National Academies Press: OpenBook

Limiting the Magnitude of Future Climate Change (2010)

Chapter: 4 Crafting a Portfolio of Climate Change Limiting Policies

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Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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CHAPTER FOUR
Crafting a Portfolio of Climate Change Limiting Policies

Reducing the threat of climate change will require providing the right incentives for behaviors and investments that drive a transition to a low-greenhouse-gas (GHG) emissions economy. One means of doing so is to create price signals that reflect the costs associated with GHG emissions. The pricing instruments most commonly considered, carbon taxes1 and cap-and-trade programs, both create incentives that are compatible with cost-effective reduction of GHG emissions.2 It is our view that a pricing policy, properly designed, is essential for creating broad incentives for emissions reductions; but evidence suggests that pricing alone will not be sufficient to achieve the necessary emission reductions (Fischer and Newell, 2008; Goulder and Parry, 2008), and carefully tailored complementary policies will be needed to address shortcomings in a pricing system.


In this chapter, we first describe the common design features of carbon-pricing schemes, including the scope of gases and emission sources covered, the points of control, how revenues can be used, and how pricing can be enforced. We then discuss how certain design choices can dilute or undermine the effectiveness of a pricing strategy, and why even a well-designed pricing strategy will have limitations that restrict the timing and scope of its effectiveness. We then identify the crucial targets of opportunity for future reduction of GHG emissions and identify a series of possible complementary policies targeted at those opportunities. Finally, we discuss the challenges of integrating these different policies into a cohesive whole. This chapter focuses primarily on national-level policy responses. The important role for state- and local-level policy responses (in relation to federal policy) is discussed in Chapter 7.

1

As noted earlier, we treat the terms “carbon price” and “carbon tax” as synonymous with the more general terms “GHG price” and “GHG tax,” as they are in most instances applied to multiple gases.

2

As discussed later in this chapter, it is possible to use both instruments simultaneously in a hybrid system.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

PRICING STRATEGY DESIGN FEATURES

Carbon taxes and cap-and-trade polices are usually discussed in terms of their differences, but many of the same design questions need to be resolved for each. Some of the key questions are discussed below.

The Scope of Coverage

Cap-and-trade policies that cover only CO2 may be administratively convenient, but they do not represent the best long-term solution. The Kyoto Protocol, for example, identifies six GHGs, which can be included in a single pricing system by translating them into CO2 equivalents. In practice, this is accomplished using global warming potentials (GWPs), defined as the cumulative radiative forcing effects of a unit mass of gas relative to CO2 over a specified time horizon (commonly 100 years). Including multiple gases under a single cap has the advantage of significantly reducing the cost of reaching a specific concentration target (Reilly et al., 1999; Weyant et al., 2006). Disadvantages include controversies over whether GWPs are an appropriate metric to account for the differing impacts among GHGs, and the fact that some types of GHG emissions (e.g., those stemming from land-use and agricultural practices) are quite difficult to monitor.


For maximizing GHG emissions reductions at minimum cost, more universal coverage is better. Yet no existing program involves universal coverage of GHG sources. As two key examples, the Regional Greenhouse Gas Initiative (RGGI) in the Northeast covers only large power generators, and the European Union Emissions Trading Scheme (EU ETS) covers only power generators and combustion installations, production and processing of ferrous metals, pulp, and paper, and some mineral industries such as cement (and for each sector, only facilities over a specified size are typically covered); in addition, aviation will be covered starting in 2012.


Extending coverage beyond these typical sectors does present challenges. Omitting non-CO2 GHGs and emissions and sequestration in the agricultural and forestry sectors is generally motivated by concerns about political feasibility, impressions that sequestration is a means of avoiding needed emissions cuts, and uncertainties in the magnitudes of potential reductions from particular sectors. In addition, smaller sources may face unreasonably high transaction costs in complying with a one-size-fits-all program. Below we discuss how these challenges can be addressed through the proper design of pricing mechanisms and how offsets can be used to address some sources not directly covered in a cap-and-trade policy.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

Targeting the Control Responsibility

In general terms, the choices for applying controls (i.e., who is assigned the cap) include upstream targeting, downstream targeting, or a hybrid involving some combination of the two. In an upstream point of regulation, allowances are surrendered at the point of extraction, production, import, processing, or distribution of substances that (when used or combusted) result in GHG emissions. This approach was originally developed with fossil fuels in mind, but it could be extended to other gases. A downstream point of regulation would focus control on the point of emission into the atmosphere (power plants, cars, etc.).


An upstream approach controls emissions indirectly rather than directly. For example, energy suppliers would either have to employ technologies to reduce the carbon in their fuels or buy allowances to cover what remains. Since fuels with high-carbon content would need relatively more allowances per BTU of energy, they would experience a relative increase in their cost—an increase that would be passed forward to consumers. This higher cost of energy in general would promote greater investments in energy efficiency, and the relative price increase for high-carbon fuels would promote some substitution of fuels with lower carbon content.


Because it involves monitoring fewer parties, an upstream approach would likely have lower administrative costs. However, it would necessitate a system for rebating fees for feedstocks that are not combusted and therefore do not become GHG emissions (such as oil used for lubrication) and for combustion gases that are captured and sequestered rather than emitted. Like so many other design choices, the point of regulation is not necessarily an either/or choice. Hybrid strategies, involving upstream control of some sources and downstream control of others, are also possible.

Allocating Entitlements

Both tax and cap-and-trade policies control access to the use of the atmosphere as a repository for emitted GHGs. When this access is limited, the access rights become very valuable, and the initial allocation of these rights can advantage certain groups. To whom, and under what terms, should this value accrue?


Both tax systems and auctioned cap-and-trade systems force users to pay for that access. This approach generates revenue—in the case of GHG control, a considerable

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

amount of revenue.3 The implicit logic behind this approach is that the atmosphere belongs to all the people and the wealth created by allocating scarce access rights should be returned to the people or used for public purposes. This is the approach taken by the RGGI program, in which all participating states are auctioning at least the majority of allowances. The alternative is to gift some or all of the allowances to parties based upon some eligibility criteria (e.g., allocations to firms with best practices in an industry, actual historic emissions, or even allocations targeted directly to households).


There can be strong political motivations to give away (gift) emissions allowances, as this offers a way for policy makers to gain support from particular industries or constituencies who would otherwise strongly oppose a carbon pricing system. Research strongly suggests, however, that use of revenue-raising instruments (either taxes or auctioned emissions allowances) is more economically efficient than gifting.4 This efficiency advantage results from a balance between two effects: a “tax-interaction” effect that intensifies preexisting market distortions and thus reduces general welfare, and a “revenue recycling” effect that mitigates preexisting market distortions and thus increases general welfare (Goulder, 1997). When the second effect is larger than the first, it can produce a “double dividend”—environmental benefits, and the welfare gained from revenue recycling.


Distributional biases can also occur with revenue-raising instruments (Parry et al., 2006). As discussed further in Chapter 6, the cost burden from a gifted cap-and-trade system (where the allowances are given directly to firms) is strongly regressive; that is, it is borne disproportionately by lower-income households (Chamberlain, 2009; Dinan, 2009).5 This is due in part to the inherently regressive nature of the policy, and in part to the fact that gifting to firms allocates the value to the shareholders of the gifted companies (who are generally in higher income brackets). Gifting allowances directly to lower-income households diminishes the regressivity.


The experience in the EU ETS has enriched our understanding of the dynamics of gifting allowances to firms. Empirical evidence has demonstrated that, in deregulated electricity markets (mainly the United Kingdom, the Netherlands, Germany, and the Nordic countries), allowances that were gifted to electricity generators allowed those

3

At $30 per ton, current emission rates of ~7,077 million metric tons of CO2-eq per year (supplied by the Energy Information Agency) would yield annual revenue of $212.3 billion.

4

This analysis compares efficient policies. The comparison may not hold if the polices in question are riddled with exemptions or exceptions.

5

These analyses are generally based on an implicit assumption that the United States alone is taking mitigation measures. A broader global market would affect energy prices internationally, which would in turn influence the distributional burden on the poor.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

parties to capture the full value of these allowances without incurring any cost, resulting in what has become widely perceived as “windfall profits” (Sijm et al., 2006).


The Congressional Budget Office (CBO, 2009) estimated that, in a scenario where emissions were reduced by 15 percent and all of the allowances were distributed free of charge to producers in the oil, natural gas, and coal sectors, the value of the allowances would be 10 times the combined profits of those producers. The windfall gains received as a result of the free allocation would far outweigh the loss in sales that might be experienced when consumers cut back on use of fossil fuels (Dinan, 2009). This finding has the important implication that, even if it is deemed politically necessary to gift some allowances (for instance, to reduce the trade vulnerability of certain energy-intensive industries), it can be accomplished with a relatively small proportion of the total value.

Using Funds from Taxes or Auctions

The distribution of revenue from auctioned allowances or carbon taxes can, in principle, enhance policy efficiency or help reduce the regressive financial burden of emissions-reduction efforts. Those benefits, however, depend upon what is done with the revenue. Evidence presented by the CBO suggests that rebating the funds back to households (on a per capita lump-sum basis) converts the regressive policy associated with gifting allowances to firms into a progressive policy. That evidence also suggests that a rebate to households is more progressive than reducing the payroll tax and much more progressive than reducing the corporate income tax (Dinan, 2009). Focusing exclusively on distributional goals and returning all revenue to households requires a trade-off with the efficiency gains from reducing distortionary taxes (Dinan and Rogers, 2002). Some recent work, however, suggests it is possible to do both while still protecting vulnerable industries. Goulder et al. (2009) suggest, for example, that vulnerable industries could be protected by gifting 15 percent or less of the allowances and auctioning the rest to raise revenue for pursuing the distributional and efficiency goals.


Competition from other uses of tax or allowance revenues is inevitable. To name a few:

  • Energy-intensive, trade-vulnerable firms may seek financial rebates as protection against competition from foreign firms that are not subject to control of GHG emissions.

  • States running their own cap-and-trade programs will seek to replace funds lost if a federal preemption results in the demise of these programs (and in the

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

funding dedicated to promoting energy efficiency and renewable resources that states have raised from auctions).

  • Negotiators seeking to bring developing countries into a binding international agreement will be looking for funds to facilitate the transition.

  • Federal departments charged with promoting new technologies or strategies will be looking for funds for research and development (R&D), for startup incentives, and for demonstration projects.

  • Funds from GHG control are tempting to use as incentives as Congress tries to build coalitions of legislators to ensure the passage of climate change legislation.

  • Other public issues such as health care may seek sources of funding, based on the rationale that climate change does affect health.

The Impact of Design on Allowance Prices

Estimating the costs and benefits of a program to limit GHG emissions is difficult because it depends on many factors that are unknown or uncertain at the time the estimates are produced and because it depends on specific characteristics and assumptions in the models being used to produce the estimates (e.g., the degree of aggregation or the handling of technical change). Estimates from the literature may vary significantly simply because the models used to derive the estimates have differing assumptions about underlying policy packages.


As discussed later, future allowance prices can be lowered by implementing complementary policies, for instance, policies that lower the demand for energy through efficiency measures, that increase low- or zero-carbon energy supplies, that allow offset credits for reductions not covered by the cap, and that promote the early introduction of carbon capture and storage (CCS). Lower allowance prices can have the advantage of lowering the financial burden on businesses and households,6 and limiting the potential competitive disadvantages and resulting emissions leakage if other countries do not follow suit. However, the disadvantage is that lower allowance prices may delay investment in more expensive, low-emitting, new technologies simply because the value of the emissions saved is too low to justify the investment.

6

As discussed later, lower allowance prices may not always reduce the burden on firms and households; if the costs associated with complementary policies are high enough, they can more than offset the advantages from lower allowance prices.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

The Role for Offsets and Offset Tax Credits

Offset credits reflect emissions reductions for sources that are not covered by the cap or not included in the base of a GHG tax but which can be credited against the cap or tax base by the acquiring party. Offsets (or offset tax credits) can perform several useful roles. First, by increasing the number of emissions-reduction opportunities, they lower the cost of compliance. Second, they extend the reach of the tax or cap by providing incentives for reducing sources that are not directly covered.7 Third, because offset credits separate the source of financing reductions from the source that actually provides the reduction, they can help secure some reductions using capital that, for affordability reasons, might not otherwise be mobilized for this purpose. Both extending the reach of the cap and offering financing may be crucial for ensuring that meaningful reductions take place in developing countries.


Some emissions sources are difficult to include directly within a pricing system. For example, fugitive emissions (arising from leaks during the processing, transmission, and/or transportation of GHGs) are very difficult to monitor and, hence, enforcement based on actual emissions would be very difficult. In these cases, offset credits can be used to secure reductions from specific projects where the reductions can be monitored and validated (i.e., projects that are capable of securing certifiable reductions). When certified, these credits can then be used by acquiring entities as one of the means of meeting their cap obligation or reducing their tax base.


Potentially the most serious problem facing offset certification is demonstrating compliance with the “additionality” requirement. An emissions reduction is considered “additional” if human-caused emissions of GHGs from that source are reduced below what would have occurred in the absence of the offset activity. In practice, that is not a trivial determination, and it often requires consideration of factors such as financial motivation and regulatory context for an activity. There is an inherent tension between the need to hold transaction costs down and the need to provide assurance that the credited reductions are real and additional. Putting considerable effort into establishing a baseline and verifying reductions is important but costly. As the transaction cost associated with certifying offset projects rises, their profitability, and hence their supply, falls. This was the case in the early U.S. Emissions Trading program for SOx during the 1970s and 1980s (Dudek and Palmisano, 1988; Hahn and Hester, 1989).


Internationally, the Clean Development Mechanism (CDM) under the Kyoto Protocol is the largest forum for the development and use of offsets, known in that program

7

Current examples from RGGI include credits for reducing methane from landfills or for the additional carbon absorption resulting from a reforestation effort.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

as certified emission reductions (CERs). The CDM provides a useful example of how an offset program can work in practice. Despite continued concern over transaction costs (Michaelowa and Jotzo, 2005), the CDM has stimulated a considerable amount of investment. As of April 2009, it had registered some 1,596 projects resulting in over 280 million tons of emissions reductions as CER credits. By the end of 2012 it expects to have issued CERs of more than 1.5 billion tons.8


The CDM program also illustrates some sources of controversy associated with offsets, including the types of projects being certified (an alleged overemphasis on non-CO2 gases), the skewed regional distribution of CER activity (with China, India, South Korea, and Brazil creating more than 60 percent of generated credits), and the amount of subsidy being granted (with actual emissions-reduction costs being well below the price received for a CER) (Wara, 2007). Another more global concern is that the CDM creates adverse incentives for host countries to pursue reductions on their own (i.e., developing counties may well hesitate to undertake projects on their own, as long as they can get someone else to pay for them through CDM) (Hall et al., 2008).


Controversies about the validity of CDM credits outside the range of domestic monitoring have led to resistance to the blanket use of nondomestic offsets (Wara, 2007). Yet the large potential impact of these offsets on allowance prices and compliance costs has created pressure for some middle ground, where international offsets are used, but only in a controlled environment where their validity can be ensured. Several types of approaches are available in this regard.


One approach for ensuring that actual domestic reductions are sufficiently high is to restrict the use of offsets (either domestic or foreign) to some stipulated percentage of the total required allowances.9 Disadvantages of this approach are that it raises compliance costs and fails to distinguish between high- and low-quality offsets. A second approach is based on distinguishing between offset types; that is, programs are open to high-quality offsets, but not to low-quality offsets. A U.S. program following this approach would need to establish eligibility criteria to identify which offset types are acceptable and to not allow those that do not meet the criteria (Hall et al., 2008). A third approach is to discount the amount of emissions reduction per offset (or the allowance price) to provide a margin of safety against uncertainty in the magnitude of the reductions that may result from this offset project. Discounting can specifically

8

The official data can be found at http://cdm.unfccc.int/index.html (accessed April 28, 2009).

9

In the RGGI, for example, CO2 offset allowances may be used to satisfy only 3.3 percent of a source’s total compliance obligation during a control period, though this may be expanded to 5 percent and 10 percent if certain CO2 allowance price thresholds are reached. Although the intention to allow limited use of CDM credits has been stated, to date the specific rules for allowing those credits remain unspecified.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

address concerns such as permanence, additionality, and leakage (Kim, 2004; Smith et al., 2007). A fourth possible approach is to allow offsets for specific countries that fulfill monitoring and certification requirements but to explicitly phase out those offset credits over time, to prevent the offset opportunity from creating incentives against acceptance of an emissions cap by the host countries. See also the discussion of offsets in Chapter 2, which raises the idea that a heavy reliance on international offsets could possibly result in needs for additional compensation to the seller countries.


Offsets can thus play a useful role both in lowering costs and in involving international participants, but it must be a carefully circumscribed role with effective oversight or else the liberal use of offsets could reduce the likelihood that GHG reduction goals will be met. Putting considerable effort into establishing an appropriate baseline and verifying reductions is costly; this cost creates a tension between the desire to increase the supply of offsets and the desire to ensure the environmental integrity of the program. Furthermore, using widespread offsets to lower the GHG price can delay the development and use of some new low-emission technologies that can only be justified at higher prices. Finally, a number of practical implementation concerns raised by offsets are described in Box 4.1.

COMPARING TAXES WITH CAP AND TRADE

As discussed above, many aspects of designing polices to put a price on GHGs are similar for both a tax and a cap-and-trade policy. Those similarities, however, should not obscure the important differences that exist as well, as summarized below.

Linking to the Existing System

The United States has considerable experience with cap-and-trade programs that goes back to the mid-1970s, including the highly successful sulfur allowance program (Ellerman, 2000; Tietenberg, 2006). It does not have similar experience with using taxation to control pollution, but it does have considerable experience with (and infrastructure for) levying taxes in general.


Generally the targets for environmental policy are stated in quantity terms (concentration or aggregate emissions limits). Meeting quantity limits is easier with a cap-and-trade policy than with a tax policy, simply because the cap can be set equal to the aggregate emissions goal, but the price that would achieve that goal is not known in advance and can only be approximated.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

BOX 4.1

Offsets: Practical Implementation Concerns

In order to be credible, offsets must be real, additional, quantifiable, verifiable, transparent, and enforceable. Guaranteeing these properties requires establishing an administrative system with several key elements, discussed below.

Certification standards. Offsets can be reviewed on a case-by-case basis (generally the approach taken for CDM projects under the Kyoto Protocol) or they can be subject to uniform performance standards by sector (for example, the Climate Action Reserve has protocols for sectors such as urban forestry, livestock, and landfills). The best strategy may be a hybrid approach that relies on the development of standardized protocols but maintains a significant amount of regulatory oversight of individual projects. This is the approach California is considering in the design of its offset program. This approach is also recommended by the Offset Quality Initiative, a joint program of nonprofits involved in the development of climate change limiting policy.

Certification process. Who should be responsible for certifying or verifying the credibility of offsets? The CDM relies on independent third-party verifiers called Designated Operational Entities; the RGGI also uses independent verifiers, while the California Climate Action Registry has adopted its own protocols for verifying offsets. Alternatively, the certification could be done by a federal agency such as the Environmental Protection Agency (EPA). An advantage of relying on independent verifiers is that many have already developed significant expertise; however, a disadvantage is that the government has less control over independent entities engaged in certification.

Enforcement. Because the establishment of a well-functioning program to oversee offsets will be complicated and highly technical, Congress may need to delegate authority to decide precisely how to design an offset program to an administrative agency such as the EPA. This agency will need the authority to investigate, subpoena records from, and penalize entities that violate the rules of the offset program, including any third-party independent verifiers, developers of projects used for emissions reduction, and regulated entities seeking to use offsets to meet their regulatory obligations. In addition, Congress should consider including a citizen suit provision within cap-and-trade or tax legislation, allowing individuals to enforce the offset provisions against violators.

Staffing and financing. The verification of offsets is likely to be a labor-intensive process. It is vital that the regulatory authority have the personnel necessary to ensure the integrity of the program. Without adequate staff, the entire credibility of a cap-and-trade program that contains offsets could be undermined. Congress may wish to consider imposing a fee on applicants for offset project approval sufficient to cover the administrative costs of oversight.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

While a few carbon tax systems exist in Europe, most existing GHG control programs (e.g., the Kyoto Protocol, the EU ETS, and the RGGI) are based on a form of cap-and-trade policy. A U.S. national cap-and-trade program could integrate with existing systems (eventually permitting allowances to be traded between programs).10 Assertions that a tax system could not be similarly integrated, however, are not merited. For example, in a carbon tax system, Certified Emission Reductions from the CDM could easily be authorized to serve as tax offsets, and U.S. firms could sell offsets to international buyers. Trading allowances, however, would have no counterpart in a tax system.


Supporters of cap and trade point out that the existence of an active carbon market could serve as a considerable lure for developing countries. These countries would almost surely be net sellers in a global carbon market and could expect to earn substantial profits from abating emissions and selling allowances. Meanwhile, because advanced economies like the EU and the United States can set the terms of access to their own markets, they would have considerable leverage to persuade those other countries to take on binding emissions targets.11 An emissions tax provides neither such an incentive nor such leverage (Keohane, 2009).

Policy Stability

One desirable aspect of any GHG pricing strategy is a stable policy platform designed to reduce regulatory uncertainty associated with energy investments. In principle, both a tax and a cap-and-trade mechanism would provide policy stability, but the form differs.12 While a carbon tax fixes the price of CO2 emissions and allows the quantity of emissions to adjust, a cap-and-trade system fixes the quantity of aggregate emissions and allows the allowance price to adjust. In practical terms, this means a cap-and-trade policy provides more certainty that the GHG reduction goal would be met, but it provides less certainty about the costs. Conversely, a tax policy provides more inherent certainty about cost, but less certainty about the resulting emissions levels. The uncertainty over emissions reductions associated with a tax approach can be lessened using the adaptive design features discussed below; however, to the ex-

10

Integration is not trivial. For an expanded exploration of the linkage possibilities offered by cap and trade see, Jaffe and Stavins (2008).

11

Admittedly, these arrangements would probably supersede the CDM, and governments of some developing countries might be reluctant to see such a change. However, the volume of credits under such a system would be much greater than in the CDM, and the great benefits to be received by developing countries would provide incentives for them to accept more credible monitoring and compliance institutions.

12

In practice, initially determined tax rates or caps may be changed by subsequent legislative action, thereby undermining the stability on which this comparison depends.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

tent changes are invoked by that process, the advantage of price stability will be lost. Similarly, more control can be exerted over prices in a cap-and-trade system, but any such intervention diminishes the degree of certainty about the resulting emissions.

Price Volatility and Cost Containment

A tax system fixes prices, and so in the absence of any intervention to change them, price volatility is not an issue. That is not the case with cap and trade, either in principle or in practice. Several cap-and-trade programs (e.g., EU ETS, RECLAIM,13 and the U.S. SOX emissions trading program) have experienced price volatility. Some of this volatility resulted from correctable design defects such as overallocation of the allowances in the first phase of the program, lack of up-to-date information about emissions levels, and a failure to permit allowances in the first phase to be banked for use in the second phase. Although such defects are correctable, that does not mean the issue of price volatility is easily dismissed.


Price volatility can potentially be addressed by coupling a “price collar” consisting of a price floor and ceiling, with an allowance reserve. A price floor (which has been adopted by the RGGI program) would help alleviate investment problems and revenue shortfalls resulting from allowance prices falling to unacceptably low levels. A price ceiling would permit additional allowances to be purchased at a predetermined price set sufficiently high that it would become a binding constraint only if allowance prices exhibited drastic spikes. To prevent these purchases from breaking the cap, they would come from an allowance reserve, established from allowances set aside for this purpose from earlier years, from an expansion in the availability of domestic or international offsets, or perhaps from allowances borrowed from future allocations (Burtraw et al., 2009; Jacoby and Ellerman, 2004; Murray et al., 2009a; Pizer, 2002). One disadvantage of a price ceiling is that it can undermine incentives for developing new technologies that would be justified only by prices higher than the ceiling.

Temporal Flexibility

Both cap-and-trade and tax systems offer options for temporal flexibility.14 For cap and trade, this flexibility is achieved by allowing banking (holding an allowance beyond

13

RECLAIM stands for the Regional Clean Air Incentives Market program of the CA South Coast Air Quality Management District.

14

Murray et al. (2009a) suggest that in a dynamic setting the cap-and-trade policy may have one distinct advantage—an advantage that arises from the unique combination of intertemporal flexibility and foresight

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

its designated year for later use), borrowing (using an allowance before its designated date), or both.15 The economic case for banking and borrowing is based on the additional flexibility it allows sources in the timing of their abatement investments. Flexibility in timing is important because the optimal timing for installing new abatement equipment, or changing the production process to reduce emissions, can vary widely across firms.


Price considerations also argue for temporal flexibility. If all firms were forced to adopt new technologies at exactly the same time, the concentration of demand at a single point in time (as opposed to spreading it out) would raise prices for the equipment, as well as for the other resources (such as skilled labor) necessary for its installation.


Banking also has the potential to reduce price volatility. Storing permits for unanticipated outcomes (such as an unexpectedly high production level, which triggers higher-than-expected emissions) can reduce future uncertainty considerably. Because stored permits can be used to achieve compliance during tight times, they provide a safety margin against unexpected contingencies.


Empirical evidence and experience with existing programs support the idea of allowing banking in any cap-and-trade program (Tietenberg, 2006). The evidence for borrowing is weaker, because it is an uncommon feature in existing programs. A regime that allows unlimited borrowing raises at least one potential concern: that it could reduce flexibility to tighten the cap in cases where new scientific information suggests that doing so is necessary.

Administrative Ease

In general, a cap-and-trade policy and a tax policy require many of the same administrative functions (e.g., defining the goals, monitoring emissions, and ensuring compli-

afforded by markets. Through dynamic market arbitrage, the cap-and-trade system allows any expectations about future benefits, costs, or target modification to be transmitted to markets (and market prices) today. The tax instrument, in contrast, does not automatically respond to changes in expectations. With a tax instrument, even if firms correctly anticipate a higher marginal cost or tax in the future, they cannot arbitrage against this outcome by overcomplying now and banking allowances for use in the future. While taxes (like the cap) can of course be adjusted over time, inefficiently high or low levels of abatement and costs will be experienced during the periods between adjustments.

15

The Corporate Average Fuel Economy (CAFE) standards program also allowed “trading” in the form of carry-forwards and carry-backs, though only within a single company, and the carry-forwards and carry-backs had a limited lifetime. Thus, when gasoline prices fell in the mid-1980s and the domestic auto manufacturers went from exceeding the CAFE standards to falling short, a significant share of the credit carry-forwards they had accumulated expired before they could be used.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

ance). The use of an offset market increases this burden considerably, but this additional burden would be borne by either approach as long as offsets were included. The cap-and-trade policy, however, does have one additional administrative burden: it must create and administer an allowance market. This responsibility includes the establishment of allowance registries to keep track of all transactions and provision of a market where buyers and sellers can meet. These are both familiar functions with strong precedents provided by the sulfur allowance programs and the RGGI, but they do add an additional administrative requirement.

The Role of Uncertainty

A crucial feature of climate change is uncertainty about the costs of emissions abatement—especially for technologies yet to be deployed or developed. As is well established in the economics literature, when marginal costs are uncertain, the relative efficiency of a price instrument versus a quantity instrument (i.e., tax versus cap and trade) depends on the relative slopes of the marginal benefit and marginal cost functions (Weitzman, 1974). This insight has implications for policy instrument choice. On efficiency grounds, a cap-and-trade policy will be preferable when the marginal benefits slope is steep relative to marginal costs. The flatter the marginal benefits slope, the stronger the preference for a tax.


The prevailing view in the economics literature is that the marginal benefits of reducing GHG emissions are likely to be flat, since the damages from climate change are driven by the accumulated concentration of GHGs (e.g., Nordhaus, 2008). This view has been supported by analyses that find a strong preference for a price instrument (Hoel and Karp, 2001, 2002; Newell and Pizer, 2003). The implication is that when marginal costs are quite sensitive to the level of emissions reduction but the damages from climate change are not, a carbon tax is preferred on efficiency grounds.


The conventional wisdom, however, assumes that the effects of climate change increase steadily as a function of atmospheric concentrations of GHGs (as discussed by Keohane, 2009). In fact, growing scientific evidence suggests that climatic responses to temperature increases are highly nonlinear and may well be characterized by thresholds or abrupt changes (see ACC: Advancing the Science of Climate Change [NRC, 2010a]). Incorporating these threshold effects in damage estimates leads to a greater sensitivity of damages to the level of emissions reduction, shifting the preference toward cap and trade. At the very least, the rationale for an emissions tax in the presence of cost uncertainty is on much less solid ground than is usually assumed in conceptual

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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models. More research on this point is needed before one policy instrument can be said to dominate the other on these grounds.

Policy Durability

The United States needs a sustainable policy for limiting GHG emissions—one that can last for many decades. It will not be sufficient to enact a well-designed carbon-pricing policy; it will be necessary as well to maintain that policy despite predictable political pressures to relax it or to create exceptions that undermine policy objectives. This reality is one instance of a generic sustainability problem, in which reforms in the public interest can sometimes be enacted, aided by high levels of media attention. But it is often difficult, when public attention wanes, to prevent those reforms from being undermined or distorted by subsequent special-interest politics. In Chapter 8, we examine historical examples of policy reforms that either proved durable or did not. The lessons to be learned from these examples are that reforms are sustainable when the major players have interests in their continuation; that reforms should be designed to provide incentives to firms to make investments that are contingent on maintenance of the programs; and that, in general, incentives should be aligned in a way that is self-reinforcing.


Both tax and cap-and-trade systems would have some participants seeking to weaken or repeal the system over time. However, a cap-and-trade system allocating allowances with a market value provides clearer incentives for GHG emitters to insist on maintaining the policy framework. Those buying, banking, and selling allowances (as well as entities involved in the infrastructure of the carbon market—brokerage houses, registries, etc.)—are likely to insist on preserving a stable market. Such effects were evident in the experience of the U.S. SOX cap-and-trade market (which was reinforced by the fact that the EPA managed the trading system well and that manipulation of the system was difficult).

Policy Adaptability

Although policy must be stable over time, it must also be flexible enough to incorporate new information. Modifying policy frameworks in the face of new information has precedent, for instance, in the Montreal Protocol: When better scientific information confirmed that more stringent targets were needed, the treaty targets were changed. Yet system modification, if not done carefully, has the potential to undermine incentives that provide the system’s foundation. The stable, predictable prices established

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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by a tax system provide the market security that investors depend on when making long-term investments. Similarly, cap-and-trade systems depend on allowance holders having secure ownership rights to the allowances. When a new understanding of the science makes adjustments in the tax rates or the caps necessary, that security can be jeopardized.


The desire to allow change can be made compatible with the desire to preserve sufficient security for investors by using an adaptive management system and flexible policy instruments (Arvai et al., 2006). In an adaptive management system, initial programs are designed in a way that allows learning about the impacts of the program; that knowledge is then used to improve subsequent programs. This is especially useful for issues such as climate change, which require many combinations of policies with complex patterns of interaction.


A key requirement is to have a transparent process for dealing with evolution of the system over time. This would include a specification of trigger points for initiating investigation of the need for modification and for invoking the policy change itself. The outcomes of policies should be reviewed on a periodic schedule, and the process for deciding whether (and how) policies are changed, and for enacting needed modifications, should be made transparent to interested parties from the outset.


Suppose, for example, that new scientific evidence suggests the need for further emissions reductions. For a tax system, this means that future tax rates need to be raised. This can be handled by specifying in advance the percent increase in rate to occur as a function of the new emissions reductions needed. Existing estimates of price elasticity in emissions reductions could be used to specify those relationships, and those estimates can be improved over time as more experience is gained. For a cap-and-trade system, a need for additional emissions reductions would simply be met by defining lower caps. The authorized level of emissions for banked allowances and offsets should be unaffected by a change in the cap. Government should not confiscate banked credits not currently in use, because this destroys the incentive to create excess entitlements.16 In general, gifted allowances should be defined as a percentage of the cap, not as a specific number of tons (a system common in fisheries with transferable catch quotas), because this allows the cap to be changed without forcing the government to buy back the resulting surplus allowances (Ostrom, 2002).


The policy mix can also evolve over time. Adjustments might be necessary, for example, because interaction effects among different policies turn out to be more

16

While this proposition may appear to be self-evident, in fact confiscation of banked credits took place in the United States in the early years of the SO2 emissions trading program and in the CAFE Program.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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important than originally anticipated. Midcourse corrections can incorporate the information gained from experience. If current policies are not achieving the desired level of investments in technological innovation or of emissions reductions, then additional policies can be added to the mix, policies can be phased out, or the design of individual policies can be refined. In each case, it is important to have the evaluation and adjustment process spelled out in advance so that all participants understand the ground rules.

Hybrid Options

Many possible forms of policy hybrids exist, some of which are dealt with elsewhere in this chapter. Here we focus on options for hybrid systems that blend cap and trade with tax policies, which can potentially exercise some degree of control over both emissions quantity and emissions price. The use of ceiling and floor prices in a cap-and-trade policy, discussed earlier, could be viewed as one example of this type of hybrid system. Another, quite different, option is the use of cap and trade for some sectors (e.g., electric utilities) and the use of taxes for others (e.g., transportation, and heating fuels).


Yet another hybrid option involves combining a minimum tax on GHG emissions with a cap for trading. This approach was used in the U.S. approach to complying with the Montreal Protocol, where low tax rates were coupled with (gifted) production and consumption quotas; over time the tax rate was raised sufficiently high that the demand for allowances was driven to zero, making taxes the de facto sole policy. When this sort of cap-and-trade system gifts all allowances, it offers the advantage of raising revenue, which can be used in lowering the regressive impacts of the policy, in promoting complementary policies, or for other useful purposes. When allowances are auctioned, however, this advantage disappears. Although the minimum tax lowers the auction price, it does not affect the amount of revenue flowing to the government, because the government is getting all the auction revenue anyway. Another advantage of such a system is that it may provide a means of transitioning to a tax (if that is the desired outcome) in cases when near-term political realities may constrain that option.

Taxes Versus Cap and Trade: Summary

In summary, the panel strongly supports a carbon-pricing system to provide economic incentives for limiting emissions. Either a cap-and-trade policy or a tax policy could work effectively, and each offers advantages and disadvantages, as described above.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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A tax system offers some unique potential advantages such as more price certainty and, for sectors with numerous small emitters, easier administration. Cap and trade, however, has been the option chosen in all recent U.S. national policy proposals, and we see no strong compelling reason to argue that this approach should be abandoned in favor of a taxation system. In fact, we suggest that a cap-and-trade policy would generally be more consistent with the strategies proposed in this report, for several reasons:

  • With regard to economic efficiency, in a tax system, concerns about equity and appeasing certain constituencies are handled by tax exemptions, which generally undermine economic efficiency because exempted emissions are uncontrolled. Under cap and trade, such concerns are handled by gifting allowances, which at a first approximation does not undermine efficiency because one retains control over the level of aggregate emissions.

  • A cap-and-trade system provides greater certainty about quantities of emissions to be reduced, and thus it is directly compatible with a cumulative emissions budget. In fact, the emissions budget is the cumulative cap, and annual increments of emissions reductions would have to conform to this cap.

  • As discussed earlier, a cap-and-trade system that allocates allowances with a market value provides clearer incentives for GHG emitters to insist on maintaining a stable policy framework, thus advancing the goal of policy durability

  • Most countries that have thus far set reduction targets have relied on cap and trade as the main policy mechanism.17 A cap-and-trade system also creates incentives for low- and middle-income countries to institute their own country-wide or sectoral caps to derive revenue from selling emissions allowances in the U.S. market. A U.S. cap-and-trade system would thus be consistent with, and help reinforce, the developing international regime.

COMPLEMENTARY OPTIONS FOR THE POLICY PORTFOLIO

As discussed in the previous section, theory suggests that imposing a sufficiently high market price on GHGs will produce the greatest incentive for innovation and lead to the pursuit of lowest-cost means of emissions reduction across economic sectors (Fischer and Newell, 2008; Tietenberg, 2006). In practice, however, pricing alone is not likely to be sufficient because of two interrelated problems. First, the initial design of the pricing mechanism is likely to have shortcomings that will require remedy over time. Second, market barriers exist that inhibit response to price signals.

17

A few European countries have proposed or instituted carbon tax systems, but generally this is supplementary to the EU-wide cap-and-trade scheme.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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Rationale for Complementary Policies

Political Realities Will Dictate the Initial Design of a GHG Pricing Scheme

The political process may require some pragmatic considerations regarding the timing, coverage, and structure of a pricing system that will make it less than ideal in terms of efficiency and effectiveness. As an example, to soften the impact of pricing on sectors and regions, the cap may be set high and emissions permits may be allocated freely at the outset of a cap-and-trade program or, in the case of a carbon tax, certain sectors and emissions sources may be excluded for a period of time. The liberal authorization of offset purchases or tax credits for GHG-offsetting activities may dilute the cap or limit the impact of a carbon tax regime. Although such concessions may be necessary in order to gain political consensus for bringing about a pricing program, the result may be less effective pricing coverage and/or a slow phase-in period when opportunities for clean energy investments may be lost.

Impracticality and High Cost of Early and Universal Coverage

Difficulties in measuring emissions reductions, uncertainties about economic impacts, and concerns over risks associated with gaming and cheating are likely to make universal coverage of emissions sources and gases unlikely, at least initially. Additionally, the time delays involved in demonstrating and implementing new technologies that will be needed in some cases to respond efficiently to carbon prices may also create practical impediments to achieving public and political acceptance for early and broad pricing coverage. Incomplete coverage of emissions sources and constrained prices can reduce incentives both to purchase emissions-reducing technologies and to engage in emissions-reducing behavior.

Barriers to a Timely and Robust Response to Pricing

Even if pragmatic considerations can be addressed in ways that produce a comprehensive carbon-pricing program, complementary policies may be desirable to bring about a more timely and robust response to pricing. Specifically, complementary policies may be needed to address the following:

  • Weak R&D investment signals. Market signals must be strong and sustained to stimulate the large amount of private investment in R&D that will be needed to further the transition to a lower-GHG economy. Private R&D expenditures

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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will provide the foundation for future technologies, but, as discussed in Chapter 5, recent levels of private-sector energy research funding have been low by historic standards. Initial GHG pricing may not be sufficiently high to incentivize greater private investments, particularly in basic research. Complementary policies may be needed to foster greater interest in such research, until the time when pricing signals reach the levels needed to reward investment risk.

  • Long-term capital investments. Many long-term capital investments (for instance, in the electricity production sector) have lifespans of 50 to 80 years and, thus, can lock in emissions-intensive technologies. Policies to accelerate replacement of existing capital stock (where new technology can yield emissions reductions) would therefore be desirable, but such turnover is less likely to be made if there is uncertainty associated with a carbon-pricing system (i.e., if it may be relaxed or strengthened over time by policy makers).

  • Market failures. The U.S. Department of Energy identified 20 barriers that have inhibited the deployment of technologies with the potential to reduce GHG emissions (Brown et al., 2007; DOE, 2009). Some of these barriers stem from market failures that limit the response to carbon pricing by consumers and businesses. One example is the principal-agent asymmetry barrier (discussed in Chapter 3), which occurs when those subject to the pricing signals are different from those who are capable of responding.

  • Policy failures. Perverse incentives can arise when other public policies undermine pricing signals. This can occur, for instance, with potentially conflicting tax policies, regulatory inflexibilities that limit technology introduction, and legal restrictions on certain behaviors (such as zoning restrictions that limit high-density development along transit corridors) (Brown and Chandler, 2008). Some of these policies may be necessary to achieve other goals (for instance, vehicle safety standards that mandate reinforced roofs and thus heavier vehicles), but their adverse impacts on GHG emissions-reduction goals can often be modified through strategic complementary policies.

  • Price inelasticities. Although price inelasticities found in some sectors should not necessarily be defined as a “barrier,” they can inhibit or slow the response to pricing policies. For example, studies have concluded that pricing strategies are less effective in reducing GHG emissions from transportation than from electric generation (e.g., see Figure 2.11 in this report). Price inelasticities imply that the good or service in question is considered highly valuable by users, or that the costs of substituting alternate goods or services are very high. Complementary policies may help overcome some of these inflexibilities by lowering substitution costs or making markets more robust for competing technologies.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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  • Imperfect or incomplete information. Individuals (whether consumers, voters, investors, or corporate decision makers) cannot be expected to alter behavior for the purpose of reducing GHG emissions without having an adequate understanding of climate change and its impacts and the response options available. The American public, however, generally suffers from limited information (Coyle, 2005) and inaccurate biases and assumptions about such matters (e.g., Bazerman and Hoffman, 1999; Hoffman and Henn, 2008; Kahneman and Tversky, 1979). As one example, psychologists find persistent belief that there is an inherent trade-off between economic development and climate change limiting strategies, regardless of evidence to the contrary. Complementary policies may be needed to help address these sorts of social and psychological barriers and resistance to change. These policies could include public education programs (akin to antismoking or healthy diet campaigns) and incentives and encouragement for low-GHG-emitting behaviors (e.g., providing incentives for more bike riding through the construction of dedicated street lanes and proper storage facilities).

  • Infrastructure limitations. Finally, consideration must be given to obstacles to innovation presented by “technological lock-in” of physical infrastructure (Fisher, 2009). Government plays a central role in creating many types of infrastructure and, thereby, has numerous opportunities to enable GHG emissions-reducing technologies. For example, advances in renewable energy and plug-in hybrid vehicles must be enabled by expansion and development of the electricity grid, development of high-speed rail requires the development of new track lines, and the city-scale development of “cool” roofs and pavements and expanded tree cover may require public incentives for private development. In these sorts of examples, government can assist innovation by gaining rights-of-way, altering regulatory structures, or providing broad-scale leadership and direction.

Building a Strategic Portfolio of Complementary Policies

Although many of the carbon-pricing system shortcomings described above could eventually be resolved over time, they need to be considered in light of the urgency and difficulty of meeting a stringent 2050 emissions budget. Delays in beginning emissions reductions, or in creating new technology options for later deployment, will make an extremely challenging task more difficult. For this reason, we believe that a set of carefully targeted complementary policies is justified. However, to avoid compromising the long-term effectiveness of a carbon-pricing policy, complementary policies need to be strategically focused on accelerating near-term emissions reductions

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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and generating long-term technology options. This section presents a short list of goals for complementary policies designed to take advantage of the highest leverage opportunities.

Near-Term, High-Leverage Opportunities

In Chapter 3 we identified the major opportunities for reducing domestic GHG emissions: increasing energy efficiency, accelerating the introduction of renewable energy sources, advancing demonstration of advanced commercial-scale nuclear power, developing and deploying CCS technology, and advancing low-GHG-emitting transportation options. In the sections below, we describe how appropriate complementary policy interventions could help overcome existing barriers in each of these areas. Examples of specific policies are presented in Table 4.1.

  • Increasing energy end-use efficiency. Exploiting opportunities to enhance efficiency in the use of electricity and fuels offers some of the largest near-term opportunities for GHG reductions (DOE, 2009). These opportunities can be realized at a relatively low marginal cost, thus leading to an overall lowering of the cost of meeting emissions-reduction goals. Furthermore, achieving greater energy efficiency in the near term can help defer new power plant construction while low-GHG technologies are being developed. Although the potential for cost-effective opportunities to reduce electricity and fuel use is large, a variety of market imperfections will reduce the effectiveness of carbon pricing as an incentive for industries and investors to take advantage of these opportunities (Brown et al., 2009b; Gillingham et al., 2009; Tietenberg, 2009). These imperfections include principal-agent problems (discussed in Chapter 3), conflicting incentives created by existing law and regulations, incomplete or imperfect information, and limited access to capital, especially for energy upgrades to industrial facilities—all of which limit the ability of a pricing system to operate as effectively as it otherwise would. In addition, the electricity distribution infrastructure limits the ability of suppliers to transmit real-time price signals to customers.

  • Accelerating deployment of renewable energy sources. Renewable energy sources, especially wind and solar power, have grown significantly in the past few years. Some renewable energy sources are competitive (or near competitive) with conventional sources even in the absence of carbon pricing, yet it is likely that a continued policy impetus will be required to encourage the widespread adoption of new renewable technology. Capital costs for renewable energy technologies have declined considerably over the past decades,

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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but they remain a constraint to widespread market penetration. Cumbersome permitting, hookup fees, and interconnection standards are impediments to deployment in many states. In addition, many renewable energy sources are remote from load centers and will require new transmission infrastructure.

  • Determining the cost and performance of new commercial nuclear power. The America’s Energy Future (AEF) study concluded that new-generation nuclear power can become a commercially available option by 2020 if large demonstration plants are built without delay (for details, see Chapter 3 and NRC [2009a]). However, significant barriers prevent these demonstrations from taking place without government intervention. Among the more pressing of these are the high costs associated with design and construction of the first few plants and associated financial risk to investors, uncertainty with respect to new licensing procedures, constraints in the supply chain infrastructure, uncertainty regarding long-term waste disposal, and the possible shortage of trained workers. Expansion of nuclear power globally is further complicated by concerns about nuclear proliferation. No new nuclear plant has been built in this country in 30 years, and the cost of a new plant today is so large as to create substantial risk for private investment.

  • Determining the cost and performance of coal with CCS. The AEF study likewise concluded that coal with CCS could become commercially available by 2020 if we move ahead immediately with construction of full-scale demonstration plants. Technical and other uncertainties surrounding CCS create similar risks for investment. Some of the principal risks are associated with the safety and permanence of geologic storage. Uncertainties also surround the legal frameworks for property rights (to underground pore space), regulatory requirements for site permitting and operation, and long-term liabilities after site closure. A relatively low carbon price, even if it were in place today, would be insufficient to overcome these risks in time to complete an accelerated demonstration program without government assistance.18

  • Advancing low-GHG transportation options. Near-term opportunities exist to reduce GHG emissions from the transportation sector, primarily through increased vehicle efficiency and the use of low-GHG alternative transportation fuels. As household incomes rise, this changes the way people value time and causes demand for motor vehicle travel to become increasingly less responsive (inelastic) to changes in fuel prices (Small and Van Dender, 2007). For instance, a price of $100 per ton of CO2 translates into about $1 per gal-

18

NRC (2009a) concluded that, even with high carbon prices (over $100/ton) to stimulate private-sector research, government funding could speed the attainment of R&D goals by 3 years.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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lon of gasoline. Until CO2 prices reach higher levels, complementary policies would be needed to realize significant near-term GHG reductions from the transportation sector. Such policies may deal directly with vehicle efficiency (in particular, ensuring that the fuel efficiency standards mandated in the 2007 Energy Independence and Security Act [EISA] are met as quickly as possible), incentivizing the use of efficient modes of passenger and freight traffic as well as investments in new infrastructure, and advancing low-GHG fuels.

Support of Basic Research

Chapter 3 discussed the urgency of conducting research into new technologies. The private sector is likely to under-invest in basic research, as the investing firms cannot fully capture the resulting benefits of such efforts. Cohen and Noll (1991) describe some of the reasons why private firms are unable to realize the benefits of basic research; for example, the benefits gained by “free riders” may dilute the benefits to the firms incurring the cost of research; the investing firm may create an innovation that turns out to be of no strategic relevance to the firm itself, leaving little motivation to pursue it; or the financial risk of pursuing a new technology may be unacceptably high. A carbon-pricing system may help mitigate this problem by creating a benefit for private-sector research into emissions-saving technologies, but a pricing system alone is not likely to result in adequate investment in basic research (Fisher, 2009). Because basic research is the necessary first step in developing many new technologies, direct governmental funding support will remain an essential complementary policy. Chapter 5 discusses the nature of the government role.

Managing Asset Turnover in the Energy Sector

Developing and deploying new technology that limits GHG emissions is essential, but decarbonizing the energy sector also requires retrofitting, retiring, or replacing embedded carbon-intensive infrastructure. The turnover of existing infrastructure can be very slow because existing capitol stock, as well as capital-intensive industrial process infrastructure, can have a long lifetime—ranging, for example, from ~15 years (light-duty vehicles) to ~50 years (refineries, including upgrades). In the absence of policies to encourage turnover, the Energy Information Administration (EIA) anticipates retirements of carbon-emitting electricity generators of less than 5 percent by 2030.19 Aggressive implementation of energy-efficiency measures could significantly reduce

19

EIA (2009) forecasts that less than 5 percent of the domestic electricity-generating capacity existing in 2007 would be retired by 2030. Almost all of these retirements would be natural gas plants.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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overall energy demand, but this would not necessarily stimulate much turnover of existing infrastructure and in fact could even reduce the rate of turnover, since there is less need to add new capacity.


Achieving the 2050 emissions budget means that it will be essential to have clear and credible policies for retiring or decarbonizing much of the current and planned emissions-intensive infrastructure. Ideally, a carbon-pricing system would define this path, but, as discussed earlier, the initial pricing mechanism may be inefficient or slow to take shape, and the initial prices may be too low to provide a sufficiently strong incentive to ensure retrofitting, replacement, or retirement of existing infrastructure.


Various alternative strategies to accelerate equipment and infrastructure turnover have been advanced, but there are few available examples of successful policy intervention. Achieving accelerated turnover requires forcing retirement of equipment and infrastructure that otherwise would continue in productive use, either by law or regulation or by subsidizing early retirement. The subsidies required might be quite large, since existing equipment and infrastructure must cover only its marginal cost to continue to operate profitably, whereas new equipment and infrastructure must offer the promise of covering its total cost.


This challenge is illustrated by the 2009 “cash for clunkers” program, which provided subsidies for scrapping older, less fuel-efficient vehicles and replacing them with newer, more fuel-efficient vehicles. While the program temporarily stimulated the purchase of newer, more fuel-efficient vehicles, its ability to generate a long-term positive impact on the energy efficiency of the automobile fleet has yet to be demonstrated. Similar programs in Europe, which did not require scrapping of the older vehicles, often led to export of the vehicles for use elsewhere.


Performance standards for fossil-fuel power plants may be a useful regulatory tool for driving change in the electricity production sector (Samaras et al., 2009), although such efforts must be carefully designed to avoid the unintentional result of actually slowing down equipment replacement rates. In the consumer products market as well, policies must be formulated carefully—for instance, to avoid the “second refrigerator option” in which new, more energy-efficient purchases are subsidized while the older technology continues to be used, thus adding to overall energy demand. Examples of effective policy options in this regard include tax credits and direct buy-down of replacements.


If complementary policies for influencing asset turnover are not implemented immediately, industry response to the early carbon pricing system should be closely monitored to determine if additional policy action is required to accelerate infrastructure

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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retirement process. If the pricing mechanism is delayed significantly, complementary policies may be essential.

Other Potential Strategies

The high-leverage opportunities discussed above were selected based on a few key criteria: (1) there is a significant near-term opportunity to reduce emissions, (2) there are circumstances that limit the early effectiveness of the pricing system to realize the potential opportunity, and (3) government can play an effective role in mitigating these adverse circumstances. As noted in Chapter 3, there are additional opportunities that will need to be considered to ultimately meet the emissions budget, but many of these are not yet developed to the point of satisfying all of our selection criteria. A few such opportunities appear to be fairly close to the point of making a useful near-term contribution, however. Below we discuss some of these key opportunities on the horizon.

  • Heavy- and medium-duty vehicle fuel efficiency.20 The opportunity noted above for improving transportation energy efficiency focuses on light-duty vehicles, because these account for 65 percent of the energy consumption in the transportation sector. Heavy- and medium-duty vehicles are the second largest category of transportation energy consumption, at ~20 percent of the total. At present, no fuel efficiency standards have been set for this vehicle category. The process of setting such standards is under way but too early in its development to know what potential savings can be realized. If the process is successful, it could result in an important near-term contribution to emissions reductions.

  • Agriculture and forestry sequestration of carbon. The economic potential for sequestering carbon in forests and soils is discussed in Chapter 3. The most likely mechanism for encouraging domestic carbon sequestration in agriculture and forestry is through the use of domestic offsets purchased by primary GHG emission sources, but this may need to be complemented by other policies in order to capture certain opportunities. In some cap-and-trade programs the high transaction costs involved have excluded certain target groups (particularly small emitters) from the market. Programs encouraging sequestration at a local level, managed by agencies such as the U.S. Department of Agriculture Natural Resources Conservation Service and Forest Service, can help reach

20

Medium and heavy trucks are trucks with a manufacturer’s gross vehicle weight exceeding 10,000 pounds (medium,10,001 to 26,000 pounds; heavy, over 26,000 pounds).

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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the potential for activities such as forest management and small farm agricultural sequestration. Avoiding deforestation can be encouraged by imposing land-clearing offsets, as is done with existing wetlands programs. A number of practical issues need to be addressed for the market to function well (e.g., dealing with transaction costs, leakage, property rights, and additionality concerns). Careful attention to these structural issues would accelerate the contribution of agriculture and forestry CO2 sequestration to meeting the overall emissions-reduction budget.

Reducing deforestation at the international level is another possibility and is the focus of mechanisms for reducing emissions from deforestation and forest degradation (REDD). As explained by Murray et al. (2009b), making REDD viable on a large scale implies that there is demand for international forest carbon reductions and a sufficient supply capacity of forest carbon credits to meet this demand at a price that is competitive with other mitigation options. In addition, this needs to be coupled with provisions to address the possibility of emissions leakage and impermanence, plus infrastructure (e.g., technological and legal) to ensure that reductions are properly quantified and monitored. Finally, the rights to REDD payments must be properly established. Numerous recent studies provide insights into the potential costs and impacts of a global market for REDD credits (e.g., Boucher, 2008; Busch et al., 2009; Kindermann et al., 2008; Sohngen et al., 2008).

  • Non-CO2GHGs. Non-CO2 GHGs could play a significant near-term role in the overall U.S. emissions-reduction effort; in most cases, including these gases in the overall GHG pricing system is likely to be the most efficient means to encourage action. But as discussed in Chapter 6, there are significant benefits to also pursuing complementary international efforts to reduce emissions of gases such as methane and hydrofluorocarbons.

Examples of Complementary Policy Options

The question of what specific complementary policies are best suited to address the goals discussed above is the subject of considerable study and debate and is ultimately a decision for policy makers. Rather than try to provide a comprehensive list of options and assessments of each, Table 4.1 offers a series of examples that are illustrative of what can be done, in terms of both mandatory regulatory standards (“sticks”) and voluntary incentives (“carrots”). This includes policies for advancing technology and policies for influencing individual behavior and consumer choices. For each policy, the table details some pros and cons regarding its effectiveness in addressing the kinds of shortcomings and barriers associated with GHG pricing.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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TABLE 4.1 Illustrative Options for Meeting Complementary Policy Goals

Option

Pro

Con

Policies for Increasing the Efficiency of Electric Energy Use

Mandatory Regulatory Standards

Building performance standards for new construction

Building codes can overcome market information and incentive problems to promote new efficient buildings where the energy savings more than cover the up-front cost. Building codes in many states have not been updated for years.

May increase up-front costs for new buildings.

Efforts to update building energy codes often result in protracted political conflict.

Raises intergovernmental issues if the legislation is instituted at the federal or state level and enforcement is at the local level.

Building performance standards for existing construction

Improvements in existing building stock can yield financial benefits to building owners.

Retrofit programs would be consistent with economic stimulus programs already under way.

May produce resistance from building owners over imposed up-front costs and extended payback periods.

Expand and intensify appliance efficiency standards

Proven ability to reduce energy use.

Current administrative structure already in place.

Will increase initial cost in many cases.

Standards must be revised periodically to take advantage of technological advances. Revisions can be time-consuming and countered by vested interests.

Standards for industrial equipment efficiencies (such as combined heat and power)

The industrial sector is the largest end-use sector, consuming more than 50 percent of delivered energy worldwide.

The relatively high costs for industrial energy-efficiency improvements may create opposition. Many large industry users already have incentives to manage energy costs to remain competitive.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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Option

Pro

Con

Voluntary Policies and Incentives

Efficiency tax incentives (and other financial incentives: subsidies, rebates, grants, direct installation/upgrade assistance) for homeowners, businesses, and building owners

Creates a clear market incentive for investments in low-GHG technologies.

May lower tax revenues in a period of already low revenues due to the economic downturn. Less effective when not stable and predictable over time

Support improvements to the electricity grid through smart grid or national grid technologies1

Necessary complement for the effective use of dispersed renewable sources.

Can yield greater efficiencies in energy use.

Can promote more informed consumer electricity choices.

Siting of new high-tension power lines is likely to face local opposition.

Developing cost-sharing arrangements to fund grid investments can produce conflict among states.

Policies for Increasing the Energy Efficiency of Transportation

Mandatory Regulatory Standards

Higher motor fuel taxes

Will create an additional economic incentive to reduce vehicle miles traveled (VMT) and purchase more fuel-efficient vehicles.

Can be a source of needed funding from users for the currently underfunded transportation infrastructure.

Reduced oil demand has benefits for national energy security.

Will directly raise costs for consumers.

Could adversely impact the poor, since fuel costs are a higher share of their transportation budget.

Must overcome considerable political opposition to raising fuel taxes at all levels of government.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

Option

Pro

Con

Energy efficiency performance standards for new vehicles (i.e., the standards promulgated in the 2007 Energy Independence and Security Act [EISA]).

Will stimulate the development and market deployment of additional low-emission vehicles.

Could raise costs for new vehicles.

May promote more VMT by lowering the cost of driving. May be resisted by motorists unless accompanied by demand-inducing measures such as higher fuel prices.

Voluntary Policies and Incentives

Feebates2 and other financial incentives to spur consumer interest in energy-efficient vehicles

Creates a clear financial incentive for investment in energy-efficient vehicles.

Can stimulate markets for fuel-efficient vehicles.

Tax incentives and other government financial incentives will increase government expenditures.

Investments in transportation infrastructure for more efficient operations

More efficient operations of highways and airways can reduce energy use through fewer delays and less circuitous routing.

More efficient operations may increase demand and shift traffic from less energy-intensive modes such as rail.

Promote “smart growth” initiatives

Reduces dependence on automobiles and increases use of public transportation; reduces urban sprawl.

Some developers may oppose efforts that appear to restrict market opportunities.

May face barriers from existing zoning codes and lack of regional-scale power over land-use decisions.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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Option

Pro

Con

Policies for Accelerating Deployment of Renewable Energy Sources

Mandatory Regulatory Standards

Adopt national renewable portfolio standards

Provides a flexible way to accelerate the deployment of renewables.

Precedent exists at the state level.

Common federal floor may be much harder to reach in some states than others (depending in part on whether renewable energy credits are tradable among states).

May require statutory alteration in federal/state oversight responsibilities for energy management.

Adopt national feed-in tariff legislation

Promotes electricity supplied to the grid from renewable sources by providing a guaranteed price.

Considerable experience with their use from Europe. Provides price stability for qualifying energy sources, which leads to increased investment and deployment.

May hit poor the hardest unless correcting policies are enacted (i.e., feebates).

Careful structuring of price mechanism is required to avoid unnecessary cost transfers onto consumers.

Voluntary Policies and Incentives

Enhance the development and deployment of cellulosic biomass and biofuel

Private investments in biomass development can be increased through government financial support for basic research to prove its scalable deployment.

Suffers from a high perceived risk related to the availability of long-term supply and commercial viability.

Support improvements to the electricity grid through smart grid or national grid technologies

Necessary complement to the effective use of dispersed renewable sources.

Can yield greater efficiencies in energy use.

Can promote more informed consumer electricity choices.

Siting of new high-tension power lines is likely to face local opposition.

Developing cost-sharing arrangements to fund grid investments can produce conflict among states.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

Option

Pro

Con

Stable production tax incentives or other renewables tax supports, including incentives for distributed generation and cogeneration

Creates a stable and predictable financial incentive for long-term investment planning.

May create concerns over the government “picking winners” in the market development of energy sources.

Policies for Deploying New Commercial Nuclear Power and Coal with Carbon Capture and Storage

Voluntary Policies and Incentives

R&D for carbon capture sequestration

CCS offers a technological option for reducing GHG emissions from a critical U.S. energy source.

Can reduce the burden that will fall on coal-producing and coal-dependent states.

Can produce a national security benefit by allowing greater dependence on domestic energy sources.

May pave the way for greater cooperation from coal-reliant countries (e.g., China, India).

Can reduce overall policy portfolio costs.

Capture technologies are still not demonstrated in commercial full-scale power plant operations. Is relatively costly.

Help underwrite the risk of constructing initial “new nuclear” power plants

Nuclear is an alternative to more carbon-intensive sources of base load power.

Would provide the risk mitigation necessary for allowing initial demonstration plants to be built.

Public opposition to nuclear power remains high.

Financing hurdles for the construction of nuclear power remain high and uncertain.

Waste disposal and proliferation problems must be resolved.

Develop long-term solutions for nuclear waste disposal

Sound nuclear waste policies are a critical enabling factor in the long-term deployment of nuclear power.

Considerable public and political opposition to a national waste repository and the transportation of nuclear waste over long distances.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

Option

Pro

Con

Policies for Decarbonizing Transportation Fuels

Mandatory Regulatory Standards

Low-carbon fuel standard

Can complement higher fuel prices by encouraging investment in low-carbon fuel sources.

Can incentivize fuel suppliers to reduce carbon at all stages of the fuel production cycle.

May lead to increased use of biofuels from food-based feedstocks.

Risk of leakage unless the standard is applied nationally. Challenges in monitoring and accounting for claimed emissions reductions by suppliers at various stages of the fuel production cycle.

Voluntary Policies and Incentives

Tax incentives or subsidies for the supply of low-GHG biofuels

Biofuels are a rapidly expanding market with great opportunity for contributing to domestic supply of energy.

If emphasis is not placed on low-GHG sources (e.g., cellulosic feedstocks), it could stimulate increased production of fuels produced from food-based feedstocks or grown on land that could have been used to produce food; it may have little or no net benefit for GHG emissions.

R&D support for the development of low-carbon vehicle propulsion systems

New drive-train technologies such as hydrogen, plug-in hybrids, electrics, and battery storage can figure prominently in both reducing GHG emissions and enhancing future economic competitiveness.

The track record of government picking specific technologies to achieve a goal is poor.

Investment in infrastructure to support the development and use of alternative vehicles and energy sources

Public support for infrastructure to aid in the distribution and delivery of alternative energy sources (e.g., biofuel, hydrogen) can accelerate deployment of the technology.

Can create long-term lock-in if infrastructure investments are misdirected.

Risk of government choosing “winners” and discouraging competing technologies with more promise.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

Option

Pro

Con

Policies for Managing Asset Turnover

Mandatory Regulatory Standards

Performance standards for new coal-fired power plants

Can prevent new coal plants from using a disproportionate share of the emissions budget.

Can create markets for CCS technologies and stimulate R&D and technology innovation (see Chapter 5).

May increase cost for new coal power plants.

May create incentive to keep old plants running.

Performance standards for existing coal-fired power plants

Can prevent existing plants from using a disproportionate share of the emissions budget.

Can create markets for CCS retrofit technologies and stimulate technology innovation.

Can accelerate the retirement of older plants that are not amenable to emission controls.

Can increase the cost to consumer for energy, yielding public and political opposition. Political opposition in regions with many coal-related jobs.

Voluntary Policies and Incentives

Incentives for the retirement of inefficient vehicles

Will stimulate the market for fuel-efficient vehicles at a time when the automobile sector is in financial distress.

Political opposition may view this as a subsidy for the auto sector.

Could affect the poor by removing lower-cost vehicles from the market.

Recent experience with “cash for clunkers” shows this may be an inefficient approach to influencing demand for fuel efficient vehicles at reasonable cost (e.g., Knittel, 2009).

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

Option

Pro

Con

Policies to promote urban redevelopment

Will stimulate the market for urban real estate, revitalizing communities.

Will promote the use of public transportation and complement “smart growth” initiatives by reducing demand for sprawl.

May require considerable funding in communities where market signals do not promote development activity on their own.

Development benefits may be slow to emerge.

1 Smart grid technology supports both energy efficiency and the deployment of renewable technology, and so appears in both sections of Table 4.1.

2 A policy where a fee is levied on the purchase of “gas guzzling” vehicles (e.g., via registration fees, surcharge on initial vehicle purchase) and the money is put toward rebates for purchasers of highly efficient vehicles.

Whatever options are selected, policy makers will have an ongoing task of evaluating their effectiveness and efficiency, and adjusting them to changing circumstances, especially in order to avoid unnecessary conflict with an evolving carbon-pricing mechanism. For instance, some policies adopted to complement the pricing mechanism in its early years may eventually outlive their usefulness, because over time the incentive created by a pricing mechanism should become sufficiently strong to elicit the most efficient response from private markets. When that happens, the complementary policies are no longer required. Thus, the design of complementary policies should include consideration of their eventual phase-out.


On the other hand, if the pricing mechanism fails to evolve to the point of providing the appropriate incentive, then the complementary policies may have to be continued, or new policies may need to be phased in (for example, in the case of managing the retirement of existing electric power plants). In the extreme, if the pricing mechanism is not enacted or is abandoned, then the complementary policies would become the foundation of our nation’s strategy to meet the 2050 GHG budget; thus, the policy portfolio would have to be adjusted accordingly.


As discussed in Chapter 3, it is useful to look across the traditional sectors of GHG emissions-reduction efforts (such as those shown in the preceding tables) and consider the perspective of who is responsible for relevant decisions and actions. Chapter 3 discussed the opportunities that exist for influencing individual or household-level

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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BOX 4.2

Policy Strategies for Reducing Household-Level GHG Emissions

As discussed in Chapter 3, GHG emissions from U.S. households could be far lower with changes in how people adopt and maintain energy-using equipment both inside the home (i.e., appliances) and outside the home (i.e., cars) (Bressand et al., 2007; Dietz et al., 2009; Hirst and O’Hara 1986). The main policy options for encouraging these sorts of changes and reducing household emissions are discussed below.

Regulations in the form of efficiency standards for homes, appliances, and automobiles have in some cases successfully changed the product mix and increased overall efficiency, although they have not altered the trend toward larger units with more energy-using features. Standards are an effective option for new equipment, but they generally do not force upgrades or retrofits of existing equipment; in some cases, standards can even strengthen incentives to prolong the life of old, inefficient equipment. This need not always be the case, however. For instance, a study by the California Energy Commission found positive benefits of regulations requiring building energy upgrades at the time of sale (California Energy Commission, 2005), and several localities (e.g., Berkeley and Austin, California) have begun to adopt codes requiring some combination of home energy rating and retrofit (City of City of Austin, 2009; Berkeley, 2008.).

Economic influences have highly variable effects on consumers. This can be seen in the tremendous variations in implicit discount rates for energy efficiency that have been calculated from studies of appliance purchases (Ruderman et al., 1987) and in the large variation in the proportions of homes that are found to make energy-efficiency improvements in response to financial incentives (Stern et al., 1986). With appliances, much of the variation is due to the fact that it is often not the consumer who makes the actual choice, but a builder or repair professional. With home retrofit incentives, it seems to be due to attributes of the organization administering the program and of its implementation (Gardner

choices and behavior related to energy use. Box 4.2 considers the types of policy interventions that can help ensure those opportunities are effectively pursued.

INTEGRATING THE POLICY OPTIONS

The nation needs a strategic, integrated strategy for evaluating and selecting the most effective portfolio of policy options. In Chapter 1 we suggested a range of principles or criteria that could be used to evaluate all policies on an individual basis. The first four of those criteria may be particularly important in the policy-making arena; this includes the criteria of policies that are environmentally effective, are cost-effective, help stimulate innovation, and promote equity and fairness of outcome. In addition, below we suggest a set of “ensemble” criteria as guidance for finding a balanced, effective portfolio of policies:

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

and Stern, 2002; Stern et al., 1986).

Communication instruments generally have had very limited effects on energy use and emissions (Abrahamse et al., 2005; Gardner and Stern, 2002; NRC, 2002a). Generic information, such as is offered in many mass media energy campaigns, has had little effect on behavior or energy consumption. Interventions such as eliciting a personal commitment or using neighbors as behavioral models can be quite effective but are not readily transferable into widespread policy. Targeted information, such as daily feedback on household energy use, has produced savings in the range of 10 percent of household use of a target fuel (usually electricity). These savings usually result from adjustments in the use of household equipment (e.g., lower temperature settings on hot water or shorter showers) rather than changes in equipment stocks.

The most effective policy interventions combine multiple approaches in order to address multiple barriers to behavioral change. For example, 85 percent of the homes in Hood River, Oregon, underwent major energy efficiency retrofits in 27 months under a program that provided large financial incentives, convenience features (e.g., one-stop shopping), quality assurance (e.g., certification for contractors, inspection of work), and strong social marketing (Hirst, 1988). Similarly structured programs have produced penetrations of up to 19 percent per year in other communities, although the same incentives with different implementation have yielded penetrations under 2 percent per year (Stern et al., 1986).

A key lesson learned from these experiences is that policy instruments are most likely to be effective when they “provide just what is needed to overcome the barriers to obtaining the [policy] objective” (Stern, 2002). For a sector facing multiple barriers, multipronged interventions can be far more effective than financial incentives or information alone. Well-designed policy interventions aimed at households can likely also increase the speed of adoption of new emissions-reducing household technology and promote household choices that contribute indirectly to reducing GHG emissions.

  • Widespread participation. The portfolio of policies should be designed to draw in vigorous action at all levels, from household and individual, to state and local, to international.

  • Temporal effectiveness. The mix of policies should stimulate immediate action and payoffs but also be consistent with long-term goals. Short-term priorities may focus on stimulating behavior change, deployment of available technologies, and capital stock turnover. Such efforts need to be complemented with longer-term priorities such as greater support for basic R&D and associated innovation policies.

  • Comprehensiveness. The mix of policies should lead to comprehensive coverage of GHGs, strategies, and major sectors of the economy.

The major strategic elements of policy integration involve recognizing and capitalizing on the interactions among policies, sequencing policies for maximum cost-effec-

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

tiveness, and taking synergies among different policy goals into account. Each of these is discussed below.

Policy Portfolio Interactions and Sequencing

It is important to consider the interactions among different emissions-reduction policy instruments, both to identify and capitalize on opportunities where the joint outcomes are greater than the sum of the independent parts and to anticipate circumstances where the joint effect may diminish the emissions-reduction effort or even be counterproductive. Below is one example that illustrates the complexity of these types of interactions.


Renewable Portfolio Standards (RPSs) and Renewable Fuels Standards or Low Carbon Fuel Standards are examples of measures that overlap with a GHG pricing policy, in the sense that they all are intended to reduce GHG emissions. If complementary policies were truly redundant with a cap-and-trade system (meaning the emissions reductions would take place in response to carbon prices even in the absence of these complementary policies), then their addition to the policy portfolio would not affect carbon prices or overall program costs. In practice, however, complementary policies would likely force technological choices that would not otherwise occur under a pricing policy alone. This may increase overall program costs, but at the same time may lower the carbon price.21 Total emissions may not be further reduced by the introduction of complementary policies (since that total is set by the cap), but the source of those emissions is affected. For instance, a recent MIT modeling study (Morris, 2009) found that adding an RPS to a cap-and-trade system forces a higher proportion of electricity generation to come from renewables. This study also found that (as proposed above) an RPS combined with a cap-and-trade policy leads to the same total emissions as cap and trade alone, but at a greater cost despite a lower carbon price (noting that such results can depend on a model’s assumptions regarding technological change and other factors).


The MIT study does not envision a large role for offsets, but adding significant offsets to the policy mix would exacerbate the cost impact that the study suggests. By itself, a generous use of offsets would lower emission allowance prices and delay the transition to using renewable energy resources. But this delay could be reduced or eliminated if an RPS is also in place to mandate that a larger proportion of electricity come

21

In a cap and trade, because renewables emit less carbon than the sources they replace, their use lowers the demand for allowances and, hence, lowers the carbon price. Overall program cost is not lowered by this additional use of renewables, however, if they supply energy at a higher cost.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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from renewables. This faster transition, however, would increase near-term program costs more significantly than in the scenario without offsets, because the renewables would be more expensive than the offsets they replaced.


Similar considerations affect how policies such as building codes and appliance standards interact with a pricing strategy. In theory, given an appropriate carbon price, all households and businesses would make cost-effective choices, realizing that higher costs of efficient buildings or appliances will be offset by lower expenditures on energy. In practice, however, historical experience shows that information deficiencies and perverse incentives create many circumstances where households and businesses make choices that are not cost-effective. Building codes and appliance standards, if appropriately designed, can help ensure that households and businesses end up making cost-effective choices. However, if the standards are set too low, they might prove to be redundant with carbon-pricing incentives; if the standards are set too high, they might increase program cost by eliminating some cost-effective choices.


A recent analysis of some existing cap-and-trade programs (Hanemann, 2009) argues that the technology innovation stimulated by cap and trade alone will likely be insufficient without also having complementary policies in place. For instance, in order to produce the desired rate of innovation in key sectors, it may be necessary to complement cap and trade with performance standards specifically targeted at those key sectors. This study also suggests that the inclusion of complementary policies can help reduce the possibility that emissions allowance prices will reach a level that is too high to be politically sustainable.


The sequence in which some policies are enacted can affect their outcome. For instance:

  • The most important early emissions reductions generally come from energy-efficiency improvements; however, due to the information and incentive gaps noted above, significant improvements may not occur unless policies to complement a carbon price (e.g., building codes, appliance standards, and fuel-economy standards) are put in place early in the process.

  • Most scenarios envision an ongoing significant role for coal, but this will not be consistent with the proposed emissions budget goals unless CCS quickly becomes available and policies are enacted to ensure its use.

  • The California Air Resources Board anticipates that low carbon fuel standards will work best if developed in concert with technology-forcing regulations designed to reduce GHG emissions from cars and trucks, as well as land-use and urban growth policies designed to reduce transportation-sector emissions (CARB, 2008).

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

An additional consideration is the interaction of climate change limiting goals with policy goals in other related areas—for instance, adapting to climate change impacts, protecting public health through air pollution mitigation, reducing dependence on foreign oil and advancing energy security, expanding economic development and employment opportunities, and enhancing national competitiveness and international markets for domestic goods. See Chapter 6 for further discussion of these issues.


Because of the complexity of these interactions, there is a diversity of views among experts about the appropriate role of complementary policies. This is another rationale for why it will be necessary to learn from experience, and adapt as needed, as we proceed with implementing a policy portfolio.

Emissions Leakage

Emissions leakage can undermine the efficacy of GHG emissions-reduction efforts in a variety of ways. For instance:

  • Leakage can occur when a regulatory scheme covers only a single region or country (or group thereof) and resulting price differentials push the emissions-producing activities into other regions that are not constrained by the same regulatory controls.

  • Leakage can occur when efforts to reduce emissions in one sector or location cause a resulting unsatisfied demand that is then satisfied somewhere else, with a consequent rise in net emissions.

  • Leakage can be caused by an inappropriate certification for offsets, causing emissions reductions from a project-based offset to be less in practice than claimed.

These are, of course, not really new issues. Basic international trade economic theory has long shown that actions that increase the cost of goods in one country for a traded commodity will cause a countervailing reaction in another country, replacing the production with a shift in market share. Leakage is just an acknowledgment that, when GHG-limiting strategies differentially raise costs and prices, there will be associated production changes, and, in turn, GHG emission patterns change. Namely, climate change limiting policies that displace production in controlled regions will inevitably stimulate additional economic activity (and consequent leakage) in uncontrolled regions. While leakage can, in theory, affect almost any GHG emission source (including agricultural sources; see Box 4.3), some studies indicate that these leakage threats are in fact likely to be quite small overall, and largely manifested in a narrow subset of energy-intensive industries(Pew Center, 2009b). A recent Organisation for Economic

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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BOX 4.3

Leakage in an Agricultural Setting

Much of the public discussion about emissions leakage concerns has focused on energy-intensive industries. However, both domestic and international leakage issues also arise frequently in the context of actions in the agricultural sector. One recent example concerns the land-use impacts of biofuels. Some evidence suggests that high commodity prices caused by diversion of U.S. corn into ethanol production have stimulated foreign competitors with undeveloped land resources to respond by increasing their production (Fargione et al., 2008; Searchinger et al., 2008). This argument suggests that land conversion leads to loss of grasslands, forests, and other valuable ecosystems, causing both current carbon releases and lost future potential for carbon sequestration. Such arguments underlie the controversial indirect land-use adjustments in the EPA’s Renewable Fuels Standard analysis.1

Other agricultural programs have faced this issue as well. For example, Wu (2000) shows evidence of leakage within the United States in association with land conversion from pasture (in the Conservation Reserve Program). Furthermore, Wear and Murray (2004) and Murray et al. (2004) show that reduced Pacific Northwest deforestation (designed to protect the spotted owl) was matched by accelerated rates of harvest on regional private lands, in the southern United States and in Canada, with total leakage estimates in the neighborhood of 85 percent.

  

1 Some in the renewable fuels industry charged that EPA overstated the impact of corn ethanol on U.S. food production and thus exaggerated the expansion of new crop planting in forests and savannahs of places such as Brazil. See discussion, for example, in The Washington Post, May 6, 2009 (EPA Proposed Changes to Biofuel Regulations).

Co-operation and Development (OECD) study (Nakano et al., 2009) concluded that the emissions embedded in internationally traded goods are only a small percentage of OECD emissions and, hence, the extent of leakage is likely to be very small.


Conceptually, several unilateral border adjustment policy options are available for dealing with emissions leakage stemming from domestic emissions controls, including, for instance,

  • Import taxes on products—or equivalently, requiring allowances from imports—with embodied carbon (that is, high levels of GHG emissions generated during their production) can level the playing field for domestic consumption; however, this does nothing to reduce the competitive disadvantage faced by exporters.

  • Export rebates return the value of the emissions embodied in exports to exporters so that they do not face a competitive disadvantage in foreign

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

markets; however, this does nothing to reduce the competitive disadvantage domestic producers face from imports.

  • Full border adjustment policies combine these two measures such that, in effect, only the emissions from domestic energy consumption are taxed.

Attempts to rank the desirability of these various approaches have proved inconclusive, since the ranking depends on many context-specific parameters. Simulations do confirm, however, that the largest share of leakage arises from the effects of climate policies on energy prices, and that adjustment policies can mitigate leakage on the margin but are quite limited in their capacity to affect total global emissions reductions (Fischer and Fox, 2009).


Concerns have been expressed about the protectionist implications of these types of measures (Grimmett and Parker, 2008). However, a recent joint report from the United Nations Environment Programme and the World Trade Organization (UNEP and WTO, 2009) suggests that border adjustments could be legal under WTO rules if they were necessary to limit the magnitude of climate change and were applied in a nondiscriminatory way. This issue is discussed further in Chapter 7.


Leakage concerns arise in the context of both domestic and international offsets. In the international context, the Kyoto Protocol GHG accounting system for participating countries is considered only on a national basis (i.e., no consideration of leakage among countries), but leakage is discussed in the context of project-based emissions reductions such as the CDM. Murray et al. (2005) argue for the importance of developing methods to design projects to minimize leakage, to monitor leakage after projects are implemented, to quantify the magnitude of leakage when it exists, and to take leakage into consideration when estimating an activity’s net GHG reduction benefits.


To alleviate leakage concerns for offsets, emissions-reduction projects thus need to be evaluated under broad national and international accounting schemes that consider both direct and indirect implications of project implementation. That is, project evaluations should look not just at the project itself but also at the related impacts in major competitive regions. Some specific strategies for addressing leakage-related offset projects that have been proposed include the following:

  • Reduction of the quantity of offsets that can be credited and sold, to account for external leakage, and use of a “leakage discount factor” in the price paid for emissions allowances (see Murray et al., 2004);

  • Use of GHG offsets that avoid displacing marketed goods by using less competitive items; for instance, in the context of renewable fuels, focusing on the

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
×

use of marginal lands and on the use of municipal, agricultural, and forestry wastes or residues;

  • Associated complementary policies, such as avoided deforestation, that independently address leakage; and

  • Attempts to extend GHG price signals to more comprehensive global coverage, such that all relevant parties face the same signals and leakage becomes a liability in areas where it occurs.

KEY CONCLUSIONS AND RECOMMENDATIONS

Evidence suggests that a carbon-pricing strategy is a critical foundation of the policy portfolio for limiting future climate change. It creates incentives for cost-effective reduction of GHGs and provides the basis for innovation and a sustainable market for renewable energy resources. An economy-wide pricing policy would provide the most cost-effective reduction opportunities and lower the likelihood of significant emissions leakage, and it could be designed with a capacity to adapt in response to new knowledge.


Options for a pricing system include taxation, cap and trade, or some combination of the two. Both systems face similar design challenges. On the question of how to allocate the financial burden, research strongly suggests that economic efficiency is best served by avoiding free allowances (in cap and trade) or tax exemptions. On the question of how to use the revenues created by tax receipts or allowance sales (or the value of the allowances themselves), revenue recycling could play a number of important roles, for instance, by supporting complementary efforts such as R&D and energy-efficiency programs, by funding domestic or international climate change adaptation efforts, or by reducing the financial burden of a carbon-pricing system on low-income groups.


In concept, both tax and cap-and-trade mechanisms offer unique advantages and could provide effective incentives for emissions reductions. In the United States and other countries, however, cap and trade has received the greatest attention, and we see no strong reason to argue that this approach should be abandoned in favor of a taxation system. In addition, the cap-and-trade system has features that are particularly compatible with others of our recommendations. For instance, it is easily compatible with the concept of an emissions budget, and more transparent with regard to monitoring progress toward budget goals. It is also likely to be more durable over time, since those receiving emissions allowances have a valued asset that they will likely seek to retain.

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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High-quality GHG offsets can play a useful role in lowering the overall costs of achieving a specific emissions reduction by expanding the scope of a pricing program and offering a financing mechanism for emissions reductions in developing countries. Those gains, however, would be valid only for cases where offsets are real, additional, quantifiable, verifiable, transparent, and enforceable.


Pricing GHGs is a crucial but insufficient component of our nation’s climate change response strategy. Because a national carbon-pricing system takes time to develop and mature into an effective market stimulus, and because perverse incentives and information deficiencies can limit the effectiveness of a carbon-pricing policy in practice, a strategic combination of well-targeted complementary policies will be needed. Complementary policies should be focused on advancing the following major objectives:

  1. Realize the practical potential for near-term emissions reductions. End-use energy demand and the technologies used for electricity generation and transportation together drive the majority of U.S. CO2 emissions. Key near-term opportunities for emissions reductions in these areas include the following:

    • Increase energy efficiency. Enhancing energy-use efficiency offers some of the largest near-term opportunities for GHG reductions. These opportunities can be realized at a relatively low marginal cost, thus leading to an overall lowering of the cost of meeting the 2050 emissions budget. Furthermore, achieving greater energy efficiency in the near term can help defer new power plant construction while low-GHG technologies are being developed.

    • Increase the use of low-GHG-emitting electricity generation options, including the following:

      • Accelerate the use of renewable energy sources. Renewable energy sources offer both near-term opportunities for GHG emissions reduction and potential long-term opportunities to meet global energy demand. Some renewable technologies are at and others are approaching economic parity with conventional power sources (even without a carbon-pricing system in place); however, continued policy impetus is needed to encourage their development and adoption. This includes, for instance, advancing the development of needed transmission infrastructure, offering long-term stability in financial incentives, and encouraging the mobilization of private capital support for RD&D.

      • Address and resolve key barriers to the full-scale testing and commercial-scale demonstration of new-generation nuclear power. Improvements in nuclear technology are commercially available, but power plants using this technology have not yet been built in the United States. Although such plants

Suggested Citation:"4 Crafting a Portfolio of Climate Change Limiting Policies." National Research Council. 2010. Limiting the Magnitude of Future Climate Change. Washington, DC: The National Academies Press. doi: 10.17226/12785.
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  • have a large potential to reduce GHG emissions, the risks of nuclear power are also of significant concern and need to be successfully resolved.

  • Develop and demonstrate power plants equipped with carbon capture and sequestration technology. Carbon capture and sequestration could be a critically important option for our future energy system. It needs to be commercially demonstrated in a variety of full-scale power plant applications to better understand the costs involved and the technological, social, and regulatory barriers that may arise.

  • Advance low-GHG-emitting transportation options. Near-term opportunities exist to reduce GHGs from the transportation sector through increasing vehicle efficiency, supporting shifts to energy-efficient modes of passenger and freight transport, and advancing low-GHG fuels.

  1. Accelerate the retirement, retrofitting, or replacement of emissions-intensive infrastructure. Transitioning to a low-carbon energy system requires clear and credible policies that enable not only the deployment of new technologies but also the retrofitting, retiring, or replacement of existing emissions-intensive infrastructure. If immediate action is not initiated, the existing emissions-intensive capital stock will rapidly consume the U.S. emissions budget.

  2. Create new technology choices. See discussion in Chapter 5.

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Climate change, driven by the increasing concentration of greenhouse gases in the atmosphere, poses serious, wide-ranging threats to human societies and natural ecosystems around the world. The largest overall source of greenhouse gas emissions is the burning of fossil fuels. The global atmospheric concentration of carbon dioxide, the dominant greenhouse gas of concern, is increasing by roughly two parts per million per year, and the United States is currently the second-largest contributor to global emissions behind China.

Limiting the Magnitude of Future Climate Change, part of the congressionally requested America's Climate Choices suite of studies, focuses on the role of the United States in the global effort to reduce greenhouse gas emissions. The book concludes that in order to ensure that all levels of government, the private sector, and millions of households and individuals are contributing to shared national goals, the United States should establish a "budget" that sets a limit on total domestic greenhouse emissions from 2010-2050. Meeting such a budget would require a major departure from business as usual in the way the nation produces and uses energy-and that the nation act now to aggressively deploy all available energy efficiencies and less carbon-intensive technologies and to develop new ones.

With no financial incentives or regulatory pressure, the nation will continue to rely upon and "lock in" carbon-intensive technologies and systems unless a carbon pricing system is established-either cap-and-trade, a system of taxing emissions, or a combination of the two. Complementary policies are also needed to accelerate progress in key areas: developing more efficient, less carbon-intense energy sources in electricity and transportation; advancing full-scale development of new-generation nuclear power, carbon capture, and storage systems; and amending emissions-intensive energy infrastructure. Research and development of new technologies that could help reduce emissions more cost effectively than current options is also strongly recommended.

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