Greenhouse Gas “Early Reduction” Programs: A Critical Appraisal
Greenhouse Gas “Early Reduction”
Programs: A Critical Appraisal
Ian Parry and Michael Toman
July 2000 • Climate Change Issues Brief No. 21
Resources for the Future
1616 P Street, NW
Washington, D.C. 20036
Telephone: 202–328–5000
Fax: 202–939–3460
Internet: http://www.rff.org
Climate Issues Briefs are short reports produced as part of
RFF’s Climate Economics and Policy Program to provide topical, timely information and analysis to a broad nontechnical audience. The preparation of these briefs is funded in part by The G. Unger Vetlesen Foundation.
© 2000 Resources for the Future. All rights reserved. No portion of this paper may be reproduced without permission of the authors.
Contents
OPERATION OF EARLY REDUCTION PROGRAMS ................................................... 3
ECONOMIC EFFICIENCY BENEFITS OF EARLY REDUCTIONS ............................ 4
ii
Greenhouse Gas “Early Reduction” Programs: A Critical Appraisal
Ian Parry and Michael Toman
INTRODUCTION
A number of ideas have recently circulated in the United States for establishing some kind of national “early reduction” program to begin lowering greenhouse gas (GHG) emissions before 2008, when binding commitments under the (not yet ratified) Kyoto Protocol are scheduled to come into force. Although these proposals differ in important details as to what activities constitute allowable early reductions and how many early reductions could be earned, the critical element common to almost all the proposals is the voluntary creation of “early reduction credits” (see the reports by GAO and Repetto in Further Readings).
These credits would be awarded to individual projects that reduce emissions below some business-as-usual level before 2008. Those holding credits in 2008 would be entitled to a greater share of the available national “emissions budget” during the 2008-2012 Kyoto commitment period. If the United States were to implement an emissions control program during that period with tradable carbon allowances, holders of early reduction credits would be allocated a share of the allowances, implying fewer allowances for others. (If the United States were to use a standards-based approach for individual GHG sources, then sources holding early reduction credits could offset some of their regulatory control requirements with these credits, and other sources presumably would need to meet higher standards to satisfy the Kyoto budget. However, this is a less straightforward way to implement an early credits program.)
One proposal that sharply differs from the early reduction credit mechanisms summarized in the previous paragraph is a proposal put forward by four researchers at Resources for the
Future in 1999 (see the report by Kopp and co-authors in Further Readings). That proposal would establish a mandatory “cap-and-trade” system for GHG control in the United States starting about 2002. This mechanism would operate “upstream,” at the points where fossil fuel
∗
Correspondence to: Dr. Michael Toman, Resources for the Future, 1616 P Street, Washington, D.C. 20036. Phone:
(202) 328-5091, email: toman@rff.org.
1
Resources for the Future Parry and Toman supplies enter the energy system. A national emissions budget would be allocated by auctioning allowances rather than tying credits to project-specific investments.
In this report, we discuss the potential performance of these various early reduction proposals. To do this, we consider first the economic efficiency of the different mechanisms.
Proponents of early reductions claim that such programs can generate net benefits by increasing total emissions control over time, thus further ameliorating climate change. Another claimed efficiency benefit is the possibility of promoting technical progress in emissions control through
“learning by doing”: by starting emissions control before 2008, it is asserted, individuals in the economy are stimulated to accelerate the use of lower-emissions technology, thus lessening unwelcome commitments to less efficient technologies and lowering the cost of meeting the
Kyoto targets.
Proponents also have advanced institutional and political arguments for early reduction programs. One argument is that by starting early to design and test the institutions of GHG emissions trading in the United States, valuable experience is gained that can be used to refine the regulatory approach. Proponents of voluntary early credit approaches also point to potential political benefits: if a broad cross section of business, environmental groups, and others could come together behind such a program, it would provide some political impetus for more ambitious goals, including eventual ratification of the Kyoto Protocol. Another component of this argument is the interest in providing a “safe harbor” for those businesses and other organizations that have made early investments in curbing GHG emissions and fear that they will be held to even higher standards by future regulations. Under early credit systems, these investments would be rewarded.
We find that the economic efficiency benefits of early reduction programs are ambiguous and very much connected to the design of the program as well as to the potential costs and benefits of GHG control. Under plausible assumptions, an early credit program may lead to costs from early reductions in excess of environmental benefits. On the other hand, early creditearning activity may be minimal because of uncertainty surrounding the future of the Kyoto
Protocol. A cap-and-trade approach has a greater economic potential than early credits because a clear regulatory target can be established for overall emissions control and because fewer problems arise in establishing and implementing baselines for the awarding of early credits. A cap-and-trade approach also avoids some adverse fiscal problems associated with early reduction credits.
2
Resources for the Future Parry and Toman
The economic case for early reductions would be stronger if the Kyoto Protocol were to be amended to allow low-cost early emissions reductions to be banked for use during 2008-2012.
This could produce very substantial cost savings by allowing firms to smooth abatement over time, but it would not increase the overall amount of abatement.
Either early credits or early cap-and-trade can generate additional benefits from technical advance through learning by doing. However, we expect that these benefits will be modest.
Finally, the purported political and institutional advantages of early reduction programs likely are overstated.
OPERATION OF EARLY REDUCTION PROGRAMS
To evaluate the potential economic benefits of early reductions, we must consider how early reduction programs would operate. We consider first an early reduction credit system. In this system, an eligible individual GHG emitter would invest in reducing emissions below some business-as-usual level to garner credit for the reductions. The credits would be an asset whose expected value is equal to the expected value of a GHG permit when and if the Kyoto Protocol is implemented. The incentive to invest in such as asset will depend on this expected value and on the cost of creating the asset through early reductions.
The cost of early reductions depends on the various factors influencing domestic GHG abatement possibilities: the degree of substitutability of lower-carbon and higher-carbon fuels, the degree of substitutability of energy and other inputs (for businesses and consumers, for example in driving), and the degree to which energy markets are distorted (for example, inefficient subsidies make the economic cost of GHG control lower). The volume of early reduction credits awarded, on the other hand, depends on how the regulatory baselines for credits are defined and what rules for participation are established, as well as the expected future value of credits and the costs of GHG control. In this respect, early domestic credit programs are much like the Kyoto Protocol’s Clean Development Mechanism for generating GHG reduction credits through GHG-reducing project investments in developing countries. The volume of credits will be more limited if eligibility is limited (for example, to only a few sectors in the economy), or if stringent rules for defining GHG reductions relative to business as usual are used. The latter would be reflected in, for example, assumptions of substantial improvements in energy efficiency even without an early reduction program.
It should be noted that, in this approach, the awarding of early reduction credits reduces the total emissions budget available to others in the Kyoto commitment period. Unless the
3
Resources for the Future Parry and Toman economy as a whole can bank early reduction credits, which is not allowed now under the Kyoto
Protocol, the economy’s total emissions budget in the commitment period is fixed. Moreover, except for the possibility of changes in the capital stock, for example, additions to the knowledge stock through learning by doing (see below), the awarding of early credits will not alter the market price of a GHG permit in the commitment period. All that early credits do is alter the distribution of the economy’s emissions budget in favor of those engaging in early reductions.
This observation has important political implications, as we discuss below.
A cap-and-trade program would operate quite differently than an early credit system. It would be a mandatory program that establishes an emissions target for the whole economy and then allocates responsibility for meeting that target to various individual actors. The upstream approach of Kopp and co-authors mentioned in the Introduction would require permits based on the carbon content of fuels for domestic suppliers and importers. (In practice, the program would regulate oil inputs to refineries, sales by coal suppliers, and deliveries of natural gas into the pipeline system; GHGs other than CO
2
would be added on a case-by-case basis). This proposal also would auction GHG permits, raising revenue for the government that could be used to reduce other taxes in the economy and provide some transitional assistance to those parts of the economy most adversely affected by GHG controls. GHG cap-and-trade programs also could be established “downstream,” at the point of emissions (for example, from a power plant), and they could involve permits issued at no charge rather than by auction, but these options are less efficient (see the papers by Fischer, Toman, and Kerr in Further Readings).
However the cap-and-trade program is implemented, the value of emissions reduction would depend on the incremental cost of reducing emissions in the early reduction period, not on the expected value of an emissions permit in the commitment period. (This assumes that early reductions cannot be banked for use in the commitment period, consistent with the Kyoto
Protocol.) This incremental cost depends in turn on the stringency of the (mandatory) economywide early reductions target. This makes the implications for economic efficiency of cap-andtrade quite different from those of an early credit system. Moreover, the cap-and-trade approach does not require the development of rules for project-specific assignment of credits.
ECONOMIC EFFICIENCY BENEFITS OF EARLY REDUCTIONS
A recent paper by Parry and Toman (see Further Readings) examines the potential efficiency of early reduction programs under different assumptions about abatement costs and environmental benefits. We summarize the results of their analysis here. The figures presented below are not the result of a detailed economic cost-benefit model. Rather, they derive from a set
4
Resources for the Future Parry and Toman of simple numerical simulations that provide plausible orders of magnitudes for the costs of early reduction and the resulting benefits. We first consider the relationship of abatement costs to environmental benefits from early reductions. We then add in the possible benefits from learning by doing. Finally, we consider the potential value of early abatement if credits could be banked and used in the Kyoto commitment period.
Abatement Costs and Environmental Benefits
Environmental benefits are taken to be the present value of future damages avoided as a consequence of slowing down global warming. These benefits are highly uncertain; accordingly,
Parry and Toman consider a range of values from $5/ton of carbon emissions reduction to
$100/ton. These figures do not include the potential “ancillary benefits” of early GHG reductions as a result of reductions in conventional pollutants, which also are uncertain. Burtraw and Toman
(see Further Readings) suggest that the ancillary health-related benefits from air pollution reduction in the United States could be on the order of $5-20/ton of carbon emission avoided, depending on how the GHG policy is structured. Additional benefits could result from, for example, reduced nitrogen deposition in water bodies.
The incremental cost of GHG abatement and the price of a GHG permit in the Kyoto commitment period also are uncertain. Parry and Toman consider two possible figures: $50/ton and $150/ton. These figures are the incremental costs of the last ton of carbon abated per year in the Kyoto commitment period. Parry and Toman further assume that the incremental cost of the first ton of carbon abated is zero (meaning that the economy contains some “low fruit” in terms of GHG abatement). The $50/ton figure can be interpreted as reflecting either an optimistic scenario for domestic abatement cost or extensive reliance on international emissions trading through the “Kyoto mechanisms” (in particular, use of low-cost emissions credits obtained from
Clean Development Mechanism investments in developing countries and/or acquisition of lowcost surplus emission allowances from Russia). The $150/ton figure is correspondingly less optimistic in regard to these factors.
Using standard figures for future U.S. business-as-usual emissions from the Energy
Information Administration, Parry and Toman peg the total emission reduction required under the Kyoto Protocol as about 30% below business-as-usual emissions. To simplify the analysis, they assume that the incremental cost of GHG control before the commitment period is proportional to the incremental cost during the commitment period. Under this assumption, the
5
Resources for the Future Parry and Toman total volume of early reductions under an early credit program is about 23% of business-as-usual assumptions under either the lower or higher abatement cost scenario.
Table 1 summarizes the results of the calculations of net benefits under different assumptions for the size of abatement costs and environmental benefits (avoided future climate damages). The figures are expressed as percentages of the total abatement cost in the precommitment period. We express the results in this form because, although the absolute magnitudes of benefits and costs depend on the particular assumptions used to generate the scenarios, the relative magnitudes are probably more robust. The key message from Table 1 is that if the cost of GHG control is relatively low (top row of figures), then reductions stimulated by an early credit program are likely to yield net benefits unless the environmental gains are quite low. On the other hand, if the cost of GHG control is larger, then early reductions yield abatement costs in excess of environmental benefits unless the environmental value is very high.
In both cases, the magnitudes of cost or benefit likely run to several billion dollars per year, a significant amount.
Permit price in commitment period
Table 1. Net Benefits from (Unlimited) Early Reduction Credits,
Relative to Early Reduction Costs (fraction or multiple)
Marginal environmental benefits ($/ton)
25 50
50
5
−
.74
.29
1.56
100
4.12
150
−
.91
−
.59
−
.15
.71
Note: Negative entries indicate early reduction environmental benefits less than abatement costs; positive entries indicate early reduction environmental benefits greater than abatement costs.
Source: Author calculations (see text for description).
Our own view is that the higher-cost scenario probably is more representative of what costs will be like under the Kyoto Protocol. (See the paper by Weyant and Hill in Further
Readings for a recent review of different possibilities for abatement costs.) Lower costs would be possible with a longer adjustment period, but the Protocol requires a relatively substantial reduction in GHG emissions in a relatively short period of time. The Kyoto mechanisms could serve to hold down domestic abatement costs; however, that result is not assured, because debate continues over how the mechanisms will be structured, and the mechanisms inevitably will not function as well as theory indicates they might in an ideal world (the paper by Hahn and Stavins
6
Resources for the Future Parry and Toman in Further Readings addresses this issue). In terms of environmental benefits of early reductions, many economists believe these are $25/ton or less, although there is certainly the possibility of much higher values (see the paper by Roughgarden and Schneider in Further Readings). Given the figures in Table 1, it seems that an early credits program could generate costs substantially in excess of environmental benefits. The reason is that emissions abatement under the Kyoto
Protocol is likely to be excessive from a cost/benefit perspective. Because the permit price is
“too high,” this would generate too much early abatement in the pre commitment period (in the absence of limits on total available credits).
A cap-and-trade program offers significant advantages over an early credits system. The early reductions cap can be set at whatever level policymakers think is best, as opposed to having incentives tied to the uncertain implementation of the Protocol. The proposal by Kopp and coauthors accomplishes this by setting a ceiling price, or “safety valve,” for the permit price, which the government would implement by making additional permits available any time the price went above the ceiling (see also the paper by Pizer in Further Readings). This provides the opportunity to avoid excessive early abatement if environmental benefits are seen to be low relative to incremental costs. At the same time, cap-and-trade provides a degree of regulatory certainty in creating incentives for early abatement that is absent in early credit systems; and it avoids inefficiencies that result from the need to undertake project-by-project assessment of early emissions abatement.
The other important advantage of cap-and-trade is more indirect but no less important.
Under cap-and-trade, it is possible to raise revenue through auctioning of permits. This revenue can be used to offset other tax burdens that reduce overall performance of the economy (see also the paper by Parry in Further Readings). In contrast, early credits not only do not raise revenue before the commitment period, they reduce the ability to undertake a “tax shift” during the commitment period because some permits have already been given away to the holders of early credits. Moreover, early reduction credits can “crowd out” government revenues, in the event that future permits are auctioned. Parry and Toman show that this difference in the fiscal implications of the two policy options greatly magnifies the advantages of cap-and-trade.
Although a number of distributional and other political factors enter into the decision to auction carbon permits or distribute them gratis, the cost difference identified here is a major consideration in the relative efficiency of the policy options for early reductions.
7
Resources for the Future Parry and Toman
Learning by Doing
We now turn to the possible advantages of early reductions in stimulating future abatement cost reductions through learning by doing. Parry and Toman consider two scenarios: in one, early reduction brings down the incremental cost of later emissions control by 5%, and in the other, the cost reduction is a fairly optimistic 30%. They also consider different assumptions for how extensively the private sector pursues early reductions out of self-interest (some of the benefits of any one emitter’s learning by doing may spill over to other emitters, but these spillover benefits will be hard to capture in many cases).
Parry and Toman conclude that only a very modest level of early abatement (well under
10% of business-as-usual emissions) is justified by learning-by-doing benefits alone. An early credit program will generate substantially more early abatement, as noted above. Learning by doing benefits offset only about 10-50% of the costs of early abatement, depending on how much the cost of later abatement is reduced. Thus learning by doing on its own is not a powerful rationale for early abatement.
Nationally Bankable Early Credits
Finally, we consider the potential cost savings if low-cost early reductions could be banked at the economy-wide level and used to offset the most expensive GHG reductions required to meet the Kyoto target in the commitment period. Here, total emissions abatement over time does not increase (unlike the case without banking), but abatement is more evenly distributed across time rather than being concentrated in the Kyoto commitment period. If banking were allowed, then early reductions would be undertaken until the marginal cost of early abatement equaled the expected present value of a future emissions permit (because the latter also reflects expected future marginal abatement cost). When this “arbitrage condition” is satisfied, cost savings from banking early reductions are at a maximum and no one has any incentive to undertake further early reduction.
Parry and Toman calculate that the potential intertemporal cost saving is on the order of
40% of the (discounted) cost of meeting the Kyoto target in the commitment period without early reductions. This could amount to several billions, or even tens of billions, of dollars per year depending on the cost of abatement. The size of this potential cost saving underscores an inherent tension in the current design of the Protocol, which only allows banking of early credits generated internationally through the Clean Development Mechanism. The postponement of
8
Resources for the Future Parry and Toman commitments under the Protocol was intended to provide Annex I countries with some transition time to implement their targets. However, given the potential incremental cost of abatement during the commitment period relative to the cost of early reduction, the postponement also creates incentives to seek early banking of domestic as well as international credits.
INSTITUTIONAL AND POLITICAL ISSUES
The figures in Table 1 assume that there are no regulatory limits on early reduction credits and no uncertainty about the implementation of the Kyoto Protocol. The introduction of limits on the total volume of early credits and the recognition of the uncertainty surrounding implementation of the Protocol both imply less investment in early credits (the latter because uncertainty implies a lower expected value of a credit). In light of the discussion in the previous paragraph, such limits on early reduction activity actually could be beneficial under a variety of plausible scenarios.
However, regulatory limits on credits also will create added incentives for different sectors to engage in costly lobbying (known as “rent-seeking” in the economics literature) to ensure favorable treatment under the program, raising the total cost of the program to society.
Such incentives exist even without credit limits, because different sectors can profit from a favorable definition of business-as-usual baselines in the awarding of credits. In addition to lobbying costs themselves, politicking over the rules for early credits could reduce efficiency by favoring costly abatement technologies (seen by proponents as “needing a boost”) rather than allowing early reductions to be undertaken in the most cost-effective fashion possible. These problems are avoided with a cap-and-trade approach to early reductions. For this reason, the argument that early credits provide benefits from testing out mechanisms for full-fledged emissions trading is not persuasive.
Another potential problem of early reduction credits is the difficulty of judging a firm’s business-as-usual emissions against which actual emissions should be compared to award the appropriate amount of credits. This problem arises in connection with “anyway reductions,” abatement that occurs as a result of actions that would be taken anyway to reduce production costs. For example, it might be in a firm’s own interest to adopt a new energy-saving technology.
Parry and Toman show that such “asymmetric information” can generate a modest amount of inefficiency because different firms do not end up with the same incremental cost of abatement.
This problem is avoided under an early cap-and-trade program, because permits are auctioned or awarded on the basis of emissions before the precommitment period rather than on the basis of unobservable business-as-usual emissions during the commitment period.
9
Resources for the Future Parry and Toman
Finally, we return to the potential political benefits of early credits in developing a broader base of support for ultimately implementing the Kyoto Protocol. This could be true in enhancing support among businesses seeking (for perfectly legitimate reasons) both economic advantages and a “greener” image. However, in the absence of economy-wide banking of early reductions, early credit programs essentially are a zero-sum game for emitters: while early actors enjoy the fruits of low-cost abatement that they can bank for use in 2008, other regulated entities must incur higher compliance costs in the commitment period because the total remaining pool of allowed emissions for these actors is smaller. The transfer of gratis permits to holders of early credits also represents in part a transfer of income from households to these credit holders. Given these distributional implications, the ultimate political advantages of early credits may be open to question. Nor is such an inefficient transfer mechanism necessary to provide a “safe harbor” to those who have, for whatever reason, chosen to pursue early action on their own. These actions are not penalized in a cap-and-trade system with auctioned permits or one with gratis allocation, provided permits are allocated based on a historical base year that precedes most early action.
CONCLUDING COMMENTS
Given the political uncertainties surrounding future climate policy in the United States, the fate of any early reduction program also is difficult to fathom. We have suggested that if such a program is to be undertaken, there are strong economic reasons to pursue a modest but mandatory cap-and-trade program rather than a voluntary but less well-targeted and less transparent early credit program. The case for early action is especially strong if permits can be banked at a national level, which is not possible under the Kyoto Protocol. The economic virtue of the mandatory cap-and-trade approach may also be its political weakness, because such an approach makes the cost of GHG control transparent and applies that cost widely throughout the economy. Given recent aversion in the United States to any increase in energy costs, the prospects for such a program in the near term may be doubtful. On the other hand, the political virtue of early crediting also is open to question. Moreover, a real commitment to GHG control in the United States will necessarily require an acceptance of the need for some increases in energy prices; the alternative of a completely “win-win” scenario of GHG reductions with no costs (or even economic benefits) is not plausible, in our view. If this basic acceptance develops, then it is easier to politically rationalize a modestly sized early cap-and-trade program and to put in place more effective regulatory institutions from the start.
10
Resources for the Future Parry and Toman
FURTHER READINGS
General Interest
Burtraw, Dallas and Michael Toman. 1998. The Benefits of Reduced Air Pollutants in the U.S.
From Greenhouse Gas Mitigation Policies. RFF Climate Issues Brief #7.
Fischer, Carolyn, Suzi Kerr, and Michael Toman. 1998. Using Emissions Trading to Regulate
U.S. Greenhouse Gas Emissions: Basic Policy Design and Implementation Issues. RFF
Climate Issues Brief #10.
Fischer, Carolyn, Michael Toman, and Suzi Kerr. 1998. Using Emissions Trading to Regulate
U.S. Greenhouse Gas Emissions: Additional Policy Design and Implementation Issues.
RFF Climate Issues Brief #11.
GAO (Government Accounting Office). 1998. Climate Change: Basic Issues in Considering a
Credit for Early Action Program. General Accounting Office, Document GAO/RCED-
99-23. Washington DC (November).
Hahn, Robert and Robert Stavins. 1999. What Has Kyoto Wrought? The Real Architecture of
International Tradable Permit Markets.” RFF Discussion Paper 99-30. Washington, DC:
Resources for the Future, March.
Kopp, Raymond, Richard Morgenstern, William Pizer, and Michael Toman. 1999. A Proposal for Credible Early Action in U.S. Climate Policy. Online at www.weathervane.rff.org.
Parry, Ian. 1997. Revenue Recycling and the Costs of Reducing Carbon Emissions. RFF Climate
Issues Brief #2.
Pizer, William. 1999. Choosing Price or Quantity Controls for Greenhouse Gases. RFF Climate
Issues Brief #17.
Repetto, Robert. 1998. Designing an Early Emission Reduction Credit System: Efficiency
Aspects. Report prepared for the U.S. Environmental Protection Agency (November).
More Technical
Parry, Ian and Michael Toman. 2000. Early Emission Reduction Programs: An Application to
CO
2
Policy. Discussion Paper 00-26. Washington, DC: Resources for the Future.
11
Resources for the Future Parry and Toman
Roughgarden, Tim and Stephen Schneider. 1999. Climate Change Policy: Quantifying
Uncertainties for Damages and Optimal Carbon Taxes. Energy Policy 27: 415-429.
Weyant, John and Jennifer Hill. 1999. Introduction and Overview. The Energy Journal, Special
Issue: vii-xliv.
12
