Global Climate Change: Controlling CO2 Emissions - Cost-limiting Safety Valves

CRS Report for Congress
Global Climate Change: Controlling CO2
Emissions — Cost-Limiting Safety Valves
Larry Parker
Specialist in Energy Policy
Resources, Science, and Industry Division
Summary
Proposed CO² reduction schemes present large uncertainties in terms of the
perceived reduction needs and the potential costs of achieving those reductions. Several
cost-limiting “safety valves” have been proposed to bound costs of any CO² control
program, including (1) a straight carbon tax, (2) a contingent reduction scheme, (3)
unlimited permit purchases, and (4) cost-based excess emissions penalties. Employing
a safety valve shifts much of the emission reduction debate from compliance targets to
the specifications of the safety valve, in particular, the level of the tax or fee involved.
This report will be updated if events warrant.
The fundamental policy assumption that has changed between the U.S. ratification
of the 1992 Framework Convention on Climate Change (FCCC) and the current Bush
Administration’s decision to abandon the Kyoto Protocol process concerns costs.¹ The
ratification of the FCCC was based at least partially on the premise that significant
reductions could be achieved at little or no cost. This assumption helped to reduce
concern some had (including those of the former Bush Administration) that the treaty
could have deleterious effects on U.S. competitiveness — a significant consideration
because developing countries are treated differently from developed countries under the
FCCC. Further ameliorating this concern, compliance with the treaty was voluntary.
While the United States could “aim” to reduce its emissions in line with the FCCC’s goal,
if the effort indeed involved substantial costs, the United States could fail to reach the
goal (as has happened) without incurring any penalty under the treaty.
This flexibility would have been eliminated under the Kyoto Protocol with its
mandatory reduction requirements. The possibility of failure to comply with a binding
commitment intensifies one’s perspective on potential costs: How confident can one be

¹ For a review of U.S. global climate change policy, see CRS Report RL30024, Global Climate
Change Policy: Cost, Competitiveness, and Comprehensiveness, by Larry Parker.
Congressional Research Service ˜ The Library of Congress

in the claim that carbon reductions can be achieved at little or no cost?² Compliance cost
estimates ranging from $5.5 billion to $200 billion annually cause some to pause.³ The
current Bush Administration was sufficiently concerned about potential CO² control costs
to reverse a campaign pledge to seek CO² emissions reductions from power plants, in
addition to its decision to abandon the Kyoto Protocol process.⁴
Proposed CO² reduction schemes present large uncertainties in terms of the
perceived reduction needs and the potential costs of achieving those reductions. In an
attempt to prevent any CO² control program from incurring unacceptable costs, several
cost-limiting “safety valves” have been proposed to bound costs. These safety valves are
designed to work with market-based CO² reduction schemes, similar to the tradeable
permit strategy used by the acid rain program,⁵ and would effectively limit the unit (per
ton of emissions) control costs sources would pay. This report examines four such safety
valves: (1) a straight carbon tax, (2) a contingent reduction scheme, (3) unlimited permit
purchases, (4) cost-based excess emissions penalties.
The Dilemma: Price versus Quantity
In general, market-based mechanisms to reduce CO² emissions focus on specifying
either the acceptable emissions level (quantity), or compliance costs (price), and allowing
the marketplace to determine the economically efficient solution for the other variable.
For example, a tradeable permit program sets the amount of emissions allowable under
the program (i.e., the number of permits available caps allowable emissions), while
permitting the marketplace to determine what each permit will be worth. Likewise, a
carbon tax sets the maximum unit (per ton of CO²) cost that one should pay for reducing
emissions, while the marketplace determines how much actually gets reduced. In one
sense, preference for a carbon tax or a tradeable permit system depends on how one views
the uncertainty of costs involved and benefits to be received.
For those confident that achieving a specific level of CO² reduction will yield
significant benefits — enough so that even the potentially very high end of the marginal
cost curve does not bother them — a tradeable permit program may be most appropriate.
CO² emissions would be reduced to a specific level, and in the case of a tradeable permit
program, the cost involved would be handled efficiently, though not controlled at a
specific cost level. This efficiency occurs because through the trading of permits,
emission reduction efforts concentrate at sources at which controls can be achieved at
least cost.
However, if one feels more certain of the potential downside risk of substantial
control costs to the economy than of the benefits of a specific level of reduction, then a

² For a further discussion of the foundations for such divergent cost estimates, see CRS Report

98-738, Global Climate Change: Three Policy Perspectives, by Larry Parker and John Blodgett.

³ CRS Report RL30024, p. 16.
⁴ President George W. Bush, Letter to Senators Hagel, Helms, Craig, and Roberts, Office of the
Press Secretary, March 13, 2001.
⁵ For more on market-based strategies to reduce greenhouse gases, see CRS Issue Brief IB97057,
Global Climate Change: Market-Based Strategies to Reduce Greenhouse Gases, by Larry Parker.

carbon tax may be most appropriate. In this approach, the level of the tax effectively caps
the marginal cost of control that affected activities would pay under the reductions
scheme, but the precise level of CO² achieved is less certain. Emitters of CO² would
spend money controlling CO² emissions up to the level of the tax. However, since the
marginal cost of control among millions of emitters is not well known, the overall
emissions reductions for a given tax level on CO² emissions cannot be accurately forecast.
Hence, a major policy question is whether one is more concerned about the possible
economic cost of the program and therefore willing to accept some uncertainty about the
amount of reduction received (i.e., carbon taxes); or one is more concerned about
achieving a specific emission reduction level with costs handled efficiently, but not
capped (i.e., tradeable permits).
A model for a tradeable permit approach is the sulfur dioxide (SO²) allowance
program contained in Title IV of the 1990 Clean Air Act Amendments. Also called the
acid rain control program, the tradeable permit system is based on two premises. First,
a set amount of SO² emitted by human activities can be assimilated by the ecological
system without undue harm. Thus the goal of the program is to put a ceiling, or cap, on
the total emissions of SO² rather than limit ambient concentrations. Second, a market in
pollution licenses between polluters is the most cost-effective means of achieving a given
reduction. This market in pollution licenses (or allowances, each of which is equal to one
ton of SO²) is designed so that owners of allowances can trade those allowances with
other emitters who need them or retain (bank) them for future use or sale. Initially, most
allowances were allocated by the federal government to utilities according to statutory
formulas related to a given facility’s historic fuel use and emissions; other allowances
have been reserved by the government for periodic auctions to ensure market liquidity.
There are no existing U.S. models of an emissions tax, although five European
countries have carbon-based taxes.⁶
Safety Valves
As a stalemate has continued on strategies to control CO² emissions, particularly
because of costs fears, attention increasingly focuses on the cost-limiting benefit of a
carbon tax, either as the primary strategy or as a component blending a carbon tax with
the reduction certainty of the tradeable permit system. The object is to create a safety
valve to avert unacceptable control costs, particularly in the short term. These safety
valves limit unit (per ton) costs of reducing emissions. Four ideas are identified below:
^!Carbon taxes: generally conceived as a levy on natural gas, petroleum,
and coal according to their carbon content, in the approximate ratio of 0.6⁷
to 0.8 to 1, respectively. However, proposals have been made to impose

⁶ Finland, the Netherlands, Sweden, Denmark, and Norway. See CRS Issue Brief IB97057,
Global Climate Change: Market-Based Strategies to Reduce Greenhouse Gases, by Larry Parker.
⁷ Larry Parker, Carbon Taxes: Cost-Effective Environmental Control or Just Another Tax? CRS
Report 92-623 ENR, August 4, 1992.

the tax downstream of the production process. Several European
countries have carbon taxes in varying degrees and forms.
^!Unlimited permits at set price: generally conceived as part of an auction
system where permits are allocated to affected sectors by auction with an
unlimited number available at a specific price. The most recent proposal
is by the National Commission on Energy Policy, which recommends an
initial limiting price of $7/ton that would increase by 5% annually.⁸ Other
variations include the Resources for the Future/Skytrust proposal, which
would increase the limiting price ($25/ton) by 7% above inflation
annually, and the Brookings proposal, which would set up a short-term
market based on a $10/ton price, and a long-term market based on market
rates.⁹
^!Contingent reduction: generally conceived as a declining emission cap
system where the rate of decline over time is determined by the market
price of permits. If permit prices remain under set threshold prices, the
next reduction in the emission cap is implemented. If not, the cap is held
at the current level until prices decline.¹⁰ Discussions have centered on
a 2% annual declining cap subject to a $5 a permit CO² cost cap.
^!Excess emissions penalty: generally involves a fee on emissions
exceeding available permits based on control costs or other economic
criteria, rather than criminal or civil considerations. For example,
Oregon’s CO² standard for new energy facilities includes a fee of 57
cents per short ton on CO² emissions in excess of the standard (increase
to 85 cents proposed).¹¹
Discussion
Table 1 summarizes the key considerations of each of the proposals identified above.
As indicated, each safety valve effectively controls cost, but at the price of some
uncertainty about the amount of emissions reduced.

⁸ The National Commission on Energy Policy, Ending the Energy Stalemate: A Bipartisan
Strategy to Meet America’s Energy Challenges, December 2004, p. 21.
⁹ Raymond Kopp, Richard Morgenstern, William Pizer, and Michael Toman, A Proposal for
Credible Early Action in U.S. Climate Policy, available at [http://www.weathervane.rff.org/
features/feature060/pb66.htm]; Americans for Equitable Climate Solutions, Sky Trust Initiative:
Economy-Wide Proposal to Reduce U.S. Carbon Emissions, available at [http://www.aecs-
inc.org/skytrust.htm]; and Warwick J. McKibbin, Moving Beyond Kyoto, Policy Brief #66,
October 2000, available at [http://www.brook.edu/comm/policybriefs/pb066/pb66.htm].
¹⁰ See Clean Power Group website: [http://www.eea-inc.com/cleanpower/index.html].
¹¹ State of Oregon, OAR, Chapter 345, Division 24.

Table 1. Key Considerations of Safety Valves
Cost-Emission Implementation Enf orcement O ther
Reduction
Balance
Carbon TaxA cost-focusedStrategy can beStrategy is self-Strategy would
strategy withimplemented eitherenforcing.generate sizeable
reductionsupstream orrevenues that
achieveddownstream. Cancould be
dependent on thealso berecycled or used
tax imposed.implementedfor other
across differentpriorities.
economic sectors.
UnlimitedA transitionalStrategy placesBesides requiringA low price for
Permits at astrategy fromfocus on the excessthe usualexcess emission
set pricecost-focused toemissions permit’smonitoring/permits could
reduction-initial price, andtrackinghave the effect
focused. the schedule of anymechanisms of aof flooding the
Emissionprices increases ortradeable permitpermit trading
reductionsexcess emissionssystem, strategymarket,
dependent on thepermit phase-out requires a systemdiscouraging any
price set forover time. to separatelytrading.
excess emissionstrack allocations
permits.of excess
emission permits.
ContingentAn interactiveStrategy requiresBesides requiringPotential market
Reductionsstrategy whereagreement onthe usualmanipulation to
costs determineemission reductionmonitoring/avoid increased
reductions andschedules,trackingreduction
reductionsappropriate permitsmechanisms of arequirements is a
determine costsprices to triggertradeable permitserious issue.
through a marketthose schedules,system, strategy
mechanism. and the specificrequires major
Emissionprice determinationoversight of
reductionsmechanism (spotpermit market
dependent on avs. long-termoperations.
freelyprices).
functioning
permit market.
ExcessAn incrementalStrategy placesRequires theStrategy is most
emissionsstrategy wherefocus on initialusual monitoring/similar to
penaltyreductionspenalty and anytrackingexisting
achieved arescheduledmechanisms of atradeable permit
dependent on theincreases in thattradeable permitsystem.

penalty imposed.penalty over time.system only.

If one uses the existing Title IV acid rain control program as a baseline, the
excess emissions penalty option is the most similar, while the carbon tax option is the
most different. The excess emissions penalty option would work in essentially the
same fashion as the acid rain program, with the primary difference being the penalty
for having insufficient permits at the end of the year. Under Title IV, the penalty is
intended to be punitive — to punish the offender for breaking the law. Thus, the
offender pays a fine three times the estimated cost of control in addition to forfeiting a
future permit. The overriding assumption is that the offender could have reduced his
emissions sufficiently, but refused to do so. Under the excess emissions penalty
option, there is uncertainty as to whether an offender could have reduced his emissions
sufficiently at the estimated price, and that reductions at a cost greater than that price
are either socially unacceptable or economically unjustifiable. Hence, the penalty is
assessed on the basis of a socially acceptable or economically justifiable price so that
the offender pays a cost for his unlawful activity and is encouraged to comply with the
law, but is not punished beyond what society has deemed reasonable. Arriving at such
an acceptable penalty could be contentious.
The carbon tax is the most radical compared with the Title IV program because it
dispenses with the permit system approach to emissions control. All the pressure under
a carbon tax scheme is on the timing, pace, and level of the tax, as there is no stigma
for not controlling pollution. The strength of this approach is that it is self-enforcing,
and considerable revenues will be generated that could be recycled to polluters or used
for other priorities. However, U.S. environmental policy has generally opposed any
approach suggesting a polluter’s right to pollute, which the carbon tax approach does
grant.
Depending on how the unlimited permit approach is implemented, it can look and
act a lot like a carbon tax. If the initial allocation of permits is by auction and
unlimited permits are available at a low price, the auction price will equal the
unlimited permit price, resulting in a carbon tax equal to the excess emissions permit
price. Thus, without limits on the quantity of permits allowed, the unlimited permits
approach is merely a carbon tax by another name, at least in the short term. In
addition, the unlimited permits system requires the tracking mechanisms of a tradeable
permit system if it is ever to evolve into a permit system. As with a carbon tax, setting
the unlimited permit price could be contentious.
The contingent reduction approach attempts to turn both the price and the
quantity of reductions into variables solved by the trading market. This requires
agreements on both the profiles of emissions reductions and threshold price triggers. It
also puts enormous pressure on the trading permit market to produce an accurate price
to make the whole system work. Although in some ways the most innovative, the
contingent approach also could be the most difficult in terms of arriving at acceptable
parameters for the reductions and triggers.
In short, employing a safety valve shifts much of the emission reduction debate
from compliance targets to the specifications of the safety valve. The safety valve
becomes the controlling mechanism of the permit tradeable system, or the sole
mechanism in the case of a carbon tax. Whether this shift would contribute to an
acceptable result is not clear.