Robert N. Stavins

Meaningful and Cost Effective Climate Policy: The Case for Cap and Trade

July 2010

By: Janet Peace and Robert N. Stavins

 

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Introduction:

There is broad consensus among those engaged in climate policy analysis—from academia, government, NGOs, and industry—that any domestic climate policy should include, at its core, market-based policy instruments targeting greenhouse gas (GHGs) emissions, because no other approach can do the job and do it at acceptable cost. By “putting a price on carbon,” market-based polices harness the power of our free enterprise system to reduce pollution at the lowest costs. Recent concern, however, about the role of financial markets—and specific fraudulent investment vehicles—in the recent recession have raised questions among the public about the efficacy and functioning of markets. Not surprisingly, some have questioned the wisdom of employing market mechanisms to tackle climate change. Critics ask, how can market-based policy instruments be trusted to look after the public’s welfare with regard to global-warming pollution (or anything else, for that matter)?

When it comes to climate change and environmental issues more generally, environmental economists recognize that the source of many problems is not markets per se, but the absence of markets for environmental goods and services, such as clean air and water. In the absence of prices (costs) associated with environmental damages, producers and consumers need not account for such damages in their activities and choices. Environmental damage is thus an unintentional byproduct of decisions to produce or consume. Because these negative consequences are external to the firm or individual creating them, economists refer to them as externalities. They are one category of market failures; in this case, the failure of existing markets to price accurately the full costs to society of producing and consuming goods that create a pollution externality.

In the case of climate change, the burning of fossil fuels and other activities that release GHGs into the atmosphere are associated with increasing global temperatures. The costs of these impacts, including an increase in extreme weather events, rising sea levels, loss of biodiversity, and other effects, are borne by society as a whole, including future generations. In the absence of a price on carbon, these environmental costs are not included in the prices of GHG-based goods—thus there is no direct cost for emitting GHG pollution into the atmosphere. From a societal perspective, this leads to an inefficient use of resources, excessive emissions, and a buildup of excess concentrations of GHGs in the atmosphere.

The current status quo or “laissez-faire” approach to dealing (or rather failing to deal) with GHG pollution results in an outcome that is not in the interest of society. For this reason, many people have advocated putting a price on GHG emissions to cause market participants to confront or “internalize” the costs of their actions and choices. A policy instrument that puts a price on GHG emissions would, for example, raise the cost of coal-generated electricity, relative to electricity generated with natural gas, because coal as a fuel emits more carbon dioxide (CO2) per unit of energy. Producers and consumers would take this relative cost differential into account when deciding how much electricity to produce and what fuels to use in producing it. That is the point — to make the cost of emitting carbon explicit, so that it becomes part of the everyday decisionmaking process.

Two alternative market-based mechanisms can be used to put a price on emissions of GHGs—cap and trade and carbon taxes. With cap and trade, an upper limit or “cap” on emissions is established. Emission allowances that equal the cap are distributed (either freely or through auction) to regulated sources which are allowed to trade them; supply and demand for these allowances determine their price. Sources which face higher abatement costs have an incentive to reduce their abatement burden by purchasing additional allowances, and sources which face lower abatement costs have an incentive to reduce more and sell their excess allowances. Thus, the government establishes the environmental goal (the cap), but the market sets the price.

In contrast, a carbon tax sets a price on emissions, but leaves the environmental outcome uncertain. The tax creates an incentive for firms to reduce their emissions up to the point where the cost of reductions is equivalent to the tax. If the tax is low, fewer reductions will result; if the tax is high, more abatement effort will be forthcoming. Given the real-world U.S. political context, the more promising of the two market-based approaches to addressing climate change is clearly cap and trade, which creates a market for GHG reductions.

While the common sense justification for putting a price on carbon emissions seems straightforward, some of the public and even some policy makers are questioning whether creating a market for GHG reductions is a cure worse than the disease itself. Some questions and concerns include the following:

  • Why employ market-based approaches to GHG emission reductions, when markets are subject to manipulation?
  • Would a market-based approach to reducing GHG emissions be a corporate handout?
  • Can markets be trusted to reduce emissions?
  • Will a market-based approach, such as cap and trade, be too costly?
  • Are other approaches—including conventional regulation and taxes—likely to be more effective and less complicated?

Our goal in this paper is to address the questions above, and—we hope—leave the reader with a better understanding of the issues, the rhetoric, and the fundamental reasons why cap and trade is the most promising approach to address the threat of climate change. We believe that past concerns about how markets operate can be effectively addressed and result in a policy that is both environmentally and economically superior to alternative approaches.

Janet Peace
Robert N. Stavins
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The Cost of U.S. Forest-based Carbon Sequestration

US Forestbased Carbon Sequestration Cove

The Cost of U.S. Forest-based Carbon Sequestration

Prepared by the Pew Center on Global Climate Change
January 2005

By:
Robert N. Stavins, Harvard University
Kenneth R. Richards, Indiana University

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Foreword

Eileen Claussen, President, Pew Center on Global Climate Change

Most analyses to date of options for mitigating the risk of global climate change have focused on reducing emissions of carbon dioxide and other greenhouse gases (GHGs). Much less attention has been given to the potential for storing (or “sequestering”) significant amounts of carbon in forests and other ecosystems as an alternative means of offsetting the effect of future emissions on GHG concentrations in the atmosphere. The tendency to overlook sequestration opportunities can lead to incorrect and overly pessimistic conclusions about both the cost and feasibility of addressing global climate change in the decades ahead.

To remedy that gap, and to inform U.S. policymaking, the Pew Center asked economists Robert Stavins of Harvard University and Kenneth Richards of Indiana University to synthesize and expand upon available studies of forest-based carbon sequestration in the United States. They analyze the true opportunity costs of using land for sequestration, in contrast with other productive uses, and examine the multiple factors that drive the economics of storing carbon in forests over long periods of time. These factors include forest management practices for different tree species and geographical regions; the costs of land and competing prices for agricultural products; the ultimate disposition of forest materials, including the potential for fire damage as well as harvesting for use in different kinds of end products; the specific carbon management policy employed; and the effect of key analytical parameters, including in particular the discount rate applied to future costs and benefits. The authors then adjust the findings from major recent studies of forest sequestration to reflect consistent assumptions in each of these areas and use the normalized results to establish a likely range for the overall scope and likely costs of large-scale carbon sequestration in the United States. 

Their conclusions are striking. Estimated costs for sequestering up to 500 million tons of carbon per year—an amount that would offset up to one-third of current annual U.S. carbon emissions—range from $30 to $90 per ton. On a per-ton basis, these costs are comparable to those estimated for other climate change mitigation options such as fuel switching or energy efficiency. A sequestration program on this scale would involve large expanses of land and significant upfront investment; as such, it would almost certainly require a phased approach over a number of years and careful attention to policy details to ensure efficient implementation. Nevertheless, the results of this study indicate that sequestration can play an important role in future mitigation efforts and must be included in comprehensive assessments of policy responses to the problem of global climate change.

The Pew Center and the authors are grateful to Ralph Alig, Ronald Sands, and Brent Sohngen for helpful comments on previous drafts of this report. A future Pew Center domestic policy report will focus on design aspects of a domestic mitigation program that includes sequestration. Insights from this report and from companion papers in the Pew Center’s Economics series are being utilized to develop a state-of-the-art assessment of the costs to the United States of taking action to address climate change.

Executive Summary

When and if the United States decides on mandatory policies to address global climate change, it will be necessary to decide whether carbon sequestration should be part of the domestic portfolio of compliance activities. The potential costs of carbon sequestration policies will presumably be a major criterion, so it is important to assess the cost of supplying forest-based carbon sequestration in the United States. In this report we survey major studies, examine the factors that have affected their carbon sequestration cost estimates, and synthesize the results.

The Earth’s atmosphere contains carbon dioxide (CO2) and other greenhouse gases (GHGs) that act as a protective layer, causing the planet to be warmer than it would otherwise be. If the level of CO2 rises, mean global temperatures are also expected to rise as increasing amounts of solar radiation are trapped inside the “greenhouse.” The level of CO2 in the atmosphere is determined by a continuous flow among the stores of carbon in the atmosphere, the ocean, the earth’s biological systems, and its geological materials. As long as the amount of carbon flowing into the atmosphere (as CO2) and out (in the form of plant material and dissolved carbon) are in balance, the level of carbon in the atmosphere remains constant.

Human activities—particularly the extraction and burning of fossil fuels and the depletion of forests—are causing the level of GHGs (primarily CO2) in the atmosphere to rise. The primary sources of the slow but steady increase in atmospheric carbon are fossil fuel combustion, which contributes approximately 5.5 gigatons (billion metric tons) of carbon per year, and land-use changes, which account for another 1.1 gigatons. In contrast, the oceans absorb from the atmosphere approximately 2 more gigatons of carbon than they release, and the earth’s ecosystems appear to be accumulating another 1.2 gigatons annually. In all, the atmosphere is annually absorbing approximately 3.4 gigatons of carbon more than it is releasing.

While the annual net increase in atmospheric carbon may not sound large compared with the total amount of carbon stored in the atmosphere—750 gigatons—it adds up over time. For example, if the current rate of carbon accumulation were to remain constant, there would be a net gain in atmospheric carbon of 25 percent over the next fifty years. In fact, the rate at which human activity contributes to increases in atmospheric carbon is accelerating. Emissions from land-use change have been growing at the global level, though not nearly as rapidly as emissions from fossil fuel combustion. In the United States, land-use change—which was a substantial source of carbon emissions in the 19th and early 20th centuries—became a sink (or absorber of carbon) by the second half of the 20th century. However, the rate of carbon absorption by terrestrial systems in the United States peaked around 1960 and has been falling since.

It may be possible to increase the rate at which ecosystems remove CO2 from the atmosphere and store the carbon in plant material, decomposing detritus, and organic soil. In essence, forests and other highly productive ecosystems can become biological scrubbers by removing (sequestering) CO2 from the atmosphere. Much of the current interest in carbon sequestration has been prompted by suggestions that sufficient lands are available to use sequestration for mitigating significant shares of annual CO2 emissions, and related claims that this approach provides a relatively inexpensive means of addressing climate change. In other words, the fact that policy makers are giving serious attention to carbon sequestration can partly be explained by (implicit) assertions about its marginal cost, or (in economists’ parlance) its supply function, relative to other mitigation options.

The economist’s notion of cost, or more precisely, opportunity cost, is linked with—but distinct from—everyday usage of the word. Opportunity cost is an indication of what must be sacrificed to obtain something. In the environmental context, it is a measure of the value of whatever must be sacrificed to prevent or reduce the chances of a negative environmental impact. Opportunity cost typically does not coincide with monetary outlays—the accountant’s measure of costs. This may be because out-of-pocket costs fail to capture all of the explicit and implicit costs that are incurred, or it may be because the prices of the resources required to produce an environmental improvement are themselves an inaccurate indication of the opportunity costs of those resources. Hence, the costs of a climate policy equal the social benefits that are foregone when scarce resources are employed to implement that policy, instead of putting those resources to their next best use.

The costs of carbon sequestration are typically expressed in terms of monetary amounts (dollars) per ton of carbon sequestered—that is, as the ratio of economic inputs to carbon mitigation outputs for a specific program. The denominator, carbon sequestered, is determined by forest management practices, tree species, geographic location and characteristics, and disposition of forest products involved in a hypothetical policy or program. The costs reflected in the numerator include the costs of land, planting, and management, as well as secondary costs or benefits such as non-climate environmental impacts or timber production. Well-developed analytical models include landowners’ perceptions regarding all relevant opportunity costs, including costs for land, conversion, plantation establishment, and maintenance.

Among the key factors that affect estimates of the cost of forest carbon sequestration are: (1) the tree species involved, forestry practices utilized, and related rates of carbon uptake over time; (2) the opportunity cost of the land—that is, the value of the affected land for alternative uses; (3) the disposition of biomass through burning, harvesting, and forest product sinks; (4) anticipated changes in forest and agricultural product prices; (5) the analytical methods used to account for carbon flows over time; (6) the discount rate employed in the analysis; and (7) the policy instruments used to achieve a given carbon sequestration target.

Given the diverse set of factors that affect the cost and quantity of potential forest carbon sequestration in the United States, it should not be surprising that cost studies have produced a broad range of estimates. This report identifies eleven previous analyses that are good candidates for comparison and synthesis. Results from these studies were made mutually consistent, or normalized, by adjusting for constant-year dollars, identical discount rates, identical geographic scope, and reporting in equivalent annual costs. This normalization narrows the range of results considerably; for a program size of 300 million tons of annual carbon sequestration, nearly all estimated supply functions (or marginal costs) fall within the range of $25 - $75 per short ton of carbon ($7.50 - $22.50 per metric ton of CO2-equivalent). This range increases somewhat—to $30 - $90 per ton of carbon—for programs sequestering 500 million tons annually. In addition, econometric methods were used to estimate the central tendency (or “best-fit”) of the normalized marginal cost functions from the eleven studies compared here; this is presented as an additional result of the analysis and as a rough guide for policy makers of the projected availability of carbon sequestration at various costs.

Three major conclusions emerge from our survey and synthesis:

1) There is a broad range of possible forest-based carbon sequestration opportunities available at various magnitudes and associated costs.

This range depends upon underlying biological and economic assumptions, as well as the analytical methods employed. Several factors affect estimates of cost: forest species and practices; the value of land for alternative uses; the disposition of biomass, forest and agricultural product prices; methods used to account for carbon flows over time; the discount rate employed; and the policy instruments used.

2) A systematic comparison of sequestration supply estimates from national studies produces a range of $25 to $75 per ton for a program size of 300 million tons of annual carbon sequestration.

The range increases somewhat—to $30 - $90 per ton of carbon—for programs sequestering 500 million tons annually. This range is obtained from a synthesis of eleven national studies of U.S. sequestration opportunities in the forestry sector, where each study was adjusted for use of equivalent annual costs in constant-year dollars, together with identical discount rates and identical geographic scope. This approach allows for consistent comparisons across a variety of studies and narrows the range of estimated supply functions considerably.

3) When a transparent and accessible econometric technique is employed to estimate the central tendency (or “best-fit”) of costs estimated in these eleven studies, the resulting supply function for forest-based carbon sequestration in the United States is approximately linear up to 500 million tons of carbon per year, at which point marginal costs reach approximately $70 per ton.

A 500-million-ton-per-year sequestration program would be very significant, offsetting approximately one-third of annual U.S. carbon emissions. At this level, the estimated costs of carbon sequestration are comparable to typical estimates of the costs of emissions abatement through fuel switching and energy efficiency improvements. This result indicates that sequestration opportunities ought to be included in the economic modeling of climate policies. It further suggests that if it is possible to design and implement a domestic carbon sequestration program, then such a program ought to be included in a cost-effective portfolio of compliance strategies when and if the United States enacts a mandatory domestic GHG reduction program.

Conclusions

When and if the United States chooses to implement a domestic GHG reduction program and/or joins in any international efforts to mitigate climate change, it will be necessary to decide whether carbon sequestration policies should be part of the domestic portfolio of compliance activities. The potential opportunities and associated costs of carbon sequestration will presumably be a major criterion in determining its role and so it is important to assess the cost of supplying forest-based carbon sequestration in the United States. Failure to include carbon sequestration as a mitigation option in economic models will lead to over-estimation of the cost of reducing net GHG emissions. However, including carbon sequestration in a naïve manner could produce misleading results as well.

In this report, we have surveyed major previous studies of sequestration, examining the factors that have affected their cost estimates and synthesizing their results. The assumptions that stand out as being particularly important in previous cost estimates include those concerning biological factors such as species, forestry practices, and carbon yield patterns; the opportunity cost of land; management practices; methods of disposition of biomass; relevant prices; and policy instruments used to achieve carbon sequestration.

We identified eleven previous analyses of carbon sequestration costs in the United States as particularly good candidates for comparison and synthesis and normalized their findings to narrow the useful range of estimated costs and allow for consistent comparisons. The normalization included adjustments for constant year dollars, use of identical discount rates, adjustments to scale for identical (national) geographic scope, and consistent reporting in equivalent annual costs. As anticipated, normalizing results across studies led to a significant narrowing of the range of estimated marginal cost functions (Figure 4). This range was subsequently narrowed further by excluding regional studies, since we judged the extrapolation from regional results to national estimates to be problematic. After excluding the three regional studies, our analysis shows that at 300 million tons of annual carbon sequestration nearly all supply functions fall within a marginal cost range of $25 - $75 per short ton of carbon ($7.50 - $22.50 per metric ton of CO2-equivalent). Not surprisingly, the range increases somewhat—to $30 - $90 per ton—for programs sequestering 500 million tons annually (Figure 5).

To make our results more transparent and accessible, we also used econometric techniques to estimate the central tendency of these marginal cost functions; the resulting “best fit” cost curve is presented as an additional output of our analysis. Graphically (Figure 6), it approximates a straight line up to 500 million tons of annual sequestration at which point each additional ton of carbon sequestration costs a bit more than $70 per ton.

Three conclusions emerge from our analysis:

(1) there is a broad range of possible forest-based carbon sequestration supply functions whose shape and magnitude depend on what is assumed about underlying biological and economic factors, as well as on the analytical methods used to estimate costs and supply;

(2) by limiting the set of supply functions to those that come from national studies and that lend themselves to quantitative normalization, the results from previous analyses can be rendered more comparable and the range of estimated supply functions can be narrowed considerably;

(3) when a transparent and accessible approach is employed to estimate econometrically the central tendency of the individual studies making up this range of results, the resulting marginal cost function indicates that the cost of supplying forest-based carbon sequestration in the United States is nearly, though not exactly, linear up to 500 million tons per year, where marginal costs reach a bit more than $70 per ton.

The results presented in this report represent a synthesis of the best existing cost studies, not the final word on the topic. Future research could benefit from further attention to important issues of programmatic leakage (or countervailing forces) that might diminish the positive impacts of a program and thus raise the social cost of sequestration, the impermanence or reversibility of forest carbon sequestration, the broader impacts of a forest carbon sequestration program on the agriculture and forestry sectors and on public finance and tax systems, and the potential secondary costs and benefits of a carbon sequestration program with respect to, for example, natural resources such as water quality and wildlife habitat. Moreover, additional exploration is needed of the interaction between different policy mechanisms to promote sequestration (whether offset trading, agricultural subsidies for specific practices, command-and-control, or direct government production) and the ultimate opportunity costs of sequestration. In general, there may be a tradeoff between the power of incentives directly linked to desired outcomes (in this case the quantity of carbon sequestered) and the costs of implementing and monitoring a program. The optimal program design for promoting sequestration, and how that design affects the issues delineated above, merits more attention.

It is important to understand the magnitude of the hypothetical programs under consideration in this study. The amount of agricultural land involved is huge—approximately 27 million acres for a program achieving 50 million tons of sequestration per year and 148 million acres for a program achieving 300 million tons of sequestration per year. Total annual costs, based on the cost estimates developed here, would be approximately $840 million and $7.2 billion, respectively, for 50 and 300 million ton programs. Because much of this cost would occur upfront, the total social cost in present value terms may be thought of as similar to incurring a one-time cost of $17 billion to $143 billion. Needless to say, this would be a large amount for the U.S. or any other economy to absorb—financially, physically, and administratively—and so a program of this size would probably need to be implemented gradually over many years.

The estimate of carbon sequestration potential discussed in this report (i.e., up to 500 million tons per year) would require a very significant sequestration program, equivalent to about one-third of annual U.S. carbon emissions. Given that available sequestration cost estimates (at these quantity levels) are not very far above typical cost estimates for emissions abatement through fuel switching and energy efficiency improvements, it follows that a domestic carbon sequestration program (assuming such a program can be designed and implemented) ought to be included in a cost-effective portfolio of compliance strategies if and when the United States chooses to implement a domestic GHG reduction program.

 

 

Kenneth R. Richards
Robert N. Stavins
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