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Costs, Benefits, and a Roadmap for Cap and Trade

Published: January 07, 2010
To read the article in Knowledge@W.P. Carey, click here.

Climate change -- and what to do about it -- took center stage recently at the United Nations climate change conference in Copenhagen.  The international agreement that came out of that meeting, the proposed federal Waxman-Markey cap-and-trade bill and the proposed regional Western Climate Initiative all make clear that there is momentum toward policies that would mitigate our impact on global climate change through limits on greenhouse gas (GHG) emissions.

But what will be the economic effect of those limits? What are the quantitative benefits of reducing GHG emissions? How much will it cost? And what's the best way to go about it? Policymakers and business leaders recently met to answer those questions at a forum co-sponsored by the Arizona Investment Council and Arizona Businesses Advancing Sustainability.

The cost of reducing GHG emissions

There is no question that reducing greenhouse gas emissions, by cap and trade or any other means, will cost. "As an economist, the idea that we will have to pay to reduce greenhouse gas emissions is a no-brainer," said Tim James, director of research and consulting at the L. William Seidman Research Institute at the W. P. Carey School of Business.

But, how much? And, what will we get in return? Those are questions that Jim Sims says are absolutely imperative for policymakers to answer. "Unless the public buys into the cost-benefit calculations, they will reject emissions-control regulations and the policymakers who champion them," said Sims, president and CEO of the Western Business Roundtable.

Achieving transparency about the costs and benefits of limiting GHG emissions is made difficult by the absolutely huge variation in estimates of the impact of emissions control. A study prepared for the Arizona Investment Council by the Seidman Institute aimed to find out -- for Arizona, at least -- where the truth lies. It analyzed the economic costs of the proposed Western Climate Initiative (WCI) -- a cap-and-trade program -- in Arizona.

A cap-and-trade program might work like this: A decision is made to cap GHG emissions at a certain level. Allowances are created to allow companies to emit certain amounts of greenhouse gases; without an allowance, a company cannot emit GHGs (the total quantity of allowances created equals the overall cap on emissions). Companies that emit less GHGs than their allowance can sell those allowances to other companies.

The costs of a cap-and-trade system come primarily from two sources: first, companies could have to purchase the allowances (though some proposals would give them away for free); second, because the overall level of emissions is limited, companies would have to develop ways to reduce their greenhouse gas emissions -- new technologies to capture emissions or new sources of energy that emit less.

The Seidman Institute study concluded that "the imposition of a GHG emission allowance trading program [i.e., 'cap and trade'] would have net negative impacts on the Arizona economy over the 2012-2020 study period."

The study compared where the state would be without cap and trade (the "baseline" case) to where the state would be with a cap-and-trade system as proposed by the WCI. The conclusion: "the state still grows over the 2012-2020 study period with a cap-and-trade program, but it grows less quickly than if there were no such program in place," James said.

In the best case scenario, the impact of cap and trade over the 2012-2020 period is slower growth amounting to $3.3 billion less in gross state product (GSP) and 17,000 fewer jobs. In the worst-case scenario slower state growth over the eight-year period would amount to $14.7 billion less in GSP and 124,000 fewer jobs than in the baseline (no cap and trade) case.

How much GHG limits actually cost will depend on the programs used to limit emissions. According to the study, the size of the impact is directly related to the price of the emissions allowance -- a $100 price is estimated to have approximately three times the effect of a $30 price. If allowances are given away the negative impacts shrink (but aren't eliminated, because companies still have to bear the cost of reducing their emissions). And the higher the percentage of cap-and-trade proceeds that are "recycled" back into the Arizona economy, the smaller the negative impacts.

Don Robinson, president and COO of Arizona Public Service Company, said that based on the cost assumptions in the Waxman-Markey bill, APS customers would see their electricity costs rise by 2 to 8 percent. Cap-and-trade legislation or no, the company plans to meet its customers' growing power needs (poised to rise 50 percent by 2025) without increasing its GHG emissions. It will do that by increasing its use of renewable energies and considering additional nuclear generation capacity. Yet developing those new sources of energy is not free, either. "However you look at it, we're in an increasing cost environment," Robinson said.

Quantifying benefits

Yet the fact that limiting greenhouse gas emissions will cost does not mean that it shouldn't be done. There are, after all, benefits to controlling the amount of GHG we emit into the atmosphere. "The cost of controlling greenhouse gas emissions is small compared to the benefits," said James. "We won't be quite as wealthy if we pay to reduce GHG emissions, but we will have a habitable planet."

According to the principles of economics, firms will carry out productive activities to the point where marginal benefit equals marginal cost. But firms' calculations of marginal cost don't take into account the wider costs imposed by the greenhouse gases emitted in the course of those productive activities. "Without programs like cap and trade, firms' decisions do not adequately account for the costs of the greenhouse gases they emit," James said.

Those there are the social costs of GHG emissions; they're not borne by the producer or the market alone, but by all of the world's inhabitants. According to the 2006 "Stern Review on the Economics of Climate Change," the social cost of climate change, which is caused in part by GHG emissions, is huge. "Hundreds of millions of people could suffer hunger, water shortages and coastal flooding as the world warms."

The principle behind a cap-and-trade system, then, is to monetize the social costs of GHG emissions and add those to firms' market costs. By raising the total cost of emitting GHGs, cap and trade would lead many companies to look for less-polluting modes of production, said James.

But where to set the price for emissions allowances depends on the monetary value of the benefits of limiting emissions -- the value of mitigating the negative environmental and health impacts associated with GHG emissions. That value is quantified using the social cost of carbon (SCC). If the social cost of emitting one additional ton of carbon dioxide includes hunger, water shortages, coastal flooding, and a rise in respiratory health problems like asthma, then the benefit of preventing that emission is avoiding those negative outcomes.

Actual estimates of the quantitative benefit of GHG emissions reductions vary widely, but a recent survey of 300 environmental economists found a median social cost of carbon of $50, with the mid-range of estimates from $20 to $100 a ton. In "Stern Review on the Economics of Climate Change," economist Lord Stern (who taught James at Warwick University) and his team estimated an SCC of $85, which the W. P. Carey School's James calls the "gold standard."

The benefit, then, of preventing the emission of one additional ton of carbon is probably somewhere between $20 and $100, with values more likely to be in the $50-85 range; that benefit figure accounts for the value of avoiding the negative environmental and health impacts of GHG emissions, said James.

But how does the quantitative cost/benefit calculation play out? The Congressional Budget Office estimated the cost of reducing GHG emissions under the Waxman-Markey bill to be $28 per ton (that accounts for the market cost -- the actual cost for companies to produce energy more cleanly). So the benefits of reducing greenhouse gas emissions are at least about equal to the associated costs and as much as three times greater.

The best way to control GHG emissions

If reducing greenhouse gas emissions is desirable -- if the benefits outweigh the costs -- what's the best way to go about it? Both the Waxman-Markey bill and the Western Climate Initiative would institute cap-and-trade regulatory systems, within which businesses and utilities would be permitted to emit limited (capped) amounts of greenhouse gases. Businesses and utilities that could run "cleaner" operations -- that is, emit less than the capped amounts -- could trade their excess emissions allowances to companies that run less clean operations.

The principle behind including "trade" provisions in the system (instead of simply capping emissions) is that it allows companies for which "cleaning up" is easier or less expensive to do it, while companies for which emitting less GHG is very difficult or expensive can simply buy others' allowances -- so in the end, GHG emissions reductions targets are met and costs of compliance are minimized.

That's how it worked in the early 1990s, when the Clean Air Act Amendments set a goal of reducing sulfur dioxide emissions by 10 million tons. The cap-and-trade system worked to reduce sulfur dioxide emissions because regulated companies had a real choice of spending money on the equipment necessary to reduce their emissions or purchasing emissions credits from less-polluting companies. "That economic choice is the oil that greases the cap-and-trade mechanism," said Sims, of the Western Business Roundtable.

Yet that economic choice may not exist for greenhouse gas emissions. According to APS' Robinson, "There is no commercially-viable technology to clean coal-powered plants to the proposed regulatory standards." That's a big deal in a state like Arizona, where about half of the electricity used is generated by coal-fired plants.

Some companies, like APS, have committed to less-polluting generation methods as they build additional capacity. Yet Sims still sees a place for coal-fired plants, if they're rehabbed to emit less. That, Sims said, will require not regulation but technology -- the development of commercially-viable technologies to economically reduce coal-generated GHG emissions.

Sims suggested an approach akin to America's push to put a man on the moon. "Focus on incentivizing technology -- creating incentives for success rather than punishments for failure," he said. He advocates "massive" tax incentives that "move emissions capture technology forward," aggressive loan guarantees, regulatory streamlining for the deployment of innovative technologies, guaranteed "first mover" credit in future regulatory frameworks, legal liability limits, IP protection, and leeway to build new traditional-technology baseload power plants to "keep the lights on" while innovative technologies are developed.

Yet the W. P. Carey School's James argued that a cap-and-trade system or tax on emissions would allow the market to work out the best way to generate energy more cleanly. "Rather than subsidizing the development of clean-coal technologies," he said, "the government should tax the most GHG-emitting means of power generation -- like coal -- and then let the market work out the most efficient way to produce energy while polluting less."

And, James said, we should look beyond the power-supply side for ways to reduce GHG emissions. "There are loads of ways to reduce the amount of power that needs to be generated. A relatively small investment of $1,000 in individual homes can yield a three- or four-fold savings in reduced energy usage almost overnight." Such home-level energy-saving investments include replacing older windows with new, more insulating ones and exchanging traditional light bulbs for less energy-intensive CFC bulbs.

Rules of the road

There is clearly momentum toward policies that will reduce greenhouse gas emissions. Yet agreeing on what those policies should look like -- and who should pay -- has proven difficult. Participants at the recent Arizona Investment Council conference agreed that the first step is to understand the costs and benefits of emissions-reduction policies; and then to find the best way to accomplish GHG-reduction goals while minimizing the costs and maximizing the benefits.

Bottom line:

•There is no question that reducing greenhouse gas emissions, by cap and trade or any other means, will cost.
•There are significant benefits to controlling the amount of greenhouse gases we emit into the atmosphere -- including avoiding the hunger, water shortages and coastal flooding that will take place as the world warms.
•The goal of a cap-and-trade system is to add the social costs of greenhouse gas (GHG) emissions (the negative environmental and health effects associated with global warming) onto the market costs so that companies will look for less-polluting ways to produce their products.
•The benefits of reducing greenhouse gas emissions are at least about equal to the associated costs and as much as three times greater.
•Some argue that government incentives for the development of commercially-viable "clean coal" technologies are the most efficient way to reduce GHG emissions. Others argue for regulation -- a tax on the dirtiest means of power generation -- to let companies work out for themselves the most efficient way to produce energy more cleanly.
•In addition to supply-side efforts to reduce the GHG emissions associated with production of power, demand-side efforts to reduce power consumption can be incredibly efficient. Individuals can make relatively inexpensive changes around the house to reduce the amount of energy they consume.