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.



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CHAPTER FOUR Crafting a Portfolio of Climate Change Limiting Policies R educing 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 com- monly 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 pos- sible 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. 

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L I M I T I N G T H E M A G N I T U D E O F F U T U R E C L I M AT E C H A N G E PRICING STRATEGY DESIGN FEATURES Carbon taxes and cap-and-trade polices are usually discussed in terms of their differ- ences, 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 cov- ers 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 ce- ment (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. Omit- ting 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. 

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Crafting a Portfolio of Climate Change Limiting Policies 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 com- bination 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 origi- nally 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 con- tent 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 con- sumers. 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 seques- tered 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 

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L I M I T I N G T H E M A G N I T U D E O F F U T U R E C L I M AT E C H A N G E 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 con- stituencies 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 effi- ciency 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 in- creases 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. 

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Crafting a Portfolio of Climate Change Limiting Policies parties to capture the full value of these allowances without incurring any cost, result- ing 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 allow- ances 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 neces- sary 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 prin- ciple, 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 as- sociated 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 allow- ances 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 protec- tion 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 

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L I M I T I N G T H E M A G N I T U D E O F F U T U R E C L I M AT E C H A N G E 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 strate- gies 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 as- sumptions in the models being used to produce the estimates (e.g., the degree of ag- gregation 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 comple- mentary policies, for instance, policies that lower the demand for energy through ef- ficiency 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 po- tential 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 house- holds; if the costs associated with complementary policies are high enough, they can more than offset the advantages from lower allowance prices. 

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Crafting a Portfolio of Climate Change Limiting Policies 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 af- fordability 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 meaning- ful 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 moni- tored 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 be- tween 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 transac- tion 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 7Current examples from RGGI include credits for reducing methane from landfills or for the additional carbon absorption resulting from a reforestation effort. 

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L I M I T I N G T H E M A G N I T U D E O F F U T U R E C L I M AT E C H A N G E 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 moni- toring 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 sec- ond 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. 

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Crafting a Portfolio of Climate Change Limiting Policies 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 off- sets 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 justi- fied 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 taxa- tion to control pollution, but it does have considerable experience with (and infra- structure for) levying taxes in general. Generally the targets for environmental policy are stated in quantity terms (concentra- tion 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. 

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L I M I T I N G T H E M A G N I T U D E O F F U T U R E C L I M AT E C H A N G E 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 provi- sion 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. 00

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Crafting a Portfolio of Climate Change Limiting Policies 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 Asser- tions 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 interna- tional 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 sub- stantial 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 coun- tries 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. 0

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L I M I T I N G T H E M A G N I T U D E O F F U T U R E C L I M AT E C H A N G E 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 equip- ment; 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 tremen- dous 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 inter- ventions 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 in- cludes 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: 

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Crafting a Portfolio of Climate Change Limiting Policies 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. In- terventions 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, in- spection 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 lo- cal, 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 technolo- gies, 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 cover- age of GHGs, strategies, and major sectors of the economy. The major strategic elements of policy integration involve recognizing and capital- izing on the interactions among policies, sequencing policies for maximum cost-effec- 

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L I M I T I N G T H E M A G N I T U D E O F F U T U R E C L I M AT E C H A N G E 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 cir- cumstances 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 comple- mentary 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 transi- tion to using renewable energy resources. But this delay could be reduced or elimi- nated if an RPS is also in place to mandate that a larger proportion of electricity come 21In 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. 

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Crafting a Portfolio of Climate Change Limiting Policies 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 stan- dards 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 mak- ing 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 insuf- ficient 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 comple- ment 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 de- signed 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). 

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L I M I T I N G T H E M A G N I T U D E O F F U T U R E C L I M AT E C H A N G E 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 em- ployment 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 ratio- nale 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 emis- sions-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 associ- ated 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 (includ- ing 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 0

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Crafting a Portfolio of Climate Change Limiting Policies BOx 4.3 Leakage in an Agricultural Setting Much of the public discussion about emissions leakage concerns has focused on energy-in- tensive 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, includ- ing, for instance, • Import taxes on products—or equivalently, requiring allowances from im- ports—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 

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L I M I T I N G T H E M A G N I T U D E O F F U T U R E C L I M AT E C H A N G E 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 ef- fect, only the emissions from domestic energy consumption are taxed. Attempts to rank the desirability of these various approaches have proved inconclu- sive, 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 reduc- tions (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 nondiscrim- inatory 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 participat- ing 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 develop- ing 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 evalu- ations 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 com- petitive items; for instance, in the context of renewable fuels, focusing on the 

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Crafting a Portfolio of Climate Change Limiting Policies use of marginal lands and on the use of municipal, agricultural, and forestry wastes or residues; • Associated complementary policies, such as avoided deforestation, that inde- pendently address leakage; and • Attempts to extend GHG price signals to more comprehensive global cover- age, 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 emis- sions 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 impor- tant 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 particu- larly compatible with others of our recommendations. For instance, it is easily com- patible 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. 

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L I M I T I N G T H E M A G N I T U D E O F F U T U R E C L I M AT E C H A N G E High-quality GHG offsets can play a useful role in lowering the overall costs of achiev- ing 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 in- formation deficiencies can limit the effectiveness of a carbon-pricing policy in practice, a strategic combination of well-targeted complementary policies will be needed. Com- plementary 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 transporta- tion 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 lower- ing 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: o 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 encour- age 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. o 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 tech- nology have not yet been built in the United States. Although such plants 

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Crafting a Portfolio of Climate Change Limiting Policies have a large potential to reduce GHG emissions, the risks of nuclear power are also of significant concern and need to be successfully resolved. o 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 applica- tions 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 ve- hicle efficiency, supporting shifts to energy-efficient modes of passenger and freight transport, and advancing low-GHG fuels. 2. Accelerate the retirement, retrofitting, or replacement of emissions-intensive infrastructure. Transitioning to a low-carbon energy system requires clear and cred- ible 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. 3. Create new technology choices. See discussion in Chapter 5. 

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