by the Congressional Budget Office

“ Some analysts have argued that the regulation of energy markets might not be costly because energy conservation pays for itself. According to that point of view, people fail to use energy efficiently, either because they do not make sensible decisions about energy use or because they are poorly informed, or because they face a variety of market failures or barriers that deter them from making more-sensible decisions or becoming better informed. ”

“ Some research indicates that climate-related uncertainty gives an emissions tax (or fixed-price permit system) significant economic advantages over a system of strictly fixed permits, or allowances. Those advantages stem from two factors: both the costs and benefits of reducing carbon emissions are uncertain, and the incremental costs can be expected to rise much faster than the incremental benefits fall as regulation becomes more restrictive. Because climate change will result only from the long-term buildup of gases over many years, incremental benefits are essentially flat in any given year ”

“ Regulation and Innovation To a great extent, the cost of controlling greenhouse gas emissions and stabilizing atmospheric concentrations will ultimately depend on technological developments over the next century. Innovation that dramatically reduces the cost of producing energy from non-fossil sources or of sequestering carbon dioxide emissions will ease the process of controlling emissions; innovation that tends to reduce the cost of finding, extracting, and using fossil fuels will complicate it. ”

“ A pricing system—of either taxes or fixed-price permits—is therefore likely to constrain emissions more cost-effectively than will a system with fixed limits on emissions. [4]
The Distributional Effects of Regulation Regulatory systems generally create winners and losers, even when the benefits of less pollution are ignored. Balancing the distributional effects of such systems can be more complicated and controversial than balancing their costs and benefits. Economic analysis provides several useful insights about the distributional issues involved in regulating greenhouse gas emissions. ”

“ Proponents of that view believe that the government may be able to regulate energy use and emissions at a net savings to the economy by providing information, overcoming market barriers, and correcting market failures—for example, by including energy-efficiency requirements in standards governing buildings and appliances—and that the resulting energy savings may more than pay for the additional costs of more-efficient equipment. ”

“ One important consequence of that fact is that efforts to restrict emissions may encourage the affected parties to seek regulatory provisions that provide them with tax exemptions or access to permits—that is, they may engage in rent-seeking behavior. For example, fossil fuel suppliers might advocate a system in which they were given emissions permits free of charge —so that they would receive the entire scarcity rent resulting from the emissions limits. ”

“ Carbon taxes fall most heavily on coal, which is composed almost entirely of carbon; they fall somewhat less heavily on petroleum products and least heavily on natural gas because those fuels also contain hydrogen. An emissions tax of $100 per metric ton of carbon equivalent translates to roughly $50 per short ton of coal, 25 cents per gallon of gasoline, and $1.50 per thousand cubic feet of natural gas. ”

“ A higher tax raises more revenues, but it reduces emissions even more; so the income loss rises faster than the tax revenues, and the ratio of revenues to income loss declines. For example, based on the analysis of the potential costs of the Kyoto Protocol by Lasky (forthcoming) , a reduction of 5 percent in U.S. carbon dioxide emissions in 2010 would involve direct costs of just over $1 billion but would raise almost $50 billion in revenues. ”

“ Because of the disparity between private incentives and public benefits, the government may be able to play a useful role by investing in—or encouraging private industry to invest in—basic and applied R&D projects that will yield widespread public benefits. However, constraints on emissions would tend to enhance private incentives to undertake such projects and weaken that rationale for government-sponsored research. ”

“ The Energy Modeling Forum, in a 1996 report, offers a comprehensive discussion of the difficulties of identifying and measuring market failures and barriers in the energy sector.↑ In recent years, the U.S. government has tried to restrain the growth of emissions through a system of voluntary programs that attempt to identify opportunities for low-cost or costless emissions reductions and to promote them in the private sector. ”

“ And many firms and workers in the energy sector—coal mine operators and miners, oil companies, and electricity producers that rely on fossil fuels for generation—would bear a disproportionate burden in lost profits and wages. ”

“ Consumers Bear Most of the Direct Costs in the Long Run Producers who are required to pay a tax will not necessarily bear the burden of the tax if they can pass it on to others. Characteristics of the markets for fossil fuels would enable producers to pass on most of the costs of emissions taxes—or the burden of higher prices under a permit system—to consumers. ”

“ Nevertheless, governments may be able to intervene in some circumstances—for instance, by setting standards in markets in which reliable product information is hard to obtain or in situations in which specific regulatory failures may constrain businesses and households from making the most cost-effective capital investments. Economists find it difficult, however, to determine the circumstances in which standards clearly induce people to reduce their use of energy at no cost or with net savings. ”

“ A permit system would be more appropriate than a tax system if the unit cost of reducing emissions was relatively constant while the incremental damages from emissions increased very quickly with rising emissions levels. ”

“ For instance, carbon emissions from fossil fuels could be partly offset by paying landowners to plant trees to absorb and sequester carbon, thus reducing net emissions. Some tree planting is already supported for other purposes, such as soil conservation, and expanding those policies would be relatively straightforward. However, for the purposes of carbon sequestration, such policies are complicated by issues that do not arise in regulating fossil fuels. ”

“ Ancillary Benefits of Greenhouse Gas Restrictions By reducing the use of fossil fuels, restrictions on greenhouse gas emissions would also reduce emissions of other pollutants such as sulfur dioxide from coal burning and nitrous oxide from automobiles. ”

“ Although energy markets do not necessarily function with textbook perfection—for instance, energy use produces pollution, the electricity distribution system is largely composed of regulated monopolies, and the electricity industry remains heavily regulated—neither are governments always able to correct energy market failures without imposing other costs that offset or even exceed the savings that the corrections might achieve. ”

“ However, emissions tax revenues would generally be greater than policy-induced increases in government expenditures and revenue losses from other taxes, so net government revenues available for redistribution would rise.↑ Regarding auctions of permits for greenhouse gas emissions, Crampton and Kerr (1998) show that a standard ascending-clock auction is the most effective system to ensure that all bidders pay a uniform price that reflects the market value of the standard emissions permit. ”

“ Another CBO study, published in 2002, discusses the relative merits of different approaches to regulating gasoline consumption, including a carbon tax.↑ In technical terms, price controls dominate when the marginal cost curve is steep or very uncertain and the marginal benefit curve is flat; quantity controls dominate when the marginal cost curve is flat or well understood and the marginal benefit curve is steep. ”

“ Regulations Impose Costs Regulations come with a price: one way or another, someone ends up paying for the environmental benefits they may generate. Households and firms, for instance, may have to make do with less energy, paying higher prices either directly or indirectly (in the form of lower wages, salaries, and profits) —or both. ”

“ Moreover, emissions controls are likely to induce more innovation if they exact a payment from emitters, as emissions taxes and auctioned permits do. In contrast, companies would have less incentive to innovate under a system of freely allocated permits—and even less under a command-and-control regulatory system. ”

“ The relative ease of regulating energy-related emissions contrasts with the difficulties of regulating emissions from most other sources, particularly the substantial fraction that originates from forestry and farming. Because those other emissions come from many different kinds of mainly small sources under highly variable conditions, they tend to be much more difficult to track and measure. ”

“ These points are true for any sort of regulation, but they are particularly applicable to climate change policy because greenhouse gas regulations could involve so much money. The United States alone emits roughly 1.5 billion metric tons of carbon annually, so every dollar of tax per mtc would raise up to $1.5 billion per year. A carbon tax of $100 per mtc would raise about 15 percent as much revenue as the individual income tax and nearly 80 percent as much as the corporate income tax. ”

“ Distributional Effects Depend on How the Government Regulates Emissions Under a system of taxes or auctioned permits, the government would receive revenues, and it could redistribute some of them in various ways—by cutting other taxes, reducing government debt, or funding new programs. ”

“ However, the programs have not been very successful in controlling emissions. For example, the Climate Change Action Plan developed in 1993 by the Executive Office of the President projected that voluntary programs would nearly stabilize U.S. greenhouse gas emissions at 1990 levels in 2000. (The plan is available at www.gcrio.org/USCCAP/toc.html.) In fact, emissions were roughly 12 percent higher in 2000 than they had been at the beginning of the decade. ”

“ Moreover, demand for fossil energy is fairly inelastic because currently there are few cheap, plentiful substitutes for it. Inelastic demand and elastic supply together imply that energy producers can pass on taxes to consumers.↑ The Department of Energy (1997) notes that those four industries accounted for about 22 percent of manufacturing gross product originating in 1994 but 78 percent of manufacturing energy use. ”