Over time, a key factor in the evolution of U.S. climate policy will be the choices made and actions taken by other nations, particularly nations with large economies and significant emissions of greenhouse gases. Without concerted global action, U.S. policies alone cannot substantially alter climate outcomes. Further, to be cost-effective - and achieve global benefits at the lowest cost - national policies will need to be coordinated, if not connected. In this context, adopting a domestic policy architecture that offers the specific ability to coordinate and adjust both carbon dioxide (CO2) prices and technology incentives is particularly valuable.2
Underlying this report is an assumption that establishing a price path for CO2 and other GHG emissions - either through a tax or tradable permit program - will be a core element of future U.S. climate policy. A pricing strategy is appealing because it responds to the need for both policy clarity and flexibility - making it possible, on the one hand, to predict prices and emissions over reasonable timeframes with a reasonable degree of certainty while also facilitating smooth adjustments over time. There are other compelling economic arguments for taking this assumption as a starting point. As a means of addressing climate-change risks, GHG reductions are equally valuable wherever they occur - but they are not equally costly. From an economic perspective, this means that costs to society can be reduced by implementing a policy that achieves cheaper emissions reductions without any trade-off in environmental benefit. Setting a price on GHG emissions sends a transparent signal to everyone engaged in emissions-producing activities - including direct emitters as well as downstream consumers of emissions-producing products - about the value of reducing emissions. Those who can reduce emissions cheaply will do so, while those who cannot will face a common CO2 price.
The alternative to a single price policy is a more traditional approach to government regulation in which emissions abatement requirements or technology standards and incentives are applied to various GHG sources, such as power plants, factories, cars, and households. While this type of strategy is feasible, evidence suggests it could be much more expensive. Studies that compare the costs of traditional regulation to the costs of market-based approaches have typically found substantial differences: for example, a recent study by economists at RFF suggests that the costs of limiting U.S. GHG emissions through traditional regulatory approaches could be ten times higher than achieving the same result through a pricing policy.3 Given that the costs of addressing climate change are likely to be far from trivial under any circumstances - the cost of an efficient policy has been estimated at 1 percent or more of GDP over many years - maximizing economic efficiency should be a primary consideration for policymakers. (By comparison, the total cost of existing environmental regulation in the United States has been estimated at 2 percent of GDP.)
In fact, recent interest in market-based policies has probably had less to do with academic arguments about economic efficiency and more to do with the experience accumulated through real-world emissions trading programs, starting with the U.S. Acid Rain program in the 1990s and continuing with subsequent broad-based trading programs for both sulfur dioxide and nitrogen oxides in the United States and, as of 2005, for large industrial sources of CO2 in Europe. Of the climate-policy proposals debated in Congress, the great majority feature a cap-and-trade style approach to limiting GHG emissions. The alternative of a carbon tax has not featured as prominently in the current debate, but the larger trend toward establishing a single CO2 price appears well established.
Strong arguments are often made for additional public support and incentives to accelerate the transition to climate-friendly technologies, particularly in the electric power and transportation sectors where a large volume of emissions are concentrated and where market problems may exist. These arguments are well supported by economic theory in the case of research and development. In the case of technology deployment, however, policies that are not carefully designed to address a specific market problem tend to raise costs relative to a simple CO2 pricing policy. Public spending on research and development, for example, is typically viewed as necessary to capture the broad public benefits that arise from new knowledge: because these benefits cannot be fully appropriated by individual firms, private-sector incentives for basic R&D typically fail to reflect the full societal benefits generated by those investments. Uncertainty about future policy commitments may further dilute incentives for private-sector investments in developing new technology.
Broadly speaking, technology deployment policies find support in economic arguments where there are information problems that impede the market response to price incentives, spillovers from learning associated with new technology investments, network effects for large integrated energy systems, and incomplete insurance markets for managing liabilities associated with new-technology investments. In these cases, technology deployment policies can lower the cost associated with achieving a given emissions-reduction target. Often, however, such policies are driven by other interests, including enthusiasm for particular technologies (renewables, biofuels, carbon capture and storage, hybrid vehicles, hydrogen, etc.), a desire to avoid imposing explicit costs in the form of higher energy prices, and a desire to shift costs to the general taxpayer via subsidies. Policies created largely for these reasons, rather than to address market problems, typically raise the overall cost to the economy of reaching the environmental goal compared to a simple pricing policy centered on an emissions tax or permit trading program.
For a given economic cost in aggregate, the distribution of costs across businesses and consumers - and over time - can vary considerably. Most discussions of cost focus on aggregate economic impacts, such as changes in the cost of energy and loss of GDP. However, the distribution of impacts across different industries, regions of the country, and demographic groups can vary considerably. Competitive industries with high energy costs, regions of the country that depend on more carbon-intensive fuels, and households that have higher energy expenditures and lower incomes, are all at greater risk.
There is also a temporal dimension to costs. Many policies currently under discussion propose to achieve relatively modest near-term reductions that lead gradually to significantly deeper reductions in the future, coupled with the flexibility to move emissions-reduction obligations over time. With the predictability and flexibility afforded by this type of approach, businesses can adjust their investments and households can save now to offset higher burdens in the future. In this way, costs should be smoothed out over time. Without predictability and flexibility - or if the policy generates inaccurate expectations that lead to poor investment decisions - costs are likely be higher in the future. Alternatively, unexpected, positive developments could lead to lower costs in the future.
Additional technology policies - including policies designed to overcome barriers to zero- and low-carbon energy sources - can be economically efficient (that is, they may lower the overall costs to society of achieving long-term environmental goals) only as complements to, rather than substitutes for, a pricing policy. Implementing public R&D investments, traditional performance standards for stationary sources or equipment, tradable portfolio standards for electricity generation or fuels, or subsidies alongside a broader pricing policy may be justified if the aim is to address other market problems while the CO2 price encourages emissions reductions. The same is true for policies that address natural gas supply, nuclear waste, the siting of renewable energy projects, electricity grid infrastructure, and efficiency, where the status quo may or may not achieve an adequate balancing of costs and benefits. Used in place of a CO2 price to achieve a given emissions-reduction target, such policies will almost certainly result in higher overall costs compared to a broad-based emissions tax or cap-and-trade program.
As a substitute for policies that effectively price CO2 emissions, for example, performance standards for energy-using equipment reduce the energy-related costs of using that equipment. The effect of lower energy costs may or may not be to cause consumers to increase their use of more efficient equipment, but certainly such standards don't serve to encourage less use. (To give a concrete example: fuel-economy standards reduce the per-mile cost of driving, thus they don't encourage consumers to use their vehicles less.) In effect, low-cost opportunities to reduce emissions by simply reducing equipment use are foregone, implying higher-cost mitigation somewhere else. Also, regulations specific to a single sector will not balance the cost of whatever actions they require against potentially less costly abatement opportunities elsewhere in the economy; as a result, someone will almost certainly spend more than necessary to meet the overall target. Third, traditional regulation does not offer the same incentives for continual innovation over time as do policies that put a price on GHG emissions - once firms meet a standard, there is no incentive to exceed it. Over time, this again leads to higher costs.
As a complement to CO2 pricing, on the other hand, technology policies may or may not lower costs or emissions, depending on the extent to which they address an existing market problem. In either case, it is important that policymakers understand the interaction between a broad-based pricing policy and narrower technology policies. If an emissions cap is in place, technology policies can, at best, only serve to reduce costs and will not produce additional emissions reductions. Similarly, under a tax or other price-setting mechanism, such policies can only serve to reduce emissions and will not lower the price.
Domestic climate policy should be viewed in the context of energy policy more broadly. More than 80 percent of U.S. GHG emissions come from the combustion of fossil fuels. Reducing these emissions implies changing the energy sources used to power the U.S. economy toward increased reliance on zero- or low-carbon fuels. Policies that affect the availability, cost, and usability of natural gas, renewable resources, nuclear power, carbon capture and storage, and end-use efficiency improvements will have important consequences for the cost and success of climate policy. While this report focuses exclusively on the design of climate policy, policies implemented to address broader energy objectives can act to significantly support or undermine climate policy goals and to mitigate or exacerbate the economic impacts associated with achieving GHG reductions. Conversely, policies intended to address climate risks may simultaneously support or undermine broader energy policy goals. For example, climate policies that reduce oil consumption could yield energy-security benefits. On the other hand, climate policies that create additional demand for natural gas in the power sector - absent new supply opportunities - could drive up natural gas prices for industrial users and give rise to additional competitiveness concerns.