Conclusions

Designing a Mandatory Greenhouse Gas Reduction Program for the U.S.

Conclusions

Policy-makers in the United States face a plethora of choices for the design of a domestic GHG regulatory program—upstream or downstream cap-and-trade, GHG tax, product standards, and hybrid programs—as well as the myriad details of program design that must be addressed once the overall approach is chosen. Using the criteria spelled out in Section IV, we evaluated the principal design options. The results of that evaluation are detailed in Section V and summarized below.

Cap-and-Trade Programs

All-source downstream cap-and-trade. An economy-wide downstream cap-and-trade program—because it implies the regulation of millions of individual GHG sources, including cars and homes—would be difficult and costly to administer. It would not be a viable prospect for a domestic GHG regulatory program.

Upstream cap-and-trade. An economy-wide upstream cap-and-trade program would be environmentally effective, could attain least-cost compliance if it incorporates flexibility measures, and would be administratively feasible. Its distributional consequences would depend on how allowances were allocated and, if auctioned, how the auction revenues were recycled back into the economy. These allocation and revenue recycling decisions would influence overall compliance costs. Some methods of allocating allowances (such as generation performance standards) are less economically efficient than others, and can be less efficient than an auction. According to some economists, using auction revenues to reduce “distortionary” taxes could partially offset the costs of the program. Finally, because an economy-wide upstream cap-and-trade program would drive up the cost of gasoline and home heating fuels, it is likely to present a political challenge.

Thus, if policy-makers were willing to accept a program that results in visible increases in gasoline and home heating fuel prices, one environmentally effective, efficient, and feasible option would be a comprehensive upstream cap-and-trade program. Such a program could be coupled with limited free distribution of allowances to compensate affected business, auction of the remaining allowances, and the use of auction revenues for tax reductions and other ends.

There are substantial theoretical benefits from such an approach. The near-term environmental outcome is clear, assuming that the government will maintain the emission limits in the face of possibly significant price uncertainty and volatility. Current analysis indicates that it would minimize economic costs to the economy, be manageable administratively, avoid overcompensating existing emitters, and perhaps capture some offsetting benefits from reduction of distortionary taxes.

But, an economy-wide upstream cap-and-trade program raises a number of issues. First, critics may characterize it as a large, ambitious, and untried experiment in regulation, and may question how it will work in practice. Second, auction revenues may be difficult to predict, making it difficult to match up those revenues with revenue losses from the tax reduction component of the program. Finally, there is the question of whether (and when) Congress will enact such a system. Even in times of most compelling national circumstances, such as the 1973 Arab oil embargo, Congress has not been willing to allow fuel prices to increase sufficiently to bring demand in balance with supply.121 On the other hand, adopting an upstream cap-and-trade program does not inevitably mean accepting a significant and immediate hike in consumer fuel prices. The price impacts could be limited to only a few cents per gallon if the program began with a moderate emissions target and then phased in a more stringent target gradually over time, or incorporated use of a “safety valve.”

A workable variant of the upstream cap-and-trade program described above is an “upstream/ downstream” design that combines a downstream cap-and-trade program for electricity generators and other large sources with an upstream cap-and-trade program for other major sectors of the economy. The McCain-Lieberman bill (see p. 9) reflects this approach.

Large-source downstream cap-and-trade. A large-source downstream program (i.e., one applicable to electricity generators and large industrial sources of CO₂ and of certain other greenhouse gases) is administratively feasible and could be environmentally effective with respect to the sectors it covered. To be fully effective, however, such an approach would have to be coupled with a program to cover other sectors. A large-source downstream program might be more acceptable politically than an upstream economy-wide program because it would not result in price increases for gasoline and home heating fuels (though it still would result in price increases for electricity).

GHG Tax Program
An upstream GHG tax program would allow for adoption of least-cost mitigation strategies, offer short-term cost certainty, and be administratively feasible. A tax program would not provide certainty in meeting a particular short-term emissions target. However, because it is cumulative rather than annual emissions that are important, taxes should be able to provide almost equivalent long-term environmental certainty if there is political will to adjust them over time. The ultimate distributional consequences of a GHG tax would depend on how policy-makers distributed revenues from the tax. However, political acceptability is likely to be a major obstacle since a GHG tax combines both new taxes and fuel price increases. A GHG tax may be more politically attractive as part of a larger tax reform program.

Sectoral Hybrid Program
A sectoral hybrid program such as the one outlined in Box 4 (p. 35) would consist of a large-source downstream program coupled with product efficiency standards. Such a program would be more environmentally effective than a downstream program alone (or standards alone), because standards could address emissions from sources, such as automobiles and appliances, that could not feasibly be covered by the downstream cap-and-trade program. Relying on existing standards programs, the first phase of such a program could attain coverage of about 80 percent of U.S. energy-related emissions. A second phase of the program could address the remaining 20 percent through an upstream cap-and-trade program or through expanded product efficiency standards; the CO₂ program could cover emissions of other greenhouse gases through other measures.

A sectoral hybrid program has the advantage of building on existing regulation, and in the case of CAFE and appliance standards, potentially improving on it (by permitting manufacturers to trade among product lines, with each other, and with other sectors). It would avoid the politically difficult step of attaching a carbon cost to the price of gasoline and home heating. The tradable standard feature would capture some (but not all) of the benefits of a full cap-and-trade system.

However, these largely political attractions of the hybrid program could come at some cost. Substituting product efficiency standards for the transportation fuel component of an upstream cap-and-trade program may downgrade the cost-effectiveness of a program. Even with a trading feature that tries to equate marginal control costs among sectors, a product efficiency standards program lacks incentives to discourage product end-use (and, indeed, might actually encourage greater use, via the “rebound effect”) or to encourage consumers to replace their existing inefficient products for the more efficient new ones (the “junker effect”). The absence of such incentives is likely to make a domestic program that relies on product efficiency standards as an alternative to upstream regulation a more expensive approach to meeting any GHG reduction target. In addition, incorporating tradable standards would present significant administrative challenges because of the need to prevent double-counting of emission reductions and to deal with potential compliance evasion. Finally, any hybrid program is likely to give some beneficiaries of the program a vested interest in retaining it, significantly increasing the difficulty of ultimately converting the hybrid program into a simpler, more efficient economy-wide upstream cap-and-trade program.

In sum, the analysis would argue against an economy-wide downstream cap-and-trade program (as difficult to administer), a stand-alone large source cap-and-trade program (as incomplete), and a GHG tax that is not part of a larger tax reform initiative (as unviable politically). The analysis does suggest that the comprehensive, upstream cap-and-trade approach and the sectoral hybrid approach are the most viable alternatives for a domestic GHG reduction program. While an economy-wide cap-and-trade approach may present the best option for low-cost reductions in greenhouse gases, there are a set of existing sector- based approaches that could be built upon to address greenhouse gases—e.g., the Acid Rain program for electricity generators, appliance efficiency standards, and motor vehicle fuel economy standards. For a variety of institutional, practical, and political reasons, a U.S. domestic emissions reduction program may evolve in this direction. If policy-makers decide on that course, then careful attention will have to be given to minimizing economic costs and administrative complexity, and assuring that the program can be effectively enforced.