Energy & Entrepreneurs #32                                                                            

The Costs of Cap-and-Trade

by Raymond J. Keating

As politicians forge ahead with plans targeted at reducing carbon-dioxide emissions, one of the big debates seems to be over the mechanism for doing this: Should a carbon tax be imposed, or a cap-and-trade regulatory scheme?

Many elected officials like the cap-and-trade idea.  This choice has little to do with the efficacy of such a scheme.  To those looking to impose major costs on consumers and businesses, regulation usually is preferable to taxation. After all, taxes tend to be quite visible, and politicians get the blame when taxes take their bite out of the economy. But while the costs of regulation are just as real as taxes, regulation tends to be more hidden from the angry eyes and votes of consumers.  With regulation, politicians stand up and do something that might sound nice, while pushing the costs onto the backs of businesses. The hope is that consumers will get mad at those in the industry, while the politicians who imposed the regulations get re-elected.

As a result, we have the push for a cap-and-trade regulation system - that is even sometimes erroneously called a "market."

But in the end, there's no way getting around the significant costs of capping or reducing carbon-dioxide emissions.  Since the Kyoto Protocol was first under consideration in the 1990s, many economic studies have placed rather grim estimates on the costs of compliance.

A current leading congressional plan for a cap-and-trade system is the "America's Climate Security Act of 2007" (S.2191) co-sponsored by U.S. Senators Joseph Lieberman (I-CT) and John Warner (R-VA).  In November 8 testimony before the Senate's Committee on Environment and Public Works, Anne E. Smith, Ph.D., vice president at CRA International, presented the findings of a study done by CRA assessing the economic costs of S.2191. 

Key points made by Dr. Smith are well worth highlighting here:

• High Costs and Economic Pain: "[M]arginal costs of controls are projected to be in the range of $32 to $55 per short ton of CO2 by 2015.  Although our projections show prices rising to levels that are much higher after 2015, even the 2015 prices are ‘high' in an absolute sense. The 2015 projected price levels, if injected into the economy in a period of only a few years, would be disruptive to the economy, and cause a painful transition.  Our modeling effort considers only long-run equilibrium outcomes, and does not in any way capture short-term transitional costs, that can be much larger.  It is my assessment, looking at these initial prices levels, that the first few years of a cap such as prescribed in S.2191 would be a time of substantial market turmoil that is not reflected in any of the impact estimates that I report next."

• Lost Economic Welfare: "MRN-NEEM is a model that optimizes economic welfare.  Thus, the change in economic welfare that will result from a policy is its key output, and it is stated as a present value over the full time period analyzed, which is 2010-2050 in the current case.  Our scenarios imply that S.2191 would decrease US average economic welfare by 1.1% to 1.7%."

• Household Costs: "Our scenarios imply that real annual spending per household would be reduced by an average of $800 to $1300 in 2015.  If the percentage consumption impacts projected for each future year were to be stated in terms of current real spending power (we use 2010 spending as the proxy for ‘current' here), these spending impacts would increase to levels of $1500 to over $2500 by the end of our modeled time period, 2050."

• Lost GDP: "Another commonly used metric of economic impact is gross domestic product (GDP).  This declines as consumers demand fewer goods and services, and it also declines if US businesses close down due to competition from international suppliers.  Offsetting these declines are increases as new investments are made in advanced energy technologies.  Our scenarios find a net reduction in 2015 GDP of 1.0% to 1.6% relative to the GDP that would occur but for S.2191.  The impact rises to the range of 2% to 2.5% thereafter.  Figure 3 shows the associated dollar amount by which GDP would be reduced in each year, stated in real 2007 dollars.  (Inflation will make the dollar amounts larger over time.)  GDP would be lower in 2015 by about $160 billion to $250 billion.  Eventually, the annual loss in GDP would increase to the range of $800 billion to $1 trillion (stated in real, 2007 dollars).  (To provide some context, current annual outlays for Social Security are about $600 billion.)"

• Lost Jobs: "Naturally, with reductions in GDP come reductions in real wages and job losses.  We have estimated 1.2 million to 2.3 million net job losses by 2015 over our set of scenarios.  By 2020, our scenarios project between 1.5 million and 3.4 million net job losses.  There is a substantial implied increase in jobs associated with "green" businesses (e.g., to produce renewable generation technologies), but even accounting for these there is a projected net loss in jobs due to the generalized macroeconomic impacts of the Bill."

• Higher Natural Gas Prices: "Even with a long-run equilibrium view, we project gas price increases of 15% to 20% by 2015, and staying high through 2030.  As I mentioned earlier, however, sudden shifts in demand such as those projected by 2015 would cause significant market turmoil and much higher price spikes until a new long-run equilibrium of gas supply can be established."

• Higher Electricity Costs: Regarding "the range of projected wholesale electricity price increases on a US annual average basis after accounting for all of the combined effects in their most cost-effective combination" - "The increases are substantial, including a 36% to 65% increase in those prices by 2015 alone.  They continue to rise thereafter, reaching the range of an 80% to 125% increase by 2050.  This occurs despite extensive technological advancements and efficiency enhancements.  These estimates do not reflect any of the volatility in allowance or natural gas prices that can be expected, particularly in the initial years of the policy."

• Leakage Means Lost U.S. Business and Industries: "Emissions from any part of the globe have comparable impacts on climate risks, as they all first accumulate together in the global atmosphere to have their combined and joint effect on the global greenhouse effect.  On the one hand, this fact offers important flexibility to reduce emissions anywhere in the globe that has cost-effective opportunities to do so, and not to confine domestic efforts to actions within US borders.  On the other hand, it also means that any GHG cap we impose domestically, and its attending domestic reductions, may be undermined by offsetting emissions increases in nations that do not have comparable caps on their own economies.  Large sums of money could be spent with no actual global environmental benefit.  US economic output and jobs leak to other countries as well.  

         "Leakage has often been talked about in very general terms.  Estimates of leakage due to a US domestic policy are suggested in the range of about 10-15%, meaning that for every 10 tons that is reduced in the US, 1 ton is just emitted elsewhere in the world.  This may sound like a relatively small price to pay in order to get a net 9 tons of reduction from US action.  The difficulty with this view, however, is that leakage is not a phenomenon that applies to every ton of emissions reduction. 

         "Instead, there may be almost no leakage associated with controls on emissions that are not trade-exposed (e.g., personal and commercial transportation, electricity generation, and services), but nearly 100% leakage associated with controls on emissions in sectors that are trade-exposed (e.g., many of the energy-intensive manufacturing processes such as cement, iron and steel, chemicals, transportation equipment manufacturing, textiles, etc.)  Concentrated economic impacts on specific sectors that offer no benefit in terms of global emissions reduction make no sense as a matter of policy design.  

         "The potential severity of the impacts to trade-exposed industries appears not yet fully appreciated by policy analysts or policymakers.  Most of the attention on estimating climate policy impacts has been focused on transportation and electricity generation, which are among the least concerned with potential leakage.  The potential plight of the trade-exposed industries has been mostly thought to be something that could be dealt with through compensating allocations.  While that might solve the concerns of some of the shareholders of those businesses, policymakers should closely examine whether they are prepared to face the economic impacts of reduced exports, increased imports, and losses of domestic output of many important elements of the US manufacturing base."

Higher energy costs, households hit hard, lost GDP, lost jobs, lost businesses, lost industries - this is not a pretty picture.

But the economics cannot be denied.  When government intervenes in the economy in such a fundamental way, the corresponding costs will be massive.

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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.