The Impact of the Kyoto Protocol on U.S. Economic Growth
and Projected Budget Surpluses

EXECUTIVE SUMMARY

Macroeconomic Effects of CO₂ Emissions Limits Are Significant. A wide range of economic models predict that reducing U.S. carbon dioxide (CO₂) emissions to either 1990 levels or to the Kyoto target (7 percent below 1990 emission levels) would reduce U.S. GDP and slow wage growth significantly, worsen the distribution of income, and reduce growth in living standards. If the United States is not able to take advantage of "where" flexibility (reducing emissions wherever it is cheapest globally) through international emissions trading to meet the Kyoto target, the cost in terms of lost output will range from about 1 percent to over 4 percent of GDP.

In addition, near-term emissions reductions would reduce U.S. competitiveness in energy-intensive manufacturing industries as well as in agriculture. Meeting the Kyoto emission targets would make it much more difficult to sustain tax cuts or "save" social security, and could require sharp changes in fiscal policy to avoid deficit spending.

The Administration's Analysis Is Questionable. The Administration's estimates of economic damage from CO₂ emission reductions are far below those of other models due to unrealistic assumptions that global trading of emissions will be available in the near term and that developing countries will participate, and the use of an economic model (SGM) which appears to assume costless capital adjustments to energy price changes.

International Emissions Trading Issues Are Major. Emissions trading could substantially reduce the cost of complying with the Kyoto targets, especially if developing countries participate. Major obstacles to trading include securing developing country participation, allocating CO₂ emissions rights, and distributing the resulting revenue.

Conclusion: Kyoto Approach Isn't the Answer. U.S. goals in international climate policy meetings should include finding ways to involve developing countries in emissions reduction, clarifying flexible mechanisms, and avoiding trading caps. Voluntary measures to reduce U.S. CO₂ emissions should include modifications to U.S. tax policy that reduce the cost of capital for energy-efficient investment. Moreover, the introduction of carbon capture and sequestration techniques from central power facilities, soil sequestration, and reforestation could radically change both the cost and character of carbon mitigation. Adopting a thoughtfully timed climate change policy-based on science, improved climate models, and global participation-is essential, both to U.S. and global economic growth and to the eventual stabilization of carbon concentrations in the atmosphere.

ACCF TESTIMONY

Introduction

My name is Margo Thorning. I am Senior Vice President and Chief Economist of the American Council for Capital Formation (ACCF).

The ACCF represents a broad cross-section of the American business community, including the manufacturing and financial sectors, Fortune 500 companies and smaller firms, investors, and associations from all sectors of the economy. Our distinguished board of directors includes cabinet members of prior Republican and Democratic administrations, former members of Congress, prominent business leaders, and public finance and environmental policy experts.

The ACCF is now celebrating its 26th year of leadership in advocating tax, regulatory, environmental, and trade policies to increase U.S. economic growth and environmental quality.
We commend Chairman Murkowski and the Senate Committee on Energy and Natural Resources for their focus on the impact of climate change policy on U.S. economic growth and the goals U.S. policymakers and legislators should seek to further at future international climate policy meetings and in congressional debate.

My testimony begins with a review of the macroeconomic consequences of limiting CO₂ emissions and purportedly stabilizing CO₂ concentrations. It includes information from several analyses sponsored by the ACCF Center for Policy Research, the public policy research affiliate of the American Council for Capital Formation. These studies, some of which were released at the Center's 1998 symposium, Climate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality, describe the economic costs of near-term limitations on U.S. carbon emissions, the impact of emissions limits on the growth of the capital stock, as well as suggest tax incentives for voluntary actions to encourage the purchase of energy-efficient equipment to reduce CO₂ emissions. (The conference volume containing the Center's studies will be published in early April. I would like to request that it be included in the record of this hearing. Summaries of the studies in the Center's forthcoming volume are available on our Web site, www.accf.org.) I also discuss issues related to long-term options for reducing CO₂ concentrations, and topics that need to be considered at future international climate policy meetings. Finally, strategies for a cost-effective, long-term approach to CO₂ stabilization are presented.

Macroeconomic Effects of CO₂ Emission Limits

The Kyoto Protocol to the United Nations Framework Convention on Climate Change, which the United States negotiated in December, 1997, calls for industrial economies such as the United States, Canada, Europe, and Japan (called Annex I or Annex B countries) to reduce their collective emissions of six greenhouse gases by an average of 5.2 percent from 1990 levels by 2008-2012. The U.S. target is a 7 percent reduction from 1990 levels; this amounts to a projected 550 million metric ton cutback in CO₂ emissions relative to the projected amount in 2010, or about a 30 percent reduction in emissions compared to the U.S. Department of Energy's baseline forecast. Many experts believe that the Kyoto agreement has potentially serious consequences for all Americans, and that these consequences have not been fully analyzed and understood.

Research conducted over the past decade for the ACCF Center for Policy Research by top climate change scholars such as Professor Gary W. Yohe of Wesleyan University, Dr. Lawrence M. Horwitz of Primark Decision Economics, Senior Vice President Mary H. Novak of WEFA, Inc., Professor Richard Schmalensee of the Massachusetts Institute of Technology, Professor Alan S. Manne of Stanford University, Dr. Richard Richels of EPRI, Dr. W. David Montgomery of Charles River Associates (CRA), and Dr. Joyce Brinner of Standard & Poor's DRI (DRI), and others, concludes that the cost of reducing CO₂ emissions in the near term would impose a heavy burden on U.S. households and industry. These studies, as well as the Department of Energy's Energy Information Administration (EIA) report released in October, 1998, stand in sharp contrast to the optimistic projections contained in the Administration's economic analysis prepared by the Council of Economic Advisers, released in July, 1998.

• Impact on GDP
  
  A wide range of models predict that reducing U.S. CO₂ emissions to either the Kyoto target (7 percent below 1990 emission levels) or to 1990 levels (the pre-Kyoto target) would reduce U.S. GDP significantly. As CO₂ emissions are reduced, economic growth would slow due to lost output as prices rise for carbon-using goods-goods that must be produced using less carbon and/or more expensive processes.
  
  In dollar terms, estimates show that near-term stabilization at the Kyoto Protocol target of 7 percent below 1990 levels would reduce U.S. GDP by about 1 percent to over 4 percent annually (see Figure 1). This translates into annual losses of $100 billion to almost $400 billion (in inflation-adjusted dollars) in GDP each year compared to the baseline forecast for energy use (see Figure 2).
  
  
  

  Figure 1	Impact of Reducing U.S. CO2 Emissions on U.S. GDP, 2008-2012 Compared to the baseline forecast

  Figure 2	Annual Real GDP Losses From Reducing CO2 Emissions, 2008-2012 Billions of inflation adjusted dollars

  
  
  
• Impact on Net Capital Stock
  
  Output would also fall because of slower net capital accumulation, reflecting the premature obsolescence of capital equipment due to sharp energy price increases. It takes an average of 20 years to "turn over" or replace the entire U.S. capital stock. Thus, meeting the Protocol's 2008-2012 timetable for reducing emissions would mean either continuing to utilize plant and equipment designed to use much cheaper energy, or replacing the capital stock much more rapidly than its owners had planned.
  
  Although the short-term outlook for the U.S. economy suggests continued growth, long-term strength and economic stability require that we carefully consider the impact of the Kyoto Protocol on the ability of U.S. business to raise enough capital to invest so that we can remain competitive in both domestic and global markets as well as further our environmental goals. Unfortunately, investment spending in the United States in recent years compares unfavorably with that of other nations as well as with our own past experience. From 1973 to 1996, gross nonresidential investment as a percent of GDP was lower for the United States than for any of our major competitors, according to data from the Organization for Economic Cooperation and Development. The U.S. net saving rate during the same period is also low relative to that of most other industrialized countries, averaging 6 percent compared to an average of 10 percent in several other major industrial countries. International comparisons aside, even more disturbing is the fact that net business investment in this country has in recent years fallen to less than 60 percent of the level of the 1960s and 1970s. Net private domestic investment averaged 8.9 percent of GDP from 1960 to 1980; since 1991, it has averaged only 6 percent (see Table 1).

Table 1	Flow of U.S. Net Saving and Investment Percent of GDP in current dollars; national income accounts basis
	Average 1960-1980	Average 1981-1985*	Average 1980-1990	Average 1991-1998**
Net private domestic saving	8.1%	8.0%	7.0%	5.5%
Net private domestic investment	8.9%	7.4%	7.2%	6.0%
*From 1981 through 1985, the Economic Recovery Tax Act of 1981 provided the United States with the equivalent of expensing (first year write-off) for new investment in plant and equipment. **Through third quarter 1998.
Source: Department of Commerce Bureau of Economic Analysis, National Income Accounts. Update prepared by American Council for Capital Formation Center for Policy Research, March 22, 1999.

If the United States were to ratify the Kyoto Protocol or require sharp near-term emission reductions through "back door" implementation of the treaty through regulatory mechanisms, U.S. capital formation and productivity growth would be seriously impacted. Though the U.S. economy is currently performing better than the economies of most other developed nations, in the long run our low saving and investment rates will inevitably result in a growth rate far short of our true potential.

• Tax Policy to Encourage Voluntary Action to Reduce CO₂ Emissions
  
  Current U.S. tax policy treats capital formation, including investments that increase energy efficiency and reduce pollution, harshly compared to other industrialized countries and to our own recent past. For example, before the 1986 Tax Reform Act (TRA '86), the United States had one of the best capital cost recovery systems in the world. The present value of the deductions for investing in machinery to produce engine blocks and modern competitive continuous casting equipment for steel production were close to 100 percent (meaning that the deductions were the equivalent of an immediate write-off of the entire cost of the equipment) under the strongly pro-investment tax regime in effect from 1981 to 1985, according to a study by Arthur Andersen LLP. In contrast, under current law the present value of the capital cost recovery allowance for that same investment is only 80.8 percent (see Table 2).

Table 2	International Comparison of the Present Value of Equipment Used to Make Selected Manufacturing Products and Pollution Control Equipment As a percent of cost
	Computer Chips	Telephone Switching Equipment	Factory Robots	Crank- shafts	Continuous Casting for Steel Production	Engine Blocks	Wastewater Treatment for Chemical Production	Wastewater Treatment for Pulp and Paper Equipment	Scrubbers Used in Electricity Plants
United States
1985 Law	100.1	100.1	100.1	100.1	100.1	100.1	100.1	100.1	89.7
MACRS1	85.2	85.2	80.8	80.8	80.8	80.8	85.2	80.8	54.5
AMT2	83.0	83.0	77.9	77.9	77.9	77.9	83.0	78.0	54.5
Brazil	75.7	74.8	74.7	74.7	88.3	74.7	74.7	74.7	79.4
Canada	76.9	75.9	74.0	73.8	74.2	73.6	85.3	85.3	85.3
Germany	83.6	83.0	82.7	83.9	82.2	83.9	71.8	69.7	68.9
Japan	87.1	86.2	83.4	83.9	81.4	83.7	84.6	83.7	82.4
Korea (w/3% ITC)	88.7	84.3	82.6	80.1	77.7	79.6	95.2	93.9	92.2
Singapore	91.7	91.7	91.7	91.7	91.7	91.7	91.7	91.7	91.7
Taiwan	83.9	78.0	79.0	64.3	63.5	63.7	147.0	147.0	147.0
Notes: 1. MACRS = Modified Accelerated Cost Recovery System (current law) for regular taxpayers. 2. AMT = Alternative minimum tax (current law, Taxpayer Relief Act of 1997). Source: Stephen R. Corrick and Gerald M. Godshaw, "AMT Depreciation: How Bad Is Bad?" in Economic Effects of the Corporate Alternative Minimum Tax (Washington, D.C.: American Council for Capital Formation Center for Policy Research, September 1991). Updated by Arthur Andersen LLP, Office of Federal Tax Services, Washington, D.C., January 1998.

The Arthur Andersen study also shows that the United States lags behind many of our major competitors in capital cost recovery for equipment that is technologically innovative, is crucial to U.S. economic strength, or helps prevent pollution. Capital cost recovery provisions for pollution-control equipment are much less favorable now than prior to TRA '86's passage. For example, the present value of cost recovery allowances for wastewater treatment facilities used in pulp and paper production was approximately 100 percent before TRA '86. Under TRA '86, the present value for wastewater treatment facilities dropped to 81 percent. Allowances for scrubbers used in the production of electricity were 90 percent before TRA '86; the present value fell to 55 percent after TRA '86. As is true in the case of productive equipment, both the loss of the investment tax credit and the lengthening of depreciable lives enacted in TRA '86 raised effective tax rates on new investment in pollution control and energy-efficient equipment. Slower capital cost recovery means that equipment embodying new technology and energy efficiency will not be put in place as rapidly as it would be under a more favorable tax code.

While the Taxpayer Relief Act of 1997 substantially improved cost recovery allowances for corporate alternative minimum tax (AMT) payers, those firms are still disadvantaged relative to firms paying the regular corporate income tax. Providing a variety of tax incentives such as partial expensing, accelerated depreciation, tax exempt bond financing, or more generous loss carrybacks that reduce the cost of capital for voluntary efforts to reduce CO₂ emissions could be more effective than the "credit for early action" proposal currently before Congress.

• Impact on U.S. Budget Surpluses and Retirement Security
  
  In light of the current debate about how to use the projected federal budget surpluses, policymakers need to consider the potentially large negative impact on GDP growth and federal budget receipts of proposals that address the potential threat of global warming by requiring sharp, near-term cutbacks in CO₂ emissions. As described above, estimates provided by various academic, private-sector, and EIA modelers show that requiring the United States to reduce CO₂ emissions to 7 percent below 1990 levels by 2008-2012 (the EIA projects U.S. CO₂ emissions will be 40 percent above this target by 2010) would reduce GDP growth in the range of 1 to 4 percent per year (see Figure 1). Using a simple calculation based on the relationship of increases in GDP in federal tax receipts, if growth falls by 3 percent per year, the projected on-budget surplus in 2008 would decline from $143 billion to $33 billion; the surplus in 2009 would fall from $164 billion to $50 billion. Therefore, implementation of the Kyoto Protocol would make it much more difficult to sustain tax cuts, "save" social security, or promote the retirement security of the baby boom generation, and could require sharp changes in fiscal policy in order to avoid deficit spending. These budgetary impacts should be considered as policymakers shape the U.S. response to the potential threat of climate change. (Attached is a copy of the letter I sent to Chairman Domenici addressing this issue.)
  
  
• Importance of International Emissions Trading
  
  A major determinant of the cost of curbing emissions is whether the United States can purchase permits from abroad where emissions can be reduced at a lower cost than in the United States. In the absence of an international trading system, the United States would be forced to curb its own CO₂ emissions by over 30 percent within 10 years. This gap between projected emissions and the Kyoto target will continue to grow.
  
  If the United States is not able to take advantage of "where" flexibility (reducing emissions wherever it is cheapest globally) by using international emissions trading to meet the Kyoto target, the cost in terms of lost output ranges from about 1 percent of GDP, according to a new study by Professor Alan Manne and Dr. Richard Richels, to 4.2 percent of GDP as estimated by EIA (see Figure 1).
  
  Full global trading in emissions, meaning that developing nations such as China, India, and Brazil are participating and reducing their emissions, could reduce costs to 0.25 percent of GDP, according to the Manne/Richels study. Most policy experts, including Professor Manne and Dr. Richels, doubt that these developing countries can be induced to participate in the foreseeable future. Limited trading schemes (involving only Annex I and Eastern Europe) which most experts believe are realistic, would cut U.S. GDP growth by between 0.9 percent annually, according to Dr. W. David Montgomery of CRA and Professor John Moroney of Texas A&M University, and 1.6 percent annually as estimated by Dr. Joyce Brinner of DRI. The Administration's estimated loss of 0.01 percent of GDP, which assumes full global trading, is far below the costs predicted by many academic and private climate policy experts (see Figure 1).
  
  In dollar terms, U.S. GDP losses from either meeting the Kyoto target or restraining emissions to 1990 levels range from about $87 billion (Manne/Richels) to $378 billion (EIA) annually if international trading is not possible. While the dollar amounts in Figure 2 use slightly different base years and thus are not precisely comparable, these model results provide an approximation of the amount of goods and services that the United States would have to forego in order to meet the Kyoto emissions targets.
  
  Real-dollar GDP losses are much less when international trading occurs, with most estimates ranging from around $21 billion annually (Manne/Richels, with full global trading) to $111 billion (Dr. Montgomery, with limited international trading). At $1 billion annually, the Administration cost estimate is far below other models' predictions.¹
  
  
• Cost of Tradable Permits
  
  Another measure of the burden that near-term reduction of emissions would place on the U.S. economy is the cost of a tradable permit to emit a metric ton of carbon. Under a permit system, permits would trade at the marginal cost of abatement. (Carbon taxes could be imposed instead of tradable permits; there should, in principle, be no difference in the energy prices under the two alternative systems.)
  
  If international trade in permits is not allowed, the cost of a permit to meet the Kyoto target varies from a low of $240, according to Professor Manne and Dr. Richels, to a high of $348 per metric ton, as estimated by EIA (see Figure 3).

Figure 3	Cost of Tradable Permits Required to Reduce Emissions, 2008-2012 Dollars per metric ton

When trading among Annex I countries is allowed, the cost of a permit under the Kyoto target varies from about $120 per metric ton (CRA) to $180 according to Dr. Brinner (DRI).

The Administration's estimated permit price of $14, which rests on the unrealistic assumption of full global trading, lies far below all other estimates.



• Impact on Energy Costs
  
  Cutting back emissions requires raising energy prices in order to reduce demand. According to most models, U.S. households and businesses would face sharply higher costs for gasoline and electricity. Prices for gasoline under the Kyoto emissions target would increase by as much as 53 percent and electricity prices would go up by 86 percent in the EIA projection (see Figure 4). When Annex I trading is allowed, prices go up a bit less sharply, according to other policy experts. For example, the DRI estimates show a 29 percent price increase for gasoline and a 54 percent increase for electricity prices.

Figure 4	U.S. Household Energy Costs: Impact of Reducing CO2 Emissions, 2008-2012 Percent change from base case

Again, the Administration's estimates of cost increases for energy (2.7 percent for gasoline and 3.4 percent for electricity) are far below those of other models, including those of EIA.



• Impact on Employment, Consumption, Income Distribution, and Living Standards
  
  Policies to curb emissions to meet the Kyoto target would have a significant impact on U.S. households' economic wellbeing and living standards, as well as negatively affect the distribution of income. For example, estimates of job losses range from 1.3 million (Brinner/DRI) to 2.4 million (Novak/WEFA) by 2010. Consumption by U.S. households falls by over 2 percent under the Kyoto emissions target, according to DRI.
  
  Curbing CO₂ emissions would also reduce wage growth by 5 to 10 percent, according to Professor Yohe. Moreover, it would worsen the distribution of income in the United States, according to the analyses of both Professor Yohe and Ms. Novak. For example, based on a standard measure of the degree of income inequality among a country's population called the GINI coefficient, Professor Yohe's analysis of the impact of reducing emissions to 1990 levels shows that carbon taxes, even when recycled through personal income tax reductions, cause relatively large losses in the poorest quintile (lowest one-fifth of the population). These losses, added to modest losses in the middle quintiles, provide gains for the richest fifth of the population (see Figure 5).

Figure 5	Impact of Reducing CO2 Emissions to 1990 Levels by 2010 on U.S. Household Income by Quintile
Note: A $260 per ton tax or tradable permit price of that amount would be needed to reduce emissions to 1990 levels by 2010 if emission reductions begin in 1997 or 1998. The analysis assumes the tax is rebated through reductions in the personal income tax. Source: "Climate Change Policies, the Distribution of Income, and U.S. Living Standards" by Gary W. Yohe, in Climate Change Policy, Risk Prioritization, and U.S. Economic Growth (Washington, D.C.: American Council for Capital Formation Center for Policy Research, June 1997), pp. 13-54.

An analysis by Professor Moroney of Texas A&M University (forthcoming in the Center's new volume) concludes that meeting the targets of the Kyoto Protocol would significantly slow the growth in U.S. living standards. His study shows that the 1.3 percent annual growth in energy per worker in the United States would become a 1.8 percent annual decrease (required by the Kyoto Protocol), thereby cutting productivity growth from 2 percent annually to only 1.1 percent.

The difference between projected productivity growth of 1.1 percent under the Kyoto Protocol and 2 percent without it implies major differences in U.S. living standards by 2010, Professor Moroney states. With productivity growth of 1.1 percent per year, U.S. living standards would be 17 percent higher in 2010 than in 1996. But with productivity growth of 2.0 percent per year, living standards would be 32 percent higher in 2010. Professor Moroney concludes that a 1.8 percent annual reduction in energy per capita required by the Kyoto Protocol would lead to U.S. living standards that are 15 percent lower in 2010 than they would be with no restrictions on energy use.

• U.S. Competitiveness for Energy-Intensive Sectors
  
  Several studies, including those by University of Colorado Professor Thomas Rutherford, DRI's Dr. Brinner, and WEFA's Ms. Novak, have concluded that near- term emission reductions would result in carbon leakage and the migration of energy- intensive industry from the United States to non-Annex I countries.
  
  Most recently, Professor Manne and Dr. Richels analyzed this question. Their model results suggest that the Kyoto Protocol could lead to serious competitive problems for energy-intensive sector (EIS) producers in the United States, Japan, and OECD Europe (see Figure 6). Meeting the emissions targets in the Protocol would lead to significant reductions in output and employment among EIS producers, and there would be offsetting increases in countries with low energy costs. U.S. output of energy-intensive products such as autos, steel, paper, and chemicals could be 15 percent less than under the reference case by 2020 (1.0 in Figure 6 is the reference or base case). In contrast, countries such as China, India, and Mexico would increase their output of energy-intensive products. In its present form, the Protocol could lead to acrimonious conflicts between those who advocate free international trade and those who advocate a low- carbon environment, Professor Manne and Dr. Richels conclude.

Figure 6	Kyoto With Leakage: Ratios of Domestic Energy-Intensive Sector Supplies to Demands
Source: Alan S. Manne and Richard G. Richels, "Economic Impacts of Alternative Emission Reduction Scenarios" (Washington, D.C.: American Council for Capital Formation Center for Policy Research, October 1998).

A recent DRI analysis reaches similar conclusions about the Kyoto Protocol's impact on U.S. competitiveness. The DRI study concludes that coal mining, electric utilities, petroleum refining, natural gas, and railroads would suffer sharp declines in demand. Energy-intensive industries such as cement, chemicals, and iron and steel would also face sharp price increases that would depress domestic demand and encourage imports.



• Impact on Agriculture
  
  U.S. agriculture would also lose competitiveness if the United States complied with the Kyoto Protocol. Another study based on the DRI model predicts that implementation of the Protocol would cause higher fuel oil, motor oil, fertilizer, and other farm operating costs. This would mean higher consumer food prices and greater demand for public assistance with higher costs. In addition, by increasing the energy costs of farm production in America while leaving them unchanged in developing countries, the Kyoto Protocol would cause U.S. food exports to decline and imports to rise. Reduced efficiency of the world food system could add to a political backlash against free trade policies at home and abroad. Further, "the higher energy costs," noted the DRI report "together with the reduced domestic and export demand, could lead to a very severe decline in investment in agriculture, and a sharp increase in farm consolidation. Small farm numbers likely would decline much more rapidly than under baseline conditions, while investment even in larger commercial farms likely would stagnate or decline."²
  
  A new report (November 1998) by CRA also concludes that U.S. agriculture would be harshly affected by the Kyoto Protocol. The CRA study predicts that agricultural sales would decline by 5 to 10 percent compared to the baseline forecast.
  
  The Administration's analysis of the impact of the Kyoto emissions targets on U.S. competitiveness differs significantly from those of Professor Manne and Dr. Richels, DRI, WEFA, and others. In its July, 1998, analysis, the Administration notes that "evaluating how the Kyoto Protocol could affect competitiveness of a few specific manufacturing industries-especially those that are energy-intensive, such as aluminum and chemicals-is complex. However, the modest energy price effects associated with permit prices of $14 per ton to $23 per ton would likely have little impact on competitiveness."³ This also appears to contradict earlier observations by the CEA in its 1998 Economic Report of the President .⁴

An Evaluation of the Administration's Analysis

Because the scale of U.S. CO₂ emissions reductions mandated by the Kyoto Protocol is quite large (a 30 percent reduction from baseline forecasts of CO₂) and, as described above, would have a potentially quite significant impact on U.S. economic growth and living standards, a careful look at the Administration's analysis is warranted. The data on GDP growth, tradable permit prices, and energy costs shown in Figures 1-4 demonstrate that the Administration's estimates of economic damage from the CO₂ emission reductions are far below those of other models (including those of EIA).

The Administration's July, 1998, economic analysis of the impact of reducing CO₂ emissions to 7 percent below 1990 levels is seriously flawed for three reasons:

• The Administration (CEA)'s cost estimates assume full global trading in tradable emissions permits (including trading with China and India). Most top climate policy experts conclude that this assumption is extremely unrealistic since the Protocol does not require developing nations to reduce their emissions and many have stated that they will not do so.
  
  
• The Administration (CEA)'s cost estimates assume that an international CO₂ emissions trading system can be developed and operating by 2008-2012. This assumption is unrealistic, according to MIT Professor A. Denny Ellerman's analysis (see discussion below in "Obstacles to Trading").
  
  
• The cost estimates are based on the Second Generation Model (SGM) developed by Pacific Northwest National Laboratory. The SGM appears to assume cost-less, instantaneous adjustments in all markets; the model is not appropriate for analyzing the Protocol's near-term economic impacts, according to Dr. Montgomery. As Massachusetts Institute of Technology Professor Henry Jacoby observes, contrary to the Department of Energy's "Five-Labs" study of technology options, there are no short-term technical changes that would significantly lower U.S. carbon emissions (see analysis in forthcoming Center volume).

International Emissions Trading: Benefits and Obstacles

• The Importance of Trading.
  
  The powerful effect from the international trading of CO₂ emissions in reducing costs was discussed briefly above. The new Manne/Richels study uses their model, MERGE, to calculate the cost-savings provided by international trade in emissions permits. They explore three options that are representative of alternative implementations of the Kyoto Protocol: 1) no trading; 2) Annex I trading plus the Clean Development Mechanism (CDM); and 3) full global trading. Each option has its own advocates and opponents, but Manne and Richels do not consider them equally likely. In their opinion, there is little likelihood of enticing all major countries to participate in a global market in emissions rights during the initial commitment period (2008-2012). The full global trading scenario places an upper bound on the CDM's potential to reduce GDP loses. Figure 7 shows the incremental value (cost) of carbon emissions rights to the United States in 2010 and 2020. In the most constrained scenario, no trading, the United States must satisfy its emissions reduction requirements within its own geographical boundaries. In this case, the value of emissions rights approaches $240 per ton in 2010. With Annex I trading plus CDM, the cost drops to slightly less than $100 per ton. As might be expected, the cost of emissions rights is lowest with full global trading, falling to below $70 per ton. For the two scenarios in which trading is permitted, the value (cost) of emissions rights increases in 2020. This is because the projected emissions of Eastern Europe and the former Soviet Union (EEFSU) lie below their negotiated constraint for 2010. They have been allocated more emissions rights than needed to satisfy their internal obligations. By 2020, however, EEFSU's economic growth is expected to be such that it no longer enjoys an excess of emissions rights. As a result, there is more competition for emissions rights in the international marketplace, and their permit prices rise.

Figure 7	Incremental Value of Carbon Emissions Rights in the United States Under "Kyoto Forever"
Source: Alan S. Manne and Richard G. Richels, "Economic Impacts of Alternative Emission Reduction Scenarios" (Washington, D.C.: American Council for Capital Formation Center for Policy Research, October 1998).

• Obstacles to Trading
  
  There are several issues that must be resolved before an international system of tradable permits can be developed. Among the most difficult are:
  
  Developing international participation. As noted earlier, the Kyoto Protocol does not require developing country participation; without their involvement, however, there can be little progress toward reducing global emissions and concentrations of CO₂. Most climate policy experts are very skeptical about enticing the major developing countries to participate over the 2008-2012 period.
  
  Allocating CO₂ emission rights and distributing revenue. MIT Professor Ellerman points out in his study (forthcoming in the Center's new volume) that there are two issues that must be resolved in order to develop a trading system for CO₂. First, we must decide how to allocate carbon trading permits. Today, most people-and certainly economists-trust markets more than governments, and auctioning off tradable permits is one way to allocate access to the carbon sink.
  
  Second, we must decide what to do with the revenue, or rents. There are two problems with any trading program that involves large amounts of revenue. In the first place, most people do not have any more faith in a government's ability to distribute rents (monopoly profits) optimally than they have in a government's ability to allocate use-a suspicion that gave rise to the auction in the first place. Even to those who participate, the auctioning of permits takes on the appearance of a disguised tax. The other and more fundamental problem is the assumption that a government owns the rights that are to be auctioned off. The inconvenient fact is that these incipient rights are possessed de facto by existing emitters and actively exercised by them. From their point of view, the auction is not just a tax in disguise, it is confiscation of rights established by time-hallowed use, Professor Ellerman states. In a society that seeks to be just and equitable in dealing with its citizens, CO₂ emitters have a legitimate claim to compensation. Resolving issues such as these will take considerable time and may preclude the establishment of an international (or even domestic) trading system in the near term, he concludes.
  
  
• Decisions Required to Achieve Emission Reductions
  
  Presuming that answers have been found to allocating permits and distributing the rents they create, other issues must be resolved before an international trading system could be developed. For example, as Dr. David Harrison of National Economic Research Associates states in the Center's forthcoming volume, a goal for long-term concentrations of CO₂ in the atmosphere has not yet been established. Without that goal in mind, determining a price for the right to emit carbon will be difficult. Moreover, no international body exists that could verify emissions reductions in individual countries, Finally, there is the question of how to enforce individual countries' commitments to reduce their CO₂ emissions and how to maintain their participation in the program as circumstances change in response to economic fluctuations or other causes.

U.S. Objectives in International Meetings

The analyses I have summarized today strongly suggest what our nation's primary objectives should be in congressional considerations as well as in future international meetings.

• First, find ways to involve developing countries in substantive emissions reductions. They would undoubtedly require funding from developed countries in order to induce them to reduce CO₂ emissions. Securing such funding would be difficult.
  
  
• Second, clarify flexible mechanisms. The Kyoto Protocol contains mechanisms, including Joint Implementation, the CDM, and emissions trading, to reduce the cost of emission reductions. The role of the developed countries, who would be paying the bills, needs to be made more transparent as the details are decided. In addition, rules of ownership, enforcement, and sanctions must be defined.
  
  
• Third, reject trading caps. Ceilings on the amount of CO₂ emissions reductions that can be purchased abroad should be avoided so that the cost of emissions reduction and stabilization is minimized.
  
  
• Fourth, be realistic about CO₂ concentration targets. As the Manne/Richels paper documents, it is extremely likely that a "Kyoto Forever" scenario will not stabilize concentrations. Non-Annex I emissions are quickly overtaking those of the OECD and the economies in transition (see Figure 8). Hence, meeting the ultimate concentration goal of the Framework Convention would eventually require the participation of developing countries. In addition, Professor Manne and Dr. Richels observe that the Kyoto Protocol appears inconsistent with a cost-effective long-term strategy for stabilizing CO₂ concentrations. Moreover, their study shows that allowing flexibility as to when CO₂ emission reductions occur yields greater benefits at lower cost than the emissions path specified by the Kyoto Protocol. In short, "when" flexibility requires a longer time period than the Kyoto Protocol timetable to accommodate both capital and technology realities.

Figure 8	Global Carbon Emissions: Reference Case
Source: Alan S. Manne and Richard G. Richels, "Economic Impacts of Alternative Emission Reduction Scenarios" (Washington, D.C.: American Council for Capital Formation Center for Policy Research, October 1998).

Conclusion

Mr. Chairman and Members of the Committee, I would like to conclude by directing your attention to economic and environmental analyses that provide ample guidance on how best to balance environmental and economic considerations when formulating climate mitigation policy. Above all, experts agree that voluntary measures clearly and cost-effectively reduce the growth in greenhouse gas emissions, as the U.S. Second National Communication to the Framework Convention on Climate Change noted in 1997. Modifications to U.S. tax policy that reduce the cost of capital for energy-efficient investment should be part of the voluntary measures. Also, reducing global CO₂ emissions should be a gradual process, according to Pacific Northwest National Laboratory's Dr. Jae Edmonds, Mr. Jim Dooley, and Mr. Marshall Wise. Moreover, a new study by Dr. Edmonds, Mr. Dooley, and Dr. Sonny Kim (forthcoming in the ACCF Center for Policy Research's new volume) concludes that the introduction of carbon capture and sequestration from central power facilities, the introduction of hydrogen fuel cells as an option for both power generation and transport, sequestration of carbon in the soil, and afforestation and reforestation would enable the economy to rely less heavily on carbon-neutral technologies such as commercial biomass harvesting and solar power (which are at an early stage in their technological development) to achieve a particular concentration level. For example, carbon sequestration at power plants and fuel cell use for electric power generation and transportation could cut the present discounted cost of satisfying the 550 parts per million by volume (ppmv) constraint by more than 60 percent. In fact, if all the potential sequestration options discussed above were combined, costs for keeping under the 550 ppmv ceiling could be reduced by more than 70 percent (see Figure 9).

Figure 9	Effect of Carbon Capture and Sequestration Technologies on the Cost of Meeting Alternative CO2 Concentration Constraints
Source: Jae Edmonds, Jim Dooley, and Sonny Kim, "Long-Term Energy Technology: Needs and Opportunities for Stabilizing Atmospheric CO2 Concentrations" (Washington, D.C.: American Council for Capital Formation Center for Policy Research, October 1998).

In short, the consensus of these noted climate policy scholars is clear. Given the need to maintain strong U.S. economic growth to address such challenges as a growing population, "saving" social security, the retirement of the baby boom generation, and a persistent trade deficit, policymakers need to weigh carefully the Kyoto Protocol's negative economic impacts and its failure to engage developing nations in meaningful action. Adopting a thoughtfully timed climate change policy--based on science, improved climate models, and global participation--is essential, both to U.S. and global economic growth and to the eventual stabilization of carbon concentrations in the atmosphere.

Endnotes

1. Council of Economic Advisers, The Kyoto Protocol and the President's Policies to Address Climate Change: Administration Economic Analysis, July 1998, p. 59.

2. Sparks Companies Inc., "United Nations Kyoto Protocol-Potential Impacts on U.S. Agriculture," October, 1998.

3. Council of Economic Advisers, The Kyoto Protocol and the President's Policies to Address Climate Change: Administration Economic Analysis, July 1998, p. 72.

4. Council of Economic Advisers, Economic Report of the President, February 1998, p. 172.

Sources

Bernstein, Paul M., and W. David Montgomery. 1998. How Much Could Kyoto Really Cost? A Reconstruction and Reconciliation of Administration Estimates. Washington, D.C.: Charles River Associates.

Bernstein, Paul M., W. David Montgomery, Gui Fang Yang, Thomas F. Rutherford, and James L. Sweeney. 1998. International Trade and Industry Impacts of the Kyoto Protocol. Washington, D.C.: The Business Roundtable.

Brinner, Joyce Y. Forthcoming. Commentary: The Impact of Meeting the Kyoto Protocol on Energy Markets and the Economy. In Climate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Corrick, Stephen R., and Gerald M. Godshaw. 1991. AMT Depreciation: How Bad Is Bad? In Economic Effects of the Corporate Alternative Minimum Tax. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Climate Action Report. 1997. Second national communication submitted to the Framework Convention on Climate Change by the United States. Washington, D.C.: Department of State.

Council of Economic Advisers. 1998. The Kyoto Protocol and the President's Policies to Address Climate Change: Administration Economic Analysis. July.

Council of Economic Advisers. 1998. Economic Report of the President. Washington, D.C.: U.S. Government Printing Office.

Edmonds, Jae, Jim Dooley, and Sonny Kim. Forthcoming. Long-Term Energy Technology: Needs and Opportunities for Stabilizing Atmospheric CO₂ Concentrations. In Climate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Edmonds, Jae, James Dooley, and Marshall Wise. 1997. Atmospheric Stabilization and the Role of Energy Technology. In Climate Change Policy, Risk Prioritization, and U.S. Economic Growth, 73-94. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Ellerman, A. Denny. Forthcoming. Obstacles to Global CO₂ Trading: A Familiar Problem. In Climate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Francl, Terry, Richard Nadler, and Joseph Bast. 1998. The Kyoto Protocol and U.S. Agriculture. Heartland Policy Study No. 87. Chicago: The Heartland Institute.

Harrison, David, Jr. Forthcoming. Commentary: International Greenhouse Gas Trading and the Kyoto Protocol. In CClimate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Horwitz, Lawrence M. 1996. The Impact of Carbon Taxes on Consumer Living Standards. In An Economic Perspective on Climate Change Policies, 119-157. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Jacoby, Henry D. Forthcoming. The Uses and Misuses of Technology Development as a Component of Climate Policy. In Climate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Manne, Alan S. and Richard G. Richels. Forthcoming. The Kyoto Protocol: A Cost-Effective Strategy for Meeting Environmental Objectives? In Climate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Montgomery, W. David. 1996. Developing a Framework for Short- and Long-Run Decisions on Climate Change Policies. In An Economic Perspective on Climate Change Policies, 15-43. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Moroney, John R. Forthcoming. Energy, Carbon Dioxide Emissions, and Economic Growth. In Climate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Novak, Mary H. 1998. Global Climate Change, Environmental Quality, and U.S. Living Standards: The Impact on Consumers. In The Impact of Climate Change Policy on Consumers: Can Tradable Permits Reduce the Cost?, 3-18. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Rutherford, Thomas. 1996. Carbon Dioxide Emission Restrictions in the Global Economy: Leakage, Competitiveness, and the Implications for Policy Design. In An Economic Perspective on Climate Change Policies, 203-222. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

Schmalensee, Richard. 1998. Tradable Emissions Rights and Joint Implementation for Greenhouse Gas Abatement: A Look Under the Hood. In The Impact of Climate Change Policy on Consumers: Can Tradable Permits Reduce the Cost?, 39-55. Washington, D.C.: American Council for Capital Formation Center for Policy Research.

U.S. Department of Energy, Energy Information Administration, Office of Integrated Analysis and Forecasting. October 1998. Impacts of the Kyoto Protocol on U.S. Energy Markets and Economic Activity. Washington, D.C.

Yohe, Gary W. 1997. Climate Change Policies, the Distribution of Income, and U.S. Living Standards. In Climate Change Policy, Risk Prioritization, and U.S. Economic Growth, 13-54. Washington, D.C.: American Council for Capital Formation Center for Policy Research.


Addendum: Text of Letter to Senator Domenici From Dr. Thorning

February 10, 1999
The Honorable Pete V. Domenici
Chairman, Committee on the Budget
United States Senate

Dear Mr. Chairman:

In light of the ongoing debate about how to use the projected budget surpluses, I would like to bring to your attention the potentially large negative impact on GDP growth and federal budget receipts of proposals that address the potential threat of global warming by requiring sharp, near-term cutbacks in CO₂ emissions.

Estimates provided by various academic, private-sector, and U.S. Department of Energy modelers show that the Kyoto Protocol, which requires the United States to reduce CO₂ emissions by 7 percent below 1990 levels by 2008-2012 (the Energy Information Administration projects U.S. CO₂ emissions will be 40 percent above this target by 2010), would reduce GDP growth in the range of 1 to 4 percent per year (see Figure 1 of the enclosed special report, "The Kyoto Protocol, Climate Change Policy, and U.S. Economic Growth"). Using a simple calculation based on the relationship of increases in GDP to increases in federal tax receipts, if growth falls by 3 percent per year, the projected on-budget surplus in 2008 would decline from $143 billion to $33 billion; the surplus in 2009 would fall from $164 billion to $50 billion. Therefore, implementation of the Kyoto Protocol would make it much more difficult to sustain tax cuts or "save" social security, and could require sharp changes in fiscal policy in order to avoid deficit spending. This should be considered in the new budget package if it deals with out-year assumptions.

Research by numerous prominent climate policy scholars, including works presented at the ACCF Center for Policy Research's 1998 forum, Climate Change Policy: Practical Strategies to Promote Economic Growth and Environmental Quality, shows that implementation of the Kyoto Protocol would have almost no impact on CO₂ emissions because developing nations such as China and India are not required to reduce emissions. Instead, these scholars urge policymakers to take advantage of "where" and "when" flexibility to reduce emissions if the science indicates it is necessary. In addition, they urge that the United States engage in research on energy-efficient technology and carbon capture and sequestration. Combining these two approaches in a long-run strategy could cut the cost of reducing CO₂ emissions by up to 70 percent and make the task of maintaining a balanced federal budget much easier.

Enclosed are summaries of several recent climate policy studies sponsored by the ACCF Center for Policy Research. I would be happy to brief you or your staff on the impact of the Kyoto Protocol on U.S. economic growth. I would also be happy to provide this information on the record before the Senate Budget Committee.

Sincerely,
Margo Thorning, Ph.D.
Senior Vice President and Chief Economist
American Council for Capital Formation