from acarbon tax, under which the tax rate oncoal, a carbon-intensive fuel, will berelatively high. Compared to the busi-ness-as-usual scenario, coal output maydecrease by 25 percent and prices mayrise by 35 percent by 2020 under a taxthat stabilizes emissions at 1990 levels(Jorgenson et al., 1992). Electric utili-ties, the next most affected sector, faceoutput losses and price increases ofjust over 5 percent compared with theprojected baseline, mainly becausethey use coal. But these reductions donot imply absolute declines becausesubstantial growth in output is project-ed for both sectors in the baseline.Some railroads would suffer adverseimpacts since coal makes up a substan-tial fraction of their freight traffic. Ofcourse, other industries, such as the

THE COSTS OF CLIMATE PROTECTION/ WORLD RESOURCES INSTITUTE 3 3

natural gas and renewable energyindustries, would probably do better ifa carbon tax were enacted.

Regional impacts of a carbon tax inev-itably correspond to sectoral impacts.Coal mining states, such as West Vir-ginia and Wyoming, would be dispro-portionately affected. But, according toone study, the Pacific Northwest wouldfare relatively well because of the avail-ability of cheap hydropower—assumingsuch power continues to be heavilysubsidized (DeWitt, Dowlatabadi,and Kopp, 1991). Global warming, likea carbon tax, would also affect someregions and industries disproportion-ately. Along with coastal areas, regionsdependent on agriculture, water sup-

ply, and forestry would suffer most(OECD, 1996).

To summarize, studies predict that acarbon tax will be only mildly regres-sive for households, and those effectscould be offset by revenue recyclingand cost-of-living adjustments in gov-ernment transfer programs. The distri-bution impacts of a carbon tax mightwell be no worse than those of globalwarming itself. However, coal miningand coal mining regions would be sig-nificantly affected, since coal outputwould fall relative to a business-as-usual scenario and, assuming a suffi-ciently high tax, would fall absolutelyas well.


CONCLUSIONS AND RECOMMENDATIONS

Despite the wide range of predictedeconomic impacts of CO2 abatement,two areas of policy agreement amongthe underlying economic models standout. First, the economic impacts willbe much more favorable if revenue-raising policy instruments are used tocontrol CO2 emissions and the rev-enues are used to reduce other bur-densome tax rates. As explained above,the two principal revenue-raising poli-cy instruments are carbon taxes andtradable permits that are auctioned offby the government rather than givenaway. Both instruments imply that car-bon-based fuels will become moreexpensive to the users, raising coststhroughout the economy. However,using the revenues to lower taxes onlabor and capital would offset some ofthese higher costs and improve theeconomic impacts.

Giving permits away to energy usersand sellers or using regulations toforce industries to reduce their CO2emissions are alternative policy ap-proaches that forgo potential revenues.These approaches would also makefossil fuels more expensive to theusers, raising costs throughout theeconomy. But, they would have quitedifferent economic implications be-cause they create no opportunities to

generate offsetting efficiency gains byreducing the marginal rates of distort-ing taxes.

Instead, the potential revenues fromauctioning off permits to burn fossilfuels remain with the firms that re-ceived free permits or regulatory per-mission. Conceding these permits tofirms may be politically advantageousbecause it awards a valuable right tocertain firms and industries that mightotherwise oppose any climate protec-tion policy. However, economic modelsagree that this political advantagewould be bought at a high economicprice. Income and economic growthwould be lower if this approach wereadopted, just as they would be if rev-enues from a carbon tax were recycledthrough lump-sum rebates.

Similarly, forgoing carbon tax revenueswould limit the government's opportu-nities to finance offsetting tax cuts andother programs to cushion the distrib-utive burden of higher energy priceson lower-income households and othervulnerable groups. Instead, those com-panies permitted to sell or use the lim-ited quantities of carbon fuels availablewould obtain windfall profits. For bothequity and efficiency reasons, the U.S.Government should base its climate

Climate protection plans should be revenue-neutral.They should include explicit proposals for offsettingcuts in distorting taxes on labor and investmentincomes.


protection plans on policy instrumentssuch as a carbon tax or auctioned-offcarbon permits that yield revenues tofinance tax reductions. Moreover, cli-mate protection plans should be rev-enue-neutral. They should includeexplicit proposals for offsetting cutsin distorting taxes on labor and invest-ment incomes. Identifying these taxcuts in advance and ensuring that thegovernment's spending and deficit areunchanged should help allay economicconcerns about climate protection.

The second area of agreement amongeconomic models that have examinedthe issue is that joint implementationwill reduce the overall costs of achiev-ing carbon abatement targets. Emis-sions trading among domestic U.S.firms and facilities has already provento be cost-effective in reducing conven-tional air pollutants. The gains frominternational joint implementation ofCO2 abatement programs should beeven larger because the costs of reduc-ing fossil fuel use vary so widely amongnations. International joint implemen-tation is compatible both with a U.S.carbon tax and with a carbon permittrading system. The United States hasconsistently favored joint implementa-tion in principle as a cost-effectivemarket-based policy approach. Ironi-cally many countries with emergingmarket economies have not approvedthe principle of such implementationeven though they would benefit signifi-cantly from the infusion of technologyand investment that it would bring.The U.S. Government should continueto consult and negotiate with other

nations to gain international acceptancefor joint implementation among nationsadopting CO2 reduction commitments,and to promote joint implementationthrough pilot projects and institutionaldevelopment.

Aside from the effects of these twopolicy choices, the remaining variationin the predicted economic impacts ofclimate protection stems from differ-ences in underlying assumptions builtinto economic simulation models. Pre-dictions that a carbon tax or a cap-and-trade policy to reduce CO2 emissionswould seriously harm the economy areunrealistic. They stem from worst-casemodeling assumptions. Under more rea-sonable assumptions and preferable pol-icy approaches, a carbon tax is a cost-effective way of reducing the risks ofclimate change and would do no dam-age to the economy. More likely, takingthe environmental effects into account,it would bring long-term benefits.

This point is likely to be obscured asthe debate over U.S. climate policybecomes increasingly intense andpoliticized as international negotiationsproceed. Various interests will touttheir preferred predictions andexperts. The media, on the principlethat controversy generates interest,will highlight the divergent predictionsrather than informing the public aboutthe underlying sources of disagree-ment. The public may become con-fused, disillusioned, or indifferent.

To counter this, it is important thatwhen the administration finalizes its

Many emerging market economies have not approvedthe principle of joint implementation even thoughthey would benefit significantly from the infusion oftechnology and investment that it would bring.


proposed climate policy it issues apublic statement incorporating its bestpredictions of the impacts these pro-posed measures would have on theeconomy, making clear the assump-tions and models on which these esti-mates are based. When Congress holdstelevised hearings on this issue, expertwitnesses and administration officialsshould be questioned closely on theassumptions underlying their predic-tions regarding the effects of climateprotection on the economy. The pressand other media can contribute signifi-cantly to public understanding anddebate of this important policy issueby in-depth reporting and analysis that

goes beyond the formulaic juxtaposi-tion of opposing viewpoints.

The real issues that need resolutionare how to cushion the impacts onthose few industries, regions, andcommunities that would be adverselyaffected and how to negotiate interna-tional agreements that will bring aboutcoordinated actions by all major eco-nomic powers. In addition, an overalltax restructuring agenda is needed thatwould incorporate a phased-in carbontax or auctioned-off tradable carbonpermits and equivalent reductions inother taxes to achieve equity and eco-nomic objectives.


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ANNEX

DETAILS OF THE STATISTICAL ANALYSIS

The data set is made up of 162 simulations derived from 16 models. From eachsimulation, the percentage change in CO2 emissions and the percentage change inGDP, both relative to the baseline projections for the terminal year of the simula-tion, were recorded. In addition, a set of descriptive variables was recorded foreach model simulation, representing basic structural assumptions and policyassumptions embedded in the model. These were represented either as binarydummy variables or as discrete numerical variables. All the variables considered inthe analysis are presented in Table A.I and include the following:

GDP

CO2

MACRO

NCBACK

RECYCLING

CLIMATE

NON-CLIMATE

JI

PRODUCTION

FUELS

YEARS

percentage change in real GDP relative to projected base-line, in terminal year

percentage reduction in CO2 emissions relative to project-ed baseline, in terminal year

1 if a macro model, 0 if a CGE model

1 if there is a constant cost, non-carbon backstop

1 if revenues from policy instrument are used to reduceexisting distorting taxes

1 if averted climate change damages are modeled

1 if averted air pollution damages are modeled

1 if joint implementation or global emissions trading ismodeled

1 if the model allows for product substitution

the number of primary fuel types recognized for possibleinter-fuel substitution

the number of years available to meet the abatementtarget

Using the data, multiple regression analysis was performed to show how thesemodeling assumptions affected the predicted relationship between the change inGDP and the change in CO2 emissions. The regression equation, with GDP as thedependent variable, was specified as a quadratic (through the origin) in the extent


of CO2 abatement from the projected baseline. The variables listed above wereassumed to shift the coefficient of the linear term in CO2, except that the variablefor the non-carbon backstop was specified to affect the coefficient of the quadrat-ic term in CO2 because the presence of a backstop fuel source mainly affects thecurvature of the abatement cost curve at high levels of abatement.

FORM OF REGRESSION:

GDP = ai . CO2 + a2. (CO2f + X? = 1 j8, . X<. (CO2) + fi9. X9. (CO2f

REGRESSION RESULTS

No. of observations: 162R2 : 0.83

CO2

(CO2)2

MACRO

NCBACK

RECYCLING

CLIMATE

NON-CLIMATE

JI

PRODUCTION

FUELS

YEARS

Notes

Coefficient

-0.02319

-0.00079

-0.05548

0.00051

0.04427

0.00943

0.03823

0.02337

0.00378

0.00018

0.00005

Standard Error

0.00907

0.00011

0.01395

0.00005

0.00652

0.00399

0.00778

0.00327

0.00365

0.00116

0.00006

1. Including an intercept term in the regression adds little to the regression's overall explanatory power.

Moreover, the assumption that the regression passes through the origin is consistent with the models'

definition of a baseline projection.

2. The inclusion of dummy variables to represent the individual models adds little to the explanatory power

of the regression beyond that provided by variables representing underlying modeling assumptions.

3. The R for a regression of GDP against CO2 and (CO2) terms alone was 0.35.

4. Typically, the number of primary fuel types differs substantially from the number of energy sectors and

energy technologies included in the models.


1 A 1 1 1 1 A . I ^ ^ E

M o d e l

BKV

CRTM

DGEM

DRI

Edmonds-Reilly-Barns

EPPA

Fossil2

G-Cubed

Global 2100

Goulder

GREEN

HAM

LINK

Markal-Macro

MERGE2

SGM

U M M A R Y OF D A T A

Primary reference

Boyd, Krutila and Viscusi (1995)

Rutherford (1992)

Jorgensen and Wilcoxen (1992)

DRI (1994)

Edmonds and Reilly (1983, 1985)

Yang et al. (1996)

AES (1990)

MeKibbin and Wilcoxen (1992)

Manne and Richels (1990a)

Goulder (1995)

Burniaux et al. (1990)

Charles River (1997)

Kaufman et al. (1992)

Hamilton et al. (1992)

Manne and Richels (1995)

Edmonds et al. (1993)

Number of modelruns

9

9

24

12

14

8

7

9

9

14

12

6

8

3

12

6

Years (rangeof end years)

2000-2040

2010-2100

2010-2050

2000-2020

2020-2095

2020-2100

2000-2020

2000-2020

2010-2100

2010-2050

2010-2050

2010-2030

2000-2010

2020-2030

2050-2100

2010-2030

Number ofprimary fuel

types

3

7

3

7

7

5

9

2

7

3

6

4

5

11

7

7

Notes

1. '1 or 0J signifies that different runs from the same model incorporate alternative assumptions.

2. The number of observations from each model varies with the number of alternative assumptions and end dates considered by the model.

3. Despite its name, the Markal-Macro model has optimizing characteristics and is not a macro model according to the distinction made

in Box 1.

4. Because the Boyd et al. model is a comparative static model, the terminal years have been interpolated.

5. The results from the HAM model come from the model's Single Open Economy Section of the model which does not include the effects of JI

that appear in the Multi-Regional Trade (MRT) section.

6. The HAM model is characterized as having no backstop because the backstop does not affect the time frame for which results were available.

7. Although the Edmonds-Reilly-Barns model has several non-carbon fuel sources, all are subject to increasing marginal costs, inconsistent with

the definition of a backstop energy source adopted here (see Section 3.D for discussion).


Productionsubstitution (1)

or not (0)

1

1

1

1

1

1

0

1

1

1

1

0

0

0

0

1

Non-carbonbackstop (1)

or not (0)

0

1

0

0

0

1

1

0

1

0

1

0

0

1

1

0

Macro (1)or CGE (0)

0

0

0

1

0

0

0

0

0

0

0

0

1

0

0

0

Efficientrevenue

recycling (1) orlump-sum {0)

0

0

1 or 0

1 or 0

0

0

0

1 or 0

0

1 or 0

0

0

1 or 0

0

0

0

Jointimplementation (1)

or not (0)

0

0

0

0

1 or 0

1 or 0

0

0

0

0

1 or 0

0

0

0

1

1 or 0

Avertedclimate

damages (1)or not (0)

0

0

1 or 0

0

0

0

0

0

0

0

0

0

0

0

1 or 0

0

Avertedpollution

damages (1)or not (0)

1

0

1 or 0

0

0

0

0

0

0

0

0

0

0

0

0

0


ADDITIONAL REFERENCES

The following references provided dataand background information on mod-els used in the analysis. This was inaddition to several references in themain text.

Burniaux, J-M, J.P. Martin, G. Nicoletti andJ.O. Martins (1991), "The Costs of Policiesto Reduce Global Emissions of CO2: InitialSimulation Results with GREEN," OECDDept. of Economic Statistics, ResourceAllocation Division, Working Paper No. 103,OECD/GD (91), Paris.

Burniaux, J-M., G. Nicoletti and J.O. Martins(1992), "GREEN: A Global Model forQuantifying the Costs of Policies to Curb CO2Emissions," OECD Economic Studies, 19(Winter), pp. 49-92.

DRI/Charles River Associates (1994), "EconomicImpacts of Carbon Taxes: Detailed Results,"Research Project 3441-01 prepared forElectric Power Research Institute, November.

Edmonds, J.A. and J.M. Reilly (1985), GlobalEnergy: Assessing the Future, OxfordUniversity Press, New York.

Edmonds, J.A. and J.M. Reilly (1983), "GlobalEnergy and CO2 to the Year 2050," EnergyJournal, 4 (3), pp. 21-47.

Edmonds, J.A. and D.W. Barns (1991) "Use ofthe Edmonds-Reilly Model to Model Energy-sector Impacts of Greenhouse Gas EmissionsControl Strategies," prepared for the U.S.Dept. of Energy, by Pacific NorthwestLaboratories, Washington, D.C.

Edmonds, J.A. and D.W. Barns (1990)"Estimating the Marginal Cost of ReducingGlobal Fossil Fuel CO2 Emissions," PacificNorthwest Laboratories, PNL-SA-18361,Washington, D.C.

Edmonds, J.A., H. Pitcher, D. Barns, R. Baronand M. Wise (1993), "Modeling FutureGreenhouse Gas Emissions: The SecondGeneration Model Description," Paperpresented to the U.N. University Conferenceon 'Global Change and Modelling,' Tokyo,Japan, October.

Hamilton, Leonard D. et al. (1992), "Markal-Macro: An Overview," Brookhaven NationalLaboratory, Upton, N.Y.

Jorgenson, D. and P. Wilcoxen (1992),"Reducing U.S. Carbon Dioxide Emissions:The Cost of Different Goals," in Advances inthe Economics of Energy and Resources, Vol.7, pp. 125-158, Greenwich, CT: JAI Press.

Jorgenson, D. and P. Wilcoxen (1990),"Intertemporal General EquilibriumModeling of U.S. Environmental Regulation,"Journal of Policy Modeling 12, pp. 715-744.

Kaufmann, Robert, H-Y Li, P. Pauly, L.Thompson, "Global Macroeconomic Effects ofCarbon Taxes: A Feasibility Study", Paperprepared for the EPA, Washington D.C,Contract no. 68-W8-0113.

Kram T. (1994), "Boundaries of Future CarbonDioxide Emission Reduction in NineIndustrial Countries," part of IEA EnergyTechnology Systems Analysis ProgrammeAnnex IV, Netherlands Energy ResearchFoundation.

Manne, A.S. (1992), "Global 2100: AlternativeScenarios for Reducing Carbon Emissions,"OECD Dept. of Economic Statistics,Resource Allocation Division, Working PaperNo. I l l , OECD/GD (91), Paris.

Manne, A.S., and R.G. Richels (1995), "TheGreenhouse Debate: Economic Efficiency,Burden Sharing and Hedging Strategies," TheEnergy Journal, Vol. 16, no. 4.


Manne, A.S. and R.G. Richels (1990b), "CO2

Emissions Limits: An Economic Cost Analysisfor the USA," The Energy Journal, Vol. 11,no. 2, pp. 51-74.

McKibbin, W. and P.J. Wilcoxen (1994), "TheGlobal Costs of Policies to ReduceGreenhouse Gas Emissions," Final Report onU.S. Environmental Protection AgencyCooperative Agreement, CR818579-01-0,Washington, D.C.: The Brookings Institution.

Yang, Zili, Eckaus, R., Ellerman, A. and H.Jacoby (1996), "The MIT EmissionsPrediction and Policy Analysis (EPPA)Model," Report No. 6, May, MIT JointProgram on the Science and Policy of GlobalChange.


ABOUT THE AUTHORS

Robert Repetto is Vice President andSenior Economist at the WorldResources Institute and Director ofthe Program in Economics andPopulation. Formerly, he was anAssociate Professor of Economics atthe School of Public Health at HarvardUniversity and a member of the eco-nomics faculty at Harvard's Center forPopulation Studies.

Duncan Austin is a Research Analystin the Program in Economics andPopulation. Prior to joining WRI, heworked as an Economist in theDepartment of the Environment in theUnited Kingdom.


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