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Limiting Carbon Dioxide Emissions: Prices versus Caps 1 (March 2005)

handle is hein.congrec/cbo8064 and id is 1 raw text is: ( g K ~£C A series of issue summaries from the Congressional Budget Office MARCH 15, 2005 Limiting Carbon Dioxide Emissions: Prices Versus Caps Scientists have identified carbon dioxide which is emit- ted during the combustion of fossil fuels (oil, natural gas, and coal)-as a key greenhouse gas that can affect the Earth's climate. Experts disagree about the potential damages that might result from those emissions, with some projecting modest damages and others projecting potentially abrupt and catastrophic effects. Given that range of projections, people disagree about whether any- thing should be done to limit emissions and if so, how much to limit them. However, one area of consensus is that any steps taken to control emissions should do so at the lowest possible cost. Two different forms of economic incentives could achieve that goal: one would reduce emissions by setting a price on them, and the other would cap the overall level of emissions. But given current infor- mation about the potential for near-term emissions to trigger abrupt and catastrophic damages, the price ap- proach is more likely than a cap to maximize the differ- ence between the policy's total benefits and total costs. This brief illustrates the advantage of a price-based incen- tive using an example contrasting policies that would set a price for U.S. fossil fuel-related emissions of carbon di- oxide with policies that would cap such emissions. The United States is the country that emits the largest amount of carbon dioxide, but to varying degrees all nations emit greenhouse gases and could potentially benefit from their control. How Emission Priccs and Emission Caps Would Work Putting a price on carbon dioxide emissions-essentially taxing those emissions- would boost their cost, thereby encouraging firms as well as households to limit emis- sions (by using smaller amounts of fossil fuels or by rely- ing on fossil fuels with relatively low carbon content) as long as the cost of doing so was below the tax or price. That price-based approach would establish an upper limit on the cost of individual emission reductions-the level of the price-but would not ensure that any particular emission target was met. That approach would balance expected benefits and actual costs provided that the price per ton was set equal to the expected benefits resulting from eliminating a ton of carbon emissions. Cap-and-trade programs, in contrast, offer a way to set an overall limit on the level of carbon dioxide emissions while relying on economic incentives to determine where and how emission controls take place. Under such a pro- gram, policymnakers would establish an overall cap on emissions but allow firms to trade rights to those emis- sions, called allowances. Trading would allow firms that could control their emissions most cheaply to do so in or- der to sell some of their allowances at a profit to firms that face higher costs to limit their emissions. Further- more, the price increases that would result from the cap would encourage households to consume smaller amounts of fossil fuels, thus leading to lower carbon emissions. A cap-and-trade program would achieve the emission target at the lowest possible cost, but (as de- scribed below) it would not necessarily balance actual costs with the expected benefits achieved by the target. A cap-and-trade program with a safety valve combines an overall cap on total emissions with a ceiling on the al- lowance price. Under that hybrid approach, policymnakers would establish an overall cap and allow firms to trade al- lowances, but they would also set an upper limit on the price for allowances, referred to as the safety-valve price. If the price of allowances rose to the safety-valve price, the government would sell as many allowances as was neces- sary to maintain that price. Thus, if the safety valve was triggered, the actual level of emissions would exceed the cap. The cap would be met only if the price of allowances never rose above the safety-valve price.

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