6 POLICY OPTIONS FOR REDUCING CO 2 EMISSIONSFigure 1-2.Relative Economic Efficiency of Various Policies to Reduce CO 2 Emissions,When Cost Uncertainty Is Taken Into Account(Index, inflexible cap = 1)6543Add bankingor a flooron allowanceprices210Inflexible CapCap WithSafety ValveModified Cap WithSafety ValveTaxSource: Congressional Budget Office based on estimates of the relative magnitude of the net benefits of various policies found in William A.Pizer, “Combining Price and Quantity Controls to Mitigate Global Climate Change,” Journal of Public Economics, vol. 85 (2002),pp. 409–434, and in Richard G. Newell and William A. Pizer, “Regulating Stock Externalities Under Uncertainty,” Journal of EnvironmentalEconomics and Management, vol. 45 (2002), pp. 416–432.Notes: The net benefits of each policy are shown in relationship to each other with the net benefits of an inflexible cap set equal to one. Theinflexible cap and the tax are assumed to be set at the most efficient level—that is, at the point at which the expected marginal cost ofcomplying with the policy would be equal to the anticipated marginal benefit of reducing emissions.The net benefits of a cap with a safety valve (a ceiling on the price of emission allowances) are based on the assumption that the capwould be set at the level of the most efficient inflexible cap and the safety-valve price would be set at the level of the most efficienttax. Banking would enable firms to save unused allowances from one period to use in a future period.The net benefits of a cap-and-trade program with a circuit breaker (not shown in the figure) would be greater than those of an inflexiblecap and less than those of a cap with a safety valve; however, CBO lacked sufficient information to determine how much greater orless they would be.A cap-and-trade program that included a safety valve and either a price floor or banking provisions could be significantly moreefficient than an inflexible cap, although somewhat less efficient than a tax.CO 2 = carbon dioxide.
CHAPTER ONE EFFICIENCY IMPLICATIONS OF DIFFERENT POLICY DESIGNS 7Figure 1-3.Volatility of SO 2 Allowance Prices andSelected Other Prices, 1995 to 2006(Average annual percentage rate of volatility)100806040200Source:Note:CPI S&P 500 SO 2 AllowancesCongressional Budget Office based on William D. Nordhaus,“To Tax or Not to Tax: Alternative Approaches toSlowing Global Warming,” Review of Environmental Economicsand Policy, vol. 1, no. 1 (Winter 2007), pp. 26–44.Volatility is calculated as the annualized absolute logarithmicmonth-to-month change in the consumer price index (CPI),the stock price index for the Standard & Poor’s 500 (S&P500), and the price of sulphur dioxide (SO 2 ) allowancesunder the U.S. Acid Rain Program.design does not include provisions to adjust for unexpectedlyhigh costs and to prevent price spikes. For example,one researcher found that the price of sulfur dioxideallowances under the U.S. Acid Rain Program was significantlymore volatile than stock prices between 1995 and2006 (see Figure 1-3). 12Price volatility was most apparent in the summer of 2000in Southern California’s Regional Clean Air IncentivesMarket (RECLAIM), a program that capped emissions ofnitrous oxide (NO x ) from the power sector. A heat wavecaused demand for electricity to soar that summer, whilethe availability of imported power from other statesdeclined. The increase in demand had to be met by runningmany of California’s old gas-fired generating facilities,which had not yet installed NO x emission controls.12. William D. Nordhaus, “To Tax or Not to Tax: AlternativeApproaches to Slowing Global Warming,” Review of EnvironmentalEconomics and Policy, vol. 1, no. 1 (Winter 2007), pp. 26–44.As a result, the demand for NO x RECLAIM TradingCredits for 2000 rose significantly, boosting their averageannual price tenfold (from $4,284 per ton in 1999 toalmost $45,000 per ton in 2000) and contributing tohigh wholesale electricity prices in California during thatperiod. 13 In addition to the California experience, allowanceprices in the European Union’s (EU’s) EmissionTrading Scheme (ETS)—a trading program that coversCO 2 emissions from roughly 12,000 sources across 27countries—fell drastically when it became evident thatpolicymakers had overallocated emission allowances.Price volatility could be particularly problematic withCO 2 allowances because fossil fuels play such an importantrole in the U.S. economy. They accounted for 85percent of the energy consumed in the United States in2006. CO 2 allowance prices could affect energy prices,inflation rates, and the value of imports and exports.Volatile allowance prices could have disruptive effects onmarkets for energy and energy-intensive goods and servicesand make investment planning difficult. 14 Thesmoother price path offered by a CO 2 tax would betterenable firms to plan for investments in capital equipmentthat would reduce CO 2 emissions (for example, byincreasing efficiency or using low-carbon fuels) and couldprovide a more certain price signal for firms consideringinvesting in the development of new emission-reductiontechnologies.Conditions Under Which a Cap Could Be MoreEfficient Than a TaxTo compare the net benefits of a tax and a cap, researchersmust estimate the marginal benefit of reducing a ton ofCO 2 emissions. The efficiency advantage of a tax over acap, however, does not depend on any particular measureof that benefit or even on the ability to place a monetaryvalue on it. Rather, the advantage of a tax stems from thecumulative nature of climate change and from the factthat a tax is better able to reduce emissions over time13. See A. Denny Ellerman, Paul L. Jaskow, and David Harrison Jr.,Emissions Trading in the U.S.: Experience, Lessons, and Considerationsfor Greenhouse Gases (Arlington, Va.: Pew Center on GlobalClimate Change, May 2003), pp. 24–25, available at www.pewclimate.org/global-warming-in-depth/all_reports/emissions_trading. Some observers argue that the lack of banking provisionscontributed to the price spikes. Such spikes could have beenprevented by the inclusion of a safety valve as well. (Those designfeatures are discussed later in this chapter.)14. Nordhaus, “To Tax or Not to Tax,” pp. 37–39.