Carbon Dioxide Emissions [1 ed.] 9781611223422, 9781606922293

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Copyright © 2010. Nova Science Publishers, Incorporated. All rights reserved. Carbon Dioxide Emissions, edited by James P. Mulligan, Nova Science Publishers, Incorporated, 2010. ProQuest Ebook Central,

Copyright © 2010. Nova Science Publishers, Incorporated. All rights reserved. Carbon Dioxide Emissions, edited by James P. Mulligan, Nova Science Publishers, Incorporated, 2010. ProQuest Ebook Central,

ENERGY POLICIES, POLITICS AND PRICES

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CARBON DIOXIDE EMISSIONS

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ENERGY POLICIES, POLITICS AND PRICES

CARBON DIOXIDE EMISSIONS

JAMES P. MULLIGAN Copyright © 2010. Nova Science Publishers, Incorporated. All rights reserved.

EDITOR

Nova Nova Science Publishers, Inc. New York

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All rights reserved. No part of this book may be reproduced, stored in a retrieval system or transmitted in any form or by any means: electronic, electrostatic, magnetic, tape, mechanical photocopying, recording or otherwise without the written permission of the Publisher. For permission to use material from this book please contact us: Telephone 631-231-7269; Fax 631-231-8175 Web Site: http://www.novapublishers.com NOTICE TO THE READER The Publisher has taken reasonable care in the preparation of this book, but makes no expressed or implied warranty of any kind and assumes no responsibility for any errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of information contained in this book. The Publisher shall not be liable for any special, consequential, or exemplary damages resulting, in whole or in part, from the readers’ use of, or reliance upon, this material. Any parts of this book based on government reports are so indicated and copyright is claimed for those parts to the extent applicable to compilations of such works.

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CONTENTS Preface Chapter 1

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Chapter 2

Chapter 3

Chapter 4

Chapter 5

Chapter 6

vii The Role of Offsets in a Greenhouse Gas Emissions Cap-and-Trade Program: Potential Benefits and Concerns Jonathan L. Ramseur

1

Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th Congress Larry Parker and Brent D. Yacobucci

43

Voluntary Carbon Offsets: Overview and Assessment Jonathan L. Ramseur

83

Options for Offsetting the Economic Impact on Lowand Moderate-Income Households of a Cap-andTrade Program for Carbon Dioxide Emissions Congressional Budget Office

99

Containing the Cost of A Cap-and-Trade Program for Carbon Dioxide Emissions Peter R. Orszag

115

Implications of a Cap-and-Trade Program for Carbon Dioxide Emissions Peter R. Orszag

135

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Contents 153

Index

155

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Chapter Sources

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PREFACE Global climate change is one of the nation's most significant long-term policy challenges. Human activities are producing increasingly large quantities of greenhouse gases, particularly CO2. The accumulation of those gases in the atmosphere is expected to have potentially serious and costly effects on regional climates throughout the world. Reducing greenhouse gas emissions would help limit the degree of damage associated with climate change. However, decreasing those emissions would also impose costs on the economy as in the case of CO2, because much economic activity is based on fossil fuels, which release carbon in the form of carbon dioxide when they are burned. One option for reducing emission is to establish a "cap-and-trade" program. This book explores the implications and containing the cost of a cap-and-trade program, its potential benefits and concerns. Chapter 1 - If Congress establishes a greenhouse gas (GHG) emissions reduction program (e.g., cap-and-trade system), the treatment of GHG emission offsets would likely be a critical design element. If allowed as part of an emissions program, offsets could provide cost savings and other benefits. However, offsets have generated concern. An offset is a measurable reduction, avoidance, or sequestration of GHG emissions from a source not covered by an emission reduction program. If allowed, offset projects could generate ―emission credits,‖ which could be used by a regulated entity (e.g., power plant) to comply with its reduction requirement. Offsets could include various activities: agriculture or forestry projects: e.g., conservation tillage or planting trees on previously non-forested lands; renewable energy projects: e.g., wind farms;

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James P. Mulligan

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energy efficiency projects: e.g., equipment upgrades; non-CO2 emissions reduction projects: e.g., methane from landfills Including offsets would likely make an emissions program more costeffective by (1) providing an incentive for non-regulated sources to generate emission reductions and (2) expanding emission compliance opportunities for regulated entities. Some offset projects may provide other benefits, such as improvements in air or water quality. In addition, the offset market may create new economic opportunities and spur innovation as parties seek new methods of generating offsets. The main concern with offset projects is whether or not they represent real emission reductions. For offsets to be credible, a ton of CO2-equivalent emissions from an offset project should equate to a ton reduced from a covered emission source, such as a smokestack or exhaust pipe. This objective presents challenges, because many offsets are difficult to measure. If illegitimate offset credits flow into an emissions trading program, the program would fail to reduce GHG emissions. Another concern is whether the inclusion of offsets would send the appropriate price signal to encourage the development of long-term mitigation technologies. Policymakers may consider a balance between price signal and program costs. If eligible in a U.S. program, international offsets are expected to dominate in early decades, because they would likely offer the lowest-cost options. Domestic sectors, such as agriculture and forestry, might benefit if international offsets are excluded. Some object to the use of international offsets due to concerns of fairness: the low-cost options would be unavailable to developing nations if and when they establish GHG emission targets. However, some offset projects may promote sustainable development. On the other hand, international offsets may serve as a disincentive for developing nations to enact laws or regulations controlling GHG emissions, because many projects would no longer qualify as offsets. Chapter 2 - Proposals to advance programs that reduce greenhouse gases have been introduced in the 110th Congress, and one bill, S. 2191, was reported on December 5, 2007, by the Senate Committee on Environment and Public Works by an 11-8 vote. In general, these proposals would create market-based greenhouse gas reduction programs along the lines of the trading provisions of the current acid rain reduction program established by the 1990 Clean Air Act Amendments. This chapter presents a side-by-side comparison

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Preface

ix

of the major provisions of those bills and includes a glossary of common terms (Appendix C). Although the purpose of these bills is to reduce greenhouse gases (GHGs), the specifics of each differ greatly. Five bills (S. 280, S. 309, S. 485, H.R. 620, and H.R. 1590) cap greenhouse gas emission from covered entities at 1990 levels in the year 2020. S. 317 places its first emissions cap at 2001 levels in 2015; S. 1766 targets reductions at 2006 levels in 2020; S. 2191 as reported would cap GHGs at about 19% below 2005 levels in 2020; and H.R. 4226 would limit 2020 emissions to 85% of their 2006 levels. Seven bills (S. 280, S. 317, S. 485, S. 2191, H.R. 620, H.R. 1590, and H.R. 4226) would establish cap-and-trade systems to implement their emission caps. In contrast, S. 1766 provides for two compliance systems — a cap-and-trade program and an alternative safety valve payment — and allows the covered entities to choose one or employ a combination of both. Finally, S. 309 provides discretionary authority to the Environmental Protection Agency (EPA) to establish a capand-trade program to implement its emission cap. The differences continue with respect to entities covered under the programs. Three bills (S. 309, S. 485, H.R. 1590) provide discretionary authority to EPA to determine covered entities by applying cost-effective criteria to reduction options. In contrast, S. 317’s emission cap is imposed solely on the electric generating sector. The other five bills (S. 280, S. 1766, S. 2191, H.R. 620, H.R. 4226) cover most economic sectors but not all (e.g., they exclude the agricultural sector). Thus, the overall reductions achieved by the bills depend partly on the breadth of entities covered. Beyond the basics of these bills, each contains other important provisions. For example, S. 280 creates a new innovation infrastructure, while S. 1766, S. 2191, and H.R. 4226 encourage foreign countries to undertake comparable control actions and specify potential consequences if they don’t. Other provisions include mandatory greenhouse gas standards for vehicles (S. 309, S. 485, H.R. 1590), and a renewable portfolio standard for the electric generating sector (S. 309, S. 485, H.R. 1590). All bills contain some provisions for the periodic review of the program’s adequacy in addressing climate change. This comparison should be considered a guide to the basic provisions contained in each bill. It is not a substitute for careful examination of each bill’s language and provisions. Further action on S. 2191 is expected. Chapter 3 - Businesses and individuals are buying carbon offsets to reduce their ―carbon footprint‖ or to categorize an activity as ―carbon neutral.‖ A carbon offset is a measurable avoidance, reduction, or sequestration of carbon

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James P. Mulligan

dioxide (CO2) or other greenhouse gas (GHG) emissions. Offsets generally fall within the following four categories: biological sequestration, renewable energy, energy efficiency, and reduction of non-CO2 emissions. In terms of the carbon concentration in the atmosphere, an emission reduction, avoidance, or sequestration is beneficial regardless of where or how it occurs. A credible offset equates to an emission reduction from a direct emission source, such as a smokestack or exhaust pipe. The core issue for carbon offset projects is: do they actually offset emissions generated elsewhere? If the credibility of the voluntary offsets is uncertain, claims of carbon neutrality may be challenged. Evidence suggests that not all offset projects are of equal quality, because they are developed through a range of standards. In the voluntary market, there are no commonly accepted standards. Although some standards are considered stringent, others are less so. At least 30 companies and organizations (domestic and international) sell carbon offsets to individuals or groups in the international, voluntary carbon market. Two recent studies that examined many of the offset sellers found a general correlation between offset price and offset quality. Due to the lack of common standards, some observers have referred to the market as the ―wild west.‖ This does not suggest that all carbon offsets are low quality, but that the consumer must necessarily adopt a buyer-beware mentality when purchasing carbon offsets. This places the responsibility on consumers to judge the quality of carbon offsets. The viability of the voluntary offset market may influence future policy decisions regarding climate change mitigation. For example, credible offsets could play an important role, particularly in terms of cost-effectiveness, in an emissions control regime. There is some concern that the range in the quality of voluntary market offsets may damage the overall credibility of carbon offsets. If this occurs, it may affect policy decisions concerning whether or not to include offsets as an option in a mandatory reduction program. Chapter 4 - This chapter is edited and excerpted testimony by Peter R. Orszag before the Committee on Energy and Natural Resources on June 17, 2008. Chapter 5 - This chapter is edited and excerpted testimony by Peter R. Orszag before the Committee on Energy and Natural Resources on May 20, 2008. Chapter 6 - This chapter is edited and excerpted testimony by Peter R. Orszag before the Committee on Energy and Natural Resources on April 24, 2008.

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Chapter 1

THE ROLE OF OFFSETS IN A GREENHOUSE GAS EMISSIONS CAP-AND-TRADE PROGRAM: POTENTIAL BENEFITS AND CONCERNS

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Jonathan L. Ramseur

SUMMARY If Congress establishes a greenhouse gas (GHG) emissions reduction program (e.g., cap-and-trade system), the treatment of GHG emission offsets would likely be a critical design element. If allowed as part of an emissions program, offsets could provide cost savings and other benefits. However, offsets have generated concern. An offset is a measurable reduction, avoidance, or sequestration of GHG emissions from a source not covered by an emission reduction program. If allowed, offset projects could generate ―emission credits,‖ which could be used by a regulated entity (e.g., power plant) to comply with its reduction requirement. Offsets could include various activities:

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agriculture or forestry projects: e.g., conservation tillage or planting trees on previously non-forested lands; renewable energy projects: e.g., wind farms; energy efficiency projects: e.g., equipment upgrades; non-CO2 emissions reduction projects: e.g., methane from landfills Including offsets would likely make an emissions program more costeffective by (1) providing an incentive for non-regulated sources to generate emission reductions and (2) expanding emission compliance opportunities for regulated entities. Some offset projects may provide other benefits, such as improvements in air or water quality. In addition, the offset market may create new economic opportunities and spur innovation as parties seek new methods of generating offsets. The main concern with offset projects is whether or not they represent real emission reductions. For offsets to be credible, a ton of CO2-equivalent emissions from an offset project should equate to a ton reduced from a covered emission source, such as a smokestack or exhaust pipe. This objective presents challenges, because many offsets are difficult to measure. If illegitimate offset credits flow into an emissions trading program, the program would fail to reduce GHG emissions. Another concern is whether the inclusion of offsets would send the appropriate price signal to encourage the development of long-term mitigation technologies. Policymakers may consider a balance between price signal and program costs. If eligible in a U.S. program, international offsets are expected to dominate in early decades, because they would likely offer the lowest-cost options. Domestic sectors, such as agriculture and forestry, might benefit if international offsets are excluded. Some object to the use of international offsets due to concerns of fairness: the low-cost options would be unavailable to developing nations if and when they establish GHG emission targets. However, some offset projects may promote sustainable development. On the other hand, international offsets may serve as a disincentive for developing nations to enact laws or regulations controlling GHG emissions, because many projects would no longer qualify as offsets.

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The Role of Offsets on a Greenhouse Gas Emissions Cap-and-Trade…

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INTRODUCTION A variety of efforts to address climate change are currently underway or being developed on the international, national, and sub-national levels (e.g., individual state actions or regional partnerships).1 These efforts cover a wide spectrum, from climate change research to mandatory greenhouse gas (GHG) emissions reduction programs.2 In the 110th Congress, Members have introduced a number of proposals that would establish a national GHG emissions reduction regime. GHG emissions reduction programs, both ongoing and proposed, vary considerably. The primary variables are scope and stringency: which emission sources are covered by the program and how much emission reduction is required.3 These factors largely determine the impacts of an emissions reduction program, but other design details can have substantive effects. One such design element is the treatment of offsets. An offset is a measurable reduction, avoidance, or sequestration of GHG emissions from a source not covered by an emission reduction program. If a cap-and-trade program includes offsets, regulated entities have the opportunity to purchase them to help meet compliance obligations.4 Offsets have generated debate and controversy in climate change policy. If Congress establishes a federal program to manage or reduce GHG emissions, whether and how to address offsets would likely be an important issue. Because most current and proposed programs allow offsets (Table 1), offset projects will probably play some part in an emissions reduction program. The first section of this chapter provides an overview of offsets by discussing different types of offset projects and describing how the offsets would likely be used in an emission reduction program. The next section discusses the supply of offsets that might be available in an emission trading program. The subsequent sections examine the potential offset benefits and the potential concerns associated with offsets. The final section offers considerations for Congress. In addition, the report includes a table comparing the role of offsets in selected emission reduction programs: proposals in the 1 10th Congress, U.S. state initiatives, and international programs.

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OFFSETS: AN OVERVIEW Offsets are sometimes described as project-based, because they typically involve specific projects or activities whose primary objective is to reduce, avoid, or sequester emissions. Because offset projects can involve different GHGs, they are quantified and described with a standard form of measure: either metric tons of carbon-equivalents (mtC-e) or metric tons of CO2equivalents (mtCO2-e).5 To be credible as offsets, the emissions reduced, avoided, or sequestered must be additional to business-as-usual (i.e., what would have happened anyway). This concept is often called ―additionality.‖ If Congress establishes a GHG emission capand-trade program, only sources not covered by the cap could generate offsets.6 Emission reductions from regulated sources (e.g., coal-fired power plants) would either be required or spurred by the emissions cap.7 In contrast, if agricultural operations were not covered under an emissions cap, a project that collects methane emissions from a manure digester would likely be an additional GHG emission reduction. If offsets are allowed as a compliance option in an emissions trading program, eligible offset projects could generate ―emission credits,‖ which could be sold and then used by a regulated entity to comply with its reduction requirement.8 This approach is part of the European Union’s (EU) Emission Trading Scheme (ETS), which EU members use to help meet their Kyoto Protocol commitments.9 Under the EU ETS, regulated entities can purchase emission credits that are created from approved offset projects.10 Regulated entities can then apply the credits towards their individual emission allowance obligations.11 For example, a regulated entity may consider purchasing offsets if the offsets are less expensive than making direct, onsite emission reductions. Assuming the offset is legitimate — i.e., a ton of carbon reduced, avoided, or sequestered through an offset project equates to a ton reduced at a regulated source — the objective to reduce GHG emissions is met. From a global climate change perspective, it does not matter where or from what source the reduction occurs: the effect on the atmospheric concentration of GHGs would be the same. Offsets increase emission reduction opportunities. When offsets are not allowed, incentives to reduce emissions or sequester carbon are limited to the covered sources, and there is little motivation to improve mitigation technologies for non-covered sources. Including offsets in a cap-and-trade program would expand these incentives.

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Table 1. Comparison of Offset Treatment in Cap-and-Trade Proposals in the 11 0th Congress GHG Reduction Program S. 280 (Lieberman)

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S. 309 (Sanders)

S. 317 (Feinstein) (Covers utilities)

Offset Types Allowed or Prohibited

Offset Quantity Limitation

Acceptable Locations of Offset Projects Domestic or international projects accepted

Specifically allows for agricultural and conser-vation practices; reforestation; forest preservation; directs EPA to determine other offset types Offsets are not included in the bill

Up to 30% of allowances can come from domestic or inter-national offsets; if offsets account for 15% of allowances, at least 1.5% must come from agricultural sequestration Offsets are not included in the bill

Offsets are not included in the bill

No specific prohibitions; specifically allows biological sequestration, including agricultural and forestry activities, and emission reductions from various industrial operations;a EPA may allow further types at its discretion

A regulated source can use domestic offsets to cover 100% of its allowances; up to 25% of allowances (50% for new sources) can come from eligible international offsets; this limit increases to 50% if allowance prices reach a level that would cause ―significant harm‖ to the economy (as determined by EPA and Secretary of Treasury)

Domestic and international projects allowed

System of Verifying Integrity of Offsets Directs the EPA Administrator, in coordination with the Secretaries of Commerce, Energy, and Agriculture, to set standards Offsets are not included in the bill Directs EPA to implement emissions reduction program; directs Secretary of Agriculture, in coordination with EPA, to develop standards for biological sequestration Directs Secretary of Agriculture, in coordination with EPA, to develop standards for biological sequestration offsets; directs EPA to craft standards for other project types

Table 1. (Continued) GHG Reduction Program S. 485 (Kerry)

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S. 1168 (Alexander) (CO2 reduction from utilities)

S. 1177 (Carper) (CO2 reduction from utilities)

Offset Types Allowed or Prohibited

Offset Quantity Limitation

Acceptable Locations of Offset Projects

System of Verifying Integrity of Offsets Offsets are not included in the bill Directs Secretary of Agriculture, in coordination with EPA, to develop standards for biological sequestration Legislation includes specific standardsb for the five offset types allowed; directs EPA to develop standards for other potential project types, including agricultural offsets

Offsets are not included in the bill;

Offsets are not included in the bill

Offsets are not included in the bill

Five offset types allowed: 1) landfill methane reduction 2) sulfur hexafluoride (SF6) reductions from industrial activities 3) afforestation projects 4) energy efficiency projects yielding reductions or avoidance of CO2 from natural gas, oil or propane combustion 5) avoided methane from manure management practices Identifies 11 eligible types, including agricultural and forestry management practices; authorizes EPA to develop standards for additional types

No quantity limitations

Any U.S. state that has signed memorandum of understanding (MOU) with EPA

No limits; directs EPA to develop regulations regarding use of offsets

Directs EPA to develop standards for domestic and international locations

Directs EPA to develop regulations and coordinate with Department of Agriculture regarding biological sequestration offset standards

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GHG Reduction Program S. 1201 (Sanders) (CO2 reduction from utilities)

Offset Types Allowed or Prohibited

Offset Quantity Limitation

Acceptable Locations of Offset Projects

System of Verifying Integrity of Offsets Offsets are not included in the bill Directs EPA to implement emissions reduction program; directs Secretary of Agriculture, in coordination with EPA, to develop standards for biological sequestration Offsets are not included in the bill Directs EPA, in coordination with Department of Agriculture, to help develop procedures for verifying biological sequestration projects Directs the President to develop offset verification system; directs Secretary of Agriculture to establish agricultural sequestration standards

Offsets are not included in the bill

Offsets are not included in the bill

Offsets are not included in the bill

S. 1554 (Collins) (CO2 reduction from utilities)

Offsets are not included in the bill

Offsets are not included in the bill

Offsets are not included in the bill

S. 1766 (Bingaman)

Four specific project types shall have streamlined standards: (1) landfill methane; (2) animal waste or municipal wastewater methane; (3) sulfur hexafluoride reductions from transformers; and (4) coal mine methane; the President may add further types

Unlimited use of domestic offsets with identified standards; international offsets limited to 10% of a regulated entity’s emissions target

Domestic and international

Table 1. (Continued)

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GHG Reduction Program S. 2191 (Lieberman) — Ordered to be reported by the Senate Committee on Environment and Public Works December 5, 2007

Offset Types Allowed or Prohibited

Offset Quantity Limitation

Specifically allows certain agricultural and forestry-related offsets: agricultural land management practices; afforestation; reforestation; forest management; manure management; other offset types may be later allowed by EPA through regulations

Domestic offsets can satisfy 15% of allowance submission In addition, ―international Emission allowances obtained on a foreign GHG emissions trading market‖ can satisfy 15% of submissionc

H.R. 620 (Olver)

Specifically allows for agricultural and conservation practices; reforestation; forest preservation; no limits on other types

H.R. 1590 (Waxman)

Offsets are not specifically addressed in the bill

Up to 15% of allowances can come from domestic and/or international offsets; if offsets account for 15% of allowances, at least 1.5% must come from agricultural sequestrationd Offsets are not specifically addressed in the bill

Acceptable Locations of Offset Projects Domestic Indirect access to international offsets through purchase of international ―emission allowances‖c

Domestic or international

Offsets are not specifically addressed in the bill

System of Verifying Integrity of Offsets Directs the EPA, in consultation with Secretary of Agriculture, to develop regulations to implement offset program; requires offset project developers to submit a petition to EPA and receive approval of project; offset projects must then be reviewed by an accredited third-party, who submits report to EPA for approval; reversal certifica-tions must be submitted annually to EPA Directs EPA — in coordination with the Secretaries of Commerce, Energy, and Agriculture — to develop verification methods and standards Offsets are not specifically addressed in the bill; EPA is to ensure that allowances are accurately tracked, reported, and verified

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GHG Reduction Program H.R. 4226 (Gilchrest)

Offset Types Allowed or Prohibited Specifically allows biological sequestration, which can include agricultural and conservation practices; reforestation; forest preservation; production of cellulosic biomass crops; and other methods determined by EPA; allows for use of other offset projects if approved and added to national registry; no restrictions on international offset types that are approved on case-by-case basis

Offset Quantity Limitation Alternative compliance mechanisms, which can include domestic and international offsets, can account for up to 15% of allowance submission; if these alternatives account for 15% of allowances, at least 1.5% must come from registered sequestration in agricultural soils

Acceptable Locations of Offset Projects Domestic or international

System of Verifying Integrity of Offsets Directs EPA, in coordination with the Secretaries of Agriculture, Energy, and Commerce, to issue regulations that establish comprehensive measurement and verification methods Directs the EPA to develop program for reviewing international offset projects

a. These projects would become ineligible if subsequent legislation required emissions reductions from these sectors (S. 317 only covers power plants). b. Offset standards similar to those required by the Regional Greenhouse Gas Initiative (RGGI), a partnership of 10 states from the Northeast and Mid-Atlantic regions. Unlike RGGI standards, S. 1168 does not require third-party verification for offset projects. c. The proposal does not define ―international emission allowance.‖ EPA is directed to develop regulations concerning their use. d. The legislation states that if an entity uses offsets to satisfy 15% of its allowances, ―it shall satisfy up to 1.5 percent of its total allowance submission [with agricultural sequestration offsets]....‖ (Section 144(b)). This language is arguably unclear as to whether it limits (―up to‖) agricultural sequestration offsets to only 1.5% or requires that (at least) 1.5% of offsets come from agricultural sequestration activities.

10

Jonathan L. Ramseur

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VOLUNTARY OFFSETS Although this chapter focuses on the use of offsets in a mandatory GHG emissions reduction program, offsets are generating interest and debate in other contexts. In the United States and around the world, a growing number of businesses, interest groups, and individuals are purchasing offsets and claiming that all or part of their GHG-emitting activities (e.g., travel or specific events) are ―carbon neutral.‖ The motivation for these purchases can vary. Some businesses may be seeking to enhance their public image; others may hope to take credit for the offsets in a future GHG reduction program. The exchanges represent a voluntary market for offsets, because there is no requirement for the parties to curtail their emissions. At least 30 companies and organizations sell offsets to individuals or groups in the voluntary carbon market. The quality of the offsets vary considerably, largely because there are no commonly accepted standards. Some offset sellers offer offsets that comply with the more explicit standards of the Kyoto Protocol’s Clean Development Mechanism. Other sellers offer offsets that meet the seller’s self-established guidelines, which may be considered proprietary information, and thus not publicly available. Due to the lack of common standards, some observers have referred to the market as the ―wild west.‖ This should not suggest that all offsets are low quality, but that the consumer must adopt a buyer-beware mentality when purchasing offsets. For more information, see CRS Report RL34241, Voluntary Carbon Offsets: Overview and Assessment, by Jonathan L. Ramseur.

Offset Types and Examples Offsets could potentially be generated from an activity that emits GHGs or that would remove or sequester GHGs from the atmosphere. This section discusses offsets in four categories. Each category is discussed below with project examples for each group. Some of the categories and examples listed below may be limited by location. If a U.S. law or regulation (other than an emissions cap) governs a specific emission source (e.g., methane from coal mines), that source’s emission reductions would not qualify as domestic offsets, unless the

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The Role of Offsets on a Greenhouse Gas Emissions Cap-and-Trade… 11 reductions made went further than the regulations required.12 For example, if the source is required by law or regulation to reduce methane emissions by 50%, reductions up to this threshold would not qualify as offsets, but reductions in excess of 50% might qualify as offsets. As more nations establish mandatory caps or require specific technological controls or practices at emission sources, the universe of potential offsets would shrink.

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Biological Sequestration Trees, plants, and soils sequester carbon, removing it from the earth’s atmosphere. Biological sequestration projects generally involve activities that either increase existing sequestration; or maintain the existing sequestration on land that might otherwise be disturbed and release some or all of the sequestered carbon. This offset category includes sequestration that results from agriculture and forestry activities, and is sometimes referred to as land use, land use change and forestry (LULUCF) projects. Example of these projects include: planting trees on previously non-forested land (i.e., afforestation); planting trees on formerly forested land (i.e., reforestation); limiting deforestation by purchasing forested property and preserving the forests with legal and enforcement mechanisms; setting aside croplands from agricultural production to rebuild carbon in the soil and vegetation; and promoting practices that reduce soil disruption: e.g., conservation tillage and erosion control.13 Compared to the other offset categories discussed here, biological sequestration projects, particularly forestry projects, offer the most potential in terms of volume. However, this category is arguably the most controversial, because several integrity issues are typically (or perceived to be) associated with biological sequestration projects. These issues are discussed in more detail in later sections of this chapter.

Renewable Energy Projects Historically, renewable energy — e.g., wind, solar, biomass — has been a more expensive source of energy than fossil fuels.14 A renewable energy offset project could provide the financial support to make renewable energy sources more economically competitive with fossil fuels. Renewable energy sources generate fewer GHG emissions than fossil fuels, particularly coal. Wind and

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solar energy produce zero direct emissions. Use of renewable sources would avoid emissions that would have been generated by fossil fuel combustion. These avoided emissions could be sold as offsets. Potential renewable energy offset projects may include:15 constructing wind farms to generate electricity; adding solar panels; retrofitting boilers to accommodate biomass fuels; installing methane digesters at livestock operations.16

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Domestic renewable energy projects are not likely to qualify as offsets in a national emissions reduction program. In a carbon-constrained context, project developers would be hard-pressed to demonstrate that a renewable energy project would not have happened anyway. In an ―economy-wide‖ cap-andtrade emissions program, energy sector emissions would likely be capped.17 The cap would make fossil fuels more expensive and renewable energy sources more attractive. In fact, none of the congressional proposals (see Table 1) that allow offsets specifically allow the use of renewable energy offsets. However, renewable energy projects may still create credible offsets in nations without GHG emission controls on their energy sectors.

Energy Efficiency A more energy efficient product or system requires less energy to generate the same output. Improvements in energy efficiency generally require a financial investment in a new product or system. These capital investments likely pay off in the long run, but the payback period may be too long or capital financing may be constrained, particularly for small businesses or in developing nations. Examples of possible energy efficiency offset projects include: Upgrading to more efficient machines or appliances; Supporting construction of more energy efficient buildings; Replacing incandescent light bulbs with fluorescent bulbs. Similar to renewable energy offsets, domestic energy efficiency offset projects would likely face substantial hurdles in proving their additionality in a carbon- constrained regime. As the price of carbon increases and raises energy prices — both outcomes expected with an emissions cap — the incentive to reduce energy use through energy efficiency improvements will increase.

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Offset ownership is another potential challenge regarding some energy efficiency offsets. Energy efficiency improvements may occur at a different location than the actual reduction in emissions. For example, a business that runs its operations with purchased electricity will use less electricity if energy efficiency improvements are made, but the actual emission reductions will be seen at a power plant. Thus, the reductions may be counted twice: first as an energy efficiency offset and second as a direct reduction at the power plant. One way to address this potential dilemma is to restrict energy efficiency projects to only those that reduce or avoid on- site combustion of fossil fuels. This approach is used in the few congressional proposals that specifically allow energy efficiency offsets. As with renewable energy projects, there could be energy efficiency projects in nations that do not limit GHG emissions.

Non-CO2 Emissions Reduction Multiple sources emit non-CO2 greenhouse gases. These emissions are often not controlled through law or regulation. These sources — primarily, agricultural, industrial, and waste management facilities — emit GHGs as byproducts during normal operations. In many cases, the individual sources emit relatively small volumes of gases. However, there are a large number of individual sources worldwide, and many of the gases emitted have greater global warming potential (GWP) than carbon dioxide.18 Offset projects in this category would generally provide funding for emission control technology to reduce these GHG emissions. Examples of emission reduction opportunities include the following: Methane (CH4) emissions from landfills, livestock operations, or coal mines (GWP = 25) Nitrous oxide (N2O) emissions from agricultural operations or specific industrial processes (GWP = 298) Hydrofluorocarbon (HFC) emissions from specific industrial processes, such as HFC-23 emissions from production of a refrigerant gas (GWP of = 14,800) Sulfur hexafluoride (SF6) from specific industrial activities, such as manufacturing of semiconductors (GWP = 22,800) This offset category is broad, as it involves many different industrial activities. As such, some offset types in this category are generally considered high quality, and others that have generated controversy. For example,

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methane reduction from landfills or coal mines has a reputation as a high quality offset. These projects are relatively easy to measure and verify, and in many cases would likely not occur if not for the financing provided by an offset market. Therefore, the challenge of proving additionality is easier to overcome. Offsets involving abatement of HFC-23 emissions from production of a common refrigerant19 have spurred controversy. Of the offset types certified through the Kyoto Protocol’s Clean Development Mechanism (CDM), HFC23 offsets represent the greatest percentage: 50% of the certified emission reductions (CERs) have come from HFC-23 abatement projects.20 Controversy has arisen, because the production facilities can potentially earn more money from the offsets (destroying HFC-23 emissions) than from selling the primary material.21 This creates a perverse incentive to produce artificially high amounts of product to generate a more lucrative by-product.

POLICY ALTERNATIVES TO OFFSETS

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Policymakers have alternative methods of addressing the emission sources and sinks that are often considered to be candidates for offsets. Some of these options are discussed below. Emissions Cap. Congress could expand the scope of the emissions cap to include emission sources that were previously excluded. The rationale for initially excluding these sources is that they are large in number, and they individually generate a relatively small quantity of emissions. Therefore, an offset program is arguably a more cost-effective means of achieving reductions from these sources. However, including certain sources, while excluding others, may raise issues of fairness. For example, some may question why specific sources are capped, while other sources can generate financial gain through the offset market. This discussion is beyond the scope of this chapter. Emissions Standards. Instead of allowing offsets from non-capped sources, Congress could establish sector-specific emission performance standards or technological requirements. This approach is sometimes described as ―command-and-control.‖ Such a policy could be applied to both emission sources and sequestration activities. If Congress sets a baseline requirement, reductions or sequestration beyond the minimum requirement could qualify as offsets.

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Set-Aside Allowances. One possible design element of an emission control program is for policymakers to allot a specific percentage of emission allowances from the overall emissions cap to non-regulated entities (i.e., parties not subject to the emissions cap). These allowances are often described as set-asides. In a carbon-constrained context, the set-aside allowances are essentially currency, because they could be sold to regulated facilities to help meet compliance obligations. Set-asides can be allocated to parties to promote various objectives, including support for activities that reduce, avoid, or sequester emissions. The allowances may also be distributed for other purposes, such as transition assistance to specific economic sectors or financial support to low-income households. These groups may pay proportionately higher costs in an emission reduction regime. Although both set-aside allowances and offsets would address emissions in sectors not subject to the cap, their impacts on regulated sources would differ substantially. Set-aside allowances are within the emissions cap. Offsets represent compliance options from sources outside of the cap. Neither offsets nor set-asides would alter the GHG reduction goal of the program: the cap would remain the same. However, offsets would increase the emission reduction opportunities available to regulated sources; set-aside allowances would not.

POTENTIAL SUPPLY OF OFFSETS The potential supply of offsets available for an emissions trading program would be determined by many variables. The first potentially limiting factor would be the design of the system. The wider the scope of the cap-and-trade program, the smaller the offset universe. In addition, policymakers may choose to restrict the types and locations (domestic versus international) of offsets eligible for use by a regulated entity (Table 1). Within these programmatic boundaries, the supply of offsets available would be primarily dependent on the price of carbon and the advancement of techniques to reduce or sequester emissions. In a cap-and-trade program, the carbon price would be the market price of a tradeable emission allowance.22 The supply of offsets would fluctuate as the allowance price changes. If the allowance price is relatively low — i.e., $1 to $5/mtCO2-e — only the ―low-

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hanging fruit‖ projects would be financially viable. If the allowance price is higher, more offset projects would become economically competitive. A 2005 EPA study estimated the potential of the U.S. agriculture and forestry sectors to reduce, avoid, or sequester GHG emissions (referred to in the study as ―mitigation potential‖).23 The study evaluated the effects of different carbon prices on this potential.24 The study found that in the year 2015 the mitigation potential (or offset supply) from these sectors would vary widely, depending on the price of carbon (Figure 1).25 If the price were $1/mtCO2-e, these sectors would potentially generate 121 million mtCO2-e of offsets; if the price rose to $50/mtCO2-e, almost 1,500 million mtCO2-e of offsets would potentially be available. To put these numbers in context, the United States is projected to generate approximately 7,736 million mtCO2-e in 2015.26 These results are included in this chapter to indicate the relative differences in mitigation potential at different carbon price levels. Note that EPA’s estimate differs from other prepared estimates.27 Figure 2 shows an estimate of the domestic supply of offsets from methane and nitrous oxide reduction projects, including methane reduction from natural gas and oil systems, landfills, and agriculture; and nitrous oxide reduction from agriculture. As with the biological sequestration offsets, more methane/nitrous oxide reduction projects become economically viable as the price of carbon increases. The estimated supply of these offset types is considerably less than the potential supply of biological sequestration offsets.

Source: Prepared by the Congressional Research Service (CRS) with data from EPA, Greenhouse Gas Mitigation Potential in U.S. Forestry and Agriculture (2005). Figure 1. Estimated Annual Supply of Offsets from U.S. Agriculture and Forestry Sectors at Different Carbon Prices (in 2015)

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Source: Prepared by CRS with data from EIA, Energy Market and Economic Impacts of S. 280, the Climate Stewardship and Innovation Act of 2007 (2007). Note: The data in Figures 1 and 2 were generated from different government agencies. A comparison of the absolute values in the two figures is problematic. The values in Figures 1 and 2 are provided to demonstrate the relative differences of potential offset supply as the allowance price increases. In addition, the figures indicate the relative difference in offset supply between biological sequestration offsets (Figure 1) and methane and nitrous oxide reduction projects (Figure 2).

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Figure 2. Estimated Annual Supply of Offsets from U.S. Methane and Nitrous Oxide Reduction Projects at Different Carbon Prices (in 2015)

It may be instructive to consider the potential supply of offsets in the context of a federal cap-and-trade program. For example, in 2015, S. 2191 (Lieberman/Warner) would distribute 5,456 million emission allowances: each allowance equals 1 mtCO2-e. Regulated entities would be permitted to use eligible offsets, including domestic agriculture and forestry projects, to meet up to 15% of their allowance submission (see Table 1). If all covered entities chose this compliance option, the maximum amount of offsets that could be submitted would be 818 million mtCO2-e (15% of 5,456). Depending on the price of carbon, this amount of offsets may not be available from suppliers. The price of carbon is not the only factor that would influence the amount of offsets available in an emissions reduction program. An EPA study stated that ―[o]ther nonprice factors, such as social acceptance, tend to inhibit mitigation option installation in many sectors.‖28 This has been observed in the forestry sector, which was initially expected to play a much larger role in the CDM. An IPCC report stated that although the forestry sector can make a ―very significant contribution to a low- cost mitigation portfolio ... this opportunity is being lost in the current institutional context and lack of

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political will to implement and has resulted in only a small portion of this potential being realized at present.‖ 29 Two factors that may limit or slow offset implementation are information dissemination and transaction costs (discussed in a subsequent section). Many of the emission abatement and sequestration opportunities, particularly in the agricultural sectors, may be widely dispersed and under the control of relatively small operations (e.g., family farms). Similarly, many of the agriculture and forestry offset projects would likely present technical challenges, particularly emission measurement and project verification. To generate offsets at these locations, parties would need to know that opportunities exist and are financially viable (based on the carbon price). In addition, the smaller operations would likely need technical support in order to initiate, measure, and verify the projects.

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POTENTIAL BENEFITS OF OFFSETS The inclusion of offsets in a cap-and-trade program could potentially provide multiple benefits. Perhaps the primary benefit would be improved cost-effectiveness. The ability to generate offsets, which could be sold as emission credits, would provide an incentive for non-regulated sources to reduce, avoid, or sequester emissions. The inclusion of offsets could expand emission mitigation opportunities, likely reducing compliance costs for regulated entities. Many offset projects have the potential to offer environmental benefits, as well. Developing countries, in particular, may gain if the United States includes international offsets in a GHG emission program. In addition, the offset market may create new economic opportunities and spur innovation as parties seek new methods of generating offsets. These issues are discussed below in greater detail.

Cost-Effectiveness A central argument in support of offsets is that their use makes an emissions reduction program more cost-effective. A wide range of activities could be undertaken that would generate offsets. Many of these individual activities would likely generate a relatively small quantity of offsets (in terms of tons), but in the aggregate, their climate change mitigation potential is

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The Role of Offsets on a Greenhouse Gas Emissions Cap-and-Trade… 19 substantial. Arguably, direct regulation of these sources — either through a cap-and-trade program or regulatory command-and-control provisions30 — may not be cost-effective because of the administrative burden. By allowing these sources to generate offsets and sell the offsets (as emission credits) to regulated entities, several benefits are achieved. First, emissions are reduced, avoided, and/or sequestered at sources that may not have otherwise occurred.31 Second, the offsets generated increase the compliance options for regulated entities: covered facilities can either make direct, onsite reductions or purchase emission credits generated from offsets. The increased reduction opportunities provided by offsets are expected to lower the cost of compliance. This impact ultimately affects consumers, because they are expected to bear the majority of an emission program’s costs. A 2007 EPA study analyzed the economic impacts of the Climate Stewardship and Innovation Act of 2007 (S. 280), a cap-and-trade proposal that would allow regulated sources to use domestic and international offsets to satisfy up to 30% of their allowance submission.32 As with other economic models of climate change regulation, the modelers necessarily make many assumptions. Thus, the relative differences between different scenarios is perhaps more useful than the absolute estimates. EPA’s study demonstrated a dramatic difference between the offset scenarios. The study found that if offsets are not allowed the price of carbon would be substantially higher (266% higher in 2015) than if offsets could be used (Figure 3). A 2008 EPA study that analyzed different offset scenarios under the framework of the Climate Security Act of 2008 (S. 2191) found similar results.33

Source: Prepared by CRS with data from EPA, EPA Analysis of The Climate Stewardship and Innovation Act of 2007 (2007). Figure 3. Effect of Three Offset Scenarios on Carbon Price Under Framework of S. 280

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Under different emission program proposals, the relative gap between carbon prices may not be as striking. Compared to some congressional proposals, S. 280 allows for more flexibility of offset use, particularly international offsets.34 The study found that international offsets would play a large role, especially in the beginning decades of the program, because there are generally more low-cost offset opportunities in other nations (Figure 4). In later years (as the carbon price rises), domestic offset types, particularly forestry-related offsets, play a larger role.

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Potential Co-Benefits Offset projects may produce benefits that are not directly related to climate change. For example, many of the offset projects that promote carbon sequestration in soil (e.g., conservation tillage) improve soil structure and help prevent erosion.35 Erosion control may reduce water pollution from nonpoint sources,36 a leading source of water pollution in U.S. waterbodies.37 Depending on a project’s specific design and how it is implemented, other agriculture and forestry offset projects could potentially yield positive environmental benefits. However, there is some concern that certain projects may produce undesirable impacts, such as depleted soil quality, increased water use, or loss of biodiversity.38 Many agriculture and forestry offset projects would likely involve land use changes, such as converting farmlands to forests or biofuel production.39 Determining whether the change imparts net benefits may be a complex evaluation, depending upon, among other things, the current and proposed species of plants and/or trees. Policymakers would likely encounter projects that offer trade-offs: for example, they offset GHG emissions, while imposing an unwanted outcome, such as increased water use, reducing availability downstream.40 EPA found that the more aggressive offset opportunities — afforestation and biofuels production — are more likely to present the most distinct trade-offs.41

Potential Benefits to Developing Nations Most observers would agree that developing nations are unlikely to limit and reduce GHG emissions on a schedule on par with developed nations. With less- regulated emission sources, the universe of eligible offset opportunities

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would be much larger in developing nations. When EPA estimated offset sources under proposed emission reduction programs (S. 280 and S. 2191), international sources accounted for the vast majority of offsets in the early decades (Figure 4).42 Offset types, such as renewable energy and/or energy efficiency projects, which could face substantial hurdles to qualify as offsets in the United States, would be eligible offsets from developing nations. These types of projects would likely provide environmental benefits beyond GHG emission reduction — improvements in local air quality — by displacing or avoiding combustion of fossil fuels.

Source: EPA, EPA Analysis of The Climate Stewardship and Innovation Act of 2007 (2007). Note: CH4 is methane; N20 is nitrous oxide. Figure 4. Estimated Contribution from Offsets by Type Under S. 280

Offset projects in developing nations have the potential to promote sustainable development, such as creation of an energy infrastructure that is less carbon-intensive and more energy efficient. In fact, this was one of the objectives in establishing the Clean Development Mechanism (CDM). Whether this objective is being met is a subject of debate. However, recent projections suggest that offset activities that promote sustainable development will account for a larger percentage of emissions credits in the coming years.

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Source: Prepared by CRS with data from United Nations Environment Programme, Capacity Development for the Clean Development Mechanism (―CDM Pipeline‖), at [http://cd4cdm. org/index. htm].

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Figure 5. CERs Issued by Offset Type (as of February 2008)

Source: Prepared by CRS with data from United Nations Environment Programme, Capacity Development for the Clean Development Mechanism (―CDM Pipeline‖), at [http://cd4cdm. org/index. htm]. Note: Forestry projects are expected to account for 0.3%; transportation projects 0.1%. Figure 6. Projected CERs Issued by 2012

In general, renewable energy and energy efficiency projects contribute more to sustainable development than the offset projects that have dominated the CDM so far (Figure 5). As a comparison between Figures 5 and 6 indicates, the proportion of renewable energy and energy efficiency projects in

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The Role of Offsets on a Greenhouse Gas Emissions Cap-and-Trade… 23 the CDM is expected to more than double by 2012. This projected shift would likely improve support for sustainable development objectives. However, offset projects — primarily, HFC and N2O reduction from industrial activities — that provide few sustainable development benefits are still expected to account for approximately 50% of emission credits issued.

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Other Potential Domestic Benefits A federal cap-and-trade emission program that allows offsets as a compliance option may provide economic benefits to particular sectors of the U.S. economy. However, there may be trade-offs, depending on which types of offsets are eligible and whether or not international offsets are allowed. If international offset projects are included in the program, some U.S. business sectors may benefit from the transfer of technology and/or services to support projects in other nations. If international offsets, generally the lowest-cost options, are excluded, the offset projects from the domestic agriculture and forestry sectors would likely gain a greater share of the offsets market, thus generating business opportunities in these sectors.43 Another potential benefit that is often highlighted is the ability of an offset market to encourage innovation. As the carbon price provides an incentive for regulated entities to find onsite emission reductions (e.g., through efficiency improvements or development of new technologies), the offset market may spur parties to find new ways to reduce, avoid, or sequester emissions from non-regulated sources. However, there is some concern that the drive to find creative offset methods may encourage offset projects that yield unknown, unintended, and possibly harmful, environmental effects. A frequently cited example in this regard is ocean fertilization, which seeks to stimulate phytoplankton growth (and ultimately improve CO2 sequestration) by releasing iron into certain parts of the surface ocean. 44

POTENTIAL CONCERNS Although offsets have the potential to provide benefits under an emissions trading program, several issues associated with offsets have generated concern and some controversy. Perhaps the primary concern regarding offsets is their integrity. To be credible, an offset should equate to an emission reduction from

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a direct emission source, such as a smokestack or exhaust pipe. This issue is critical, if offsets are to be used in an emissions trading program. However, implementing this objective would likely present challenges. This and other concerns are discussed below.

SUPPLEMENTARITY Supplementarity refers to the idea that the role of offsets in an emission reduction program should be secondary to reduction efforts at regulated emission sources. The term comes from the text of the Kyoto Protocol, which states that emissions credits (or offsets) must be ―supplemental to domestic actions for the purpose of meeting quantified emission limitations and reduction commitments....‖ (Article 17, emphasis added).

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Integrity Concerns If offsets are to be included in an emissions trading program, offset integrity — i.e., whether or not the offsets represent real emission reductions — is critical. Several issues need to be addressed when evaluating offsets. Some of these issues may present implementation challenges, which if not overcome, could damage the integrity of the offset. These issues are discussed below.

Additionality Additionality means that the offset project represents an activity that is beyond what would have occurred under a business-as-usual scenario. In other words, would the emission reductions or sequestration have happened anyway? Additionality is generally considered to be the most significant factor that determines the integrity of the offset. In the context of an emissions control program, a test of additionality would examine whether the offset project would have gone forward in the absence of the program. An additionality determination would likely consider the following questions: Does the activity represent a common practice or conforms to an industry standard? Is the offset project required under other federal, state, or local laws?

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The Role of Offsets on a Greenhouse Gas Emissions Cap-and-Trade… 25 Would the project generate financial gain (e.g., be profitable) due to revenues from outside the offset market?45

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Offset credits allow regulated entities to generate GHG emissions above individual compliance obligations. If project developers are able to generate emission credits for projects that would have occurred regardless (i.e., in the absence of the trading program), the influx of these credits into the program would undermine the emissions cap and the value of other, legitimate offset projects. Additionality is at the crux of an offset’s integrity, but applying the additionality criterion may present practical challenges. For instance, it may be impossible to accurately determine ―what would have happened anyway‖ for some projects. Assessing a project’s additionality may involve some degree of subjectivity, which may lead to inconsistent additionality determinations.

Measurement Reliable GHG emissions data are a keystone component of any climate change program. If Congress allows offsets as a compliance option, offset data (emissions reduced, avoided, or sequestered) should arguably be as reliable as data from regulated sources. From a practical standpoint, however, achieving this objective may be difficult. It is generally much simpler to measure and quantify an emission reduction from a direct source than from an offset project. Indeed, the more difficult measurement may be the main reason such reductions are not required by a control program. Regulated sources determine their compliance by comparing actual GHG emissions data against their allowed emissions.46 In contrast, project developers determine offset emission data by comparing the expected reduced, avoided, or sequestered GHG emissions against a projected, business-as-usual scenario (sometimes referred to as a counter-factual scenario). To accomplish this task, offset project managers must establish an emissions baseline: an estimate of the ―business-as-usual‖ scenario or the emissions that would have occurred without the project. If project managers inaccurately estimate the baseline, the offsets sold may not match the actual reductions achieved. For example, an overestimated baseline would generate an artificially high amount of offsets. Baseline estimation may present technical challenges. In addition, project developers have a financial incentive to err on the high side of the baseline determination, because the higher the projected baseline, the more offsets generated. Requiring third-party

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verification (as some proposals do) would potentially address this specific concern. Biological sequestration offset projects may present particular challenges in terms of measurement. The carbon cycle in trees and soils is only partially understood.47 Variations exist across tree species, ages, soil conditions, geographic locations, and management practices.48 Estimates of carbon uptake and storage are frequently considered imprecise or unreliable. Further, changes in vegetation cover may have non-emission effects on climate, such as how much of the Sun’s energy is reflected or absorbed by the Earth. A recent study in the Proceedings of the National Academy of Sciences stated, ―Latitudespecific deforestation experiments indicate that afforestation projects in the tropics would be clearly beneficial in mitigating global-scale warming, but would be counterproductive if implemented at high latitudes and would offer only marginal benefits in temperate regions.‖49

Double-Counting To be credible, when an offset is sold, it should be retired and not sold again or counted in other contexts. However, opportunities for doublecounting exist. For example, a regulated entity may purchase offsets generated through the development of a wind farm in a nation that has not established GHG emissions targets. The U.S. buyer would count the offsets, which may have been purchased to negate increased, onsite emissions at the regulated source. In addition, the nation, in which the wind farm is located, would likely see an emissions reduction due to the wind farm. If this decrease is reflected in the nation’s GHG emissions inventory, the offset project (wind farm) might replace other reduction activities that the nation might have taken to meet its target. Some may argue that double-counting is less of a problem if the offset project occurs in a nation with only a voluntary target (as opposed to a nation subject the Kyoto Protocol). However, the impact would be the same if the nation eventually establishes a mandatory target and takes credit for the earlier reductions associated with the offset project. By taking credit for an earlier reduction, the nation might need to make fewer reductions to be in compliance with the new mandatory program. A tracking system could help avoid such double-counting.50 Most would agree that a domestic tracking system would be simpler to establish and monitor than a system that follows international offset trading. The latter would require, at a minimum, cooperation with the nations hosting the offset projects.

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Permanence With some offset projects there may be a concern that the emission offsets will be subsequently negated by human activity (e.g., change in land use) or a natural occurrence (e.g., forest fire, disease, or pestilence). This issue is most pertinent to biological sequestration projects, specifically forestry activities. Although many observers expected forestry offsets to play a large role in the CDM, this has not been observed in practice. This result is partially due to concerns of offset permanence in developing nations.51 Offset buyers need some assurance that the land set aside for forests (and carbon sequestration) will not be used for a conflicting purpose (e.g., logging or urban development) in the future. Although natural events (fires or pests) are hard to control, human activity can be constrained through legal documents, such as land easements. In addition, an offset could come with a guarantee that it would be replaced if the initial reduction is temporary. Permanence may be more difficult to monitor at international projects. Leakage In the context of climate change policy, GHG emissions leakage generally refers to a situation in which an emissions decrease from a regulated (i.e., capped) source leads to an emissions increase from an unregulated source. EPA states that leakage ―occurs when economic activity is shifted as a result of the emission control regulation and, as a result, emission abatement achieved in one location that is subject to emission control regulation is [diminished] by increased emissions in unregulated locations.‖52 Leakage scenarios may involve emission sources from the same economic sector, but located in different countries. Many voice concern that if the United States were to cap emissions from specific domestic industries (e.g., cement, paper), these industries would relocate to nations without emission caps and increase activity (and thus emissions) to compensate for the decreased productivity in the United States. Thus, global net emissions would not decrease, and affected domestic industries would likely see employment losses. In the context of offsets, leakage may occur in an analogous fashion. The opportunity for leakage exists when an offset project decreases the supply of a good in one location, leading to greater production of the good somewhere else. Compared to other offset types, forestry projects, particularly those that sequester carbon by curbing logging, likely present the greatest risk of leakage.53 For example, an offset project that restricts timber harvesting at a specific site may boost logging at an alternative location, thus reducing the

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effectiveness of the offset project.54 Preventing or accounting for leakage from these projects poses a challenge.

Delay of Technology Development As discussed above, the inclusion of offsets would likely lower the overall cost of compliance. Although many consider this a desired outcome, some contend that the price of carbon needs to reach levels high enough to promote the long-term technological changes needed to mitigate climate change. Offsets also can delay key industries’ investments in transformative technologies that are necessary to meet the declining cap. For instance, unlimited availability of offsets could lead utilities to build high-emitting coal plants instead of investing in efficiency, renewables, or plants equipped with carbon capture and storage.55

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Transaction Costs Transaction costs generally refer to the costs associated with an exchange of goods or services. In an offset market, transaction costs may encompass the following: searching for offset opportunities; studying and/or measuring offset projects; negotiating contracts; monitoring and verifying reduced, avoided, or sequestered emissions; seeking regulatory approval; obtaining insurance to cover risk of reversal (i.e., non-permanence).56 Depending on the price of carbon in the offset market, transaction costs may represent a substantial percentage of the value of the offset. Several studies have examined offset projects in an effort to estimate transaction costs. Generally, the studies’ results include a transaction cost range that varies by offset type and project size.

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Table 2. Comparison of Offset Treatment in GHG Emissions Reduction Initiatives in the U.S. States

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GHG Reduction Program Regional GHG Initiative (RGGI) (CO2 reduction from utilities)

California’s Statewide Emission Programd

Offset Types Allowed or Prohibited

Offset Quantity Limitation

Acceptable Locations of Offset Projects

System of Verifying Integrity of Offsets

Five offset project types allowed:a 1) landfill methane reduction 2) Sulfur hexafluoride (SF6) reductions from industrial activity 3) Afforestation projects 4) Energy efficiency projects yielding reductions or avoidance of CO2 from natural gas, oil or propane combustion 5) Avoided methane from manure manage-ment practices

RGGI was designed to require that 50% of emission reductions come from regulated sources; offsets can be used to achieve the remaining 50% of required reductions;b to apply this objective, offsets are limited to 3.3% of a source’s emissions; the limit increases to 5% if the market price of an allowance exceeds $7 (in 2005 dollars, adjusted annually); if price exceeds $10 (in 2005 dollars, adjusted annually), the limit increases to 10%c Not specified in statute; details deferred to California Air Resources Board

1) RGGI states; 2) non-RGGI states that have their own GHG reduction program or have signed a memorandum of understanding (MOU) with a RGGI state; 3) international projects (e.g., CDM certified emission credits) allowed if carbon price exceeds $10

Standards Approach: each project must meet general standards and standards specific to the project type; each project must be certified by a thirdparty

Not specified in statute; details deferred to California Air Resources Board

Not specified in statute; details deferred to California Air Resources Board

Not specified in statute; details deferred to California Air Resources Board;

Table 2. (Continued) GHG Reduction Program

Offset Types Allowed or Prohibited

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The Market Advisory Committee (MAC)e recommended starting with a small number of project types, such as those allowed under RGGI

Offset Quantity Limitation

Most members of the MAC rejected quantity limitations

Acceptable Locations of Offset Projects

Most MAC members rejected geographic limitations

System of Verifying Integrity of Offsets

MAC recommended adopting a standardsbased approach

Note: Other states have recently enacted legislation to reduce GHG emissions, and a number of states have signed regional agreements that call for GHG reduction. However, these programs are relatively new, and the design details (in particular, offset treatment) have not yet been officially specified. Thus, they are not listed in the above table. For more information, on these programs, see CRS Report RL338 12, Climate Change: Action by States To Address Greenhouse Gas Emissions, by Jonathan L. Ramseur. a. More projects may be added in the future. b. See RGGI Staff Working Group, Analysis Supporting Offsets Limit Recommendation, at [http://www.rggi.org/documents.htm]. c. The RGGI Memorandum of Understanding describes this increase in the use of offsets as a ―safety-valve.‖ Unlike a traditional safetyvalve, the cap would be maintained, because additional allowances cannot be purchased at a threshold price. The RGGI ―safetyvalve‖ would effectively allow regulated parties to meet the majority (at the 5% limit) or possibly all (at the 10% limit) of their reduction requirements through offsets: the RGGI cap is projected to require regulated sources to reduce their annual emissions by about 7% on average (based on RGGI Offsets Limits Analysis data at [http://www.rggi.org/documents.htm].) The cost protection provided by RGGI’s safety-valve will depend on the offset market. For example, if the supply of acceptable RGGI offsets cannot meet demands, the offset price may increase such that the safety-valve is negated. An assessment of offset supply and demand conducted by RGGI officials suggests that this outcome seems unlikely (Evaluation of Offsets Supply and Potential Demand, at [http://www.rggi.org/documents.htm].) d. California Governor Schwarzenegger signed ―The Global Warming Solutions Act‖ (AB32) into law September 27, 2006. AB32 creates a mandatory GHG emissions target: return to 1990 levels by 2020. The statute authorizes, but does not require, the use of market-based mechanisms. The California Air Resources Board (CARB) is responsible for crafting most of the logistical details,

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including offsets. For more information on AB32 see CRS Report RL33962, Greenhouse Gas Reductions: California Action and the Regional Greenhouse Gas Initiative, by Jonathan L. Ramseur. e. The MAC recommendations are included in the table for comparison purposes, because the regulations are being developed. Per California Executive Order S-20-06, the Market Advisory Committee was formed to develop recommendations regarding design details for a market-based emissions reduction program. The Committee includes national and international experts with backgrounds in economics, environmental policy, regulatory affairs, and energy technologies. See Market Advisory Committee, 2007, Recommendations for Designing a Greenhouse Gas Cap-and-Trade System for California.

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For example, a study by the Lawrence Berkeley National Laboratory (LBL) found a transaction cost range of $0.03/mtCO2-e to $4.05/mtCO2-e.57 Overall, the various studies found that smaller offset projects (measured by tons of CO2-e) may be at a disadvantage, because they would likely face proportionately higher transaction costs: the LBL study found that the mean transaction cost for small projects was $2.00/mtCO2-e, but only $0.3 5/mtCO2e for the largest projects. The transaction costs may hinder innovation by serving as an obstacle to small, but promising offset projects. However, transaction costs are inherent in an emissions program that requires project developments to meet certain provisions — additionality, measurement, verification, monitoring — to maintain the integrity of the offset allowed as compliance alternatives.

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Concerns in Developing Nations Some argue that offset use, particularly unlimited access to international offset opportunities, raises questions of fairness. Most of the world’s GHG emissions (especially on a per capita basis) are generated in the developed nations, while most of the lower-cost offset opportunities are in developing nations. Many observers expect the developing nations to establish mandatory GHG reduction programs several years (if not decades) after developed nations’ emission programs are underway. The developed nations are likely to initiate the lower-cost projects and retire the offsets, thus removing the ―lowhanging fruit.‖ If and when the developing nations subsequently establish GHG emission caps, the lower-cost compliance alternatives would not be available to them.58 Some have described this as a form of environmental colonialism.59 Another concern is that international offsets may serve as a disincentive for developing nations to enact laws or regulations limiting GHG emissions. For instance, if a developing nation established emission caps or crafted regulations for particular emissions sources, reductions from these sources would no longer qualify as offsets. Developing nations may be hesitant to forego the funding provided by offset projects.

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The Role of Offsets on a Greenhouse Gas Emissions Cap-and-Trade… 33

CONSIDERATIONS FOR CONGRESS

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From a climate change perspective, the location of an emission activity does not matter: a ton of CO2 (or its equivalent in another GHG) reduced in the United States and a ton sequestered in another nation would have the same result on the atmospheric concentration of GHGs. Moreover, unlike many air pollutants — e.g., acid rain precursors sulfur dioxide and nitrogen oxide, particulate matter, and mercury — a localized increase or decrease of CO2 emissions does not directly impart corresponding local or regional consequences. This attribute of CO2 emissions, the primary GHG, allows for offset opportunities.60 If allowed as part of an emissions reduction program, offsets have the potential to provide various benefits. The ability to generate offsets may provide an incentive for non-regulated sources to reduce, avoid, or sequester emissions (where these actions would not have occurred if not for the offset program); expand emission mitigation opportunities, thus reducing compliance costs for regulated entities; offer environmental co-benefits for certain projects; support sustainable development in developing nations; and create new economic opportunities and spur parties to seek new methods of generating offsets. The main concern with offset projects is whether or not they produce their stated emission reductions. To be credible, an offset ton should equate to a ton reduced from a direct emission source, such as a smokestack or exhaust pipe. If offset projects generate emission credits for activities that would have occurred anyway (i.e., in the absence of the emission trading program), these credits would not satisfy the principle of additionality. For many offset projects, determining additionality will likely pose a challenge. Other offset implementation issues — baseline estimation, permanence, accounting, monitoring — may present difficulties as well. If illegitimate offset credits flow into the trading program, the cap would effectively expand and credible emissions reductions would be undermined. The program would fail to meets its ultimate objective: overall GHG emissions reductions. Offset projects vary by the quantity of emission credits they could generate and the implementation complexity they present. For instance, domestic landfill methane projects are comparatively simple to measure and

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verify, but offer a relatively small quantity of offsets. In contrast, biological sequestration activities, particularly forestry projects, offer the most offsetgenerating potential, but many of these projects pose multiple implementation challenges. This may create a tension for policymakers, who might want to include the offset projects that provide the most emission reduction opportunities, while minimizing the use of offset projects that pose more implementation complications. Addressing these challenges may require independent auditing and/or an appreciable level of oversight and administrative support from government agencies. A report from the National Commission on Energy Policy stated, ―Proposals that expect to achieve significant (> 10 percent) compliance through offsets in the near term will be obligated to create a substantial enforcement bureaucracy or risk an influx of illegitimate credits.‖61 If concerns of legitimacy can be resolved, the next question for policymakers may be whether the potential benefits provided by offsets would outweigh any potential harm. One debate may involve whether including offsets would send the appropriate price signal to encourage the development and deployment of new technologies, such as carbon capture and storage. Policymakers may consider striking a balance between sending a strong price signal and reducing the costs of the emissions reduction program. Another debate may focus on the possible effects of offsets in the developing world (assuming international offsets are allowed in a federal program). On one hand, many of the offset projects may offer significant benefits — more efficient energy infrastructure, improved air quality — to local communities. On the other hand, some maintain that if developed nations use all of the low-cost offsets in developing nations, the developing nations will face higher compliance costs if and when they establish GHG emission reduction requirements. Moreover, there is some concern that international offsets may serve as a disincentive for developing nations to enact laws or regulations limiting GHG emissions, because they would lose funding from the offset market. Whether to include international offsets in a federal program raises other considerations as well. The ability to use international offsets for compliance purposes would substantially expand emission reduction opportunities, compared to only allowing domestic offsets. The more emission mitigation opportunities available, the lower the carbon price. This highlights the debate over the balance between overall program costs and price signal for technological development.

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Table 3. Comparison of Offset Treatment in International Emissions Trading Programs GHG Reduction Program

Offset Types Allowed or Prohibited

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Clean Development Mechanism (CDM) projects: projects judged individually; wide range of types have been accepted; prohibits use of reductions generated from nuclear facilities;a land use, land use changes, and forestry (LULUCF) offset projects imited to reforestation and afforestationb Kyoto Protocol

Joint Implementation (JI) projects: may allow a broader array of project types than the CDM, and would include revegetation, forest management, cropland anagement and grazing land management; JI projects may be limited by a host country’s emission control regulations

Offset Quantity Limitation CDM and JI: ―Supplementarity‖ constraint: offsets must be ―supplemental to domestic action and that domestic action shall thus constitute a significant element of the effort made by each Party...‖ (emphasis added);c but no specific quantity limitations CDM: Reforestation and afforestation projects limited to 1% of party’s baseline emissions

Acceptable Locations of Offset Projects CDM projects: developed nations finance projects in developing nations JI projects: developed nations finance projects in other developed nations; both nations must be parties to the Kyoto Protocol

System of Verifying Integrity of Offsets Case-by-case approval process, which includes test of ―additionality‖:d CDM: each project must have letter of approval from both buyer and seller’s governments; must be evaluated and approved by an Executive Board (EB);e independent third party (accredited by EB) determines the certified emissions reductions (CERs) JI: Track 1 - eligible host country may approve projects and assign emission reduction units (ERUs); Track 2 - Joint Implementation Supervisory Committee (JISC)f approves project and assigns ERUs

Table 3. (Continued) GHG Reduction Program

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European Union’s Emissions Trading System

a. b. c. d.

Offset Types Allowed or Prohibited Kyoto Protocol limitations listed above; Additional limitations: regulated sources cannot use offsets from land use, land use changes, and forestry (LULUCF) projects;g offsets from hydroelectric power projects must satisfy certain conditions

Offset Quantity Limitation First phase (2005-2007): no limits for offsets from CDM, but no JI projects; Second phase (2008-2012) EU members set own limits for offsets from CDM or JI projects, but limit must fall within range set by the European Commission (EC):h at minimum EU states must allow regulated sources to use offsets to cover 10% of their allowances; at a maximum, offsets can cover up to 50% of the reductions required by cap (in some EU states this equates to 20% of allowances)i

Acceptable Locations of Offset Projects CDM projects: developing nations JI projects: other EU nations Domestic offset projects (DOPs) not allowedj

System of Verifying Integrity of Offsets CDM/JI offsets follow Kyoto Protocol verification process (described above)

UNFCCC, 2001, Conference of the Parties, Sixth Session, Decision Five. UNFCCC, 2001, Conference of the Parties, Seventh Session (―Marrakesh Accords‖), Decision 11. Afforestation involves planting trees on previously non-forested land; reforestation involves planting trees on formerly forested land. UNFCCC, 2006, Conference of the Parties serving as the meeting of the Parties to the Kyoto Protocol on its first session, held at Montreal from 28 November to 10 December 2005, Decision 2/CMP 1. ―Additionality‖ is a critical component of the environmental integrity of an offset. The concept refers to whether the offset project would have gone forward on its own merits (e.g., financial benefits) without the support of an offset market or the impetus to

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comply with a legal requirement. In other words, would the offset project have happened anyway? If the project would have occurred, the project is not additional, and should not qualify as an offset. e. The EB is composed of 10 members from parties to the Kyoto Protocol; the members’ terms are limited. f. The JISC is composed of 10 members from parties to the Kyoto Protocol; the members’ terms are limited. g. Although private parties subject to the ETS cap cannot purchase LULUCF offsets, EU governments can purchase eligible LULUCF offsets — i.e., from afforestation or reforestation projects — up to 1% of their state’s base year (1990) emissions each year (See European Union Directive 2004/101/EC (October 27, 2004); Kyoto Protocol, Decision 17/CP.7 (November 2001)). The World Bank reported that global transactions of LULUCF offsets have only accounted for 6% of this allowable limit. h. European Commission Communication (COM/2006/725), November 29, 2006. i. If EU state governments purchase offsets (e.g., to sell as allowances for new sources), these offsets will reduce the percentage of offsets that can be used as allowances by affected sources within that state. j. This issue has received interest in recent months, and some EU members support including domestic offset projects. See European Climate Change Programme Working Group, 2007, Report of the First Meeting (March 8-9, 2007).

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If eligible in a U.S. program, international offsets from countries without binding reduction targets are likely to dominate in early decades because of their comparatively lower costs. Certain domestic economic sectors, primarily agriculture and forestry (if eligible as offsets), would benefit if international offsets are excluded. However, the inclusion of international offsets may benefit other U.S. economic sectors through the transfer of technology and services to support the projects. Moreover, as noted above, the more offset opportunities, the lower the overall costs of the cap-and-trade program.

End Notes

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1

In 1992, the United States ratified the United Nations Framework Convention on Climate Change (UNFCCC), which called on industrialized countries to initiate GHG reduction. The UNFCCC defines GHGs to include carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), sulfur hexafluoride (SF6), hydrofluorocarbons (HFC), and perfluorocarbons (PFC). 2 See CRS Report RL33826, Climate Change: The Kyoto Protocol, Bali ‘Action Plan,’ and International Actions, by Susan R. Fletcher and Larry Parker; CRS Report RL31931, Climate Change: Federal Laws and Policies Related to Greenhouse Gas Reductions, by Brent D. Yacobucci and Larry Parker; CRS Report RL33812, Climate Change: Action by States To Address Greenhouse Gas Emissions, by Jonathan L. Ramseur. 3 See CRS Report RL30024, U.S. Global Climate Change Policy: Evolving Views on Cost, Competitiveness, and Comprehensiveness, by Larry B. Parker and John E. Blodgett. 4 In this way, offsets would complement the more traditional emissions trading that can occur between two covered sources. For example, a covered source (e.g., power plant) can make reductions beyond its compliance obligations and then sell these reductions as credits to other covered sources. This type of transaction represents the ―trade‖ component of a capand-trade program. 5 An emissions cap might require only CO2 emission reductions, but still allow CO2-e offsets from projects that involve non-CO2 GHGs. 6 Although Congress could address GHG emissions with alternative policies — e.g., by enacting a carbon tax or setting emission limits for each source type (―command-and-control) — the option to use offsets is generally discussed in the context of a cap-and-trade regime. Offsets could be a component of a carbon tax framework (e.g., as tax credits), but that discussion is beyond the scope of this chapter. 7 For instance, if a covered source reduced its emissions beyond its compliance obligation, the source could sell the reductions as ―credits‖ to other sources subject to the cap. This financial opportunity would create the incentive for sources to find and make reductions beyond their compliance obligations. These type of exchanges represent the foundation of the cap-and-trade system. 8 For comparison purposes — e.g., estimating the quantity of offsets and potential offset benefits — this chapter generally assumes that emission sources and sequestration activities will either not be regulated in any fashion or they will qualify as offsets. However, there are alternative means of addressing emission sources and sinks that are often considered good candidates for offsets. See the Text Box on p. 8: Policy Alternatives to Offsets. 9 For more information, see CRS Report RL34150, Climate Change: The EU Emissions Trading Scheme (ETS) Gets Ready for Kyoto, by Larry Parker.

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10

The credits are called ―certified emission reductions‖ (CERs) or ―emission reduction units‖ (ERUs), depending on whether they originate from the Clean Development Mechanism (CDM) or from Joint Implementation projects, respectively. The CDM is the Kyoto Protocol compliance mechanism, which has been used widely in the EU-ETS, that allows for developing nations to generate offsets and sell them to regulated sources in developed nations. The CDM was established by Article 12 of the Kyoto Protocol. For more information on the Kyoto Protocol’s ―flexible mechanisms,‖ see [http://unfccc.int/ kyoto_protocol/mechanisms/items/1673.php]. 11 Although the credits are equivalent to allowances in environmental and economic terms, they are not interchangeable. For more on the EU ETS, see CRS Report RL33581, Climate Change: The European Union’s Emissions Trading System (EU-ETS), by Larry Parker. 12 If the source was subject to an emissions cap, reductions beyond compliance obligations would be sold directly as emission credits. 13 For more information on agricultural activities, see CRS Report RL33898, Climate Change: The Role of the U.S. Agriculture Sector, by Renee Johnson. 14 This comparison does not account for the externalities associated with fossil fuel combustion: air pollution, environmental degradation, health problems linked to emissions, etc. 15 In addition, some may argue that nuclear energy could be considered a renewable energy. This debate is beyond the scope of this chapter. 16 The digesters capture the methane, which can be used for energy purposes. 17 See CRS Report RL33846, Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th Congress, by Larry Parker and Brent D. Yacobucci. 18 GWP is an index of how much a GHG may contribute to global warming over a period of time, typically 100 years. GWPs are used to compare gases to carbon dioxide, which has a GWP of 1. For example, methane’s GWP is 25, and is thus 25 times more potent a GHG than CO2. The GWPs listed in this chapter are from: Intergovernmental Panel on Climate Change, Climate Change 2007: The Physical Science Basis (2007), p. 212. 19 Chlorodifluoromethane, referred to as HCFC-22. 20 Of the CERs expected to be issued by 2012, the percentage drops to 22% (still the highest percentage by offset type). See the United Nations Environment Programme (UNEP), CDM Pipeline data, at [http://cdmpipeline.org/index.htm]. 21 This calculus depends on the market price for offsets. See Michael Wara, Measuring the Clean Development Mechanism’s Performance and Potential, Working Paper #56, Stanford Center for Environmental Science and Policy (2006). 22 The allowance price would be influenced by several factors. The central factor would be the structure of the emission reduction program, particularly the program’s scope (which sources are covered) and stringency (the amount and timing of required emission reductions). 23 U.S. Environmental Protection Agency (EPA), Greenhouse Gas Mitigation Potential in U.S. Forestry and Agriculture (2005). 24 Although the study did not address different means of implementing the price structure, one mechanism would be to allow parties to generate offsets and sell the offsets to regulated entities for compliance purposes. 25 The mitigation options in these sectors included afforestation, forest management, soil sequestration, fossil fuel reduction/avoidance from crop production, agriculture-related methane and nitrous oxide mitigation, and biofuel production. 26 This figure reflects net GHG emissions, thus includes emission sinks (e.g., land-based activities). The figure is derived from a linear extrapolation of projections for 2012 and 2020. See U.S. Department of State, Fourth Climate Action Report to the UN Framework Convention on Climate Change, Table 5-2 (2007). 27 For example, a 2007 EIA study estimated that in 2015 at a carbon price of $15/mtCO2-e, 122 million mtCO2-e (compared to EPA’s estimated 629 million mtCO2-e) would be available

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as offsets. U.S. Energy Information Administration (EIA), Energy Market and Economic Impacts of S. 280, the Climate Stewardship and Innovation Act of 2007 (2007). 28 EPA, Global Mitigation of Non-CO2 Greenhouse Gases, p. 1-23 (2006). 29 Intergovernmental Panel on Climate Change, Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report, p. 543 (2007). 30 A command-and-control program may require, for example, that certain technologies be installed to control emissions from landfills or animal waste, or that specific practices (e.g., conservation tillage) be performed in agricultural operations. 31 If they would have occurred, they would not be additional (to business-as-usual), and thus, not qualify as offsets. 32 EPA, EPA Analysis of The Climate Stewardship and Innovation Act of 2007 (2007). 33 EPA, EPA Analysis of the Lieberman-Warner Climate Security Act of 2008, S. 2191 in the 110th Congress (2008). 34 Section 145 allows covered entities to satisfy 30% of its total allowance submission requirement with international credits obtained from offset projects. 35 Intergovernmental Panel on Climate Change, Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report (2007), p. 526. 36 Nonpoint source pollution is caused by rainfall or snowmelt moving over and through the ground. As the runoff moves, it picks up and carries away natural and human-made pollutants, finally depositing them into lakes, rivers, wetlands, coastal waters, and even underground sources of drinking water. See EPA’s Nonpoint Source Pollution website, at [http://www.epa.gov/owow/nps/qa.html]. 37 See CRS Report RL33800, Water Quality Issues in the 110th Congress: Oversight and Implementation, by Claudia Copeland. 38 Intergovernmental Panel on Climate Change, Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report (2007), pp. 529-530. 39 In fact, these activities are often categorized, particularly in international contexts, as land use, land use changes, and forestry (LULUCF) projects. 40 For example, certain evergreen plantations (tree farms) generally have higher water use than the land they replace. Intergovernmental Panel on Climate Change, Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report (2007), p. 530. 41 EPA, Greenhouse Gas Mitigation Potential in U.S. Forestry and Agriculture (2005), p. 8-8. 42 EPA’s analyses indicate that international offsets would play a larger role under S. 280 than S. 2191. This is likely due to the different limitations posed by the two proposals. S. 280 would allow regulated entities to use approximately twice the amount of international offsets as S 2191 (Table 1). 43 As discussed above, the inclusion of international offsets would lower the emission allowance price, which would benefit regulated entities and ultimately consumers. 44 See Ken O. Buesseler, et al.,‖Ocean Iron Fertilization — Moving Forward in a Sea of Uncertainty,‖ Science Vol. 319 (2008), 162. 45 See, World Resources Institute, The Greenhouse Gas Protocol for Project Accounting (2005), at [http://www.ghgprotocol.org]. 46 The emissions data may not be a direct measurement, but an estimate calculated by using related data, such as fuel consumption. 47 See CRS Report RL34059, The Carbon Cycle: Implications for Climate Change and Congress, by Peter Folger. 48 See CRS Report RL31432, Carbon Sequestration in Forests, by Ross W. Gorte. 49 Govindasamy Bala, et al., ―Combined climate and carbon-cycle effects of large-scale deforestation,‖ Proceedings of the National Academy of Sciences, Vol. 104 (2007): 65506555. 50 See Anja Kollmuss, ―Carbon Offsets 101,‖ World Watch (2007).

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Frank Lecocq and Philippe Ambrosi, ―The Clean Development Mechanism: History, Status, and Prospects,‖ Review of Environmental Economics and Policy (Winter 2007), pp. 134151. 52 See Environmental Protection Agency (EPA), Office of Air and Radiation, Tools of the Trade: A Guide To Designing and Operating a Cap and Trade Program For Pollution Control (2003), Glossary. 53 Nicholas Institute for Environmental Policy Solutions, Harnessing Farms and Forests in the Low-Carbon Economy: How to Create, Measure, and Verify Greenhouse Gas Offsets, Zach Wiley and Bill Chameides, eds. (2007), pp. 18-19. 54 Similarly, forest sequestration projects could shift demand to substitute products (e.g., steel or aluminum studs to replace wood studs in homebuilding) whose production requires more energy, and thus releases more carbon. See CRS Report RL31432, Carbon Sequestration in Forests, by Ross Gorte. 55 Testimony of David Hawkins, Climate Center, Natural Resources Defense Council, before the Senate Committee on Environment and Public Works, November 13, 2007, at [http://docs.nrdc.org/globalwarming/glo_07111301A.pdf] 56 These are the costs assessed in the following study: Camille Antinori and Jayant Sathaye, Assessing Transaction Costs of Project-Based Greenhouse Gas Emissions Trading (2007), Ernest Orlando Lawrence Berkeley Laboratory. 57 Ibid. 58 See e.g., David M. Driesen, 1998, ―Free Lunch or Cheap Fix?: The Emissions Trading Idea and the Climate Change Convention,‖ Boston College Environmental Affairs Law Review 26:1-87; see also Emily Richman, 2003, ―Emissions Trading and the Development Critique: Exposing the Threat to Developing Countries,‖ New York University School of Law Journal of International Law and Politics 36:133-176. 59 See e.g., Ross Gelbspan, ―Toward A Global Energy Transition,‖ Foreign Policy In Focus (2004). 60 This attribute also creates critical challenges for policymakers. For instance, if one nation invests in emission reductions, any resulting benefits (e.g., decreased atmospheric GHG concentration) would be shared by all nations, including those that continue to increase their emissions. This dynamic has led some to refer to climate change as the ―ultimate global commons pollution problem,‖ because it discourages unilateral emission reduction. See Henry Lee, 2001, ―U.S. Climate Policy: Factors and Constraints,‖ in Climate Change: Science, Strategies, & Solutions (Eileen Clausen, editor). 61 National Commission on Energy Policy, 2007, Energy Policy Recommendations to the President and the 110th Congress.

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Chapter 2

GREENHOUSE GAS REDUCTION: CAP-ANDTRADE BILLS IN THE 110TH CONGRESS Larry Parker and Brent D. Yacobucci

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SUMMARY Proposals to advance programs that reduce greenhouse gases have been introduced in the 110th Congress, and one bill, S. 2191, was reported on December 5, 2007, by the Senate Committee on Environment and Public Works by an 11-8 vote. In general, these proposals would create market-based greenhouse gas reduction programs along the lines of the trading provisions of the current acid rain reduction program established by the 1990 Clean Air Act Amendments. This chapter presents a side-by-side comparison of the major provisions of those bills and includes a glossary of common terms (Appendix C). Although the purpose of these bills is to reduce greenhouse gases (GHGs), the specifics of each differ greatly. Five bills (S. 280, S. 309, S. 485, H.R. 620, and H.R. 1590) cap greenhouse gas emission from covered entities at 1990 levels in the year 2020. S. 317 places its first emissions cap at 2001 levels in 2015; S. 1766 targets reductions at 2006 levels in 2020; S. 2191 as reported would cap GHGs at about 19% below 2005 levels in 2020; and H.R. 4226 would limit 2020 emissions to 85% of their 2006 levels. Seven bills (S. 280, S. 317, S. 485, S. 2191, H.R. 620, H.R. 1590, and H.R. 4226) would establish

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Larry Parker and Brent D. Yacobucci

cap-and-trade systems to implement their emission caps. In contrast, S. 1766 provides for two compliance systems — a cap-and-trade program and an alternative safety valve payment — and allows the covered entities to choose one or employ a combination of both. Finally, S. 309 provides discretionary authority to the Environmental Protection Agency (EPA) to establish a capand-trade program to implement its emission cap. The differences continue with respect to entities covered under the programs. Three bills (S. 309, S. 485, H.R. 1590) provide discretionary authority to EPA to determine covered entities by applying cost-effective criteria to reduction options. In contrast, S. 317’s emission cap is imposed solely on the electric generating sector. The other five bills (S. 280, S. 1766, S. 2191, H.R. 620, H.R. 4226) cover most economic sectors but not all (e.g., they exclude the agricultural sector). Thus, the overall reductions achieved by the bills depend partly on the breadth of entities covered. Beyond the basics of these bills, each contains other important provisions. For example, S. 280 creates a new innovation infrastructure, while S. 1766, S. 2191, and H.R. 4226 encourage foreign countries to undertake comparable control actions and specify potential consequences if they don’t. Other provisions include mandatory greenhouse gas standards for vehicles (S. 309, S. 485, H.R. 1590), and a renewable portfolio standard for the electric generating sector (S. 309, S. 485, H.R. 1590). All bills contain some provisions for the periodic review of the program’s adequacy in addressing climate change. This comparison should be considered a guide to the basic provisions contained in each bill. It is not a substitute for careful examination of each bill’s language and provisions. Further action on S. 2191 is expected.

INTRODUCTION Climate change is generally viewed as a global issue, but proposed responses generally require action at the national level. In 1992, the United States ratified the United Nations Framework Convention on Climate Change (UNFCCC), which called on industrialized countries to take the lead in reducing the six primary greenhouse gases to 1990 levels by the year 2000.1 For more than a decade, a variety of voluntary and regulatory actions have been proposed or undertaken in the United States, including monitoring of power plant carbon dioxide emissions, improved appliance efficiency, and

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Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th Congress 45 incentives for developing renewable energy sources. However, carbon dioxide emissions have continued to increase. In 2001, President George W. Bush rejected the Kyoto Protocol, which called for legally binding commitments by developed countries to reduce their greenhouse gas emissions.2 He also rejected the concept of mandatory emissions reductions. Since then, the Administration has focused U.S. climate change policy on voluntary initiatives to reduce the growth in greenhouse gas emissions. In contrast, in 2005, the Senate passed a Sense of the Senate resolution on climate change declaring that Congress should enact legislation establishing a mandatory, market-based program to slow, stop, and reverse the growth of greenhouse gases at a rate and in a manner that ―will not significantly harm the United States economy‖ and ―will encourage comparable action‖ by other nations.3 A number of congressional proposals to advance programs designed to reduce greenhouse gases have been introduced in the 110th Congress. These have generally followed one of three tracks. The first is to improve the monitoring of greenhouse gas emissions to provide a basis for research and development and for any potential future reduction scheme. The second is to enact a market-oriented greenhouse gas reduction program along the lines of the trading provisions of the current acid rain reduction program established by the 1990 Clean Air Act Amendments. The third is to enact energy and related programs that would have the added effect of reducing greenhouse gases4; an example would be a requirement that electricity producers generate a portion of their electricity from renewable resources (a renewable portfolio standard). This chapter focuses on the second category of bills. (For a review of additional climate change related bills, see CRS Report RL34067, Climate Change Legislation in the 110th Congress, by Jonathan L. Ramseur and Brent D. Yacobucci.)

PROPOSED LEGISLATION IN 110TH CONGRESS In the 110th Congress, nine bills have been introduced that include provisions to impose or permit some form of market-based controls on emissions of greenhouse gases. General descriptions of those bills follow, beginning with S. 2191, which was reported, with amendments, on December 5, 2007, by the Senate Committee on Environment and Public Works. The

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major provisions of the six Senate bills are compared in Appendix A. The major provisions of the three House bills are compared in Appendix B. S. 2191, as introduced October 18, 2007, by Senators Lieberman and Warner, would cap greenhouse gas emissions from the electric generation, industrial, and transportation sectors (for facilities that emit more than 10,000 metric tons of carbon dioxide equivalent). As introduced, the cap is estimated by the sponsors to reduce emissions to 15% below 2005 levels in 2020, declining steadily to 63% below 2005 levels in 2050. The program would be implemented through an expansive allowance trading program to maximize opportunities for cost-effective reductions. Credits obtained from increases in carbon sequestration and acquisition of allowances from foreign sources could be used to comply with 30% of reduction requirements. The bill also establishes a Carbon Market Efficiency Board to observe the allowance market and implement cost-relief measures if necessary. (For recent action on S. 2191 and for modifications to the provisions, see the next section.) S. 280, introduced January 12, 2007, by Senator Lieberman, would cap emissions of the six greenhouse gases specified in the United Nations Framework Convention on Climate Change at reduced levels from the electric generation, transportation, industrial, and commercial sectors — sectors that account for about 85% of U.S. greenhouse gas emissions. The reductions would be implemented in four phases, with an emissions cap in 2012 based on the affected facilities’ 2004 emissions (for an entity that has a single unit that emits more than 10,000 metric tons of carbon dioxide equivalent); the cap steadily declines until it is equal to one-third of the facilities’ 2004 levels. The program would be implemented through an expansive allowance trading program to maximize opportunities for cost-effective reductions, and credits obtained from increases in carbon sequestration, reductions from non-covered sources, and acquisition of allowances from foreign sources could be used to comply with 30% of reduction requirements. The bill also contains an extensive new infrastructure to encourage innovation and new technologies. S. 309, introduced January 16, 2007, by Senator Sanders, would cap greenhouse gas emissions on an economy-wide basis beginning in 2010. Beginning in 2020, the country’s emissions would be capped at their 1990 levels, and then proceed to decline steadily until they were reduced to 20% of their 1990 levels in the year 2050. The EPA has the discretion to employ a market-based allowance trading program or any combination of cost-effective emission reduction strategies. The bill also includes new mandatory greenhouse gas emission standards for vehicles and new powerplants, along with a new energy efficiency performance standard. The bill would establish a

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Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th Congress 47 renewable portfolio standard (RPS) and a new low-carbon generation requirement and trading program. S. 317, introduced January 17, 2007, by Senator Feinstein, would cap greenhouse gas emissions from electric generators over 25 megawatts. Beginning in 2011, affected generators would be capped at their 2006 levels, declining to 2001 levels by 2015. After that, the emission cap would decline 1% annually until 2020, when the rate of decline would increase to 1.5%. The allowance trading program includes an allocation scheme that provides for an increasing percentage of all allowances to be auctioned, with 100% auctioning in 2036 and thereafter. The capand-trade program allows some of an entity’s reduction requirement to be meet with credits obtained from foreign sources and a variety of other activities specified in the bill. S. 485, introduced February 1, 2007, by Senator Kerry, would cap greenhouse gas emissions on an economy-wide basis beginning in 2010. Beginning in 2020, the country’s emissions would be capped at their 1990 levels. After 2020, emissions economy-wide would be reduced 2.5% annually from their previous year’s level until 2031, when that percentage would increase to 3.5% through 2050. The allowance trading system includes an allocation scheme that requires an unspecified percentage of allowances to be auctioned. The bill also includes new mandatory greenhouse gas emission standards for vehicles, along with a new energy efficiency performance standard. The bill would establish a renewable portfolio standard (RPS), increase biofuel mandates under the Renewable Fuels Standard, and mandate new infrastructure for biofuels. Finally, the bill expands and extends existing tax incentives for alternative fuels and advanced technology vehicles, and establishes a manufacturer tax credit for advanced technology vehicle investment. S. 1766, introduced July 11, 2007, by Senator Bingaman, would set emissions targets on most of the country’s greenhouse gas emissions. Greenhouse gas emitting activities such as methane emissions from landfills, coal mines, animal waste, and municipal wastewater projects, along with nitrous oxide emissions from agricultural soil management, wastewater treatment, and manure management, are not included under the targets, although credits for use by covered entities are available or may be generated by verified GHG reductions in these areas. Beginning in 2012, covered entities would have emissions targets set at their 2006 levels in 2020. The emissions targets would decline steadily until 2030 when the emission target would be set at the entities’ 1990 levels. Compliance can be secured either through an allowance trading program or by paying a safety valve price (called a

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Technology Accelerator Payment or TAP). Under the trading program, allowances are allocated according to various categories, including covered entities; eligible facilities, such as coal mines and carbon-intensive industries; states; and sequestration activities. Initially, 24% of all allowances are auctioned, a percentage that increases over time. The TAP is set at $12 a metric ton of carbon dioxide equivalent; it increases 5% annually above the rate of inflation. The bill also requires countries that do not take comparable action to control emissions to submit special allowances (or their foreign equivalent) to accompany exports to the United States of any covered greenhouse intensive goods and primary products. H.R. 620, introduced February 7, 2007, by Representative Olver, is a substantially modified version of S. 280. Using the same basic structure as S. 280, the emission caps under H.R. 620 are more stringent. Reductions from affected sectors (electric generation, transportation, industrial, and commercial) would be set at 2004 levels in 2012 and then steadily decline until the cap is equal to about one- fourth of facilities’ 2004 levels. Although H.R. 620 permits affected entities to comply with the reduction requirements with credits from foreign sources, sequestration, and reductions from noncovered entities, these credits are limited to 15% of the source’s reduction requirement. H.R. 1590, introduced March 20, 2007, by Representative Waxman, is similar to S. 485. H.R. 1590 would cap greenhouse gas emissions on an economy-wide basis beginning in 2010. Beginning in 2020, the country’s emissions would be capped at their 1990 levels. After 2020, emissions economy-wide would be reduced by roughly 5% annually from their previous year’s level through 2050, when emissions levels would be capped at 80% below 1990 levels. The allowance trading system includes an allocation scheme that requires an unspecified percentage of allowances to be auctioned. The bill also includes new mandatory greenhouse gas emission standards for vehicles, along with a new energy efficiency performance standard. The bill would also establish a renewable portfolio standard. H.R. 4226, introduced November 15, 2007, by Representative Gilchrest, is a modified version of H.R. 620. Using the same basic structure as H.R. 620, emission limitations are based on percentages of 2006 emission levels. Reductions from affected sectors (electric generation, transportation, industrial, and commercial) would be set at 2006 levels in 2012 and then steadily decline until the cap is equal to about one-fourth of facilities’ 2006 levels in 2050. The bill provides that the President may establish a program to require importers to pay the value of GHGs emitted during the production of

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Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th Congress 49 goods or services imported into the United States from countries that have no comparable emission restrictions to those of the United States. The program’s requirement may not be imposed on countries until negotiations to achieve agreement on such restrictions have been attempted. In addition, the bill also establishes a Carbon Market Efficiency Board to observe the allowance market and implement cost-relief measures if necessary.

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LEGISLATIVE ACTION IN THE 110TH CONGRESS On November 1, 2007, the Senate Committee on Environment and Public Works’ Subcommittee on Private Sector and Consumer Solutions to Global Warming and Wildlife Protection reported out a revised version of S. 2191. As reported from subcommittee, S. 2191 is estimated to reduce greenhouse gas emissions 19% below 2005 levels by 2020 (up from 15% as introduced) and 63% below 2005 levels by 2050. The increase in the estimated reductions in 2020 is the result of amended text that includes greenhouse gases from all natural gas uses under the overall emissions cap. Other amendments approved included modifications to eligibility requirements for the advanced technology vehicles manufacturing incentive program and the advanced coal generation technology demonstration program. Modifications were also made to the proposed allocation of allowances to help tribal communities respond to climate change and to encourage international forest carbon activities, along with 1% of allowances reserved for rural cooperatives and a corresponding reduction in allowances allocated to the rest of the electric power industry. The revised bill also added two new recipients of auction revenues: a Bureau of Land Management Emergency Firefighting Fund ($300 million) and a Forest Service Emergency Firefighting Fund ($800 million). On December 5, 2007, the full committee ordered reported out a revised version of S. 2191 by a 11 to 8 vote. The revised bill expands the greenhouse gas reduction program coverage by replacing the previous definition of covered facility based on the electric power, transportation, and industrial sectors with a comprehensive upstream definition, including coal mines, oil refineries, and natural gas processing plants. Among the amendments agreed to by the full committee were a new Low- Carbon Performance Standard that would require the carbon intensity of transportation fuel to be frozen in 2011 and then reduced by 5% in 2015 and 10% in 2020. Other amendments agreed to would increase incentives for states to modify their utility regulatory

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structures to encourage energy efficiency, and would broaden the ability of states to use their allowance allocations to mitigate adverse economic impacts resulting from the bill’s implementation. Further action on S. 2191 is expected.

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APPENDIX A. COMPARISON OF KEY PROVISIONS OF SENATE GREENHOUSE GAS REDUCTION BILLS S. 309 (Sanders)

S. 317 (Feinstein)

Topic

S. 280 (Lieberman)

Emission reduction/ limitation scheme

Absolute cap on total emissions from all covered entities in the electric power, transportation, industry, and commercial sectors.

Absolute cap on total emissions economy- wide.

Absolute cap on total emissions from covered electric generators.

Absolute cap on total emissions economy- wide.

Responsible agency

Environmental Protection Agency (EPA). Carbon dioxide, methane, nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulfur hexafluoride (SF6).

EPA.

EPA.

EPA.

Same six gases as S. 280.

Same six gases as S. 280.

Same six gases as S. 280.

Greenhouse gases defined

S. 485 (Kerry)

S. 1766 (Bi ngaman) Emissions targets for all covered entities that refine petroleum, process natural gas, consume coal, or import petroleum products, coke, and natural gas. Includes importers of HFCs, PFCs, SF6, N2O, or products containing such compounds. To be determined by the President. Same six gases as S. 280.

S. 2191 as reported (Lieberman/ Warner) Absolute cap on total emi-ssions from all covered enti-ties in the electric power, transportation, and industry sectors.

EPA.

Same six gases as S. 280.

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(Continued) Topic

S. 280 (Lieberman)

Specific emissions limits

Beginning in 2012, emissions from covered entities are capped at 6.13 billion metric tons, minus 2012 emissions from non-covered entities. Beginning in 2020, emission cap declines to 5.239 billion metric tons, minus 2020 emissions from noncovered entities. Beginning in 2020, emission cap declines to 5.239 billion metric tons, minus 2020 emissions from noncovered entities. Beginning in 2030, emission cap declines to 4.1 billion metric tons, minus 2030 emissions from noncovered entities.

S. 309 (Sanders)

S. 317 (Feinstein)

Beginning in 2010, emissions economy- wide to be reduced 2% annually. Beginning in 2020, emission cap on economy-wide basis set at 1990 level, with declining emission caps of 26.7% below 1990 levels in 2030 and 53.3% in 2040. Beginning in 2050, emission cap set at 80% below 1990 levels.

Beginning in 2011, emissions from affected electric generators capped at 2006 levels. Beginning in 2020, emission cap declines 1.5% annually from previous year’s level.

S. 485 (Kerry) Beginning in 2010, emissions economy- wide to be reduced by appropriate measures to cap emissions at 1990 levels by 2020. Beginning in 2031 through 2050, emissions economywide to be reduced 3.5% annually from previous year’s level.

S. 1766 (Bi ngaman) In 2012, the emissions target for covered entities is set at 6.652 billion metric tons. Target is reduced annually thereafter until 2030. Emission target for covered sources in 2020 is 6.188 billion metric tons. Emission target for covered sources in 2030 is 4.819 billion metric tons. If the President determines that scientific, technological, and international considerations suggest further reductions are warranted, his recommendations are to be considered by Congress under expedited procedures.

S. 2191 as reported (Lieberman/ Warner) In 2012, emissions from covered entities are capped at 5.2 billion metric tons. Cap is reduced annually thereafter until 2050. Emission cap for covered sources in 2030 is 3.472 billion metric tons. Emission cap for covered sources in 2040 is 2.512 billion metric tons.

(Continued) Topic

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Covered entities

S. 280 (Lieberman) In metric tons of carbon dioxide equivalents (CO2e): any electric power, industrial, or commercial entity that emits over 10,000 CO2e annually from any single facility owned by the entity; any refiner or importer of petroleum products fortransportation use that, when combusted, will emit over 10,000 metric tons annually; and any importer or producer of HFCs, PFCs, or SF6 that, when used, will emit over 10,000 CO2e.

S. 309 (Sanders) EPA promulgates rule within two years of enactment that applies the most cost-effective reduction options on sources or sectors to achieve reduction goals.

S. 317 (Feinstein) Any fossil fuelfired electric generating facility that has a capacity of greater than 25 megawatts and generates electricity for sale, including cogeneration and governmentowned facilities.

S. 485 (Kerry) EPA promulgates rule within two years of enactment that applies the most costeffective reduction ptions on the largest emitting sources or sectors to achieve reduction goals.

S. 1766 (Bi ngaman) Regulated fuel distributors include petroleum refineries, natural gas processing plants, and imports of petroleum products, coke, or natural gas. Regulated coal facilities are entities that consume more than 5,000 tons of coal a year. Regulated nonfuel entities are importers of HFCs, PFC, SF6, N2O, or products containing such compounds.

S. 2191 as reported (Lieberman/ Warner) Assuming no capture of GHGs, any producer or importer of petroleumor coal-based liquid or gaseous fuel that emits GHGs, or any facility that produces or imports more than 10,000 CO2e of GHG chemicals annually; any facility that uses more than 5,000 tons of Coal annually; any natural gas processing plant or importer (including LNG); or, any facility that emits more than 10,000 CO2e of HFCs annually as a byproduct of hydrochlorofluorocarbon production.

(Continued) Topic

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General allocating and Implementing strategy

S. 280 (Lieberman) A tradeable allowance system is established:

S. 309 (Sanders)

S. 317 (Feinstein)

Tradeable allowance system permitted. In implementing reduction program, EPA shall select the most costeffective emission reduction strategies. EPA shall allocate to various sectors and interests any allowances that are not allocated to affected entities, including households, dislocated workers, energy efficiency and renewable energy activities, sequestration activities, and ecosystem protection activities.

Tradeable allowance system is established. Allocations to existing sources based on historic electricity output, and includes allowance allocations for incremental nuclear capacity and renewable energy, along with sequestration and early action provisions. From 2011 on, an increasing percentage of all allowances are to be auctioned, with 100% of

S. 485 (Kerry) A tradeable allowance system is established. The President submits to Congress an allocation plan within one year of enactment that includes a com-bination of auctions and free alloca-tion of allowances. To the maximum extent practicable, the allocation and revenues received should maximize public benefits, promote economic growth, assist households and dislocated workers,

S. 1766 (Bi ngaman) Two compliance systems are provided. Covered entities

S. 2191 as reported (Lieberman/ Warner) A tradeable allowance system is established. In

(Continued)

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Topic

S. 280 (Lieberman) EPA shall determine allocations based on several economic, equity, and sectorspecific criteria, including economic efficiency, competitive effects, and impact on consumers. Allowances are to be allocated upstream to refiners and importers of transportation fuel, along with producers of HFCs, PFCs, and SF6, and downstream to electric generation, industrial, and commercial entities. Allocations to covered entities are provided at no cost.

S. 309 (Sanders)

S. 317 (Feinstein) allowances auctioned in 2036 and thereafter.

S. 485 (Kerry) encourage energy efficiency, renewable energy, and Sequestration activities, and assist states in addressing the impact of climate change. Congress has one year to enact an alternative to the plan; otherwise, EPA shall implement it.

S. 1766 (Bi ngaman) May choose which one to use or employ a combination of both. First, a tradeable allowance system is established. In 2012, 53% of allowances allocated to covered and eligible industrial entities; 23% allocated to States and for sequestration and early reduction activities; 24% are auctioned to fund low income assistance, carbon capture and storage, and adaptation activities

S. 2191 as reported (Lieberman/ Warner) 2012 (adjusted in future years): 40% of allowances allocated to covered electric utilities, industrial facilities, and coops, declining steadily to 0 in 2036; 9% allocated to states for conservation, extra reductions, and other activities; 11.5% for various sequestration activities; 10% allocated for electricity consumer assistance; 5% for early reductions; 0.5% for tribal governments; and 18% (plus an early auction of 6%) auctioned to fund technology deployment, carbon capture

(Continued) Topic

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Public sale/auction of allowances

S. 280 (Lieberman)

EPA shall determine the number of allowances allocated to the Climate Change Credit Corporation (CCCC) (established by the bill).

S. 309 (Sanders)

EPA may choose to provide for trustees to sell allowances for the benefit of entities eligible to receive assistance under the proposal (see above).

S. 317 (Feinstein)

From 2011 on, an increasing percentage of all allowances are to be auctioned, with 100% of allowances auctioned in 2036 and thereafter.

S. 485 (Kerry)

The President shall determine the number of allowances to be auctioned. The proceeds of the auction to be deposited with the Climate Reinvestment Fund created by the Department of the Treasury. (See ―Revenue recycling‖ below.)

S. 1766 (Bi ngaman) The percentage auctioned increases steadily, reaching 53% by 2030. Second, a Technology Accelerator Payment (i.e., safety valve) may be paid in lieu of submitting one or more allowances. Beginning in 2012, 24% of available allowances are auctioned to fund low income assistance, technology, and adaptation activities. The percentage auctioned increases steadily, reaching 53% by 2030; after that it increases 1 percentage point annually through 2043.

S. 2191 as reported (Lieberman/ Warner) And storage, low income and rural assistance, and adaptation activities. The percentage auctioned for CCCC activities increases steadily, reaching 73% by 2036 and thereafter. Beginning in 2012, 18% (plus 6% from an early auction of 2012 allowances) of allowances are auctioned to fund the activities of the CCCC. This percentage increases steadily to 73% by 2036 and thereafter.

(Continued) Topic

S. 280 (Lieberman)

S. 309 (Sanders)

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EPA shall allocate to the CCCC allowances before 2012 to auction to raise revenue for technology deployment and dissemination. The CCCC may buy and sell allowances, and use the proceeds to reduce costs borne by consumers and other purposes. (See “Revenue recycling” below.)

Cost-limiting safety valve

No explicit provision.

S. 317 (Feinstein)

S. 485 (Kerry)

Revenues from the auction are to be deposited in the Climate Action Trust Fund created by the Department of the Treasury.

No explicit provision. However, if the President determines a national security emergency exists, the President may temporarily adjust, suspend, or

No explicit provision. However, limited borrowing against future reductions is

S. 1766 (Bi ngaman) Revenues from the auction are to be deposited in one of three funds created by the Department of the Treasury: the Energy Technology Deployment Fund, the Climate Adaptation Fund, and the Energy Assistance Fund.

No explicit provision.

A Technology Accelerator Payment (TAP) (i.e., safety valve) may be paid in lieu of submitting one or more allowances. For 2012, the TAP price is set at $12 per metric ton, rising 5% above inflation annually thereafter.

S. 2191 as reported (Lieberman/ Warner) Revenues from the auction are to be deposited in one of six funds created by the Department of the Treasury: the Climate Change Worker Training Fund, the Adaptation Fund, the Climate Change and National Security Fund, the Energy Assistance Fund, and two Emergency Firefighting Funds. A Carbon Market Efficiency Board is established to observe the allowance market and implement

(Continued)

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Topic

S. 280 (Lieberman)

S. 309 (Sanders)

S. 317 (Feinstein)

waive any regulation promulgated under this program (subject to judicial review).

permitted if EPA determines allowance prices have reached and sustained a level that is or will cause significant harm to the U.S. economy. Also, EPA may increase to 50% the share of international credits that can be used in such cases.

S. 485 (Kerry)

S. 1766 (Bi ngaman) If the President determines the TAP should be increased or eliminated to achieve the act’s purposes, his recommendationsare to be considered by Congress under expedited procedures.

S. 2191 as reported (Lieberman/ Warner) cost- relief measures if necessary. Measures include permitting increased allowance borrowing from future allocations; increased offsets and foreign allowance use; expanded payback period for such allowances; lower interest charged for borrowed allowances; and expanded total borrowed allowances. Increased borrowing limited to 5% of emission cap and repayment schedule can not be longer than 15 years.

(Continued) Topic

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Penalty for noncompliance

S. 280 (Lieberman)

Excess emission penalties are equal to three times the market price for allowances on the last day of the year at issue.

S. 309 (Sanders)

Existing enforcement provisions of Section 113 of the Clean Air Act are extended to program.

S. 317 (Feinstein)

$100 per excess ton indexed to inflation plus a 1.3 to 1 offset from future allowances. If the market price for an allowance exceeds $60, the penalty is $200 per excess ton, adjusted for inflation.

S. 485 (Kerry)

Excess emission penalties are equal to twice the market price for allowances as of December 31 of the year at issue, plus a 1 to 1 offset from next year’s allowance allocation.

S. 1766 (Bi ngaman)

Excess emissions penalties are equal to three times the TAP price for that calendar year. In addition, civil penalties are $25,000 a day for violating provisions of the act.

S. 2191 as reported (Lieberman/ Warner) If the President determines a national security emergency exists, the President may temporarily adjust, suspend, or waive any regulation promulgated under this program (subject to judicial review). Excess emission penalties per ton are equal to the higher of $200 or three times the mean market price for allowances during the year the allowance was due, plus a 1-to-1 offset from a future year allocation.

(Continued) Topic

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Other market trading system features

S. 280 (Lieberman) Up to 30% of required reductions may be achieved through credits obtained through pre-certified international emissions trading programs, approved reduction projects in developing countries, domestic carbon sequestration, and reductions from noncovered entities. Borrowing against future reductions is permitted.

S. 309 (Sanders)

S. 317 (Feinstein)

Market trading systems incorporated into Renewable Portfolio Standard, new energy efficiency performance standard, and new low-carbon generation requirement. No limit on use of domestic biological sequestration to meet reductions requirements.

Up to 25% (50% for new affected units) of required reductions may be achieved with credits obtained through EPAapproved foreign government programs developed under United Nations Framework Convention on Climate Change (UNFCCC) protocols. Limited borrowing against future reductions is permitted if EPA determines allowance prices have reached and

S. 485 (Kerry)

S. 1766 (Bi ngaman)

Market trading systems incorporated into Renewable Portfolio Standard and new energy efficiency performance standard. No limit on use of domestic biological sequestration to meet reductions requirements.

If the President determines that emission credits issued under foreign programs or foreign offset projects are comparable to U.S. ones, he may promulgate rules allowing such credits or offsets to be used to meet the act’s emission targets. No more than 10% of an entity’s emissions target can be met through foreign offset project credits. Establishes program to provide credits obtained through verified reductions from non- covered activities. No limit on their use to meet reduction targets.

S. 2191 as reported (Lieberman/ Warner) Up to 15% of required reductions may be achieved through credits obtained through agricultural sequestration, land use change, forestry, manure management, and other specified activities. Percentage may be increased by the Carbon Market Efficiency Board Up to 15% of required reductions may be achieved through allowances obtained through certified foreign allowance market. Percentage may be increased by the Carbon Market Efficiency Board.

(Continued)

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Topic

S. 280 (Lieberman)

S. 309 (Sanders)

Banking

Banking of allowances is permitted; allowances may be saved for use in future years.

No specific prohibition on banking.

Early reduction credits and bonus credits

Entities with registered emission reductions achieved before 2012 may receive allowances for them, including

Reductions previously achieved under state programs that are at least as stringent as a federal trading

S. 317 (Feinstein) sustained a level that is causing or will cause significant harm to the U.S. economy. Also, EPA may increase to 50% the share of international credits that can be used in such cases. Banking of allowances is permitted; allowances may be saved for use in future years. Entities with reductions achieved from 2000 through 2010 shall receive credits under specific

S. 485 (Kerry)

S. 1766 (Bi ngaman)

Banking of allowances is permitted; allowances may be saved for use in future years. Recognizing and rewarding early reductions is a stated goal of the program.

Banking of allowances is permitted; allowances may be saved for use in future years. One percent of allowances available from 2012 through 2020 are allocated to early reductions reported under the 1992 Energy Policy Act’s 1605(b)

S. 2191 as reported (Lieberman/ Warner) Borrowing against future reductions is permitted.

Banking of allowances is permitted; allowances may be saved for use in future years. Five percent of allowances established for 2012 (declining steadily to 0 in 2017) are allocated to early reductions reported under the 1992

(Continued)

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Topic

Revenue recycling

S. 309 (Sanders)

S. 317 (Feinstein)

reductions achieved under more stringent mandatory state programs. For the time period 2012-2017, entities that have entered into an agreement with EPA to reduce emissions to 1990 levels by 2012 are entitled to additional allowances to cover their additional reductions and are allowed to achieve 40% of their reduction requirement (as opposed to 30%; see above) through international emissions trading and projects, sequestration, or reductions by noncovered entities.

program may be recognized by the federal program. Entities that demonstrate reductions achieved early (but not before 1992) that are as verifiable as reductions under a federal trading program may be recognized by the federal program.

criteria, including EPA rules that ensure reductions are real, additional, verifiable, enforceable, and permanent, and that they were reported under either 1605(b) of the 1992 Energy Policy Act, or according to a state or regional registry. Quantity of credits given is limited to 10% of the 2011 allowance allocation.

Revenues generated by allowance auctions and trading proceeds

Allowances may be allocated by EPA to

Revenues generated from the auction

S. 280 (Lieberman)

S. 485 (Kerry)

S. 1766 (Bi ngaman) program, EPA’s Climate Leaders Program, or a Stateadministered or privately administered registry. Geologic sequestration projects built from 2008 through 2030 receive bonus allowances for the first 10 years of operation.

Revenues generated by allowance

A new Energy Technology Deployment Fund is

S. 2191 as reported (Lieberman/ Warner) Energy Policy Act’s 1605(b) program, EPA’s Climate Leaders Program, a State-administered or voluntary program. Four percent of allowances established for 2012 through 2035 available on a steadily declining basis from 2012 through 2039 for geologic sequestration projects for electric generating plants built from 2008 through 2035. The bonus allowances are limited to the first 10 years of operation.

Revenues received by allowance auctions are to be

(Continued)

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Topic

S. 280 (Lieberman)

are received by a new Climate Change Credit Corporation (CCCC). Activities to be funded include mechanisms to reduce consumer costs and to assist dislocated workers, low-income persons, and affected communities, along with programs to encourage deployment of new technology and wildlife restoration. Allocations to the CCCC are to be determined by EPA based on the funding needs of the advanced technologies demonstration and deployment programs. Further, at least 50% of revenue received must be used for Technology deployment.

S. 309 (Sanders) households, dislocated workers, energy efficiency and renewable energy activities, sequestration activities, and ecosystem protection activities.

S. 317 (Feinstein)

S. 485 (Kerry)

S. 1766 (Bi ngaman)

are to be deposited in the Climate Action Trust Fund created by the Department of the Treasury. Activities to be funded include an Innovative Lowand Zeroemitting Carbon Technologies Program, a Clean Coal Technologies Program, and an Energy Efficiency Technology Program, along with research And development. Adaptation and mitigation activities to

auctions and penalties are received by a new Climate Reinvestment Fund created by the Department of the Treasury. Activities to be funded include mechanisms to reward early reductions, maximize public benefits, romote economic rowth, Assist households and dislocated workers, encourage energy efficiency, renewable energy, and sequestration activities, and assist states in

funded by TAPs received and some auction proceeds. Activities to be funded include zeroor low-carbon energy, advanced coal and sequestration, cellulosic biomass, and advanced technology vehicles. A new Climate Adaptation Fund is funded by some auction proceeds. Activities to be funded include coastal, arctic, and fish and wildlife impact mitigation. A new Energy Assistance Fund is funded by some auction proceeds. Activities to be funded include lowincome and rural energy assistance, and weatherization.

S. 2191 as reported (Lieberman/ Warner) received by the Climate Change Credit Corporation (CCCC). Activities to be funded include technology deployment activities (including zero- or low- carbon energy, advanced coal and sequestration, cellulosic biomass, and advanced technology vehicles); assistance activities (including low income, weatherization, and rural assistance); worker transition assistance; and adaptation activities (including wildlife conservation and restoration, aquatic ecosystems, and coastal habitats).

(Continued)

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Topic

Other key Provisions

S. 280 (Lieberman)

Provisions include studies of research on abrupt climate change and impact of climate change on the world’s poor, among others, and creation of a national greenhouse gas database. A new Innovation Infrastructure is created, along with

S. 309 (Sanders)

Provisions include mandatory greenhouse gas emission standards for vehicles by 2010, for new electric powerplants that begin operation after December 31, 2011, and a new energy efficiency

S. 317 (Feinstein)

S. 485 (Kerry)

be funded include affected workers and communities, and fish and wildlife habitat.

addressing the impact of climate change.

Establishes program to encourage offsets from the agricultural sector. Offset credits available for agricultural, forestry, grazing, and wetlands

Provisions include manda-tory greenhouse gas emission standards for vehicles by 2010, and a new energy efficiency standard beginning in 2009.

S. 1766 (Bi ngaman)

Provisions include periodic review of the activities of the nation’s 5 largest trading partners, an NAS assessment of the status of the science and control technologies, and energy security implications.

S. 2191 as reported (Lieberman/ Warner) Revenues would also fund a Climate Change and Natural Security Council to report annually on the ramifications of climate change for national security. $1.1 billion from auction revenues is directed toward wildland fire suppression activities by the Bureau of Land Management and the Forest Service. Provisions require new appliance standards in 2012 and provide for new model building efficiency standards by 2010 and a new low- carbon fuel performance standard for the transportation sector beginning in 2011.

(Continued) Topic

S. 280 (Lieberman)

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program initiatives to promote less carbonintensive technology, adaptation, sequestration, and related activities. Requires periodic review of target adequacy by the Under Secretary of Commerce for Oceans and Atmosphere.

S. 309 (Sanders)

S. 317 (Feinstein)

performance standard. Establishes a Renewable Portfolio Standard and credit program. Establishes a new low- carbon generation requirement and trading program. Requires periodic review of target adequacy by the National Academy of Sciences (NAS).

management, sequestration projects, or practices that meet specific criteria in the proposal. Offset credits also available for approved Emission reduction offset projects from a variety of activities listed in the proposal. Requires periodic review of target adequacy by EPA, taking into account the Recommendations of a newly established Climate Science Advisory Panel.

S. 485 (Kerry)

S. 1766 (Bi ngaman)

Establishes a Renewable Portfolio Standard and credit program. Increases biofuel mandates under the Renewable Fuels Standard, and mandates infrastructure for biofuels. Expands and extends existing tax incentives for alternative fuel and advanced technology vehicles, and establishes manufacturer tax credit for advanced technology vehicle investment.

Beginning in 2019, requires foreign countries that do not take comparable emission reduction actions to submit international reserve allowances (or foreign equivalents) to accompany exports of any covered greenhouse gas intensive goods and primary products to the United States. Least developed nations or those that contribute no more than 0.5% of global emissions are excluded. Proceeds from the sale of such reserve allowances are to be deposited in an International Energy Deployment Fund to encourage and finance

S. 2191 as reported (Lieberman/ Warner) Beginning in 2018, requires annual review of foreign countries’ GHG control actions. Beginning in 2019, requires foreign countries that do not take comparable emission reduction actions to submit international reserve allowances (or foreign equivalents) to accompany exports of any covered greenhouse gas intensive goods and primary products to the United States. Least developed nations or those that contribute no more than 0.5% of global emissions are excluded.

(Continued) Topic

S. 280 (Lieberman)

S. 309 (Sanders)

S. 317 (Feinstein)

S. 485 (Kerry)

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Establishes new National Climate Change Vulnerability and Resilience Program. Requires periodic review of target adequacy by the NAS.

S. 1766 (Bi ngaman) international technology development.

S. 2191 as reported (Lieberman/ Warner) Requires periodic review of the bill’s implementation and purposes by the NAS.

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APPENDIX B. COMPARISON OF KEY PROVISIONS OF HOUSE GREENHOUSE GAS REDUCTION BILLS Topic Emission reduction/ limitation scheme

H.R. 620 (Olver) Absolute cap on total emissions from all covered entities in the electric power, transportation, industry, and commercial sectors.

H.R. 1590 (Waxman) Absolute cap on total emissions economywide.

Responsible agency Greenhouse gases defined

EPA.

EPA.

H.R. 4226 (Gilchrest) Absolute cap on total emissions from all covered entities in the electric power, transportation, industry, and commercial sectors. EPA.

Same six gases as S. 280. (Carbon dioxide, methane, nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulfur hexafluoride (SF6).) Beginning in 2012, emissions from covered entities are capped at 6.15 billion metric tons, minus 2012 emissions from noncovered entities. Beginning in 2020, emission cap declines to 5.232 billion metric tons, minus 2020 emissions from non-covered entities.

Same six gases as S. 280.

Same six gases as S. 280.

Beginning in 2010, emissions economywide to be reduced by roughly 2% annually to cap emissions at 1990 levels by 2020. Beginning in 2021, through 2050, emissions

Beginning in 2012, emissions from covered entities are capped at 2006 levels, minus 2012 emissions from noncovered entities. Beginning in 2020, emission cap declines to 85% of 2006 levels, minus 2020 emissions from non-covered entities.

Specific emissions limits

(Continued) Topic

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Covered entities

H.R. 620 (Olver)

H.R. 1590 (Waxman)

H.R. 4226 (Gilchrest)

Beginning in 2030, emission cap declines to 3.858 billion metric tons, minus 2030 emissions from non-covered entities. Beginning in 2050, emission cap further declines to 1.504 billion metric tons, minus annual emissions from noncovered entities.

economy-wide to be reduced roughly 5% annually from previous year’s level. Beginning in 2050, emission cap set at 80% below 1990 levels.

Beginning in 2030, emission cap declines to 63% of 2006 levels, minus 2030 emissions from non-covered entities. Beginning in 2050, emission cap further declines to 25% of 2006 levels, minus annual emissions from non-covered entities.

In metric tons of carbon dioxide equivalent: any electric power, industrial, or commercial entity that emits over 10,000 metric tons carbon dioxide equivalent annually from any single facility owned by the entity; any refiner or importer of petroleum products for transportation use that, when combusted, will emit over 10,000 metric tons annually; and any importer or producer of HFCs, PFCs, or SF6 that, when used, will emit over 10,000 metric tons of carbon dioxide equivalent.

EPA promulgates rule within two years of enactment that applies the most costeffective reduction options on the largest emitting sources or sectors to achieve reduction goals.

In metric tons of carbon dioxide equivalent: any electric power, industrial, or commercial entity that emits over 10,000 metric tons carbon dioxide equivalent annually from any single facility owned by the entity; any refiner or importer of petroleum products for transportation use that, when combusted, will emit over 10,000 metric

Topic

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General allocating and implementing strategy

H.R. 620 (Olver)

(Continued) H.R. 1590 (Waxman) .

A tradeable allowance system is established: EPA shall determine allocations based on several economic, equity, and sector-specific criteria, including economic efficiency, competitive effects, and impact on consumers. Allowances are to be allocated upstream to refiners and importers of transportation fuel, along with producers of HFCs, PFCs, and SF6, and downstream toelectric generation, industrial, and commercial entities. Allocations to covered entities are provided at no cost.

A tradeable allowance system is established. The President submits to Congress an allocation plan within one year of enactment that includes a combination of auctions and free allocation of allowances. To the maximum extent practicable, the allocation and revenues received should maximize public benefits, promote economic growth, assist households and dislocated workers, encourage energy efficiency, renewable

H.R. 4226 (Gilchrest) tons annually; and any importer or producer of HFCs, PFCs, or SF6 that, when used, will emit over 10,000 metric tons of carbon dioxide equivalent. A tradeable allowance system is established: EPA shall determine allocations based on several economic, equity, and sector-specific criteria, including economic efficiency, competitive effects, and impact on consumers. Allowances are to be allocated upstream to refiners and importers of transportation fuel, along with producers of HFCs, PFCs, and SF6, and downstream to electric generation, industrial, and commercial entities.

Topic

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Public sale/auction of allowances

(Continued) H.R. 620 (Olver) H.R. 1590 (Waxman) energy, and sequestration activities, and assist states in addressing the impact of climate change. Congress has one year to enact an alternative to the plan; otherwise, EPA shall implement it. EPA shall determine the number of The President shall allowances allocated to the Climate determine the number of Change Credit Corporation (CCCC) allowances to be (established by the bill). auctioned. The proceeds of The CCCC may buy and sell allowances, the auction are to be and use the proceeds to reduce costs deposited with the borne Climate Reinvestment by consumers and other purposes. (See Fund created by the ―Revenue recycling‖ below.) Department of the Treasury. (See ―Revenue recycling‖ below.)

H.R. 4226 (Gilchrest) Allocations to covered entities are provided at no cost.

EPA shall determine the number of allowances allocated to the Climate Change Credit Corporation (CCCC) (established by the bill). The CCCC may buy and sell allowances, and use the proceeds to reduce costs borne by consumers and other purposes. (See ―Revenue recycling‖ below.)

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(Continued) Topic Cost-limiting safety valve

H.R. 620 (Olver) No explicit provision.

H.R. 1590 (Waxman) No explicit provision.

Penalty for noncompliance

Excess emission penalties are equal to three times the market price for allowances on the last day of the year at issue.

Excess emission penalties are equal to twice the market price for allowances as of December 31 of the year at

H.R. 4226 (Gilchrest) A Carbon Market Efficiency Board is established to observe the allowance market and implement costrelief measures if necessary. Measures include permitting increased allowance borrowing from future allocations; expanded payback period for such allowances; lower interest charged for borrowed allowances; and expanded total borrowed allowances. Increased borrowing limited to 5% of emission cap and repayment schedule cannot be longer than 15 years. Excess emission penalties are equal to three times the market price for allowances on the last day of the year at issue.

Topic

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Other market trading system features

Banking

Early reduction credits and bonus credits

(Continued) H.R. 1590 (Waxman) issue, plus a 1- to-1 offset from next year’s allowance allocation. Up to 15% of required reductions may be Market trading systems are achieved through credits obtained through incorporated into new pre-certified international emissions energy efficiency trading programs, approved reduction performance standard. projects in developing countries, domestic No explicit provision on carbon sequestration, and reductions from use of domestic or non- covered entities. international offsets to Borrowing against future reductions is meet reduction requirements. However, permitted. one goal of program is to encourage sequestration of carbon in the forest and agricultural sectors. Banking of allowances is permitted; Banking of allowances is allowances may be saved for use in future permitted; allowances may years. be saved for use in future years. Entities with registered emission Recognizing and reductions achieved before 2012 may rewarding early reductions receive allowances for them. is a stated goal of the program. H.R. 620 (Olver)

H.R. 4226 (Gilchrest)

Up to 15% of required reductions may be achieved through credits obtained through pre-certified international emissions trading programs, approved reduction projects in developing countries, domestic carbon sequestration, and reductions from non-covered entities. Borrowing against future reductions is permitted. Banking of allowances is permitted; allowances may be saved for use in future years. Entities with registered emission reductions achieved before 2012 may receive allowances for them.

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Topic

Revenue recycling

(Continued) H.R. 620 (Olver) H.R. 1590 (Waxman) For the time period 2012-2017, entities that have entered into an agreement with EPA to reduce emissions to 1990 levels by 2012 are entitled to additional allowances to cover their additional reductions and are allowed to achieve 35% of their reduction requirement (as opposed to 15%; see above) through international emissions trading and projects, sequestration, or reductions by non- covered entities.

Revenues generated by allowance auctions and trading proceeds are received by a new Climate Change Credit Corporation (CCCC). Activities to be funded include mechanisms to reduce consumer costs and to assist dislocated workers and affected communities, along

Revenues generated by allowance auctions and penalties are received by a new Climate Reinvestment Fund created by the Department of the Treasury. Activities to be

H.R. 4226 (Gilchrest) For the time period 20122017, entities that have entered into an agreement with EPA to reduce emissions to 1990 levels by 2012 are entitled to additional allowances to cover their additional reductions and are allowed to achieve 35% of their reduction requirement (as opposed to 15%; see above) through international emissions trading and projects, sequestration, or reductions by non-covered entities. Revenues generated by allowance auctions and trading proceeds are received by a new Climate Change Credit Corporation (CCCC). Activities to be funded include mechanisms

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Topic

Other key provisions

(Continued) H.R. 620 (Olver) H.R. 1590 (Waxman) with programs to encourage deployment funded include of new technology and wildlife mechanisms to reward restoration. early reductions, maximize public benefits, promote economic growth, assist households and dislocated workers, encourage energy efficiency, renewable energy, and sequestration activities, and assist states in addressing the impact of climate change. Provisions include studies of the impact of climate change on coastal ecosystems and communities, and the world’s poor, among others; assessment of adaptation technologies; and creation of a national greenhouse gas database. Requires periodic review of target adequacy by the Under Secretary of Commerce for Oceans and Atmosphere.

Provisions include mandatory greenhouse gas emission standards for vehicles by 2010, and a new energy efficiency standard beginning in 2010. Establishes a Renewable Portfolio Standard.

H.R. 4226 (Gilchrest) to reduce consumer costs and to assist dislocated workers and affected communities, along with programs to encourage deployment of new technology and wildlife restoration. Bill specifies that 25% of allowances allocated to the CCCC be used to restore large-scale freshwater aquatic and estuarine ecosystems. The President may establish a program to require importers to pay the value of GHGs emitted during the production of goods or services imported into the United States from countries that have no comparable emission restrictions to those of the United States. The program’s requirement may

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Topic

H.R. 620 (Olver)

(Continued) H.R. 1590 (Waxman) Requires periodic review of target adequacy by the NAS.

H.R. 4226 (Gilchrest) not be imposed on countries until negotiations to achieve agreement on such restrictions have been attempted. Provisions include studies of the impact of climate change on coastal ecosystems and communities, and the world’s poor, among others; assessment of adaptation technologies; creation of a national greenhouse gas database; and an outreach initiative to inform agriculture of the bill’s revenue opportunities. Requires periodic review of target adequacy by the Under Secretary of Commerce for Oceans and Atmosphere.

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APPENDIX C. COMMON TERMS Allocation Schemes (Upstream and Downstream)

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Regulatory approaches to allocating allowances (as opposed to auction schemes) can choose different points and participants along the production process to assign allowances and the resulting compliance responsibility. Upstream allocation schemes establish emission caps and assign allowances at a production, importation, or distribution point of products that will eventually produce greenhouse emissions further down the production process. For example, in the natural gas sector, emission caps could be established and allowances assigned at processing facilities where facilities and participants shrink from about 400,000 wells and 8,000 companies to 500 plants and 200 companies. In contrast, downstream allocation schemes establish emission caps and assign allowances at the point in the process where the emissions are emitted. In the case of the natural gas industry, to achieve the same coverage as the upstream scheme, this would involve assigning allowances to natural gas-fired electric generators, industry, and even residential users. Thus, some downstream proposals choose either to exempt certain sectors (such as residential use) from a cap-and-trade program or to employ a hybrid allocation scheme where some of the allowances are allocated upstream and others downstream (such as the electric generators).

Allowance An allowance is generally defined as a limited authorization by the government to emit 1 ton of pollutant. In the case of greenhouse gases, an allowance generally refers to a metric ton of carbon dioxide equivalent. Although used generically, an allowance is technically different from a credit. A credit represents a ton of pollutant that an entity has reduced in excess of its legal requirement. However, the terms tend to be used interchangeably, along with others, such as permits.

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Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th Congress 77

Auctions Auctions can be used in market-based pollution control schemes in several different ways. For example, Title IV of the 1990 Clean Air Act Amendments uses an annual auction to ensure the liquidity of the credit trading program. For this purpose, a small percentage of the credits permitted under the program are auctioned annually, with the proceeds returned to the entities that would have otherwise received them. Private parties are also allowed to participate. A second possibility is to use an auction to raise revenues for a related (or unrelated) program. For example, the Regional Greenhouse Gas Initiative (RGGI) is exploring an auction to implement its public benefit program to assist consumers or pursue strategic energy purposes. A third possibility is to use auctions as a means of allocating some, or all, of the credits mandated under a GHG control program. Obviously, the impact that an auction would have on cost would depend on how extensively it was used in any GHG control program, and to what purpose the revenues were expended.

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Banking Although allowances are generally allocated on an annual basis, most capand-trade programs do not require participants to either use the allowance that year or else lose it. Under many proposals, allowances can be banked by the receiving participant (or traded to another participant who can use or bank it) to be used or traded in a future year. Banking reduces the absolute cost of compliance by making annual emission caps flexible over time. The limited ability to shift the reduction requirement across time allows affected entities to better accommodate corporate planning for capital turnover, allow for technological progress, control equipment construction schedules, and respond to transient events such as weather and economic shocks.

Bubble A bubble is a regulatory device that permits two or more sources of pollutants to be treated as one for the purposes of emission compliance.

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Cap-and-trade Program A cap-and-trade program is based on two premises. First, a set amount of pollutant emitted by human activities can be assimilated by the ecological system without undue harm. Thus, the goal of the cap-and-trade program is to impose a ceiling (i.e., an emissions cap) on the total emissions of that pollutant at a level below the assimilative capacity. Second, a market in pollution licenses (i.e., allowances) between polluters is the most cost-effective means of reducing emissions to the level of the cap. This market in allowances is designed so that owners of allowances can trade those allowances with other emitters who need them or retain (bank) them for future use or sale. In the case of the sulfur dioxide program contained in the 1990 Clean Air Act Amendments, most allowances were allocated free by the federal government to utilities according to statutory formulas related to a given facility’s historic fuel use and emissions; other allowances have been reserved by the government for periodic auctions to ensure market liquidity.

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Carbon Tax A carbon tax is generally conceived as a levy on natural gas, petroleum, and coal according to their carbon content, in the approximate ratio of 0.6 to 0.8 to 1, respectively. However, proposals have been made to impose the tax downstream of the production process when the carbon dioxide is actually released to the atmosphere. In contrast to a cap-and-trade program, in which the quantity of emissions is limited and the price is determined by an allowance marketplace, with a carbon tax, the price is limited and the quantity of emissions is determined by the participants based on the cost of control versus the cost of the tax.

Coverage Coverage is the breadth of economic sectors covered by a particular greenhouse gas reduction program.

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Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th Congress 79

Emissions Cap A mandated limit on how much pollutant (or greenhouse gases) an affected entity can release to the atmosphere. Caps can be either an absolute cap, where the amount is specified in terms of tons of emissions on an annual basis, or a rate-based cap, where the amount of emissions produced per unit of output (such as electricity) is specified but not the absolute amount released. Caps may be imposed on an entity, sector, or economy-wide basis.

Generation Performance Standard (GPS) Also called an output-based allocation, allowances are allocated gratis to entities in proportion to their relative share of total electricity generation in a recent year.

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Grandfathering Grandfathering generally refers an allocation scheme in which allowances are distributed to affected entities on the basis of historic emissions. These allowances are generally distributed free-of-charge by the government to the affected entities. Grandfathering can also refer to entities that because of age or because they have met an earlier standard, or other factors, are exempted from a new regulatory requirement.

Greenhouse Gases The six gases recognized under the United Nations Framework Convention on Climate Change are carbon dioxide (CO2), methane (CH4) nitrous oxide (N2O), sulfur hexafluoride (SF6), hydrofluorocarbons (HFC), and perfluorocarbons (PFC).

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Hybrid Program Generally a greenhouse gas reduction program that allows emitters to choose between complying with the reduction requirement of a cap-andtrade program or paying a set price (safety valve price) to the government in lieu of making reductions.

Leakage Decreases in greenhouse gas-related reductions or benefits outside the boundaries set for defining a project’s or program’s net greenhouse gas impact resulting from mitigation activities. For example, emissions could be reduced in an area with greenhouse gas controls by moving an emitting industry to an area without such controls.

“No regrets” Policy

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A ―no regrets‖ policy is one of establishing programs for other purposes that would have concomitant greenhouse gas reductions. Therefore, only those policies that reduce greenhouse gas emissions at no cost are considered.

Offsets Offsets generally refer to emission credits achieved by activities not directly related to the emissions of an affected source. Examples of offsets would include forestry and agricultural activities that absorb carbon dioxide, and reduction achieved by entities that are not regulated by a greenhouse gas reduction program.

Revenue Recycling Some greenhouse gas reduction programs create revenues through auctions, compliance penalties, or imposition of a carbon tax. Revenue recycling refers to how a program disposes of those revenues. How a program

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Greenhouse Gas Reduction: Cap-and-Trade Bills in the 110th Congress 81 handles revenues received can have a significant effect on the overall cost of the program to the economy.

Safety Valve Devices designed to prevent or to respond to unacceptably high compliance costs for greenhouse gas reductions. Generally triggered by prices in the allowance markets, safety valve approaches can include (1) a set price alternative to making reductions or buying allowances at the market price, (2) a slowdown in tightening the emissions cap, and (3) lengthening of the time allowed for compliance. Depending on the interplay between the emissions cap and safety valve and actual compliance costs, a safety valve can affect the integrity of the emissions cap.

Sequestration

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Sequestration is the process of capturing carbon dioxide from emission streams or from the atmosphere and then storing it in such a way as to prevent its release to the atmosphere.

End Notes 1

Under the United Nations Framework Convention on Climate Change (UNFCCC), those gases are carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulfur hexafluoride (SF6). Some greenhouse gases are controlled under the Montreal Protocol on Substances that Deplete the Ozone Layer, and are not covered under UNFCCC. 2 For further information, see CRS Report RL30692, Global Climate Change: The Kyoto Protocol, by Susan R. Fletcher. 3 S.Amdt. 866, passed by voice vote after a motion to table failed 43-54, June 22, 2005. 4 For discussions of relevant energy legislation, see CRS Report RL34294, Energy Independence and Security Act of 2007: A Summary of Major Provisions, by Fred Sissine, and CRS Report RL33831, Energy Efficiency and Renewable Energy Legislation in the 110th Congress, by Fred Sissine, et al.

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In: Carbon Dioxide Emissions Editors: James P. Mulligan

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Chapter 3

VOLUNTARY CARBON OFFSETS: OVERVIEW AND ASSESSMENT Jonathan L. Ramseur

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SUMMARY Businesses and individuals are buying carbon offsets to reduce their ―carbon footprint‖ or to categorize an activity as ―carbon neutral.‖ A carbon offset is a measurable avoidance, reduction, or sequestration of carbon dioxide (CO2) or other greenhouse gas (GHG) emissions. Offsets generally fall within the following four categories: biological sequestration, renewable energy, energy efficiency, and reduction of non-CO2 emissions. In terms of the carbon concentration in the atmosphere, an emission reduction, avoidance, or sequestration is beneficial regardless of where or how it occurs. A credible offset equates to an emission reduction from a direct emission source, such as a smokestack or exhaust pipe. The core issue for carbon offset projects is: do they actually offset emissions generated elsewhere? If the credibility of the voluntary offsets is uncertain, claims of carbon neutrality may be challenged. Evidence suggests that not all offset projects are of equal quality, because they are developed through a range of standards. In the voluntary market, there are no commonly accepted standards. Although some standards are considered stringent, others are less so. At least 30 companies and organizations

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Jonathan L. Ramseur

(domestic and international) sell carbon offsets to individuals or groups in the international, voluntary carbon market. Two recent studies that examined many of the offset sellers found a general correlation between offset price and offset quality. Due to the lack of common standards, some observers have referred to the market as the ―wild west.‖ This does not suggest that all carbon offsets are low quality, but that the consumer must necessarily adopt a buyer-beware mentality when purchasing carbon offsets. This places the responsibility on consumers to judge the quality of carbon offsets. The viability of the voluntary offset market may influence future policy decisions regarding climate change mitigation. For example, credible offsets could play an important role, particularly in terms of cost-effectiveness, in an emissions control regime. There is some concern that the range in the quality of voluntary market offsets may damage the overall credibility of carbon offsets. If this occurs, it may affect policy decisions concerning whether or not to include offsets as an option in a mandatory reduction program.

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INTRODUCTION In the United States and around the world, a growing number of businesses, interest groups, and individuals are purchasing carbon offsets and asserting that all or part of their greenhouse gas (GHG) emitting activities (e.g., air travel, corporate events, or personal automobile use) are ―carbon neutral‖ as a result. These exchanges represent a voluntary market for carbon offsets, because there is currently no federal requirement that GHG emissions be curtailed. The concept of purchasing carbon offsets to achieve carbon neutrality (or reduce one’s ―carbon footprint‖) has spurred both interest and debate in recent years. This chapter provides an overview of carbon offsets and examines some of the issues that are generating debate (and controversy). Although there is some overlap of issues between voluntary carbon offsets and the offsets used to comply with mandatory reduction regimes, this chapter focuses on the voluntary offsets market. Unless otherwise stated, the carbon offsets in this chapter refer to those exchanged in the voluntary market.

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Voluntary Carbon Offsets: Overview and Assessment

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WHAT ARE CARBON OFFSETS? A carbon offset is a measurable avoidance, reduction, or sequestration of carbon dioxide (CO2) or other greenhouse gas (GHG) emissions. Offsets generally fall within the following four categories (discussed in greater detail later in the report): biological sequestration, renewable energy, energy efficiency, and reduction of non-CO2 emissions. Carbon offsets are sometimes described as project-based because they typically involve specific projects or activities that reduce, avoid, or sequester emissions. Because offset projects can involve different GHGs,1 they are quantified and described with a standard form of measure: either in tons of carbon-equivalents or CO2-equivalents (frequently expressed as tC-e or tCO2-e). To be considered a credible offset, the emissions reduced, avoided, or sequestered need to be additional to business-as-usual: i.e., what would have happened anyway. In the context of a mandatory GHG emission reduction regime, an offset can come only from sources not covered by the reduction program (i.e., outside the emissions cap).2 Emission reductions from regulated sources would be required under the cap, and thus would not be additional. By comparison, a reduction activity may be additional if it occurs from a source in a nation that does not limit the source’s GHG emissions. As more nations (or U.S. states) establish mandatory caps on emission sources, the universe of potential carbon offsets will shrink.

The Size of the Voluntary Carbon Offset Market There is currently no registry or tracking system that follows exchanges in the voluntary market. For this reason, the precise size or value of the voluntary offset market is unknown. However, a series of World Bank reports — The State and Trends of the Carbon Market — provides some estimates for recent years.3 These estimates are listed in Table 1. The estimates indicate that the size of the market has increased rapidly every year since 2004. The World Bank report cites forecasts of increasing growth in coming years. One projection (described as ―optimistic‖ by the World Bank) indicates that the volume of transactions in the international voluntary market will be 400 MtCO2-e by 2010.4 To put this figure in context, the U.S. GHG emissions were approximately 7,200 MtCO2-e in 2005.5

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Jonathan L. Ramseur Table 1. Estimates of the Volume and Value of the Voluntary Carbon Market

Year 2004 2005 2006

Estimated Volume of Transactions (in million metric tons of CO2-equivalents, MtCO2-e) 3 MtCO2-e 6 MtCO2-e 10 MtCO2-e

Estimated Value of Transactions $6 million $44 million $100 million

Source: Prepared by Congressional Research Service with data from the following: 2004 estimates from World Bank 2006, State and Trends of the Carbon Market 2006; 2005-2006 data from World Bank, 2007, State and Trends of the Carbon Market 2007.

Carbon Offset Integrity Issues

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A primary concern regarding voluntary carbon offsets is their integrity. It is generally agreed that a credible offset should equate to an emission reduction from a direct emission source, such as a smokestack or exhaust pipe. Several criteria determine the integrity or quality of an offset project.

Additionality This is generally considered to be the most significant factor that determines the integrity of the carbon offset. Additionality refers to whether the offset project (e.g., wind farm) would have gone forward on its own merits (or own financial benefits) without the support of the offset market. In other words, would the project have happened anyway? If the project would have occurred without the financial support of the offset buyer, the emission reductions generated from the project would not be additional. The additionality criterion is at the crux of an offset’s integrity, but additionality can be difficult to assess in practice. The standards used to analyze a project’s additionality vary, and some groups may downplay the importance of this attribute. An offset seller who employs a more stringent additionality analysis will likely offer ―higher quality‖ offsets.

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Baseline Determination To determine the amount of emissions avoided by an offset project, project managers must establish an emissions baseline: an estimate of the ―business-as-usual‖ scenario or the emissions that would have occurred without the project. If project managers inaccurately estimate the baseline, the offsets sold may not match the actual reductions achieved. For example, an overestimated baseline (projecting more emissions than would have been emitted in the project’s absence) would generate an artificially high amount of offsets. Baseline measurement may present technical challenges. In addition, project developers would have a financial incentive to err on the high side of the baseline determination, because the higher the projected baseline, the more offsets generated. Double Counting A carbon offset is meaningful if it is only counted once. To be credible, when an offset is sold, it should be retired and not sold again or counted in other contexts. However, opportunities for double-counting exist. For example, a U.S. buyer may purchase offsets generated through the development of a wind farm in a country, state, or locality that has established GHG emissions targets. The U.S. buyer will count the offsets, which may have been purchased to counter an increase in personal air travel. In addition, the nation (state or locality), in which the wind farm is located, may see an emissions reduction due to the wind farm. This decrease will be reflected in the nation’s GHG emissions inventory. Thus, the offset project (wind farm) may replace other reduction activities that the nation might have taken to meet its target. A tracking system needed to avoid such double-counting does not exist.6 Some may argue that double-counting is less of a problem if the offset project occurs in a U.S. state (county or city) with only a voluntary target (as opposed to a nation subject the Kyoto Protocol). However, the impact would be the same if the state is eventually part of a federal emissions reduction program, and the state is allowed to take credit for the earlier reductions associated with the offset project. By taking credit for an earlier reduction, the state will need to make fewer reductions to be in compliance with the new mandatory program. Permanence When carbon offsets are generated from a project, there should be confidence that the emission offsets are permanent — that the emissions are

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not merely postponed. This characteristic is most pertinent to biological sequestration projects, specifically forestry activities. For example, buyers need some assurance that the land set aside for forests will not be used for a conflicting purpose (e.g., logging or urban development) in the future. Although natural events (fires or pests) are hard to control, human activity can be constrained through legal documents such as land easements. In addition, an offset could come with a guarantee that it would be replaced if the initial reduction is temporary.

Carbon Offset Types and Potential Integrity Concerns

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In the voluntary market, carbon offsets can be generated from multiple economic sectors. This chapter discusses carbon offsets grouped into the four categories identified above. Each category contains a list of possible carbon offset examples. Specific integrity issues may be associated with particular offset categories. These issues are discussed below. The potential problems highlighted below should not necessarily rule out entire carbon offset categories. If offset project developers can address these potential obstacles, the offsets may be credible. However, it may be difficult for offset buyers to know if these problems were addressed (as discussed later in the report).

Biological Sequestration Trees, plants, and soils sequester carbon, thereby reducing its amount in the earth’s atmosphere.7 Biological sequestration projects generally involve activities that either increase sequestration or preserve an area’s existing sequestration ability that is under threat (e.g., from logging or development). This offset category includes sequestration that results from activities related to agriculture and forests, and is sometimes referred to as land use, land use change and forestry (LULUCF) projects. Example of these projects include: Planting trees on previously non-forested land (i.e., afforestation) Planting trees on formerly forested land (i.e., reforestation) Limiting deforestation by purchasing forested property and preserving the forests with legal mechanisms (e.g., land easements) Setting aside croplands from production to avoid emissions released during crop production Promoting practices that reduce soil disruption (e.g., conservation tillage)

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Compared to the other offset categories, biological sequestration projects offer the most potential in terms of volume (particularly forestry projects). However, this category is arguably the most controversial, because of several integrity issues that are typically associated (or perceived to be associated) with biological sequestration projects. Some agricultural sequestration offsets may raise concerns of additionality: i.e., the sequestration activity would have happened regardless of the payments received from offset buyers. For example, farmers may be able to generate offsets by conducting no-till operations on their land, but for the offsets to be credible, the impetus to adopt this practice should be driven by the financial gain from the offset market. If the no-till practice was part of normal operations before the offset market, then the offset would fail the additionality test. There is anecdotal evidence indicating that some farmers have been using the no-till technique for years, but still received compensation for the offsets.8 If this is the case, this would be a fairly straightforward example of a non-additional offset. Should this bar other farmers, who have not been practicing conservation measures (e.g., no-till farming), from receiving offsets for initiating such measures? Arguably the measures provide some benefit on their own (e.g., less fuel use), because some farmers have been using the techniques for years. However, the offset incentive may be a primary driver at some farms. This example demonstrates the difficulties associated with proving that a project is additional. Biological sequestration offset projects may present challenges in terms of measurement. This issue is especially relevant to forestry-related offsets. The carbon cycle in trees and soils is complex: variations across tree species, ages, and geographic locations increase the measurement challenge.9 In addition, other variables complicate the measurement of reductions from forestry projects. For example, a recent study in the Proceedings of the National Academy of Sciences stated: We find that global-scale deforestation has a net cooling influence on Earth’s climate, because the warming carbon-cycle effects of deforestation are overwhelmed by the net cooling associated with changes in albedo10 and evapotranspiration.11 Latitude-specific deforestation experiments indicate that afforestation projects in the tropics would be clearly beneficial in mitigating global-scale warming, but would be counterproductive if implemented at high latitudes and would offer only marginal benefits in temperate regions.12

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As mentioned earlier, biological sequestration projects often raise questions of permanence: i.e., whether the activity that generates offsets will continue. Although many observers expected biological sequestration offsets to dominate the international market, this has not been observed in practice. Concern of permanence has been one of the issues that has hindered the development of biological sequestration offsets in developing nations.13

Renewable Energy Projects Renewable energy sources generate less GHG emissions (wind and solar energy produce zero emissions) than fossil fuels, particularly coal. Therefore, use of renewable energy sources would avoid emissions that would have been generated by fossil fuel combustion. These avoided emissions could be sold as carbon offsets. Historically, renewable energy sources — wind, solar, biomass — have been more expensive (per unit of energy delivered) than fossil fuels in most applications.14 Sales of renewable energy offsets may provide the financial support to make a renewable energy more economically competitive with fossil fuels. Potential renewable energy offset projects may include:

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Constructing wind farms to generate electricity Installing solar panels Retrofitting boilers to accommodate biomass fuels Some renewable energy offsets may raise concerns of additionality. Several offset sellers offer renewable energy certificates or credits (RECs) as carbon offsets. One REC represents the creation of 1 megawatt-hour of electricity from a renewable energy source. RECs generally convey the environmental attributes of renewable energy projects, and RECs may be sold to promote further use of renewable energy. However, a REC does not necessarily equate with a carbon offset. A credible offset must be additional to the status quo; RECs are not subject to the same standard. Although some offset sellers closely scrutinize the RECs they offer for sale as offsets, there is no system or standard in place to ensure that RECs are additional.15 Several factors, other than CO2 emission reductions, may drive the development of a renewable energy project. Although renewable energy has historically been more expensive, higher fossil fuel prices and tax incentives16 have made renewable energy more competitive in recent years. Moreover, many states have enacted or are developing Renewable Portfolio Standards (RPS). An RPS requires that a certain amount or percentage of electricity is

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generated from renewable energy resources. Twenty-eight states have implemented or are developing some type of RPS.17 Although some sellers will not issue RECs that were counted towards an RPS, it is uncertain whether all sellers follow this protocol.18 These factors complicate the determination of additionality regarding renewable energy offsets projects, particularly offsets based only on RECs.

Energy Efficiency An improvement in a system’s energy efficiency will require less energy to generate the same output. Advances in energy efficiency generally require a financial investment. These capital investments may pay off in the long run, but may be unprofitable in the short-term, particularly for small businesses or in developing nations. Examples of possible energy efficiency offset projects include:

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Upgrading to more efficient appliances or machines Supporting construction of more energy efficient buildings Replacing incandescent light bulbs with fluorescent bulbs Energy efficiency improvements are sometimes described as a ―no regrets‖ policy, because the improvements would likely provide net benefits (e.g., cost savings) regardless of their impact on other concerns (climate change or energy independence). Thus, the issue of additionality may be a particular concern for energy efficiency offsets. For example, in some cases, it may be difficult to discern if the improvements would have been made regardless of the offset market. Offset ownership is another potential challenge regarding some energy efficiency offsets. Energy efficiency improvements may occur at a different location than the actual reduction in emissions. For example, a business that runs its operations with purchased electricity will use less electricity if energy efficiency improvements are made, but the actual emission reductions will be seen at a power plant. This may create a double-counting situation. Although the federal government has not set a mandatory GHG emission reduction, several states and local governments have enacted limits.19 If the state counts the emission reductions at the electricity plant towards its goal, while the business sells the offsets, the reductions will be counted twice.20

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Reduction of Non-CO2 Emissions from Specific Sources There are multiple GHG emissions sources, whose emissions are not generally controlled through law or regulation. These sources — primarily, agricultural, industrial, and waste management facilities — emit non-CO2 GHGs as by-products during normal operations. In many cases, the individual sources emit relatively small volumes of gases, but there are a large number of individual sources worldwide. In addition, these non-CO2 gases emitted have greater global warming potentials (GWP) than carbon dioxide.21 Offset projects in this category could provide funding for emission control technology to capture these GHG emissions. Examples of emission capture opportunities include:

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Methane (CH4) emissions from landfills, livestock operations, or coal mines (GWP = 25) Nitrous oxide (N2O) emissions from agricultural operations or specific industrial processes (GWP = 298); Hydrofluorocarbon (HFC) emissions from specific industrial processes, such as HFC-23 emissions from production of HCFC-22 (GWP of = 14,800) Sulfur Hexafluoride (SF6) from specific industrial activities, such as manufacturing of semiconductors (GWP = 22,800) This offset category is relatively broad, as it can involve many different industrial activities. As such, there are offset types in this category that are generally considered high quality, and others that have generated some controversy. For example, methane capture (and destruction through flaring) from landfills or coal mines has a reputation as a high quality offset. These projects are relatively easy to measure and verify, and in many cases would not have occurred if not for the offset market. Offsets involving abatement of HFC-23 emissions from production of HCFC-22 (primarily used as a refrigerant) have spurred controversy.22 Although offsets from HFC-23 abatement are primarily used in the compliance market (i.e., nations complying with the Kyoto Protocol or other emission reduction obligations), the concerns highlighted by this offset type could apply to the voluntary market as well.23 Of the offset types certified through the Kyoto Protocol’s Clean Development Mechanism (CDM), HFC-23 offsets represent the greatest percentage: 50% of the certified emission reductions (CERs)24 have come from HFC-23 projects. Before the formation of the carbon offset market,

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facilities in the developing world, which produce about half of all HCFC-22, vented the by-product (HFC-23) to the atmosphere.25 With the carbon market in play, facilities can generate offsets by capturing the HFC-23 emissions. Controversy has arisen, because the HCFC-22 production facilities can potentially earn more money from the offsets (destroying HFC-23 emissions) than from selling the primary material (HCFC-22).26 This creates the perverse incentive to produce artificially high amounts of product, in order to generate the more lucrative by-product.

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Supplementarity This issue is perhaps more relevant within the context of a mandatory GHG reduction program, but it may have an analogous application in a voluntary offset market. The Kyoto Protocol states that emissions credits (or carbon offsets) must be ―supplemental to domestic actions for the purpose of meeting quantified emission limitations and reduction commitments....‖ (emphasis added).27 Proponents of supplementarity argue that carbon offsets are a means of escaping or postponing real reductions. This concept could also apply in the context of voluntary GHG reduction. Advocates of supplementarity may argue that if parties (individuals or companies) want to achieve carbon neutrality, parties should focus primarily on reducing their own emission-generating actions — e.g., travel, vehicle choice, size of home or office, etc — instead of looking to counterbalance the emissions from lifestyle choices through the purchase of offsets.28

Assessment of Carbon Offset Sellers At least 30 companies and organizations sell carbon offsets to individuals or groups in the international, voluntary carbon market. The quality of the offsets may vary considerably, largely because there are no commonly accepted standards. Some offset sellers offer offsets that comply with standards that are generally regarded as the most stringent: e.g., the Clean Development Mechanism29 or the Gold Standard.30 These standards generally have a robust test for additionality, as well as more substantial monitoring and verification procedures. As such, offsets meeting these standards incur higher transaction costs, adding to the cost per ton of carbon.

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Some offset sellers offer offsets that meet the seller’s self-established guidelines. These self-established protocols can vary considerably, raising questions of integrity. Are the protocols addressing additionality concerns? Are the offsets accounted in such a way as to avoid double-counting? Are the offset projects verified by independent third parties? Assessing the standards can be challenging for a consumer. Moreover, some company’s standards are not made public, but may be considered proprietary information.31 Two recent studies have examined approximately 30 companies and/or groups that sell carbon offsets on the voluntary market.32 The following list highlights findings from the analyses: The prices for carbon offsets range between $5 and $25 per ton of carbon. Offset prices show a correlation with offset quality. Overhead costs can vary substantially by seller. However, this factor may not be a good indicator of offset quality.33 The tax status of a seller (profit firm vs. non-profit group) was not a good indicator of offset quality.

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Arguably, the most significant finding of the two studies is the general correlation between offset price and offset quality. This correlation is more striking, considering the range of offset prices ($5 to $25 per ton of carbon reduced).

Congressional Activity Several bills in the 110th Congress have the potential to impact the voluntary carbon offset market: 2007 ―Farm Bill‖: Both the House-passed bill (H.R. 2419, H.Rept. 110256) and the Senate Agriculture Committee-approved (bill number forthcoming) versions include provisions that would facilitate the development of private-sector market-based approaches for a range of environmental goods and services (e.g., water and air quality, carbon storage, habitat protection, etc.) involving the agriculture and forestry sectors. The House version would, among other things, establish an Environmental Services Standards Board chaired by the U.S. Department of Agriculture (USDA) that would provide grants and a framework to develop consistent standards and processes for

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quantifying offsets from the farm and forestry sectors. The Senate version differs in approach but also directs USDA to develop a framework to develop standards and procedures; however, the Senate bill requires the initial focus to be on carbon markets.34 H.R. 823 (Welch): Introduced February 5, 2007, this bill would authorize federal agencies to purchase offsets or renewable energy credits, and direct the Department of Energy to certify whether the offsets are eligible, based on rules developed by the Department.

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Conclusions Carbon offset purchases are intended to generate emission reductions that would not have occurred otherwise. In terms of global climate change mitigation, an emission reduction, avoidance, or sequestration is beneficial regardless of where or how it occurs. For example, a ton of carbon reduced at a power plant will have the same atmospheric effect as a ton of carbon reduced, avoided, or sequestered through an offset project. The core issue for carbon offset projects is: do they actually offset emissions generated elsewhere? If the credibility of the voluntary offsets is uncertain, claims of carbon neutrality may lack merit. Evidence suggests that not all offset projects are of equal quality, because they are developed through a range of standards. Although some standards are considered stringent, others are less so. In some cases, the standards used are not even made available to the purchaser. Due to the lack of common standards, some observers have referred to the current voluntary market as the ―wild west.‖ This does not suggest that all carbon offsets are low quality, but that the consumer is forced to adopt a buyer-beware mentality when purchasing carbon offsets. This places the responsibility on consumers to judge the quality of carbon offsets. The voluntary carbon offset market raises several issues that Congress may consider. The viability — both actual and perceived — of the offset market may influence future policy decisions regarding climate change. For instance, some people are concerned that the range in the quality of voluntary market offsets may damage the overall credibility of carbon offsets.35 If this occurs, it may affect policy decisions concerning whether or not to include offsets as an option in a mandatory reduction program. This is an important policy question for Congress. Although some oppose the use of offsets based on supplementarity concerns (see discussion above), other argue that credible

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offsets would expand the compliance alternatives and likely lower the costs of a GHG emissions reduction program.36 The voluntary program may inform the climate change policy debate in another manner. If Congress were to enact a federal GHG emissions control program that included the use of offsets, all of the integrity concerns — e.g., additionality, permanence, accounting — would need to be addressed in some fashion. The experiences gained in the voluntary market may help policymakers develop standards or a process by which the integrity of offset projects could be assessed.

End Notes

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1

Six GHGs have been identified by the United Nations Framework Convention on Climate Change (UNFCCC) as being those of major interest: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluorane. 2 This approach is part of the European Union's (EU) Emission Trading Scheme (ETS), which the EU members use to meet their Kyoto Protocol commitments. For more information, see CRS Report RL34 150, Climate Change: The EU Emissions Trading Scheme (ETS) Gets Ready for Kyoto, by Larry Parker. 3 The World Bank report states that the estimates are based on an unpublished study. The authors of the study provided the estimates to the World Bank prior to its publication. World Bank, 2007, State and Trends of the Carbon Market 2007, p. 10. 4 The 2007 World Bank (p. 41) report cites ICF, 2006, Voluntary Carbon Offsets Market: Outlook 2007. 5 U.S. EPA, 2007, Inventory of U.S. Greenhouse Gas Emissions and Sinks:1990 – 2005. 6 See Anja Kollmuss, 2007, Carbon Offsets 101, World Watch. 7 For more information on these processes see CRS Report RL34059, The Carbon Cycle: Implications for Climate Change and Congress, by Peter Folger. 8 Jeff Goodell, 2006, ―Capital Pollution Solution,‖ New York Times Magazine, July 30, 2006. 9 For more on these challenges, see CRS Report RL3 1432, Carbon Sequestration in Forests, by Ross W. Gorte. 10 Albedo refers to the reflectivity of the Earth's surface. For more on this effect, see CRS Report RL33849, Climate Change: Science and Policy Implications, by Jane A. Leggett. 11 Evapotranspiration is the sum of evaporation and transpiration. The transpiration aspect of evapotranspiration is essentially evaporation of water from plant leaves. For more on this issue see the U.S Geological Survey website at [http://ga.water.usgs.gov/edu/watercycle evapotranspiration.html]. 12 Govindasamy Bala, et al, 2007, "Combined climate and carbon-cycle effects of large-scale deforestation," Proceedings of the National Academy of Scieneces, 104: 6550-6555. 13 Frank Lecocq and Philippe Ambrosi, 2007, The Clean Development Mechanism: History, Status, and Prospects, Review of Environmental Economics and Policy, Winter 2007, pp. 134-15 1. 14 This comparison does not account for the externalities associated with fossil fuel combustion: air pollution, environmental degradation, and health problems linked to emissions. 15 Anja Kollmuss and Benjamin Bowell, ―Voluntary Offsets For Air-Travel Carbon Emissions Evaluations and Recommendations of Voluntary Offset Companies,‖ Tufts Climate Initiative, Revised April 5, 2007, p. 13.

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See CRS Report RL33578, Energy Tax Policy: History and Current Issues, by Salvatore Lazzari. See EPA, Summary of State Clean Energy-Environment Policy Data Table (current as of 1/1/2007), at [http://www.epa.gov/cleanenergy/stateandlocal/activities.htm]. Additional states identified by the Pew Center on Global Climate Change, Map: States with Renewable Portfolio Standards, at [http://www.pewclimate.org]. 18 See Anja Kollmuss and Benjamin Bowell, ―Voluntary Offsets For Air-Travel Carbon Emissions Evaluations and Recommendations of Voluntary Offset Companies,‖ Tufts Climate Initiative, Revised April 5, 2007. 19 See CRS Report RL338 12, Climate Change: Action by States To Address Greenhouse Gas Emissions, by Jonathan L. Ramseur. 20 One way to address this potential dilemma is to restrict energy efficiency projects to only those that reduce or avoid on-site combustion of fossil fuels. 21 A GWP is an index of how much a GHG may, by its potency and quantity, contribute to global warming over a period of time, typically 100 years. GWPs are used to compare a gas’s potency relative to carbon dioxide, which has a GWP of 1. For example, methane’s GWP is 25, and is thus a more potent GHG than carbon dioxide by a factor of 25. The GWPs listed in this chapter are from: Intergovernmental Panel on Climate Change, 2007, Climate Change 2007: The Physical Science Basis, p. 212. 22 Of the CERs expected to be issued by 2012, the percentage drops to 22% (still the highest percentage by offset type). See the United Nations Environment Programme (UNEP) Risoe Centre CDM Pipeline data, at [http://cdmpipeline.org/index.htm]. 23 Moreover, HFC-23 offsets may be in the voluntary market. There is no system or registry in place to track the exchanges in the voluntary market. 24 Regulated facilities can use CERs to meet compliance requirements under Kyoto or the European Union’s Emission Trading Scheme. 25 By comparison, major producers in the developed world continue to voluntarily capture and destroy HFC-23. See Michael Wara, 2006, Measuring the Clean Development Mechanism’s Performance and Potential, Working Paper #56, Stanford Center for Environmental Science and Policy. 26 This calculus depends on the market price for carbon offsets. See Michael Wara, 2006, Measuring the Clean Development Mechanism’s Performance and Potential, Working Paper #56, Stanford Center for Environmental Science and Policy. 27 Article 17, Kyoto Protocol. 28 Taking this argument a step further, some have compared carbon offsets to indulgences that were sold during medieval times: i.e., purchasing offsets helps to assuage the guilt associated with carbon-intensive activities or lifestyles. See e.g., Kevin Smith, 2007, The Carbon Neutral Myth, Carbon Trade Watch, at [http://www.carbontradewatch.org/pubs/ carbon_neutral_myth.pdf]. 29 The Clean Development Mechanism (CDM) was developed under the Kyoto Protocol. Projects are assessed on an individual basis and must be approved by an Executive Board. An independent third-party verifies the projects emission reductions. For more information, see [http://unfccc.int/kyoto_protocol 30 The Gold Standard was developed by a group of non-governmental organizations. The Gold Standard sets requirements beyond the CDM, but only applies to renewable and energy efficiency projects. See [http://www.cdmgoldstandard.org]. 31 For example, one report found it difficult to evaluate certain offset marketers, because the offset certification and verification process was deemed proprietary. See Anj a Kollmuss and Benjamin Bowell, 2007, Voluntary Offsets For Air-Travel Carbon Emissions Evaluations and Recommendations of Voluntary Offset Companies, Tufts Climate Initiative, Revised April 5, 2007. 32 Ibid; Clean Air-Cool Planet, 2006, A Consumer’s Guide to Retail Carbon Offset Providers, prepared by Trexler Climate + Energy Services (―Trexler Report‖). 17

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33

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The Trexler report stated that low overhead costs may indicate that only minimal time was spent evaluating the quality of the project. 34 For more on this aspect of the legislation see CRS Report RL34042, Environmental Services Markets: Farm Bill Proposals, by Renee Johnson. 35 See Trexler, Mark, and Kosloff, Laura, 2006, "Selling Carbon Neutrality," Environmental Forum, March/April 2006; and Hayes, David J., 2007, "Bring the U.S. into the Global Carbon Market," The Environmental Forum, Vol.24, no. 4 (March/April 2007). 36 Both the Environmental Protection Agency (EPA) and the Energy Information Administration (EIA) analyzed the costs associated with S. 280 (a cap-and-trade proposal that would allow the use of offsets). See, U.S. EPA, 2007, EPA Analysis of The Climate Stewardship and Innovation Act of 2007; and EIA, 2007, Energy Market and Economic Impacts of S. 280, the Climate Stewardship and Innovation Act of 2007.

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Chapter 4

OPTIONS FOR OFFSETTING THE ECONOMIC IMPACT ON LOW- AND MODERATE-INCOME HOUSEHOLDS OF A CAP-AND-TRADE PROGRAM FOR CARBON DIOXIDE EMISSIONS

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Congressional Budget Office Honorable Jeff Bingaman Chairman Committee on Energy and Natural Resources United States Senate Washington, DC 20510 Dear Mr. Chairman: Global climate change poses one of the most significant long-term policy challenges for the nation. Reducing greenhouse-gas emissions would be beneficial in limiting the degree of damage associated with climate change, especially the risk of significant damage. However, decreasing those emissions would also impose costs on the economy—in the case of carbon dioxide (CO2), because much economic activity is based on fossil fuels, which release that gas when burned.

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Congressional Budget Office

Under a cap-and-trade program for CO2 emissions, the government would set gradually tightening limits on emissions, issue rights (or allowances) corresponding to those limits, and then allow firms to trade the allowances among themselves. The net financial impact of such a program on low- and moderate- income households would depend in large part on how the value of emission allowances was allocated. By itself, a cap-and-trade program would lead to higher prices for energy and energy-intensive goods. Those price increases would impose a larger burden, relative to either income or household consumption, on low- and moderate-income households than on higherincome households. Lawmakers could choose to offset the price increases experienced by low- and moderate-income households by providing for the sale of some or all of the CO2 emission allowances and using the revenues to compensate such households. In response to your letter of June 4, 2008, the Congressional Budget Office (CBO) has prepared the attached analysis of options for offsetting the economic impact on low- and moderate-income households of a cap-and-trade program for CO2 emissions. As you requested, the analysis also explores the use of tax incentives for households that invest in energy-saving technologies. The analysis presented here is qualitative in nature; CBO will provide a more detailed analysis when it releases an update, which you have also requested, to its 2000 study of the distributional effects of a cap-and trade program. In keeping with CBO’s mandate to provide objective, impartial analysis, the analysis includes no recommendations. CBO would be pleased to address any further questions you have. I can be reached at (202) 226-2700. The staff contacts for the analysis are Terry Dinan in the Microeconomic Studies Division, who can be reached at (202) 2262927, and Frank Sammartino in the Tax Analysis Division, who can be reached at (202) 226-2688. Sincerely,

Peter R. Orszag Director

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Attachment cc: Honorable Pete V. Domenici Ranking Member Honorable Barbara Boxer Chairman Senate Committee on Environment and Public Works

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Honorable James M. Inhofe Ranking Member Senate Committee on Environment and Public Works Global climate change is one of the nation’s most significant long-term policy challenges. Reducing greenhouse-gas emissions would be beneficial in limiting the degree of damage associated with climate change, especially the risk of significant damage. However, decreasing those emissions would also impose costs on the economy—in the case of carbon dioxide (CO2), because much economic activity is based on fossil fuels, which contain carbon and, when burned, release it in the form of that gas. A cap-and-trade program for CO2 emissions is an incentive-based approach for regulating the quantity of emissions. Under such a program, policymakers would set a limit (the cap) on total emissions during some period and would require regulated entities to hold rights, or allowances, to the emissions permitted under that cap. After allowances were initially distributed, entities would be free to buy and sell them (the trade part of the program). Reducing emissions to the level required by the cap would be accomplished mainly by stemming demand for carbon-based energy by increasing its price. The size of the required price increase would depend on the extent to which emissions had to be reduced— larger reductions would require larger price increases to reduce demand sufficiently. Under a cap-and-trade program, a key decision for policymakers is whether to sell emission allowances or to give them away. The net financial impact of such a program for CO2 emissions on low- and moderate-income households would depend in large part on how the allowances were allocated and how any proceeds from selling them were used. By itself, a cap-and-trade program for CO2 emissions would lead to higher prices for energy and energy-intensive goods. Except in limited circumstances (for electricity in states with price regulation, for instance), such price increases would occur regardless of whether the government sold the

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allowances or gave them away. Those price increases are essential to the success of a cap-and-trade program because they would be the most important mechanism through which businesses and households were encouraged to make economically motivated consumption and investment changes that reduced CO2 emissions. Because energy is an input for almost all goods and services, the price of most items would rise in response to the imposition of a cap-and-trade program. Prices of energy-intensive items such as electricity, natural gas, home heating fuels, and gasoline would increase the most. Those price increases would impose a larger burden, relative to either income or household consumption, on low- and moderate-income households than on higher-income households. High-income households typically spend more in absolute dollars on energy-intensive items than other households do. As a share of total household income, however, spending by low-income households on those items is more than five times that by high-income households (see Table 1). The pass-through of higher energy prices to other items would also disproportionately affect low- and moderate-income households because those items account for a larger fraction of their total income than they do for high-income households. Lawmakers could choose to offset the price increases experienced by lowand moderate-income households by providing for the sale of some or all of the CO2 emission allowances and using a portion of the revenues to compensate such households. For example, the Congressional Budget Office (CBO) found that lower-income households could be financially better off as a result of a cap-andtrade program (compared with no program—and without consideration of any benefit in terms of reduced risk of damage from climate change) if the government chose to sell the allowances and used the revenues to pay an equal lump-sum rebate to each household in the United States. In that case, the size of the rebate would be larger than the average increase in low-income households’ spending on energy-intensive goods. High-income households would be worse off (again, with any benefit from reducing the risks associated with climate change excluded) under that scenario because their average increase in spending would be larger than the rebate. Lawmakers could also choose to use some of the revenues from selling emission allowances to offset the economic effects of higher energy prices by reducing existing taxes. One motivation for this approach is that the price increases caused by a cap-and-trade program would have adverse economic effects similar to those of taxes. For example, taxes on earnings can discourage entry into the labor force or additional hours of work. Higher energy costs

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would act as an additional tax on earnings (by raising the price of the goods and services that households purchase with their earnings) layered on top of existing taxes. Consequently, using a share of the auction revenues to lower income and payroll tax rates could reduce the near-term cost that a cap-andtrade program would impose on the economy. Choosing among options for using revenues from the sale of allowances could involve a trade-off between providing targeted assistance to low- and moderate- income households and offsetting some of the adverse effects on economic activity caused by the price increases. For example, using some of the auction proceeds for an equal lump-sum rebate paid to every household in the United States (set at an amount equal to the increase in energy costs for the average household) could actually more than offset the average increase in spending on energy-intensive goods by low-income households; however, a lump-sum rebate would not lower existing tax rates and thus would not offset any of the adverse effects that higher energy prices had on incentives to work. In contrast, using a portion of the auction proceeds to reduce corporate income tax rates could offset a substantial share of the additional adverse economic incentives, but it would relieve only a small portion of the increase in energy costs experienced by low- income households. Policies can be designed to achieve a mixture of outcomes. For example, lowering payroll tax rates on a portion of earnings or reducing the rate at which the earned income tax credit (EITC) phases out would target more relief to lower-income families than would a reduction in corporate tax rates, while offsetting some of the adverse economic effects of the program. An important consideration in using revenues to provide assistance to households would be to do so in a way that did not incur significant new administrative or compliance costs. Using existing transfer programs or providing rebates through the income tax system would avoid creating new institutional structures for administering payments. Existing systems that already collect information on household income also are well suited to targeting assistance based on need. No single existing system would reach all households, however. Not everyone–– especially members of low-income households and retirees––pays payroll taxes or files an income tax return. But people would need to file a return to participate in a rebate program based on the income tax system. The response to the recent stimulus rebates suggest that such an approach can work, but it is too early to tell if a significant fraction of households that otherwise are not required to file an income tax return will file to claim the rebate.

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Table 1. Average Annual Household Expenditures on Energy-Intensive Items, by Income Quintile, 2006 (Dollars) Total Utility Expenditures Total Gasoline Expenditures Total Spending on EnergyIntensive Items Spending on Energy-Intensive Items as a Percentage of Income

Quintiles 3 4 1,835 2,137

5 2,741

All Households 1,913

2,829

3,508

2,227

4,017

4,966

6,249

4,140

8.9

7.0

4.2

6.8

1 1,236

2 1,614

991

1,624

2,182

2,227

3,238

22.3

12.1

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Source: Bureau of Labor Statistics, Consumer Expenditure Survey, 2006, available at www.bls.gov/cex/2006/Standard/ quintile.pdf. Note: Energy-intensive items include natural gas, electricity, fuel oil, other fuels, gasoline, and motor oil.

Delivering rebates through a combination of the income tax system and existing transfer programs in theory would do a better job of reaching affected households than would relying on either approach by itself and would not require a new program. It is not easy in practice, however, to coordinate among existing programs to avoid overlap and ensure that economically equivalent households receive roughly the same benefit.

Reductions in Income Tax Rates Reductions in individual or corporate income tax rates would be straightforward to administer and would provide the largest benefits in terms of economic efficiency but would score low in their ability to offset energy price increases for low- and moderate-income households. Reductions in individual income tax rates would enable taxpayers to reduce the amount of taxes withheld from their paychecks to cover the cost of additional expenditures on energy-intensive items as they occurred throughout the year.

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A proportional reduction in all individual income tax rates would provide the largest percentage increase in after-tax income and the largest dollar tax reductions for taxpayers in the highest income tax brackets, while providing minimal benefits to taxpayers who were in the 10 percent or 15 percent marginal tax brackets, who constitute roughly two-thirds of taxpayers with taxable income. Limiting the rate reductions to only the two lowest income tax brackets would provide a larger share of the tax benefits to taxpayers in those brackets, but taxpayers whose income put them near the top of the 15 percent bracket ($83,000 for a couple and $41,450 for a single taxpayer in 2008) would benefit the most. Reductions in income tax rates would not directly help low-income households that did not have sufficient income to owe income taxes. A reduction in corporate income tax rates would benefit owners of corporate stock in the short run, with most of the benefits going to higherincome households. As capital markets adjusted over the longer term, however, the economic gain from reducing the tax would spread across all types of capital. And over time, at least some of the economic gains could also be shifted to wage earners, although the degree of such shifting is uncertain. Nevertheless, any gains by low- and moderate-income households from a reduction in corporate taxes would be modest even over the longer term and insufficient to offset their increased energy costs.

Payroll Tax Rebates A payroll tax rebate would reach the approximately 165 million workers who are covered under the Social Security and Medicare programs. Economist Gilbert Metcalf of Tufts University has proposed a payroll tax rebate for Social Security and Medicare taxes as an offset to a carbon dioxide tax.1 Under that proposal, the rebate would apply to the tax on the first $3,660 of earnings. With a combined employee and employer tax rate of 15.3 percent, the maximum energy credit per worker would be $560.2 Households without covered earnings would not benefit from a payroll tax rebate. Many of those are low-income households and retirees. Data from the Current Population Survey, produced by the Bureau of the Census, indicate that although about 80 percent of all households would be eligible for a payroll tax rebate, only slightly more than half (54 percent) of the households in the lowest fifth of the income distribution would qualify. About three-quarters of the households in that quintile that would not qualify for a payroll tax rebate

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receive Social Security benefits and thus would be partially protected from higher energy costs by costof-living adjustments. Among those who qualified, some would receive less than a full $560 rebate if their earnings were less than $3,660. Administering a payroll tax rebate would raise a number of issues. Adjusting payroll tax withholding would impose some administrative burden on employers, who also would lack the necessary information to adjust withholding for workers with more than one job. Rather than adjusting withholding, a payroll tax rebate could be paid through the income tax system when workers filed their returns. Although that approach would be easier to administer, the timing of the rebate would not coincide with the timing of individuals’ increased expenditures. Also, because some workers who pay payroll taxes do not currently file income tax returns, some additional administrative costs would be incurred to process more returns. A payroll tax rebate would be progressive over most of the income distribution, providing benefits that were a larger percentage of income for lower-income households except for the very lowest income households with little or no earnings. (The rebate would not necessarily be equal for households with the same income, as the rebate amount would depend upon the number of workers within each household.) A payroll tax rebate would provide modest incentives for increased participation in the labor force by increasing workers’ take-home pay. It would not offer new work incentives for people already in the labor force with earnings high enough to qualify for the maximum rebate.

Income Tax Rebates The Internal Revenue Service (IRS) has experience, most recently with the 2008 stimulus payments, in delivering rebates based on information in income tax returns. When filing, households could claim a rebate as a credit against their income tax liability. That transaction would present the same timing issues described in the preceding section. Unless the rebates were refundable (that is, payable in excess of the amount of income tax owed), they would be of little or no value to taxpayers who filed income tax returns but owed no income tax—which was the case for approximately 45 million of the 138 million returns filed in 2006. Moreover, as seen in the experience with stimulus payments, the IRS would need to undertake substantial educational efforts, and many wage earners and others who otherwise would not file

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income tax returns (because their income falls below the statutory requirements for filing) would need to file a return to obtain the rebate. In 2006, for example, approximately 20 million households did not file a return, though that figure is uncertain. Households with very low income and households headed by elderly people account for most of those that do not file a return. Recent experience is not very encouraging regarding the participation of new filers in modest rebate programs. Only about 6 percent of the estimated 22 million potential new filers submitted a return to claim the federal telephone excise tax rebate in 2007, though the small rebate amount—ranging from $30 to $ 60—may have been a factor for those choosing not to file. The economic stimulus rebates that are available this year to households that do not normally file a tax return will provide some indication of the percentage of eligible households that are likely to file an income tax return in order to claim a larger rebate. A refundable tax rebate of a fixed dollar amount would be progressive, providing greater relief as a percentage of income to low-income households. Rebates can be adjusted for differences in family size. They can also be targeted to lower- income taxpayers by reducing (phasing out) the amount of the credit at higher incomes. For example, the individual income tax rebates that were part of the economic stimulus package enacted this year were reduced by 5 percent of income in excess of $75,000 for individuals and $150,000 for couples. Phasing out a rebate reduces its budgetary cost but adds complexity to the calculation of tax liability and makes the true tax on additional income (the marginal tax rate) less transparent. An issue is whether the rebates would be paid to all households or only those that met certain income requirements. The recent economic stimulus rebates were payable to households without income tax liability if their combined income from earnings, Social Security, and veterans’ disability payments was at least $3,000. Allowing all households to claim a refundable income tax rebate would increase administrative costs and raise compliance issues. A fixed rebate that did not depend on earnings would not provide households with any additional incentives to work or save and thus would not offset any of the economic costs associated with a cap-and-trade program.

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Table 2. Average Annual Household Expenditures on Energy-Intensive Items, by Age, 2006 (Dollars) All Households Total Utility Expenditures Total Gasoline Expenditures Total Spending on Energy-Intensive Items Spending on Energy-Intensive Items as a Percentage of Income Spending on Energy-Intensive Items as a Percentage of Total Spending

1,913 2,227 4,140

Under Age 65 1,931 2,436 4,367

Age 65 and Over 1,837 1,359 3,196

6.8

6.6

8.4

8.6

8.5

9.1

Source: Bureau of Labor Statistics, Consumer Expenditure Survey, 2006, available at www.bls.gov/cex/2006/ Standard/sage.pdf. Note: Energy-intensive items include natural gas, electricity, fuel oil, other fuels, gasoline, and motor oil.

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Increased EITC Payments An option based on the current tax system but more targeted to lowincome households would be to expand the earned income tax credit. The EITC is a refundable credit (households receive a payment if the credit exceeds their income tax liability), payable to low-income families with earnings. In 2007, single parents with one child and income up to $33,241 ($35,241 for a married couple) were eligible for the credit. Single parents with two or more children could qualify with income up to $37,783 ($39,783 for a married couple). Childless workers between the ages of 25 and 65 are eligible for a much smaller credit but must have income less than $15,000 to qualify. In 2006, taxpayers filed for the earned income tax credit on 23.4 million tax returns. The total amount of the credit was $45.4 billion, of which $39.9 billion (88 percent) was refundable. About half of the total EITC payments went to families with income under $15,000.3 Increasing EITC payments would be straightforward for the IRS to administer. If the increase was proportional to the existing credit, most of the benefits would go to low-income families with children and very little to

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childless workers. Increasing the EITC would not provide any benefits to households without earnings, however. Increasing EITC payments would have some positive economic effects. Studies have found that increases in that tax credit have had a positive effect on the participation of low-income single women in the labor force.4 Though increasing the EITC would raise marginal tax rates for some workers, that characteristic of the existing EITC appears to have little adverse effect (in particular, on the number of hours worked by people already working).

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Automatic Increases in Social Security and Supplemental Security Income Benefits Households receiving Social Security benefits and benefits from the Supplemental Security Income (SSI) program would be partially protected from higher energy costs because those benefits are automatically increased each year to reflect increases in consumer prices. Therefore, considered in combination with automatic increases in Social Security benefits and SSI, options such as a payroll tax rebate that are limited to households with earnings can reach a large portion of the low- and moderate-income population. Data from the Current Population Survey indicate that about 95 percent of households would qualify for a payroll tax rebate or an automatic cost-of-living increase in Social Security benefits, including 85 percent to 90 percent of households in the lowest income quintile. Cost-of-living increases for Social Security and SSI would only partially protect households receiving those benefits, however, because income from those sources covers only part of their total expenditures. That effect would be exacerbated because expenditures on energy-intensive items are a higher share of total expenditures for the elderly (see Table 2).

Supplement to Food Stamp Benefits An energy credit based on the same eligibility rules as those that exist for the Food Stamp program would be a way to target benefits to low-income households. To be eligible for food stamps, an applicant’s monthly income must be at or below 130 percent of the federal poverty guideline ($2,238 for a family of four) and countable assets must be less than $2,000 ($3,000 for

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households with elderly and disabled members). Approximately 27 million people receive Food Stamp benefits each month. About 65 percent of eligible people participate in the program, and nearly 90 percent of eligible children do.5 An energy credit could be distributed to households through the same system as food stamps, which are paid through an electronic benefit transfer (EBT) system. Benefits are deposited electronically in individual accounts each month, and food stamp recipients use a card to debit their account when paying for groceries. An energy supplement to Food Stamp benefits would not affect work or savings incentives at the margin and thus would not offset any of the economic efficiency costs of higher energy prices.

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Increased Funding for the Low Income Home Energy Assistance Program Increases in funding for the Low Income Home Energy Assistance Program (LIHEAP) could supplement other options for offsetting higher energy costs but by themselves would not be an effective way to help the majority of low- and moderate-income households. Federal rules restrict LIHEAP assistance to households with income up to 150 percent of the federal poverty guideline (or 60 percent of state median income if greater). States, however, can choose to set lower income limits, and as a result, eligibility requirements vary from state to state. In 2005, an estimated 5.3 million households received assistance through LIHEAP, 15 percent of federally eligible households. Providing assistance to all low- and moderate-income households would require a massive expansion of the program, a substantial increase in administrative costs, and possibly a major overhaul of the program. The current program is funded as a block grant from the federal government to the states and other entities, leaving wide latitude in the types of assistance provided. Increasing LIHEAP subsidies would not offset any of the economic efficiency costs of higher energy prices.

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Increased Incentives for Energy-Saving Investments by Households The increase in energy prices that would result from a cap-and-trade program would encourage businesses and households to adjust their energy usage. Using revenues from auctioning allowances to subsidize household investments that reduced carbon dioxide emissions would lower the cost to households of adapting to higher energy prices. For example, subsidizing weatherization improvements would enable households to use less energy for heating and cooling. However, incentives for energy-saving investments in combination with a capand-trade program would not reduce CO2 emissions below the level set by the cap-and-trade program by itself. Although investment incentives could alter the timing of emission reductions by lowering the cost of meeting the targets, the cap set by the program would ultimately determine the total amount of emission reductions each year. Furthermore, such incentives could increase the total costs (including both public and private costs) of meeting the cap because the incentives would encourage households to choose certain alternatives over others in adjusting to higher energy prices. For example, a tax credit for solar heating would encourage the use of that technology even if it was not the most cost-efficient alternative in the absence of the credit. Creating a tax-incentive system without distorting technology choices is difficult. A wide variety of deductions and credits related to saving energy already exist at both the federal and state levels. A federal credit (termed the section 45 production tax credit) is available for electricity produced using certain renewable energy sources, including wind, biomass, geothermal energy, solar energy, and others. Other credits are available for the manufacture of energysaving appliances, the construction of new energy-efficient homes, energyefficient improvements to existing homes, and purchases of alternative types of motor vehicles. Incentives aimed at households typically favor expenses related to installing a system relying on renewable energy or reducing the energy required to heat or cool a home. The most common incentives are for installing solar-powered systems (10 states and, from 2006 through 2008, the federal government offer such a tax incentive). Incentives for wind power and biomass systems are also relatively common, and ones for geothermal and hydropowered systems are less so. Three states provide tax incentives to purchase items such as insulation, storm doors and windows, and weather

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stripping (in 2006 and 2007, the federal government did so as well). Montana and Oregon offer credits for purchases of energy-efficient furnaces, heat pumps, and air conditioners, and Oregon provides rebates for purchases of other home appliances, such as dishwashers, clothes washers, and refrigerators, as long as they meet certain standards for energy savings. California also has a unique incentive: a deduction for interest paid on loans used to purchase qualifying items. The generosity of the incentives varies widely among states. Some states allow a deduction or credit for only a portion of the qualifying expense. Most cap the deduction or credit at a certain dollar amount or require that it be spread over multiple years. Montana, at one extreme, allows a 100 percent credit up to $500 for installing a system based on renewable energy, while Arizona allows only a 5 percent deduction, up to a maximum deduction of $5,000, for purchasing an exceptionally energy-efficient house. Credits of 25 percent seem to be the most common. Table 3. Utilization of Federal Residential Energy Credits, 2006

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Adjusted Gross Income Under$15,000 $15,000 to $30,000 $30,000 to $50,000 $50,000 to $100,000 $100,000 to $200,000 $200,000 and Above Total

Number of Tax Returns (Thousands)

Percentage of Total

37,614 29,649

27.2 21.4

Percentage Claiming Residential Energy Expenses 0.1 1.0

24,907

18.0

3.2

208

30,053

21.7

6.6

223

12,110

8.7

8.9

252

4,088

3.0

6.9

305

138,420

100.0

3.2

230

Average Usable Residential Energy Credit (Dollars) 111 197

Source: Congressional Budget Office based on Internal Revenue Service, ―Individual Income Tax Returns, Preliminary Data, 2006,‖ Statistics of Income Bulletin (Spring 2008), Table 1, pp. 6–17.

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The Oregon program is among the most widely used, with about 39,000 taxpayers (constituting 2.6 percent of returns) claiming a credit in 2005.6 Historically, three- quarters of Oregon’s credits have been for purchases of energy-efficient heating and cooling systems or home appliances. Of the state’s credits for installing renewable energy systems, over 80 percent have been for solar systems, but that amounted to only 17,000 systems between 1978 and 2001.7 A credit for solar systems in California was claimed by around 4,500 taxpayers in 2005, after which it expired.8 North Carolina’s 35 percent credit for installing renewable energy systems was claimed by only 263 individual taxpayers in 2007.9 Data on the utilization of federal residential energy credits are available for 2006 (see Table 3). Those credits apply to expenses for both energy conservation and renewable energy systems, but the vast majority of qualifying expenses are for the former. Almost 4.5 million taxpayers claimed a credit in 2006 (representing about 3.2 percent of the returns filed in that year). Both participation and average benefits increased with income.

End Notes

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1

Gilbert E. Metcalf, ―A Green Employment Tax Swap: Using a Carbon Tax to Finance Payroll Tax Relief,‖ Brookings Institution and World Resources Institute, Washington, D.C. (June 2007). 2 A payroll tax rebate would not have to affect the financial status of Social Security and Medicare or the future retirement benefits of workers. Workers would be credited with their full covered earnings, and the Social Security and Medicare trust funds could be credited for the full amount of the payroll tax. 3 Brian Balkovic, ―Individual Income Tax Returns, Preliminary Data, 2006,‖ Statistics ofIncome Bulletin (Internal Revenue Service, Spring 2008). 4 See Bruce D. Meyer, ―The U.S. Earned Income Tax Credit, Its Effects, and Possible Reforms,‖ Harris School of Public Policy Studies, University of Chicago and National Bureau of Economic Research (August 2007); and Nada Eissa and Hilary Hoynes, ―Behavioral Responses to Taxes: Lessons from the EITC and Labor Supply,‖ in James M. Poterba, ed., Tax Policy and the Economy, vol. 20 (Cambridge, Mass.: MIT Press, 2006), pp. 163–192. 5 Kari Wolkwitz, ―Trends in Food Stamp Program Participation Rates: 1999–2005‖ (U.S. Department of Agriculture, Food and Nutrition Service, June 2007). 6 See Oregon Department of Energy, ―The Oregon Department of Energy Tax Credits‖ (presentation, April 2006), p. 13, available at www.epa.gov/cleanenergy/ documents/4_20_06_OR_Tax_Credits_Dillard.pdf. 7 S. Gouchoe, V. Everette, and R. Haynes, Case Studies on the Effectiveness of State Financial Incentives for Renewable Energy, NREL/SR-620-32819 (National Renewable Energy Laboratory, 2002), p. 56, available at www.nrel.gov/docs/fy02osti/32819.pdf. 8 State of California, Franchise Tax Board, Annual Report, 2006, p. 141, available at www.ftb.ca.gov/aboutftb/annrpt/2006/2006AR.pdf.

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North Carolina Department of Revenue, ―William S. Lee Tax Credits,‖ available at www.dor.state.nc.us/publications/cred_inct/article3band3etc2007.pdf.

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In: Carbon Dioxide Emissions Editors: James P. Mulligan

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Chapter 5

CONTAINING THE COST OF A CAP-ANDTRADE PROGRAM FOR CARBON DIOXIDE EMISSIONS

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Peter R. Orszag Chairman Bingaman, Senator Domenici, and Members of the Committee, thank you for the invitation to discuss the implications of cap-and-trade programs that are designed to reduce U.S. emissions of greenhouse gases, most prominently carbon dioxide (CO2). Under a cap-and-trade program, policymakers would set a limit on emissions and allow entities to buy and sell permits (or allowances) to emit CO2 and other greenhouse gases. Global climate change is one of the nation’s most significant long-term policy challenges. Human activities are producing increasingly large quantities of greenhouse gases, particularly CO2. The accumulation of those gases in the atmosphere is expected to have potentially serious and costly effects on regional climates throughout the world. Although the magnitude of such damage remains highly uncertain, there is growing recognition of the risk that the damage could prove extensive and perhaps even catastrophic. The risk of potentially catastrophic damage associated with climate change can justify actions to reduce that possible harm in much the same way that the hazards we all face as individuals motivate us to buy insurance. Reducing greenhouse-gas emissions would provide benefits to society by helping to limit the damage associated with climate change, especially the risk

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Peter R. Orszag

of significant damage. However, decreasing those emissions would also impose costs on the economy—in the case of CO2, because much economic activity is based on fossil fuels, which release carbon when they are burned. Most analyses suggest that an appropriately designed program to begin lowering CO2 emissions would produce greater benefits than costs. Marketoriented approaches to reducing carbon emissions, such as a cap-and-trade program or a carbon tax, would reduce emissions more cheaply than would command-and-control approaches, such as regulations requiring across-theboard reductions by all firms. Those market-oriented approaches are relatively efficient because they create incentives and flexibility for emission reductions to occur where and how they are least expensive to accomplish. I will focus today on two key design elements of a cap-and-trade system that could help to improve its efficiency further in terms of reducing the cost of emission reductions: (1) structural features to allow the timing of reducing emissions to respond to year-to-year differences in conditions that affect the cost of doing so and (2) the use of the allowances’ value created by a cap-andtrade system to reduce its cost. The Congress is currently considering a bill, S. 2191, which would reduce emissions by establishing a cap-and-trade program.1 S. 2191 would also establish a Carbon Market Efficiency Board, which would be authorized to transfer emission allowances across years to help minimize the cost of meeting a long-term target for reducing emissions. Other approaches—such as imposing limits on the price of allowances— could also be used to contain the costs that a cap might impose on the economy. My testimony makes the following key points: The cost of meeting an emission target with a cap-and-trade program could be reduced, potentially quite substantially, by providing firms flexibility in the timing of their efforts to reduce emissions. In particular, the most cost-effective cap-andtrade design would encourage firms to make greater reductions when the cost of doing so was low and would allow them leeway to lessen their efforts when the cost was high. Providing firms with such flexibility could also prevent large fluctuations in the price of allowances that could be disruptive to the economy. The reduction in economic burden need not come at the cost of additional environmental risk: The flexibility to shift emission reductions across years could be designed to achieve any given cumulative reduction in emissions over the medium or long term.

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One option for allowing firms flexibility in determining when to reduce emissions while also achieving compliance with a cumulative target would be through setting both a ceiling—typically referred to as a safety valve—and a floor on the allowance prices each year. The price ceiling would allow firms to exceed the annual target when the cost of cutting emissions was high, while the price floor would induce firms to cut emissions more than the annual target in low-cost years. The price ceiling and floor could be adjusted periodically to ensure that emission reductions were on track for achieving the long-run target; such a dynamic price system could substantially reduce the cost of a cumulative target for emissions. Another option would be to authorize firms to ―borrow‖ future allowances for use in the current year or to ―bank‖ allowances for use in future years. Firms would have an incentive to borrow allowances, though, only if they expected the price in the future to be sufficiently lower than the current price to make borrowing cost- effective. Similarly, firms would have an incentive to bank allowances only if they expected the price in the future to be sufficiently higher than the current price. Most proposals for borrowing and banking would impose limits on the degree to which they could be undertaken, and partially as a result of those limits, this approach is likely to be less effective at reducing cumulative costs for any given cumulative target for reducing emissions than a dynamic price system would be. Under the Carbon Market Efficiency Board described in S. 2191, which would be authorized to transfer emission allowances across time periods, regulators would attempt to shift allowances in a manner that led to more reductions when costs were relatively low and less reductions when costs were high. An alternative approach, which may be easier for regulators to implement efficiently, would be to have the board set a ceiling and floor for allowance prices and be responsible for adjusting those price limits periodically as needed to achieve a long-term target for reducing emissions. Policymakers’ choices about whether to distribute the allowances without charge or to auction them—and if they are auctioned, how to use the proceeds—could also have a significant effect on the overall economic cost of capping emissions. Evidence suggests that the cost to the economy of a 15 percent cut in U.S. emissions (not counting any benefits from mitigating climate change) might be half as large if policymakers sold the allowances and used the revenue to lower

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Peter R. Orszag current taxes on capital that discourage economic activity, rather than giving the allowances away to energy suppliers and energy-intensive firms or using the auction proceeds to reduce the costs that the policy could impose on low-income households. Using the allowances’ value to lower the total economic cost could, however, exacerbate the regressivity of the cap-and-trade program.

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CONTAINING COSTS BY PROVIDING FLEXIBILITY IN THE TIMING OF EMISSION REDUCTIONS A cap-and-trade program, which creates financial incentives for firms and households to cut their greenhouse-gas emissions, is a lower-cost approach to reducing emissions than more restrictive command-and-control approaches, which mandate how much those entities can emit or what emission-reduction technologies they should use. The lower cost of a cap-and-trade program stems from the flexibility it provides as to where and how emission reductions are to be achieved. Under a cap-and-trade program for CO2, policymakers would set a limit on total emissions during some period and would require regulated entities to hold allowances for the emissions permitted under that cap. (Each allowance would entitle companies to emit one ton of CO2 or to have one ton of carbon in the fuel that they sold.) After the allowances for a given period were distributed, entities would be free to buy and sell them. The trading aspect of the program could lead to substantial cost savings relative to command-andcontrol approaches: Firms that were able to reduce emissions most cheaply could profit from selling allowances to firms that had relatively high abatement costs. The cost-effectiveness of a cap-and-trade program could be further improved by providing firms with flexibility in determining when to reduce their emissions.

The Importance of Flexibility in the Timing of Emission Reductions In its most inflexible form, a cap-and-trade program would require that a specified cap on emissions was met each year. That lack of flexibility would increase the cost of achieving any long-term goal because it would prevent

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firms from responding to year- to-year differences in conditions that affected costs for reducing emissions, such as fluctuations in economic activity, energy markets, and the weather (for example, an exceptionally cold winter would increase the demand for energy and make meeting a cap more expensive), and the technologies available for reducing emissions. In contrast, because of the long-term nature of climate change, the key issue from an environmental perspective involves emissions over the long term and concentration paths of greenhouse gases, not the year-to-year fluctuations in emissions. In other words, limiting global climate change will entail substantially reducing the amount of greenhouse gases that accumulate in the atmosphere over the next several decades, but the benefits of doing so are largely independent of the annual pattern of those reductions.2 Consequently, a cap-and-trade program could achieve roughly the same level of benefits at a significantly lower cost if it provided firms with an incentive to make greater reductions in emissions at times when the cost of doing so was low and allowed them leeway to lessen their efforts when the cost was high. Including features in a cap-and-trade program that enabled to firms to reduce emissions less when costs were high and more when costs were low could also reduce the volatility of allowance prices. Experience with cap-andtrade programs has shown that price volatility can be a major concern when a program’s design does not include provisions to adjust for unexpectedly high costs and to prevent price spikes. For example, one researcher found that the price of sulfur dioxide allowances under the U.S. Acid Rain Program was significantly more volatile than stock prices between 1995 and 2006 (see Figure 1).3 Price volatility could be particularly problematic with CO2 allowances because fossil fuels play such an important role in the U.S. economy. In 2006, fossil fuels accounted for 85 percent of the energy consumed in the United States. CO2 allowance prices could affect energy prices, inflation rates, and the value of imports and exports. If those prices were volatile, they could have disruptive effects on markets for energy and energy-intensive goods and services and could make investment planning difficult.

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Source: Congressional Budget Office based on William D. Nordhaus, ―To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming,‖ Review of Environmental Economics and Policy, vol. 1, no. 1 (Winter 2007), pp. 26–44. Note: Volatility is calculated as the annualized absolute logarithmic month-to-month change in the consumer price index (CPI), the stock price index for the Standard & Poor’s 500 (S&P 500), and the price of sulphur dioxide (SO2) allowances under the U.S. Acid Rain Program.

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Figure 1. Volatility of SO2 Allowance Prices and Selected Other Prices, 1995 to 2006

Design Features Providing Flexibility in the Timing of Emission Reductions Recent proposals for cap-and-trade proposals include a variety of design features that would provide firms or regulators with flexibility in the timing of emission reductions, thereby reducing the economic costs of the effort to limit greenhouse gas emissions. A Price Ceiling and a Price Floor The combination of a price ceiling and a price floor offers one method of allowing timing flexibility and thereby reducing the economic burden of achieving any desired cumulative target for reducing emissions: Setting a ceiling, or safety valve, for the price of allowances could prevent the cost of reducing emissions from exceeding either the best

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available estimate of the environmental benefits or the cost that policymakers considered acceptable. The government could maintain a price ceiling by selling companies as many allowances as they would like to buy at the safety-valve price. Similarly, policymakers could prevent the price of allowances from falling too low by setting a price floor. If the government chose to auction a significant share of the allowances, it could specify a so-called reserve price and withhold allowances from the auction as needed to maintain that price. The efficiency advantage of a price floor would stem from the fact that it could prevent the cost of emission reductions from falling below the expected benefits or below the level of effort that policymakers intended. A cap-and-trade program that included both a ceiling and a floor for allowance prices could achieve a long-term target for emissions while minimizing both the overall cost of achieving the target and price volatility. Under such a program, policymakers would specify annual emission targets as well as a ceiling and a floor for the price of allowances for each year. Regulators could adjust the levels of the price ceiling and floor periodically (for example, every five years) to ensure that emission reductions were on track for achieving the long-term target. For example, the rate at which the price floor or ceiling rose over time could be increased if regulators determined that the reductions in the previous five-year period were significantly lower than the amount needed to achieve the long-term target. Alternatively, policymakers could include provisions in a cap-and-trade program that would automatically trigger adjustments in the price ceiling and floor. For example, the rate at which the price ceiling and floor rose could be based on the percentage gap between anticipated and actual emissions in the previous five-year period. Figures 2 and 3 illustrate the effects of price ceilings and floors. The figures present a simple example of an inflexible cap each year relative to a system involving price ceilings and floors. In Figure 2, the results illustrate what happens in 2018 if the costs of reducing emissions by roughly 15 percent are twice as high or 50 percent lower than expected. Under an inflexible cap, the emission reductions are unaffected. Under a price ceiling, fewer emission reductions are undertaken when costs are high; the result is lower economic costs that year but also less of a reduction in emissions. Under a price floor, more emission reductions are undertaken when costs are low.

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Source: Congressional Budget Office. Notes: This example examines the emission reductions and total costs that would result in 2018, assuming that the policy covered only the United States. The cost of firms' emission reductions is derived from Mark Lasky, The Economic Costs of Reducing Emissions of Greenhouse Gases: A Survey of Economic Models, Congressional Budget Office Technical Paper No. 2003- 03 (May 2003). A safety valve is a ceiling on the price of emission allowances. a. Assumes that the actual marginal cost of reducing emissions by 869 million metric tons is $30 per metric ton, the cost that policymakers anticipated when they set the cap. b. Assumes that the actual marginal cost of reducing emissions by 869 million tons is $60 per metric ton but that the safety valve induces less reductions (691 million tons instead of 869 million), up to a marginal cost of $45 per metric ton. c. Assumes that the actual marginal cost of reducing emissions by 869 million tons is $15 per metric ton but that the price floor induces more reductions (1,047 million tons instead of 869 million) at a marginal cost of $19 per metric ton. Figure 2. Illustrative Comparison of Various Cap-and-Trade Policies to Reduce CO2 Emissions by Roughly 15 Percent Under Different Cost Conditions in 2018

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Source: Congressional Budget Office. Notes: This example represents the cumulative emission reductions and costs over two years of a cap-and-trade policy that would reduce emissions of CO2 by 869 million tons in each year (roughly a 15 percent reduction in 2018). The cost of firms' emission reductions is derived from Mark Lasky, The Economic Costs of Reducing Emissions of Greenhouse Gases: A Survey of Economic Models, Congressional Budget Office Technical Paper No. 2003-03 (May 2003). A safety valve is a ceiling on the price of emission allowances. For the high-cost year, CBO assumes that the marginal cost of reducing emissions by 869 million tons is $60 per metric ton but that the safety valve induces less reductions (691 million tons instead of 869 million), up to a marginal cost of $45 per metric ton. For the low-cost year, CBO assumes that the marginal cost of reducing emissions by 869 million tons is $15 per metric ton but that the price floor induces more reductions (1,047 million tons instead of 869 million) at a marginal cost of $19 per metric ton. Figure 3. Illustrative Comparison of Total Emission Reductions and Total Costs and After One High-Cost and One Low-Cost Year

Figure 3 shows the results after one high-cost year and one low-cost year. Cumulative reductions of emissions are the same under the inflexible cap and the combined price ceiling-and-floor system, but costs are more than 20 percent lower under the latter approach. The reason, again, is that more of the emission reductions are undertaken in the low-cost year under that approach. Borrowing and Banking Allowances An alternative but generally somewhat less effective approach to reducing economic costs involves allowing companies to borrow future allowances in

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high-cost years, thereby deferring emission reductions to later years. Borrowing allowances from future years would tend to reduce allowance prices in the current year but then raise prices in the future (because borrowing would allow smaller reductions now but require greater reductions later). Firms would want to borrow allowances only if they expected the price of allowances in the future to be sufficiently below the current price as to make deferring reductions profitable. Most proposals would impose limits on borrowing, furthermore, in part because of concerns about enforcement and questions about who would be liable if the firm that borrowed future allowances was unable to pay them back (if it declared bankruptcy, for example). Similarly, policymakers could help keep the price of allowances from falling too low by allowing companies to exceed their required emission reductions in low-cost years in order to bank allowances for use in future highcost years. The additional emission reductions motivated by banking in lowcost years would put upward pressure on the price of allowances in those years. S. 2191 and the Carbon Market Efficiency Board S. 2191 would address sustained high prices for allowances by allowing an administrative board, the Carbon Market Efficiency Board, to transfer future allowances to the current year. That action could be viewed as a form of forced borrowing—that is, it would require firms to trade lower reductions today for higher reductions in the future, even if they would not have found it profitable to do so voluntarily. Such transfers could ultimately raise or lower the overall cost of meeting a long-run target depending on how the price of allowances changed over time. For example, if a low-cost, low-carbon energy technology became available in the future, transferring future allowances to the current period would have successfully shifted emission reductions to a time when the cost of achieving them was lower. Alternatively, if policymakers borrowed future allowances with the expectation that such a technology would become available, but it did not, then the transfer could cause even more reductions to be made at a relatively high-cost time. (An alternative approach to the one embodied in S. 2191, which may be easier for regulators to implement efficiently, would be to have the board be the entity responsible for setting a ceiling and a floor for allowance prices and for adjusting those price limits periodically as needed to achieve a long-term target for reducing emissions.)

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USING THE VALUE OF ALLOWANCES TO REDUCE ECONOMIC COSTS In establishing a cap-and-trade program, policymakers would create a new commodity: the right to emit CO2. The emission allowances would have substantial value. For example, on April 10, 2008, CBO estimated that the value of the allowances created under S. 2191 (as order reported) would be roughly $145 billion (in 2006 dollars) once the proposed program took effect in 2012; in subsequent years, the aggregate value of the allowances would be even greater. (See Box 1 for a short description of CBO’s cost estimate for S. 2191.)

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Options for Distributing Emission Allowances Policymakers would need to decide how to allocate the allowances that corresponded to each year’s CO2 cap. One option would be to have the government capture their value by selling the allowances, as it does with licenses to use the electromagnetic spectrum. Another possibility would be to give the allowances to energy producers or some energy users at no charge. The European Union has used that second approach in its two-year-old capand-trade program for CO2 emissions, and in the United States, the federal government has distributed nearly all of the allowances issued under the 13year-old U.S. cap-and-trade program for sulfur dioxide emissions (which contribute to acid rain) that way. Selling the allowances would provide lawmakers with an opportunity to reduce the overall economic impact of a CO2 cap. For instance, the government could use the revenue from auctioning allowances to reduce existing taxes that tend to dampen economic activity—primarily, taxes on labor, capital, or personal income. As research indicates, a CO2 cap would exacerbate the economic effects of such taxes: The higher prices caused by the cap would lower real (inflation-adjusted) wages and real returns on capital, which would be equivalent to raising marginal tax rates on those sources of income. Using the value of the allowances to reduce such taxes could help mitigate that adverse effect of the cap. Alternatively, policymakers could choose to use the revenue from auctioning allowances to reduce the federal deficit. If doing so lessened the need for future tax increases, the end result could be similar to dedicating the revenue to cuts in existing taxes.

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CBO’S COST ESTIMATE FOR S. 2191 On April 10, 2008, the Congressional Budget Office (CBO) issued a cost estimate for S. 2191, the America’s Climate Security Act of 2007, as ordered reported by the Senate Committee on Environment and Public Works in December 2007. CBO also issued a cost estimate for a slightly amended version of the legislation that was transmitted by the committee on April 9. The legislation would create a cap-and-trade system for carbon dioxide and other greenhouse gases. (The bill actually calls for two separate capand-trade programs—a bigger one covering most types of greenhouse gases and a smaller one covering hydrofluorocarbons.) Some of the emission allowances would be auctioned—through a new entity, the Climate Change Credit Corporation; the remaining allowances would be distributed at no charge to states and other recipients. Over the roughly 40 years that the proposed capand-trade programs would be in effect, the number of allowances—and thus the emissions of relevant gases—would be reduced each year. On the basis of an analysis of the results of several economic models, CBO estimates that if the legislation was enacted, the auction price of emission allowances for those gases would rise from about $23 per metric ton of carbon-dioxide-equivalent (mt CO2e) emissions in 2009 to about $44 per mt CO2e in 2018.1 (In 2006 dollars, the auction price per metric ton of CO2e would rise from about $21 in 2009 to $35 in 2018.) Measured relative to base-case emissions (that is, those that would occur under current law), emissions of the main greenhouse gases covered by the programs would decline by 7 percent in 2012 and by 17 percent in 2018; over the 2012–2050 period, emissions would decline by a total of 42 percent relative to the base case. Enacting S. 2191 as it was ordered reported would increase revenues by about $1.19 trillion over the 2009–2018 period, CBO estimates. Direct spending from distributing those proceeds would total about $1.21 trillion over the period. The net effect of the original legislation (as ordered reported) would be to increase the deficit (excluding any effects on future discretionary spending) by an estimated $15 billion over the next 10 years. The effect of the amended version, in contrast, would be to reduce the deficit (again excluding any effects on future discretionary spending) by roughly $80 billion over the same period. In addition, if policymakers appropriated the amounts necessary to implement S. 2191, discretionary

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spending would increase over the 2009– 2018 period, CBO estimates, by about $4 billion under the original legislation and by about $80 billion under the amended version. The cost estimates for the two versions of the bill differ because the amendment would increase the proportion of allowances that were auctioned, deposit some of the auction proceeds in a Climate Change Deficit Reduction Fund, and make spending from that fund subject to appropriation. 1. A carbon dioxide equivalent is defined for each greenhouse gas as the quantity of that gas that makes the same contribution to global warming as one metric ton of carbon dioxide, as determined by the Environmental Protection Agency.

The decision about whether or not to sell the allowances and how to use the proceeds could have a significant impact on the overall cost. For example, researchers have estimated that the efficiency cost of a 15 percent cut in emissions could be reduced by more than half if the government sold allowances and used the revenue to lower corporate income taxes, rather than devoting the revenue to providing lump-sum rebates to households or giving the allowances away (see the top panel of Figure 4).4

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The Distributional Consequences of Different Approaches The ways in which lawmakers allocated the revenue from selling emission allowances would affect not only the total economic cost of a cap-and-trade policy but also its distributional consequences. The ultimate distributional impact of a cap-and-trade program would be the net effect of two distinct components: the distribution of the costs of the program (including the cost of paying for the allowances) and the distribution of the allowances’ value. (Because someone would pay for them, someone would benefit from their value.) Market forces would determine who bore the costs of a cap-and-trade program, but policymakers would determine who received the value of the allowances. The ultimate effect could be either progressive or regressive, imposing disproportionately large burdens on high-income or low-income households, respectively.

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Market Forces Would Determine Who Bore the Costs of a Cap Obtaining allowances—or taking steps to cut emissions to avoid the need for such allowances—would become a cost of doing business for firms that were subject to the CO2 cap. However, those firms would not ultimately bear most of the cost of the allowances. Instead, they would pass the cost along to their customers (and their customers’ customers) in the form of higher prices. By attaching a cost to CO2 emissions, a cap-and-trade program would thus lead to price increases for energy and energy-intensive goods and services. Such price increases would stem from the restriction on emissions and would occur regardless of whether the government sold emission allowances or gave them away. Indeed, the price increases would be essential to the success of a cap-and-trade program because they would be the most important mechanism through which businesses and households were encouraged to make investments and change their behavior to reduce CO2 emissions. (In regulated electricity industries, distributing the permits at no cost might mitigate or prevent price increases in those markets but only at the cost of requiring even larger price increases in other markets. Ultimately, consumers will, in one way or another, bear costs roughly equal to the value of the permits.) The rise in prices for energy and energy-intensive goods and services would impose a larger burden, relative to income, on low-income households than on high-income households. For example, without incorporating any benefits to households from lessening climate change, CBO estimated that the price increases resulting from a 15 percent cut in CO2 emissions would cost the average household in the lowest one-fifth (quintile) of all households arrayed by income slightly more than 3 percent of its income; such increases would cost the average household in the top quintile just under 2 percent of its income (see Table 1).5 The higher prices that resulted from a cap on CO2 emissions would reduce demand for energy and energy-intensive goods and services and thus create losses for some current investors and workers in the sectors of the economy supplying such products. Investors might see the value of their stock decline, and workers could face the risk of unemployment as jobs in those sectors were cut. Stock losses would tend to be widely dispersed among investors, because shareholders typically diversify their portfolios. In contrast, the costs borne by workers would probably be concentrated among relatively few households and, by extension, communities.

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Sources: Terry M. Dinan and Diane Lim Rogers (top panel), ―Distributional Effects of Carbon Allowance Trading: How Government Decisions Determine Winners and Losers,‖ National Tax Journal, vol. 55, no. 2 (June 2002) and Congressional Budget Office (bottom panel).

Notes: These figures do not reflect any of the benefits from reducing climate change. The policy examined here is a cap-and-trade program designed to reduce carbon dioxide (CO2) emissions by 15 percent from 1998 levels. (CBO performed the analysis in 2000 and used 1998 emission levels so the distributional effects could be based on actual, rather than projected, data on consumer spending and taxes.) In the bottom panel, the costs of the cap-and-trade policy are shown as decreases in real household income, measured as a percentage of after-tax income before the policy change. Those numbers reflect data on each quintile’s cash consumption and estimates of cash income. (A quintile contains one-fifth of U.S. households arrayed by income.) Because of data limitations, those numbers should be viewed as illustrative and broadly supportive of the conclusions in this analysis rather than as precise estimates. a. These estimates assume that the government would use any positive net revenue remaining after accounting for ways in which the policy affected the federal budget to provide equal lump-sum rebates to households. The results would be more regressive if the government used any positive net revenue to decrease corporate taxes or payroll taxes. b. Indicates the net effect of households’ increased expenditures because of cap-induced price increases and the income that households would receive as a result of the allowance-allocation strategy.

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Figure 4. Effects of a 15 Percent Cut in CO2 Emissions, with the Allowances’ Value Used in Various Ways

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Policymakers Would Determine Who Received the Value of the Allowances Although the price increases triggered by a cap-and-trade program for CO2 emissions would be regressive, the program’s ultimate distributional effects would depend on policy- makers’ decisions about how to allocate the allowances. As noted above, those allowances would be worth tens or hundreds of billions of dollars per year. Who received that value would depend on how the allowances were distributed. Table 1. Effects on U.S. Households of the Higher Prices Resulting from a 15 Percent Cut in CO2 Emissions

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Annual Cost Increase in 2006 Dollars Annual Cost Increase as a Percentage of Incomea

Average for Income Quintile Lowest Second Middle Fourth Highest 680 880 1,160 1,500 2,180 3.3

2.9

2.8

2.7

1.7

Source: Congressional Budget Office, Who Gains and Who Pays Under CarbonAllowance Trading? The Distributional Effects of Alternative Policy Designs (June 2000). Notes: These numbers do not reflect any of the benefits from reducing climate change. The policy examined here is a cap-and-trade program designed to lower U.S. carbon dioxide (CO2) emissions by 15 percent from 1998 levels. (CBO performed the analysis in 2000 and used 1998 emission levels so that the distributional effects could be based on actual, rather than projected, data on consumer spending and taxes.) CBO assumed that the full cost of cutting emissions would be passed along to consumers in the form of higher prices and that the price increase for a given product would be proportional to the amount of CO2 emitted from the fossil fuels used in its production. These numbers reflect data on each quintile’s cash consumption and estimates of cash income. (A quintile contains one-fifth of U.S. households arrayed by income.) Because of data limitations, the numbers should be viewed as illustrative and broadly supportive of the conclusions in this analysis rather than as precise estimates. a. The cost increases are equivalent to percentage declines in households’ after-tax income.

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Lawmakers could more than offset the price increases experienced by low-income households or the costs imposed on workers in particular industrial sectors by providing for the sale of some or all of the allowances and using the revenue to pay compensation. For example, when CBO examined the ultimate distributional effects of a capand-trade program that would reduce CO2 emissions in the United States by 15 percent, it concluded that lowerincome households could be better off (even without any benefits from reducing climate change considered) as a result of the policy if the government chose to sell the allowances and use the revenue to pay an equal lump- sum rebate to every household in the United States. In that case, the size of the rebate would be larger than the average increase in low-income households’ spending on energy and energy-intensive goods.6 Such a strategy would, on net, increase average income for households in the lowest income quintile by about 2 percent (see the bottom panel of Figure 4). At the same time, the net average income for households in the top quintile would fall by less than 1 percent, CBO estimated. In contrast, if lawmakers chose to use the allowances to decrease corporate income taxes, the overall cost to the economy would fall but the distributional effects would be significantly more regressive than the initial price increases. Because low-income households pay relatively little in corporate taxes, the cut in corporate tax rates would not offset their increased spending on energy and energy-intensive goods. Households in the top income quintile, however, would experience an increase in after-tax income as a result of the policy. Should policymakers decide to use the revenue from selling allowances to decrease payroll taxes, the effects (not shown in the figure) would be regressive as well, although less so than for a cut in corporate taxes.7 Giving all or most of the allowances to energy producers to offset the potential losses of investors in those industries—as was done in the cap-andtrade program for sulfur dioxide emissions—would also exacerbate the regressivity of the price increases. On average, the value of the CO2 allowances that producers received would more than compensate them for any decline in profits caused by a drop in demand for energy and energy-intensive goods and services. As a result, the companies that received allowances could experience windfall profits. For example, in 2000, CBO estimated that if emissions were reduced by 15 percent, as in the scenario discussed above, and all of the allowances were distributed free of charge to producers in the oil, natural gas, and coal sectors, the value of the allowances would be 10 times as large as the producers’ combined profits in 1998. Profits for those industries have climbed

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substantially since then, yet the value of the allowances associated with the policy that CBO analyzed would still be large relative to those producers’ profits.8 Because the additional profits from the allowances’ value would not depend on how much a company produced, such profits would be unlikely to prevent the declines in production and resulting job losses that the price increases (and resulting drop in demand) would engender. In addition, those profits would accrue to shareholders, who typically are from higher-income households, and would more than offset those households’ increased spending on energy and energy-intensive goods and services. Low-income households, by contrast, would benefit little if allowances were given to energy producers for free, and they would still bear a disproportionate burden from the price increases that would nonetheless occur. Thus, giving away allowances would be significantly regressive, making higher-income households better off as a result of the cap-and-trade policy while making lower-income households worse off. Further, giving away the allowances would preclude the government from dedicating the value of the allowances to reducing the overall economic impact of the policy.

End Notes

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1

The Congressional Budget Office (CBO) reviewed S. 2191 as the bill was ordered reported by the Senate Committee on Environment and Public Works on December 5, 2007. As discussed later, on April 10, 2008, CBO provided a cost estimate for the bill as it was ordered reported and a cost estimate for it with a proposed amendment transmitted to the agency on April 9, 2008. 2 Although costs and benefits are difficult to measure, the long-term cumulative nature of climate change implies that the benefit of emitting one fewer ton of CO2 in a given year—referred to as the marginal benefit—is roughly constant. In other words, the benefit in terms of averted climate damage from each additional ton of emissions reduced is roughly the same as the benefit from the previous ton of emissions reduced, and shifting the reductions from one year to another does not materially affect the ultimate impact on the climate. In contrast, the cost of emitting one fewer ton of CO2 in a given year—the marginal cost— tends to increase with successive emission reductions. The reason is that the least expensive reductions are made first and progressively more-expensive cuts would then have to be made to meet increasingly ambitious targets for emission reductions. 3 See William D. Nordhaus, ―To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming,‖ Review of Environmental Economics and Policy, vol. 1, no. 1 (Winter 2007), pp. 37–39. 4 The efficiency cost of a policy reflects the economic losses that occur because prices are distorted so that they do not reflect the nonenvironmental resources used in their production. That cost includes decreases in the productive use of labor and capital as well as costs (both monetary and nonmonetary) associated with reducing emissions. To provide perspective on the magnitude of such efficiency costs, they are depicted as a share of gross domestic product.

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6

7

Those numbers are based on an analysis that CBO conducted using 1998 data; see Congressional Budget Office, Who Gains and Who Pays Under Carbon-Allowance Trading? The Distributional Effects of Alternative Policy Designs (June 2000). CBO is in the process of updating those figures, using recent data on households’ expenditures and income. One researcher has suggested that an environmental tax credit based on earnings could offer another means of reducing the regressive effects of the price increases that would result from a tax or cap on CO2 emissions. See Gilbert E. Metcalf, A Proposal for a U.S. Carbon Tax Swap (Washington, D.C.: Brookings Institution, October 2007). For those results, see Congressional Budget Office, Trade-Offs in Allocating Allowances for CO2 Emissions (April 25, 2007). Specifically, CBO estimated that the value in 1998 of the allowances stemming from the 15 percent reduction in U.S. emissions would total $155 billion (in 2006 dollars). By comparison, profits for U.S. producers of oil, natural gas, and coal totaled $13.5 billion in 1998 (in 2006 dollars). Those companies’ total profits have grown substantially—for example, in 2006, they totaled $174 billion.

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8

Peter R. Orszag

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Chapter 6

IMPLICATIONS OF A CAP-AND-TRADE PROGRAM FOR CARBON DIOXIDE EMISSIONS

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Peter R. Orszag Chairman Baucus, Senator Grassley, and Members of the Committee, thank you for the invitation to discuss the implications of cap-and-trade programs that are designed to reduce U.S. emissions of greenhouse gases, most prominently carbon dioxide (CO2). Global climate change is one of the nation’s most significant long-term policy challenges. Human activities are producing increasingly large quantities of greenhouse gases, particularly CO2. The accumulation of those gases in the atmosphere is expected to have potentially serious and costly effects on regional climates throughout the world. The magnitude of such damage remains highly uncertain, but there is growing recognition of the risk that the damage may be extensive and perhaps even catastrophic. The risk of potentially catastrophic damage associated with climate change can justify actions to reduce that possible harm in much the same way that the hazards we all face as individuals motivate us to buy insurance. Reducing greenhouse-gas emissions would help limit the degree of damage associated with climate change, especially the risk of significant damage. However, decreasing those emissions would also impose costs on the economy—in the case of CO2, because much economic activity is based on

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fossil fuels, which release carbon in the form of carbon dioxide when they are burned. Most analyses suggest that a carefully designed program to begin lowering CO2 emissions would produce greater benefits than costs. One option for reducing emissions is to establish a ―cap-and-trade‖ program. Under such a program, policymakers would set a limit on emissions and allow entities to buy and sell rights (referred to as allowances) to emit CO2. In designing a cap-and-trade program to achieve emission reductions, policymakers would face a number of critical decisions, including whether to limit fluctuations in the price of allowances and whether to sell the allowances or give them away. If the government chose to sell them, decisions would also have to be made about whether to use the resulting revenue to offset other taxes, to assist workers or low-income households that might be adversely affected by the emission cap, to support other legislative priorities, or to reduce the deficit. My testimony makes the following key points about those issues: Market-oriented approaches to reducing carbon emissions (such as a capandtrade program or a carbon tax) are much more efficient than command-andcontrol approaches (such as regulations that require across-the-board reductions by all firms). The reason is that the market-oriented approaches create incentives and flexibility for emissions reductions to occur where and how they are least expensive to accomplish. Within the relatively efficient category of approaches that rely on the power of markets, a tax on emissions is generally more efficient than a cap-and-trade system. The reason is that although both a tax and a cap-and-trade system encourage firms to find the lowest-cost reductions at a particular point in time, a tax provides greater flexibility over time, allowing firms to achieve reductions when they are least expensive. In particular, a tax encourages firms to make greater reductions in emissions at times when the cost of doing so is low and allows them leeway to lessen their efforts when the cost is high. A cap-andtrade program can be designed to capture many of those time-related efficiencies by incorporating design features that prevent large fluctuations in the price of allowances (for example, a floor and a ceiling on allowance prices). A cap-and-trade program, like a tax on CO2 emissions, could raise a significant amount of revenue because the value of the allowances created under such a program would probably be substantial. For

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example, in 2012, the value of the emission allowances that would be issued under S. 2191 would be roughly $145 billion, CBO estimates. As the cap that is included in that legislation became more stringent over time, the value of the allowances would grow. A key decision for policymakers is whether to sell emission allowances, thereby capturing their value in the form of federal revenue, or give them away. Under a cap-and-trade program, firms would not ultimately bear most of the costs of the allowances but instead would pass them along to their customers in the form of higher prices. Such price increases would stem from the restriction on emissions and would occur regardless of whether the government sold emission allowances or gave them away. Indeed, the price increases would be essential to the success of a capand-trade program because they would be the most important mechanism through which businesses and households would be encouraged to make investments and behavioral changes that reduced CO2 emissions. Policymakers’ decisions about whether to sell or give away the allowances could significantly affect the overall economic cost of capping CO2 emissions and the way gains and losses from such a program were distributed among U.S. households. A policy of giving away rather than selling a large share of the allowances could be more costly to the economy and impose disproportionately large burdens on lowincome households. Evidence suggests that the cost to the economy of a 15 percent cut in U.S. emissions (not counting any benefits from mitigating climate change) might be more than twice as large if policymakers gave allowances away than if they sold them and used the revenue to lower current taxes on capital that discourage economic activity. In addition, providing allowances free of charge to energy producers and energy-intensive firms could create ―windfall profits‖ for relatively high- income shareholders of those companies, even though the emission cap would be likely to cause price increases that would disproportionately affect people at the lower end of the income scale. Further, allocating allowances without charge would not prevent the loss ofjobs in affected industries because such firms would probably reduce their output in response to higher prices for carbon-intensive goods and services. Those job losses, in turn, would impose concentrated income losses in some

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Peter R. Orszag households and communities. In contrast, if the government chose to sell emission allowances, it could use some of the revenue from those sales to offset the disproportionate economic burden that higher prices would impose on low-income households and to provide transitional assistance to dislocated workers. CBO has concluded that the federal budget should record the value of allowances that are given away by the government if the recipients of the allowances could readily convert them into cash. In particular, the budget should record the value of those allowances, when they are distributed, as both revenues and outlays. That procedure, which CBO has already applied in its estimates for S. 2191, underscores that giving away allowances is economically equivalent to auctioning the allowances and then dedicating the proceeds to the recipients.

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FLEXIBILITY IN THE TIMING OF EMISSION REDUCTIONS Incentive-based approaches, which create financial incentives for firms and households to cut their greenhouse-gas emissions, are a lower-cost approach to reducing emissions than more restrictive command-and-control approaches, which would mandate how much such entities could emit or what emission-reduction technologies they should use. The lower cost of incentivebased approaches stems from the flexibility they provide as to where and how emission reductions are to be achieved. Either a tax or a cap-and-trade program would offer such flexibility at a given point in time: Under a tax, policymakers would levy a fee for each ton of CO2 emitted or for each ton of carbon contained in fossil fuels. The tax would motivate entities to cut back on their emissions if the cost of doing so was less than the cost of paying the tax. As a result, the tax would place an upper limit on the cost of reducing emissions, but the total amount of CO2 that would be emitted in any given year would be uncertain. Under a cap-and-trade program, policymakers would set a limit on total emissions during some period and would require regulated entities to hold rights, or allowances, to the emissions permitted under that cap. (Each allowance would entitle companies to emit one ton of CO2 or to have one ton of carbon in the fuel that they sold.) After the allowances

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for a given period were distributed, entities would be free to buy and sell the allowances. The trading aspect of the program could lead to substantial cost savings relative to command-and-control approaches: Firms that were able to reduce emissions most cheaply could profit from selling allowances to firms that had relatively high abatement costs. Cap-and-trade programs can vary substantially in the amount of leeway that they provide regulated entities in the timing of emission reductions. Designs that allow for more timing flexibility are generally more costeffective.

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Potential Savings in Costs as a Result of Timing Flexibility In its most inflexible form, a cap-and-trade program would require that a specified cap on emissions be met each year. That lack of flexibility would boost the cost of achieving any long-term goal because it would prevent firms from responding to year-to-year differences in conditions that affected emission reduction costs, such as fluctuations in economic activity, energy markets, the weather (for example, an exceptionally cold winter would increase the demand for energy and make meeting a cap more expensive), and the technologies available for reducing emissions. In contrast, the benefits of meeting inflexible annual emission targets are unlikely to be significantly different from the benefits of achieving the same long-term reductions but allowing firms to reduce their emissions by more than a given target in some years and by less in others. That insensitivity of benefits to patterns of annual emissions is a result of the long-term nature of climate change. Limiting global temperature increases would entail making substantial reductions in the amount of greenhouse gases that accumulate in the atmosphere over the next several decades. However, the benefits of doing so are largely independent of the annual pattern of those reductions.1 Available research suggests that a tax on CO2 emissions (which would provide firms with maximum flexibility in how they undertook emission reductions over time and could keep the cost of reductions in line with anticipated benefits) could achieve a long-term target at roughly one-fifth the cost of the most inflexible type of cap-and-trade program (that is, one with no leeway in the timing of emission reductions). No existing policy proposals envision such an inflexible cap, however. Among recent proposals for a cap-

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and-trade program, the amount of timing flexibility that firms are allowed would vary depending on the program’s specific design features.

Design Features That Provide Firms with Timing Flexibility

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When combined, some design features could allow a cap-and-trade program to achieve many of the advantages in efficiency associated with a tax on emissions. One simple way of evaluating how close a cap-and-trade system would come to the efficiency of a carbon tax is to consider how much the price of allowances would fluctuate over time; the less fluctuation, the closer the cap-and-trade system would come to achieving the timing flexibility that is central to the efficiency of a tax. Minimizing price fluctuations requires measures to limit both unintended price increases and unintended price declines. Keeping Costs from Climbing Too High Setting a ceiling—typically referred to as a safety valve—on the price of allowances could make a cap-and-trade program more efficient than an inflexible cap. Such a policy could prevent the cost of reducing emissions from exceeding either the best available estimate of the environmental benefits that would result from those reductions or the cost that policy- makers consider acceptable. The government could maintain a price ceiling by selling companies as many allowances as they would like to buy at the safety- valve price. Alternatively, policymakers could allow companies to defer emission reductions to later years by allowing them to ―borrow‖ future allowances for use in an earlier year. Borrowing allowances from future years would tend to reduce allowance prices in the current year but then raise prices in the future (because borrowing would allow smaller reductions now but require greater reductions later). Firms would want to borrow allowances only if they expected the price of allowances in the future to be sufficiently below the current price as to make deferring reductions profitable. That is, borrowing could help deal with temporary spikes in allowance prices but not circumstances in which allowance prices were expected to remain high over the long term. As a result, borrowing is likely to be less effective than a price ceiling in preventing higher-than-anticipated allowance prices.

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Keeping Costs from Falling Too Low Policymakers could prevent the price of allowances from falling too low by setting a price floor. If the government chose to auction a significant share of the allowances, it could specify a so-called reserve price and withhold allowances from the auction as needed to maintain that price. The efficiency advantage that a price floor offers stems from the fact that it can prevent the cost of emission reductions from falling below the benefits that they were expected to produce—or below the level of effort that policymakers intend that emitters should maintain. Alternatively, policymakers could help keep the price of allowances from falling too low by allowing companies to exceed their required emission reductions in low-cost years in order to ―bank‖ allowances for use in future high-cost years. The additional emission reductions motivated by banking in low-cost years would put upward pressure on the price of allowances in those years. Similar to borrowing, banking would be most effective in addressing short-term lows in allowance prices rather than in circumstances in which allowance prices were expected to remain low over the long term. As a result, banking is likely to be less effective than a price floor in preventing lowerthan-anticipated allowance prices. The effects of a cap-and-trade system would also depend substantially on whether the allowances were sold or issued at no cost, as discussed below.

THE DISTRIBUTIONAL CONSEQUENCES OF A CAP-ANDTRADE PROGRAM In establishing a cap-and-trade program, policymakers would create a new commodity: the right to emit CO2. The emission allowances—each of which would represent the right to emit, say, one ton of CO2—would have substantial value. On the basis of a review of the existing literature and the range of CO2 policies now being debated, CBO estimated that by 2020, the value of those allowances could total between $50 billion and $300 billion annually (in 2006 dollars). The actual value would depend on various factors, including the stringency of the cap (which would need to grow tighter over the years to keep CO2 from continuing to accumulate), the possibility of offsetting CO2 emissions through carbon sequestration or international allowance trading, and other features of the specific policy that was selected.2 On April 10, 2008, CBO estimated that the value of the allowances created under S. 2191 would

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be roughly $145 billion once the proposed program took effect in 2012; in subsequent years, the aggregate value of the allowances would be even greater. (See Box 1 for a short description of CBO’s cost estimate for S. 2191.) Policymakers would need to decide how to allocate the allowances that corresponded to each year’s CO2 cap. One option would be to have the government capture their value by selling the allowances, as it does with licenses to use the electromagnetic spectrum. Another possibility would be to give the allowances to energy producers or some energy users at no charge. The European Union has used that second approach in its 2-year-old cap-andtrade program for CO2 emissions, and nearly all of the allowances issued under the 13-year-old U.S. cap-and-trade program for sulfur dioxide emissions (which contribute to acid rain) are distributed in that way. Whether policymakers decided to sell the allowances or give them away would have significant implications for the distribution of gains and losses among U.S. households and for the overall cost of the policy. The ultimate distributional impact of a cap-and-trade program would be the net effect of two distinct components: the distribution of the costs of the program (including the cost of paying for the allowances) and the distribution of the allowances’ value. (Because someone will pay for them, someone will benefit from their value.) Market forces would determine who bore the costs of a cap-and-trade program, but policymakers would determine who received the value of the allowances. The ultimate effect could be either progressive or regressive, imposing disproportionately large burdens on high-income or lowincome households, respectively.

Market Forces Would Determine Who Bore the Costs of a Cap Obtaining allowances—or taking steps to cut emissions to avoid the need for such allowances—would become a cost of doing business for firms that were subject to the CO2 cap. However, those firms would not ultimately bear most of the costs of the allowances. Instead, they would pass them along to their customers (and their customers’ customers) in the form of higher prices. By attaching a cost to CO2 emissions, a cap-and-trade program would thus lead to price increases for energy and energy-intensive goods and services, the production of which contributes the most to those emissions. Such price increases would stem from the restriction on emissions and would occur regardless of whether the government sold emission allowances or gave them away. Indeed, the price increases would be essential to the success of a cap-

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and-trade program because they would be the most important mechanism through which businesses and households would be encouraged to make investments and behavioral changes that reduced CO2 emissions. The rise in prices for energy and energy-intensive goods and services would impose a larger burden, relative to income, on low-income households than on high-income households. For example, without incorporating any benefits to households from lessening climate change, CBO estimated that the price increases resulting from a 15 percent cut in CO2 emissions would cost the average household in the lowest one-fifth (quintile) of all households arrayed by income slightly more than 3 percent of its income; such increases would cost the average household in the top quintile just under 2 percent of its income (see Table 1).3

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CBO’S COST ESTIMATE FOR S. 2191 On April 10, 2008, the Congressional Budget Office (CBO) issued a cost estimate for S. 2191, the America’s Climate Security Act of 2007, as ordered reported by the Senate Committee on Environment and Public Works in December 2007. CBO also issued a cost estimate for a slightly amended version of the legislation that was transmitted by the committee on April 9. The legislation would create a cap-and-trade system for carbon dioxide and other greenhouse gases. (The bill actually calls for two separate capand-trade programs—a bigger one covering most types of greenhouse gases and a smaller one covering hydrofluorocarbons.) Some of the emission allowances would be auctioned—through a new entity, the Climate Change Credit Corporation; the remaining allowances would be distributed at no charge to states and other recipients. Over the roughly 40 years that the proposed cap-and-trade programs would be in effect, the number of allowances—and thus the emissions of relevant gases—would be reduced each year. On the basis of an analysis of the results of several economic models, CBO estimates that if the legislation was enacted, the auction price of emission allowances for those gases would rise from about $23 per metric ton of carbon-dioxide-equivalent (mt CO2e) emissions in 2009 to about $44 per mt CO2e in 2018.1 (In 2006 dollars, the auction price per metric ton of CO2e would rise from about $21 in 2009 to $35 in 2018.) Measured relative to base-case emissions (that is, those that would occur under current law), emissions of the main greenhouse gases covered by the programs

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would decline by 7 percent in 2012 and by 17 percent in 2018; over the 20 12–2050 period, emissions would decline by a total of 42 percent relative to the base case. Enacting S. 2191 as it was ordered reported would increase revenues by about $1.19 trillion over the 2009–2018 period, CBO estimates. Direct spending from distributing those proceeds would total about $1.21 trillion over the period. The net effect of the original legislation (as ordered reported) would be to increase the deficit (excluding any effects on future discretionary spending) by an estimated $15 billion over the next 10 years. The effect of the amended version, in contrast, would be to reduce the deficit (again excluding any effects on future discretionary spending) by roughly $80 billion over the same period. In addition, if policymakers appropriated the amounts necessary to implement S. 2191, discretionary spending would increase over the 2009–2018 period, CBO estimates, by about $4 billion under the original legislation and by about $80 billion under the amended version. The cost estimates for the two versions of the bill differ because the amendment would increase the proportion of allowances that would be auctioned, deposit some of the auction proceeds in a Climate Change Deficit Reduction Fund, and make spending from that fund subject to appropriation. Copyright © 2010. Nova Science Publishers, Incorporated. All rights reserved.

1

A carbon dioxide equivalent is defined for each greenhouse gas as the quantity of that gas that makes the same contribution to global warming as one metric ton of carbon dioxide, as determined by the Environmental Protection Agency.

The higher prices that would result from a cap on CO2 emissions would reduce demand for energy and energy-intensive goods and services and thus create losses for some current investors and workers in the sectors of the economy that supply such products. Investors might see the value of their stock decline, and workers could face the risk of unemployment as jobs in those sectors were cut. Stock losses would tend to be widely dispersed among investors, because shareholders typically diversify their portfolios. In contrast, the costs borne by existing workers would probably be concentrated among relatively few households and, by extension, their communities.

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Table 1. Effects on U.S. Households of the Higher Prices Resulting from a 15 Percent Cut in CO2 Emissions

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Annual Cost Increase in 2006 Dollars Annual Cost Increase as a Percentage of Incomea

Lowest 680 3.3

Average for Income Quintile Second Middle Fourth Highest 880 1,160 1,500 2,180 2.9

2.8

2.7

1.7

Source: Congressional Budget Office, Who Gains and Who Pays Under CarbonAllowance Trading? The Distributional Effects of Alternative Policy Designs (June 2000). Notes: These numbers do not reflect any of the benefits from reducing climate change. The policy examined here is a cap-and-trade program designed to lower U.S. carbon dioxide (CO2) emissions by 15 percent from 1998 levels. (CBO performed the analysis in 2000 and used 1998 emission levels so that the distributional effects could be based on actual, rather than projected, data on consumer spending and taxes.) CBO assumed that the full cost of cutting emissions would be passed along to consumers in the form of higher prices and that the price increase for a given product would be proportional to the amount of CO2 emitted from the fossil fuels used in its production. These numbers reflect data on each quintile’s cash consumption and estimates of cash income. (A quintile contains one-fifth of U.S. households arrayed by income.) Because of data limitations, the numbers should be viewed as illustrative and broadly supportive of the conclusions in this analysis rather than as precise estimates. a. The cost increases are equivalent to percentage declines in households’ after-tax income.

Policymakers Would Determine Who Received the Value of the Allowances Although the price increases triggered by a cap-and-trade program for CO2 emissions would be regressive, the program’s ultimate distributional effect would depend on policymakers’ decisions about how to allocate the emission allowances. As noted above, those allowances would be worth tens or hundreds of billions of dollars per year. Who received that value would depend on how the allowances were distributed.

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Sources: Congressional Budget Office (top panel); Terry M. Dinan and Diane Lim Rogers (bottom panel), ―Distributional Effects of Carbon Allowance Trading: How Government Decisions Determine Winners and Losers,‖ National Tax Journal, vol. 55, no. 2 (June 2002). Figure 1. Effects of a 15 Percent Cut in CO2 Emissions, with the Allowances’ Value Used in Various Ways

Notes: These figures do not reflect any of the benefits from reducing climate change. The policy examined here is a cap-and-trade program designed to reduce carbon dioxide (CO2) emissions by 15 percent from 1998 levels. (CBO performed the analysis in 2000 and used 1998 emission levels so the distributional effects could be based on actual, rather than projected, data on consumer spending and taxes.) In the top panel, the costs of the cap-and-trade policy are shown as decreases in real household income, measured as a percentage of after-tax income before the

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b.

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policy change. Those numbers reflect data on each quintile’s cash consumption and estimates of cash income. (A quintile contains one-fifth of U.S. households arrayed by income.) Because of data limitations, those numbers should be viewed as illustrative and broadly supportive of the conclusions in this analysis rather than as precise estimates. Indicates the net effect of households’ increased expenditures because of capinduced price increases and the income that households would receive as a result of the allowance-allocation strategy. These estimates assume that the government would use any positive net revenue remaining after accounting for ways in which the policy affected the federal budget to provide equal lump-sum rebates to households The results would be more regressive if the government used any positive net revenue to decrease corporate taxes or payroll taxes.

Lawmakers could more than offset the price increases experienced by low-income households or the costs imposed on workers in particular industrial sectors by providing for the sale of some or all of the allowances and using the revenue to pay compensation. For example, CBO examined the ultimate distributional effects of a cap-and-trade program that would reduce CO2 emissions in the United States by 15 percent, and it concluded that lowerincome households could be better off (even without including any benefits from reducing climate change) as a result of the policy if the government chose to sell the allowances and use the revenue to pay an equal lump-sum rebate to every household in the United States. In that case, the size of the rebate would be larger than the average increase in low-income households’ spending on energy and energy-intensive goods.4 Such a strategy would increase average income for households in the lowest income quintile by about 2 percent (see the top panel of Figure 1). At the same time, average income for households in the top quintile would fall by less than 1 percent, CBO estimates. In contrast, if lawmakers chose to use the allowances to decrease corporate income taxes, the effect would be significantly more regressive than the initial price increases. Because low-income households pay relatively little in corporate taxes, the cut in corporate tax rates would not offset their increased spending on energy and energy-intensive goods. Households in the top income quintile, however, would experience an increase in after-tax income as a result of the policy. Should policymakers decide to use the revenue from selling allowances to decrease payroll taxes, the effect (not shown in the figure) would be regressive as well, although less so than for a cut in corporate taxes.5

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Giving all or most of the allowances to energy producers to offset the potential losses of investors in those industries—as was done in the cap-andtrade program for sulfur dioxide emissions—would also exacerbate the regressivity of the price increases. On average, the value of the CO2 allowances that producers would receive would more than compensate them for any decline in profits caused by a drop in demand for energy and energyintensive goods and services whose production causes emissions. As a result, the companies that received allowances could experience windfall profits. For example, in 2000, CBO estimated that if emissions were reduced by 15 percent, as in the scenario discussed above, and all of the allowances were distributed free of charge to producers in the oil, natural gas, and coal sectors, the value of the allowances would be 10 times as large as coal, oil, and natural gas producers’ combined profits in 1998. Profits for those industries have climbed substantially since then, yet the value of the allowances associated with the policy that CBO analyzed would still be large relative to those producers’ profits.6 Because the additional profits from the allowances’ value would not depend on how much a company produced, such profits would be unlikely to prevent the declines in production and resulting job losses that the price increases (and resulting drop in demand) would engender. In addition, those profits would accrue to shareholders, who are primarily from higher-income households, and would more than offset those households’ increased spending on energy and energy-intensive goods and services. Low-income households, by contrast, would benefit little if allowances were given to energy producers for free, and they would still bear a disproportionate burden from the price increases that would nonetheless occur. Thus, giving away allowances would be significantly regressive, making higher-income households better off as a result of the cap-and-trade policy while making lower-income households worse off.

REDUCING THE OVERALL ECONOMIC IMPACT OF A CO2 CAP The ways in which lawmakers could allocate the revenue from selling emission allowances would affect not only the distributional consequences of a cap-and-trade policy but also its total economic cost. For instance, the government could use the revenue from auctioning allowances to reduce existing taxes that tend to dampen economic activity—primarily, taxes on

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labor, capital, or personal income. As research indicates, a CO2 cap would exacerbate the economic effects of such taxes: The higher prices caused by the cap would lower real (inflation-adjusted) wages and real returns on capital, which would be equivalent to raising marginal tax rates on those sources of income. Using the value of the allowances to reduce such taxes could help mitigate that adverse effect of the cap. Alternatively, policy-makers could choose to use the revenue from auctioning allowances to reduce the federal deficit. If that reduction lessened the need for future tax increases, the end result could be similar to dedicating the revenue to cuts in existing taxes. The decision about whether or not to sell the allowances and use the proceeds in ways that would benefit the economy could have a significant impact. For example, researchers have estimated that the efficiency cost (discussed below) of a 15 percent cut in emissions could be reduced by more than half if the government sold allowances and used the revenue to lower corporate income taxes, rather than devoting the revenue to providing lumpsum rebates to households or giving the allowances away (see the bottom panel of Figure 1). The efficiency cost of a policy reflects the economic losses that occur because prices in the economy are distorted so that they do not reflect the (nonenvironmental) resources used in their production. That cost includes decreases in the productive use of labor and capital as well as costs (both monetary and nonmonetary) associated with reducing emissions. To provide perspective on the magnitude of such efficiency costs, they are depicted as a share of gross domestic product.

CAP-AND-TRADE PROGRAMS AND THE FEDERAL BUDGET A final topic involves the budgetary treatment of cap-and-trade programs. The auctioning of allowances would clearly generate receipts for the federal government, and those amounts would be recorded as revenues. In some cases, cap-and-trade allowances that are given away by the government should also be reflected in the federal budget, in CBO’s view, and the agency used that approach in its treatment of most of the allowances that, under S. 2191, would be distributed at no charge. Specifically, the budget should show, as both revenues and outlays, the value of those allowances distributed at no cost to the recipients. That treatment stems from the fact that the government is essential to the existence of the allowances and is responsible for their readily realizable monetary value through its enforcement

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of the cap on emissions; it also derives from the fact that once created, the allowances would trade in a liquid secondary market—because firms or households could buy and sell them—and thus would be similar to cash. CBO therefore considers the distribution of such allowances at no charge to be functionally equivalent to the distribution of cash. (In contrast, the proceeds as sociated with the allowances allocated free of charge to producers and importers under smaller, more constrained cap-and-trade programs—such as the cap-andtrade program for hydrofluorocarbons proposed under S. 2191— should not be recorded in the budget, CBO believes, primarily because the market created for such allowances would be relatively illiquid and thus the allowances would be less like cash.) In CBO’s view, an approach that reflects the value of free emission allowances in the federal budget best illuminates the trade-offs between different policy choices. Distributing allowances at no charge to specific firms or individuals is, in effect, equivalent to collecting revenue from an auction of the allowances and then distributing the auction proceeds to those firms or individuals. In other words, the government could either raise $100 by selling allowances and then give that amount in cash to particular businesses and individuals, or it could simply give $100 worth of allowances to those businesses and individuals, who could immediately and easily transform the allowances into cash through the secondary market. Treating allowances issued at no charge as both revenues and outlays reflects the equivalency of those two options. Another cost-estimating issue involves the long-standing methodology used to hold overall economic activity (gross domestic product, or GDP) constant when estimating the effect of legislation on the federal budget. Under such estimating assumptions, higher amounts of indirect business charges reduce other income in the economy. (For example, if firms that must purchase allowances were unable to pass those costs along, their profits would fall. More likely, some substantial portion of those costs would be passed along to others in the economy, such as consumers, in the form of higher prices, and employees, in the form of lower wages. Lower wages would reduce federal revenues from income and payroll taxes. An increase in the price level would reduce income taxes—because the tax system is indexed to prices—and increase expenditures for indexed benefits, such as Social Security. Those changes would offset some of the revenues from the allowances.) The tradition in such estimating is to assume that 25 percent of any change in indirect business charges will be offset by changes in income and payroll taxes (25 percent is an approximate marginal tax rate). In preparing cost estimates for

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cap-and-trade proposals, CBO does not apply the 25 percent reduction to all of the gross revenues that would be generated but instead applies it on the basis of how those revenues would be used: To the extent that revenues would be used in ways that generated new taxable income, those uses would offset the loss of income and payroll taxes resulting from the initial purchase of allowances. Therefore, CBO does not apply the 25 percent reduction to any revenues that would go toward making transfer payments to taxable entities if the policy would impose no conditions on recipients’ use of the payments. Although such payments do not directly affect GDP (because they are not made in exchange for goods or services), they are typically taxable. Thus, providing transfers to taxable entities would generate additional federal revenues that would essentially offset the 25 percent reduction applied to revenues from the issuance of allowances. In contrast, CBO does apply the 25 percent reduction to any revenues that would be spent by the government on goods and services (for example, on research and development activities). That treatment is used because such government spending would substitute for other economic activity (under the assumption that GDP is unchanged). As a result, revenues used in that way would not generate any new taxable income.

End Notes 1

Although costs and benefits are difficult to measure, the long-term cumulative nature of climate change implies that the benefit of emitting one less ton of CO2 in a given year—referred to as the marginal benefit—is roughly constant. In other words, the benefit in terms of averted climate damage from each additional ton of emissions reduced is roughly the same as the benefit from the previous ton of emissions reduced, and shifting the reductions from one year to another does not materially affect the ultimate impact on the climate. In contrast, the cost of emitting one less ton of CO2 in a given year—the marginal cost—tends to increase with successive emission reductions. The reason is that the least expensive reductions are made first and progressively more-expensive cuts would then have to be made to meet increasingly ambitious targets for emission reductions. 2 Carbon sequestration is the capture and long-term storage of CO2 emissions underground (geological sequestration) or in vegetation or soil (biological sequestration). For more information, see Congressional Budget Office, The Potentialfor Carbon Sequestration in the United States (September 2007). 3 Those numbers are based on an analysis that CBO conducted using 1998 data; see Congressional Budget Office, Who Gains and Who Pays Under Carbon-Allowance Trading? The

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Distributional Effects ofAlternative Policy Designs (June 2000). CBO is in the process of updating those figures, using recent data on households’ expenditures and income. 4 One researcher has suggested that an environmental tax credit based on earnings could offer another means of reducing the regressive effects of the price increases that would result from a tax or cap on CO2 emissions. See Gilbert E. Metcalf, A Proposalfor a U.S. Carbon Tax Swap (Washington, D.C.: Brookings Institution, October 2007). 5 For those results, see Congressional Budget Office, Trade-Offs in Allocating Allowances for CO2 Emissions (April 25, 2007). 6 Specifically, CBO estimated that the value in 1998 of the allowances stemming from the 15 percent reduction in U.S. emissions would total $155 billion (in 2006 dollars). By comparison, profits for U.S. producers of oil, natural gas, and coal totaled $13.5 billion in 1998 (in 2006 dollars). Those companies’ total profits have grown substantially—for example, in 2006, they totaled $174 billion.

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CHAPTER SOURCES

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The following chapters have been previously published: Chapter 1 – This is an edited, excerpted and augmented edition of a United States Congressional Research Service publication, Report Order Code RL34436, dated April 4, 2008. Chapter 2 – This is an edited, excerpted and augmented edition of a United States Congressional Research Service publication, Report Order Code RL33846, dated January 31, 2008. Chapter 3 – This is an edited, excerpted and augmented edition of a United States Congressional Research Service publication, Report Order Code RL34241, dated November 7, 2007. Chapter 4 – These remarks were delivered as Statement of Peter R. Orszag, Director, Congressional Budget Office, before the Committee on Energy and Natural Resources, U.S. Senate, dated June 17, 2008. Chapter 5 – These remarks were delivered as Statement of Peter R. Orszag, Director, Congressional Budget Office, before the Committee on Energy and Natural Resources, U.S. Senate, dated May 20, 2008. Chapter 6 – These remarks were delivered as Statement of Peter R. Orszag, Director, Congressional Budget Office, before the Committee on Energy and Natural Resources, U.S. Senate, dated April 24, 2008.

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INDEX

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A abatement, 14, 18, 27, 92, 118, 139 accounting, 28, 33, 96, 130, 147 acid, viii, 33, 43, 45, 125, 142 adaptation, 55, 56, 63, 65, 74, 75 agricultural sector, ix, 18, 44, 72 agriculture, vii, viii, 2, 11, 16, 17, 18, 20, 23, 38, 39, 75, 88, 94 air pollutants, 33 air quality, 21, 34, 94 alternatives, 9, 32, 96, 111 annual review, 65 assessment, 30, 64, 74, 75 assumptions, 19, 150 availability, 20, 28 avoidance, vii, ix, x, 1, 3, 6, 29, 39, 83, 85, 95

B banking, 61, 117, 124, 141 bankruptcy, 124 behavioral change, 137, 143 binding, 38, 45 biodiversity, 20 biofuel, 20, 39, 47, 65 biomass, 9, 11, 12, 63, 90, 111 boilers, 12, 90

borrowing, 57, 58, 60, 71, 117, 124, 140, 141 Bureau of Land Management, 49, 64 bureaucracy, 34 Bush, President George W., 45 buyer, x, 10, 26, 35, 84, 86, 87, 95 by-products, 13, 92

C candidates, 14, 38 carbon dioxide, vii, x, 13, 38, 39, 44, 46, 48, 53, 68, 69, 76, 78, 79, 80, 81, 83, 85, 92, 96, 97, 99, 101, 105, 111, 115, 126, 127, 130, 131, 135, 136, 143, 144, 145, 146 category a, 13 Census, 105 children, 108, 110 Clean Air Act, viii, 43, 45, 59, 77, 78 climate change, vii, ix, x, 3, 18, 19, 20, 25, 27, 28, 33, 41, 44, 45, 49, 55, 64, 70, 74, 75, 84, 91, 95, 96, 99, 101, 102, 115, 117, 119, 128, 130, 131, 132, 133, 135, 137, 139, 143, 145, 146, 147, 151 coal, 4, 7, 10, 11, 13, 14, 28, 47, 49, 51, 53, 63, 78, 90, 92, 132, 134, 148, 152 combustion, 6, 12, 13, 21, 29, 39, 90, 96, 97 commodity, 125, 141 compensation, 89, 132, 147 complexity, 33, 107 compliance, viii, ix, 2, 3, 4, 9, 15, 17, 18, 19, 23, 25, 26, 28, 32, 33, 34, 38, 39, 44,

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Index

54, 59, 71, 76, 77, 80, 81, 87, 92, 96, 97, 103, 107, 117 components, 127, 142 compounds, 51, 53 concentration, x, 4, 33, 41, 83, 119 confidence, 87 Congress, iv, v, vii, viii, 1, 3, 4, 5, 14, 25, 33, 38, 39, 40, 41, 43, 45, 49, 52, 54, 55, 58, 69, 70, 81, 94, 95, 96, 116 Congressional Budget Office, v, 99, 100, 102, 112, 120, 122, 123, 126, 129, 131, 133, 134, 143, 145, 146, 151, 152, 153 conservation, vii, 2, 8, 9, 11, 20, 40, 55, 88, 89, 113 construction, 12, 77, 91, 111 consumer price index, 120 consumers, x, 19, 40, 55, 57, 69, 70, 77, 84, 95, 128, 131, 145, 150 consumption, 40, 100, 102, 130, 131, 145, 147 control, ix, x, 11, 13, 14, 15, 18, 19, 20, 24, 25, 27, 35, 38, 40, 44, 48, 64, 65, 77, 78, 84, 88, 92, 96, 116, 118, 138, 139 cooling, 89, 111, 113 correlation, x, 84, 94 cost saving, vii, 1, 91, 118, 139 counterbalance, 93 covering, 126, 143 credibility, x, 83, 84, 95 credit, 10, 26, 65, 76, 77, 87, 103, 105, 106, 107, 108, 109, 110, 111, 112, 113 crop production, 39, 88 customers, 128, 137, 142

D database, 64, 74, 75 decisions, x, 84, 95, 131, 136, 137, 145 deficit, 125, 126, 136, 144, 149 definition, 49 deforestation, 11, 26, 40, 88, 89, 96 Department of Agriculture, 94, 113 Department of Energy, 95, 113 developed countries, 45 developed nations, 20, 32, 34, 35, 39, 65

developing countries, 60, 72 developing nations, viii, 2, 12, 20, 21, 27, 32, 33, 34, 35, 36, 39, 90, 91 distribution, 76, 127, 142, 150

E earnings, 102, 103, 105, 106, 107, 108, 109, 113, 134, 152 economic activity, vii, 27, 99, 101, 103, 116, 118, 119, 125, 135, 137, 139, 148, 150, 151 economic efficiency, 69, 104, 110 economic growth, 54, 69, 74 economic incentives, 103 ecosystem, 54, 63 elderly, 107, 109, 110 electricity, 12, 13, 45, 53, 54, 55, 79, 90, 91, 101, 102, 104, 108, 111, 128 electromagnetic, 125, 142 emitters, 78, 80, 141 energy efficiency, viii, x, 2, 6, 12, 13, 21, 22, 46, 47, 48, 50, 55, 60, 63, 64, 69, 72, 74, 83, 85, 91, 97 Energy Independence and Security Act, 81 environmental degradation, 39, 96 environmental effects, 23 environmental policy, 31 Environmental Protection Agency, ix, 39, 41, 44, 51, 98, 127, 144 EPA, ix, 5, 6, 7, 8, 9, 16, 17, 19, 20, 21, 27, 39, 40, 41, 44, 46, 51, 53, 54, 55, 56, 57, 58, 60, 61, 62, 63, 65, 67, 68, 69, 70, 73, 96, 97, 98 equity, 55, 69 erosion, 11, 20 estimating, 38, 150 EU, 4, 36, 37, 38, 39, 96 European Commission, 36, 37 European Union, 4, 37, 39, 96, 97, 125, 142 evaporation, 96 evapotranspiration, 89, 96 Executive Order, 31 expenditures, 104, 106, 109, 130, 134, 147, 150, 152

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Index exports, 48, 65, 119 externalities, 39, 96

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F fairness, viii, 2, 14, 32 family, 18, 107, 109 farms, 18, 40, 89 fertilization, 23 finance, 35, 65 financial support, 11, 15, 86, 90 financing, 12, 14 fire suppression, 64 fires, 27, 88 firms, 100, 116, 117, 118, 119, 120, 122, 123, 124, 128, 136, 137, 138, 139, 142, 150 flexibility, 20, 116, 117, 118, 120, 136, 138, 139, 140 fluctuations, 116, 119, 136, 139, 140 food, 109, 110 forest management, 8, 35, 39 forests, 11, 20, 27, 88 fossil, vii, 11, 12, 13, 21, 39, 53, 90, 96, 97, 99, 101, 116, 119, 131, 136, 138, 145 fuel, 12, 39, 40, 49, 53, 55, 64, 65, 69, 78, 89, 90, 96, 104, 108, 118, 138 funding, 13, 32, 34, 63, 92, 110 funds, 57, 113

G gases, vii, 13, 39, 51, 67, 79, 81, 92, 115, 119, 126, 135, 143 gasoline, 102, 104, 108 GDP, 150, 151 generation, 46, 47, 48, 49, 55, 60, 65, 69, 79 global climate change, 4, 95, 119 goals, 53, 68 goods and services, 94, 102, 103, 119, 128, 132, 133, 137, 142, 143, 144, 148, 151 government, iv, 17, 34, 35, 37, 53, 55, 60, 76, 78, 79, 80, 91, 100, 101, 102, 110, 111, 121, 125, 127, 128, 130, 132, 133,

157

136, 137, 138, 140, 141, 142, 147, 148, 149, 150, 151 GPS, 79 grants, 94 grazing, 35, 64 greenhouse gases, vii, viii, ix, 13, 43, 44, 45, 46, 49, 76, 79, 81, 115, 119, 126, 135, 139, 143 gross domestic product, 133, 149, 150 groups, x, 10, 15, 84, 86, 93, 94 growth, 23, 45, 85 guidelines, 10, 94 guilt, 97

H habitat, 64, 94 harm, 5, 34, 45, 58, 61, 78, 115, 135 harvesting, 27 hazards, 115, 135 health, 39, 96 health problems, 39, 96 heat, 111 heating, 102, 111, 113 House, 46, 67, 94 household income, 102, 103, 130, 146 households, 15, 54, 63, 69, 74, 100, 101, 102, 103, 104, 105, 106, 107, 108, 109, 110, 111, 118, 127, 128, 130, 131, 132, 133, 134, 136, 137, 138, 142, 143, 144, 145, 147, 148, 149, 150, 152 human activity, 27, 88 hybrid, 76 hydroelectric power, 36

I implementation, 18, 24, 33, 50, 66 imports, 53, 119 incentives, 4, 45, 49, 103, 106, 107, 110, 111, 112, 116, 118, 136, 138 inclusion, viii, 2, 18, 28, 38, 40 income, 15, 55, 56, 63, 100, 101, 102, 103, 104, 105, 106, 107, 108, 109, 110, 113,

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Index

118, 125, 127, 128, 130, 131, 132, 133, 134, 136, 137, 142, 143, 145, 146, 147, 148, 149, 150, 151, 152 income distribution, 105, 106 income tax, 103, 104, 105, 106, 107, 108, 127, 132, 147, 149, 150 industrial sectors, 49, 132, 147 industrialized countries, 38, 44 industry, 24, 49, 51, 67, 76, 80 inflation, 48, 57, 59, 119, 125, 149 infrastructure, ix, 21, 34, 44, 46, 47, 65 innovation, viii, ix, 2, 18, 23, 32, 44, 46 insulation, 111 insurance, 28, 115, 135 integrity, 11, 23, 24, 25, 32, 36, 81, 86, 88, 89, 94, 96 interest groups, 10, 84 Internal Revenue Service, 106, 112, 113 investment, 12, 47, 65, 91, 102, 111, 119 investment incentive, 111 investors, 128, 132, 144, 148

M management, 6, 8, 26, 35, 47, 65 mandates, 47, 65 manufacturer, 47, 65 manufacturing, 13, 49, 92 manure, 4, 6, 8, 29, 47, 60 market, viii, x, 2, 8, 10, 14, 15, 18, 23, 25, 28, 29, 30, 31, 34, 36, 39, 43, 45, 46, 49, 57, 59, 60, 71, 72, 77, 78, 81, 83, 84, 85, 86, 88, 89, 90, 91, 92, 93, 94, 95, 96, 97, 116, 136, 150 marketplace, 78 markets, 81, 95, 119, 128, 136, 139 measurement, 9, 18, 25, 26, 32, 87, 89 measures, 46, 49, 52, 58, 71, 89, 140 median, 110 Medicare, 105, 113 models, 19, 126, 143 money, 14, 93 Montana, 112 motivation, 4, 10, 102

J N

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jobs, 128, 144

L labor, 102, 106, 109, 125, 133, 149 labor force, 102, 106, 109 land, 8, 11, 20, 27, 35, 36, 39, 40, 60, 88, 89 land use, 11, 20, 27, 35, 36, 40, 60, 88 landfills, viii, 2, 13, 14, 16, 40, 47, 92 language, ix, 9, 44 legislation, 9, 30, 45, 81, 98, 126, 137, 143, 144, 150 licenses, 78, 125, 142 limitation, 51, 67 liquidity, 77, 78 livestock, 12, 13, 92 local government, 91

nation, vii, 26, 32, 33, 41, 64, 85, 87, 99, 101, 115, 135 national security, 57, 59, 64 natural gas, 16, 49, 51, 53, 76, 78, 102, 104, 108, 132, 134, 148, 152 negotiating, 28 nitrogen, 33 nitrous oxide, 16, 17, 21, 38, 39, 47, 51, 67, 79, 81, 96

O objectives, 15, 21, 23 obligation, 38 oil, 6, 16, 29, 49, 104, 108, 132, 134, 148, 152 order, 18, 93, 107, 124, 125, 141 ownership, 13, 91

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Index

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P payback period, 12, 58, 71 payroll, 103, 105, 106, 109, 113, 130, 132, 147, 150, 151 penalties, 59, 63, 71, 73, 80 pests, 27, 88 planning, 77, 119 plants, 11, 20, 28, 49, 53, 62, 76, 88 policy choice, 150 pollutants, 40, 77 polluters, 78 pollution, 20, 39, 40, 41, 77, 78, 96 poor, 64, 74, 75 portfolio, ix, 17, 44, 45, 47, 48 portfolios, 128, 144 poverty, 109, 110 power, vii, 1, 4, 9, 13, 38, 44, 49, 51, 53, 67, 68, 91, 95, 111, 136 power plants, 4, 9 pressure, 124, 141 price ceiling, 117, 120, 121, 123, 140 price changes, 15 price floor, 117, 120, 121, 122, 123, 141 prices, 5, 12, 16, 20, 58, 60, 81, 90, 94, 100, 101, 102, 103, 109, 110, 111, 117, 119, 121, 124, 125, 128, 131, 133, 136, 137, 140, 141, 142, 143, 144, 145, 149, 150 primary products, 48, 65 private costs, 111 producers, 45, 55, 69, 97, 125, 132, 133, 134, 137, 142, 148, 150, 152 production, 9, 11, 13, 14, 20, 27, 39, 41, 48, 53, 74, 76, 78, 88, 92, 93, 111, 131, 133, 142, 145, 148, 149 productivity, 27 profit, 94, 118, 139 profits, 132, 133, 134, 137, 148, 150, 152 protocol, 39, 91, 97

R rain, viii, 33, 43, 45, 125, 142 range, x, 18, 28, 35, 36, 83, 84, 94, 95, 141

159

reason, 25, 85, 123, 133, 136, 151 recognition, 115, 135 recycling, 56, 57, 62, 70, 73, 80 reflectivity, 96 regulation, 10, 13, 19, 27, 58, 59, 92, 101 regulations, viii, 2, 6, 8, 9, 11, 31, 32, 34, 35, 116, 136 regulators, 117, 120, 121, 124 regulatory affairs, 31 relief, 46, 49, 58, 71, 103, 107 renewable energy, vii, x, 2, 11, 12, 13, 21, 22, 39, 45, 54, 63, 83, 85, 90, 95, 111, 112, 113 reputation, 14, 92 resolution, 45 resources, 45, 91, 133, 149 returns, 106, 108, 113, 125, 149 revenue, 57, 63, 75, 117, 125, 127, 130, 132, 136, 137, 138, 147, 148, 149, 150 risk, 27, 28, 34, 99, 101, 102, 115, 116, 128, 135, 144

S safety, ix, 30, 44, 47, 56, 57, 71, 80, 81, 117, 120, 122, 123, 140 savings, 110, 112 Secretary of Commerce, 65, 74, 75 seller, 10, 35, 86, 94 semiconductors, 13, 92 Senate, viii, 8, 41, 43, 45, 49, 51, 94, 99, 101, 126, 133, 143, 153 shareholders, 128, 133, 137, 144, 148 social acceptance, 17 Social Security, 105, 106, 107, 109, 113, 150 soil, 11, 20, 26, 39, 47, 88, 151 solar system, 113 species, 20, 26, 89 spectrum, 3, 125, 142 Spring, 112, 113 SSI, 109 standards, ix, x, 5, 6, 7, 8, 9, 10, 14, 29, 30, 44, 46, 47, 48, 64, 74, 83, 84, 86, 93, 94, 95, 96, 112

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Index

stimulus, 103, 106, 107 stock, 105, 119, 120, 128, 144 stock price, 119, 120 storage, 26, 28, 34, 55, 56, 94, 151 strategies, 46, 54 sulfur, 6, 7, 33, 38, 51, 67, 78, 79, 81, 96, 119, 125, 132, 142, 148 sulfur dioxide, 33, 78, 119, 125, 132, 142, 148 suppliers, 17, 118 supply, 3, 15, 16, 17, 27, 30, 144 sustainable development, viii, 2, 21, 22, 33

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T targets, viii, ix, 2, 26, 38, 43, 47, 51, 60, 87, 111, 121, 133, 139, 151 tax credit, 38, 47, 65, 109, 111, 134, 152 tax incentive, 47, 65, 90, 100, 111 tax increase, 125, 149 tax rates, 103, 104, 105, 109, 125, 132, 147, 149 tax system, 103, 108, 150 technological change, 28 technological progress, 77 telephone, 107 temperature, 139 threshold, 11, 30 timing, 39, 106, 111, 116, 120, 139, 140 Title I, 77 Title IV, 77 total costs, 111, 122 tracking, 26, 85, 87 tracks, 45 trade policy, 123, 127, 130, 133, 146, 148 trade-off, 20, 23, 103, 150 trading, viii, 2, 3, 4, 8, 15, 23, 24, 25, 26, 33, 38, 43, 45, 46, 47, 48, 60, 61, 62, 64, 65, 72, 73, 77, 118, 139, 141 transaction costs, 18, 28, 32, 93 transactions, 37, 85 transfer payments, 151 transition, 15, 63 transpiration, 96

transportation, 22, 46, 48, 49, 51, 55, 64, 67, 68, 69 trees, vii, 2, 11, 20, 26, 36, 88, 89

U U.S. economy, 23, 58, 119 UN, 39 unemployment, 128, 144 United Nations, 22, 38, 39, 44, 46, 60, 79, 81, 96, 97 United States, 10, 16, 18, 21, 27, 33, 38, 44, 45, 48, 49, 65, 74, 84, 99, 102, 103, 119, 122, 125, 132, 147, 151, 153 universe, 11, 15, 20, 85 updating, 134, 152 USDA, 94

V variables, 3, 15, 89 vegetation, 11, 26, 151 vehicles, ix, 44, 46, 47, 48, 49, 63, 64, 65, 74, 111 volatility, 119, 121

W wages, 125, 149, 150 waste management, 13, 92 wastewater, 7, 47 water quality, viii, 2 wetlands, 40, 64 wildlife, 63, 64, 74 wildlife conservation, 63 wind, vii, 2, 11, 12, 26, 86, 87, 90, 111 wind farm, vii, 2, 12, 26, 86, 87, 90 winter, 119, 139 workers, 54, 63, 64, 69, 73, 74, 105, 106, 108, 109, 113, 128, 132, 136, 138, 144, 147 World Bank, 37, 85, 86, 96

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