Reducing Greenhouse Gas Emissions: Five Lessons of Economic Analysis

May 18, 2010

This afternoon I spoke at a Brookings conference on climate and energy policy. CBO has done a great deal of work in this area, applying the research done by outside experts as well as our own analysis and modeling to help the Congress understand the likely budgetary and economic effects of alternative policy approaches and specific legislative proposals being considered. In my comments today I focused on one particular issue—efforts to reduce emissions of greenhouse gases—and what CBO sees as the lessons of economic analysis for those efforts. (These slides capture the key points that I made today; all of CBO’s work on climate change is available here and relevant links are noted throughout this blog post.) CBO’s analysis focuses on how economic principles would apply to emission-reduction efforts, but following its standard practice, CBO does not make recommendations regarding specific policies. 

Lesson #1: To reduce greenhouse-gas emissions at the lowest social cost, the government should put a price on emissions.

Putting a price on emissions—for example, by taxing them or creating a cap-and-trade system—would create incentives for conservation, substitution in production, and technological innovation—the changes needed to reduce emissions. In addition, a price-based approach would allow firms and households to reduce emissions in the lowest-cost way. However, achieving cost-effective emission reductions would probably require other policies as well, because price signals do not always work effectively and because government has a key role to play in funding basic research and in other areas.

Lesson #2: To reduce greenhouse-gas emissions at the lowest social cost, the price should rise gradually over time and should avoid unnecessary volatility.

Gradual reductions in emissions are important because it takes time for research to be conducted and technology to be designed, tested, refined, and disseminated widely; time for patterns of production and consumption to change; and time for business and household capital to wear out and be replaced with different sorts of capital. Unnecessary volatility in the price of emissions would make a given amount of emissions reduction more costly, because it would force too many reductions when the cost of cutting emissions was relatively high and motivate too few when the cost was relatively low.

Lesson #3: To reduce greenhouse-gas emissions at the lowest social cost, the scope of emissions that are priced should be as broad as possible.

Market-based methods of reducing emissions would be most cost-effective if the largest number of producers and consumers are involved. That does not mean that everyone needs to be under exactly the same system or face exactly the same price: As long as the prices faced by different producers and consumers were similar, the outcome would be fairly efficient. This issue arises in several contexts in climate policy—in designing one system for the entire economy or different systems for different parts of the economy, in considering approaches for international coordination, and in addressing so-called “offsets” (reductions in emissions from activities not subject to limits).

Lesson #4: An efficient system for reducing greenhouse gas emissions would probably lower overall GDP, employment, and households’ purchasing power by a modest amount relative to what would occur otherwise (and leaving aside the economic effects of slowing climate change).

Although estimates are very uncertain, most experts project that the long-term loss in gross domestic product (GDP) from a policy like the American Clean Energy and Security Act of 2009 (ACESA) would be a few percent, which is roughly equal to normal growth in GDP over just a few years. Employment would probably also fall slightly as production shifted away from industries related to the production of carbon-based energy and energy-intensive goods and services, and toward the production of alternative and lower-emission energy sources, goods that use energy more efficiently, and non-energy-intensive goods and services; workers would follow those shifts in demand, but that would take time and entail costs. The reduction in households’ purchasing power would occur because resources would be devoted to achieving a goal not included in measured income. CBO estimated that the loss in purchasing power from the primary cap-and-trade program that would be established by ACESA would rise from about 0.1 percent of GDP in 2015 to about 0.8 percent of GDP in 2050.

Lesson #5: The details of policies to reduce greenhouse gas emissions would have significant effects on how workers in different industries and households at different income levels would be affected by those policies.

Policies can be designed to cushion the effects on certain industries. Of course, the protection of those firms and workers would have costs, because the resources that would be given away through those channels would not be available to be given to other people. A policy that reduced emissions would affect households at different income levels differently, depending crucially on how the revenues collected under the policy were returned to households. The amount of revenue involved could be large: CBO estimated that the value of allowances under ACESA would total nearly $900 billion during the next decade.