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The structural effects of cap and trade climate policy
Energy Economics 31 (2009) S244–S253
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Energy Economics j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / e n e c o
The structural effects of cap and trade climate policy Richard J. Goettle a,⁎, Allen A. Fawcett b a b
College of Business Administration, Northeastern University, United States U.S. Environmental Protection Agency's Climate Change Division, United States
a r t i c l e
i n f o
Article history: Received 3 April 2009 Received in revised form 25 June 2009 Accepted 25 June 2009 Available online 3 July 2009 JEL classification: C68 H23 Q43 Q54 Q58
a b s t r a c t The Inter-temporal General Equilibrium Model (IGEM) explores the cost to the U.S. economy of increasingly more stringent cap and trade regimes. The economy-wide losses are small with energy, agriculture, chemicals, high tech manufacturing and trade being most affected. The availability of lower cost offsets substantially reduces these economic losses. The economy becomes less capital but more labor intensive. Household welfare losses are smaller for full consumption (goods, services and leisure). A more inelastic trade-off between consumption and leisure dramatically reduces policy costs as do more favorable revenue recycling options. Induced technical change yields a small, measurable reduction in policy costs. © 2009 Elsevier B.V. All rights reserved.
Keywords: Cap and trade Allowance prices Climate policy Welfare Capital and labor markets Induced technical change Revenue recycling
1. Introduction This paper is one of a series in the Energy Modeling Forum's analysis of U.S. and international climate policy scenarios and architectures (EMF 22). In it, we employ the Inter-temporal General Equilibrium Model (IGEM) of Dale Jorgenson Associates (DJA) to simulate the economy's reaction to the three U.S. cap and trade regimes considered in EMF 22. Our focus is estimating the economic costs of these regimes as there are no considerations of the effects of climate change, positive or negative, on the economy or the possible benefits of these regimes in terms of avoided economic damages. IGEM is a dynamic computable general equilibrium (CGE) model of the growth and structure of the U.S. economy and has been used in a variety of efforts related to climate change and climate change policy (e.g., see Jorgenson et al., 2000, 2004, 2008, 2009; EPA, 2009). Because IGEM represents a comprehensive range of economic responses in 35 commodity-industry groups and 5 final demand sectors and because it is econometrically estimated from over forty years of market data, it is well suited to address both the broad and detailed market implications of climate change policy over the intermediate term. The market-based incentives arising from cap and trade climate policy ⁎ Corresponding author. E-mail address: [email protected] (R.J. Goettle). 0140-9883/$ – see front matter © 2009 Elsevier B.V. All rights reserved. doi:10.1016/j.eneco.2009.06.016
secure emissions abatement through three sources — output reductions, input and output restructuring and induced technical change. In this paper, we emphasize IGEM's structural content in exploring these three pathways. The remainder of our paper is organized as follows. Section 2 presents policy assumptions unique to this analysis. Sections 3, 4 and 5 provide, respectively, discussions of the temporal consequences of six cap and offset combinations, the details of macroeconomic adjustment common to all years and all model runs and the effects on domestic production and U.S. capital and labor markets. Section 6 considers the impacts on household welfare and the effects of less responsiveness in household consumption and leisure decisions. Section 6 also considers the welfare effects of alternative revenue recycling mechanisms. Section 7 examines the role of induced technical change in easing the economic burden of adjustment and also provides estimates of its magnitudes. Finally, section 8 offers a summary and series of conclusions. 2. Policy assumptions While these simulations only approximate the details of a complex and comprehensive cap and trade proposal, they nevertheless incorporate the full variety of provisions considered to date. These include emissions constraints or “caps,” the allocation of tradable
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emissions allowances, banking (but not borrowing) and abatement opportunities in the form of domestic (but not international) offsets. The details of these scenarios are reported elsewhere in this volume and are not repeated here. The analysis examines three alternative caps on cumulative, economy-wide greenhouse gas (GHG) over the period 2012–2050. These alternatives are in the amounts of 287 giga-tonnes (metric) of carbon dioxide (CO2) equivalent (GtCO2-e), 203 GtCO2-e and 167 GtCO2-e. The first of these (287 GtCO2-e) involves a relatively flat emissions path, beginning in 2012 at 7342 million metric tonnes of CO2 equivalent (MtCO2-e) and rising to 7376 MtCO2-e by 2050; these amounts are 2.2 and 2.7% higher, respectively, than the 7182 MtCO2-e estimated for 2008. The time paths for the latter two regimes (203 and 167 GtCO2-e) yield reductions in emissions levels in 2050 that are 50% and 80% below the 6148 MtCO2-e observed in 1990. The caps reference the economy-wide emissions of six greenhouse gases — carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulfur hexafluoride (SF6) — as measured by their global warming potentials (GWPs) over a 100-year horizon (EPA, 2008; IPCC, 1996) and expressed in terms of metric tonnes of carbon dioxide equivalent (tCO2-e). In IGEM, revenue from the free allocation of allowances accrues to the employee–shareholder–household while revenue from the auction of allowances flows to the U.S. government. For the aggregate representation of the household sector, there is only a “representative” consumer and so there are no distinguishing behaviors among IGEM's employee–shareholders who, in the “real” world, would differ by reasons of occupation, industry of employment and corporate ownership among other things. This means that the inter-temporal choices of households (i.e., present versus future spending on consumption and leisure) followed by their consumption-versus-leisure decisions are unaffected by the initial allocations of allowances to specific stakeholders in specific industries. Put differently, the estimated market outcomes in these simulations are independent of and invariant among alternative allocation schemes. Under the condition that a policy scenario is both deficit and revenue neutral with respect to the fiscal positions of federal, state and local governments, the following two allocation options yield identical market outcomes in IGEM. In one scheme, all allowances are distributed freely to emissions sources. Motivated by economic self interest, these entities use, buy or sell allowances as market conditions dictate. Governments are assumed to adjust their tax policies through changes in personal exemptions (i.e., through lump-sums) so as to preserve pre-policy deficit and spending levels. In the alternative scheme, all allowances are auctioned with the proceeds flowing to the U.S. Treasury. These revenues then are redistributed to households in lump-sums but only to the extent that government deficit and spending levels are maintained. Lump-sum redistributions are well known as the least favorable means of revenue recycling and such an assumption begs additional considerations of possible joint tax reforms and even a “double dividend.” While the existence and magnitude of a double dividend remain unsettled empirical questions, there is broad agreement that there are better and worse ways to recycle allowance revenues (e.g., Goulder, 1994; Jorgenson and Yun, 1991; Jorgenson et al., 2000; Tuladhar and Wilcoxen, 1999). Adopting the assumption of lump-sum transfers in this analysis helps insure the upper-bound nature of the policy cost estimates. It simultaneously suggests that modest changes in government tax policies can serve to ameliorate these costs. Similarly, there is no presumption that base case deficit and spending levels are somehow preferable to any others, only that their preservation avoids the complications over what to do with new allowance revenues or about any tax losses. In addition to tradable allowances, the scenarios evaluated here allow sources to meet their compliance obligations by purchasing domestic abatement offsets from “outside” the system (i.e., the model). As the “economics” warrant, emissions reductions can be
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acquired from new opportunities in the coal, oil and gas sectors, in landfill management and in domestic agriculture including afforestation and soils sequestration. Central to this analysis is the concept of marginal abatement cost (MAC). This cost measures the sacrifice to the economy of diverting additional scarce resources to the elimination of the next tonne of emissions. Both theory and practice confirm this cost to increase as the number of tonnes abated increases, often at an increasing rate and often with areas of “no regrets” or minimum cost thresholds. Currently, all foreseeable abatement opportunities related to the emissions from CO2 sources are handled internally by the structure of and parameter estimates in IGEM. This means the marginal abatement cost schedules implicit in IGEM simulations accurately portray all the economic costs of intermediate-term mitigation. External to IGEM are judged to be those abatement opportunities related to non-CO2 greenhouse gases, carbon dioxide capture-andstorage (CCS) technologies, bioelectricity and biofuels in transportation (biotransport). External to IGEM but competing under the cap are the MACs associated with CCS, bioelectricity, biotransport, and the HFCs, PFCs and SF6. External to IGEM but considered as domestic offsets outside the cap are the CH4s and N2Os from the coal, oil and gas sectors, landfills, and agriculture (e.g., afforestation, animal waste, forest management and soils sequestration). The external MAC schedules are taken from analyses internal to or sponsored by the U.S. Environmental Protection Agency (EPA) and include simulation results from the FASOM and ADAGE models for agriculture and CCS, respectively. There are concerns that “domestic offsets” provide lower costs but in exchange for lower certainty of environmental integrity. This arises from the greater uncertainty of their abatement potential, their additional complexity to a cap and trade system, and their not-soinsignificant costs for measurement, monitoring, and verification. While legitimate, the external MAC schedules employed here were carefully developed and fully vetted by EPA with these concerns in mind. The MACs and their underlying assumptions and methodologies have long been in the public domain and are widely used and shared by the modeling and analysis communities. Their use here is predicated on the belief of the best information currently available. 3. The temporal consequences of cap and trade policy The three cap scenarios are combined with two assumptions regarding domestic offsets to create six scenarios. Accordingly, we ran simulations for the 287, 203 and 167 GtCO2-e caps first with no domestic offsets allowed and next with domestic offsets limited only by their abilities to be cost-competitive with other abatement options. In the current naming convention, we label these scenarios as allowing unlimited domestic offsets in the sense that they are free of any policyimposed constraints on their ability to compete solely on their “economics.” Our focus here is on the time path of allowance prices, the structure of abatement and, in turn, their effects on the overall economy over the intermediate term, 2012–2050. Fig. 1 shows the allowance prices for the six simulations in terms of year 2005 GDP purchasing power. Allowance prices begin at $2 to $4 per tCO2-e for the 287 GtCO2-e cap, $15 to $26 for the 203 GtCO2-e cap and $24 to $45 for the 167 GtCO2-e cap. Each then rises annually under conditions of optimal banking at an assumed (exogenous) interest rate of 5%. Two conclusions emerge from these results. First and most obvious, allowance prices in all cases continue to rise as the emissions constraint becomes more stringent or, equivalently, as the gap widens between the cap and what emissions would have been in its absence. Second, economic agents choose the least expensive portfolio of abatement options subject to their individual availability and, here, domestic offsets are the low cost source. Given the MAC schedules for abatement opportunities from these sources and under the condition that buyers can acquire whatever abatement is economically justified
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Fig. 1. Allowance prices. Fig. 3. 203 GtCO2-e with unlimited domestic offsets.
from these markets, abatement overall is cheaper with domestic offsets than it is without them. The importance of these allowable external alternatives cannot be overemphasized. In their absence, long-run allowance prices are 66% (287 GtCO2-e) to 87% (167 GtCO2-e) higher. Limits on their use, statutory or otherwise, force more expensive alternatives. The sources of abatement are illustrated in Figs. 2 and 3 which detail the 203 GtCO2-e simulation results. Without domestic offsets, there is less banking, more expensive abatement from CO2 and non-CO2 sources and earlier and larger market penetrations of the more expensive bioelectricity and CCS (Fig. 2). However, with unlimited domestic offsets over this period, businesses choose the lowest cost options available to them. There is more banking, less expensive abatement from CO2 and non-CO2 sources and delayed commercialization of bioelectricity and CCS (Fig. 3) all because cheaper abatement is available. The consequences for the overall economy correspond to the patterns of allowance prices and abatement costs. Fig. 4 shows the effects on real GDP. Clearly, the economy can absorb these constraints on emissions with relative ease. The largest of these involves an almost imperceptible 18 basis point reduction in annual GDP growth. For comparison, IGEM benchmarks to the Energy Information Administration's (EIA's) Annual Energy Outlook (AEO) 2006 and to AEO 2008 (used here) differ by 33 basis points (EIA, 2006, 2008) or almost twice as much. Across all scenarios by 2025, economic losses range from 0.3 to 3.7% of the baseline GDP estimate. By 2050, this range expands to 0.7 to 7.3%. Not surprisingly, the losses in real GDP are, on average, almost 40% smaller under each of the three caps when the less expensive domestic offsets are allowed to compete. As discussed below, the impacts on GDP are spread across all its components with the effects on household spending being proportionally among the smaller. As shown in Fig. 5, the reductions in consumption are, ultimately, a third to a half of those of GDP. By 2025,
Fig. 2. 203 GtCO2-e with no domestic offsets.
the consumption losses range from 0.1% to 1.5% of the baseline estimate. By 2050, the range of losses grows to 0.2% to 3.6% and, again, the losses are about 40% smaller with unlimited domestic offsets. Obviously, progressively more stringent caps raise allowance prices (Fig.1) and increase their economic costs (Figs. 4 and 5). Equally obvious is that the cheaper abatement available in limited quantities from domestic offsets eases these burdens. From a policy design perspective, two points remain clear. First, under even the most restrictive cap, the economic losses are small with overall growth being only slightly slowed. Second, and most importantly, allowing any and all measurable, verifiable and permanent abatement sources to compete freely for their rightful place in the mitigation hierarchy is the principal way of avoiding or minimizing these adverse market consequences. 4. The details of macroeconomic adjustment We next more closely examine the economy's responses to policy by considering the more detailed adjustments in a particular year, 2030, and scenario, 203 GtCO2-e cap. These adjustments along with those discussed in section 5 are qualitatively identical to what happens in all other years and scenarios with the observed changes being merely matters of degree. Our choice of the 203 GtCO2-e scenario also is motivated by the fact that it is closest in spirit and magnitude to the numerous public policy initiatives to which IGEM recently has been applied (EPA, 2009). Given this proximity to legislative proposals, the ensuing discussions of the details of this scenario are more likely to be of interest and relevance to those crafting these proposals. As shown in Fig. 6, the emissions constraint and resulting allowance prices adversely affect each aspect of aggregate demand (real GDP) — consumption, investment, government purchases, exports and
Fig. 4. Impacts on real GDP.
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Fig. 5. Impacts on real consumption.
imports. Perhaps surprising are the disproportionate losses borne by each of these components. Consumption, which is 60% of final demand, accounts for only 27% of the $0.35 trillion loss while investment and exports, at 20% and 12% of GDP respectively, account for 40% and 28% of the year's loss. To the extent the cap is binding, everything becomes more expensive and everyone then must adjust to the higher prices. However, the reactions to these higher prices are far from uniform and are rather more complex and varied. The impacts on industry prices (and domestic production) are presented in Fig. 7. Clearly, energy prices — coal, oil, gas and electricity — are most affected, with coal more so than any other commodity. This is not surprising in that 87% of the year 2006 GHG emissions are related to the use of coal (30%), oil (41%) and gas (16%). In addition, coal is high in carbon content in relation to the other fossil fuels and is used extensively along with gas and some oil in the manufacture of electricity. Domestic crude oil and gas extraction prices decline as the lower domestic production that follows from reduced petroleum demand is obtained at lower cost. However, this is the only price (cost) reduction that occurs. All non-energy prices increase. Some — like those of agriculture, chemicals, stone, clay and glass, primary metals, electrical machinery (semiconductors) and services (waste management) — are affected both directly and indirectly as their activities are emissions generating. Others like construction, food, textiles, furniture, paper, publishing, motor vehicles, instruments, communications and trade are affected only indirectly. The overall impacts on the economy are dominated by the decisions of households. Their first decision concerns the intertemporal allocation of expenditure on good, services and leisure.
Fig. 6. Composition of GDP and losses, 2030.
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When leisure is added, total household expenditure is denoted as full consumption. Households know that the price increases from mitigation policy will be larger “tomorrow” than they are “today” as the emissions from a growing economy make meeting the various binding constraints more difficult over time. Households view this as a progressive erosion of real incomes and purchasing power. Accordingly, there occurs a redistribution of expenditure on full consumption toward the present and away from the future. Put another way, households spend “now” rather than “tomorrow.” This small but measurable inter-temporal shifting is recognizable in the “pre-policy” time patterns of both GDP (Fig. 4) and consumption (Fig. 5). Households next decide on the allocation of full consumption between goods and services on the one hand (i.e., traditional consumption) and leisure on the other. As discussed in section 6, this decision is central to explaining the magnitude of economic outcomes. Because mitigation policy makes all consumer goods and services more expensive, the overall price of consumption now is also higher. The increased price of consumption relative to the price of leisure prompts households to substitute the latter for the former. Within the overall increase in full consumption arising from the inter-temporal effect, comparatively more is spent on leisure than is spent on consumer goods and services. The decline in real consumption occurs because the increase in consumer spending is proportionally smaller than the increase in consumer prices. In addition to the consumption-related impact on aggregate demand, this second decision by households also has important implications for the supply side of the economy. The rising price of goods and services relative to wages results in a reduction in household labor supply that is equal to and opposite from the increase in household leisure demand. Households respond to the decrease in real wages by supplying less labor and demanding more leisure. While increasing leisure is welfare improving for households (again, section 6), their reductions in labor supply at prevailing wages reduce labor and, hence, national income. The third decision by households concerns the allocation of real purchases among the variety of consumer goods and services but within the overall level of reduced total real spending. Like the adjustments above, there occurs a redirection of expenditure away from those goods and services incurring the larger price increases and toward those goods and services experiencing the smaller price increases. Because household spending is such a large fraction of overall spending, the actions taken here strongly influence the structure of real GDP and the domestic production that supports it. The reduction in labor income arising from the household sector's reduced labor supply and increasing demand for leisure combines with lower capital income from businesses to yield a reduction in national income and nominal GDP. However, as indicated above, personal consumption increases due to the inter-temporal effect of shifting spending from the future to the present and to the fact that overall consumption is price inelastic. With falling income and rising consumption, private saving falls. The reduction in saving leads to a corresponding reduction in private investment, hence, the comparatively large investment effect in Fig. 6. With higher prices for investment goods, the available investment funding buys even fewer capital goods. Lower saving leads to lower investment, a lower capital stock, lower returns on that capital stock and less capital availability. This and the reduced availability of labor are primarily what limit the economy's domestic supply possibilities following the introduction of policy. IGEM's saving–investment balance summarizes the net flow of funds available for investment. These funds arise from three sources. The first source, discussed above, is the domestic saving of households and businesses. All things being equal, increases in saving lead to more investment while decreases in saving lead to less. The second source reflects the behavior of the collection of governments that comprise the national economy and the magnitude of their combined annual deficit or surplus. The third source focuses on the nation's interactions with the rest of the world and whether the annual current account balance is deficit or surplus.
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Fig. 7. Impacts on domestic prices and production, 2030.
To eliminate governments' direct effects on real investment spending through the saving–investment balance, the simulations conducted for this analysis assume both deficit and revenue neutrality in nominal terms. Accordingly, as the prices facing governments rise, there occurs a proportionally equal reduction in the real goods and services that governments are able to purchase. While there are numerous potential reactions concerning the fiscal policies of governments, the above assumptions give rise to transparent outcomes that are uncomplicated by speculations on what governments might do to soften any adverse policy impacts. The prices of U.S. exports rise relative to goods and services from the rest of the world. As exports are estimated to be price-elastic, export volumes fall by proportionally more than export prices rise explaining the large export effect in Fig. 6. In addition, there is no simulated overseas income effect associated with exports and, so, with only the aforementioned price effects, U.S. export earnings decline. Real and nominal imports also decline. First, import reductions occur from the overall reductions in spending associated with a smaller economy. Second, import reductions occur in those commodities directly affected by mitigation policy. By assumption, the emissions cap and allowances fall on all of the commodities that contribute to U.S. greenhouse gases, irrespective of whether they were produced domestically or imported. Thus, within total imports, there are disproportionate reductions in oil, gas and other policy-sensitive commodities as their prices rise along with those of their domestic counterparts. Finally, import substitution partially offsets these two forces. There is a greater incentive to import as domestic prices now are relatively higher for the commodities not directly affected by policy. For unaffected imports, there occurs a restructuring toward those commodities that obtain the greater price advantages in relation to those produced domestically and to those imports that are relatively cheaper within overall imports.
With only prices affecting exports and both prices and incomes affecting imports, the reduction in nominal imports exceeds the decline in export earnings. To neutralize this impact so that the effects on investment arise solely and transparently from those on domestic saving, the dollar strengthens to the point where it restores the current account balance to its pre-policy level. The condition in policy experiments that the value of the dollar adjusts to preserve existing (i.e., base case) current account balances (i.e., desired foreign saving) and U.S. indebtedness (i.e., willingness to hold dollar-denominated assets) is intentional in that IGEM is specified to represent only the domestic U.S. economy. 5. Production and the capital and labor markets All industries with the exception of processed food, tobacco and textiles, but especially those related to energy, experience declines in output volumes (Fig. 7). This results not only from higher prices, the restructuring of inputs and outputs and declining demands throughout the economy but also from the limitations on supply that arise from changes in labor and capital availability and from productivity. Producers do their best to insulate their output prices from the impacts of more expensive energy and non-energy inputs. Substitutions away from more costly inputs and toward relatively cheaper materials, labor and capital help minimize the adverse effects. Beyond these factor substitutions, there is also price-induced technical change at work in each industry (section 7). Ultimately, producers can do only so much in the face of reduced demands and limited factor supplies. In the end, firm and industry profits and cash flows (i.e., the revenues accruing to owner–shareholders) are unavoidably less. Fig. 8 illustrates the relative magnitudes in comparing the importance of an industry in total output to that of its loss in the total loss. In ascending order, the largest losses in absolute terms are
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Fig. 8. Composition of output and losses, 2030.
Fig. 9. Impacts on revenues and incomes, 2030.
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borne by agriculture, chemicals, non-electric and electric machinery and trade. Small sectors of the economy that are emissions intensive bear disproportionately large shares of the mitigation costs with the energy industries among the foremost. These include coal mining, oil and gas extraction, petroleum refining, electric and gas utilities, agriculture, chemicals, primary metals and stone, clay and glass. At the other extreme, there are sectors of the economy, including the two largest, that are less energy and emissions intensive with disproportionately small burdens and even some realized gains. These include finance, services, communications and processed food. Finally, it is noteworthy that the high technology industries of electric and nonelectric machinery, the “stars” of U.S. manufacturing, incur costs well in excess of their comparatively large shares in total output. Traditionally, changes in economic activity are viewed from the demand side as policies affect overall spending, its components and related production. However, in CGE models, it is equally appropriate to focus on aggregate supply and, in particular, on primary factor markets. Fig. 9 shows the impacts on industry revenues, in producer prices, and on capital and labor incomes. These changes follow the patterns of industry price and output effects depicted in Fig. 7. In broad terms, the losses in revenue are comparably borne by employees and “shareholders.” The components of value added appear to share the consequences of mitigation policy more or less equally. However, a closer examination reveals that the reductions in capital incomes are generally somewhat larger than those for labor. This is certainly consistent with the policy's adverse impacts on investment and capital accumulation and suggests that shareholders fair marginally worse than do employees under these cap and trade regimes. Of major concerns to policy makers are the impacts of climate change initiatives on jobs and employment. CGE models like IGEM cannot address
specifically these concerns as labor is measured in terms of qualityadjusted hours rather than persons and prices adjust to equate the labor (hours) demanded by employers with the labor (hours) supplied by households. Still, inferences can be drawn from the observed changes in labor. Fig. 10 shows the changes in capital and labor quantities that correspond to the income changes in Fig. 9. Fig. 10 also shows the changes in the labor intensity of output as measured by industry input–output ratios. The real changes in primary inputs in Fig. 10 match the nominal changes shown in Fig. 9. More importantly, the economy becomes more labor intensive. Households substitute leisure for labor and consumption for saving. Businesses substitute labor for energy, now more expensive, and capital, now less available. The bad news is that the unfortunate reductions in output lead to corresponding reductions in capital and labor demands. The good news is that the adjustments are labor-protecting. 6. Welfare considerations The theoretical structure of IGEM's household sector and its empirical representation permit the measurement of welfare changes for the “representative” consumer at the levels of consumption (goods and services) and full consumption (goods, services and leisure). These are expressed as equivalent variations in the present values of lifetime expenditure and measure the changes in household welfare (utility) at the base case prices and interest rates. Fig. 11 shows these metrics for the six scenarios of this exercise. Several conclusions emerge from these results. First, the substitution toward leisure is welfare improving for households. For the least restrictive cap (287 GtCO2-e), this substitution more than compensates the welfare loss in goods and services. For the more restrictive caps (203 and 167 GtCO2-e), the welfare losses in terms of full
Fig. 10. Impacts on input demands and labor intensity, 2030.
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Fig. 11. Equivalent variations in consumption and full consumption.
consumption are only 18 to 34% of those exclusive of leisure. Second, allowing the use of domestic offsets is welfare improving. When measured in terms of consumption, the welfare losses are 36 to 39% smaller with unlimited offsets. This loss improvement increases to 55% when measured by full consumption and, in the 287 GtCO2-e scenario, the welfare gain is 31% larger with unlimited offsets. Third, the percentage point loss in welfare per giga-tonne abated increases with the severity of the cap but is smaller for full consumption than for consumption and is smaller with unlimited domestic offsets than with no domestic offsets. This is not surprising in that these measures reflect the underlying, increasingly expensive MAC schedules both internal and external to IGEM. Fig. 11 also shows the welfare changes for a policy scenario, labeled as 216 GtCO2-e, from an ongoing EPA analysis. This scenario is similar in scale to the 203 GtCO2-e cap with unlimited domestic offsets. It differs in that 1) the cap is less severe and not economy-wide, 2) international permit trading is allowed and is cheaper but limited, and 3) bioelectricity and CCS are subsidized. As a result, the welfare losses are about 75% of those for the 203 GtCO2-e case. The average annual losses in real GDP are in the range of 80% of those for the 203 GtCO2-e case while real consumption losses, like overall welfare, are 25% smaller. The 216 GtCO2-e scenario is included here to demonstrate two things. First, as is well documented (Jorgenson et al., 2000, 2008, 2009), the parameter governing the allocation of full consumption between the demand for goods and services (i.e., consumption) and the demand for leisure is a dominant factor in CGE model outcomes, and not just IGEM's. Household choices concerning leisure demand simultaneously determine labor supply and, hence, labor income. For a given national income, decisions on how much to consume determine the household and business saving that funds private investment. Investment adds to the capital stock which, in turn, is the source of capital income. From these, it is evident that this single decision influences the entire supply side of the economy. With IGEM as estimated, the compensated elasticity of labor supply in the 216 GtCO2-e simulation averages around 1.0 for the period 2007–2050. As shown in Fig. 11, altering IGEM's parameters and approximately halving this number approximately halves the welfare losses. Accordingly, this single trade-off has clear and important implications for reconciling simulation results across methodologies. Second, all the simulation runs described thus far presumed lumpsum redistributions of allowance revenues. To examine preferred
alternatives, the 216 GtCO2-e scenario is simulated with auction revenues recycled, first, through reductions in the average marginal tax rate on labor income and, second, through changes in a general, economy-wide investment tax credit. The welfare changes for these simulations also appear in Fig. 11. In terms of consumption, each of these mechanisms is welfare improving as each nearly halves the welfare losses arising with lump-sum transfers. The investment tax credit is favored only slightly over reductions in the marginal labor tax rate. In terms of full consumption, there emerges a rather different conclusion. In the longrun, the investment tax credit further improves welfare with greater capital accumulation substituting for labor and allowing more leisure to compensate the loss in consumption. Conversely, the marginal labor tax rate is inferior to both mechanisms when considering full consumption. True, there is an improvement in terms of goods and services but the labor tax promotes labor supply (and demand) at the expense of leisure and, so, the welfare losses in full consumption are greater. 7. Induced technical change As indicated at the onset, emissions abatement occurs as a consequence of output reductions, input and output substitutions and induced technical change (ITC) with the latter in the form of either innovation or end-of-pipe treatments. The magnitude of ITC is important because its presence lowers the economic costs of achieving a given emissions target or, equivalently, allows more aggressive reductions for a given willingness-to-pay (Goulder, 2004). Price-induced patterns of innovation are represented formally in IGEM's structure of production (Jorgenson and Jin, 2005, 2006). Nonprice trends in factor intensities (cost shares) such as capital-using or labor- or energy-saving behaviors combine with evolving patterns of input prices to influence industry output prices and, hence, demand, either favorably or unfavorably. While this formulation captures what occurred historically, IGEM also provides a plausible sense of the magnitude of future ITC benefits to the extent that the estimated trends in observed innovation accurately portray future realities. Accordingly, a policy change introduced into IGEM alters the future patterns of relative prices and so “induces” changes in productivity, albeit, through policy-invariant multipliers of innovation. The end-of-pipe treatments from specific technologies are not represented formally within IGEM but are and can be introduced externally into a given simulation. Indeed, the abatement opportunities
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underlying the external domestic MAC schedules aggregate many such options, particularly in agriculture, forestry, carbon dioxide captureand-storage (CCS) technologies, bioelectricity and biotransport. Others, such as electric and hybrid vehicles or hydrogen fuel cells, easily could be modeled in a similar way. Emissions in IGEM are driven by domestic production and imports at industry-commodity levels. Emissions coefficients and their trends, like the aforementioned patterns of technical change, are estimated and projected from historical data. If the endogenous penetration of end-of-pipe treatments cannot be represented through the development of external technology-specific offsets, then exogenous changes in IGEM's emissions factors offer an alternative mechanism through which induced technical change may be represented. However, unlike MAC schedules, this approach captures only the benefits of these treatments, ignoring their costs. To ascertain the importance of IGEM's econometric representation of ITC, model results are used to calculate the magnitudes of ITC within a given simulation. Next, the differences between a policy case and the base case are determined. These differences measure the changes in ITC that are induced by the policy experiment and imparted to the relative prices in IGEM. Fig. 12 shows these effects for the years 2030 and 2050 from the 203 GtCO2-e simulation with unlimited domestic offsets. Clearly, the ITC effects that arise from this policy have an overall positive effect on economic performance. As evidenced by the valueshare weighted average of the ITC effects in each industry, prices are lower and the economy is larger than would be the case in the absence of ITC. Ironically, as the economy is larger, GHG emissions are higher as are the allowance prices required to achieve the targeted abatement. Equally clearly, the role of ITC is small in comparison to the much larger effects of substitution and economic restructuring seen above (see also Jorgenson et al., 2000). However, these relative magnitudes
are consistent with findings summarized in Goulder (2004) and with other informative contributions to the literature (Nordhaus, 2002; Sue Wing, 2003). The favorable impacts of ITC are cumulative. From the onset, there are measurable and positive benefits and these increase with the passage of time, e.g., the 2050 impacts exceed those of 2030. Again, these ITC effects arise solely from the interactions of the estimated factor biases and the policy-induced changes in relative prices. If policy were to induce or, more importantly, if it also provided incentives designed to appropriately alter these biases (e.g., through targeted R&D and investment tax credits) and stimulate the development and expansion of end-of-pipe treatments, then these results would be magnified. The role of ITC would become vastly more significant reflecting the driving forces of not only relative price changes but also policy-induced innovation as reflected in non-price changes in factor intensities, emissions drivers and sources of abatement. These ITC effects also have structural implications for the economy and, so too, for energy use and GHG emissions. This is illustrated by focusing on three sectors in Fig. 12 — electric utilities, trade and services. ITC in the electric utilities sector plays the dominant role in the overall ITC effect observed. In the presence of ITC, electricity prices are lower and demand is higher than were there no ITC. In short, the empirically observed ITC in this sector works somewhat against the goals of policy. Since ITC helps to lower electricity prices, unconstrained energy use and emissions are higher which means that allowance prices also have to be higher to achieve a given emissions reduction. However, in the absence of ITC, electricity prices would be higher and demand lower. These imply a corresponding reduction in energy inputs to this sector and, hence, lower emissions. The absence of ITC in the electricity sector would reduce the electricity intensity of the economy which means that allowance prices would not have to rise as high to satisfy an emissions constraint.
Fig. 12. Endogenous technical change, 2030 and 2050.
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ITC in trade and services has different implications but contributes similarly to this outcome. Here, the ITC effects work to raise their prices. This is harmful to their growth and to the overall economy. Eliminating these ITC effects would lower the relative prices of trade and services, improve their relative performance and help the economy. But these sectors are not energy or emissions intensive. The restructuring that occurs in the absence of these calculated ITC effects would yield an economy that is less energy and emissions intensive and, again, the allowance prices that would be necessary to achieve the targeted reduction would be marginally lower.
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with empirically observed non-price trends in factor intensities. What is unknown is the degree to which this or any other mitigation policy influences or can be made to influence the trends and biases in innovation and the development and adoption of end-of-pipe treatments. Investment tax credits and other such market incentives, targeted to reducing greenhouse gas emissions and to promoting alternative technologies, could accelerate the realization of ITC benefits by further altering the speeds and directions of innovation along with relative prices. Bringing empirical content to the growing literature on policy- and price-induced technical change remains a high priority on the research agenda.
8. Summary and conclusions The purpose of this exercise is to offer an economic analysis of the U.S. economy under increasingly severe cap and trade regimes. The overall economic impacts of these alternatives are estimated to be small even in the most restrictive of cases. While the aggregate costs are small and readily absorbed, there are much larger impacts at the industry level. The energy sectors — coal mining, crude oil and gas extraction, petroleum refining and electric and gas utilities — are particularly hard hit. Beyond the energy sectors, agriculture, chemicals, high technology manufacturing and trade incur relatively large losses. The declines in communications, finance and services sectors are minimal while food, tobacco and textile outputs actually increase. In terms of primary inputs, employee and shareholder incomes decline as do the demands and supplies of labor and capital inputs. However, the former are relatively less affected than the latter, so the economy becomes more labor intensive and less capital intensive in reaction to the caps on emissions so, implicitly, there is some job protection in these adjustments. A principal conclusion of this analysis concerns the limits independently placed on emissions offsets. These alternatives offer abatement at a lower cost than can be secured elsewhere within the activities covered by policy and so reduce the already small economic costs of mitigation policy. In the spirit of market-based incentives, the limits governing the use of marketable and verifiable abatement offsets should arise solely from their “economics” within an overall assessment of policy costs. The magnitudes of policy costs are heavily influenced by household consumption-saving and labor-leisure decisions and by the choices of revenue recycling mechanisms. The comparatively strong substitution toward leisure is an offsetting influence on the welfare costs of higher prices and lower outputs and incomes. IGEM's top-down view has tended to yield labor supply elasticities toward the upper end of the range observed in the empirical literature. Bottom-up approaches have tended to yield estimates toward the lower end of this range. Confining IGEM to a lower elasticity estimate substantially reduces the adverse impacts of policy on household welfare. Through these same household responses, alternative recycling policies are seen to be welfare improving or welfare destroying depending on the tax vehicle and welfare measure. The lack of definitive resolutions in these areas opens the possibility of smaller policy costs arising from less responsive household behavior and more favorable tax treatments. The empirical content of IGEM permits a first approximation of the effects of induced technical change (ITC) at both the industry and macroeconomic levels. The net effect of ITC economy-wide is to reduce the economic costs of mitigation policy. The ITC effects in IGEM arise from combining policy-induced changes in relative input prices
Acknowledgements The efforts underlying this paper were sponsored by the U.S. Environmental Protection Agency (EPA) under Contract No. EP-W-05035. We are grateful to our colleagues at Dale Jorgenson Associates and the U.S. Environmental Protection Agency, to Martin Ross of RTI International, Inc. and to our two referees.
References Energy Information Administration (EIA). Annual Energy Outlook 2006 and 2008. At http://www.eia.doe.gov/oiaf/archive.html. Goulder, L.H., 1994. Energy taxes: traditional efficiency effects and environmental implications. In: Poterba, J.M. (Ed.), National Bureau of Economic Research (NBER). In: Tax Policy and the Economy, vol. 8. The MIT Press, Cambridge, MA, pp. 105–158. Goulder, L.H., 2004. Induced Technical Change and Climate Policy. Pew Center on Global Climate Change. October, Arlington, VA. Intergovernmental Panel on Climate Change (IPCC), 1996. Climate Change 1995: The Science of Climate Change. Cambridge University Press, Cambridge, UK. Jorgenson, D.W., Jin, H., 2005. State-space Modeling of Endogenous Innovation in the U.S. Economy. Working paper. Harvard University, Cambridge, MA. Jorgenson, D.W., Jin, H., 2006. Econometric Modeling of Technical Change. Presented at the 20th Anniversary Symposium of the Korean Econometric Society, Seoul National University. 19 July, Revised 22 August. http://post.economics.harvard. edu/faculty/jorgenson/papers/papers.html. Jorgenson, D.W., Yun, K.-Y., 1991. The excess burden of U.S. taxation. Journal of Accounting, Auditing, and Finance 6 (4), 487–509. Jorgenson, D.W., Goettle, R.J., Wilcoxen, P.J., Ho, M.S., 2000. The Role of Substitution in Understanding the Costs of Climate Change Policy. Pew Center on Global Climate Change, Arlington, VA. September. Jorgenson, D.W., Goettle, R.J., Hurd, B.S., Smith, J.B., Chestnut, L.G., Mills, D.M., 2004. The U.S. Market Consequences of Global Climate Change. Pew Center on Global Climate Change, Arlington, VA. April. Jorgenson, D.W., Goettle, R.J., Wilcoxen, P.J., Ho, M.S., 2008. The Economic Costs of a Market-based Climate Policy. Pew Center on Global Climate Change, Arlington, VA. June. Jorgenson, D.W., Goettle, R.J., Wilcoxen, P.J., Ho, M.S., 2009. Cap and trade climate policy and U.S. economic adjustments. The Journal of Policy Modeling 31 (3), 362–381 (May/June). Nordhaus, W.D., 2002. Modeling induced innovation in climate change policy. In: Grubler, A., Nakicenovic, N., Nordhaus, W.D. (Eds.), Modeling Induced Innovation in Climate Change Policy. Resources for the Future, Washington DC, pp. 259–290. Prepublication Version. Sue Wing, I., 2003. Induced Technical Change and the Cost of Climate Policy. MIT Joint Program on the Science and Policy of Global Change, Report No. 102. InMassachusetts Institute of Technology, Cambridge, MA. September. Tuladhar, S.D., Wilcoxen, P.J., 1999. An Econometric Look at the Double Dividend Hypothesis. National Tax Association Proceedings 1998, pp. 57–62. U.S. Environmental Protection Agency (EPA), 2008. Inventory of U.S. Greenhouse Gas Emissions and Sinks: 1990–2006. At http://www.epa.gov/climatechange/emissions/usgginv_archive.html. April 15th. U.S. Environmental Protection Agency (EPA). (2009). Follow “Related Links” for Senate Bills S.280 (The Climate Stewardship and Innovation Act of 2007), S.1766 (The Low Carbon Economy Act of 2007), S.2191 (The Lieberman-Warner Climate Security Act of 2008) and the Waxman-Markey Discussion Draft of The American Clean Energy and Security Act of 2009. At http://www.epa.gov/climatechange/economics/ economicanalyses.html.
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Energy Economics j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / e n e c o
The structural effects of cap and trade climate policy Richard J. Goettle a,⁎, Allen A. Fawcett b a b
College of Business Administration, Northeastern University, United States U.S. Environmental Protection Agency's Climate Change Division, United States
a r t i c l e
i n f o
Article history: Received 3 April 2009 Received in revised form 25 June 2009 Accepted 25 June 2009 Available online 3 July 2009 JEL classification: C68 H23 Q43 Q54 Q58
a b s t r a c t The Inter-temporal General Equilibrium Model (IGEM) explores the cost to the U.S. economy of increasingly more stringent cap and trade regimes. The economy-wide losses are small with energy, agriculture, chemicals, high tech manufacturing and trade being most affected. The availability of lower cost offsets substantially reduces these economic losses. The economy becomes less capital but more labor intensive. Household welfare losses are smaller for full consumption (goods, services and leisure). A more inelastic trade-off between consumption and leisure dramatically reduces policy costs as do more favorable revenue recycling options. Induced technical change yields a small, measurable reduction in policy costs. © 2009 Elsevier B.V. All rights reserved.
Keywords: Cap and trade Allowance prices Climate policy Welfare Capital and labor markets Induced technical change Revenue recycling
1. Introduction This paper is one of a series in the Energy Modeling Forum's analysis of U.S. and international climate policy scenarios and architectures (EMF 22). In it, we employ the Inter-temporal General Equilibrium Model (IGEM) of Dale Jorgenson Associates (DJA) to simulate the economy's reaction to the three U.S. cap and trade regimes considered in EMF 22. Our focus is estimating the economic costs of these regimes as there are no considerations of the effects of climate change, positive or negative, on the economy or the possible benefits of these regimes in terms of avoided economic damages. IGEM is a dynamic computable general equilibrium (CGE) model of the growth and structure of the U.S. economy and has been used in a variety of efforts related to climate change and climate change policy (e.g., see Jorgenson et al., 2000, 2004, 2008, 2009; EPA, 2009). Because IGEM represents a comprehensive range of economic responses in 35 commodity-industry groups and 5 final demand sectors and because it is econometrically estimated from over forty years of market data, it is well suited to address both the broad and detailed market implications of climate change policy over the intermediate term. The market-based incentives arising from cap and trade climate policy ⁎ Corresponding author. E-mail address: [email protected] (R.J. Goettle). 0140-9883/$ – see front matter © 2009 Elsevier B.V. All rights reserved. doi:10.1016/j.eneco.2009.06.016
secure emissions abatement through three sources — output reductions, input and output restructuring and induced technical change. In this paper, we emphasize IGEM's structural content in exploring these three pathways. The remainder of our paper is organized as follows. Section 2 presents policy assumptions unique to this analysis. Sections 3, 4 and 5 provide, respectively, discussions of the temporal consequences of six cap and offset combinations, the details of macroeconomic adjustment common to all years and all model runs and the effects on domestic production and U.S. capital and labor markets. Section 6 considers the impacts on household welfare and the effects of less responsiveness in household consumption and leisure decisions. Section 6 also considers the welfare effects of alternative revenue recycling mechanisms. Section 7 examines the role of induced technical change in easing the economic burden of adjustment and also provides estimates of its magnitudes. Finally, section 8 offers a summary and series of conclusions. 2. Policy assumptions While these simulations only approximate the details of a complex and comprehensive cap and trade proposal, they nevertheless incorporate the full variety of provisions considered to date. These include emissions constraints or “caps,” the allocation of tradable
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emissions allowances, banking (but not borrowing) and abatement opportunities in the form of domestic (but not international) offsets. The details of these scenarios are reported elsewhere in this volume and are not repeated here. The analysis examines three alternative caps on cumulative, economy-wide greenhouse gas (GHG) over the period 2012–2050. These alternatives are in the amounts of 287 giga-tonnes (metric) of carbon dioxide (CO2) equivalent (GtCO2-e), 203 GtCO2-e and 167 GtCO2-e. The first of these (287 GtCO2-e) involves a relatively flat emissions path, beginning in 2012 at 7342 million metric tonnes of CO2 equivalent (MtCO2-e) and rising to 7376 MtCO2-e by 2050; these amounts are 2.2 and 2.7% higher, respectively, than the 7182 MtCO2-e estimated for 2008. The time paths for the latter two regimes (203 and 167 GtCO2-e) yield reductions in emissions levels in 2050 that are 50% and 80% below the 6148 MtCO2-e observed in 1990. The caps reference the economy-wide emissions of six greenhouse gases — carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulfur hexafluoride (SF6) — as measured by their global warming potentials (GWPs) over a 100-year horizon (EPA, 2008; IPCC, 1996) and expressed in terms of metric tonnes of carbon dioxide equivalent (tCO2-e). In IGEM, revenue from the free allocation of allowances accrues to the employee–shareholder–household while revenue from the auction of allowances flows to the U.S. government. For the aggregate representation of the household sector, there is only a “representative” consumer and so there are no distinguishing behaviors among IGEM's employee–shareholders who, in the “real” world, would differ by reasons of occupation, industry of employment and corporate ownership among other things. This means that the inter-temporal choices of households (i.e., present versus future spending on consumption and leisure) followed by their consumption-versus-leisure decisions are unaffected by the initial allocations of allowances to specific stakeholders in specific industries. Put differently, the estimated market outcomes in these simulations are independent of and invariant among alternative allocation schemes. Under the condition that a policy scenario is both deficit and revenue neutral with respect to the fiscal positions of federal, state and local governments, the following two allocation options yield identical market outcomes in IGEM. In one scheme, all allowances are distributed freely to emissions sources. Motivated by economic self interest, these entities use, buy or sell allowances as market conditions dictate. Governments are assumed to adjust their tax policies through changes in personal exemptions (i.e., through lump-sums) so as to preserve pre-policy deficit and spending levels. In the alternative scheme, all allowances are auctioned with the proceeds flowing to the U.S. Treasury. These revenues then are redistributed to households in lump-sums but only to the extent that government deficit and spending levels are maintained. Lump-sum redistributions are well known as the least favorable means of revenue recycling and such an assumption begs additional considerations of possible joint tax reforms and even a “double dividend.” While the existence and magnitude of a double dividend remain unsettled empirical questions, there is broad agreement that there are better and worse ways to recycle allowance revenues (e.g., Goulder, 1994; Jorgenson and Yun, 1991; Jorgenson et al., 2000; Tuladhar and Wilcoxen, 1999). Adopting the assumption of lump-sum transfers in this analysis helps insure the upper-bound nature of the policy cost estimates. It simultaneously suggests that modest changes in government tax policies can serve to ameliorate these costs. Similarly, there is no presumption that base case deficit and spending levels are somehow preferable to any others, only that their preservation avoids the complications over what to do with new allowance revenues or about any tax losses. In addition to tradable allowances, the scenarios evaluated here allow sources to meet their compliance obligations by purchasing domestic abatement offsets from “outside” the system (i.e., the model). As the “economics” warrant, emissions reductions can be
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acquired from new opportunities in the coal, oil and gas sectors, in landfill management and in domestic agriculture including afforestation and soils sequestration. Central to this analysis is the concept of marginal abatement cost (MAC). This cost measures the sacrifice to the economy of diverting additional scarce resources to the elimination of the next tonne of emissions. Both theory and practice confirm this cost to increase as the number of tonnes abated increases, often at an increasing rate and often with areas of “no regrets” or minimum cost thresholds. Currently, all foreseeable abatement opportunities related to the emissions from CO2 sources are handled internally by the structure of and parameter estimates in IGEM. This means the marginal abatement cost schedules implicit in IGEM simulations accurately portray all the economic costs of intermediate-term mitigation. External to IGEM are judged to be those abatement opportunities related to non-CO2 greenhouse gases, carbon dioxide capture-andstorage (CCS) technologies, bioelectricity and biofuels in transportation (biotransport). External to IGEM but competing under the cap are the MACs associated with CCS, bioelectricity, biotransport, and the HFCs, PFCs and SF6. External to IGEM but considered as domestic offsets outside the cap are the CH4s and N2Os from the coal, oil and gas sectors, landfills, and agriculture (e.g., afforestation, animal waste, forest management and soils sequestration). The external MAC schedules are taken from analyses internal to or sponsored by the U.S. Environmental Protection Agency (EPA) and include simulation results from the FASOM and ADAGE models for agriculture and CCS, respectively. There are concerns that “domestic offsets” provide lower costs but in exchange for lower certainty of environmental integrity. This arises from the greater uncertainty of their abatement potential, their additional complexity to a cap and trade system, and their not-soinsignificant costs for measurement, monitoring, and verification. While legitimate, the external MAC schedules employed here were carefully developed and fully vetted by EPA with these concerns in mind. The MACs and their underlying assumptions and methodologies have long been in the public domain and are widely used and shared by the modeling and analysis communities. Their use here is predicated on the belief of the best information currently available. 3. The temporal consequences of cap and trade policy The three cap scenarios are combined with two assumptions regarding domestic offsets to create six scenarios. Accordingly, we ran simulations for the 287, 203 and 167 GtCO2-e caps first with no domestic offsets allowed and next with domestic offsets limited only by their abilities to be cost-competitive with other abatement options. In the current naming convention, we label these scenarios as allowing unlimited domestic offsets in the sense that they are free of any policyimposed constraints on their ability to compete solely on their “economics.” Our focus here is on the time path of allowance prices, the structure of abatement and, in turn, their effects on the overall economy over the intermediate term, 2012–2050. Fig. 1 shows the allowance prices for the six simulations in terms of year 2005 GDP purchasing power. Allowance prices begin at $2 to $4 per tCO2-e for the 287 GtCO2-e cap, $15 to $26 for the 203 GtCO2-e cap and $24 to $45 for the 167 GtCO2-e cap. Each then rises annually under conditions of optimal banking at an assumed (exogenous) interest rate of 5%. Two conclusions emerge from these results. First and most obvious, allowance prices in all cases continue to rise as the emissions constraint becomes more stringent or, equivalently, as the gap widens between the cap and what emissions would have been in its absence. Second, economic agents choose the least expensive portfolio of abatement options subject to their individual availability and, here, domestic offsets are the low cost source. Given the MAC schedules for abatement opportunities from these sources and under the condition that buyers can acquire whatever abatement is economically justified
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Fig. 1. Allowance prices. Fig. 3. 203 GtCO2-e with unlimited domestic offsets.
from these markets, abatement overall is cheaper with domestic offsets than it is without them. The importance of these allowable external alternatives cannot be overemphasized. In their absence, long-run allowance prices are 66% (287 GtCO2-e) to 87% (167 GtCO2-e) higher. Limits on their use, statutory or otherwise, force more expensive alternatives. The sources of abatement are illustrated in Figs. 2 and 3 which detail the 203 GtCO2-e simulation results. Without domestic offsets, there is less banking, more expensive abatement from CO2 and non-CO2 sources and earlier and larger market penetrations of the more expensive bioelectricity and CCS (Fig. 2). However, with unlimited domestic offsets over this period, businesses choose the lowest cost options available to them. There is more banking, less expensive abatement from CO2 and non-CO2 sources and delayed commercialization of bioelectricity and CCS (Fig. 3) all because cheaper abatement is available. The consequences for the overall economy correspond to the patterns of allowance prices and abatement costs. Fig. 4 shows the effects on real GDP. Clearly, the economy can absorb these constraints on emissions with relative ease. The largest of these involves an almost imperceptible 18 basis point reduction in annual GDP growth. For comparison, IGEM benchmarks to the Energy Information Administration's (EIA's) Annual Energy Outlook (AEO) 2006 and to AEO 2008 (used here) differ by 33 basis points (EIA, 2006, 2008) or almost twice as much. Across all scenarios by 2025, economic losses range from 0.3 to 3.7% of the baseline GDP estimate. By 2050, this range expands to 0.7 to 7.3%. Not surprisingly, the losses in real GDP are, on average, almost 40% smaller under each of the three caps when the less expensive domestic offsets are allowed to compete. As discussed below, the impacts on GDP are spread across all its components with the effects on household spending being proportionally among the smaller. As shown in Fig. 5, the reductions in consumption are, ultimately, a third to a half of those of GDP. By 2025,
Fig. 2. 203 GtCO2-e with no domestic offsets.
the consumption losses range from 0.1% to 1.5% of the baseline estimate. By 2050, the range of losses grows to 0.2% to 3.6% and, again, the losses are about 40% smaller with unlimited domestic offsets. Obviously, progressively more stringent caps raise allowance prices (Fig.1) and increase their economic costs (Figs. 4 and 5). Equally obvious is that the cheaper abatement available in limited quantities from domestic offsets eases these burdens. From a policy design perspective, two points remain clear. First, under even the most restrictive cap, the economic losses are small with overall growth being only slightly slowed. Second, and most importantly, allowing any and all measurable, verifiable and permanent abatement sources to compete freely for their rightful place in the mitigation hierarchy is the principal way of avoiding or minimizing these adverse market consequences. 4. The details of macroeconomic adjustment We next more closely examine the economy's responses to policy by considering the more detailed adjustments in a particular year, 2030, and scenario, 203 GtCO2-e cap. These adjustments along with those discussed in section 5 are qualitatively identical to what happens in all other years and scenarios with the observed changes being merely matters of degree. Our choice of the 203 GtCO2-e scenario also is motivated by the fact that it is closest in spirit and magnitude to the numerous public policy initiatives to which IGEM recently has been applied (EPA, 2009). Given this proximity to legislative proposals, the ensuing discussions of the details of this scenario are more likely to be of interest and relevance to those crafting these proposals. As shown in Fig. 6, the emissions constraint and resulting allowance prices adversely affect each aspect of aggregate demand (real GDP) — consumption, investment, government purchases, exports and
Fig. 4. Impacts on real GDP.
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Fig. 5. Impacts on real consumption.
imports. Perhaps surprising are the disproportionate losses borne by each of these components. Consumption, which is 60% of final demand, accounts for only 27% of the $0.35 trillion loss while investment and exports, at 20% and 12% of GDP respectively, account for 40% and 28% of the year's loss. To the extent the cap is binding, everything becomes more expensive and everyone then must adjust to the higher prices. However, the reactions to these higher prices are far from uniform and are rather more complex and varied. The impacts on industry prices (and domestic production) are presented in Fig. 7. Clearly, energy prices — coal, oil, gas and electricity — are most affected, with coal more so than any other commodity. This is not surprising in that 87% of the year 2006 GHG emissions are related to the use of coal (30%), oil (41%) and gas (16%). In addition, coal is high in carbon content in relation to the other fossil fuels and is used extensively along with gas and some oil in the manufacture of electricity. Domestic crude oil and gas extraction prices decline as the lower domestic production that follows from reduced petroleum demand is obtained at lower cost. However, this is the only price (cost) reduction that occurs. All non-energy prices increase. Some — like those of agriculture, chemicals, stone, clay and glass, primary metals, electrical machinery (semiconductors) and services (waste management) — are affected both directly and indirectly as their activities are emissions generating. Others like construction, food, textiles, furniture, paper, publishing, motor vehicles, instruments, communications and trade are affected only indirectly. The overall impacts on the economy are dominated by the decisions of households. Their first decision concerns the intertemporal allocation of expenditure on good, services and leisure.
Fig. 6. Composition of GDP and losses, 2030.
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When leisure is added, total household expenditure is denoted as full consumption. Households know that the price increases from mitigation policy will be larger “tomorrow” than they are “today” as the emissions from a growing economy make meeting the various binding constraints more difficult over time. Households view this as a progressive erosion of real incomes and purchasing power. Accordingly, there occurs a redistribution of expenditure on full consumption toward the present and away from the future. Put another way, households spend “now” rather than “tomorrow.” This small but measurable inter-temporal shifting is recognizable in the “pre-policy” time patterns of both GDP (Fig. 4) and consumption (Fig. 5). Households next decide on the allocation of full consumption between goods and services on the one hand (i.e., traditional consumption) and leisure on the other. As discussed in section 6, this decision is central to explaining the magnitude of economic outcomes. Because mitigation policy makes all consumer goods and services more expensive, the overall price of consumption now is also higher. The increased price of consumption relative to the price of leisure prompts households to substitute the latter for the former. Within the overall increase in full consumption arising from the inter-temporal effect, comparatively more is spent on leisure than is spent on consumer goods and services. The decline in real consumption occurs because the increase in consumer spending is proportionally smaller than the increase in consumer prices. In addition to the consumption-related impact on aggregate demand, this second decision by households also has important implications for the supply side of the economy. The rising price of goods and services relative to wages results in a reduction in household labor supply that is equal to and opposite from the increase in household leisure demand. Households respond to the decrease in real wages by supplying less labor and demanding more leisure. While increasing leisure is welfare improving for households (again, section 6), their reductions in labor supply at prevailing wages reduce labor and, hence, national income. The third decision by households concerns the allocation of real purchases among the variety of consumer goods and services but within the overall level of reduced total real spending. Like the adjustments above, there occurs a redirection of expenditure away from those goods and services incurring the larger price increases and toward those goods and services experiencing the smaller price increases. Because household spending is such a large fraction of overall spending, the actions taken here strongly influence the structure of real GDP and the domestic production that supports it. The reduction in labor income arising from the household sector's reduced labor supply and increasing demand for leisure combines with lower capital income from businesses to yield a reduction in national income and nominal GDP. However, as indicated above, personal consumption increases due to the inter-temporal effect of shifting spending from the future to the present and to the fact that overall consumption is price inelastic. With falling income and rising consumption, private saving falls. The reduction in saving leads to a corresponding reduction in private investment, hence, the comparatively large investment effect in Fig. 6. With higher prices for investment goods, the available investment funding buys even fewer capital goods. Lower saving leads to lower investment, a lower capital stock, lower returns on that capital stock and less capital availability. This and the reduced availability of labor are primarily what limit the economy's domestic supply possibilities following the introduction of policy. IGEM's saving–investment balance summarizes the net flow of funds available for investment. These funds arise from three sources. The first source, discussed above, is the domestic saving of households and businesses. All things being equal, increases in saving lead to more investment while decreases in saving lead to less. The second source reflects the behavior of the collection of governments that comprise the national economy and the magnitude of their combined annual deficit or surplus. The third source focuses on the nation's interactions with the rest of the world and whether the annual current account balance is deficit or surplus.
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Fig. 7. Impacts on domestic prices and production, 2030.
To eliminate governments' direct effects on real investment spending through the saving–investment balance, the simulations conducted for this analysis assume both deficit and revenue neutrality in nominal terms. Accordingly, as the prices facing governments rise, there occurs a proportionally equal reduction in the real goods and services that governments are able to purchase. While there are numerous potential reactions concerning the fiscal policies of governments, the above assumptions give rise to transparent outcomes that are uncomplicated by speculations on what governments might do to soften any adverse policy impacts. The prices of U.S. exports rise relative to goods and services from the rest of the world. As exports are estimated to be price-elastic, export volumes fall by proportionally more than export prices rise explaining the large export effect in Fig. 6. In addition, there is no simulated overseas income effect associated with exports and, so, with only the aforementioned price effects, U.S. export earnings decline. Real and nominal imports also decline. First, import reductions occur from the overall reductions in spending associated with a smaller economy. Second, import reductions occur in those commodities directly affected by mitigation policy. By assumption, the emissions cap and allowances fall on all of the commodities that contribute to U.S. greenhouse gases, irrespective of whether they were produced domestically or imported. Thus, within total imports, there are disproportionate reductions in oil, gas and other policy-sensitive commodities as their prices rise along with those of their domestic counterparts. Finally, import substitution partially offsets these two forces. There is a greater incentive to import as domestic prices now are relatively higher for the commodities not directly affected by policy. For unaffected imports, there occurs a restructuring toward those commodities that obtain the greater price advantages in relation to those produced domestically and to those imports that are relatively cheaper within overall imports.
With only prices affecting exports and both prices and incomes affecting imports, the reduction in nominal imports exceeds the decline in export earnings. To neutralize this impact so that the effects on investment arise solely and transparently from those on domestic saving, the dollar strengthens to the point where it restores the current account balance to its pre-policy level. The condition in policy experiments that the value of the dollar adjusts to preserve existing (i.e., base case) current account balances (i.e., desired foreign saving) and U.S. indebtedness (i.e., willingness to hold dollar-denominated assets) is intentional in that IGEM is specified to represent only the domestic U.S. economy. 5. Production and the capital and labor markets All industries with the exception of processed food, tobacco and textiles, but especially those related to energy, experience declines in output volumes (Fig. 7). This results not only from higher prices, the restructuring of inputs and outputs and declining demands throughout the economy but also from the limitations on supply that arise from changes in labor and capital availability and from productivity. Producers do their best to insulate their output prices from the impacts of more expensive energy and non-energy inputs. Substitutions away from more costly inputs and toward relatively cheaper materials, labor and capital help minimize the adverse effects. Beyond these factor substitutions, there is also price-induced technical change at work in each industry (section 7). Ultimately, producers can do only so much in the face of reduced demands and limited factor supplies. In the end, firm and industry profits and cash flows (i.e., the revenues accruing to owner–shareholders) are unavoidably less. Fig. 8 illustrates the relative magnitudes in comparing the importance of an industry in total output to that of its loss in the total loss. In ascending order, the largest losses in absolute terms are
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Fig. 8. Composition of output and losses, 2030.
Fig. 9. Impacts on revenues and incomes, 2030.
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borne by agriculture, chemicals, non-electric and electric machinery and trade. Small sectors of the economy that are emissions intensive bear disproportionately large shares of the mitigation costs with the energy industries among the foremost. These include coal mining, oil and gas extraction, petroleum refining, electric and gas utilities, agriculture, chemicals, primary metals and stone, clay and glass. At the other extreme, there are sectors of the economy, including the two largest, that are less energy and emissions intensive with disproportionately small burdens and even some realized gains. These include finance, services, communications and processed food. Finally, it is noteworthy that the high technology industries of electric and nonelectric machinery, the “stars” of U.S. manufacturing, incur costs well in excess of their comparatively large shares in total output. Traditionally, changes in economic activity are viewed from the demand side as policies affect overall spending, its components and related production. However, in CGE models, it is equally appropriate to focus on aggregate supply and, in particular, on primary factor markets. Fig. 9 shows the impacts on industry revenues, in producer prices, and on capital and labor incomes. These changes follow the patterns of industry price and output effects depicted in Fig. 7. In broad terms, the losses in revenue are comparably borne by employees and “shareholders.” The components of value added appear to share the consequences of mitigation policy more or less equally. However, a closer examination reveals that the reductions in capital incomes are generally somewhat larger than those for labor. This is certainly consistent with the policy's adverse impacts on investment and capital accumulation and suggests that shareholders fair marginally worse than do employees under these cap and trade regimes. Of major concerns to policy makers are the impacts of climate change initiatives on jobs and employment. CGE models like IGEM cannot address
specifically these concerns as labor is measured in terms of qualityadjusted hours rather than persons and prices adjust to equate the labor (hours) demanded by employers with the labor (hours) supplied by households. Still, inferences can be drawn from the observed changes in labor. Fig. 10 shows the changes in capital and labor quantities that correspond to the income changes in Fig. 9. Fig. 10 also shows the changes in the labor intensity of output as measured by industry input–output ratios. The real changes in primary inputs in Fig. 10 match the nominal changes shown in Fig. 9. More importantly, the economy becomes more labor intensive. Households substitute leisure for labor and consumption for saving. Businesses substitute labor for energy, now more expensive, and capital, now less available. The bad news is that the unfortunate reductions in output lead to corresponding reductions in capital and labor demands. The good news is that the adjustments are labor-protecting. 6. Welfare considerations The theoretical structure of IGEM's household sector and its empirical representation permit the measurement of welfare changes for the “representative” consumer at the levels of consumption (goods and services) and full consumption (goods, services and leisure). These are expressed as equivalent variations in the present values of lifetime expenditure and measure the changes in household welfare (utility) at the base case prices and interest rates. Fig. 11 shows these metrics for the six scenarios of this exercise. Several conclusions emerge from these results. First, the substitution toward leisure is welfare improving for households. For the least restrictive cap (287 GtCO2-e), this substitution more than compensates the welfare loss in goods and services. For the more restrictive caps (203 and 167 GtCO2-e), the welfare losses in terms of full
Fig. 10. Impacts on input demands and labor intensity, 2030.
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Fig. 11. Equivalent variations in consumption and full consumption.
consumption are only 18 to 34% of those exclusive of leisure. Second, allowing the use of domestic offsets is welfare improving. When measured in terms of consumption, the welfare losses are 36 to 39% smaller with unlimited offsets. This loss improvement increases to 55% when measured by full consumption and, in the 287 GtCO2-e scenario, the welfare gain is 31% larger with unlimited offsets. Third, the percentage point loss in welfare per giga-tonne abated increases with the severity of the cap but is smaller for full consumption than for consumption and is smaller with unlimited domestic offsets than with no domestic offsets. This is not surprising in that these measures reflect the underlying, increasingly expensive MAC schedules both internal and external to IGEM. Fig. 11 also shows the welfare changes for a policy scenario, labeled as 216 GtCO2-e, from an ongoing EPA analysis. This scenario is similar in scale to the 203 GtCO2-e cap with unlimited domestic offsets. It differs in that 1) the cap is less severe and not economy-wide, 2) international permit trading is allowed and is cheaper but limited, and 3) bioelectricity and CCS are subsidized. As a result, the welfare losses are about 75% of those for the 203 GtCO2-e case. The average annual losses in real GDP are in the range of 80% of those for the 203 GtCO2-e case while real consumption losses, like overall welfare, are 25% smaller. The 216 GtCO2-e scenario is included here to demonstrate two things. First, as is well documented (Jorgenson et al., 2000, 2008, 2009), the parameter governing the allocation of full consumption between the demand for goods and services (i.e., consumption) and the demand for leisure is a dominant factor in CGE model outcomes, and not just IGEM's. Household choices concerning leisure demand simultaneously determine labor supply and, hence, labor income. For a given national income, decisions on how much to consume determine the household and business saving that funds private investment. Investment adds to the capital stock which, in turn, is the source of capital income. From these, it is evident that this single decision influences the entire supply side of the economy. With IGEM as estimated, the compensated elasticity of labor supply in the 216 GtCO2-e simulation averages around 1.0 for the period 2007–2050. As shown in Fig. 11, altering IGEM's parameters and approximately halving this number approximately halves the welfare losses. Accordingly, this single trade-off has clear and important implications for reconciling simulation results across methodologies. Second, all the simulation runs described thus far presumed lumpsum redistributions of allowance revenues. To examine preferred
alternatives, the 216 GtCO2-e scenario is simulated with auction revenues recycled, first, through reductions in the average marginal tax rate on labor income and, second, through changes in a general, economy-wide investment tax credit. The welfare changes for these simulations also appear in Fig. 11. In terms of consumption, each of these mechanisms is welfare improving as each nearly halves the welfare losses arising with lump-sum transfers. The investment tax credit is favored only slightly over reductions in the marginal labor tax rate. In terms of full consumption, there emerges a rather different conclusion. In the longrun, the investment tax credit further improves welfare with greater capital accumulation substituting for labor and allowing more leisure to compensate the loss in consumption. Conversely, the marginal labor tax rate is inferior to both mechanisms when considering full consumption. True, there is an improvement in terms of goods and services but the labor tax promotes labor supply (and demand) at the expense of leisure and, so, the welfare losses in full consumption are greater. 7. Induced technical change As indicated at the onset, emissions abatement occurs as a consequence of output reductions, input and output substitutions and induced technical change (ITC) with the latter in the form of either innovation or end-of-pipe treatments. The magnitude of ITC is important because its presence lowers the economic costs of achieving a given emissions target or, equivalently, allows more aggressive reductions for a given willingness-to-pay (Goulder, 2004). Price-induced patterns of innovation are represented formally in IGEM's structure of production (Jorgenson and Jin, 2005, 2006). Nonprice trends in factor intensities (cost shares) such as capital-using or labor- or energy-saving behaviors combine with evolving patterns of input prices to influence industry output prices and, hence, demand, either favorably or unfavorably. While this formulation captures what occurred historically, IGEM also provides a plausible sense of the magnitude of future ITC benefits to the extent that the estimated trends in observed innovation accurately portray future realities. Accordingly, a policy change introduced into IGEM alters the future patterns of relative prices and so “induces” changes in productivity, albeit, through policy-invariant multipliers of innovation. The end-of-pipe treatments from specific technologies are not represented formally within IGEM but are and can be introduced externally into a given simulation. Indeed, the abatement opportunities
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underlying the external domestic MAC schedules aggregate many such options, particularly in agriculture, forestry, carbon dioxide captureand-storage (CCS) technologies, bioelectricity and biotransport. Others, such as electric and hybrid vehicles or hydrogen fuel cells, easily could be modeled in a similar way. Emissions in IGEM are driven by domestic production and imports at industry-commodity levels. Emissions coefficients and their trends, like the aforementioned patterns of technical change, are estimated and projected from historical data. If the endogenous penetration of end-of-pipe treatments cannot be represented through the development of external technology-specific offsets, then exogenous changes in IGEM's emissions factors offer an alternative mechanism through which induced technical change may be represented. However, unlike MAC schedules, this approach captures only the benefits of these treatments, ignoring their costs. To ascertain the importance of IGEM's econometric representation of ITC, model results are used to calculate the magnitudes of ITC within a given simulation. Next, the differences between a policy case and the base case are determined. These differences measure the changes in ITC that are induced by the policy experiment and imparted to the relative prices in IGEM. Fig. 12 shows these effects for the years 2030 and 2050 from the 203 GtCO2-e simulation with unlimited domestic offsets. Clearly, the ITC effects that arise from this policy have an overall positive effect on economic performance. As evidenced by the valueshare weighted average of the ITC effects in each industry, prices are lower and the economy is larger than would be the case in the absence of ITC. Ironically, as the economy is larger, GHG emissions are higher as are the allowance prices required to achieve the targeted abatement. Equally clearly, the role of ITC is small in comparison to the much larger effects of substitution and economic restructuring seen above (see also Jorgenson et al., 2000). However, these relative magnitudes
are consistent with findings summarized in Goulder (2004) and with other informative contributions to the literature (Nordhaus, 2002; Sue Wing, 2003). The favorable impacts of ITC are cumulative. From the onset, there are measurable and positive benefits and these increase with the passage of time, e.g., the 2050 impacts exceed those of 2030. Again, these ITC effects arise solely from the interactions of the estimated factor biases and the policy-induced changes in relative prices. If policy were to induce or, more importantly, if it also provided incentives designed to appropriately alter these biases (e.g., through targeted R&D and investment tax credits) and stimulate the development and expansion of end-of-pipe treatments, then these results would be magnified. The role of ITC would become vastly more significant reflecting the driving forces of not only relative price changes but also policy-induced innovation as reflected in non-price changes in factor intensities, emissions drivers and sources of abatement. These ITC effects also have structural implications for the economy and, so too, for energy use and GHG emissions. This is illustrated by focusing on three sectors in Fig. 12 — electric utilities, trade and services. ITC in the electric utilities sector plays the dominant role in the overall ITC effect observed. In the presence of ITC, electricity prices are lower and demand is higher than were there no ITC. In short, the empirically observed ITC in this sector works somewhat against the goals of policy. Since ITC helps to lower electricity prices, unconstrained energy use and emissions are higher which means that allowance prices also have to be higher to achieve a given emissions reduction. However, in the absence of ITC, electricity prices would be higher and demand lower. These imply a corresponding reduction in energy inputs to this sector and, hence, lower emissions. The absence of ITC in the electricity sector would reduce the electricity intensity of the economy which means that allowance prices would not have to rise as high to satisfy an emissions constraint.
Fig. 12. Endogenous technical change, 2030 and 2050.
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ITC in trade and services has different implications but contributes similarly to this outcome. Here, the ITC effects work to raise their prices. This is harmful to their growth and to the overall economy. Eliminating these ITC effects would lower the relative prices of trade and services, improve their relative performance and help the economy. But these sectors are not energy or emissions intensive. The restructuring that occurs in the absence of these calculated ITC effects would yield an economy that is less energy and emissions intensive and, again, the allowance prices that would be necessary to achieve the targeted reduction would be marginally lower.
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with empirically observed non-price trends in factor intensities. What is unknown is the degree to which this or any other mitigation policy influences or can be made to influence the trends and biases in innovation and the development and adoption of end-of-pipe treatments. Investment tax credits and other such market incentives, targeted to reducing greenhouse gas emissions and to promoting alternative technologies, could accelerate the realization of ITC benefits by further altering the speeds and directions of innovation along with relative prices. Bringing empirical content to the growing literature on policy- and price-induced technical change remains a high priority on the research agenda.
8. Summary and conclusions The purpose of this exercise is to offer an economic analysis of the U.S. economy under increasingly severe cap and trade regimes. The overall economic impacts of these alternatives are estimated to be small even in the most restrictive of cases. While the aggregate costs are small and readily absorbed, there are much larger impacts at the industry level. The energy sectors — coal mining, crude oil and gas extraction, petroleum refining and electric and gas utilities — are particularly hard hit. Beyond the energy sectors, agriculture, chemicals, high technology manufacturing and trade incur relatively large losses. The declines in communications, finance and services sectors are minimal while food, tobacco and textile outputs actually increase. In terms of primary inputs, employee and shareholder incomes decline as do the demands and supplies of labor and capital inputs. However, the former are relatively less affected than the latter, so the economy becomes more labor intensive and less capital intensive in reaction to the caps on emissions so, implicitly, there is some job protection in these adjustments. A principal conclusion of this analysis concerns the limits independently placed on emissions offsets. These alternatives offer abatement at a lower cost than can be secured elsewhere within the activities covered by policy and so reduce the already small economic costs of mitigation policy. In the spirit of market-based incentives, the limits governing the use of marketable and verifiable abatement offsets should arise solely from their “economics” within an overall assessment of policy costs. The magnitudes of policy costs are heavily influenced by household consumption-saving and labor-leisure decisions and by the choices of revenue recycling mechanisms. The comparatively strong substitution toward leisure is an offsetting influence on the welfare costs of higher prices and lower outputs and incomes. IGEM's top-down view has tended to yield labor supply elasticities toward the upper end of the range observed in the empirical literature. Bottom-up approaches have tended to yield estimates toward the lower end of this range. Confining IGEM to a lower elasticity estimate substantially reduces the adverse impacts of policy on household welfare. Through these same household responses, alternative recycling policies are seen to be welfare improving or welfare destroying depending on the tax vehicle and welfare measure. The lack of definitive resolutions in these areas opens the possibility of smaller policy costs arising from less responsive household behavior and more favorable tax treatments. The empirical content of IGEM permits a first approximation of the effects of induced technical change (ITC) at both the industry and macroeconomic levels. The net effect of ITC economy-wide is to reduce the economic costs of mitigation policy. The ITC effects in IGEM arise from combining policy-induced changes in relative input prices
Acknowledgements The efforts underlying this paper were sponsored by the U.S. Environmental Protection Agency (EPA) under Contract No. EP-W-05035. We are grateful to our colleagues at Dale Jorgenson Associates and the U.S. Environmental Protection Agency, to Martin Ross of RTI International, Inc. and to our two referees.
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