Economic assessment of the U.S. Cap

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Economic assessment of the U.S. Cap Trade system

• Kate Kokosinski
• Christina Tsiarta
• ESM 286 2/29/08

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Background

• US cap trade (CT) scheme will have
  implications in both the short and long term wrt
• costs
• benefits (particularly challenging)
• distributional impacts
• These need to be evaluated empirically from an
  economic perspective
• Implications will inevitably affect the
  short-term cost effectiveness and long-term
  dynamic incentives for innovation the CT scheme
  offers

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Issue 1 Cost assessment of CT

• The CT scheme offers opportunities for cost
  savings through
• what, where and when flexibility
• what encourages emissions reductions through
  whatever measures are the least-costly
• where exploits variation in costs across
  households, firms, countries to encourage
  reductions where it is least-costly to do so
• when allows flexibility in timing of emissions
  reductions as emissions accumulate over long
  periods of time allows for banking and borrowing
  of allowances for future use facilitates
  implementation as allows firms time to adapt
• Incentives for long-term technological change
• In both technologies and how fossil fuels are
  used

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Issue 2 how to empirically evaluate costs of CT

• 2 empirical models
• National Energy Modeling System (NEMS) U.S.
  Department of Energy
• Emissions Prediction and Policy Analysis (EPPA)
  MITs Joint Program on the Science and Policy of
  Global Change
• Models differ in their structure, assumptions and
  hence results
• Factors found to have greatest effect on
  cost-estimates are
• Background emissions business-as-usual (BAU)
• Policy stringency and its trajectory
• Scope of policy coverage across economy
• Ability to switch fuels
• Energy efficiency improvements
• Availability of offsets
• Uses of revenue from auctioned allowances

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Issue 2 continued

• Assumptions, characteristics and limitations of
  EPPA model

Does not allow for biological C sequestration
Impacts overestimated as model analyzes GHGs not
just CO2
Assumes perfect, frictionless markets, with 0
transition costs and full employment of resources
Models emissions reductions, not policies
Assumes similar climate policies elsewhere in the
world effects on fuel prices etc.
Ignores other state and regional programs
Underestimates costs
Overestimates costs
Excludes uncertainty and risk, assuming perfect
information
Does not allow for nuclear power safety
Ignores costs of monitoring or transactions
Assumes no linkage and no international trading
in allowances
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Issue 2 continued
Most cost-effective solution Reduce CO2
emissions well below the cap in the early years,
and bank allowances to be used in the future

• Proposed by the National Commission on Energy
  Policy (2004, 2007b) - NEMS
• - Proposed by the U.S. Climate Action Partnership
  (2007) EPPA

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Issue 3 Impacts on Various Stakeholders

• Industry
• Price of fossil fuel
• Costs of using fossil fuel
• Electric Power Sector
• Electric power production
• Government
• Economy
• Aggregate costs to economy

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(1) Industry

• Allowance and fossil fuel prices
• As required emissions reductions increase over
  time, the market prices of the allowances will
  increase
• Cap-and-trade system will raise the price of
  fossil fuel
• Cost of using fossil fuels
• With higher prices, the cost of using fossil
  fuels will increase
• Depends on productgreatest impacts are on the
  users of coal (most carbon-intensive fuel)
• Petroleum sector less affected because demand for
  these products (gasoline) is price insensitive
• Effect on natural gas unclear - could potentially
  increase or decrease demand

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(2) Electric Power Sector

• Increases in cost depend on carbon intensity of
  sources of electricity and regional output
• Impact of costs depend on state regulationwho
  will bear the burden of costs?
• Less regional variation across restructured
  markets (cost internalized by generator) than
  across markets regulated by cost-of-service (cost
  passed onto consumer)
• Coal-fired generation price will increase. Some
  costs may be offset by increased electricity
  price, but profitability will still be reduced.

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(3) Government

• Federal and state governments will bear some cost
  of an emissions cap
• Increases price of providing government services
• Higher government spending on programs whose
  outlays are adjusted for inflation (social
  security)
• Government will receive more corporate tax
  revenue for firms that raise profits under
  cap-and-trade system

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(4) Economy

• GDP is slightly reduced under cap-and-trade
  systems compared to what would otherwise be
  expected (business as usual)
• Less aggressive trajectory 0.5 reduction in
  each year of program
• More aggressive trajectory up to 1 reduction
  in each year of program.
• Changes in labor income (job losses) and
  investment income
• Low-income vs. high income

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Issue 4 Auction vs. Free

• Potential revenue from allowance auctions
• Aggregate value of allowances would exceed total
  cost burden to economy use revenue for public
• Distributional impacts
• Free allocation increases firm profitability, but
  does not benefit consumers, suppliers, employees,
  etc.
• Amount of allowances distributed for free should
  decline over time
• Distribute to most cost burdened sectors first
• Gradual phasing in of policy allows firms time to
  adapt

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Lessons learned

• Hard to quantify and compare benefits with costs
  perhaps further work can focus more on
  empirically measuring benefits to be able to sell
  political feasibility of CT scheme
• To cost-effective reduce emissions, need to
  carefully plan when, where, what and how
• Impacts to several parties, not only industry
  (government, economy, etc.)
• Stresses importance of developing an appropriate
  policy
• Seems like this policy just makes everything more
  expensive (govt. services, energy, goods). Can
  this be made attractive to consumers, and does
  their opinion matter?

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Discussion questions

• Do you think that the benefits of the scheme are
  comparable to the costs, and if so, are they
  greater or less?
• Is the use of just 2 empirical models enough to
  base their economic analysis of the costs and
  benefits of the CT?
• Where will revenues from allowances be allocated?
  How do we know revenue is used for public good?
• Gradual phasing in of policy allows firms to
  adapt, but is this the point? Should we take the
  alternative approach of introducing a stringent
  cap all at once?