The Economic Effects of Legislation to Reduce Greenhouse-Gas Emissions

September 17, 2009

Today CBO released a report that summarizes its analyses of the economic effects of proposed policy changes aimed at reducing emissions of greenhouse gases.

Global climate change poses one of the nations most significant long-term policy challenges. A strong consensus has developed in the expert community that, if allowed to continue unabated, the accumulation of greenhouse gases in the atmosphere will have extensive, highly uncertain, but potentially serious and costly impacts on regional climates throughout the world. Moreover, the risk of abrupt and even catastrophic changes in climate cannot be ruled out.

Those expected and possible harms may motivate policy actions to reduce the extent of climate change. However, the cost of doing so could be significant because it would entail substantial reductions in U.S. emissions and in emissions from other countries over the coming decades. Achieving such reductions in this country would probably involve some combination of three broad changes:

Transforming the U.S. economy from one that runs on carbon-dioxide-emitting fossil fuels to one that increasingly relies on nuclear and renewable fuels;
Accomplishing substantial improvements in energy efficiency; and
Implementing the large-scale capture and storage of carbon dioxide emissions.

CBOs report makes several points regarding the economic implications of policies that might be chosen to address climate change:

The economic impact would depend importantly on the design of the policy. Decisions about whether to reduce greenhouse gases primarily through market-based systems (such as taxes or a cap-and-trade program) or primarily through traditional regulatory approaches that specify performance or technology standards would influence the total costs of reducing emissions and the distribution of those costs. The costs would also depend on the stringency of the policy; whether other countries imposed similar policies; the amount of flexibility about when, where, and how emissions would be reduced; and the allocation of allowances if a cap-and-trade system was used.

Reducing the risk of climate change would come at some cost to the economy. A cap-and-trade system, for example, would lead to higher prices for energy from fossil fuels and for energy-intensive goods, which would in turn provide incentives for households and businesses to use less carbon-based energy and to develop energy sources that emit smaller amounts of carbon dioxide. Changes in the relative prices for energy and energy-intensive goods would also shift income among households at different points in the income distribution and across industries and regions of the country. Policymakers could counteract some of those income losses and shifts by having the government sell emission allowances and use the revenues to compensate certain households or businesses, or by having the government give allowances away to some households or businesses. Even so, some income losses and shifts would occur.

For example, CBO concludes that the cap-and-trade provisions of H.R. 2454, the American Clean Energy and Security Act of 2009, would reduce GDP below what it would otherwise have beenby roughly to percent in 2020 and by between 1 and 3 percent in 2050. By way of comparison, CBO projects that real (that is, inflation-adjusted) GDP will be roughly two and a half times as large in 2050 as it is today, so those changes would be comparatively modest. In the models that CBO reviewed, the long-run cost to households would be smaller than the changes in GDP because consumption falls by less than GDP and because households benefit from more time spent in nonmarket activities. Moreover, these measures of potential costs do not include any benefits of averting climate change.

Climate legislation would cause permanent shifts in production and employment away from industries that produce carbon-based energy and energy-intensive goods and services and toward industries that produce alternative energy sources and less-energy-intensive goods and services. While those shifts were occurring, total employment would probably be reduced a little compared with what it would have been without such a policy, because labor markets would most likely not adjust as quickly as would the composition of demand for different outputs.

CBO has estimated the loss in purchasing power that would result from the primary cap-and-trade program in H.R. 2454. CBOs measure reflects the higher prices that households would face and the compensation they would receive, primarily through the allocation of allowances or the proceeds from their sale. However, the measure omits some channels of influence on households well-being that cannot be readily quantified. It appears that CBOs measure probably understates the true burden to a small degree. As estimated, the loss in purchasing power would be modest and would rise over time as the cap became more stringent, accounting for 0.2 percent of after-tax income in 2020 and 1.2 percent in 2050.

The distribution of the loss in purchasing power across households depends importantly on policymakers decisions about how to allocate the allowances. According to CBOs calculation, households in the lowest fifth of households when arrayed by income would see gains in purchasing power in both 2020 and 2050, because the compensation they would receive would exceed the costs they would bear. However, households in the middle fifth would see net losses in purchasing power amounting to 0.6 percent of after-tax income in 2020 and 1.1 percent in 2050.