Witness Panel 1

• Dr. Anne Smith

  Read statement

  Witness Panel 1

  Dr. Anne Smith

  Prepared Statement of
  Anne E. Smith, Ph.D.
  before the
  Committee on Energy and Natural Resources
  United States Senate
  Washington, DC
  September 20, 2005
  Mr. Chairman and Members of the Committee:
  Thank you for your invitation to participate in today’s hearing. I am Anne Smith, and I am
  a Vice President of CRA International. Starting with my Ph.D. thesis in economics at
  Stanford University, I have spent the past twenty-five years assessing the most costeffective
  ways to design policies for managing environmental risks. For the past fifteen
  years I have focused my attention on the design of policies to address climate change risks,
  with a particular interest in the implications of different ways of implementing greenhouse
  (GHG) gas emissions trading programs. I thank you for the opportunity to share my
  findings and climate policy design insights with you. My written and oral testimony today
  is a statement of my own research and opinions, and does not represent a position of my
  company, CRA International.
  I would like to start by summarizing what I think are the most important and overarching
  considerations that should be accounted for in devising a sound and effective policy to
  mitigate risks of climate change. I will then provide a basis for these points, present more
  extensive detail on the trade-offs in policy design alternatives, and summarize results of
  analysis my colleagues and I have done of the comparative costs and effectiveness of
  proposals now before the Congress.
  The key points that I have to offer about designing an effective climate change policy are:
  • The linkage between near-term domestic GHG reductions and real reduction of
  climate change risk is, for all practical purposes, nonexistent. Near-term domestic
  controls cannot have any meaningful impact on global emission levels at any cost
  that is currently deemed realistic. Such policies also will not stimulate the kinds of
  technological progress necessary to enable meaningful emissions reductions later on
  (because one can expect that carbon prices will be driven to the lowest level
  necessary to incentivize adoption of important new technology – a level that is too
  low to provide innovators with a return of their one-time investment cost).
  • The current debate about how to impose ineffectual near-term controls is
  encouraging policy makers to neglect much more important, more urgently needed
  actions for reducing climate change risks. The top priority for climate change
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  policy should be a greatly expanded government-funded research and development
  (R&D) program, along with concerted efforts to reduce barriers to technology
  transfer to key developing countries. Neither of these will be easy to accomplish
  effectively, yet they are receiving minimal attention by policy makers.
  • Developing new technologies is crucial and it will require long-run, high-risk, highcost
  R&D to produce radically new GHG-free energy sources. Even with
  moderately expensive GHG limits, the private sector will under-invest in this kind
  of R&D, and only government can provide the needed R&D investment. The
  existing climate policy proposals, including the McCain/Lieberman (M/L) Bill and
  the NCEP or Bingaman proposals, focus on providing subsidies to existing
  technologies rather than R&D aimed at developing new technologies. New
  government efforts to pick winning technologies and subsidize their deployment
  would probably undermine the cost-effectiveness of any emissions control program,
  without producing the forward-looking R&D that we really need.
  • Although no near-term emissions control program will have much impact on
  solving the climate problem, a price on carbon in the near-term can be justified as a
  supplement to a meaningful R&D mission once that mission has clearly defined
  targets for success. The near-term control program’s role would be to stimulate
  emissions reductions that can be achieved now more cheaply than the present value
  of future control costs targeted by the R&D program; the maximum near-term
  carbon price could therefore be determined by discounting the R&D program’s
  defined targets for technology costs and dates of commercial availability.
  • The design of such a policy for near-term emissions control matters tremendously.
  CRA’s modeling work and the economics literature indicate the relative costeffectiveness
  of the various options for the climate change situation.
  a. Hard caps are the most costly and least desirable option.
  b. The safety valve approach and carbon taxes are alternatives to hard caps that
  are much less costly, and that are more consistent with the inherently
  subsidiary role of any near-term reductions program. (The contrast between
  a safety valve and hard cap approach is especially evident in my comparison
  below of results of CRA’s modeling of the McCain/Lieberman Bill and the
  cap program of the Bingaman Amendment.)
  c. One factor highlighted by CRA’s work but often slighted in other analyses
  is the possibility of using allowances to limit the costs of controls. Domestic
  GHG controls will cause small but not trivial losses of government revenue.
  Auctioning some of the allowances and using proceeds to offset other
  expected reductions in Federal revenue would noticeably reduce the
  program’s total cost to society.
  d. There are no simple analytical methods for determining allocations of
  allowances to individual companies or sectors to equitably mitigate the
  financial impacts of the policy.
  e. There is no allocation design that can make all affected parties better off
  under a cap-and-trade or other carbon pricing policy.
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  f. The inherent complexity of a safety valve approach does not appear to be
  justified compared to a simpler carbon tax. A carbon tax would provide
  identical emissions reduction incentives at identical costs to those of the
  safety valve proposal without the political, institutional, and analytical
  complications apparent in today’s safety valve proposals.
  To provide a foundation supporting the above statements, I will begin with a review of the
  basic elements of climate science and projections of future greenhouse gas emissions that
  are relevant to economic questions about the design of climate policies. In section 2, I will
  describe the range of potential policy designs, which include carbon-pricing schemes and
  technology strategies. Section 3 will focus on just the carbon-pricing approaches in more
  detail, and will include a comparative analysis that my colleagues and I have done of the
  costs and effectiveness of proposals now before the Congress. I will address costs and
  risks to the economy from different policy designs, the ability of economically feasible
  mandatory caps on emissions to accomplish long-term climate goals, the role of allocations
  in policy design, and alternatives to “mandatory limits on greenhouse gas emissions.” In
  Section 4, I will turn to technology strategies. I will explain the reasons for my conclusion
  that the most important first step for the Congress to take in developing a cost-effective US
  climate policy is to provide incentives for R&D into new energy technologies.
  In all of the following, I wish to be clear that I use the term R&D as a distinctly different
  concept from providing subsidies for the initial uptake of existing but yet-to-be deployed
  technologies. By R&D, I mean investment to create technologies that do not exist today,
  and which would require major new scientific breakthroughs before they could become an
  option that any private entity might consider proposing in a competition for actual
  implementation under a subsidy program. The R&D may entail basic science as well as
  work that is identifiably on an energy technology with low or zero carbon emissions.
  Subsidies are aimed at bringing technologies into the market, and by definition, such
  technologies must be already reasonably well developed, if not yet cost-effective to use
  under current prices without supporting funding. There may be a sometimes unclear line
  dividing the two, but it is clear that we do not yet have enough forms of energy
  technologies that could, as a group, provide a carbon-free energy economy at any
  reasonable cost. Creating that capability should be the mission of an R&D program.
  1. Key Points from Climate Science and Global Emissions Scenarios
  The key points from climate science and emissions scenarios that are critical to the
  economic analysis of policy options are:
  • Increases in global average temperatures are related to the concentration of
  greenhouse gases in the atmosphere. Once emitted, greenhouse gases remain in the
  atmosphere for many decades, so cumulative emissions over a long period of time
  determine changes in greenhouse gas concentrations. As a result, climate change
  risk is a function of cumulative greenhouse gas emissions, not emissions in any
  given year.
  4
  • Discussions of long-term objectives for climate policy usually focus on stabilizing
  greenhouse gas concentrations at some level, so as to limit temperature increases.
  The concentration of greenhouse gases in the atmosphere will continue to increase
  as long as there are net additions of greenhouse gases. To achieve stabilization of
  concentrations and temperature at any level will require that average economy-wide
  greenhouse gas emissions be reduced to nearly zero.
  • Given the scale of projected increases in global greenhouse gas emissions,
  achieving zero net carbon emissions by the middle of the next century will require
  producing at least as much energy as is now produced from all sources by means of
  processes that have near-zero net carbon emissions. It is not possible to accomplish
  this with current technologies at anything close to the current or projected cost of
  energy produced from oil, natural gas, and coal.
  • Within the next decade or two, developing countries will overtake the industrial
  world in total greenhouse gas emissions, so that by 2025 more than half of global
  annual emissions of greenhouse gases will be coming from developing countries.
  Thus no long-term objective of climate policy can be achieved without effective
  actions to reduce emissions from developing countries. Moreover, comparison of
  greenhouse gas intensity between developing and industrial countries suggests that
  there is a large potential for near-term emission reductions in developing countries
  at costs far lower than comparable emission reductions in the United States and
  other industrial countries.
  These features of the climate problem have some very strong implications for policy
  design. Since only cumulative emissions over long time periods matter for climate risk,
  mandatory caps that place specific limits on near-term emissions in each year create
  significant cost risks without accompanying benefits. Near-term limits on greenhouse gas
  emissions require the use of current technology for reducing greenhouse gas emissions, and
  as I will discuss in Section 4, they provide no credible incentive for research and
  development aimed at wholly new and more affordable technologies.
  Nearly-zero greenhouse gas emissions cannot be achieved with current technologies
  without massive disruption to standards of living. Once technologies are developed that
  can make massive emissions cuts affordable (even if still quite costly) then it will be
  possible to “make up for” reductions that we might not undertake today. Therefore the
  only reductions in emissions that make sense economically until zero-carbon energy
  becomes affordable as the mainstay of our energy system are those that are very cheap
  now.1
  These considerations suggest that the most important long-term feature of any policy
  initiative is the impact it will have on investment in R&D and the development of new
  technologies to provide essentially carbon-free energy at an affordable cost. For near-term
  emission reductions, the most cost-effective emission reductions available today are in
  1 Their cost should be less than the present value of the cost of “making up” for them when the zero-carbon
  economy becomes viable. For example, if nearly all GHG emissions could be eliminated or offset at
  $25/tonne CO2-equivalent starting in 2050 (i.e., $93/tonne carbon-equivalent), then the most that it makes
  economic sense to pay for emissions reductions in 2010 is about $3.60/tonne CO2-eq. (or $13/tonne carboneq.),
  using a 5% real discount rate.
  5
  developing countries, placing a high priority on near-term control policies to bring about
  changes in how energy is used in developing countries.
  2. Overview of Range of Available Policy Approaches
  Proposed approaches for climate change policies that involve a commitment by the
  government to bring about changes in future greenhouse gas emissions include:
  • Pure cap-and-trade
  • Cap-and-trade with a safety valve
  • Carbon tax
  • An R&D-focused “technology strategy”
  • Market transformation and technology transfer in developing countries
  These policy approaches form a continuum, all of which can be implemented in a marketbased
  manner. At one end of the scale are policy designs that impose specific, rigid limits
  on greenhouse gas emissions on specified dates. These are the pure cap-and-trade
  programs, which place a cap on emissions and allow trading of allowances between
  regulated parties to create an incentive for choice of the most cost-effective mitigation
  options. Much attention has been paid to these designs, which have been used successfully
  in other environmental areas such as the Acid Rain program (Title IV) of the Clean Air
  Act. The McCain/Lieberman amendment to the 2005 Senate Energy Bill (S.1151) falls in
  this category.
  The rigidity of emission limits is progressively loosened in proposals for combining capand-
  trade with a “safety valve” or for simply using a carbon tax to penalize the use of all
  fossil fuels in proportion to their carbon content. Both safety valve and carbon tax
  approaches avoid the imposition of a rigid cap, and instead rely on the economic incentive
  of putting a price on carbon emissions to achieve changes in emissions levels.
  An R&D-focused technology strategy would commit the Federal government to supporting
  the research to create new technologies whose adoption in the future will enable much
  larger and more cost-effective emission reductions than are possible today; this also can,
  and should be designed in a market-based manner.
  Thus, even now, the Congress is looking at a continuum of proposals, with the most rigid
  being the M/L Bill with its specific targets and timetables for near-term reductions, and the
  least rigid and potentially most cost-effective being a focus on devising and implementing a
  major and comprehensive R&D program to produce affordable, zero-emitting technology
  that will be possible to adopt on a massive scale, throughout our economy and that of the
  globe.
  The pure cap-and-trade approach places the highest priority on achieving fixed and
  predictable emission reductions, and accepts whatever the cost of achieving those emission
  reductions may be. The pure carbon tax limits the cost of achieving emission reductions to
  be no greater, per unit of carbon removed, than the tax. The emission reduction achievable
  6
  from a carbon tax is uncertain, because it depends on how much emission reduction is
  possible at a cost equal to or less than the tax. Thus the carbon tax places the highest
  priority on cost containment, while tolerating some uncertainty in the level of emission
  reductions to be achieved. The safety valve becomes indistinguishable from a carbon tax
  once the price limit on emission allowances is reached.
  Technology policy and policies toward developing countries address the two features of
  climate policy that are not addressed by mandatory limits on near-term emissions. These, I
  will suggest, offer far more potential for cost-effective emission reductions in the near and
  long term, and are appropriate places for Congress to consider immediate action.
  This Congress has considered proposals in four out of these five categories. The proposed
  McCain/Lieberman amendment to the Senate Energy Bill of 2005 fell in the first category,
  of mandatory caps. Proposals by the National Commission on Energy Policy (NCEP) and
  Senator Bingaman (S.A. 868) fall into the second, safety valve, category. An approach to
  reducing emissions from developing countries was passed into law as Title XVI of the
  Energy Policy Act of 2005, along with some of the elements of a technology strategy.
  Only carbon taxes per se are not talked about in Washington, but the choice between
  carbon caps and carbon taxes is a very important one in the literature on climate policy.
  I do not believe it is appropriate to narrow consideration at this time to only “mandatory”
  programs in the sense of binding caps on specific schedules, which if taken literally would
  include only the McCain/Lieberman proposal. Although used and justifiable in other
  environmental areas, this is not the most suitable policy design for climate change. Costs
  of large near-term reductions are high, mandatory caps create large risks and uncertainty
  about cost, and even mandatory caps cannot provide a credible incentive for R&D to
  develop needed technologies. Safety valve proposals, which become indistinguishable
  from carbon taxes once the safety valve becomes effective, offer additional flexibility and
  need not imply greater climate risks.
  Therefore, I would encourage you to include in your thinking about “mandatory” programs
  all policies that force households and businesses to take into account a cost of greenhouse
  gas emissions. This would recognize that carbon taxes, as well as the NCEP and Senator
  Bingaman’s approaches, are all “mandatory” approaches to emissions reductions.
  However, none of the mandatory programs aimed at putting limits on future carbon
  emissions will provide a credible incentive for R&D or actions by developing countries.
  Such mandatory programs are not the only actions that can be taken today. I have
  concluded that commitments to support technology development and bring about change in
  the rate of growth of emissions from developing countries are a more effective and
  appropriate focus for current action on climate policy. To my mind, it makes the most
  economic sense to start where resources committed to mitigation of climate change can
  achieve the greatest gains, considering both near-term and long-term outcomes as a whole.
  Therefore, we should start with a clearly articulated and carefully implemented R&D
  program for developing affordable zero-carbon emitting technologies. Neither the
  technologies nor the necessary R&D program to create them presently exists.
  7
  The first three approaches (pure cap-and-trade, cap-and-trade with a safety valve, and
  carbon taxes) all function by placing a direct price on GHG emissions. In the next section, I
  will discuss each of the individually, highlighting their respective strengths and
  weaknesses. I will then provide comparisons of the outcomes under a pure cap-and-trade
  proposal (i.e., the McCain/Lieberman proposal) to those of a proposal that directly limits
  costs rather than emissions (i.e., the GHG cap program of the Bingaman/NCEP proposal)
  to highlight how they tend to differ in their impacts. I complete the next section by
  addressing a number of issues related to allocation of allowances that I feel are greatly
  misunderstood, yet extremely important if a cap-and-trade approach is selected instead of a
  carbon tax approach for imposing a price on carbon emissions. The following, and last
  section, will then turn to an important limitation of all approaches that directly price
  emissions in the unique situation of climate change policy, and the reasons that an R&Dfocused
  technology strategy needs to be the first and foremost consideration in any policy
  to address climate change risks. It is my view that none of the proposed policies to date
  properly address this R&D need. In general, they have confused subsidies with the need
  for R&D on new technologies, and for the most part the subsidy programs that have been
  proposed are also unnecessary for motivating a least-cost response under a carbon-pricing
  program.
  3. Approaches that Place a Direct Price on Emissions
  A. Pure cap-and-trade with rigid emission limits
  Emission caps are enforced, under cap-and-trade proposals, by distributing a set of
  emission allowances, limited to the quantitative cap. These emission allowances can be
  traded, so that emission reductions will occur where they are most cost-effective given
  current technology. The cost of a cap-and-trade program depends on how tightly the caps
  are set initially and how they are tightened over time. How emission allowances are
  distributed also affects the overall economic impact of this policy approach.
  Near-term caps, such as those proposed by Senators McCain and Lieberman, can only be
  met through use of costly measures based on today’s technology. This raises their costs
  substantially compared to a policy sequence in which new and more affordable
  technologies are developed first, so that much larger emission reductions can be achieved
  at much lower cost.
  Emission caps, even if never tightened, will become more expensive over time, because
  energy needs are always growing as population increases and the economy expands.
  Holding greenhouse gas emissions constant in the face of ever-increasing energy demand
  requires going to ever more costly control options. The depth of the cuts required can be
  seen by comparing business-as-usual, or current-policy emissions to emissions under the
  cap. Based on the current EIA Annual Energy Outlook forecast for emissions under
  current policies, the limits proposed by Senators McCain and Lieberman would require
  total CO2 emissions from covered sectors to be reduced to 15% below current policy levels
  in 2010 and 26% below current policy levels in 2020. Continuing the McCain/Lieberman
  8
  cap to 2050 would require a reduction of emissions to 48% below current policy levels in
  that year. Tightening the cap to a level consistent with current proposals for programs that
  could stabilize greenhouse gas concentrations in the atmosphere would require emissions to
  be reduced to more than 80% below what CRA International projects for current policy
  emissions in 2050.
  The imposition of rigid limits creates unnecessary cost risks, even in the near-term, because
  rigid limits can become very expensive if economic growth exceeds expectations or if costs
  of measures required to reduce emissions turn out to be higher than assumed. Since
  climate risks are not affected by variations in emissions from one year to the next, but only
  by cumulative emissions over long time periods, these cost risks associated with rigid caps
  are completely unnecessary to achieving long-term climate goals.
  The perception that fixed caps create excessive cost risks is, I believe, widely shared. The
  McCain/Lieberman amendment would have created specific fixed and mandatory caps.
  Other policy approaches before Congress are based on a recognition that setting this kind
  of mandatory cap is not the only way to take effective action to address climate change.
  All the other approaches before the Congress involve market based incentives, but do not
  place a rigid cap on emissions. These approaches are more suitable to the nature of the
  climate problem.
  B. Cap-and-trade with a safety valve
  Combining cap-and-trade with a safety valve has the purpose of reducing the cost risk
  associated with the pure cap-and-trade approach. Senator Bingaman and NCEP’s
  proposals also reflect a concept called an “intensity-based” cap, but this only serves to
  reduce the expected costs of the policy. The real reason that these proposals have reduced
  risk of unexpectedly (and unacceptably) high costs lies wholly in the safety valve
  provision.
  The original concept of an “intensity-based” target is that caps would only be tightened in
  relation to economic activity levels. If economic activity is high, an intensity approach
  would allow a somewhat looser cap to accommodate the extra need for energy, rather than
  to choke it off by having a rigid cap no matter what the level of economic activity.
  However, as implemented in these two current proposals, the “intensity-based” cap would,
  in fact, still be an absolute cap, computed up to ten years in advance and rigid thereafter.
  Its primary novelty is that by computing a cap that is tied to economic growth rather than
  historical outcomes, it would more gradually phase in the cap’s apparent stringency. This
  certainly makes such a cap less costly than a tighter cap that prevents any further emissions
  growth at all. However, as long as the cap is binding at all (which is the intention), there is
  still uncertainty on how costly it will actually be to attain, especially given its rigidity over
  ten-year periods. (A cap that is truly flexible from year to year in response to economic
  activity outcomes might somewhat mitigate this cost uncertainty, but would require
  continual, year-to-year updating of allocations. This updating would probably be more
  detrimental than helpful in producing compliance planning certainty, while still not
  assuring that costs of control would remain below some planned level.)
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  Nevertheless, the Bingaman and NCEP proposals do have much less cost risk than previous
  cap-and-trade proposals, entirely due to the safety valve provision. The safety valve places
  a ceiling on the price of carbon allowances under the cap provision. This would be
  accomplished by allowing companies to achieve compliance by paying the safety valve
  price to the government in lieu of turning in actual allowances that have been issued.
  Alternatively, the government could issue more allowances at the safety valve price, which
  would then be turned in along with originally-issued allowances. Either way, the effect of
  the safety valve is to make the cap itself flexible rather than rigid. However, its flexibility
  is linked to the cost of control rather than to economic activity per se.
  In summary, the safety valve is a very important way of minimizing cost risk under a
  carbon emissions control policy, and it does so by converting the carbon cap into a carbon
  tax if the cost of control to meet the cap is higher than the pre-agreed safety valve price.
  By design (and also just like a tax), this can alter the amount of emission reduction that is
  achieved, thus making emissions reductions uncertain instead.
  C. Carbon taxes
  Once the safety valve becomes effective, the environmental outcomes and control costs
  under a program based on safety valves become indistinguishable from a carbon tax.
  However, a carbon tax policy would avoid creating the costs and bureaucracy associated
  with allocating allowances and administering an emission trading and enforcement system.
  All of these approaches – rigid caps, caps with safety valve, and carbon taxes – share a
  common feature of mandatory but market-based emission limitation. They require an
  emitter to pay for its legal emissions, either by purchasing an allowance, foregoing
  revenues from the sale of an allowance it was allocated, or paying a tax. Each creates
  revenues, and the choice must be made in designing the policy of who will collect these
  revenues and how they will be used. This is the choice between auction and allocation of
  allowances under a cap-and-trade system.
  The safety valve involves the sale of emission allowances for a fixed price. It is equivalent
  to charging a carbon tax on the use of fossil fuels, with the tax rate set for each fuel based
  on its carbon content. Use of a carbon tax would also leave control of how to use the
  revenues under the normal budget process. In contrast, revenues from auctioning
  allowances or from selling allowances under a safety valve can be placed outside the
  budget process, as they are in both the McCain-Lieberman and Bingaman proposals. Using
  a free allocation of carbon allowances to compensate some of those harmed by the
  imposition of limits on greenhouse gas emissions is also a use of potential revenues that
  could accrue to the government, and removes decisions about that use of revenues from the
  normal budget and authorization and appropriation process. This has a very important
  influence on overall economic costs.
  The proposed cap-and-trade and safety valve programs are likely to impose higher costs
  than a carbon tax. In part, this is true because they are likely to have greater administrative
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  costs than an explicit tax. But more importantly, by taking revenues outside the normal
  budget process, these policy designs eliminate the possibility of using some or all of the
  revenues to replace taxes that would otherwise have to be raised through other federal tax
  programs. As I discuss in subsection E below, not allowing revenues from allowance
  auctions to be used to offset impacts of emission limitations on total government revenues
  substantially increases the cost of the Bingaman and McCain/Lieberman approaches.
  Otherwise, the effects of cap-and-trade with a safety valve and a carbon tax are
  indistinguishable. Consumers of energy will experience increases in the cost of energy, in
  one case by the price that energy producers must pay for carbon allowances and the other
  by the carbon tax they must pay. The response of businesses and households to these
  altered prices will be identical. Differences will arise only from how potential revenues
  from the safety valve or carbon tax are utilized.
  D. Analysis of the costs of mandatory caps and safety valves
  In order to quantify the costs and emission impacts of the McCain/Lieberman and
  Bingaman amendments, my colleagues and I have used CRA’s Multi-Region National
  Model of the U.S. economy.2 This model has been used in a variety of studies over the past
  10 years, and was used by the National Commission on Energy Policy in its own analysis
  of the economic impacts of its proposals.
  We have analyzed a range of estimates for the impacts of the McCain/Lieberman proposal
  (M/L) and of the carbon cap program in the Bingaman Amendment (BA). For M/L our
  range was based on assumptions about the cost at which a carbon free “backstop”
  technology will become available and how that cost will drop over time; the availability
  and cost of “offsets” to CO2 emissions in covered sectors; and the choices that will be made
  about long-term emission limits after 2020. For the BA, at the low end of the range, we
  assume that regulated non-CO2 GHGs are able to be costlessly reduced up to the point
  where the marginal cost of reducing those other GHGs exceeds the safety valve price,
  based on marginal abatement cost curves prepared by MIT. At the high end of the range,
  we assume that non-CO2 GHGs are reduced costlessly only up to the point where they
  achieve their own share of the intensity targets. Our baseline or “current policy” emissions
  trajectory was based on the AEO 2005 reference case forecast of CO2 emissions, and was
  not varied, though this would be another source of cost uncertainty, especially for the M/L
  rigid caps.
  The form of Senator Bingaman’s carbon cap proposal that we analyzed sets a cap on
  greenhouse gas (GHG) emissions from 2010 onward. The cap is to be calculated in 2006
  so that it will cause greenhouse gas intensity (GHG emissions divided by GDP) to fall by
  2.4% per year from 2010 to 2020, and then to fall by 2.8% per year thereafter. The
  required improvements in GHG intensity are converted to fixed caps for the next decade by
  multiplying the required GHG intensity times the level of GDP in each year that is
  projected as of 2006.
  2 For documentation of the MRN model, see http://www.crai.com/pubs/pub_3694.pdf.
  11
  We applied a “safety valve” which allows regulated entities to purchase carbon allowances
  for a price of $7 per ton of CO2 in 2010, escalating at 5% per year (nominal). Both the
  safety valve escalation and the annual improvement in GHG intensity can be revised by
  joint resolution. The bill requires the President to report to Congress on what other
  countries are doing to reduce GHG emissions as a basis for recommending such revisions.
  The proposal includes some, but not all, emissions of non-CO2 GHGs in the calculation of
  GHG intensity and allows banking of allowances for use in future years.
  We assumed that under Senator Bingaman’s proposal a large fraction of carbon allowances
  will be “allocated” to businesses that face disproportionately large negative impacts, and
  that 5% in 2010, rising to 10% by 2020, of the allowances will be auctioned to provide
  funding for subsidies for the development and deployment of selected energy technologies.
  Sources of economic impacts. Economic impacts arise from four major sources. Direct
  costs of complying with emission limitations or of adjusting energy supply and use in
  response to a safety valve/carbon tax are incurred by energy producers and consumers.
  These costs arise from the necessity of diverting resources from other productive uses to
  reducing greenhouse gas emissions. The activities involved include substituting more
  costly but lower carbon forms of energy for fossil fuels, making investments and incurring
  higher costs to improve energy efficiency, and losing the benefits of foregone energy
  services.
  A second set of costs arises from an increased excess burden of existing taxes. Both the
  Bingaman and M/L proposals provide for allocations of allowances and specify how
  revenues from allowance auctions will be utilized. They do not allow proceeds to be used
  to reduce other taxes. It is widely accepted among economists who study the Federal tax
  system that the current set of income, payroll and corporate taxes impose a deadweight loss
  on the U.S. economy. It has been found in a number of studies that a system of emission
  limits or carbon taxes that raises energy costs effectively increases the burden of existing
  taxes on the economy.3 Using the revenues from sale of carbon allowances or from a
  carbon tax to substitute for revenues that would otherwise be raised through conventional
  taxes can reduce or eliminate this distortion. Allocating emission allowances at no cost
  removes that ability to reduce the distortions of the tax system and contributes to higher
  costs, as does reserving revenues for new spending programs that are created by the policy.
  CRA’s analyses have revealed a need for governments to use allowance auctions under a
  GHG cap to generate a certain amount of new government revenue to offset likely
  reductions in existing tax revenues due to a decline in economic activity from the cost of
  the policy. If such offsetting revenues are not tapped from the value of the allowances,
  then governments will either have to cut services or else raise existing tax rates. The latter
  action would actually exacerbate the costs of the policy, and thereby create an inefficiency
  due to tax distortions even while the carbon allowance market may function in a perfectly
  efficient manner in achieving cost-effective emissions reductions to meet the cap. Neither
  3 On the issue of how existing tax distortions are magnified by emission limits, see Larry Goulder, Ian Parry
  and Dallas Burtraw, “Revenue-Raising vs. Other Approaches to Environmental Protection: The Critical
  Significance of Pre-Existing Tax Distortions,” RAND Journal of Economics, Winter 1997; and Larry Goulder
  and Lans Bovenberg, “Optimal Environmental Taxation in the Presence of Other Taxes: General Equilibrium
  Analyses,” American Economic Review, September, 1996.
  12
  of the proposals analyzed provides for any revenues to be used to offset tax base erosion.4
  Although there are some revenues from auctions and safety valve sales, these revenue
  sources are earmarked for new spending programs rather than to supplement other, falling
  sources of government revenues.
  A third cost element arises from the transition costs of job search which are triggered by
  the changes in real wages and shift in industry structure causes by emission limits or safety
  valve/carbon tax policies. This cost element shows up directly in the results as an increase
  in transitional unemployment, and contributes to reduced GDP and to lower household
  consumption and welfare.
  Finally, since MRN is a fully dynamic computable general equilibrium model with
  forward-looking expectations, the prospect of rising carbon allowance prices and future
  economic impacts leads households to change their current saving and investment
  behavior. Households reduce their current consumption, in order to save and provide for
  higher future income to cover the increasing costs of tighter emission limits and rising
  safety valve/carbon taxes. This anticipatory behavior makes future costs show up in the
  present. The banking option included in both M/L and BA also encourages businesses to
  undertake emission reductions in early years in excess of those required by carbon limits, in
  order to avoid even higher future mitigation costs due to tightening emission limits or
  higher safety valve/carbon taxes. This also contributes to costs in early years.
  I provide details of our comparison of the impacts of M/L and BA in Exhibits 1 – 4 at the
  end of this testimony. Generally speaking, our results suggest that M/L impacts are about 3
  to 4 times larger than the impacts for the BA cap program. Key economic indicators all
  follow this pattern:
  • For 2010, the GDP loss under BA would be about $21 billion to $34 billion, or a
  0.1% to 0.2% reduction (compared to 0.3% to 1.0% for M/L). The GDP loss
  increases over time, both because the percent impact of BA increases with time, and
  because GDP increases with time.
  • GDP loss under BA in 2020 is $70 billion to $96 billion. (This compares to $214 to
  $517 billion for M/L) It reflects a 0.3% to 0.4% reduction in 2020 GDP (compared
  to 0.8% to 1.9% for M/L).
  • Per household consumption losses under BA are $135 to $147 in 2010 and $147 to
  $164 in 2020. (Comparable M/L losses are in the $450 to $800 range.)
  • Job losses under BA in 2020 are 281,000 to 326,000 (compared to 793,000 to
  1,306,000 under M/L).
  • Reduction in coal output in 2020 is 8% to 11% (compared to 23% to 42% for M/L).
  • Reduction in refined oil output in 2020 is 2% (compared to 6% - 13% for M/L).
  4 In very approximate-terms, the share of the allowances that the government would need to offset tax base
  erosion and thus avoid exacerbating policy costs appears to be between 30% and 60%. This is based on
  multiple scenarios analyzed by CRA International using its MRN model, and apparently has been
  corroborated by analyses by Prof. Goulder of Stanford University (personal communication).
  13
  • Carbon prices are $13 to 18/tonne C in 2010 and $21 to 29/tonne C in 2020. (M/L
  carbon prices are $47-$130 in 2010and $75-$209 in 2020.)
  • Under BA, carbon allowance prices hit the safety valve price in 2020 in the high
  case and 2035 in the low case.
  The greater cost certainty associated with the safety valve is apparent in the fact that our
  M/L cost ranges are much wider than those we estimated for the BA cap. However, the
  lower overall costs of the BA cap simply reflect the fact that it imposes a much less
  stringent demand for near-term emissions reductions. Over the period from 2020 to 2050
  BA provides emission reductions that total between one-third and two-fifths (32% to 40%)
  of those provided by M/L. Since the costs of BA range from 25% to 33% of M/L, the
  comparison also illustrates the law of diminishing returns, in that it costs proportionately
  more to achieve the larger emission reductions required by M/L.
  E. Issues in allocating allowances
  Allocations versus auctions. I understand the committee is very interested in the issue of
  allocation of allowances under Senator Bingaman’s proposal. This is a feature of policy
  design for which there are several alternatives. Senator Bingaman distinguishes between
  auction and allocation. Some allowances would be allocated to parties that suffer
  disproportionate harm from emission limits, and some would be auctioned and provide
  revenues.
  The first question that the Committee might want to consider is who should control the use
  of the revenues from any auctioned or safety valve allowances. If revenues are placed in
  the general fund, then Congress will retain the ability to make the decisions about how the
  revenues will be utilized. This will allow Congress to consider all societal needs together,
  and to balance competing needs as they evolve. To place the proceeds into a Trust Fund
  that earmarks them for spending only related to climate policy is tantamount to deciding
  now that climate-related spending needs to be separated from all other government
  spending decisions, and given a separate, more elevated priority than all other societal
  needs, including future needs that may not be anticipated at present. Public finance
  practitioners generally frown on the idea of earmarking funds from particular revenue
  sources to particular purposes, because the amount of money that will be collected from a
  particular source is only connected loosely, if at all, to the amount that it is wise to spend
  on even a related purpose. Thus earmarking is likely to produce either too much or too
  little funding, and it removes the decision about how much should be spent from the
  normal budget, authorization, and appropriation process.
  In this regard, I also note that free allocation of allowances is not the only way to provide
  for compensation of affected parties. Any compensation that can be achieved by a free
  allocation formula could, in principle, be replicated under a 100% auction – it would only
  require that the auction revenues be returned to companies by the same formula that would
  have been used for allocations. Funds could be appropriated to provide compensation for
  those disproportionately harmed, or specific tax credits could be enacted. Determining
  how to make this compensation using normal budget processes would be no harder than
  14
  determining how to allocate allowances under the procedures outlined in Senator
  Bingaman’s proposal.
  While general principles of public finance suggest that separation of revenues from such a
  policy into a Trust Fund is probably unwise, my personal research has found that such an
  approach also could exacerbate the total costs of any carbon-pricing policy, and thus would
  be inconsistent with principles of minimizing policy costs. Paradoxically, allocating all of
  the allowances at no cost to affected parties, and/or using all of the proceeds from sale of
  allowances to fund new spending programs, can lead to far larger costs to the economy
  than necessary. This policy cost inflation can be averted by using some allowance or
  carbon tax revenues to replace other taxes that would have to be raised to meet budget
  targets. By allowing carbon policy revenues to flow to the general fund, Congress retains
  its ability to determine how much of the proceeds from allowance sales or carbon taxes
  should be used for replacement of other tax revenues that can be expected to decline under
  the carbon policy.
  Free allocations cannot compensate all businesses and households. Impacts on households
  and industry are not determined by where regulations are put in place. An upstream system
  like that in Senator Bingaman’s proposal still imposes costs on households and industries.
  Not all the costs are borne by fuel suppliers, even if they are the point of regulation. All
  users of energy have higher production costs. Some will be able to pass some of these
  costs to their consumers, while others will have little ability to pass costs through, and the
  brunt of the financial impact will be borne by their shareholders. In the end, households
  cannot pass the costs on to anybody, and they ultimately bear the entire cost, as consumers
  of higher cost of goods and services, and as shareholders in companies that cannot pass the
  costs on.
  Conceptually, allocations could be used to help compensate the companies that bear an
  exceptional and unfair burden. We have, in other contexts, estimated the average loss in
  capital value to owners of assets in aggregated economic sectors such as the oil, gas, coal
  and electricity generation sectors. However, there is no simple formula to identify exactly
  which companies these are, or what amount of allocation would actually provide for an
  equitable burden sharing arrangement. Companies within the same economic sector may
  face diverse impacts, so that an estimate of the “average” loss of profitability for each
  sector may bear no correlation to the sum of losses across the negatively affected
  companies within each sector. Even if one could identify reasonable allocations to each
  sector of the economy, comparable allocations to each company within a sector would have
  little chance of equalizing burdens within the sector. Attempts to analytically identify
  company-specific burdens within a sector would be even more challenging than attempts to
  identify needs by sector, as the relevant data are not even publicly available. Thus, the
  idealized concept of mitigating the impact of the rule on individual companies cannot be
  estimated quantitatively at the level of detail needed to define company-level allocations,
  let alone be condensed to a relatively simple formula.
  It is also important to realize that the energy sectors (including non-regulated entities in the
  energy sectors) are not the only sectors that will bear losses of capital value as a result of a
  15
  carbon pricing policy. All sectors of the economy will be affected to some degree, as all
  are consumers of energy to varying degrees. As more and more of the needs to be
  compensated are recognized, the identification of a “fair” allocations rule will become
  exceedingly complex.
  More importantly, once it is recognized that needs for compensation include all individual
  energy consumers, and not just companies, policy makers will have to realize that it is not
  possible to offset losses for everyone through allocations of allowances. The total cost of a
  cap-and-trade system will always exceed the total value of the allowances in that system:
  • This is because companies must pay (1) to reduce emissions down to the level of
  the cap and also (2) for every ton of emissions that remains after meeting the cap.
  The value of the allowances equals only the second component of total costs. At
  most, the government can give that entire value back to the companies by free
  allocation of 100% of the allowances, but that leaves companies still incurring the
  first cost component, and without any way to compensate them for that cost – which
  is the real net cost to society.
  • It is true that companies may be able to pass some of these two cost components on
  to their customers, and so directly-regulated companies could be given more
  compensation than the cost that their shareholders bear if all of the allowances were
  allocated to them alone. However, this only means that a part of the net cost has
  been spread to other, non-regulated parties, including consumers. They, in turn,
  would require their share of the allowance allocation to be compensated for the part
  of the cost that was passed to them. There is not enough value in the allowances to
  cover all costs to regulated companies if they cannot pass those costs on, and
  neither can that value cover all the incurred costs after they are divided up and
  spread throughout the entire economy.
  Thus, a carbon pricing policy will always impose a real net cost on the economy that
  cannot be eliminated through any allocation formula that may be devised. All that an
  allocation scheme can do is alter the companies and individual consumers that end up
  bearing the burden of that cost.
  These challenges in identifying fair allocations are not a result of proposing an upstream
  point of compliance. They would be equally difficult under any downstream or hybrid
  form of implementation. They do, however, present more prominent issues when using a
  cap-and-trade approach than under a carbon tax, because the former system does require
  that a specific decision be made for how to distribute the allowances. (At the same time,
  needs for compensation and burden sharing would also exist under a carbon tax, and there
  would also be equivalent degrees of ability to achieve such compensation under a carbon
  tax.)
  Administrative costs and bureaucracy for small and distant emission reductions. I have
  estimated that under Senator Bingaman’s proposal, the price of carbon allowances would
  rise above the safety valve level between 2020 and 2035. EIA puts this somewhat earlier.
  16
  This effectively turns the Bingaman proposal into a carbon tax program, but with the much
  higher costs of an administrative apparatus for issuing, enforcing, and trading carbon
  allowances that doesn’t actually do anything other than impose a pre-determined price on
  carbon emissions.
  This leads to the question of whether it is desirable to create the bureaucracy and
  administrative burden of a comprehensive national emission trading program for the small
  reductions that are possible with a safety valve. The main differences between safety valve
  proposals and simply establishing a federal fuels tax based on carbon content are (1) that
  the safety valve has a greater administrative burden, and (2) the safety valve approach
  allows revenues that would otherwise go into the normal budget process to be handed out
  by an executive agency or quasi-government corporation.
  Thus the government cedes the ability to set overall social priorities for the use of the
  funds. Further, it sets the stage for automatically spending whatever is collected on
  climate-related technologies, without regard to the need for spending at such a level.
  Because it is not tied to an R&D program with clearly specified goals and a plan for
  meeting those goals, much of the spending is likely to result in subsidies on investments
  that would occur anyway (because they are cost-effective under the carbon price) or on
  investments that are not desirable (because they are only feasible at a cost that is higher
  than the safety valve price, which by definition reflects the maximum that is deemed
  reasonable to spend on near-term emissions reductions).5 The use of an outside entity does
  not solve the problem of creating a good R&D program; but it does mean that Congress
  loses the opportunity to make those R&D spending decisions directly and transparently.
  4. The Need for R&D Strategy to Be the Leading Edge of Climate Policy
  A. New technology is not encouraged by mandatory limits
  Although M/L has much more substantial (and uncertain) costs than the BA cap proposal,
  both proposals have substantial costs. But despite these costs to the economy, neither fixed
  caps nor safety valve/carbon tax policy designs can provide an adequate incentive for the
  critical piece of the solution – which is creation of radically new technologies. In my
  opinion, it would be better now to put resources into developing new technologies than in
  forcing the use of existing technology to achieve relatively small and costly emission
  reductions. Creating an effective R&D program will not be cheap, but it ultimately has to
  happen if climate risks are to be reduced. The difficult decisions are how much to spend
  now, and how to design programs to stimulate R&D that avoid mistakes of the past.
  5 Nuclear power presents a different situation. Although the technology is nearly zero-emitting (there are
  some emissions associated with its fuel cycle), available now, and cost-effective under even a modest carbon
  pricing scheme, its deployment is hampered by existing policy. Removal of institutional and political barriers
  to new nuclear generation might be the most important way of enabling existing nuclear generation
  technology to provide cost-effective emissions reductions within the next two decades.
  17
  The subsidies to current technology embodied in BA and M/L are not likely to bring about
  that change in the fundamental direction of R&D, because they are directed at the
  demonstration and use of current technology. These subsidies should be carefully
  distinguished from funding for R&D. Most subsidies would be unnecessary under a
  carbon-pricing program, as the market price of carbon due to the cap provides the
  appropriate financial incentives for the optimal use of the control methods that would then
  also benefit from the subsidies. A well-designed policy to address needs for R&D in
  entirely new technologies is needed, not subsidies to get existing technologies deployed in
  the market place. A very different commitment is needed to create programs that will
  change the direction of basic research toward creation of climate friendly, zero carbon
  technologies. Subsidies for demonstration and use of currently available technologies do
  not create incentives for creation of entirely new technologies.
  In BA, the carbon intensity basis for mandatory caps ensures that they rise gradually, so
  that there is little change in emissions for the next decade. The safety valve, by design,
  takes over from the mandatory cap when its costs begin to rise. By design, the safety valve
  will not stimulate the desired level of R&D. By attempting to limit cost to a level deemed
  tolerable, it eliminates adequate incentives for R&D on new technology.
  Nor will an adequate incentive be provided if the safety valve were eliminated, now or in
  the future. This would provide a trajectory of rising allowance prices and tightening limits.
  But those future policy results cannot be a credible incentive for current R&D, as I explain
  next.
  B. Carbon pricing programs cannot provide credible incentives for technology
  development
  Whether cap-and-trade or a carbon tax is the policy approach taken, these mandatory
  programs cannot achieve the most important need in a climate program, which is to
  stimulate development of the kinds of technologies that alone can make significant
  mitigation of climate risk possible in the long run.
  Emission caps are not only premature and risky for the economy. They are not capable of
  stimulating the kind of technology development that is an absolute necessity to achieve any
  of the objectives of climate policy. Putting a stop to the continued growth of greenhouse
  gas concentrations in the atmosphere requires meeting all of today’s energy needs in a way
  that produces zero net carbon emissions, and does so at acceptable cost. That is not
  possible with the set of technologies that exist today.
  Hoffert et al. argue that “the most effective way to reduce CO2 emissions with economic
  growth and equity is to develop revolutionary changes in the technology of energy
  production, distribution, storage and conversion.”6 They go on to identify an entire
  portfolio of technologies, suggesting that the solution will lie in achieving advances in
  more than one of the following categories of research:
  6M. I. Hoffert et al., “Advanced Technology Paths to Global Climate Stability: Energy for a Greenhouse
  Planet” Science, Vol. 298, Nov.1, 2002, p. 981.
  18
  • wind, solar and biomass
  • nuclear fission
  • nuclear fusion
  • hydrogen fuel cells
  • energy efficiency
  • carbon sequestration
  Currently available technologies cannot provide sufficient or low cost reductions to meet
  the GHG challenge. Developing that supply will require basic science and fundamental
  breakthroughs in a number of disciplines. The magnitude of possible reductions in the next
  decade or two achievable with today’s technology is dwarfed by the magnitude of
  reductions that successful innovation would supply through these routes.7
  Emission caps cannot provide adequate incentives. Even combined with an allowance
  trading system that puts a price on emissions, fixed caps cannot provide the incentives for
  the necessary technological change to occur. Thus, efforts to address climate change by
  imposing costly caps or taxes in the near-term will fail to provide long-term reductions.
  Additionally, if the R&D externality is being effectively addressed, implementation today
  of a cap or tax that will not become stringent until a later date will provide little or no
  further benefit in the form of an “announcement effect.” The only role for near-term GHG
  caps or taxes would be to achieve emissions reductions that are justifiable immediately
  because their cost per ton removed is less than the present value of the cost of avoided
  future emission reductions that would come from the future technologies, once they
  become available. Any other degree of stringency is unwarranted before R&D is
  successful, and unnecessary to supplement policies that will address the fundamental
  market failures associated with R&D.
  Announcements of high future carbon prices to stimulate R&D are not credible, because
  those carbon prices would not be necessary once technologies are developed.8 When new
  technology and new capacity investments are the issue, the only policy strategies that
  matter immediately are those that will increase incentives to invest in R&D, and direct the
  R&D toward technologies that will create a much larger supply of carbon-free energy
  alternatives at acceptable costs. Therefore, the only attribute of a cap-and-trade program
  that will matter will be the future course of the cap and its implications for future allowance
  prices.
  7 For example, if all of the existing US natural gas-fired combined cycle generating capacity were to suddenly
  be fully utilized, we estimate based on our models of the US power sector that current annual US CO2
  emissions would be reduced by about 80 MMTC – about a 4% reduction in total US GHG emissions – and it
  would come at a cost of about $80/tonne C, even if gas prices would not be inflated by the sudden surge in
  natural gas demand.
  8 These points are developed in a more rigorous fashion in W. D. Montgomery and Anne E. Smith “Price,
  Quantity and Technology Strategies for Climate Change Policy.” To appear in Human-Induced Climate
  Change: An Interdisciplinary Assessment, Cambridge University Press, forthcoming 2005.
  
  None of the “mandatory” programs under consideration could stimulate the kind of R&D in
  new energy technologies that is required. The “safety valve” in the NCEP program and
  Senator Bingaman’s amendment is designed to provide assurance that the price of emission
  allowances will not reach economically unsustainable levels. But that policy design causes
  the prices to be set at a level far too low to provide an adequate incentive for private
  investors to develop radically new technologies.
  To motivate the large R&D investments required, it would be necessary for governments to
  announce policies that will lead to high enough implicit taxes on carbon emissions to
  provide an adequate expected return on R&D investment. This tax will necessarily exceed
  the tax needed to induce adoption of the technology once it is developed. Once affordable
  technologies are produced, a relatively low carbon tax price will be enough to motivate
  companies to adopt the new technologies. That lower carbon price will not be enough to
  compensate the investors who paid for the R&D, but it will be enough to get it utilized.
  Even if laws passed today served to announce a future emissions tax high enough to create
  such an incentive, no future Congress or Administration would keep that commitment once
  the technology was developed. As in the case of patents, there is a tradeoff between
  efficiency in resource allocation and providing an incentive for R&D. A carbon price
  above the level necessary to induce adoption of the new technology will cause avoidable
  deadweight losses as all energy supply and use decisions are distorted. Reducing implicit
  carbon taxes to the lowest possible level to get the new technology deployed will always be
  beneficial to the economy. Therefore, future governments will face irresistible pressure to
  let the implicit tax on carbon emissions fall back to a level just sufficient to get the R&D
  utilized, taking away all the rewards to innovation.
  This leads to a fundamental dynamic inconsistency that makes any effort to set emission
  caps or announce future carbon prices sufficient to stimulate R&D not credible. Since
  private investors can understand this is the optimal strategy for government – and indeed
  would likely be skeptical of the political ability of any government to proceed with what
  will look like “corporate welfare” – they will not be motivated to invest in R&D by any
  announcement of future climate policy.

  
  C. Design of technology policy

  
  What this argument demonstrates is that it is not possible to rely on caps on future
  emissions, or on announcements of a safety valve or carbon tax, to motivate R&D to
  develop the new technologies needed for long-term reduction of climate risk. This means
  that there is an extraordinarily high priority to designing effective programs to stimulate
  that R&D through incentives provided today. I would urge Congress to turn its interest in
  climate policy toward a subject it knows well – how to craft a program that will lead to
  effective use of private and government funds to carry out the R&D needed to provide the
  radically new technologies required to stabilize concentrations of greenhouse gases and
  ultimately, global climate.

  D. Large opportunities for near-term emission reductions exist in developing
  countries

  
  For near-term emission reductions, developing countries offer far larger and more costeffective
  opportunity for emission reduction that mandatory emission limits on U.S.
  businesses and consumers. There are a number of ways in which the U.S. Congress could
  act to increase technology transfer and encourage foreign investment in developing
  countries, and these actions could lead to near-term reductions in emission larger than any
  of the mandatory limits on U.S. emissions under considerations.
  The provisions of the McCain/Lieberman and Bingaman Amendment proposals dealing
  with developing countries create no mechanism for bringing about changes in those
  countries. A great deal of the difference in greenhouse gas intensity between developing
  countries and industrial countries can be explained by fundamental failures of markets and
  institutions in developing countries. Much more cost-effective emission reductions are
  possible in the near-term through programs directed at developing countries by focusing on
  fundamental institutional and market reforms to create the property rights and investment
  climate required for private foreign direct investment and technology transfer.9 These
  needs are already a focus of the Climate Change Title (Title XVI) of the Energy Policy Act
  of 2005, which passed into law after the Bingaman Amendment was released. I believe
  that approach of Title XVI should be followed, and further enhanced if necessary. The
  more general and less focused provisions expressed in the Bingaman Amendment proposal
  are unnecessary additions, and could distract from implementing the more focused
  provisions that already exist as law.

• Dr. Richard Morgenstern

  Read statement

  Witness Panel 1

  Dr. Richard Morgenstern

  Prepared Statement of
  Richard D. Morgenstern, Ph.D.
  Before
  Senate Committee on Energy and Natural Resources
  On
  Sense of the Senate Climate Resolution
  September 20, 2005

  Mr. Chairman:  I am pleased to appear before this committee to comment on the recently adopted Senate resolution calling for a “…national program of mandatory market-based limits and incentives on greenhouse gases that (1) will not significantly harm the United States economy; and (2) will encourage comparable action by other nations that are major trading partners and key contributors to global emissions.” 

  To set the context, I will briefly discuss a number of policy developments since the late 1990s when the Kyoto Protocol was being negotiated.  Then, I will turn to some design issues relevant to the implementation of the new Senate Resolution, including the mechanisms that will encourage the development and adoption of new technologies, and the use of a safety valve or price cap as an integral part of a cap-and-trade system.  Finally, I will comment on possible means of encouraging comparable mitigation actions by other large emitters.

  I speak as an economist who has been involved with the issue of climate change for almost two decades.  Previously a tenured college professor, I have also had the privilege of serving in senior policy positions under prior Republican and Democratic administrations.  Currently, I am a senior fellow at Resources for the Future (RFF), a 53-year-old research institution, headquartered here in Washington, D.C., that specializes in energy, environmental, and natural resource issues.  RFF is both independent and nonpartisan, and shares the results of its economic and policy analyses with members of both parties, as well as with environmental and business advocates, academics, members of the press, and interested citizens.  RFF encourages scholars to express their individual opinions, which may differ from those of other RFF scholars, officers, and directors.  I emphasize that the views I present today are mine alone. 

  Let me begin by observing what many recent press reports have failed to note: recent policy proposals, such as those advanced by the National Commission on Energy Policy (NCEP), differ dramatically from the Kyoto Protocol.  While the details of Kyoto are well known to members of this committee, the NCEP proposal is novel in a number of respects, as it combines federal support for innovative technologies with a program to reduce greenhouse gas emissions that involves a cap on costs.   Overall, the NCEP program would have a truly minimal impact on the U.S. economy and is revenue neutral with respect to the federal budget.  Whereas the Kyoto Protocol involves fairly steep short-term reductions and, correspondingly, potentially high costs, the NCEP proposal calls for relatively modest initial emissions reductions which are, in fact, quite similar to the voluntary intensity reductions proposed by the Bush administration.  Because of the more modest start, combined with the safety valve, the costs of the NCEP proposal are much lower. 

  To see this point more clearly, consider the results of three separate analyses by the independent Energy Information Administration (EIA) of the costs of alternative climate proposals conducted over the past several years.  Relying on its standard National Energy Modeling System, EIA compared the effects of implementing the Kyoto Protocol, The Climate Stewardship Act introduced by Senators McCain and Lieberman (S. 139), and the NCEP proposal.  Although the EIA studies were conducted in different years, and involve slightly different baselines, the results are quite illuminating (see the accompanying table).
   

  EIA’s Analysis of the Kyoto Protocol, S. 139, and Energy Commission Proposals: 2020
   NCEP S. 139 Kyoto (+9%)
  GHG emissions (% domestic reduction) 4.5 17.8 23.9
  GHG emissions (tons CO2 reduced) 404 1346 1690
  Allowance price ($2003 per ton CO2) 8 35 43
  Coal use (% change from forecast) -5.7 -37.4 -72.1
  Coal use (% change from 2003) 14.5 -23.2 -68.9
  Natural gas use (% change from forecast) 0.6 4.6 10.3
  Electricity price (% change from forecast) 3.4 19.4 44.6
  Potential GDP (% loss) 0.02 0.13 0.36
  Real GDP (% loss) 0.09 0.22 0.64
  ______________________
  SOURCES.  NCEP:  GHG emissions and allowance price is from EIA analysis, Table 118 (May 2005).  All other data is from Table 1, “AEO 2005 Reference Case” and “Greenhouse Gas Policy.”  (EIA, April 2005).  This is available at www.eia.doe.gov/oiaf/servicerpt/bingaman/index.html
  McCain Lieberman (S139):  From Analysis of Senate Amendment 2028, the Climate Stewardship Act of 2003. Emissions data and allowance price is from Table B20. GDP is from Table B21.  All other data is from Table B1. (EIA, May 2004). This is available at www.eia.doe.gov/oiaf/servicerpt/ml/pdf/sroiaf (2003)02.pdf
  Kyoto Protocol:  Impacts of the Kyoto Protocol on U.S. Energy Markets and Economic Activity.  Emissions data is from Table B19.  Allowance price and GDP is from Table ES-2.  All other data is from Table B1.  (EIA, October 1998). This is available at www.eia.doe.gov/oiaf/kyoto/pdf/sroiaf9803.pdf
  _____________________

  
  For the Kyoto Protocol, EIA forecast greenhouse gas reductions of 23.9 percent in 2020.  Under Kyoto, allowance prices were predicted to reach $43 per ton of carbon dioxide, while coal use was expected to decline by 68.9 percent below 2003 levels.  Real GDP was forecasted to decline by 0.36 percent.  In analyzing the NCEP proposal, EIA foresaw smaller emissions reductions and, most importantly, quite different economic impacts.  Allowance prices were effectively capped at $8 per ton of carbon dioxide; coal use was forecasted to increase by 14.5 percent above 2003 levels by 2020, and real GDP losses were considerably smaller (0.09 percent).  EIA noted that this policy would not “materially” affect average economic growth rates for the 2003 to 2025 period (p. xi).  For McCain Lieberman, EIA forecast impacts that would fall between Kyoto and NCEP, although they were considerably closer to Kyoto in terms of both emissions reductions and costs.

  The principal reason that NCEP’s approach is so much less costly than Kyoto or S. 139 is that it is based on a strategy for mitigating climate change that is not designed to avert climate change over the next 20 years.   Rather, the focus is on developing and deploying technologies needed to address the problem in the decades beyond.   NCEP does this primarily in two ways: 1) by directly subsidizing a wide range of new technologies including coal, nuclear, fuel-efficient vehicles, biofuels and others; and 2) by encouraging private-sector research and development through incentives for the deployment of cost-effective carbon saving technologies of all types.  NCEP’s cap-and-trade system has the added benefit of generating a revenue stream to fund the technology subsidies.

  Major progress on climate change will not be possible without new technologies.  It is also widely recognized that government has an important role to play in spurring the development and diffusion of these technologies.  Without some kind of additional incentives, the private sector typically will under-invest in research, development, and demonstration because innovators cannot reap the full benefits to society of their advances.  The existence of these “spillovers” reduces private incentive to pursue innovation, as others will mimic the innovation without compensating the inventors.   While patents and similar means are used to protect investments in innovation, that protection is limited.   A successful innovator typically captures substantial rewards, but those gains are sometimes only a fraction of the total benefits to society arising from the innovation.   This rationale underlies government support of research, development, and demonstration programs, including the National Science Foundation, public universities, and others. 

  Environmental and knowledge externalities have long been at the center of debates about technology policy.  More recently, we have come to understand some additional market failures that may operate in the adoption and diffusion of new technologies.  For a variety of reasons, the cost or value of a new technology to one user may depend on how many other users have adopted the technology.  Generally speaking, users will be better off the more others use that same technology, as this increases what is known as “learning by doing” and “network” externalities.  Typically, it takes time for potential users to learn of a new technology, try it, adapt it to their particular circumstances, and become convinced of its superiority.  Consequently, the early adopter of a new technology creates a positive benefit for others by generating information about the existence, characteristics, and likely success of the new technology.

  The argument for public support is even stronger in the case of climate change technologies, where not only do inventors fail to capture all the gains from their investments but the gains themselves are not fully translated to the firms’ bottom line because there is no market value associated with emissions reductions.  Further, the prospect of future value—which is driven by policy outcomes—is highly uncertain. 
   
  Absent government incentives, corporate concern for the environment may overcome some hurdles.  Working against this kind of “corporate altruism,” however, is the need to compete in the marketplace.  A company that puts meaningful effort into reducing greenhouse gas emissions, rather than reducing costs, may eventually lose out to one that only seeks to reduce costs.   

  It is exactly this need to align public and private interests that underlies the argument for an emissions trading program, or similar mechanism, alongside technology development and demonstration programs.  While the government seeks technologies to cut carbon, the private sector seeks technologies to cut costs.  Market-based policies that put a value on emissions reductions encourage firms to conserve energy, reduce emissions from existing technologies, and adopt new low-carbon or no-carbon technologies.  In contrast, policies that only focus on technology adoption fail to take advantage of reductions that could come from existing technologies and conservation. 

  Market-based policies to reduce emissions have two distinct effects:  they reduce emissions in the near term and they alter the incentives that firms have for developing and adopting new technologies for the future.  Few would disagree that it is the private sector, not the government, which has driven innovation and growth in modern economies.  Industry, according to data from the National Science Foundation, funded 63 percent and performed 68 percent of all research and development in 2003 (the latest year for which data is available).   Even as the government tries to encourage greenhouse gas-reducing technologies, private efforts to improve greenhouse gas-increasing technologies will likely continue unless firms see some kind of value associated with emissions reductions. 

  Technology programs alone may succeed in bringing down the cost of integrated gasification and combined cycle (IGCC) coal plants so that they eventually overtake conventional pulverized coal.  That said, how can technology programs ever make capture and sequestration cheap enough so that firms will voluntarily capture and sequester emissions?  The real choice is whether capture and sequestration will eventually be required under a command-and-control style regulation, or whether a market-based system will be used to flexibly encourage adoption of the cheapest option.  There is growing evidence on the performance of these alternative approaches, including a volume I recently co-edited which compares the U.S. and European records of both command-and-control and market-based mechanisms.   Overall, the analysis finds that market-based programs are considerably cheaper than command-and-control alternatives.  For example, the U.S. sulfur dioxide program achieved savings of over 40 percent compared to the command-and-control alternatives.  Additionally, market-based programs have the advantage of encouraging innovation in a direction that minimizes costs and reduces emissions.

  Another point sometimes overlooked is the opportunity for relatively inexpensive emissions reductions right now.  Emissions reductions using more conventional technologies may not provide a complete solution to the climate problem, but by delaying the accumulation of greenhouse gases in the atmosphere, they provide additional time to develop long-term solutions.  Even if a major technology breakthrough is needed to reach climate stabilization goals, there are many small- and medium-sized innovations—the type typically associated with learning by doing—that can yield significant benefits.   Sending a signal about the value of emissions reductions provides the right information to the private sector about the importance of undertaking those activities.

  Consistent with this logic, the NCEP proposal tries to link the technology development and the mitigation sides of the problem into a coherent policy framework.  By coupling technology incentives with an emissions trading program they provide significant incentives—along with the necessary funding—to develop new technologies that are essential to the long-term success of any effort to reduce greenhouse gases.   

  As a final point on the link between research and development, and mitigation, I will mention one particular line of thought in circulation these days that is somewhat at odds with the ideas laid out here.  Because climate change is such a long-term problem, the thinking goes, it is not appropriate to encourage emissions reductions now—the policy focus should, instead, be entirely oriented to technology development.   Although there are many complex issues here, the single point I would make is that even this view supports near-term emissions reductions as long as the cost is no higher than the expected value of future mitigation benefits.  While one can debate the true magnitude of these benefits, the economics literature on this issue would certainly support the $8 per ton of carbon dioxide proposed by NCEP.

  I now turn my focus to a discussion of the use of a safety valve or price cap to avoid unpleasant cost surprises.  In the context of a mandatory cap-and-trade system, a safety valve would specify a maximum market price at which the government stands ready to sell additional emissions allowances in order to prevent excessive prices. 

  At the outset, one must ask a basic question: given the success of cap-and-trade programs without a safety valve, such as the one for sulfur dioxide, what is the basis for including a safety valve to control carbon dioxide and other greenhouse gases?  The answer is simple and straightforward: carbon controls are potentially more costly to the economy than these other programs and, most importantly, there is greater uncertainty about the true costs.  Unforeseen events such as a warm summer or cold winter, a spurt in economic growth, or a technological failure of some sort, may drive up control costs dramatically.   One needs only point to the unforeseen events in California’s RECLAIM program that propelled the prices of permits for nitrogen oxides above $80,000 per ton, or the similar, albeit less costly, problems that arose in comparable programs on the East Coast.  Because of these concerns a number of nations are considering safety valves.  For example, Canada recently announced it would incorporate such a mechanism in its domestic program.

  As Harvard economist Martin Weitzman pointed out three decades ago, when higher control costs are of concern but the potential environmental damages are not particularly sensitive to short-term emissions fluctuations, it is unnecessary to impose strict quantity-based controls.  Although the experience with sulfur dioxide trading suggests that the actual costs may be lower than expected, recent Congressional debates indicate a clear concern that mandatory carbon mitigation policies may become quite costly—even those involving modest targets.  Part of the cost uncertainty arises from uncertainty about the level of future baseline emissions that would occur even in the absence of new policies.  There are also uncertainties about the cost of reducing emissions below baseline, and about the overall efficiency of the emissions trading system.  

  One way to address this issue is by using a safety valve that fixes binding emissions targets as long as costs remain reasonable and allows the target to rise a little if costs are unexpectedly high.  In practical terms, the safety valve would involve an initial allocation of permits followed by the subsequent sale of additional permits that would become available at a fixed trigger price.  Several of my RFF colleagues and I first proposed applying this mechanism to the control of carbon dioxide back in 1977.   Recently, NCEP has embraced the idea as part of a broader package that involves incentives for technology development, as described previously.
   
  In daily life, most individuals like to avoid unpleasant surprises (hence the popularity of insurance). It is possible to use certain policy options to avoid unpleasant surprises in the broader economy as well. Just as the Federal Reserve protects against wide swings in bond and currency prices, the incorporation of a safety valve in a greenhouse gas mitigation policy would prevent sharp increases in energy prices. The ideal climate policy is one that sets an upper limit on mitigation expenditures. Most consumers are interested in reducing their out-of-pocket expenditures for energy as well as other goods and services, and most businesses are interested in maintaining a stable environment for purposes of planning and investment. The risk of unexpectedly high compliance costs under a strict permit system would threaten that stability.

  The safety valve approach guarantees that emissions will not exceed the target as long as the price of the tradable permits does not rise above the trigger price.  It differs in a few important respects from a well-known provision in the 1990 Clean Air Act Amendments that establishes a $2,000 per ton penalty (1990$) for violations of the stipulated sulfur dioxide emissions standards.   Since the Clean Air Act penalty is far above the expected marginal control cost, it has a very low probability of being invoked.   The notion of a safety valve reflects the society’s willingness to pay for carbon mitigation.  It is not intended strictly as a punitive measure.  For those who believe that the costs of reducing greenhouse gas emissions are relatively low, permit prices would never reach the trigger level and emissions would remain capped. 

  One thing that has plagued policy proposals in the past is that different analysts using different models can produce quite disparate results.  For example, in analyzing the Kyoto Protocol, President Clinton’s Council of Economic Advisers forecasted allowance prices below $8 per ton of carbon dioxide as compared to EIA’s $43 estimate.  Interestingly, with the safety valve the emissions estimates may vary among models but the costs cannot rise above the price cap.  Observe that the EIA estimates of the NCEP proposal, which contains a safety valve, are extremely close to those of the respected consulting firm, Charles River Associates, which conducted that macro-economic analysis for NCEP.  Similarly, recent EIA sensitivity analyses of the NCEP proposal released just last week reveal that compliance costs are virtually invariant with respect to a wide range of assumptions about natural gas supplies, the availability of non-carbon offsets, and other factors.

  A final point about safety valves concerns the claim by some that such a mechanism is unnecessary as long as banking and offsets are allowed.  Citing the successful sulfur dioxide trading system, unexpected events of the type that doomed the RECLAIM program in California are dismissed as the product of a flawed design—namely, the absence of provision for emissions banking and offsets—rather than as an inherent problem of applying a fixed quantity trading system to control emissions.  The alternative view, espoused by at least two former chairmen of the President’s Council of Economic Advisors, is that banking or offset systems cannot reasonably adapt to unexpected events such as higher energy demand or inadequate technology as effectively as a safety valve.  According to this view, offsets can reduce the expected cost of a particular goal, but they cannot address concerns about unexpected events.  In fact, if the system becomes dependent on such offsets, their inclusion can actually increase uncertainty about program costs if the availability and cost of the offsets themselves is not certain.  In regard to the banking or borrowing of emissions, the two Council chairmen note that “… [The]…features that…provide additional allowances when shortages arise…are helpful, but only to the extent they can ameliorate sizeable, immediate and persistent adverse events.”   That is, offsets or banking systems may reduce the problem, but they may not be sufficient to address all the uncertainties arising from unexpected spurts in economic growth, weather variations, or other events. 

  Finally, I will briefly comment on the challenges of bringing developing countries into an emissions limiting agreement.  While this is clearly a critical need for long-term success of any effort to address climate change, so far, no proposal has made much.  Developing nations are certainly not lining up behind the idea of binding emissions limits as laid out in the Kyoto Protocol.  The president’s proposed use of intensity targets, which takes into account economic growth when measuring environmental performance, is clearly more attractive to developing nations than fixed emissions levels.  However, there is no serious indication that developing nations are prepared to adopt this approach either.  Senators McCain and Lieberman’s Climate Stewardship Act incorporates some limited incentives for developing nations by allowing up to 15 percent of the total emissions to come from offsets, including offsets from abroad.  Recent proposals by Senator Bingaman incorporate a similar mechanism, albeit at a lower (five percent) level.  How well such international offsets would compete against domestic agricultural and forestry projects, or against domestic non-carbon dioxide sources is an open question.  Nonetheless, this approach clearly has some appeal.  

  The recent Senate resolution on climate change represents an important step forward in redefining the initial terms of developing country participation in greenhouse gas mitigation by opening the door to potential linkages between climate change and other issues of international concern.  The original Byrd-Hagel language requiring “new specific scheduled commitments to limit or reduce greenhouse gas emissions” by developing countries has been replaced by the stipulation that U.S. policies “encourage comparable action by other nations that are major trading partners and key contributors to global emissions.”  This new language lowers the bar somewhat for developing countries and creates a more realistic expectation for participation by these countries. At the same time, it properly focuses attention on major trading partners with large emissions.

  Consistent with this new Senate language, a proposal advanced by NCEP and embraced by Senator Bingaman calls for periodic Congressional review of the new U.S. mandatory program.  Under this mechanism Congress would make a determination every five years to accelerate, decelerate, or leave unchanged the key program parameters including the emissions target and the safety valve price.  In making this determination, Congress would review a wide range of factors, including recent technological advances.  Of particular interest would be the mitigation actions of other nations, both developed and developing, to reduce emissions.   Further, if the United States or other developed nations had established a program to support clean energy projects in a poor nation, that too would become part of the review.   If one believes, as I do, that the key to international cooperation on climate change is linkage on a broad range of issues, including global trade, development aid, and technology transfer, then such a procedure would potentially provide Congress an opportunity to influence the actions of both developing and developed nations as climate policies evolve over the next few years, all the while avoiding, in EIA's words, “material” impacts on the U.S. economy.

  In sum, Mr. Chairman, we have come a long way since the early discussions on the Kyoto Protocol.  We are no longer talking about steep near-term emissions reductions with the concurrent dangers for the U.S. economy.  Rather, the debate has now shifted to motivating both the public and private sectors to pursue technology innovation over the long term and capturing the low-hanging fruit of cheap emissions reductions, all the while protecting the economy from unwarranted burdens.   Such an approach has great potential to encourage the development and adoption of new technologies that can put the United States and other nations on a long-term path to address the climate change issue.

  I thank you for the opportunity to appear before this committee and I would be pleased to answer any questions.       
  

• Mr. Jason Grumet

  Bipartisan Policy Center

  Read statement

  Witness Panel 1

  Mr. Jason Grumet

  Jason S. Grumet,
  Executive Director
  National Commission on Energy Policy
  Testimony Before the U.S. Senate
  Committee on Energy and Natural Resources

  September 20, 2005

  
  Good morning Chairman Domenici and Members of the Committee and thank you for holding this hearing to explore the benefits and economic impacts of approaches to reduce greenhouse gas emissions.  I speak to you today on behalf of the National Commission on Energy Policy, a diverse and bi-partisan group of energy experts that first came together in 2002 and last December issued a comprehensive set of consensus recommendations for future U.S. energy policy.

  I would like to begin by commending Chairman Domenici and Senator Bingaman and many others on this Committee for their leadership in winning Senate adoption of a landmark resolution recognizing the importance of the climate problem and, for the first time, putting this body on record in support of the need for mandatory efforts to reduce greenhouse gas emissions. I believe that in years to come, passage of this resolution will come to be seen as a pivotal moment in the evolution of our collective response to the risks posed by climate change.

  The resolution marks a turning point, but it also represents a logical next step for the Senate on this issue. When the Senate last expressed its views on climate change — in the Byrd-Hagel resolution of 1997 — it set out two basic criteria for future U.S. climate policy that continue to serve as critical guideposts for our discussions today. The first criterion is that any efforts to combat climate change must not compromise the vitality or competitiveness of the U.S. economy. The second criterion is that all nations, and particularly developing nations with rapidly growing emissions, must also act to address this problem. As we heard from the panel of distinguished scientists who testified before this Committee in July, the scientific consensus about climate change has steadily strengthened over the last decade. While a majority of Senators have now agreed that it is time to act, Senators on this Committee have clearly expressed a shared view that the solution to this global problem will not come easily.  It was also widely and correctly noted at the previous hearing that mitigating the risks from global warming will require the deployment of an array of clean energy technologies, many of which have not been commercialized or even invented.  The challenge before us is to determine the most effective and efficient means of developing and deploying these new technologies while satisfying the criteria articulated in both the Byrd-Hagel and the more recent Bingaman-Domenici resolutions.

  Our group, the National Commission on Energy Policy, has developed an approach that we believe can reduce domestic emissions, spur technology development and meet the twin tests of economic responsibility and international equity.
  But before outlining key elements of that approach, let me say a few additional words about the Commission itself. The Commission was formed in 2002 by the Hewlett Foundation and several other private, philanthropic foundations. Its ideologically and professionally diverse 16-member board included recognized energy experts from business, government, academia, and the non-profit sector. Our final recommendations, which are described in a report that was released on December 8, 2004, were informed by intense discussions over several years, by dozens of analyses contained in a 2,800 page Technical Appendix, and by extensive outreach to over 200 other groups. Those recommendations, I should stress, deal with a comprehensive set of energy policy issues including (in addition to climate change) our nation’s dependence on oil and the need for increased investment in new energy technologies and critical energy infrastructure.

  As a group, however, we recognized from the outset that climate change presented one of the central energy challenges of our time and so we devoted considerable energy to developing a detailed set of recommendations for addressing this issue. I would like to begin my remarks by summarizing the Commission’s view that volunteerism and tax-payer supported incentives alone do not provide an effective or economically efficient response to this challenge.  After explaining our support for mandatory market-based limits to slow, stop and ultimately reverse the growth of greenhouse gas emissions, I will focus on the attributes of a mandatory program that are needed to protect our economy.

  
  The Imperative of Mandatory Action - Our Commission strongly supports the need for continued government efforts to accelerate the development and early deployment of low and non-carbon energy sources.  We applaud the Administration’s efforts in this regard.  However, in a competitive market-economy, where companies are encouraged and in some cases obligated to maximize shareholder value, it is contrary to the rules of free-market competition to expect companies to invest scarce resources absent a profit motive.  While there are numerous cases where a combination of good will, good public relations, and positive ulterior motives (like reduced energy bills), create an adequate basis to reduce greenhouse gas emissions, these cases will remain limited if the financial value of reducing a ton of GHG emissions remains zero.

  It is somewhat ironic that the European Union is actively implementing market-based regulatory approaches developed here in the Unites States while we pursue a top-down program of government-directed, tax-payer funded research and deployment incentives.  Developing and commercializing new technologies will cost money.  The question is who is best positioned to secure and effectively spend these resources.  While there is certainly a role for public funding and government incentives, the Commission believes that there must also be a role for those who emit greenhouse gases to share in the costs of developing solutions.  As we have learned over the last twenty years, given a rational reason to invest, the private sector is far better than the government in developing technological solutions.  The success of the acid rain program demonstrates that the most effective way to engage the ingenuity of the private sector is to place a monetary value on a ton of reduced emissions thus creating a real economic incentive to develop cleaner forms of energy. By imposing a modest market signal to pull private sector technology investment forward in combination with continued tax-payer supported investment to push longer-term solutions, the Commission believes we can significantly reduce GHG emissions without hampering economic growth or prosperity. 

  Many in the environmental community and some industry analysts have argued that the modest-market signal proposed by the Commission is inadequate, in and of itself, to spur the technology innovation needed to solve the climate problem.  The Commission wholeheartedly agrees.  While modeling performed by Charles Rivers Associates under contract to the Commission and by the Energy Information Administration demonstrates that a modest carbon price will inspire considerable near-term reductions, both analyses conclude that proposed market-signal is unlikely by itself to make technologies such as carbon sequestration, a massive deployment of renewable energy generation, or advanced nuclear facilities cost-competitive over the next two decades.  This conclusion is precisely why the Commission believes that an effective response to climate change requires both a market signal and significant technology incentives.

  This basis of this conclusion is best revealed by examining the alternatives.  While providing a strong incentive for technology development, imposing a much higher carbon price on corporations and share-holders would be economically disruptive and politically unacceptable.  This approach would strand billions of dollars of existing, long-lived capital stock and cause potentially significant economic dislocations while new technologies were developed and deployed.  It also fails to address widely accepted market failures that discourage the investment of private capital in the development of long-term technologies with uncertain market value.  Conversely, the placing the entire burden on the public sector is equally unacceptable.  By discouraging private investment and innovation, this approach will ultimately prove ineffective, too costly to the Treasury or both.  Moreover, absent a market signal, there will be little or no incentive to deploy low carbon technologies even if the tax payer covers the full cost of their development.  In sum, relying entirely upon the private or public sectors to advance our national interest in technology advancement, offers a policy prescription that is akin to pushing one-end of a rope.

  The elegance of combining a both market signals and public incentives is further supported by the opportunity to auction a small fraction of the emission permits in order support technology innovation without burdening the general tax base.  The Commission proposed to double U.S. energy R&D, triple international energy R&D partnerships, and provide significant incentives to accelerate the deployment of coal gasification and sequestration, bio-fuels, renewable generation, domestically produced efficient vehicles and advanced nuclear facilities using the $35 billion in revenue generated by auctioning up to 10% of the emission permits over a decade.
  . 
  Overview of Commission Proposal – In addition to advocating for the combination of a market-based price signal and technology incentives, the Commission’s proposal is explicitly designed to ensure that the proposed market-based emission reduction requirements do not undermine economic growth or competitiveness.  Specifically, the Commission recommends that the United States adopt a mandatory, economy-wide, tradable-permits system for reducing greenhouse gas emissions, with a safety valve designed to limit costs.  This approach is similar to the successful acid rain program in the United States, but differs in one very critical respect. Rather than proposing a hard cap on emissions, we have proposed an absolute cap program costs. 

  The aim of the Commission’s proposal is to slow growth in U.S. emissions over the 2010-2020 timeframe as a prelude to stopping and eventually reversing current emissions trends in the 2020s and beyond.  We also explicitly designed our approach to recognize the importance of participation by major trading partners like China and India. Our program includes a regular 5-year review of progress which is intended to assess both the performance of the U.S. program and progress by other countries. If major U.S. trading partners and competitors (including China, India, Mexico, and Brazil) fail to implement comparable emission control programs, further U.S. efforts — including the gradual increase in stringency built into our program — could be suspended or adjusted. Conversely, the U.S. program could be strengthened if international progress, technology advances, or scientific developments warrant.

   

  
  International participation and other issues will be the subject of future hearings, so I want to return now to the main focus of this panel: economic impacts. 

  Two key policy choices: 1) a modest reduction target; 2) the cost–cap or “safety-valve”  enable the Commission to propose a mandatory, economy-wide GHG reduction program that according to EIA does not “materially affect,” the U.S. economy.   I will describe each of these design features in turn.

  Modest Reduction Target – The Commission believes that if we begin now, there is time to gradually phase-in GHG reductions across the economy.  Like the Administration, we believe that reducing the GHG intensity of the economy is an effective means of slowing, stopping and ultimately reducing U.S. GHG emissions.  Over the first decade of the program, we propose to set an economy-wide emission limit based upon a 2.4% decrease in GHG emission intensity.  If achieved, this target would slow annual emissions growth by roughly 2/3 from business as usual allowing actual emissions to increase by 0.5% per year instead of by the currently projected 1.5% annual increase in total emissions. Absent Congressional intervention to adjust the target, the intensity decline would increase to 2.8% after a decade effectively stopping emissions growth.  Many have argued that this reduction pathway is too slow and criticize the Commission plan for explicitly allowing emissions to increase for a decade after implementation.  We acknowledge this critique, but believe that a modest and low-cost reduction pathway is critical to achieving the near-term consensus needed for timely action.  The Commission believes that it is critical for the United States to move forward now to implement a robust regulatory architecture that can adjust over time as our understanding of climate impacts and the costs of solutions matures. 

  Cost-Certainty (the “Safety-Valve”) -  Under a traditional cap and trade program the reduction target is fixed in statute or regulation while the costs are “best guesses” of what will be necessary to achieve the fixed targets.  While our experience in the acid rain program suggests that projected costs are more likely to be exaggerated than understated, there remains a real possibility that costs for meeting any target will be higher than expected or desired.  Under the safety-valve, regulated entities are allowed to buy additional permits from the government at a pre-determined price.  This feature of the Commission’s proposal ensures that program compliance costs will not exceed estimates.  If technology fails to progress at the projected rate, the program will reduce less emissions than desired but compliance costs will not increase. 

  EIA’s analysis and the work of Charles River and others reveal that expectations of technological progress are by far the most significant assumptions affecting the costs of achieving a particular emissions target.  Under EIA’s base-case average technology assumptions achieving the Commissions modest 2.4% annual intensity reduction will begin to cost more than the safety-valve price beginning in 2015 causing firms to avail themselves of safety-valve permits.  However, when EIA projects costs using more optimistic assumptions about technology progress that seek to capture the Commission’s “recycling” of auction revenue back into technology incentives, the target is met throughout the first decade with the safety-valve never being triggered at all.  Under the more optimistic technology assumptions, a $7/ton incentive results in nearly double the reductions, but the overall cost of the program is the same.

  The Commission’s decision to place a priority on cost-certainty over emissions certainty reflects our appreciation of strongly held and fundamentally irresolvable disagreements about technological progress and the ultimate costs of emission reductions. Rather than spending several more years paralyzed by differing climate change modeling assumptions, the safety-valve allows us to begin, albeit cautiously, to reduce U.S. greenhouse gas emissions while protecting our economy, affording time for key industries to adjust and maintaining America’s global competitiveness.

  The safety valve also gives businesses the planning certainty they need to make wise long-run investments that will minimize the costs of achieving greenhouse gas emissions reductions over time. We chose an initial safety valve level of $7 per metric ton of carbon dioxide equivalent because analyses suggest that it roughly reflects the mid-point in the scientific literature of the expected harm that can presently be attributed to a ton of GHG emissions given current scientific understanding.  Equally if not more important, the $7 figure is low enough to ensure that valuable, long-lived energy assets won’t be prematurely retired, yet also high enough to send a meaningful market signal for future investment in clean, low-carbon energy alternatives. In our proposal, the safety valve price increases gradually over time, at a nominal rate of 5 percent per year, to generate a steadily stronger market signal for reducing emissions.

  Overall Economic Impacts - To assure ourselves that we had successfully addressed potential economic concerns, we subjected our proposal to detailed economic analysis. The analysis indicated that the impacts of the program on businesses and households would be modest. Our own modeling results were subsequently supported by an independent analysis of our proposal by the Department of Energy’s Energy Information Administration (EIA). 

  EIA’s analysis indicates that the impacts of the program on businesses and households are likely to be modest. Projected annual GDP growth would decline by less than .02% against a baseline average growth or 3.1%.  This impact equate to an average annual cost of $78 per household between program inception and 2025.  Assessed cumulatively between 2005 and 2025, overall, predicted GDP growth would change from 80.8 percent to 80.6 percent, or a difference of 0.2 percent. In the EIA’s own words: “the overall growth rate of the economy between 2003 and 2025, in terms of both real GDP and potential GDP, is not materially altered.”  Put another way, the nation would be as wealthy on January 15, 2025 with the program in place, as it would have been on January 1, 2025 under business as usual.  At the relatively minor cost of slowing economic growth by two weeks twenty years hence, we can make a significant start to address global climate change.

  Because the models predict that a large share of reductions in the early years of the program would come from industrial greenhouse gases such as HFCs, PFCs, and SF6, total energy consumption would be expected to decline by only 1 percent below forecast levels for 2020, while still growing 14 percent in absolute terms over the first decade of program implementation (i.e., 2010–2020). Also noteworthy, natural gas demand is barely affected by the Commission’s climate proposal increasing by less than 1% over business as usual.  When additional proposals to increase energy efficiency and support coal gasification are modeled, total natural gas demand actually declines against business as usual projections.  Finally, while coal use grows more slowly than under BAU, significant growth in coal is projected by both the Commission and EIA’s analysis even when excluding new markets that will be created by IGCC.

  Of course, a very small fraction of a very large economy can still look like a lot of money if taken out of context. You will undoubtedly hear from critics that our proposal will cost $313 billion in lost GDP between 2005 and 2025. What the critics are less likely to mention is that this is just a tiny fraction of the $323 trillion of cumulative growth in GDP the economy is expected to generate over the same time period. Similarly, those who oppose any action on climate change are likely to point to EIA’s estimate of 140,000 lost jobs by 2020 as a result of the tradable permits program. Again, this number needs to be viewed in context. EIA’s estimate of job losses comes to just 0.4 percent of the 36 million new jobs that the economy is expected to create between 2005 and 2025. 

  At Chairman Inhofe’s request, EIA also recently examined the impacts of the program assuming higher natural gas prices and higher costs for reducing emissions of non-CO2 greenhouse gas emissions. EIA found that the costs of the Commission’s proposal would actually be less if natural gas prices turned out to be higher than projected.  Higher natural gas prices under business-as-usual assumptions would tend to lower total demand for energy, thus making it somewhat easier to meet the Commission’s proposed emission target.  While more pessimistic assumptions regarding the costs of controlling non-CO2 greenhouse gas emissions would result in lower total reductions of greenhouse gas emissions, they would not materially affect program costs.  This recent analysis makes clear the value of the safety-valve both as a substantive protection in case 2005 economic assumptions are not borne out over time and as a political device to set aside some of the more contentious and unknowable “what if” arguments that have undermined our ability to forge a consensus for mandatory actions to reduce GHG emissions.

  The trade-off for low cost is a program that also achieves relatively modest emission reduction benefits, at least in its early stages. We believe that a flexible, gradual, market-based approach that provides cost certainty is appropriate at a time when uncertainties remain about the pace of actual warming and about the speed with which we can develop and commercialize lower-carbon alternatives. While this program will necessarily need to evolve as other nations join in the reduction effort and as our understanding of the climate induced impacts continues to improve. We believe that it is the right approach to get us started.

  In fact, the importance of getting started is exactly what I hope you will not lose sight of as the inevitable debate about numbers and dollars and tons and jobs unfolds in the months to come. A war of numbers too easily leads to paralysis. And right now it matters less which numbers you choose than that you recognize the essential principle at the core of our proposal:  Strictly voluntary, seemingly costless approaches will not enable the marketplace to attach a known value to carbon reductions. Only when reductions have real value — however small — can companies justify long-term investments in new, low-carbon energy alternatives and only then will we unleash the ingenuity and innovation of the private sector in addressing the climate change problem and in developing the clean technologies that will be in global demand for decades to come.

  Finally, the Commission firmly recognizes that climate change is a global problem requiring an effective and equitable global solution.  The United States can not meaningfully mitigate the risks of climate change absent commensurate efforts by the rest of the world.  Similarly, the rest of the world can not solve the climate problem absent leadership from the United States.  The Commission believes that undertaking mandatory domestic reduction efforts here at home is a condition precedent to achieving a truly global solution.  This recognition that actions in the developing world will inevitably follow those of the United States provides further impetus to take action now so that we can work more effectively to encourage similar actions overseas.

  Thank you for this opportunity to testify. I speak on behalf of the entire Commission in offering whatever further support and information we can provide to assist your deliberations in the months to come.
   

  Summary of Key Features of the National Commission on Energy Policy’s Proposal for Reducing Greenhouse Gas Emissions

  • Mandatory, economy-wide, tradable-permits system would go into effect in 2010. This would allow U.S. companies adequate lead time to plan and make needed adjustments or investments. The program would cover carbon dioxide (CO2) and other major greenhouse gases (including methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride).

  • Environmental target based on annual reductions in emissions intensity, where intensity is measured in tons of CO2-equivalent emissions per dollar of GDP. Between 2010 and 2019 the Commission recommends a target emissions intensity decline of 2.4 percent per year. Based on current GDP forecasts, achieving this target would reduce projected emissions growth from a business-as-usual rate of 1.5 percent per year to 0.5 percent per year. Starting in 2020 and subject to the Congressional review described below, the Commission proposes raising the target intensity decline to 2.8 percent per year (the “stop phase” in the figure).

  • Cost cap is achieved by making additional permits (beyond the quantity of permits established through the target intensity decline described above) available for purchase from the government at a pre-determined price. The Commission proposes an initial cost cap or “safety valve” permit price of $7 per metric ton of CO2-equivalent. This price would increase by 5 percent per year in nominal terms.

  • Permit allocation for a given year would be calculated well in advance based on available GDP forecasts. For the first three years of program implementation, the Commission recommends that 95 percent of initial permits be issued at no cost to emitting sources. The remaining 5 percent would be auctioned. Starting in 2013 and every year thereafter, an additional 0.5 percent of the target allocation would be auctioned, up to a limit of 10 percent of the total permit pool.

  • Congressional review in 2015 and every five years thereafter to assess the U.S. program and evaluate progress by other countries. If major U.S. trading partners and competitors (including China, India, Mexico, and Brazil) fail to implement comparable emission control programs further U.S. efforts (including continued escalation of the safety valve price and permit auction, as well as more aggressive intensity reduction target in 2020) could be suspended. Conversely, the U.S. program could be strengthened if international progress, technology advances, or scientific developments warrant.

   

   

• Dr. Howard Gruenspecht

  Acting Administrator

  Energy Information Administration

  Read statement

  Witness Panel 1

  Dr. Howard Gruenspecht

  
  Testimony of
  Howard Gruenspecht, Deputy Administrator
  Energy Information Administration
  U.S. Department of Energy
  before the
  Committee on Energy and Natural Resources
  United States Senate
  September 20, 2005

  
  Mr. Chairman and members of the committee, I appreciate the opportunity to appear
  before you today to discuss the Energy Information Administration’s (EIA) recent
  analyses of greenhouse gas reduction policies.
  EIA is the independent statistical and analytical agency within the Department of Energy.
  We are charged with providing objective, timely, and relevant data, analyses, and
  projections for the use of Congress, the Administration, and the public. We do not take
  positions on policy issues, but we do produce data, analyses, and forecasts that are meant
  to assist policy makers in their energy policy deliberations. Because we have an element
  of statutory independence with respect to this work, our views are strictly those of EIA
  and should not be construed as representing those of the Department of Energy, the
  Administration, or any other organization.
  My testimony today will focus on EIA’s recent assessment of the impacts on energy
  supply, demand, and the economy that would result from the recommendations proposed
  in a December 2004 report entitled Ending the Energy Stalemate: A Bipartisan Strategy
  to Meet America’s Energy Challenges, prepared by the National Commission on Energy
  Policy (NCEP), a nongovernmental privately- funded entity. EIA’s report, Impacts of
  Modeled Recommendations of the National Commission on Energy Policy, released in
  April 2005, compares cases incorporating the NCEP recommendations to the projections
  of domestic energy consumption, supply, prices, and energy-related carbon dioxide
  emissions through 2025 in the reference case of the Annual Energy Outlook 2005
  (AEO2005). AEO2005 is based on Federal and State laws and regulations in effect on
  3
  October 31, 2004. The potential impacts of pending or proposed legislation, regulations,
  and standards—or of sections of legis lation that have been enacted but that require funds
  or implementing regulations that have not been provided or specified—are not reflected
  in the projections. AEO2005 explicitly includes the impact of the American Jobs
  Creation Act of 2004, the Military Construction Appropriations Act for Fiscal Year 2005,
  and the Working Families Tax Relief Act of 2004. AEO2005 does not include the
  potential impact of energy legislation that is now being considered by the Congress or
  regulations such as the Environmental Protection Agency’s (EPA) Clean Air Interstate
  and Clean Air Mercury rules that were promulgated earlier this year.
  The projections in the AEO2005 and our analysis of the impacts of the NCEP policy
  recommendations are not meant to be exact predictions of the future but represent likely
  energy futures, given technological and demographic trends, current laws and
  regulations, and consumer behavior as derived from known data. EIA recognizes that
  projections of energy markets are highly uncertain and subject to many random events
  that cannot be foreseen such as weather, political disruptions, and technological
  breakthroughs. In addition to these phenomena, long-term trends in technology
  development, demographics, economic growth, and energy resources may evolve along a
  different path than expected in the projections. Both the AEO2005 and our report on the
  NCEP policy recommendations include a number of alternative cases intended to
  examine these uncertainties.
  Since EIA’s report has been provided to the committee and is available to the public on
  EIA’s web site, my testimony presents only a summary of its key findings. My testimony
  4
  focuses on the NCEP case in our report, which includes all of the NCEP
  recommendations that EIA was able to model. However, I will also discuss some results
  for individual recommendations modeled separately, such as the proposed cap-and-trade
  program (CAP-TRADE case) linked to an intensity target for greenhouse gas (GHG)
  emissions, the proposed fuel economy standards (CAFE case), and the deployment
  incentives (INCENT case). Then, I will turn to sensitivity cases that highlight the effect
  of alternative technology assumptions on our results. Lastly, I will offer some
  comparisons to findings from some previous EIA analyses of policies to limit GHG
  emissions.
  Main Results of the EIA Analysis
  The December 2004 NCEP report outlined a broad array of policy measures, not all of
  which were amenable to analysis using the EIA model of U.S. energy markets, the
  National Energy Modeling System (NEMS). Our analysis focused on the
  recommendations that could be modeled and which were thought to have a significant
  potential to affect energy consumption supply and prices. Where the NCEP
  recommendations required further specification, specific assumptions were developed in
  consultation with staff of the requesting committee.
  Our results show that the largest projected impacts on emissions, energy production,
  consumption, prices, and imports result from three of the NCEP recommendations: the
  cap-and-trade program linked to an intensity target for GHG emissions beginning in
  5
  2010, a major increase in corporate average fuel economy (CAFE) standards for cars and
  light trucks, and the new building and appliance efficiency standards. Other
  recommended policies generally affect specific fuels or technologies but do not have
  large overall market or emissions impacts.
  The impacts of the modeled NCEP recommendations, analyzed together unless otherwise
  noted, relative to the AEO2005 reference case, are discussed below.
  Energy Consumption
  Primary energy consumption is 2.26 quadrillion Btu (1.9 percent) lower in 2015 and 6.73
  quadrillion Btu (5 percent) lower in 2025 as the combination of efficiency programs and
  new CAFE standards reduces energy dema nd. Fossil fuel energy consumption is 2.5
  quadrillion Btu (2.4 percent) lower in 2015 and 8.1 quadrillion Btu (6.9 percent) lower in
  2025. In absolute terms, the use of all fossil fuels is projected to grow from 2003 levels
  through 2025.
  Figure 1 illustrates the impacts of the NCEP policies on oil consumption. Oil
  consumption in the NCEP case is 0.83 million barrels per day (3.4 percent) lower in 2015
  and 2.1 million barrels per day (7.4 percent) lower in 2025. The import share of
  petroleum product supplied declines from 62.4 percent to 61.3 percent in 2015 and from
  68.4 percent to 66.8 percent in 2025. As shown in Figure 1, almost all of the projected
  reduction in oil consumption results from the recommendation to increase fuel economy
  6
  standards (CAFE case). More than two-thirds of oil consumption is currently used in the
  transportation sector, and the transportation share of total oil use is projected to grow to
  71 percent in 2025 in the reference case. Because of the GHG permit safety valve, which
  caps the price of traded permits at $6.10 per metric ton of carbon dioxide (CO2) in 2010
  rising to $8.50 per metric ton in 2025 (2003 dollars), the maximum direct effect of the
  cap-and-trade policy on the delivered price of gasoline, diesel, or jet fuel is roughly 7
  cents per gallon (2003 dollars). Taken alone, a 7-cent price increase is not expected to
  spur either a switch to alternative fuels or prompt a significant increase in fuel efficiency
  (CAP-TRADE case).
  Figure 2 illustrates the impacts of the NCEP policies on natural gas consumption.
  Natural gas consumption in the NCEP case is slightly lower (0.45 quadrillion Btu or 1. 6
  percent) in 2015 and 1.1 quadrillion Btu (3.6 percent) lower in 2025, due mainly to lower
  electricity demand from the building standards recommendation and the incentives
  provided for deployment of renewable, coal- fired integrated gasification combined-cycle
  (IGCC), and nuclear power plants that further reduce the size of the market for naturalgas-
  fired electricity generation. In contrast, when the cap-and-trade program is
  considered alone (CAP-TRADE case), projected natural gas consumption rises above the
  reference case level as natural gas replaces coal in electricity generation.
  Figure 3 illustrates the impacts of the NCEP policies on coal consumption. Coal
  consumption in the NCEP case is slightly reduced (0.46 quadrillion Btu or 1.8 percent) in
  2015 and more significantly reduced (3.0 quadrillion Btu or 9.8 percent) in 2025, due
  7
  mainly to the lower electricity demand and shifts in the generation fuel mix that are
  caused by the cap-and-trade program. The technology incentives and building standards
  packages have offsetting effects on coal use, by encouraging IGCC plants while reducing
  electricity generation, so the net effect on coal use of the cap-and-trade program alone
  (CAP-TRADE case) is similar to that of the combined NCEP policy case.
  Figure 4 shows how the NCEP policies affect projected electric generation capacity
  additions over the 2004 to 2025 period. Because of the early deployment incentives
  (INCENT case) and the cap-and-trade proposal, projected IGCC capacity additions more
  than double, and renewable generation increases by 23 percent relative to the reference
  case. However, the projected capacity additions of conventional coal- fired technology
  decline to less than 25 percent of the reference case level. The shift from conventional
  coal-fired plants to more efficient IGCC plants results in an increase in the amount of
  generation per ton of coal consumed.
  Energy Prices
  The NCEP policy recommendations generally reduce the demand for fossil fuels, which
  tends to lower wellhead or minemouth prices. However, the cost of permits required
  under the cap-and-trade program tends to increase the delivered price of fossil fuels.
  When these effects are taken together, the cost of permits tends to dominate even with the
  safety- valve limit on permit prices in place, so the energy prices paid by end users
  generally rise.
  8
  The average petroleum price to all users (including the price of emissions permits) is 2.2
  percent higher in 2015 and 1.4 percent higher in 2025 than in the reference case, with the
  permit prices more than offsetting the lower crude oil prices resulting from the new
  CAFE standard. When the cap-and-trade (CAP-TRADE) program is considered without
  new fuel economy standards, the reduction in oil demand is much smaller, so the
  expected impact on delivered petroleum prices is larger.
  The average delivered natural gas price in our NCEP case is $0.17 per thousand cubic
  feet (2.7 percent) lower in 2015, with the wellhead cost reduction partially offset by the
  increased GHG permit price, and $0.52 per thousand cubic feet (7.6 percent) higher in
  2025, largely because of the permit price which is added to the delivered fuel costs. The
  2015 result reflects the impacts of building and appliance standards, which reduce
  residential electricity demand, and incentives for IGCC, which favor coal- fired
  generation relative to natural gas.
  When the costs of emissions permits are included, the average delivered coal price is
  $0.54 per million Btu (43 percent) higher in 2015 and $0.74 per million Btu (56 percent)
  higher in 2025 than in the reference case because of the high carbon content of coal. The
  much higher percentage change in delivered coal prices compared to the other fossil fuels
  reflects both its high carbon content per unit of energy and its relatively low price in the
  reference case.
  9
  The average delivered electricity price is projected to be unchanged in 2015 but is 0.4
  cents per kilowatthour (5.8 percent) higher in 2025 because of the mandatory cap-andtrade
  program. EIA’s electricity price estimates reflect the assumption that consumers
  capture the economic benefits of the allocation of GHG permits to regulated utilities in
  areas of the country where electricity rates are set under cost-of-service regulation.
  Emissions
  Projected reductions in energy-related CO2 emissions, which are concentrated in the
  electric power and transportation sectors, are 2.8 percent in 2015 and 7.7 percent in 2025.
  These reductions are larger than the corresponding reductions in primary energy use (1.9
  and 5.1 percent, respectively for 2015 and 2025), as the NCEP policy recommendations
  promote a less CO2 –intensive energy mix.
  Covered GHG emissions are 393 million metric tons equivalent (5.2 percent) lower in
  2015 and 964 million metric tons CO2 equivalent (11 percent) lower in 2025. Covered
  GHG emissions intensity decreases by 5.1 percent in 2015 and by 10.6 percent in 2025.
  The absolute level of covered GHG emissions is projected to grow at an annual average
  rate of 1.1 percent over the 2003 to 2025 period, compared to annual average growth of
  1.5 percent in the reference case.
  As shown in Figure 5, reductions in emissions of non-CO2 GHG emissions, which are
  not represented in a detailed fashion in NEMS, account for over 50 percent of the covered
  10
  GHG emissions reductions in 2015 and 35 percent of the covered GHG emissions
  reductions in 2025. Estimates for non-CO2 GHG emissions were developed using
  emissions baselines and abatement cost curves based on engineering cost estimates that
  were supplied by EPA. Real- world factors affecting the behavior of decisionmakers and
  the use of incomplete cost information may result in an overstatement of the actual level
  of non-CO2 abatement achieved at each level of the permit price. However, as discussed
  below, due to the safety- valve feature of the proposed cap-and-trade program, the
  projected energy sector and economic impacts of the NCEP policy recommendations
  would not change significantly even if the assumptions used regarding the supply of
  GHG abatement opportunities were too optimistic.
  Because of the safety- valve price mechanism in the cap-and-trade program for GHGs, the
  GHG intensity targets specified by the NCEP are not reached. EIA projects that total
  emission reductions fall short of the emission target by 557 million metric tons CO2
  equivalent in 2025.
  Economic Impacts
  Figure 6 shows the projected effect of the NCEP policy recommendations and the capand-
  trade policy considered separately on the projected level of real gross domestic
  product (GDP). By 2025, real GDP in the NCEP and CAP-TRADE cases are,
  respectively, 0.4 percent ($79 billion dollars) and 0.13 percent ($27 billion dollars) below
  the reference case levels. These changes do not materially affect average economic
  11
  growth rates for the 2003 to 2025 period. Real consumption is also reduced over the 2010
  to 2025 period relative to the reference case, with the impact reaching about 0.55 percent
  in 2025 ($74 billion in year 2000 dollars).
  Cap and trade systems or emissions taxes are generally considered the most economically
  efficient approach for reducing emissions, since they allow reductions to be made where
  they can be achieved at the lowest cost. In a pure cap-and-trade program, the price of
  emissions permits, which generally rises as the cap is made more stringent, is a good
  indicator of economic impacts. However, in a program that combines a cap-and-trade
  program with regulatory measures, a lower permit price does not imply lower economic
  impacts. Although the regulatory measures included in the NCEP case result in a lower
  projected price of emissions permits than would be expected if the cap-and-trade policy
  was implemented alone, the projected economic impacts in the NCEP case are higher
  than for the cap-and-trade only case in our analysis.
  Technology Sensitivities
  While the AEO2005 reference case used as the basis for comparisons in our analysis
  incorporates significant improvements in technology cost and performance over time, it
  may either overstate or understate the actual future pace of improvement, since the rate at
  which the characteristics of energy-using and producing technologies will change is
  highly uncertain. Relative to the reference case, EIA’s high technology case generally
  12
  assumes earlier availability, lower costs, and higher efficiencies for end- use technologies
  and new fossil-fired, nuclear, and nonhydropower renewable generating technologies.
  Although the NCEP recommends increases in the funding for research and development,
  EIA, consistent with its established practice in other recent studies, did not attempt to
  estimate how increased government spending might specifically impact technology
  development. Instead, to illustrate the importance of technology characteristics in
  assessing the impacts of the NCEP recommendations, EIA prepared a set of NCEP policy
  cases using its high technology assumptions. Figure 7 shows how the use of high
  technology assumptions tends to reduce projected energy use with or without the
  recommended NCEP policies. Relative to the AEO2005 high technology case, the high
  technology case combined with the NCEP recommendations reduces fossil fuel use by
  1.46 quadrillion Btu (1.5 percent) in 2015 and 4.48 quadrillion Btu (4.1 percent) in 2025.
  Under the high technology assumptions, the NCEP’s greenhouse gas intensity goals are
  met, reducing covered GHG emissions intensity from 480 to 463 metric tons CO2
  equivalent per million dollars of GDP in 2015 (3.5 percent) and from 405 to 373 metric
  tons CO2 equivalent per million dollars in 2025 (7.9 percent). Attainment of the
  emissions intensity goal depends heavily on estimated reductions of non-CO2 GHG
  emissions, subject to the caveats above and on the use of banked GHG emissions permits
  that are exhausted in 2025, at the end of the forecast horizon for this analysis.
  13
  Because energy consumption is already lower in the high technology case than in the
  reference case, the NCEP recommendations have a smaller relative impact to the high
  technology case. However, due the lower baseline consumption, the GHG intensity goals
  are easier to attain.
  Relationship to Previous EIA Greenhouse Gas Analyses
  EIA has completed several other reports on policy proposals to limit or reduce GHG
  emissions. EIA’s previous analyses of emission reduction proposals indicate that the
  economic impacts are largely determined by the size of the energy market change
  required to satisfy the policy and the speed with which the change must occur. In 2003,
  EIA considered the original version of the Climate Stewardship Act (S.139), which
  would cap GHG emissions at the 2000 level in 2010 and the 1990 level in 2016 and
  beyond. In 2004, EIA considered an amended version of that bill (S.A.2028) that
  removed a provision for a tightening of the emissions cap beginning in 2016. The NCEP
  proposal, S.A.2028, and S.139 all have a 2010 start date for their cap-and-trade systems.
  The NCEP proposal is less stringent than the others because it is expressed in terms of
  GHG emission intensity, starts from the 2010 level, and includes a safety valve.
  These earlier reports suggest that either version of the Climate Stewardship Act is
  projected to provide larger reductions in emissions from the energy sector than the NCEP
  policy recommendations. To achieve this, higher permit prices (Figure 8) and larger
  energy system changes, particularly for electricity generation and demand, are required.
  14
  That is, S.A.2028 and S.139 would require more significant changes in the U.S. energy
  system and larger increases in delivered energy prices than the NCEP recommendations,
  resulting in larger estimated economic impacts. As permit prices increase, electricity
  prices typically increase and reduce demand while electricity generation tends to shift
  away from coal technologies because of the high carbon content of the fuel and toward
  low or no-carbon emitting technologies like renewable, natural gas, and nuclear power
  generation (Figure 9).
  Finally, while all baseline and policy projections are inherently uncertain, differences in
  policy design can affect the impacts on the energy system and the level of GHG
  emissions. The safety-valve feature of the NCEP cap-and-trade proposal would allow
  GHG emissions to rise above the level projected in our report in the event that emissions
  reduction inside or outside the energy sector proves to be more costly than we expect,
  while protecting against the prospect of larger energy system and economic impacts in
  these circumstances. In contrast, policies that impose a “hard” cap on emissions without
  a safety- valve price for GHG credits, would force the GHG emissions target to be met
  through higher GHG prices, regardless of the cost to the econo my.
  This concludes my testimony, Mr. Chairman and members of the Committee. I would be
  pleased to answer any questions you may have.