Cap and trade climate policy and U.S. economic adjustments

The purpose of this exercise is to offer an economic analysis of some of the key policy provisions currently considered for dealing with climate change. The analysis is structured to highlight those empirical and design issues that most influence policy outcomes. The overall economic impacts from a modest initiative such as described here are estimated to be small. While the aggregate costs are small and readily absorbed, there are much larger impacts at the industry level. The energy sectors - coal mining, crude oil and gas extraction, petroleum refining and electric and gas utilities - are most affected. The declines in communications, finance and services sectors are minimal while agricultural and food processing outputs actually increase. These magnitudes are heavily influenced by household consumption-saving and labor-leisure decisions. IGEM's top-down view tend to yield labor supply elasticities toward the upper end of the range observed in the empirical literature. Bottom-up approaches tend to yield estimates toward the lower end of this range. Confining IGEM to these lower elasticity estimates substantially reduces the adverse impacts of policy on all aspects of the economy, particularly, household consumption. The lack of definitive resolution in this area merits further investigation as it opens the possibility of smaller policy costs arising from less responsive household behavior. The empirical content of IGEM permits a first approximation of the effects of ITC at both the industry and macroeconomic levels. The net effect of ITC economy-wide is to reduce the economic costs of mitigation policy. Consumers, however, are ITC's main beneficiaries with nearer-term cost savings in the range of 18-22% and longer-term cost reductions in excess of 25%. The benefits from ITC materialize quickly and increase with time. The ITC effects in IGEM arise from combining policy-induced changes in relative input prices with empirically observed non-price trends in factor intensities. What is unknown is the degree to which this or any other mitigation policy influences or can be made to influence the trends and biases in innovation and the development and adoption of end-of-pipe treatments. Investment tax credits and other such market incentives, targeted to reducing greenhouse gas emissions and to promoting alternative technologies, could accelerate the realization of ITC benefits by further altering the speeds and directions of innovation along with relative prices. Bringing empirical content to the growing literature on policy- and price-ITC remains a high priority on the research agenda. The principal conclusion of this analysis concerns the limits independently placed on emissions offsets from households, small businesses, domestic sequestration and international permit purchases. These alternatives offer abatement at a lower cost than can be secured elsewhere within the activities covered by policy and so reduce the already small economic costs of mitigation policy. In the spirit of market-based incentives, the limits governing the use of marketable and verifiable abatement offsets should arise solely from their "economics" within an overall assessment of policy costs. The goal of any climate policy is to balance politically the benefits and costs of climate change and climate change policy where these are broadly defined to include both market and non-market phenomena and are measured in a variety of dimensions. Arguably, there are already private costs arising from government and business mitigation initiatives just as there are already damages associated with climate change (Smith, 2004). Some of these damages are market-based and are numerically comparable to the economic costs of climate change policy (Jorgenson et al., 2004). Policy-driven reductions in emissions will lead to lower greenhouse gas concentrations. In turn, these will have favorable impacts on climate in terms of their effects on temperatures, precipitation, storms, floods and the like. The favorable outcomes for climate produce both market and non-market benefits in the form of delayed or avoided damages. At a minimum, the market benefits help to reduce the net economic costs of environmental policy. At their best, the market benefits more than compensate policy costs and, thus, would justify timely enactment on this basis alone.