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close this bookThe Costs of Climate Protection: A Guide for the Perplexed (WRI, 1997, 60 pages)
View the document(introduction...)
View the documentACKNOWLEDGMENTS
View the documentFOREWORD
View the documentINTRODUCTION
Open this folder and view contents3. MORE DETAIL ON THE KEY ASSUMPTIONS
Open this folder and view contents4. TRADE AND EQUITY ISSUES
View the documentREFERENCES
View the documentANNEX
View the documentABOUT THE AUTHORS
View the documentBOARD OF DIRECTORS


The latest international scientific assessment concludes that human activity is affecting the global climate (IPCC, 1996a). Population growth, rapid industrialization, increasing fossil fuel use, and continuing deforestation imply that without drastic action carbon dioxide concentrations in the atmosphere will double their pre-industrial levels by about the year 2060 and eventually cause average global temperature to rise by 1C-3.5C (IPCC, 1996a). The consequences of warming on this scale are hard to predict. Although some effects, such as rising sea levels and changing agricultural patterns, can be clearly foreseen, other effects, some potentially catastrophic, can only be guessed at. Nations have committed themselves to a precautionary approach designed to limit the accumulation of greenhouse gases.

Policies to prevent climate change focus mainly on carbon dioxide (CO2) emissions, the most important greenhouse gas. As a first step toward the ultimate goal of stabilizing concentrations, the industrialized nations that signed the Framework Convention on Climate Change voluntarily undertook to return their emissions of carbon dioxide and other greenhouse gases to 1990 levels by the year 2000. However, many countries, including the United States, will fail to meet this target.

In 1995, at the first Conference of Parties to the Convention (COP-1) in Berlin, signatories acknowledged that even if emissions were stabilized at 1990 levels, concentrations would continue to rise rapidly because CO2, once released, remains in the atmosphere for decades. The Berlin Mandate calls for strengthened commitments from developed countries to reduce their emissions after 2000. Negotiations since COP-1 have led to various proposals, the most stringent calling for industrialized countries to reduce emissions to 20 percent below 1990 levels by 2005 (AOSIS, 1995). The United States Government has stated that it is prepared to accept legally binding commitments in future protocols in the hope that this will prompt other countries to adopt a similar stance. Agreement on future commitments will be embodied in a formal protocol to be signed at the third Conference of the Parties in Kyoto in December 1997.

If the United States and other nations do agree on binding limits on greenhouse gas emissions, they will need to adopt measures to reduce carbon emissions with the least adverse economic impacts. One of the most effective and efficient mechanisms is a carbon tax - a tax levied on all fossil fuels in proportion to their carbon contents. Raising the prices of fuels and energy-intensive products would discourage all fossil fuel uses in proportion to their carbon contents and encourage development of less carbon-intensive alternatives. A recent statement by leading economists points out that a tax mechanism would be much more efficient than a regulatory approach (Economists' Statement on Climate Change, 1997).

One of the most effective and efficient mechanisms to reduce carbon emissions is a carbon tax - a tax levied on all fossil fuels in proportion to their carbon contents.

An alternative proposal under serious consideration in the United States is a tradable permits program, in which permits would be required in order to sell or use fossil fuels. By limiting the total number of permits, the regulatory authority could control carbon emissions. If the government allowed permits to be bought and sold, the program would create efficient incentives like those of a carbon tax, because the permit price in the marketplace would signal how much firms should reasonably spend on abatement measures. If the government initially distributed the permits through an auction, it could mitigate adverse economic impacts by using the revenues to reduce other taxes without increasing fiscal deficits. In this sense, auctioned-off tradable permits to sell or use fossil fuels have economic implications similar to those of a carbon tax. (In this report, statements about the effects of a carbon tax apply equally to the impacts of tradable carbon permits that are auctioned off.)

Though one argument for tradable permits is the perceived political difficulty of proposing a change in the tax structure, the tradable permits approach also faces potential difficulties. It would be less efficient than a revenue-neutral tax and would encounter political opposition if valuable permits were given away to energy companies and utilities. Moreover, it would be difficult to include small fuel users in a tradable permits program, though their aggregate energy use is important, without creating administrative burdens much greater than those implied by raising energy taxes. Furthermore, if new scientific information necessitated further emissions reduction, canceling carbon permits that had been purchased in an auction or market transaction would be more difficult than raising a carbon tax.

Many interest groups claim that a carbon tax or any other efficient policy to reduce carbon emissions, such as a tradable permits policy, would impose high economic costs and reduce economic growth. For support, they point to simulations with economic models, some of which have suggested that stabilizing CO2 emissions at 1990 levels could require a tax of up to $430 per ton of carbon by 2030 and could impose total costs of up to 2.5 percent of annual gross domestic product (GDP) (Charles River Associates, 1997). Of course, other economic models predict that similar emissions reductions could be achieved with far smaller energy taxes and negligible, or even favorable, overall impacts on the economy (Gaskins and Weyant, 1993).

Despite the complexity of the models, only a handful of easily understandable assumptions are important in determining the simulation results.

Which predictions should we believe - if any? Interested groups on different sides of the issues have their own preferred models (and modelers), and these tend to produce simulations supporting the policy positions of their respective sponsors. The underlying economic models may contain dozens of complicated equations that are nearly impenetrable to all but trained econometricians. How and why such models reach the predictions that they do is hard to comprehend. Yet, it matters greatly what the economic impacts of policies to reduce the long-term risks of global warming will be.

This report provides a guide for the perplexed - an explanation in simple terms of the key assumptions in the models being used to simulate the economic effects of carbon taxes or similar policies to control carbon dioxide emissions. The report also provides a quantitative analysis of 16 widely used models, demonstrating how key assumptions affect the predicted economic impacts of reaching CO2 abatement targets. It turns out that despite the complexity of the models, only a handful of easily understandable assumptions are important in determining the simulation results. By showing the effect of these assumptions on the predicted economic costs, not just in one particular model but in all of them, this report can help readers to apply their own judgments about which models are more realistic and to reach their own conclusions about which economic predictions are more credible.