Robert R. Nordhaus
Designing a Mandatory Greenhouse Gas Reduction Program for the U.S.
Prepared for the Pew Center on Global Climate Change
Robert R. Nordhaus
Kyle W. Danish
Eileen Claussen, President, Pew Center on Global Climate Change
In response to the goal of the U.N. Framework Convention on Climate Change to stabilize greenhouse gas concentrations at a level that would prevent dangerous human interference with the climate system, the United States has instituted a number of programs since 1992. These include voluntary greenhouse gas mitigation programs, research and development, and a subset of energy policies that focus on energy efficiency and renewable energy. More than a decade of experience with these programs shows that while they have at times inspired significant action on the part of individual companies, these measures have not succeeded in reducing, or even stabilizing, total U.S. emissions. U.S. greenhouse gas emissions increased roughly 12 percent between 1990 and 2001, and are projected to increase another 12 percent by 2012. In order for the United States to achieve the significant greenhouse gas reductions necessary to address climate change, it must implement a mandatory greenhouse gas reduction program.
The Pew Center asked report authors Robert Nordhaus of Van Ness Feldman, P.C., and George Washington University Law School, and Kyle Danish of Van Ness Feldman to examine options for designing a mandatory U.S. greenhouse gas reduction program. Three options are specifically evaluated: (1) cap-and-trade programs, (2) greenhouse gas taxes, and (3) a “sectoral hybrid” program that combines efficiency standards for automobiles and consumer products with a cap-and-trade program applicable to large sources of greenhouse gases. In addition to identifying design issues unique to each type of program, the authors evaluate the options according to the following criteria: environmental effectiveness, cost-effectiveness, administrative feasibility, distributional equity, and political acceptability.
The analysis suggests that a comprehensive, upstream cap-and-trade approach (or a workable variation) and the sectoral hybrid approach are the most viable alternatives for a domestic greenhouse gas reduction program. While an economy-wide cap-and-trade approach may present the best option for low-cost greenhouse gas reductions, a sectoral hybrid approach building on existing programs may evolve. Whatever approach is taken, policy-makers should attempt to reach their environmental goal in a way that incorporates market mechanisms and minimizes administrative complexity.
With growing Congressional interest in programs to address climate change—including the recent introduction of economy-wide cap-and-trade legislation controlling greenhouse gas emissions—the analysis of U.S. greenhouse gas reduction program options is timely. In addition to this review, the Pew Center is simultaneously releasing a complementary report, Emissions Trading in the U.S.: Experience, Lessons, and Considerations for Greenhouse Gases, which examines six diverse U.S. emissions trading programs, drawing general lessons for future applications and discussing considerations for controlling greenhouse gas emissions.
The Pew Center and the authors would like to thank Joe Goffman, Granger Morgan, Tom Wilson, Ev Ehrlich, and Billy Pizer for providing comments on a previous draft of this report, Anne Smith for reviewing the description of modeling results, and William Nordhaus for his useful insights. The views expressed in this report are the authors’ and not those of the reviewers, Van Ness Feldman, or its clients.
This report identifies issues that must be addressed in the design of a mandatory, domestic greenhouse gas (GHG) reduction program. Three options are specifically evaluated: (1) cap-and-trade programs, (2) GHG taxes, and (3) a “sectoral hybrid” program that combines efficiency standards for automobiles and consumer products with a cap-and-trade program applicable to large GHG emission sources.
Criteria for Evaluating Options
In order to compare various approaches to GHG reductions, each option is evaluated using the following criteria:
- Environmental Effectiveness. How effective is the program in meeting its emissions reduction target?
- Cost-Effectiveness. Will the program design permit cost-effective compliance?
- Administrative Feasibility. Can the program be administered effectively and does it minimize administrative and transaction costs?
- Distributional Equity. Are the burdens of compliance fairly apportioned?
- Political Acceptability. Are there elements of the program’s design that affect its political acceptability?
Analysis of Options
1. Cap-and-Trade Programs
A conventional cap-and-trade program establishes an economy-wide or sectoral “cap” on emissions (in terms of tons per year or other compliance period), and allocates or auctions tradable “allowances” (the right to emit a ton of greenhouse gases) to GHG emission sources or fuel distributors. The total number of allowances is equal to the cap. A “downstream” cap-and-trade program applies to sources of GHG emissions and requires them to surrender allowances equal to their emissions. An “upstream” program applies to fuel suppliers and requires them to surrender allowances equivalent to the carbon content of fossil fuels they distribute. The primary focus of a cap-and-trade program would be on sources of emissions that can be readily measured and monitored; these include almost all sources of carbon dioxide (CO2) emissions from fossil-fuel combustion as well as many sources of other GHG emissions. Sources not amenable to regulation through a cap-and-trade program can be covered on an “opt in” or project basis or addressed through supplemental regulation. Four major issues should be considered in the design of such a cap-and-trade program:
2) Downstream vs. Upstream. Does the program regulate firms that emit greenhouse gases (“downstream”) or does it regulate their fuel suppliers (“upstream”)?
3) Allowance Allocation. Does the program distribute free allowances to firms affected by GHG regulation, does it auction them to the highest bidder, or is some combination of approaches involved? If free allowances are distributed, what allocation formula is used? If allowances are auctioned, how are the revenues used? How might the allocation process change over time?
4) Cost Cap. Does the program incorporate a “safety valve” in which additional allowances are made available at a pre-set price?
Evaluation of the Cap-and-Trade Approach
Upstream cap-and-trade. An economy-wide upstream cap-and-trade program would be environmentally effective, could attain cost-effective compliance if it incorporates flexibility measures, and would be administratively feasible. Its distributional consequences would depend on how allowances were allocated and, if auctioned, how the auction revenues were recycled back into the economy. These allocation and recycling decisions can also affect overall compliance costs, because some methods of allocating allowances may be less economically efficient than an auction, and according to some economists, using auction revenues to reduce “distortionary” taxes on capital or labor can reduce the net costs of the program. Finally, because an economy-wide upstream cap-and-trade program will drive up the cost of gasoline and home heating fuels, it is likely to present a political challenge.
All-source downstream cap-and-trade. An economy-wide downstream cap-and-trade program—because it implies the regulation of literally millions of individual GHG sources, including cars and homes—would be difficult and costly to administer, and therefore is not a viable prospect for a domestic GHG regulatory program.
Large-source downstream cap-and-trade. A large-source downstream program (i.e., one applicable only to electricity generators and large industrial sources of greenhouse gases) is administratively feasible and could be environmentally effective with respect to the sectors it covered. To be fully effective, however, such an approach would have to be coupled with a program to cover other sectors. A large-source downstream program might be more acceptable politically than an upstream economy-wide program because it would not result in price increases for gasoline and home heating fuels (though it still would result in price increases for electricity).
2. GHG Tax
A GHG tax is a tax on emissions of greenhouse gases or on the carbon content of fossil fuel. Many of the design issues discussed in connection with cap-and-trade programs are also present—though in somewhat different form—in the design of a GHG tax.
Evaluation of the GHG Tax Approach
An upstream GHG tax program could be environmentally effective, but would not provide certainty in meeting a particular emissions target. It would allow for adoption of least-cost mitigation strategies, would offer cost certainty, and would be administratively feasible. The ultimate distributional consequences of a GHG tax would depend on how policy-makers distributed revenues from the tax. Again, according to some economists, using revenues from allowance auctions or emissions taxes to reduce “distortionary” taxes can reduce the net costs of the program. However, political acceptability is likely to be a major obstacle, since the GHG tax combines both new taxes and fuel price increases. A GHG tax could have better prospects as a part of a larger tax reform effort.
3. Sectoral Hybrid Programs (Product Efficiency Standards Plus Large Source Cap-and-Trade)
One way to increase the environmental effectiveness and cost-effectiveness of a domestic program that relies on a large-source downstream cap-and-trade policy is to regulate uncapped sectors through product efficiency standards. Such a “sectoral hybrid” program would combine a large source cap-and-trade program with product efficiency standards. The product efficiency standard component would be similar to current automobile and appliance efficiency standards, and would be designed to limit GHG emissions from new automobiles and consumer products.
Issues in designing the product efficiency standards component of the sectoral hybrid include: the scope of the program (which products are regulated); the extent to which standards are made “tradable” (i.e., whether manufacturers can trade between product lines within the firm, with other manufacturers, or with facilities regulated under the cap-and-trade program); and whether the program “caps” projected lifetime emissions from use of the product (“capped tradable standards”).
Evaluation of the Sectoral Hybrid Approach
A sectoral hybrid program consisting of a large-source downstream program coupled with product efficiency standards would be more environmentally effective than a downstream program alone (or standards alone), because standards could address emissions from sources (such as automobiles and appliances) that could not feasibly be covered by the downstream cap-and-trade program. Building on existing standards programs, such a hybrid program could attain coverage of about 80 percent of U.S. energy-related CO2 emissions. However, product efficiency standards would not address the intensity of product use or the replacement rate of new products for old, less-efficient products. A hybrid program would be a more costly means of achieving any particular emissions target than an economy-wide upstream cap-and-trade or tax program, though making the standards “tradable” would reduce the disparity. Incorporating tradable standards would present significant administrative challenges, however, because of the need to prevent double-counting of emission reductions and the technical issues in setting and revising standards. Finally, a sectoral hybrid program may score better on political acceptability because it constrains domestic GHG emissions while largely shielding consumers from
fuel price increases.
Summary of Analysis
The paper’s analysis would argue against an economy-wide downstream cap-and-trade program (as unadministrable), a stand-alone large-source cap-and-trade program (as incomplete), and a GHG tax program (as unviable politically, unless coupled with structured tax reform). The paper’s analysis indicates that at least two major alternatives appear to be feasible: (1) an economy-wide upstream cap-and-trade program, or (2) a sectoral hybrid program under which product efficiency standards complement a large-source downstream cap-and-trade program.
The first alternative (a comprehensive upstream cap-and-trade program) may be the best one if it can be put in place. However, U.S. energy policy experience over the past three decades suggests that putting it in place may be extraordinarily difficult. Even in times of most compelling national circumstances, such as the 1973 Arab oil embargo, Congress was unwilling to use energy price increases to rein in consumer demand. The second alternative—a sectoral hybrid program—may be all that can be implemented in the near term. If policy-makers take that course, careful attention will have to be given to minimizing economic costs and administrative complexity, and assuring that the program can be effectively enforced.
Early Action and Global Climate Change: An Analysis of Early Action Crediting Proposals
Robert R. Nordhaus and Stephen C. Fotis
Eileen Claussen, Executive Director, Pew Center on Global Climate Change
The challenge of our generation will be addressing climate change while sustaining a growing economy. We need to take concrete actions to reduce emissions, both here and abroad. The sooner we begin, the more likely we are to succeed in stabilizing atmospheric concentrations at a level that will prevent dangerous anthropogenic interference with the climate.
This report, which analyzes proposals to credit early, voluntary actions to mitigate greenhouse gas emissions, is the first in a series to be published by the Center. The Pew Center was established in 1998 by the Pew Charitable Trusts to bring a new cooperative approach and critical scientific, economic, and technological expertise to the global climate change debate. Some U.S. companies have indicated support for early action programs in keeping with their desire to take immediate action to reduce greenhouse gases and their need for assurance that such actions will be rewarded and not punished.
This report addresses the issues that policy makers will face in designing a domestic early action program, analyzes current proposals, and suggests a set of principles to guide an effective program. It suggests that, regardless of any eventual international framework, the U.S. can take steps to credit reductions in gases now, and therefore encourage and reward companies that act to minimize their emissions. The longer we wait to address climate change, the more it is likely to cost—both environmentally and economically. The Pew Center concludes:
- The cost of delay is significant. Steps taken now represent an investment that will pay environmental and economic dividends into the future. Conversely, continued inaction will result in greater environmental challenges and increased costs down the line.
- U.S. Leadership is imperative. Since the U.S. has both the highest greenhouse gas emissions and per capita income, implementing a voluntary early action program demonstrates to the world our commitment to address the problem of climate change.
- Leadership must start with Congress. Congress must provide the legislative framework to encourage early action.
The Pew Center and its Business Environmental Leadership Council believe climate change is serious business. Our effort is founded on the belief that enough is known about the science and environmental impacts of climate change for us to take action now to address its consequences. Awarding credit for early action is an important first step.
The ultimate objective of the Rio Convention, which the United States ratified in 1992, is to stabilize atmospheric concentrations of greenhouse gases (ghg) at levels that will prevent dangerous anthropogenic interference with the climate system. Such stabilization will require significant reductions in ghg emissions by the United States and other countries. One mechanism proposed for encouraging U.S. companies to begin reducing ghg emissions now is an early action crediting program. Such a program would provide U.S. companies with credits for ghg reductions achieved prior to the year 2008 (i.e., before the first budget period under the proposed Kyoto Protocol) that would be usable by those companies for compliance with any future domestic ghg regulatory program.
This paper analyzes the legal, policy, and technical issues that policy makers may wish to consider in designing an early action crediting program. Although many of these issues are quite complex and cannot be fully addressed with simple and uniform crediting rules for all industry sectors, the paper attempts to formulate a set of general principles to guide policy makers in fashioning an administratively workable and effective program. The paper begins with a review of current U.S. efforts to mitigate ghg emissions through voluntary actions and programs and provides an analysis of five early action crediting proposals publicly available as of July 1998.
Voluntary GHG Mitigation Efforts in the United States. The Rio Convention's non-binding goal for developed countries was to return ghg emissions to 1990 levels by 2000. To meet this goal, the Clinton Administration developed the Climate Change Action Plan (CCAP), which outlined a portfolio of about 50 ghg mitigation actions. The plan applied to all sectors of the economy that emit ghg emissions and was intended to foster voluntary partnerships with the private sector and local governments. Generally speaking, the CCAP initiatives were designed to provide information and tools to encourage participants to voluntarily undertake physical or operational changes that will reduce ghg emissions. Although they demonstrate that industry and government can work together to achieve cost-effective ghg reductions, the CCAP initiatives have not achieved the level of reductions necessary to return U.S. emissions to 1990 levels, as contemplated by the Rio Convention.
Review of Design Issues and of Current Extant Early Action Crediting Proposals. The paper provides an analysis of the legal, policy, and technical issues raised in the early action crediting proposals developed by the Environmental Defense Fund, the Coalition to Advance Sustainable Technology, the Center for Clean Air Policy, Resources for the Future, and Niagara Mohawk Power Corporation. Key issues include the legal framework for the program, source of credits, flexibility, actions eligible for credit, and technical design of the program.
Principles for Designing An Early Action Program. Based on the review of these issues, the paper identifies the following general principles that may be useful as a guide to policy makers in fashioning a workable and effective program:
1. Provide a predictable credit mechanism and clear legal framework for the program. The principal purpose of an early action crediting program is to encourage voluntary ghg reductions in the near term. The program should provide a substantial and reliable incentive that will stimulate immediate efforts to slow down the increase of, and, ultimately, to decrease, ghg emissions levels in the United States. For such an incentive to be effective, participants must know in advance the credits they will earn for particular ghg reductions or sequestration activities and be given clear assurances that they possess a legally enforceable right to receive earned credits. Existing law does not provide the legal framework to give participants that right. For that reason, the crediting mechanism should be clearly delineated by statute or in agreements authorized by statute.
2. Keep the program simple and flexible. Any early action crediting program will be voluntary. The extent of participation in the program will depend, among other things, on whether potential participants perceive benefits of participation to exceed the costs of complying with the requirements of the program. Simplicity and flexibility are key components of minimizing transaction and compliance costs. Because of the range of potential participants, the agency administering the program will need flexibility to tailor the program to the needs and circumstances of particular industries and companies. The program will also need the flexibility to encourage innovation and reward efficiency. The best mechanism for doing this is through agreements between the participants and the government that spell out the specifics of the crediting mechanism for that participant, or industry. Model agreements for particular industries may be useful tools in this regard.
3. Reward real reductions, not gaming. An early action crediting program takes ghg credits otherwise available to U.S. companies during the initial period of domestic ghg regulation and gives them to participants in the early action program as a spur to reducing ghg emissions before that initial period. It is important that credits be used to reward real net reductions in ghg emissions, rather than paper reductions. The program needs to incorporate safeguards that give the public and other emitters confidence that the system will not be gamed.
4. Provide some form of recognition of past voluntary ghg reductions. Voluntary ghg reductions achieved between 1990 and 1998 and reported to the federal government should be recognized either in the form of a baseline adjustment or as a direct credit. It is important to maintain the principle that companies will not be disadvantaged because of prior voluntary reductions. However, the reward for past mitigation efforts should be provided only to the extent that the ghg reductions are real, quantifiable, verified, and not double-counted.
5. Don't predetermine the eventual domestic regulatory program. An early action crediting program should be designed to operate within the framework of any likely domestic regulatory or tax program that might be fashioned to control domestic ghg emissions. This includes a range of regulatory options such as carbon taxes, direct regulatory programs, and marketable permit schemes (implemented through, for example, an auction or administrative allocation of allowances).
6. Don't make the early action crediting program contingent upon ratification of the kyoto protocol. The early action program should not depend upon Senate ratification of the Kyoto Protocol in its present form. Rather, it should be designed to operate in the context of whatever international control regime may eventually be adopted and ratified by the U.S.
7. Focus principally on domestic early action. The allocation of credits to the U.S. under Kyoto or any other international agreement is an asset that should be carefully husbanded for use by the U.S. economy. For that reason, the principal but not exclusive focus of the program should be on rewarding early domestic actions to mitigate ghg emissions. There are, however, a number of circumstances where credit for actions outside the U.S. should be considered.
8. Don't over-mortgage the U.S. ghg allocation. The Kyoto Protocol, if ratified, will not provide international credit for reductions attained prior to 2008 in developed countries. Early action credits for ghg reductions within the United States thus would have to come out of the U.S. first budget allocation under the Protocol. Careful consideration needs to be given to the impact of an early action credit program on the availability of credits to non-participants once domestic regulation commences, and the extent to which credit should be given for action outside the U.S.