Budgetary effects of Lieberman-Warner climate bill

April 10, 2008

CBO has issued a cost estimate of S. 2191, the America's Climate Security Act of 2007, as ordered reported by the Senate Committee on Environment and Public Works in December 2007. We've also issued a cost estimate on a slightly amended version of the legislation that was transmitted to us on April 9, 2008.

The legislation would create a cap-and-trade system for carbon dioxide and other greenhouse gases. (Technically, there would be two separate cap-and-trade programsa bigger one covering most types of greenhouse gases and a smaller one covering hydrofluorocarbons.) Some of the permits would be auctioned -- through a new entity, the Climate Change Credit Corporation -- and the remaining permits would be distributed at no charge to states and other recipients. Over the 40 years that the proposed cap-and-trade programs would be in effect, the number of allowances and emissions of the relevant gases would be reduced each year.

CBO estimates that enacting S. 2191 as it was ordered reported would increase revenues by about $1.2 trillion over the 2009-2018 period. Over that period, we estimate that direct spending from distributing those proceeds would also total about $1.2 trillion, but more than the revenues. The net effect of the original legislation (as ordered reported) would be to increase deficits (excluding any effects on future discretionary spending) by an estimated $15 billion over the next 10 years; the amended version would instead reduce future deficits (again excluding any effects on future discretionary spending) by roughly $80 billion over the next ten years. In addition, assuming appropriation of the necessary amounts, CBO estimates that implementing S. 2191 would increase discretionary spending by about $4 billion under the original legislation and about $80 billion under the amended version over the 2009-2018 period.

The estimates for the two versions of the bill differ because the amendment would increase the portion of allowances that would be auctioned, deposit some of the auction proceeds into a Climate Change Deficit Reduction Fund, and make spending from that fund subject to appropriation.

This complex legislation posed several scoring questions and challenges:

  • The first involved how to treat the corporation it creates; the Climate Change Credit Corporation would be responsible for auctioning the allowances created by the federal government and for spending the resulting proceeds on various initiatives. How to treat the Corporation, though, seemed relatively straightforward: The Corporation would be part of the federal government, and the cash flows associated with auctioning the allowances and spending the proceeds should therefore be recorded in the federal budget.
  • A second scoring question involved the emissions allowances that are given away at no charge. In CBO's view, these should also be recorded in the budget as revenues and outlays. The government is essential to the existence of the allowances and is responsible for their readily realizable monetary value through its enforcement of the cap on emissions. The allowances would trade in a liquid secondary market since firms or households could buy and sell them, and thus they would be similar to cash. CBO estimates that the value of the market created by the major cap-and-trade program would be large, exceeding $100 billion in 2012. Therefore, CBO considers the distribution of such allowances at no charge to be functionally equivalent to distributing cash.

In our view, this scoring approach best illuminates the trade-offs between different policy choices. Distributing allowances at no charge to specific firms or individuals is, in effect, equivalent to collecting revenue from an auction of the allowances and then distributing the auction proceeds to those firms or individuals. In other words, the government could either raise $100 by selling allowances and then give that amount in cash to particular businesses and individuals, or it could simply give $100 worth of allowances to those businesses and individuals, who could immediately and easily transform the allowances into cash through the secondary market. Treating allowances that are issued at no charge as both a revenue and an outlay would mean that those two equivalent transactions were reflected in parallel ways in the scoring process.

In contrast, the proceeds associated with the allowances allocated for free to producers and importers under the smaller cap-and-trade program covering hydrofluorocarbons should not be recorded on the budget in CBOs view, primarily because we expect that the market created for such allowances would be relatively small and illiquid. Based on information from industry representatives, CBO estimates that fewer than 30 entities would be considered covered entities under this program. And given our estimate of the price for consumption allowances, CBO expects that the size and value of the overall market created by the cap-and-trade program for hydrofluorarbons would be smallless than $2 billion annually in most years. Therefore, unlike the allowances for the other greenhouse gases, these allowances would not be sufficiently cash-like to merit inclusion in the federal budget, in CBOs view.

  • A third scoring challenge involved the technical process of estimating the permit price for the main cap-and-trade program, which would cover carbon dioxide and other greenhouse gases. Based on an analysis of the results of several economic models, our estimates suggest that under the legislation, the auction price of emission allowances for these greenhouse gases would rise from about $23 per metric ton of carbon dioxide equivalent (mt CO2e) emissions in 2009 to about $44 per mt CO2e in 2018. (In 2006 dollars, the auction price per mt CO2e would rise from about $21 in 2009 to $35 in 2018.) Covered emissions of group I gases would decline by 7 percent in 2012 and by 17 percent in 2018 from base-case emissions (that is, those that would occur under current law); over the entire 2012-2050 period, they would decline by 42 percent from the base case.
  • A final issue involved the longstanding methodology in the federal budget process to assume that overall economic activity (GDP) is held constant. Under that assumption, higher amounts of indirect business charges reduce other income in the economy. (For example, if firms that must purchase allowances would be unable to pass those costs along, their profits would fall. More likely, some substantial portion would be passed along to others in the economy, such as consumers and employees, and other income would fall. Either way, the result would be lower taxable income in the economy, which would reduce federal revenues from income and payroll taxes.) The tradition is to assume that 25 percent of any change in indirect business charges is offset by changes in income and payroll taxes (25 percent is an approximate marginal tax rate). For this estimate, CBO did not apply the 25 percent reduction to all of the gross revenues, however, depending on how those revenues would be used:
    • To the extent that the revenues would be used in ways that would generate new taxable income, such uses would offset the loss of income and payroll taxes that would result from the initial purchase of allowances. Therefore, CBO did not apply the 25 percent reduction to any revenues that would be used to make transfer payments to taxable entities without any conditions placed on the recipient regarding the use of those payments. While such transfer payments do not directly affect GDP because they are not made in exchange for goods or services, they are typically taxable. Thus, providing transfers to taxable entities generates additional federal revenue that would essentially offset the 25 percent reduction in revenue collections. Most of the estimated revenues from allowances given away under S. 2191 would be used for such purposes.
    • CBO also did not apply the 25 percent reduction in revenues to any allowances that would be given away under the bill and would not be immediately taxable to the individuals or businesses that receive them, but would generate taxable income when they were used or sold to others. Such allowances include those given away to facilities that generate electric power from fossil fuels and to facilities that produce or import petroleum-based fuel.
    • In contrast, we applied the 25 percent reduction to any revenues that would be spent by the government on goods and services (for example, on research and development activities) because such government spending would substitute for other economic activity (under the assumption that GDP is unchanged by the bill). As a result, revenue used in this way would not generate any new taxable income. All of the proceeds from the auction of allowances would be used for those purposes.

The two cost estimates provide much more information about the legislation and its projected effects.

Analyzing a complicated piece of legislation like this requires resources from across the agency. CBO has formed a climate change team, and more information about CBO's activities on climate change can be found here. The cost estimates and the associated mandate statements were prepared by Mark Booth, Susanne S. Mehlman, Deborah Reis, Megan Carroll, Kathleen Gramp, Tyler Kruzich, Robert G. Shackleton Jr., Mark J. Lasky, Terry Dinan, Natalie Tawil, Neil Hood, and Amy Petz.