The Economic Costs of Reducing Emissions of Greenhouse Gases: A Survey of Economic Models: Technical Paper 2003-03

Working Paper
May 1, 2003

Mark Lasky

In response to fears about the damages global warming may cause in the future, most of the world’s nations signed the Kyoto Protocol in December 1997, agreeing to cap human-induced emissions of carbon dioxide and other human-induced greenhouse gases in the United States and 37 other industrial nations beginning in 2008. At that time, they left many details unresolved. Since then, the Bush Administration has indicated it would not submit the protocol to the Senate for ratification, and the other parties have agreed to rules for implementation that will likely result in a much smaller reduction in emissions than originally envisioned by the protocol. Nonetheless, the considerable volume of studies of the Kyoto agreement as originally intended may have some lessons for any future attempts to limit greenhouse gases. This paper reviews those studies in order to assess the economic cost of limiting greenhouse emissions through a system of tradable emissions permits and investigates the impact of alternative rules for trading.

Economists have used a variety of models to estimate the costs of complying with emissions caps. These models assume that a permit system would raise the cost of goods or services that cause greenhouse gas emissions when they are either used or produced. Carbon dioxide from the combustion of coal, oil and natural gas accounts for the bulk of such emissions, so prices of energy and energy-intensive goods and services would rise the most. The higher the price of such goods rose, the fewer of them people would use, until emissions were reduced to the level of the cap.

This paper surveys and synthesizes the predictions of several such economic models of the cost of meeting the Kyoto caps. The models produce a wide variety of cost estimates, depending on many factors. The most important of those factors are differences in the amount of permit trading assumed and different model assumptions about the sensitivity of energy usage to energy prices and the response of the economy to higher inflation. In some cases, differences in the assumed path of baseline emissions, the response of labor supply to the real wage, and the impact of international capital flows are also important. All models are simplifications of reality, and thus to some extent make unrealistic assumptions—often different ones in different models. However, by comparing model assumptions and results, it is possible to assess the effect of those assumptions and to adjust for them. The synthesis presented in this paper provides an integrated view that minimizes the role of unrealistic assumptions, and thus gives a clearer view of the likely economic impact of alternative rules for permit trading.

Depending on how much permit trading is allowed, a wide range of costs is possible. Based on forecasts released in 2000, gasoline prices in the United States could be 12 to 38 cents per gallon (1997 dollars) higher in 2010 than they would without emission limits, depending on trading rules. (Throughout this paper, prices are expressed in 1997 dollars. To convert 1997 dollars in to 2002 dollars, multiply by 1.085.) The price of natural gas to households could be 13 percent to 42 percent higher, while the price of electricity to households could be 13 percent to 36 percent higher. Real GDP in the United States under the protocol could be 0.5 percent to 1.2 percent lower in 2010 than otherwise, while real consumption could be 0.4 percent to 1.0 percent lower. In every case, costs are smallest when no restrictions are imposed on international permit trading. (Taking account of uncertainty widens the range of estimates further.)

Although different rules for permit trading would have a large impact on the cost of emissions restrictions, they would have little impact on the environmental benefits, that is, on the reduction in global emissions of greenhouse gases. In most cases, restrictions like those specified in the Kyoto Protocol would reduce global emissions of carbon dioxide in 2010 by about 6 percent from what it would otherwise be, or from 40 percent above 1990 levels to 33 percent above 1990 levels. Only if countries could not sell their excess permits (permits from a cap in excess of baseline emissions) would the reduction in emissions be larger. Unfortunately, costs are also largest in this case. Thus, one of the key findings of this paper is that the United States would be better off the fewer restrictions there were on international permit trading.

If no trading were allowed at all, costs would rise well above those in the worst case scenario for the protocol. On the other hand, if developing and newly developed nations accepted caps on emissions, essentially creating a global market for permits, costs could be reduced to half of what they would be under the best case scenario for the Kyoto Protocol.

The distributional impacts of restrictions on greenhouse emissions could be large. Such limits, if implemented through permits, would essentially transfer income from energy users to permit recipients. (If the permits are auctioned by the government and the revenues recycled as tax cuts or transfer payments, then the recipients are those people who receive the tax cuts or transfers.) To the extent that the users are the same as the recipients, there is no net redistribution. However, the amount at stake is potentially large: depending on the amount of permit trading allowed, the value of permits used in the United States would be between 0.9 percent and 2.0 percent of GDP in 2010.

In the interest of simplicity, the models, and thus the model synthesis, leave out certain aspects of the possible costs of emissions caps. For example, most models assume that energy usage will decline in the future by the same percentage amount for a given percentage increase in energy prices as it has in the past. However, opportunities to reduce energy usage today may be either more or less abundant than in the past. In addition, the models assume that emissions can be monitored and permits transacted at no cost, and that countries do not cheat. Also, the models do not estimate how much costs could be reduced by substituting new forest growth for the most costly reductions in emissions.

The estimates in this paper are based on projections of emissions and energy prices released by the U.S. Department of Energy’s Energy Information Administration (EIA) in 2000. In more recent projections, EIA has raised its forecasts of both energy prices in the United States and emissions in most signatories of the Kyoto Protocol. Those upward revisions would increase the adverse impact of the protocol on energy prices, GDP, and consumption, but also would increase the impact on emissions. However, the comparative impacts of restrictions on permit trading or of a global market for permits would be similar.

This paper looks only at the costs of emissions restrictions like those in the Kyoto Protocol and their effect on global emissions. A full evaluation of the treaty would also assess the science that underlies the claim that a significant risk of global warming exists, and the benefits of lower emissions. Such an assessment, however, is beyond the scope of this paper.