Policy options for reducing carbon emissions

February 13, 2008

CBO released a new report today on policy options for reducing carbon emissions.

Global climate change represents one of the nation's most serious long-term problems. Rising concentrations of CO2 and other greenhouse gases are gradually warming the Earths climate, and some risk exists that the buildup of those gases could trigger abrupt changes and extreme damage. Substantially reducing emissions of those gases, however, could impose significant costs on the U.S. and global economies.

Minimizing the costs involved in reducing emissions would require a reliance on incentive-based policies that provide flexibility about where and how such reductions will take place, rather than more restrictive command-and-control style policies (such as technology standards).

In this study, CBO examined a variety of incentive-based policies for reducing CO2 emissions, including a tax and a cap-and-trade system:

  • A tax would set an upper limit on the cost of emission reductionsfirms would undertake reductions that cost less than the taxbut would leave the amount of emissions uncertain.
  • An inflexible cap-and-trade program would set an upper limit on the amount of emissions but would leave the cost of reducing emissions uncertain.
  • A flexible cap-and-trade program would maintain the structure of a cap-and-trade program, but would include features designed to limit the cost of meeting the cap. Specifically, a cap-and-trade program could include one or more of the following:
    • A price ceiling (often referred to as a safety-valve) and/or a price floor;
    • Provisions that permit firms to bank unused allowances in one year for use in a future year and/or borrow future allowances for use in an earlier year;
    • Provisions to make the cap less stringent if the price of allowances rises beyond an agreed upon amount. A circuit breaker would directly modify the cap. Alternatively, the government could indirectly modify the cap by changing the terms under which firms could use borrowed allowances.

The study examines the relative efficiency and administrative issues surrounding these approaches. It should be noted that other criteria could be of interest to policymakers in determining how best to address concerns about climate change. For example, economic efficiency addresses how well policies might function to minimize the cost of reducing emissions over a period of several decades; however, policymakers may choose to place more emphasis on providing certainty about the amount of emissions at specific points in time. Similarly, policymakers may also wish to focus on how different policy designs affect different segments of society.

The study finds that:

  • A tax could achieve a long-term emission reduction target at a much smaller economic cost than an inflexible cap.
    • Provided that the tax was set equal to the expected benefit of reducing a ton of CO2, a tax could thus result in substantially greater net benefits (benefits minus costs) than a comparable cap-and-trade program.
    • The advantage of a tax stems from the long-term nature of climate change (which depends on the build-up of emissions over many decades, but is not sensitive to the amount of emissions in any given year) and the uncertain and variable nature of the cost of reducing emissions (which will vary from year to year based on the weather, conditions in energy markets, and the availability of new technologies).
    • An inflexible cap-and-trade program would provide more certainty about annual emissions than would a tax; however, that certainty would come at a cost: The cap would require too many reductions when the cost of achieving them was high and would mandate too few reductions when the cost was low.
  • Flexible cap-and-trade programs could achieve some, but not all, of the efficiency-improving/cost-minimizing advantages of a tax:
    • Out of the flexible cap designs that CBO considered, a cap-and-trade program that included both a safety valve and either a price floor or banking provisions could offer the greatest potential to minimize the cost of meeting a given long-term target.
    • Including a circuit breaker, or altering the extent to which firms could use borrowed allowances, could help prevent the price of allowances from going higher than policymakers wanted. Either approach, however, would be less direct, and less effective than including a safety valve.
  • Either a tax or a cap-and-trade program could be relatively easy to implement.
    • Some flexible design features, such as banking, borrowing or a safety valve, would be straightforward to implement.
    • In contrast, price volatility in the allowance market could make it difficult for the government to know when to implement a circuit breaker (or to change the terms associated with borrowing allowances).
  • Minimizing the cost of reaching a global emissions target would entail undertaking the lowest-cost emission reductions regardless of where in the world they were located.
    • If coordinated among emitting countries, a tax would help minimize the cost of achieving any given target.
    • Linking the cap-and-trade programs of various countries could help minimize global costs, but could create some significant concerns:
      • Countries would give up sovereignty over the price of allowances traded in their programs.
      • Poor monitoring or enforcement in any one country could undermine the integrity of the allowances traded throughout the whole system.
      • Flexible design features, such as a safety valve, banking, or borrowing, would become available to all regulated entities in the linked system.
    • Major emitting countries could help minimize global cost of reducing emissions by establishing national cap-and-trade programs that each included a safety valve set at roughly the same level.

The report was written by Terry Dinan, who joined CBO in 1989. She is a member of the Microeconomic Studies Division and serves as CBOs Senior Advisor for Climate Policy. She has written numerous CBO papers examining the effects of alternative policies for reducing carbon dioxide emissions as well as addressing other environmental issues, including CAFE standards, drinking water regulations, and the control of ground-level ozone. She has published in a variety of journals, including the Journal of Environmental Economics and Management, the National Tax Journal, the Journal of Urban Economics, the Journal of Regulatory Economics and the Natural Resources Journal. She served as an associate editor for the Journal of Environmental Economics and Management and was on the board of directors for the Association of Environmental and Resource Economists. She has a Ph.D. in economics from Iowa State University. Terry drives a Prius and rides her bike to work when her schedule permits.