WITNESS LIST

U.S. SENATE COMMITTEE ON ENERGY AND NATURAL RESOURCES

OVERSIGHT HEARING TO RECEIVE TESTIMONY ON THE ECONOMIC IMPACTS OF THE KYOTO PROTOCOL TO THE FRAMEWORK CONVENTION ON CLIMATE CHANGE

THURSDAY, MARCH 25, 1999

9:30 A.M. SENATE DIRKSEN OFFICE BUILDING, ROOM 366

WASHINGTON, DC

The Hon. Chuck Hagel
U.S. Senate

Dr. Janet Yellen
Chair, Council of Economic Advisers
Washington, DC

Panel One

The Hon. Jay Hakes
Administrator
Energy Information Administration
U.S. Department of Energy
Washington, DC

Ms. Mary Novak
Senior Vice President, Energy Service
WEFA
Burlington, Massachusetts

Dr. Margo Thorning
Senior Vice President & Chief Economist
American Council for Capital Formation
Washington, DC

Mr. Cecil Roberts
President
United Mine Workers of America
Washington, DC


JANET YELLEN

Thank you, Mr. Chairman. I appreciate having this opportunity to discuss with you the economics of climate change and the Administration's efforts to address this significant environmental challenge. As you know, the Administration released a report last July, entitled "The Kyoto Protocol and the President's Policies to Address Climate Change: Administration Economic Analysis." The report states that, in the Administration's view, the costs of achieving our Kyoto target would be modest if we can succeed in implementing international trading, joint implementation, and the Clean Development Mechanism in an efficient manner and we achieve meaningful developing country participation. In addition, since the 1997 Kyoto Conference, a variety of research on the economics of Kyoto, and especially on the economics of Kyoto's flexibility mechanisms, has been undertaken. Today, I will provide a brief summary of the Administration's Economic Analysis and review several of the key findings in the recent economic literature on climate change.

The Potential Impact of Climate Change

The Intergovernmental Panel on Climate Change (IPCC) concluded in 1995 that "the balance of evidence suggests that there is a discernible human influence on global climate." Current concentrations of greenhouse gases have reached levels well above those of preindustrial times. If growth in global emissions continues unabated, the atmospheric concentration of carbon dioxide (CO2) will likely double relative to its preindustrial level by midway through the next century and continue to rise thereafter. As a result of the increased concentration of CO2, the IPCC estimates that global temperatures will increase by between 2 to 6 degrees Fahrenheit in the next 100 years, with a best guess of about 3.5 degrees Fahrenheit. Potential consequences associated with this shift in climate include a rise in sea levels, greater frequency of severe weather events, shifts in agricultural growing conditions from changing weather patterns, threats to human health from increased range and incidence of diseases, changes in availability of freshwater supplies, and damage to ecosystems and biodiversity. Further discussion of the costs of climate change is contained in the Administration Economic Analysis.

The Kyoto Protocol and the Buenos Aires Conference of the Parties

The Kyoto Protocol provides several mechanisms that would allow countries to achieve the emissions targets established in this agreement in a cost-effective fashion. These mechanisms, which permit what we have termed "when", "what", and "where" flexibility in meeting the Kyoto emissions targets, are described in detail in the Administration Economic Analysis. Since securing international emissions trading, the Clean Development Mechanism, and joint implementation in Kyoto, the Administration has worked in bilateral and multilateral arenas to promote understanding of these mechanisms and to develop rules that will promote their efficient operation. Last fall in Buenos Aires, a workplan to resolve key implementation issues regarding these mechanisms by the end of 2000 was agreed to by all the participating countries. I want to reiterate that efficient implementation of these flexibility mechanisms is critical to reducing the costs of achieving the targets established in the Kyoto Protocol.

Costs of Action

In assessing the economic effects of the Kyoto Protocol, the Administration has drawn on the insights of a wide range of models and analysis. Examples include models of the energy sector and economy over the next 25 years, such as those participating in the Stanford Energy Modeling Forum, the Intergovernmental Panel on Climate Change's review of the economic and social dimensions of climate change, the work of the Organisation for Economic Co-operation and Development (OECD) on the economic dimensions and policy responses to global warming, and the Administration's staff-level interagency analysis. In addition, the Administration used other tools, such as a meta-analysis, basic economic reasoning, overviews of the domestic and international energy sectors, statistics regarding energy efficiency and greenhouse gas emissions, and economic indicators from World Bank, International Energy Agency, and Energy Information Administration databases.

Assuming that effective mechanisms for international trading, joint implementation, and the Clean Development Mechanism are established, and assuming also that the United States achieves meaningful participation by key developing countries, the Administration's overall assessment is that the economic cost of attaining the targets and timetables specified in the Kyoto Protocol will be modest for the United States in aggregate and for typical households. This conclusion is not entirely dependent upon, but is fully consistent with, formal model results. The Administration believes that there are limitations to relying on any single model to assess the economic impact of the Kyoto Protocol. However, model results can further inform and improve the understanding of the effects of climate change policy. To complement the economic analysis of the Administration's policy to address climate change, we have conducted an illustrative assessment with a modified version of the Second Generation Model (SGM). The results from the SGM substantiate the conclusion that the economic effects of an efficient, effective, and global policy to address the risks of climate change will be modest.

An assessment using the SGM model that accounts for effective trading and developing country participation yields permit price estimates ranging between $14/ton and $23/ton, and direct resource costs to the U.S. between $7 billion and $12 billion/year (1997 dollars). The range reflects uncertainty about the extent of Annex I participation in international trading.

Under the assumptions of the Administration's analysis, permit prices in the range of $14/ton to $23/ton translate into energy price increases at the household level between 3 and 5%. Under these permit prices, fuel oil prices would increase about 5 to 9 percent, natural gas prices about 3 to 5 percent, gasoline prices about 3 to 4 percent (or around 4 to 6 cents per gallon), and electricity prices about 3 to 4 percent. This increase in energy prices at the household level would raise the average household's energy bill in ten years by between $70 and $110 per year, although such predictions may not be observable because they would be small relative to typical energy price changes, and nearly fully offset by electricity price declines from Federal electricity restructuring. By 2008-2012, the anticipated 10 percent decline in electricity prices from restructuring is projected to lead to expenditure reductions of about $90 per year for the average household.

The illustrative modeling analysis does not account for several key components of the Kyoto Protocol and the Administration's policies to reduce greenhouse gas emissions. These include the benefits of reducing net emissions through carbon sinks, the Administration's electricity restructuring proposal, the Administration's Climate Change Technology Initiative (increases in R&D funding and new tax incentives in the Administration's FY 2000 Budget), the Administration's sectoral consultations to encourage and support voluntary efforts by U.S. industry to undertake emissions reductions, including the provision of credit for early action, and the Administration's efforts to reduce federal energy use. There are also ancillary benefits of reducing greenhouse gas emissions -- in particular, the corresponding reductions in conventional air pollutants like sulfur dioxide and fine particulate matter. These benefits alone could produce savings equal to about a quarter of the costs of meeting our Kyoto target.

The Administration released last year its proposed electricity restructuring legislation and the analysis supporting that proposal. The Administration's proposed Comprehensive Electricity Competition Act (CECA) is estimated to reduce greenhouse gas emissions by about 25 to 40 million metric tons of carbon equivalent per year by 2010. Further, the electricity restructuring proposal provides potential cost-savings in four areas: dispatch efficiency, improved capital utilization, savings in capital additions and cost reductions in fuel procurement, non-fuel operation and maintenance expenses, and administrative and general expenses. These four categories of savings, when translated to consumers, are likely to reach or exceed $20 billion annually. The Department of Energy's CECA supporting analysis documents contain further discussion of the Administration's electricity restructuring proposal.

Recent Research on the Economics of Climate Change

Since December 1997, many economists have conducted and made available their analyses of the Kyoto Protocol. I have noted in previous appearances before Congressional Committees that there are limitations to relying on one or a small set of models and that we were eager to see assessments of the Kyoto Protocol by other models. Two large efforts have been undertaken to coordinate and compile modeling results on the Kyoto Protocol. First, the Stanford University Energy Modeling Forum (EMF), a long-running model comparison exercise involving many of the leading climate and energy models, has coordinated full scale analyses of the Kyoto Protocol. Second, the Organisation for Economic Co-operation and Development (OECD) held an economic modeling workshop this past fall, and has since published the proceedings of this workshop which includes 16 papers. In addition, several research teams have undertaken work in evaluating the potential for intergas trading and the cost-savings of a six-gas target relative to a carbon dioxide-only target. I would like to take this opportunity to provide an overview of this recent research.

Kyoto Modeling Analyses

The Energy Modeling Forum comparison exercise of the Kyoto Protocol has included ten modeling teams from the United States, Europe, and Asia. In evaluating the Kyoto Protocol, all of the participating teams used economic models that incorporate the potential for international trading in greenhouse gas permits. The OECD workshop included presentations by 10 modeling teams, 9 of which had global models as well. By explicitly incorporating international trading, these models can evaluate the opportunities for cost-savings through trading among Annex I nations and among Annex I and developing countries were they to adopt emissions targets. Since the Kyoto Protocol enables all countries with emissions targets to trade emissions allowances among other countries with targets, these models are well-suited to assess the economic implications of the international trading component of the agreement.

While the models used in the EMF exercise and the OECD workshop can assess international trading, there are several other flexibility mechanisms of the Kyoto Protocol that they cannot, at present, readily assess. For example, these models did not incorporate the effects of sinks. While several modelers did assess the economic costs of achieving the Kyoto targets with "off-line" assumptions about sink activity, none incorporated an integrated energy-land use model. Further, most of the modelers did not evaluate opportunities to reduce costs by trading across greenhouse gases. These models are primarily energy models and are focused on the economics of reducing carbon emissions from fossil fuel combustion. Again, some modelers analyzed the Protocol by making some "off-line" assumptions about the potential reductions in non-carbon dioxide greenhouse gases, but none employed a model with cost curves for these gases. Finally, it should be noted that these models did not include opportunities for emissions reduction through Administration proposals, such as electricity restructuring or the Climate Change Technology Initiative, that could slow the growth over time of greenhouse gas emissions thereby lowering greenhouse gas permit prices.

The results from both the EMF and OECD efforts provide very useful context for the Administration's economic analysis. First, the illustrative model used by the Administration, the Second Generation Model of the Pacific Northwest National Laboratory, tends to fall in the middle of the range of this set of models in terms of U.S. permit prices. For example, under Annex I trading SGM generates a permit price which is at the median of this set of models. Under full global trading, the SGM permit price is just below the median permit price. Second, the EMF exercise found that the reduction in permit prices as trading expands from no trading to Annex I trading to full global trading is robust. On average, the EMF models found that Annex I trading would cut the U.S. permit price by 53% relative to a no trading scenario. Of these models, one estimated a 72% reduction in the permit price under Annex I trading. In full global trading, the permit price would be, on average, 80% lower than the no trading price. Several models estimated permit price reductions of about 90%.

The reported results from the OECD workshop found similar reductions in permit prices by going from no trading to Annex I trading. On average, the OECD workshop models found that Annex I trading would cut the U.S. permit price by 57% relative to a no trading scenario. Moreover, they found that the European Union and Japan would benefit more from unconstrained Annex I trading. For both the E.U. and Japan, the average reduction in permit prices across these models would be nearly 75%.

Analyses of Trading Constraints

In addition to the modeling of various efficient international trading scenarios, several EMF modeling teams have considered the impact of constraints on the opportunity to buy or sell emissions allowances in an international market. While the United States is unambiguously opposed to trading restrictions, several parties to the agreement have indicated support for some form of a trading constraint, for example, by setting a limit on the amount a party can purchase through the trading system. Trading restrictions would generate no benefit for the global climate while they could significantly increase the costs of achieving the Kyoto targets.

Before describing the economic costs of trading constraints, I would like to explain why such constraints yield no climate benefits. Regardless of where a greenhouse gas emission reduction occurs, it has the same effect on total emissions and the same effect on the climate. A ton reduced in New York generates the same climate benefit as a ton reduced in Berlin. In proposing trading constraints, some have focused on countries such as Russia, that will have emissions below their Kyoto targets during the commitment period because of the decline in their economic output associated with the transition to market economies. If trading constraints are established that restrict the ability of Russia to sell permits (or restrict the opportunity for other Annex I countries to buy Russian permits), then emissions during the first commitment period would be lower than in the absence of such constraints. However, Russia would simply bank its allowances and use these allowances in a subsequent commitment period when its emissions exceed its target. While a trading constraint might lower emissions during the first commitment period, the cumulative emissions over several commitment periods from Annex I countries would be the same with and without the trading constraint. Given the long residence times of greenhouse gases (on the order of a 100 or more years), the cumulative effect is what is most relevant in terms of changes in the global climate.

To provide a sense of the economic implications of trading constraints, I would like to share with you two examples from work done by EMF modeling teams. First, consider a trading constraint that mandates that at least two-thirds of the emissions reductions necessary for a country to achieve its Kyoto target must occur through domestic actions. Evaluating this trading constraint with the EPPA model based at the Massachusetts Institute of Technology, the permit price for the United States is almost four times higher with the constraint than under an unconstrained global trading system. It is important to note that the effects of this constraint are even more pronounced for the European Union and for Japan. The permit price for the EU would be more than five times higher than the unconstrained global trading permit price, and the Japanese permit price would be thirteen times higher. As these results indicate, the trading constraint would result in each country experiencing a different marginal cost of abatement, and there would be no common permit price for a ton of carbon equivalent. Since the constraint restricts opportunities for countries like the United States, Japan, and members of the EU to buy emissions allowances, the competitive price for emission allowances from countries like Russia would fall below the unconstrained level.

Second, consider a trading constraint that mandates that acquisitions of permits through international trading could not exceed 10% of a country's emissions allocation. For example, the U.S. target is approximately 1.5 billion tons of carbon equivalent on an annualized basis. Under this trading constraint, the United States, or private firms in the United States, could not purchase more than 150 million tons on an annual basis from other countries. Assessing this trading constraint with the Second Generation Model, the permit price for the United States would more than triple relative to the unconstrained global trading permit price. For the E.U., the permit price would nearly double, and for Japan, the permit price would be eleven times as high as the unconstrained global price.

While trading constraints increase greenhouse gas permit prices (and subsequently, energy prices) in the United States, the European Union, and Japan, they also reduce the gains from trade by the countries likely to be sellers of emissions allowances. For example, Russia and large developing countries that adopt emissions growth targets and participate in international trading, e.g., China and India, would sell fewer emissions allowances at lower international permit prices under such trading constraints than in an unconstrained global trading environment. Such restrictions lessen the benefits of participation by developing countries in international trading.

Estimated reduction in costs from trading across gases

As we note in the Administration Economic Analysis, the Kyoto Protocol provides additional flexibility in achieving emissions targets by specifying these targets as a basket of 6 types of greenhouse gases (carbon dioxide, methane, nitrogen dioxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride). Countries can effectively trade across gases, based on their global warming potential, so that the aggregate weighted emissions reductions occur at least cost. Most models used to evaluate the Kyoto Protocol have not incorporated this kind of flexibility, although several modeling teams are actively working to modify their models to include emissions of non-CO2 greenhouse gases. In the Administration's analysis, cost curves for these other gases for the United States were used in conjunction with the SGM model. These simulations suggest that trading across greenhouse gases can lower costs up to 15% relative to a situation where no trading across gases occurs.

Complementing this finding, recent work by a group of researchers at the Massachusetts Institute of Technology has found that including the opportunity to abate non-CO2 greenhouse gas emissions and promote carbon sinks reduces the costs to the United States by about 25% relative to a carbon-only approach (assuming no international trading). On average, they find that Annex I countries' costs would fall by more than 20%. In addition, work by University of Illinois researchers and others has evaluated the changes in costs of abating methane and carbon dioxide to achieve the U.S. Kyoto target instead of abating carbon dioxide alone. They found that meeting an emissions target through cost-effective trading between carbon dioxide and methane reductions could reduce costs by nearly 20% relative to a case with no intergas trading. Finally, research by several Dutch analysts presented at the OECD workshop found significant opportunities for the European Union to substitute abatement of non-CO2 greenhouse gas emissions for carbon dioxide reductions. They found that 27% of the total reduction effort necessary for E.U. countries to achieve their emissions targets could occur through the abatement of these non-carbon dioxide gases.

Developing Country Participation

Last year during the Buenos Aires Conference, two non-Annex I countries, Argentina and Kazakstan stated that they will announce emissions targets and expressed their interest in engaging in international emissions trading. We believe that these two countries' efforts may encourage other non-Annex I countries to follow their lead. Economic and environmental benefits could accrue to developing countries if they adopt binding emissions targets and participate in international trading. Setting a target below the business as usual emissions level for the commitment period would generate climate benefits by reducing global emissions below what they would otherwise have been. In addition, if the target is set not too far below the business as usual emissions level, the participation of the country in a global trading system would produce economic benefits or "gains from trade" for both the developing country and its trading partners. Emissions trading by developing countries would occur only if they chose to undertake emissions reductions above and beyond their commitments -- reductions that would generate trading extra income for them as long as their marginal abatement cost is below the world trading price for greenhouse gas permits. Many of the EMF models reveal that, for large developing countries, like China, such excess reductions would indeed be profitable, so that these countries would export allowances and gain from trade. Developing countries would also reap ancillary benefits of reducing conventional air pollutants, which may be substantial. Benefits from trading would also accrue to Annex I countries. Annex I countries (and private firms in these countries), who would purchase these emissions allowances in the world market, would achieve their targets at lower costs than without the participation of the developing countries. However, it should be noted that the more stringent the target for the developing country, the lower the gains from trade both for that country and for Annex I countries such as the United States. Indeed, an extremely stringent target could conceivably make the developing country a net importer of emissions allowances, and raise the international trading price for a greenhouse gas permit. Still, these models illustrate the potential to create targets that simultaneously make the environment, the developing country, and Annex I countries all better off.

Conclusion

The Administration's overall conclusion is that the economic impact of the Protocol will be modest under the conditions we have identified in our economic analysis. The purpose of this testimony has been to summarize the analysis we have presented in the Administration Economic Analysis on climate change and to provide a brief update of recent research efforts outside of the government.

I look forward to continuing to work with members of this Committee, as well as with other interested parties, in further analyzing the Kyoto Protocol and evaluating the net effects of reducing greenhouse gas emissions. It is my hope that economic analysis will continue to play a key role in designing policies in this area.

I welcome your questions.

Margo Thorning, Ph.D.

Macroeconomic Effects of CO2 Emissions Limits Are Significant. A wide range of economic models predict that reducing U.S. 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 e mission 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 emission 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 emission 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.


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