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Climate Change Policy in the United States 2006

How the bipartisan Senatorial team of Pete Domenici and Jeff Bingaman might break new ground in US Cimate Change Policy.

bridges vol. 9, April 2006 / Feature Article
By William A. Pizer

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Recent History
For the past few years, the dynamics of trans-Atlantic climate change policies have featured a mandatory emissions trading scheme in Europe and a voluntary, technology-based approach in the United States. Part of that story in the United States has played out in the US Senate: The US Senate passed the 1997 Byrd-Hagel Amendment , stipulating that the Senate would not ratify any international treaty that did not require meaningful participation by developing countries or that harmed the US economy. The US Senate has also been the venue for debate over the cap-and-trade program authored by Senators McCain (R-AZ) and Lieberman (D-CT).

More recently, however, another bipartisan Senatorial team has begun working on the issue - Pete Domenici (R-NM) and Jeff Bingaman (D-NM), the Chairman and Ranking Member of the Senate Energy Committee. Senator Bingaman engaged the issue early last year, when his staff examined the recently completed work of the National Commission on Energy Policy (NCEP) . During a brief window of opportunity in June 2005, Senator Bingaman considered introducing a proposal based on the NCEP report as an amendment to the 2005 Energy Bill. The Senate was debating the 2005 Energy Policy Act, and there appeared to be genuine interest in a NCEP-like alternative to the McCain-Lieberman proposal.


{access view=guest}Access to the full article is free, but requires you to register. Registration is simple and quick - all we need is your name and a valid e-mail address. We appreciate your interest in bridges.{/access} {access view=!guest}With too little time to seriously engage other senators on the proposal, however, Bingaman instead co-sponsored an amendment with Senator Arlen Specter (R-PA) calling for mandatory action on climate change - an amendment that passed the Senate with 53 votes. Unlike the earlier Byrd-Hagel amendment, the language here stipulated that the action should engage developing countries (rather than requiring "meaningful participation") and not significantly harm the US economy.

Perhaps more important than this call to action, Senator Domenici has become actively involved in the issue with Senator Bingaman. They have jointly held hearings on the science and economics of climate change and, most recently, on responses to their white paper seeking comments on allocation, point of regulation, and international linkages - all associated with a mandatory emissions trading program. Although action in the current session is unlikely, these developments suggest a building momentum for action.

A New Formula
Underlying this momentum is an innovative policy formula that differs from the Kyoto Protocol, the McCain-Lieberman proposal, and most recently a proposal by Senator Diane Feinstein (D-CA). The defining element in all of these policies was a environmental goal: 1990 emissions in the Kyoto Protocol, 2000 emissions in the (amended) McCain-Lieberman proposal, and 2005 emissions in the Feinstein proposal.

The Domenici-Bingaman formula, based on the NCEP report, turns all of this on its head. There is a target, but it is expressed in terms of improvements in emissions intensity - 2.4 percent (later 2.8 percent) annual improvement in tons of emissions per dollar of GDP - in the same manner as the Bush administration's target of an 18 percent improvement from 2002 to 2012. But more importantly, Domenici-Bingaman explicitly limits the cost of the program by letting firms pay a fixed price, $7 per ton in 2010, rising 5 percent per year thereafter, instead of trading allowances. In all of this, the emission outcome takes a backseat to assuring businesses that their maximum cost will be $7 per ton and deflating any criticism that the program will be more expensive than proponents claim.

While there is a tendency to look at such a "safety valve" mechanism as a purely political compromise, there are, in fact, a number of good substantive arguments for such an approach. Most importantly, it means that participants are not paying high prices one day and low prices the next, for emission reductions whose value over time should be the same. Consider the experience with the NOx program in the United States. The figure below shows how prices have twice spiked to more than six times the otherwise average price of about $1000 per ton.



Why the price spikes? In the first instance, there was concern that Maryland would not initially join the program. An expected net supplier of allowances, Maryland's potential absence at the beginning created expectations of a shortage. The second spike is more interesting. By that time, participants had built up a significant "bank" of allowances - a consequence of extra reductions in early years that left them with surplus allowances available for future needs. That future need arose in 2003 when the program expanded and tightened, but use of the bank was thwarted by restrictions on how the bank could be drawn down and carried forward - again producing a shortage and a price spike.

Still, in this NOx case it is arguably reasonable for prices to fluctuate in order to achieve the target in a particular year - there are health and mortality consequences associated with episodic NOx emission peaks. But in the CO2 case, there is no such rationale: the only consequences of CO2 emissions are associated with long-term accumulations. There is no reason to spend extra money to hit the target in a given year versus emitting more now and less some other time. While banking can provide some of this flexibility, it only works when there is a large enough bank available. In the current EU Emissions Trading Scheme (ETS), for example, with no banking between the initial 2005-2007 period and the 2008-2012 Kyoto period, there is a possibility of price spikes right now as no bank has accumulated, and again in 2008 as no bank can be held over. The safety valve, in contrast, provides a reliable and transparent insurance policy against price spikes.

The path of the safety valve also provides a long-term vision for business. In contrast to Europe, where targets and prices are uncertain after 2012, the Domenici-Bingaman model provides a presumptive price path through 2020 and beyond. Subject to periodic tweaks in 2015 and every five years thereafter, that picture is $7 per ton in 2010 rising 5 percent each year after that.

Is $7 per ton of CO2 too low?
Even among people who like the idea of a safety valve, the $7 per ton of CO2 articulated in the NCEP report and assumed in the Domenici-Bingaman discussions is sometimes viewed as too low. To understand whether $7 is too high or too low, it is useful to translate that number into other values. $7 per ton of CO2 translates into a roughly 5 percent increase in household energy costs or perhaps $100 more per household per year. A higher CO2 price means higher costs.

Another important metric is the impact on coal use in the United States. Except for the use of international offsets or biological sequestration, each with their own set of problems, and given our unshakeable thirst for petroleum, there is no way around the conclusion that reducing coal use is the only way to reduce CO2 emissions in the short term. At the same time, national security concerns (and short-term infrastructure constraints) leave us somewhat wary of a large shift into natural gas. In addition, coal interests - including mining companies, mining unions, and coal-burning utilities - all have a stake in maintaining coal's position.

The graph below summarizes a series of studies by the Energy Information Administration (EIA), looking at coal use under a variety of proposed climate change policies. The graph shows the use of coal (horizontal axis) versus the allowance price (vertical axis). The takeaway message from this graph is that at $7 per ton of CO2, coal use grows, but not as much as in the business-as-usual forecast. At $15-20 per ton, coal use is flat compared to 2003. Somewhere in that range is a likely compromise.



The Road Ahead
The safety valve along with other elements of the NCEP report has provided an opening to engage more people on the idea of mandatory climate change policy, but still leaves many questions unanswered. As Domenici and Bingaman press ahead, they now confront three even harder questions: where to regulate emissions, how to allocate allowances, and how to deal with international aspects of the trading program - all of which were the subject of a day-long Senate Energy Committee workshop on April 4.

On the first question, there are strong arguments for regulating upstream, where fossil fuels are produced or processed - the coal mine, refinery, or major pipeline. This may sound strange to those familiar with US trading programs that use continuous emission monitors on smokestacks to determine how many allowances each source must retire. And even in the EU ETS, it is the emitters of greenhouse gases that are required to surrender allowances. But an interesting little secret in the EU ETS is that allowance obligations are not based on actual emissions, but on emission factors applied to fossil fuel use. There is no reason such a calculation can't be made upstream where the fuel is produced and, voila, you can cover all carbon dioxide emissions in one program - rather than only 50 percent in the EU ETS (notably excluding transportation).


The second question, concerning allocation, has already been a painful one to answer in the member states of the EU, and promises to be equally hard in the US. Several lessons, however, can be learned from the recent EU experience. First, those who are regulated - be they large coal-burning utilities or upstream coal mines - may pass on much of the cost associated with emission allowances even if they get them for free. The controversy surrounding recent windfall profits in the German power market is a case in point. Even if a decision is made to freely distribute allowances, they need not go to those who are directly regulated but might instead go to others in the energy supply and demand chain who are adversely affected. Alternatively, as suggested by the NCEP, a portion of the allowances could be auctioned off, with the revenues used to support technology development.

Another EU ETS lesson is that updating allocations may be a way to ameliorate trade concerns. Economists typically frown on making allocations based on updated, annual data on production - this amounts to a production subsidy and reduces the incentives to conserve product. Yet, in cases where domestic producers sell in an internationally competitive market and output price is fixed at a world price, reduced domestic production will simply shift overseas. Such an allocation scheme might be just what is needed to avoid that shift.

The third area where Domenici and Bingaman will need to spend some time concerns international linkages. Some people are eager to see a global trading system, but caution may be in order if the EU continues to experience higher prices. Meanwhile, in developing countries, the Clean Development Mechanism under the Kyoto Protocol is finding both supporters and detractors . A new US program offers a fresh opportunity to revisit all of these issues.

Concluding Remarks
While the US played a central role in climate change negotiations in the 1990s, the center of gravity in the climate change world has remained in Europe for the past five years. Yet, there are clear rumblings in the United States. In addition to increasingly serious efforts at the state level, particularly in California and the northeastern states , the US Senate has been the stage for a gradual shift toward serious concern and calls for action. The current policy model is different from Kyoto and the EU ETS, with greater concern about economic costs, competitiveness, and predictability. As these discussions and debates continue, we might yet see that center of gravity shift back to the US.


The author, William A. Pizer, is senior fellow at Resources for the Future and senior economist at the National Commission on Energy Policy.{/access}


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