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Budgetary and Economic Effects of Climate Change Proposals

Proposals to limit emissions of greenhouse gases include imposing taxes on greenhouse gas emissions and selling rights to businesses to produce set amounts of those emissions. Such proposals aim to minimize the change in the climate and the negative consequences of such a change, but they also would impose economic costs, primarily by raising the cost of producing goods and services, and could have significant effects on the federal budget.

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  • Offsetting a Carbon Tax’s Costs on Low-Income Households: Working Paper 2012-16

    November 13, 2012
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Offsetting Costs of a Carbon Tax on Low-Income Households

presentation

November 16, 2012

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  • Offsetting Costs of a Carbon Tax on Low-Income Households

    November 16, 2012
  • The Estimated Costs to Households From the Cap-and-Trade Provisions of H.R. 2454

    June 19, 2009
  • The Supplemental Nutrition Assistance Program

    April 19, 2012
  • Options for Offsetting the Economic Impact on Low- and Moderate-Income Households of a Cap-and-Trade Program for Carbon Dioxide Emissions

    June 17, 2008
  • The Estimated Costs to Households From the Cap-and-Trade Provisions of H.R. 2454

    June 19, 2009
  • The Distributional Consequences of a Cap-and-Trade Program for CO2 Emissions

    March 12, 2009
  • The Distribution of Revenues from a Cap-and-Trade Program for CO2 Emissions

    May 07, 2009
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Offsetting a Carbon Tax’s Costs on Low-Income Households: Working Paper 2012-16

working paper

November 13, 2012

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Abstract

Terry Dinan

Imposing a tax on carbon dioxide emissions would reduce the damage from climate change but would also impose a larger burden, relative to income, on low-income households than on high-income households. This paper evaluates two broad groupings of options for reducing the regressive effects of a carbon tax; one group of options would affect large segments of the economy, for example by reducing payroll taxes, and the other group of options would be targeted at low-income households, for example by providing an additional payment to households currently receiving electronic transfer benefits. Each option is evaluated based on the percent of low-income households that it would affect, whether it would provide comparatively larger benefits for lower-income households, its administrative costs, and its implications for economic efficiency, specifically whether it would increase incentives to work and invest and whether it would preserve the incentives to reduce emissions that the carbon tax would create. The broad based options could potentially provide support for a relatively large share of low-income households, but some of those options would provide relatively small benefits to those households. Options specifically targeting low-income households could be most effective in reaching households that do not file income taxes or that do not have earnings. Three of the seven options considered would increase the incentive to work or invest and all but one of the options would preserve the incentive to reduce emissions of carbon dioxide.


Effects of Federal Tax Credits for the Purchase of Electric Vehicles

Sep 2012 - CBO’s report assesses how the credits affect the relative cost of owning an electric vehicle, and how cost-effectively the credits reduce gasoline consumption and greenhouse gas emissions.

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  • The Potential for Carbon Sequestration in the United States

    September 12, 2007
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Federal Efforts to Reduce the Cost of Capturing and Storing Carbon Dioxide

report

June 28, 2012

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CBO Publishes Report and Infographic on Energy Security in the United States

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May 9, 2012


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Energy Security in the United States - Infographic

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May 9, 2012

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  • Energy Security in the United States - Infographic

    May 09, 2012
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Energy Security in the United States

report

May 9, 2012

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Federal Financial Support for the Development and Production of Fuels and Energy Technologies

report

March 6, 2012

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Highlights

Federal Support for Developing and Producing Fuel and Energy Technologies Totaled $24 Billion in 2011

  • Tax preferences totaled $20.5 billion, or about 85 percent of the total.
  • Funding for the Department of Energy’s (DOE’s) spending programs totaled $3.5 billion, or about 15 percent of the total.

Tax Preferences Were Mostly for Renewable Energy and Energy Efficiency in 2011, but Many of Them Have Expired or Will Expire Soon

The budgetary costs of tax preferences aimed at encouraging energy efficiency and energy produced from renewable sources (such as wind and the sun) increased considerably in 2006, when several new preferences came into effect. Some of those preferences have expired or will expire soon.

  • Four major preferences, each costing at least $500 million, expired in 2011.
  • Those expiring preferences accounted for about 60 percent of the total cost of tax preferences in 2011.
  • Credits for energy from renewable sources available under another preference are scheduled to expire by the end of 2013.

Only four major energy tax preferences are permanent: three are for fossil fuels and one is for nuclear energy.

Tax Preferences Are Generally an Inefficient Way to Reduce Environmental Costs of Producing and Consuming Energy

  • They may reward businesses for investments and actions they intended to take anyway.
  • They target only specific technologies, which may not be the least expensive technology in many cases.
Energy-Related Tax Preferences, by Type of Fuel or Technology

DOE's Spending Supports Direct Investments and Subsidized Credit Programs

  • Over 50 percent of the $3.3 billion in 2012 funding for direct investments by DOE is for energy efficiency and renewable energy programs.
  • Between 2009 and 2012, DOE provided an estimated $4.0 billion in subsidies for about $25 billion in loans, primarily to producers of advanced vehicles, generators of solar power, and manufacturers of solar equipment.
  • Federal support for energy research and development has often yielded benefits greater than costs; however, DOE's spending on large demonstration projects has produced mixed results.
  • Despite some R&D successes, the use of technologies aimed at improving energy efficiency and producing energy from renewable sources has been limited in part because consumers and businesses do not have to pay for the environmental damage or other costs to the nation from the use of fossil fuels and those fuels retained their commercial advantage as their prices fell.


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Evaluating Limits on Participation and Transactions in Markets for Emissions Allowances

report

December 10, 2010

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Abstract

In response to concerns that the accumulation of greenhouse gases in the atmosphere could have serious and costly effects, the Congress has considered creating a nationwide cap-and-trade program that would limit emissions of those gases below the levels projected under current law and would allow trading of rights, or allowances, to produce those emissions. In creating markets for allowance trading, policymakers would face important questions about how best to ensure that any instability in those markets did not raise the cost of reducing emissions or spill over to the rest of the U.S. economy (as happened with instability in mortgage markets during the recent financial crisis). Some observers have proposed excluding certain participants or transactions from allowance markets. This study examines the likely impact of prohibiting allowance trading by entities not directly covered by a cap-and-trade program and of banning the use of allowance derivatives. The report also discusses some alternative restrictions on participation and transactions in allowance markets that could impose lower costs on covered entities while reducing the risk of instability in those markets and in the overall economy.


Highlights

Following the recent financial crisis, concerns about how financial markets function and what can destabilize them have increased. In a cap-and-trade program to reduce greenhouse gas emissions--such as the programs that have been considered by the Congress--a central feature would be the markets in which emissions allowances would be traded. Thus, issues of key interest to policymakers designing such a program include what kinds of participants and transactions would be permitted in allowance markets.

Under a cap-and-trade program, entities covered by the cap--which could include oil refiners, natural gas distributors, and large electricity generators that use fossil fuels--would be required to hold government-issued allowances that would give them the right to emit a specific amount of greenhouse gases into the atmosphere. Those covered entities would be free to buy and sell allowances, which would give rise to markets to facilitate that trading. Active allowance trading would reduce the total cost of meeting a cap on emissions by helping covered entities manage fluctuations in their need for allowances caused by changes in the production of emissions-intensive goods and services.

At the same time, observers worry that active allowance markets could foster complex or opaque transactions, price bubbles, market manipulation, or other instabilities that could raise the cost of reducing emissions and harm the broader economy. That potential has spurred proposals to prohibit or otherwise limit certain types of market participants or transactions under a cap-and-trade program. This analysis finds that less restrictive limits would generally have a greater chance of addressing observers' concerns, with fewer negative effects, than outright prohibitions would.

Concerns About Allowance Markets

Unless regulation prevented it, allowance markets would probably attract many of the same types of traders and transactions as existing markets for agricultural, energy, and financial products. Besides covered entities (and other entities that might receive allowances from the government), traders would include banks, investors, and other parties that would not be subject to a cap on emissions but would facilitate transactions by trading allowances with covered entities. The transactions of those various parties would probably include allowance derivatives--financial contracts that, for example, would guarantee the holder a price for a specific number of allowances at a specified future time. Such traders and transactions are common in existing allowance markets, including the ones created by current cap-and-trade programs for greenhouse gas emissions in the northeastern United States and the European Union.

Some observers, however, are concerned that transactions by traders who are not covered entities (sometimes called "speculators") and derivatives transactions can pose risks to the stability of allowance markets and reduce the cost-effectiveness of a cap-and-trade program. For example, concerns exist that speculative traders and complex or opaque financial transactions can make allowance markets less transparent, cause allowance prices to spike and perhaps differ (become "decoupled") from the cost of reducing emissions, or contribute to market manipulation. Moreover, instability in allowance markets might harm the broader economy. That concern is underscored by the recent collapse of the market for private mortgage-backed securities, which illustrated how disruptions in one market or sector of the economy can spill over into other markets--a phenomenon known as systemic risk.

Limiting Participants in Allowance Markets

To reduce worries about systemic risk, price decoupling, and manipulation, some observers have proposed limiting participation in allowance markets only to covered entities. Prohibiting other parties from trading in allowance markets, however, would most likely raise costs for covered entities by reducing market liquidity (the ease with which firms could buy or sell large quantities of allowances without affecting their current market price). In addition, a ban on certain participants would be difficult and costly to enforce.

Such a ban would also be unlikely to address concerns about allowance markets effectively. The reason is that the same financial incentives that would motivate noncovered entities to participate in the market--the ability to profit from absorbing the risk of price changes or the potential to realize gains from investing in allowances--would probably cause some covered entities to pursue those same opportunities. But to the extent that those covered entities were less effective at doing so than the excluded participants, the cost of complying with the program would be higher and market stability could decline.

Alternatively, participation limits that were less stringent and more targeted could address some of the concerns noted above at a lower cost. For example, many markets for agricultural, energy, and financial products have implemented "position limits," which restrict the number of contracts a participant can hold. Many of those markets also use "circuit breakers," which limit the total amount by which prices can rise or fall over a given period. Position limits would probably lessen the possibility of systemic risk and manipulation in allowance markets, and circuit breakers would reduce the likelihood that allowance prices would become decoupled from the cost of reducing emissions. Both types of regulations have the drawback of tending to make prices less informative, but they would impose lower costs on covered entities than a ban on certain participants would.

Limiting Derivatives Transactions in Allowance Markets

Participants in many markets for commodities or financial securities use derivatives extensively to reduce their exposure to changes in prices. However, certain types of derivatives played key roles in the recent financial crisis, and their potential complexity and opacity have prompted concerns that derivatives in allowance markets could also foster systemic risk and decrease transparency.

Some observers have responded to those concerns by proposing that a potential cap-and-trade program prohibit the trading of allowance derivatives. Not being able to use derivatives contracts, however, would increase covered entities' exposure to changing allowance prices, which would raise the costs of complying with the cap-and-trade program. Moreover, like banning certain market participants, prohibiting derivatives would probably not reduce the risk of disruptions in allowance markets--and might even increase that risk. In particular, the costs associated with absorbing price uncertainty could encourage firms to seek the benefits of derivatives from other financial transactions that would be harder to regulate or less transparent because they might, for example, occur in markets outside the United States. Consequently, enforcing a ban on derivatives would be difficult and expensive.

Other approaches could be more effective than a ban at addressing concerns about derivatives. For instance, increasing reliance on centralized clearing houses (institutions that facilitate the settlement of transactions between two parties) and on exchanges (organized markets, such as the Chicago Mercantile Exchange, where standardized financial transactions take place) would increase transparency and probably reduce systemic risk in allowance markets. In addition, raising transaction fees on trades that occurred "over the counter" rather than through a clearing house or exchange would create an incentive to move trading to those more transparent settings. And if set correctly, the fees would also cover the cost of the risks posed by transactions that were not suited to clearing houses or exchanges. Such changes would address concerns about systemic risk and lack of transparency while continuing to allow covered entities to use derivatives to reduce their costs of complying with a cap-and-trade program.

The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203) includes similar changes to existing financial markets. The law requires the federal agency that regulates derivatives transactions in commodity markets to set position limits for exchange-traded derivatives on all energy, metal, agricultural, and other physical commodities. It also expands the use of clearing houses and exchanges and increases regulation of over-the-counter derivatives. Although the regulations implementing the Dodd-Frank law are still being drafted, the law's provisions would probably apply to any allowance markets created as part of a nationwide cap-and-trade program for greenhouse gas emissions.



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Managing Allowance Prices in a Cap-and-Trade Program

report

November 5, 2010

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Highlights

The accumulation of greenhouse gases in the atmosphere--particularly carbon dioxide released as a result of deforestation and the use of fossil fuels--could create costly changes in regional climates throughout the world. Concern about the damage from such changes has led policymakers and analysts to consider policies designed to reduce emissions of those gases.

Many proposals have focused on cap-and-trade programs, which would limit the number of tons of greenhouse gases emitted into the atmosphere over several decades from certain sectors of the U.S. economy. Under such a program, lawmakers would set gradually tightening annual caps on greenhouse gas emissions that together would imply a cumulative limit over the duration of the policy. Rights to emit the gases, referred to as allowances, would then be distributed to businesses or other entities, such as state governments, in amounts that corresponded to those limits. (One allowance would permit one ton of emissions.) The government could distribute the allowances by either selling them, possibly in an auction, or giving them away. Once the allowances were distributed, they could be bought and sold in the secondary market for them that would develop.

Firms subject to the caps--for example, firms that emitted large quantities of greenhouse gases or that produced or imported fossil fuels that released emissions when burned--would be required to submit allowances to the agency charged with implementing the program. Under most proposed programs, firms could shift their use of allowances from one year to another by “banking” unused allowances for the future or, to a more limited degree, by “borrowing” allowances from future allocations. That trading and flexibility in timing would allow firms to undertake emissions reductions where, how, and to some extent when it was least costly for them to do so.

In choosing the level of the annual caps on emissions, policymakers would be making decisions complicated by uncertainty about the damage that might result from greenhouse gas emissions, and thus the benefits to be gained from reducing them, and about the costs of such reductions. Those costs would increase what firms spent in producing goods and services and would be borne by households in the form of higher prices. In establishing a program’s annual limits on emissions, policymakers ideally would have reliable information about the allowance prices that would be associated with the various caps they might consider. Those prices would reflect the cost of the most expensive reduction in emissions made to comply with the program at a given point in time. But projections of allowance prices are inherently uncertain. Once a cap-and-trade program was in place, actual prices would vary on the basis of current conditions, such as the weather and the economy, and firms’ expectations about factors affecting their compliance costs over the duration of the policy.

In fact, prices in the allowance market would be continually changing and could reach levels that were much higher or lower than policymakers had anticipated. Changes in prices that were caused by new information could help ensure that the caps on emissions were met at the least possible cost. Higher allowance prices, for example, would encourage firms to invest more in emissions-reducing equipment in the near term as a way to curtail their longer-term costs for meeting the caps. However, unexpectedly high (or low) allowance prices would make the cost of meeting the caps much higher (or lower) than policymakers had expected, which could alter the trade-off between costs and benefits that policymakers had anticipated when they selected the caps.

Concerns about unexpectedly high or low allowance prices have led to proposals to place upper or lower limits on those prices. The Congressional Budget Office (CBO) has examined the possible effects of several features that would change the number of allowances available to firms at various prices and in so doing help limit the range of allowance prices.

CBO’s Findings

CBO examined the effects on allowance prices and greenhouse gas emissions of three mechanisms that would help prevent allowance prices from reaching unexpected highs and lows: a price ceiling, which would be implemented by offering an unlimited number of allowances for sale at a given price, thereby placing an upper bound on allowance prices; an allowance reserve, in which a limited number of additional allowances would be offered to firms at or above a given price, thereby curtailing but not eliminating price increases beyond that level; and a price floor, which would be implemented by decreasing the number of allowances available at a given time to maintain a lower bound on prices.

An upper bound on allowance prices could prevent the policy’s costs to the economy from being unacceptably high, but it could also cause emissions to exceed the cumulative cap because the bound would be sustained by adding allowances to the program. The effects of a lower bound would depend on whether firms could bank allowances. If banking was not permitted, a lower bound could motivate firms to make additional cuts in emissions over the duration of the policy beyond those that would otherwise be required by the cap. If banking was permitted, firms would probably not make such additional cuts.

A Price Ceiling
Policymakers could set an upper limit, or ceiling, on allowance prices by allowing firms to buy an unlimited number of allowances, in addition to those created under the cap, at a specified “ceiling price.” Such a policy would have the following consequences:

  • It would provide an upper limit on allowance prices but not on emissions.
  • The higher the ceiling price was set above the projected path of allowance prices, the less likely it would be that firms would buy additional allowances and if they did buy them, the fewer they would buy. As a result, a higher ceiling would generally lead to fewer additional emissions than would arise under a lower ceiling.
  • Provided that firms were able to shift allowances from one year to another--that is, bank and borrow them--a ceiling could dampen the price of allowances, even when the market price was below the ceiling price. Such price dampening, which would be most likely when the market price of allowances was near the ceiling price, would occur because firms would attach a lower value to an allowance today to reflect the fact that its price in the future could not rise above the ceiling price.
  • If the ceiling lowered allowance prices, it would diminish firms’ incentives to invest in equipment that reduced emissions and in efforts to develop new lower-cost emissions-reducing technologies. That decrease in investment would lower firms’ spending for emissions reductions in the near term but could increase it in the future, when firms’ compliance costs rose.

An Allowance Reserve
Alternatively, policymakers could offer to sell firms a limited number of “reserve” allowances at or above a given price, referred to here as an “access price.” Such a reserve would have the following effects:

  • It would impose an upper limit on emissions--which might be different from the cap--but would not set an upper limit on the price of allowances.
  • The environmental and economic consequences of using the allowances in the reserve would depend on whether the reserve increased or decreased the number of allowances that would otherwise be permitted under the cap.

    • A reserve created by supplementing the number of allowances supplied under the cap would allow a limited loosening of the cap when costs were high. A supplemental-allowance reserve would tend to increase emissions and lower allowance prices relative to a policy with the same cap but no reserve. All else being equal, the larger the reserve and the lower the access price for releasing the allowances it contained, the more likely that the reserve would dampen allowance prices and allow emissions to exceed the cap.
    • A reserve created by withholding allowances that would otherwise be distributed under the cap could increase firms’ compliance costs but allow fewer emissions than those under a program with the same cap but no reserve. All else being equal, the larger the reserve and the higher the access price, the more likely that the reserve would increase prices and curb emissions to a greater extent than would a similar program without a reserve.
  • The effect of a reserve on emissions and allowance prices might be greater but would be less certain if regulators could restock the reserve by using offset credits, which reflect reductions in domestic or overseas emissions that would not otherwise be subject to the cap. Under such an approach, regulators would purchase the credits, then retire them and add a corresponding number of allowances to the reserve. Allowing regulators to restock the reserve in that way could lower firms’ costs for compliance because the number of reserve allowances would rise. However, that reliance might also prompt questions about the credibility of the cap: Regulators could find it challenging to verify that offset credits represented actual reductions relative to projected emissions in the absence of the cap-and-trade program.
  • If the federal government used auctions to sell the reserve allowances it created, it would capture their full value. Alternatively, if the reserve allowances were distributed by offering firms options to purchase them at a fixed price, the government and firms would share the allowances’ value.

A Price Floor
Another approach, a price floor, would set a lower limit on the price of all traded allowances. With a “hard” price floor, the simplest form of such an approach, the government would be required to purchase an unlimited number of allowances at a predetermined price. Broadly speaking, including a price floor in a cap-and-trade program would tend to boost allowance prices in the near term but would probably not result in fewer emissions over the duration of the policy if firms were permitted to bank allowances. CBO’s analysis also indicates the
following:

  • The further below the projected path of allowance prices that the floor price was set, the less likely it would be that the floor would become binding--that is, prevent any further decline in prices.
  • At the time that it was binding, a price floor would increase firms’ compliance costs, relative to a policy with the same cap and no price floor, because it would require firms to reduce emissions more than they otherwise would.
  • To the extent that a price floor increased the price of allowances, it would strengthen firms’ incentives to invest in emissions-reducing capital equipment and to develop new lower-cost technologies for reducing emissions. Those investments would boost firms’ spending in the near term but decrease their compliance costs (and lower allowance prices) in the future.
  • If firms could shift allowances from one period to another, a price floor would probably not result in cumulative emissions over the life of the policy (typically several decades) that were less than the amount permitted under the policy’s cap. Instead, a floor would shift reductions forward in time.
  • Policymakers could try to set a lower limit on the price of allowances by establishing a minimum bid price for the allowances sold in a government-run auction. But that bid price would establish a floor for prices in the secondary market only if the demand for allowances was great enough that firms would want to buy at least some of the allowances being auctioned.

Unintended Consequences of Managing Allowance Prices

Actual experience in managing allowance prices through the approaches that CBO examined is quite limited, which could make it harder to anticipate the effects of such features if they were included in a cap-and-trade program for greenhouse gas emissions. For example, a hard price floor might turn out to be very costly to implement. Also, some analysts are concerned that a price ceiling or an allowance reserve could result in allowances being added to the program under circumstances--including firms’ attempts to manipulate allowance prices through those features--that in the end might not be justified by actual compliance costs. A further consideration is that the mere presence of a price ceiling or a price floor might cause allowance prices to gravitate toward those levels. Moreover, allowing firms to buy an unlimited number of allowances at a ceiling price could complicate possible efforts to tighten the annual caps in the future: Firms could bank allowances during the time that the price ceiling was in effect and then use those allowances to exceed the tighter caps established for future periods.



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