Maine Climate Change Policy: Should Cost-benefit Analysis Play a Role?

American Council for Capital Formation
By Margo Thorning, Ph.D., Vice President and Chief Economist
February 22, 2005

Testimony Before the Joint Natural Resources Committee of the 122nd Maine Legislature

EXECUTIVE SUMMARY

Cost Benefit Analysis: Scholars have made much progress over the past thirty years in understanding the economic impact of social regulation. In no small part, that progress is due to efforts to systematize knowledge, including the use of cost-benefit analysis.

First, these tools illustrate that the cost-effectiveness of government regulations can vary substantially. Second, they show that government regulation is often inefficient in the sense that it is possible to get more for less, most notably in areas of environmental quality and life-saving investments. Third, they demonstrate that a significant fraction of regulations are likely to fail a cost-benefit test based on the government's numbers and a significant fraction are likely to pass. All proposed regulation should be subjected to cost-benefit analysis.

Impact of Carbon Reductions on the U.S. Economy: The reason that the Bush Administration rejected the Kyoto Protocol approach to addressing climate change was that they had analyzed the costs of sharp, near-term emission reductions and found that the economic costs were significant. A range of credible macroeconomic models showed that reducing U.S. CO2 emissions to the Kyoto Protocol level (7 percent below 1990 levels by 2010) would reduce U.S. GDP by 2 to almost 4 percent annually.

Impact of Carbon Caps on Maine's Economy and on Employment: Analyses prepared by Charles River Associates, an internationally recognized energy modeling firm, analyzed: (1) the impact on Maine of adopting CCAP simultaneously with other northeastern states while the rest of the U.S. does not and (2) the impact of reducing CO2 emissions from the electricity sector using the targets in the CCAP proposal. Under all three scenarios, gross state product, employment and state budget receipts decline and the poor and elderly are affected more than other groups.

A Better Path Forward: Transferring technology to the developing world, where most of the growth in emissions will occur over this century, can play a major role in emission reductions. Promoting economic freedom and economic growth in the developing world can have a strong impact on reducing greenhouse gases. As countries become wealthier, their energy use becomes more efficient and they have more resources to address issues like climate change.

Conclusions: The Kyoto Protocol will inevitably be replaced by a new framework for addressing climate change: one that encourages economic freedom and economic growth that will lead to gradually reducing carbon intensity per unit of output and overall carbon emissions. This approach is likely to be much more productive than having individual states sacrifice their economic well-being and job growth to make emission reductions that are too small to affect global concentrations of GHGs.

Introduction

My name is Margo Thorning and I am pleased to present this testimony to the Joint Natural Resources Committee of the Maine Legislature.

The American Council for Capital Formation 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 celebrating nearly 30 years of leadership in advocating tax, regulatory, environmental, and trade policies to increase U.S. economic growth and environmental quality.

• Cost-Benefit Analysis as a Tool for Policy Makers

The use of cost-benefit analysis as a tool for evaluating proposed regulations is becoming more prevalent at the Federal level. For example, Dr. John Graham, now Administrator of the Office of Information and Regulatory Affairs and a former member of the American Council for Capital Formation Center for Policy Research Board of Scholars, has made extensive use of this type of analysis. As Robert W. Hahn points out in a recent report, the main reason most policy makers are turning to cost-benefit analysis is the growing cost of regulation, particularly in the area of environmental, health and safety regulation.(1) According to government estimates, the costs associated with this regulation are substantial-on the order of $200 billion for all social regulation and $40 billion for major federal regulations alone. The benefits, which are harder to pin down, may be even larger. Thus, making small or large changes in the regulatory apparatus could have significant implications for the public's health and welfare.

One approach that scholars have used to gain insight into the general impact of regulation is scorecards. These scorecards typically attempt to summarize the impact of different regulations based on a number of indicators, including costs, benefits, cost savings, lives or life-years saved, cost-effectiveness, and net benefits. In an important early article applying economic principles to regulatory analysis, John Morrall suggested that the cost effectiveness, of regulation-measured by the cost per life saved-varied over several orders of magnitude, ranging from $100,00 per life saved for steering column protection regulation to $72 billion per life saved for formaldehyde regulation. As Hahn notes, the range of cost-effectiveness across different investments in environmental and health and safety regulations has important implications for public policy. Because such investments are frequently expensive and resources are limited, regulations must be prioritized, Hahn concludes. Because of the potential economic impact of policies to address climate change on the economy and on employment, it is useful first to review studies of the costs of climate change polices for the U.S. and for the State of Maine.

• The Costs of Carbon Emission Reductions to the U.S. Economy

The reason that the Bush Administration rejected the Kyoto Protocol approach to addressing climate change was that they had analyzed the costs of sharp, near-term emission reductions and found that the economic costs were significant and the benefits (in terms of reduced global concentrations of CO2) were negligible because most of the growth in emissions is coming from developing countries. A range of credible macroeconomic models showed that reducing U.S. CO2 emissions to the Kyoto Protocol level (7 percent below 1990 levels by 2010) would reduce U.S. GDP by 2 to almost 4 percent annually (see Figure 1).

The models on which the Administration relied showed that as carbon emissions are capped or constrained, economic growth slows due to lost output as new energy taxes are imposed and prices rise for carbon-intensive goods, which must be produced using less carbon and more expensive production processes. In addition, the capital stock accumulates more slowly, reflecting the premature obsolescence of capital equipment due to the sharp energy price increases required to meet a target of reducing emissions to 93 percent of 1990 levels by 2010.

Given the quality and quantity of empirical research demonstrating that near-term targets and timetables for CO2 emission reductions would cost the U.S. jobs, economic growth and competitiveness and have no material impact on global concentrations of GHGs in the atmosphere, policymakers in individual states should consider carefully whether they want to proceed down this path alone.

• An Evaluation of the Cost versus Benefits of the "Targets and Timetables" Approach to GHG Reduction

According to scholars such as Brookings Institution economist Dr. Robert Crandall, setting targets and timetables for U.S. greenhouse gas emissions is premature. He bases this conclusion on:

-- The uncertainty about whether or the extent to which global warming is occurring; new data from climatologist and U.N. Intergovernmental Panel on Climate Change author Professor John Christy of the University of Alabama demonstrates that while surface-based measures show warming, satellite data shows little warming; and

-- The high cost of foregone investment if the United States sacrifices badly needed economic growth to reduce emissions.

In a 1999 report, Dr. Crandall observes that the economic estimates of the costs and benefits of reducing emissions to 1990 levels that are in the literature are not particularly supportive of going ahead immediately with any policy of abatement. For example, as an analysis by Brookings Institution Fellows Drs. Warwick McKibben and Peter Wilcoxen points out, the estimates of the costs of capping emissions at 1990 levels generally range from 1 to 2 percent of GDP per year, while the benefits, estimated at most to be 1/3 percent of GDP, will not arise for at least 30 to 50 years. Dr. Crandall notes that "Every dollar dedicated to greenhouse gas abatement today could be invested to grow into $150 in the next 50 years at a 10 percent social rate of return, even at a puny 5 percent annual return, each dollar would grow into $12 in 50 years. Therefore, we need to be sure that the prospective benefits, when realized, are at least 12 to 150 times the current cost of securing them. Otherwise, we should simply not act, but use our scarce resources in other ways." Moreover, the climate models generally forecast that it would require far greater reductions than a return to 1990 emissions to stabilize the climate. Dr. Crandall concludes, "We cannot justify a return to 1990 emissions based on the average estimates in the literature, no matter how efficiently it has done."

It is clear that the marginal costs of abatement in low-income societies such as China and India are substantially below those in developing countries, Dr. Crandall notes. Economists envision a marketable permits program as being global in scope. The United States, France, Japan and Germany, for example, would buy permits from China, India or Bangladesh. The latter would, in turn, reduce their CO2 or other greenhouse gas emissions by this amount over the levels that would have occurred without the permits policy in all future years. The difficulties involved in such a future program would be immense: measuring emissions from millions of sources from motor scooters to bovine animals; forecasting emission levels for the uncontrolled scenario; and finally, enforcing the reductions from these myriad sources. If enforcing nuclear nonproliferation treaties is difficult, enforcing a global greenhouse gases trading program would be incomparably more complicated.

Yale University Professor William D. Nordhaus has also analyzed the costs and benefits of CO2 emission limits. Dr. Nordhaus' research shows that the costs of even an efficiently designed emission reduction program exceed the value of environmental benefits by a ration of 7 to 1 and that the United States would bear almost two-thirds of the global cost.

Targets and timetables for emission reductions would also tend to discourage businesses and households from investing now in new equipment and processes that would reduce greenhouse gas emissions. This unfortunate result stems from the fact that tax depreciation schedules for many types of investments that could reduce CO2 emissions are very slow. Slow capital cost recovery means that investments that are deemed "risky" because of possible future emission caps face a much higher hurdle rate to gain acceptance than would an investment whose cost could be recouped immediately through expensing (first-year write-off). The prospect of emission constraints in the future will tend to retard the very type of capital expenditures that many believe would facilitate emission reductions without curtailing economic growth. The U.S. capital cost recovery system needs to be improved to allow faster write off of this type of investments (see Table 1).

• Impact of Carbon Caps on Maine's Economy and on Employment

The State of Maine has endorsed climate policy legislation modeled on the New England Governor/East Canadian Premier's agreement. This proposal would cap greenhouse gas emissions (GHGs) at 1990 levels by 2010, reduce the cap to 10% below 1990 levels by 2020, and then reduce emissions to between 75% to 85% below 2000 levels by about 2050.

Two recent analyses of the economic consequences for Maine of adopting the New England Governor/East Canadian Premier's agreement (CCAP hereafter) to reduce greenhouse gas emissions show significant negative impacts on households, workers and state budget receipts. The first analyses, prepared by Charles River Associates, (CRA), analyzed: 1) the impact on Maine of adopting CCAP simultaneously with other northeastern states while the rest of the U.S. does not and 2) the impact of reducing CO2 emissions from the electricity sector using the targets in the CCAP proposal.

• Methodology

The Charles River Associates' general equilibrium model of the U.S. economy (MRN) assumes that carbon sequestration technology could sequester carbon at $300/tonne of carbon in 2010, and this cost would decline to about $100/tonne of carbon by 2050.(2) In addition, banking of carbon permits is allowed. These assumptions of limits on the cost of reducing carbon emissions could be based on other long-term future technologies utilizing carbon-free sources of energy, but in light of current assessments carbon sequestration seems the most likely possibility.

These may be optimistic assumptions, given the current unproven status of sequestration technology and lack of agreement on how carbon dioxide can be stored safely and permanently. Therefore, costs could exceed those estimated in this study, especially in later years with particularly severe caps.

• Results of Maine and Other Northeastern States Adopting the New England Governors' Proposal

If Maine and other northeastern states (Delaware, Connecticut, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, Vermont) adopt the New England governor's proposal (CCAP), there are significant economic losses. Some industrial production in Maine (as well as the other NE states) relocates to other states where no emission limits exist. A region-wide carbon trading program (in effect a tax) ensures that the marginal cost of abatement is equalized among the 9 states but the cost of buying a permit is high: $244 per tonne of carbon in 2010, rising to $288 per tonne by 2020. Consumers in the 9 states would pay a "tax" of 61 cents in 2010 and 72 cents per gallon of gasoline in 2020 due to the requirement that businesses must buy the right to emit carbon.

Maine's household annual consumption falls by $2303 in 2010 and by $2309 in 2020, state budget receipts decline by $71 million in 2010. The poor and elderly bear much harsher burdens under the NE coalition's GHG emission reduction policies than do higher-income and younger households because they spend more of their budgets on energy. The poorest households will devote an additional 3.8% of their total expenditures on energy goods, while the wealthiest households would only dedicate an additional 1.9%. Making the same computation for the elderly (over 65 years old) and non-elderly, the CCAP policy leads to the elderly paying out an additional 3.7% of total expenditures on energy while the non-elderly's increase is less at 2.6%. Other key economic indicators, including employment, are similarly impacted (see Table 2).

• Results of Maine Reducing Greenhouse Gas Emissions From the Electricity Sector (RGGI)

In April 2003, New York Governor George E. Pataki sent letters to the 11 governors from Maine to Maryland, inviting their states' participation in discussions to develop a regional cap-and-trade program covering carbon dioxide emissions from power plants within two years. By July 2003, Governor Pataki had received positive responses from governors from the following eight states: Maine, Delaware, Connecticut, Massachusetts, New Hampshire, New Jersey, Rhode Island, and Vermont. Currently, these states participate actively in the ongoing discussions.

The results of the analysis by Charles River Associates, which uses the same methodology as the study reported above, shows that while limiting the CO2 emission reductions under the New England Governors' plan (CCAP) to electricity plants alone is less costly in terms of jobs, income and state budget receipts than when all sectors of the Maine economy are included, there are negative impacts nonetheless. For example, household income in $100 dollars less each year by 2020 and more than 230 jobs are lost (see Table 3).

The poor and elderly also bear much harsher burdens under the RGGI's carbon emission reduction policies than do higher-income and younger households because they spend more of their budgets on electricity. The poorest households will devote an additional 0.8% of their total expenditures on electricity, while the wealthiest households will only dedicate an additional 0.4%. Making the same computation for the elderly (over 65 years old), the CCAP policy leads to the elderly paying out an additional 0.8% of total expenditures on electricity while the non-elderly's increase is less at 0.5%

Putting Maine's Climate Change Plan in a Global Perspective

• What Does Implementation of the Kyoto Protocol Signify?

As Maine considers climate policy proposals, state policymakers need to consider that many experts from around the world are realizing that the Kyoto Protocol is not working. Participants at COP 10, the international climate policy meeting held this past December in Buenos Aires, sensed the need for a change in strategy because the "targets and timetables" approach to emission reductions embodied in the Kyoto Protocol has failed to make much of a dent in emission growth. First, latest data from the European Environmental Agency show that the EU is not on track to meet its required 8% emission reduction from 1990 levels required under the Kyoto Protocol. Second, there appears now to be a rift within Europe as Italy expresses growing concerns with Kyoto's targets and timetables approach because of concerns about its economic and competitiveness impacts. Third, China announced at the COP 10 meeting that it would never be party to a treaty that would place restraints on its growth. (China may soon be the world's largest emitter of GHGs) Fourth, Europe has become increasingly isolated on climate policy, as COP 10 demonstrated an increasing level of understanding and cooperation between the United States and the developing world on the need for adaptation and technological change as a solution to reducing emissions of GHGs. Finally, a recent European Commission report reinforces the conclusion that after weighing the cost and benefits of targets and timetables, the European Union policymakers do not intend to take on further fixed commitments to reduce GHGs in the post 2012 period.

• A Positive Approach to GHG Reduction
  

In contrast to the EU targets and timetables approach to climate change, the U.S. has chosen a different path, one based on gradually reducing energy intensity. The reason that the Bush Administration rejected the Kyoto Protocol approach was that they had analyzed the costs of sharp, near-term emission reductions and found that the economic costs were significant and the benefits (in terms of reduced global concentrations of CO2) were negligible.

In fact, the U.S. government's voluntary approach to emission reduction shows more promise than the targets and timetables approach in the 1997 Kyoto Protocol supported by the Clinton Administration and now by the EU. It should be noted that the Clinton Administration never submitted the Kyoto Protocol to the U.S. Senate for ratification because they knew it would be overwhelmingly rejected. According to data the U.S. Department of Energy's Energy Information Administration, the U.S., using a voluntary approach, has cut its energy intensity (or the amount of energy required to produce a dollar of GDP) by a significantly larger percentage than has the European Union. The EU, which ratified the Kyoto Protocol and thus faces mandatory emission reductions, has reduced energy intensity by only 7.5% compared to the 15.8% reduction achieved by the U.S. over the 1992-2001 period (see Figure 3). Similarly, the ratio of CO2 emissions per dollar of output has decreased faster in the U.S. than in the EU over the past decade, 15.3% for the U.S. compared to 13.8% in Europe. By adopting a voluntary approach to emission reductions, the Bush Administration balances multiple policy objectives, including maintaining strong economic growth and enhanced environmental quality. In contrast, EU economic growth is weak and unemployment high (about 10% in recent years).

The U.S. government's approach will, however, require a major commitment to incentives for deploying new technology, a long-term research and development program for carbon sequestration, alternative energy sources for electricity generation, transportation and energy conservation.

• A Better Path Forward

Renewables may also have a role to play in the goal of reducing GHGs. However, as a November 2002 article in Science Magazine points out, developing renewables requires a major commitment to a long-term R&D program for alternative energy sources for electricity and transportation. Candidates include solar, wind, biomass, nuclear fission, fusion, and fossil fuels from which carbon has been sequestered. Efficiency improvements, hydrogen production, super-conducting global electric grids and geo-engineering also hold great promise for reducing the growth of CO2 during the 21st century. Commercially viable technologies capable of weaning the world from fossil fuels are still a long way off. Achieving major advances in energy technology will require both serious government and private sector investment in R&D.

Transferring technology to the developing world, where most of the growth in emissions will occur over this century, can play a major role in emission reductions. It is essential to continue transferring existing technologies, such as clean coal, combined heat and power, and others, that will enable those countries to "grow" their economies without similarly growing their emissions. It would be a positive step if developed countries could accelerate efforts to alleviate global poverty and increase the developing world's access to cleaner energy sources. In addition, barriers to the adoption of new energy technologies in the developing world (where the most emission growth is occurring) must be removed so that these countries can enjoy higher living standards while helping to reduce global emission growth.

Promoting economic freedom and economic growth in the developing world can have a strong impact on reducing greenhouse gases, according to new research by David Montgomery of Charles River Associates and Roger Bate of the American Enterprise Institute in a July, 2004 report. Simply put, as countries get wealthier, their energy use becomes more efficient and they have more resources to address issues like climate change. Economic freedom-specifically meaning removing trade barriers and subsidies from state-run enterprises and promotion of intellectual property rights protection-will lead to growth and cleaner environments in the developing world. For instance, if new investment in countries like China and India were as energy efficient as that of Japan or the U.S., we would see substantial declines in carbon emission growth in developing countries where most of the future growth in emissions will occur. Of course, we need continued research and development on new technologies that promote efficiency and reduction in emissions of carbon dioxide.

Conclusion

Policymakers around the globe have weighed the costs and benefits to the targets and timetables approach to reducing GHG and found that the costs far exceed the potential benefits. A more productive approach is to adopt a thoughtfully timed climate change policy-one that is based on accurate science, improved climate models, and global participation. This approach is essential to global economic growth and to the eventual stabilization of the carbon concentration in the atmosphere, if growing scientific understanding indicates such a policy is needed. As the COP 10 meeting in Buenos Aires drew to a close in December 2004, one thing was clear. The Kyoto Protocol will inevitably be replaced by a new framework for addressing climate change-one that encourages economic freedom and economic growth which will lead to gradually reducing carbon intensity per unit of output and overall carbon emissions. This approach is likely to be much more productive than having individual states like Maine sacrifice their economic well-being and job growth to make emission reductions too small to affect global concentrations of GHGs.

Footnotes

1. Robert W. Hahn, "The Economic Analysis of Regulation: A Response to the Critics," working paper 04-03, January, 2004, AEI-Brookings Joint Center for Regulatory Studies.

2. In the MRN model, the existence of a backstop technology is reflected as an exogenously specified price per tonne (denoted in $/tonne of carbon) at which CO2 can be sequestered. This technology can be deployed in any sector that emits carbon dioxide, and for simplicity, we assume a uniform price across all sectors. Realistically, it will be much less costly to develop technology to sequester CO2 emissions from large point sources and therefore, the cost is likely to vary greatly across sectors. To be conservative, cost estimates were derived from estimates of carbon capture technologies combined with integrated gasification combined cycle power generation.