The 111th Congress is taking up the issue of addressing the risks associated with climate change, a task that would entail the regulation of emissions of a variety of greenhouse gases from a variety of sources. The Environmental Protection Agency estimates that, in 2006, households and businesses in the United States emitted nearly 7.1 billion metric tons of carbon dioxide equivalent of greenhouse gases. Those emissions were partially offset by the net absorption of roughly 900 million metric tons of carbon dioxide by the nations forests and soils.
Several different approaches, or combinations of approaches, could be used to manage emissions, including direct regulations, cap-and-trade restrictions, and taxes that would directly raise the price of emitting gases. A program based on such approaches could be used to regulate any or all of those emissions.
CBO has previously produced several estimates of the budgetary impact of policies designed to mitigate emissions of greenhouse gases and will produce additional estimates during the current Congress. To do so, CBO undertakes a detailed analysis of the specific provisions of the legislation. In particular, it must estimate the marginal, or incremental, cost of reducing emissions of a number of different greenhouse gases at various levels of mitigation and at different points in the future.
On Friday, CBO released a paper describing the methodology that it uses to estimate the costs of mitigating emissions. In preparing its estimates, CBO uses projections of mitigation costs that, by construction, are in the middle of the range of estimates produced by current state-of-the-art energy-economy models. CBO can use its approach to calculate the amount of emissions generated at a given price or tax, or to determine the price or tax required to achieve a given emissions target.
The methodology involves several steps. CBO first projects a base case that serves as a marker against which to measure the effects of the proposed policies; that base case encompasses projections of future greenhouse-gas emissions and future prices of fossil fuels, electricity, and other products and services closely associated with such emissions---all assuming no new federal policies to control those emissions. For its base-case projections, CBO relies primarily on projections from the Energy Information Administration of the Department of Energy.
Then, CBO estimates how firms and households will respond to the proposed regulatory program. In the case of a cap-and-trade system, CBO determines how the proposals would affect the prices of emission allowances, and estimates how those allowance prices would filter through to prices of fuels and other emission-intensive products, affecting the aggregate demand for such goods and services.
CBO draws on a variety of sources to calculate how sensitive emissions are likely to be to changes in the allowance price. That sensitivity is, in effect, an elasticity of emissions with respect to the price. (An elasticity is a measure of the response of one variable to changes in another; for example, the elasticity of household demand for electricity measures how much an increase in the price of electricity would reduce households electricity consumption.) To develop its measures of price sensitivity, CBO applies six different models, available from government agencies, academic institutions, and other researchers, that represent the current state of the art.
CBOs estimate implicitly includes the sensitivity of end-use energy demand to changes in allowance prices as well as the amount of substitution that might occur among energy sources. For example, rising prices for fossil fuels would lead electric utilities to substitute some sources for others, by using more natural gas or wind and using less coal to generate electricity, but would also lead households and firms to consume less electricity. Both types of responses are implicitly built into CBOs estimates.