Brookings: Experts - Peter J. Wilcoxen

China’s Carbon Tax Proposal Highlights the Need for a New Track of Climate Talks

Adele Morris, Warwick J. McKibbin and Peter J. Wilcoxen — Fri, 15 Mar 2013 00:00:00 -0400

China’s Ministry of Finance recently announced a carbon tax. Although the statement was vague about the timetable and the tax rate, the mere prospect of China pricing carbon should have prompted swift laudatory international responses, especially by countries that have long hectored China to take stronger action on climate. China’s announcement, and the underwhelming response of the international community, shows that it’s time to start an international conversation about pricing carbon and invite anyone who’s interested aboard. A Carbon Pricing Consultation (CPC) would allow China and other countries that want to price carbon (via a carbon tax, cap-and-trade system or a hybrid approach) to learn more about it, exchange views, find out what other countries are considering, and potentially coordinate their policies.

In a recent paper we proposed a CPC process that would lead to detailed, pragmatic, and ongoing international discussion of the implementation details of domestic carbon pricing approaches, policies that economists widely agree could address the climate problem cost effectively. A domestic carbon price creates broad, efficient incentives to reduce greenhouse gas emissions. Done well, it would gradually shift consumer demand, production methods, new investment, and technology development towards less emissions-intensive goods and services without unduly burdening poor households. Pricing carbon can also raise revenue to fund government programs or cut distortionary taxes. Finally, a carbon price can promote economic growth by replacing less efficient regulatory and spending policies.

Accordingly, we think parties should embrace carbon pricing as a key low-carbon growth strategy and establish a venue to discuss it. Disparate carbon prices across different countries can shift emissions, production, investment, and trade patterns, and mutual understanding of these cross-border effects is of interest to all. Several countries have adopted or are implementing carbon pricing policies, so there is increasing experience to discuss. And the vehement opposition to the EU’s efforts to price carbon in aviation fuels suggests that unilateral approaches to carbon pricing can undermine progress.

This moment to begin a CPC process is opportune. Climate talks in December 2012 in Doha, Qatar, resolved contentious questions about the future of the Kyoto Protocol and finally retired the constraints of the Bali agenda. Now negotiators will turn to developing a new agreement under the United Nations Framework Convention on Climate Change to cover the post-2020 period. At the same time, the Major Economies Forum (MEF) needs a new thrust of engagement, having developed the Clean Energy Ministerial into an enduring venue for technology discussions. A CPC would fit nicely within the MEF, or possibly the G20.

This new line of discussion would address a glaring gap in climate talks to date. Negotiations have tackled emissions targets, temperature targets, technology transfer, financial assistance to poor countries, forest preservation, and many other topics, but not the practical design of cost-effective domestic mitigation policy. Indeed, few countries include their finance and trade ministries in climate talks outside of discussions of finance. This vacuum of economic expertise and leadership leaves parties prone to commitments, such as a two degree maximum global mean temperature increase, that imply implausibly stringent global efforts and fail to identify concrete solutions.

The CPC, unlike existing clean energy and climate consultations, would be led by finance and trade ministries (not the environment and energy ministries). It would focus exclusively on the practical administrative and technical aspects of responsible mitigation policy. One advantage of this pragmatic approach is that parties could sidestep divisive issues such as who bears responsibility for collective mitigation goals, who should compensate whom for what, and whose approach is more ethical. However justifiable, these debates have done little to promote real emissions mitigation.

The CPC would focus on the technical and administrative aspects of the policies, such as options to identify taxable or regulated entities and sources and methods to track revenue, minimize administrative costs, and ensure compliance. Parties could also discuss the role of international offsets and the interplay between carbon pricing and other domestic climate and energy policies. Countries could discuss ways to predict the effects of alternative tax trajectories, and they could discuss how to distribute and manage markets of allowances and tax revenue. Other topics could include the design of border carbon adjustments and other trade-related issues. The CPC could also steer existing resources to assist developing countries in reducing fossil fuel subsidies and pricing carbon.

One impediment to climate policy in the United States is the concern that without meaningful action by developing countries, pricing carbon will harm the US economy with little overall environmental benefit. A move towards transparent price-based policies give all major emitters comfort they are moving forward in concert with others. The first step is to discuss how to do it.

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Publication: East Asia Forum

Image Source: © Darley Shen / Reuters

A Climate Diplomacy Proposal: Carbon Pricing Consultations

Adele Morris, Warwick J. McKibbin and Peter J. Wilcoxen — Fri, 08 Feb 2013 10:19:00 -0500

I. Introduction

Climate talks in December 2012 in Doha, Qatar, wrapped up lines of negotiation that were begun years before in Bali. Negotiators resolved contentious questions about the future of the Kyoto Protocol and finally put the constraints of the Bali agenda behind them. Now they will turn to developing by 2015 a new agreement under the United Nations Framework Convention on Climate Change (UNFCCC) to cover the post-2020 period. At the same time, the Major Economics Forum (MEF) needs a new thrust of engagement, having developed the Clean Energy Ministerial into an enduring venue for technology discussions.[1] This momentary opening for new agenda items offers an excellent opportunity to expand the dialogue to include technical aspects of the one policy approach that would actually address the climate problem cost effectively: pricing carbon and other greenhouse gases (GHGs).

Negotiators should take this opportunity to establish a Carbon Pricing Consultation (CPC) process: a detailed, pragmatic, and ongoing discussion of the implementation details of domestic cap-and-trade and GHG taxes. A CPC process would address a glaring gap in climate talks to date. Negotiations have tackled national emissions targets, global temperature targets, technology transfer, assistance to poor countries for adaptation and mitigation (a.k.a. “finance”), clean energy, forest preservation, compensation for countries affected economically by mitigation measures, and many other topics. Carbon pricing, however, has received little multilateral attention. It has generally been considered to be a national-level policy—to be adopted at the discretion of individual governments—and therefore outside the purview of international talks. However, much could be gained by bringing countries together to discuss carbon pricing. A CPC process would provide an opportunity for negotiators, as well as the administrators of national pricing policies, to discuss how to induce, practically and efficiently, the broad economic shifts required to de-couple emissions and economic activity.

Why focus on carbon pricing? A carbon price, arising either via a cap-and-trade market or a carbon tax, creates broad, efficient incentives to reduce greenhouse gas emissions. Done well, it would gradually shift consumer demand, production methods, new investment, and technology development towards less emissions-intensive goods and services without unduly burdening poor households. A carbon tax or auctioned cap-and-trade allowances can also raise revenue to fund government outlays or reduce other, more distortionary, taxes. Finally, a carbon price can promote economic growth by replacing less efficient tax, regulatory, and spending policies. For these reasons, there is nearly universal agreement among economists that a price on carbon is a highly desirable step for reducing the risk of climatic disruption. Most would also agree that to be effective in the long run, any significant carbon policy will have to involve a price signal.

Why international consultations? First, outside of finance issues, few countries have sufficiently included their finance and trade ministries in climate negotiations. Thus the perspectives and expertise most familiar with the economics of market-based emissions approaches have been missing in the talks. Second, many countries have recently adopted carbon pricing policies, so there is increasing experience to analyze and discuss. Third, some countries that have not yet adopted carbon prices, such as the U.S., have considerable expertise in efficient administration of excise taxes and could provide valuable advice. Fourth, talks to date have focused on emissions targets, both collectively and by country, divorcing the dialogue from the economic realities of achieving those commitments. It is much easier to reach consensus on the goal of containing global mean temperature increases to 2 degrees centigrade than to grapple with the potentially high price signals on carbon that would may necessary globally to achieve the goal. Until negotiators directly address the levels of economic effort involved and how to minimize the cost, collective commitments to stabilization targets will remain both theoretical and infeasible, however compelling they may be scientifically. Fifth, disparate carbon prices across different countries can shift emissions, production, investment, and trade patterns, and mutual understanding of these cross-border effects is of interest to all parties. Finally, the vehement opposition to the EU’s efforts to price carbon in aviation fuels suggests that unilateral approaches to carbon pricing can undermine cooperation and climate policy progress. Not least, it shows the critical relationship between carbon pricing and international commerce and bolsters the case that this topic is a natural basis for a new climate diplomacy.

II. Towards Carbon Pricing Consultations

The international community should establish a CPC to provide a much needed place to discuss, laud, and understand efforts by countries to price greenhouse gases. It would differ from most talks under the United Nations Framework Convention on Climate Change (UNFCCC) in that the agenda would focus specifically on administrative, economic, and trade-related aspects of policies that price carbon and other GHGs. For example, discussions could include an exchange of countries’ views, experience, and methodologies related to:

how cap-and-trade and/or carbon tax systems work administratively;
administration of excise taxes on carbon content of fuels, including ways to identify taxable entities, establish a tax base (emissions and sources), set reporting requirements for firms, track revenue, minimize administrative costs, and ensure compliance;
ways to harmonize tax administration across countries to foster compliance by multi-national firms and prevent tax gaps and double-taxation;
the potential economic benefits to developing countries of carbon pricing as a low carbon growth strategy and efficient revenue instrument;
the environmental and economic effects of alternative carbon tax levels and tax trajectories;
mechanisms for managing allowance markets and registries, and distributing allowances or allowance auction proceeds;
the design and implementation of border carbon adjustments;
approaches to taxing carbon in bunker fuels;
the feasibility of including non-CO₂ gases, agriculture- and forest-related emissions, and process-related CO₂ emissions in a carbon pricing system;
the role of sub-national approaches;
the macroeconomic and trade impacts of carbon pricing;
the distributional effects of a price on carbon, such as effects on poor households or disproportional regional effects, and how to address them;
approaches to pricing carbon in imported and exported fossil fuels and closely-related products;
experience with the environmental performance of carbon pricing;
other fiscal reforms made in conjunction with carbon pricing (such as budget deficit reductions or reductions in other taxes), and their impacts;
approaches to fiscal cushioning (such as reducing other energy taxes while establishing a price on carbon);
how to report on carbon pricing policies so that measures can be compared across countries;
the relationship between carbon pricing and other policies, such as energy efficiency standards and renewable energy subsidies; and
efficient implementation of carbon pricing in large, complex, federalist systems.

The goal of these international discussions would be to build mutual comfort and confidence in carbon pricing, share views, prevent disputes and trade disruptions, identify and replicate successful approaches, learn from one another’s mistakes, build institutional capacity, and generally promote mutual cooperation on serious, economically efficient, measures to mitigate emissions.

The CPC could also consider how to guide resources and activities of existing bilateral consultations, multi-lateral development banks, the Green Climate Fund, other institutions, and private sector entities towards efficient carbon pricing. One particular option could be to find ways to assist developing countries in their efforts to reduce fossil fuel subsidies and adopt a carbon tax or cap-and-trade program for greenhouse gases. For example, the U.S. Environmental Protection Agency already works with China’s Ministry of Environmental Protection to build the institutions and infrastructure for sulphur dioxide cap-and-trade programs.[2] And the Asian Development Bank currently assists its member countries in establishing and enforcing value-added taxes. The CPC could discuss whether multilateral technical support, either directly through member agencies or through regional development banks, could assist developing countries with similar measures for greenhouse gas emissions trading and carbon excise taxes.

The CPC could also consider ways to enlist existing institutions for analytical support related to carbon pricing. For example, the International Monetary Fund recently issued a report on fiscal policy approaches to mitigate climate change that can help policymakers in its member countries think through the potential for a carbon tax.[3] Likewise, the OECD has prepared an illuminating cross-country comparison of energy and carbon pricing approaches.[4] The CPC could consider ways to expand or target efforts by these institutions to facilitate cooperation on climate change.

It may be possible—and it is desirable—to embed the CPC within the Major Economies Forum, the G-20, or other existing forums as much as feasible. The defining characteristic of the CPC, distinguishing it from existing clean energy and climate consultations, would be that the finance and trade ministries (not the environment and energy ministries) would take the lead. These are the ministries charged with international economic relationships, tax administration, and general macroeconomic stewardship. Of course, to the extent that environment or energy ministries oversee domestic carbon tax or cap-and-trade systems, they would play a role. However, the focus of the discussions would be on the technical, administrative, and economic cooperation aspects of carbon pricing policies, with minimal attention to whether any particular country’s approach would achieve any particular emissions target or other goal. To that end, the typical level of engagement within the CPC may best lie below that of the ministerial level, and it should include those with technical expertise.

One advantage of this approach is that it would separate the work of the CPC, i.e. the pragmatic details of carbon pricing, from divisive issues such as who bears what responsibility for collective mitigation goals, who should compensate whom for what, and whose approach is more ambitious or moral. These debates, however important, have contributed little to global emissions mitigation. Subsequent or parallel efforts can review the adequacy of the price signals and seek to increase and/or harmonize them; the CPC should center on relatively low-profile but critically important administrative and technical policy exchanges by interested countries. An underlying premise is that most major emitters have a mutual interest in effective policy machinery to price carbon.

One useful outcome of the CPC dialogue could be to shape negotiations under the UNFCCC so that countries can supplement their emissions targets with commitments in the form of carbon pricing, allowing compliance by either achieving their emissions targets or by demonstrating significant effort through imposing agreed price signals.[5] Price-based commitments would reduce the risk of inadvertent stringency or laxity, help achieve and document compliance, and allow Parties to compare their efforts transparently.

III. Why a CPC is in the interests of the United States

Consultations around mutual efforts to price carbon are clearly in the interests of countries that have already adopted or are seriously considering adopting such policies. However, even though the U.S. does not currently price carbon at the Federal level, it would also benefit from carbon pricing consultations.

First, an increasing number of US trading partners are adopting carbon pricing, and it is in the US interest to follow these developments closely. Carbon taxes have been adopted in Sweden, Australia, Finland, Ireland, Norway, and South Africa, and the EU has a major CO₂ emissions trading system. As mentioned above, India has a small tax on coal, and China is experimenting with cap-and-trade measures at the local and regional level for possible expansion nationwide. Canada also has several sub-national carbon pricing systems.

To be sure, the magnitude of the price signals and the scope of emissions to which they apply vary significantly across and within countries. But gradually more global fossil fuel consumption is falling under some sort of carbon pricing policy. The United States should welcome a venue in which it can learn from other countries’ efforts, discuss potential economic spillovers and effects on international commerce, and foster discussions that could prevent international incidents such as the dispute over the EU aviation tax.

Second, the United States has considerable tax administration and cap-and-trade expertise that could highlight potentially successful approaches. Although this experience is not climate-related, the United States deploys an efficient and highly compliant excise tax system, and it could assist developing country efforts to build their own capacity to tax carbon. For example, the United States missed an opportunity to applaud and support India’s recent adoption of a small tax on coal. The United States could offer to share its experience in administering its similar coal excise tax, which it collects under the Black Lung Benefits Act of 1977. The United States also has long experience with cap-and-trade systems for criteria air pollutants, much of which is transferable to greenhouse gas emissions trading.

Finally, one key impediment to carbon pricing in the United States is the concern that if the United States prices carbon and other major emitters don’t, then U.S. climate efforts will harm its economy to little environmental benefit. An international venue to discuss carbon pricing policies among major emitters could fruitfully evolve into a place to address such concerns and coordinate, if not fully harmonize, carbon price signals.

IV. Next Steps

As a way forward, we recommend that at their next meeting this spring in Washington, MEF members discuss their preliminary views around the potential for carbon pricing consultations and options for CPC agenda items for future MEF meetings. Australia, given its experience in carbon pricing design, could also propose a CPC agenda item for the G-20 meetings that it will host in Brisbane next year. Discussions within the MEF and G20 could explore whether members believe a CPC agenda item would be productive within the UNFCCC process.

[1] The 17 major economies participating in the MEF are: Australia, Brazil, Canada, China, the European Union, France, Germany, India, Indonesia, Italy, Japan, Korea, Mexico, Russia, South Africa, the United Kingdom, and the United States.

[2] For more, see EPA’s Clean Air Markets website: http://www.epa.gov/airmarkt/international/china/index.html

[3] Fiscal Policy to Mitigate Climate Change: A Guide for Policymakers, edited by Ian W.H. Parry, Ruud de Mooij, and Michael Keen, International Monetary Fund, 2012.

[4] Taxing Energy Use: A Graphical Analysis, OECD Publication, January 28, 2013.

[5] McKibbin, Morris, and Wilcoxen (2012) outline just such an approach. http://www.brookings.edu/research/papers/2012/07/carbon-tax-mckibbin-morris-wilcoxen.

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Bridging The Gap: Integrating Price Mechanisms Into International Climate Negotiations

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Mon, 03 Dec 2012 15:34:00 -0500

EXECUTIVE SUMMARY

The Parties to the United Nations Framework Convention on Climate Change (UNFCCC) continue their efforts to forge a new binding international agreement by 2015. The negotiations face daunting odds, but the 2009 Copenhagen Accord’s shift towards heterogeneous national commitments was a positive step forward for climate policy. The prior presumption that binding commitments could only take the form of a percentage reduction relative to historical levels alienated rapidly industrializing countries and led to unproductive disputes over base years and other issues of target formulation. However, the disparate approaches now under discussion complicate comparing the likely emissions reductions and economic efforts required to achieve the commitments.

This paper makes two points. First, we offer good reasons and ways to adapt international negotiations to allow for price-based commitments. The economic uncertainty surrounding target-only commitments is enormous. Combining a clear cumulative emissions target with limits on the cost associated with achieving the target would balance the environmental objective with the need to ensure that commitments remain feasible. This economic insurance could foster greater participation in the agreement and more ambitious commitments. Specifically, we suggest that in addition to their cumulative emissions targets for the 2013 to 2020 period, major economies could agree to a "price collar" on greenhouse gas emissions in their domestic economies. This would include starting floor and ceiling prices on a ton of CO2 and a schedule for real increases in those prices. All major parties would need to show at least a minimum level of effort regardless of whether they achieve their emissions target, and they would be allowed to exceed their target if they are unable to achieve it in spite of undertaking a high level of effort. The paper provides an example of how a price collar would work in the U.S. context under a cap-and-trade system.

Second, analyzing proposed climate commitments in terms of their implied economic stringency, as measured by the implied price on carbon necessary to achieve the targets, offers transparent and verifiable assurance of the comparability of effort across countries. It possible to calculate "carbon price equivalents" of climate commitments in a conceptually similar way to the tariff equivalents used in international trade negotiations.

In sum, the lack of transparency in the level of effort involved in achieving particular emissions targets highlights the potential value of allowing for price-based commitments and argues for greater economic transparency in the international negotiation process.

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Bridging The Gap: Integrating Price Mechanisms Into International Climate Negotiations

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Pricing Carbon in the U.S.: A Model-Based Analysis of Power Sector Only Approaches

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Wed, 10 Oct 2012 12:25:00 -0400

EXECUTIVE SUMMARY

In June 2010, as the prospects in the U.S. Senate for an economy-wide cap-and-trade bill dimmed, some proponents of climate policy began to push for an approach more limited in scope. One proposed way to limit the scope of the bill was to apply the cap-and-trade program only to the carbon dioxide (CO2) emissions from electricity generation. This paper uses an intertemporal computable general equilibrium (CGE) model of the world economy called G-Cubed to compare a power-sector-only climate policy with economy-wide measures that either place the same price on carbon or achieve the same cumulative emissions reduction as the program limited to the power sector.

We first model a power-sector-only scenario (the Core Scenario) that broadly represents the emissions reduction ambition of a proposal offered by Senator Bingaman in July 2010. We calculate a linearly declining series of emissions caps for U.S. electricity generation from 2012 to 2030 that fall to 17 percent below 2005 levels in 2020 and 42 percent below 2005 levels in 2030. We calculate the CO2 price path that rises at the real interest rate that achieves cumulative emissions equal to the sum of the caps. The price rises at the real interest rate to 2030 and is constant thereafter. We assume that all tax revenues are distributed lump sum back to U.S. households. We then model a second scenario (the Same Price Scenario) in which the carbon price from the first scenario is applied to all fossil CO2 emissions in the US economy, not just CO2 from the power sector. Comparing this with the Core Scenario shows the incremental emissions reductions and other effects of expanding the policy from the power sector to the entire economy. The third scenario (the Same Emissions Scenario) calculates the increasing CO2 price path that if applied to all fossil energy CO2 achieves the same cumulative reductions as the Core Scenario through 2030. Comparing it with the Core Scenario shows the consequences, for both carbon prices and other effects, of using a narrow rather than a broad-based policy. To isolate the effects of U.S. policy, we assume the U.S. alone adopts these climate policies, with no comparable efforts abroad.

As might be expected, the Core Scenario results in a carbon price in the power sector that is almost twice the economy-wide price that achieves the same cumulative emissions. In particular, the power-sector-only approach requires a price on CO2 that begins at $23 in 2012 and rises to $46 in 2030, whereas the economy-wide price begins at $13 in 2012 and rises to $25 in 2030. We find that a price on carbon only in the power-sector does not produce offsetting increases in emissions in other sectors. Rather, we find that carbon emissions outside the power sector fall slightly relative to baseline. This is because of the economic linkages between sectors and the consequences of higher electricity prices on overall economic activity. Global emissions leakage is negligible as the price of oil in other currencies changes little.

All three policies have modest (less than one percent) negative effects on employment in the first decade and little effect thereafter. The policies that price carbon in oil, the Same Price and Same Emissions scenarios, produce much more revenue than the Core scenario.

We find that GDP grows in all of the scenarios at a rate slightly below the reference average in the first decade, but then remains close to reference thereafter. The most environmentally effective policy, the Same Price scenario, also produces the largest short run negative effect on GDP growth and long run negative effect on investment and consumption levels.

We find that all three policy scenarios reduce investment in the capital-intensive energy sector, which lowers imports of durable goods and strengthens the U.S. terms of trade. Thus we find trade consequences of climate policy even in the power-sector-only scenario, which one might think would have relatively low effects on terms of trade given that the U.S. electricity sector uses mostly non-traded fuels. All of the policy scenarios produce an overall decrease in consumption and investment in the U.S. relative to baseline. For consumption, the positive effect from relatively lower price of imported goods is offset by the declines due to higher embodied energy prices.

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Pricing Carbon in the U.S.: A Model-Based Analysis of Power Sector Only Approaches

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The Potential Role of a Carbon Tax in U.S. Fiscal Reform

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Tue, 24 Jul 2012 16:15:00 -0400

Executive Summary

This paper examines fiscal reform options in the United States with an intertemporal computable general equilibrium model of the world economy called G-Cubed. Six policy scenarios explore two overarching issues: (1) the effects of a carbon tax under alternative assumptions about the use of the resulting revenue, and (2) the effects of alternative measures that could be used to reduce the budget deficit. We examine a simple excise tax on the carbon content of fossil fuels in the U.S. energy sector starting immediately at $15 per metric ton of carbon dioxide (CO2) and rising at 4 percent above inflation each year through 2050. We investigate policies that allow the revenue from the illustrative carbon tax to reduce the long run federal budget deficit or the marginal tax rates on labor and capital income. We also compare the carbon tax to other means of reducing the deficit by the same amount.

We find that the carbon tax will raise considerable revenue: $80 billion at the outset, rising to $170 billion in 2030 and $310 billion by 2050. It also significantly reduces U.S. CO2 emissions by an amount that is largely independent of the use of the revenue. By 2050, annual CO2 emissions fall by 2.5 billion metric tons (BMT), or 34 percent, relative to baseline, and cumulative emissions fall by 40 BMT through 2050.

The use of the revenue affects both broad economic impacts and the composition of GDP across consumption, investment and net exports. In most scenarios, the carbon tax lowers GDP slightly, reduces investment and exports, and increases imports. The effect on consumption varies across policies and can be positive if households receive the revenue as a lump sum transfer. Using the revenue for a capital tax cut, however, is significantly different than the other policies. In that case, investment booms, employment rises, consumption declines slightly, imports increase, and overall GDP rises significantly relative to baseline through about 2040. Thus, a tax reform that uses a carbon tax to reduce capital taxes would achieve two goals: reducing CO2 emissions significantly and expanding short-run employment and the economy.

We examine three ways to reduce the deficit by an equal amount. We find that raising marginal tax rates on labor income has advantages over raising tax rates on capital income or establishing a carbon tax. A labor tax increase leaves GDP close to its baseline, reduces consumption very slightly and expands net exports slightly. Investment remains essentially unchanged. In contrast, a capital tax increase causes a significant and persistent drop in investment and much larger reductions in GDP. A carbon tax falls between the two: it lowers GDP more than a labor tax increase because it reduces investment. However, its effects on investment and GDP are more moderate than the capital tax increase, and it also significantly reduces CO2 emissions. A carbon tax thus offers a way to help reduce the deficit and improve the environment, and do so with minimal disturbance to overall economic activity.

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The Potential Role of a Carbon Tax in U.S. Fiscal Reform

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Subsidizing Household Capital: How Does Energy Efficiency Policy Compare to a Carbon Tax?

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Wed, 26 Oct 2011 17:28:00 -0400

The full article, included in the Quarterly Journal of the IAEE's Energy Economics Education Foundation Volume 32, Special Issue, can be accessed through the journal website or is available as a direct download (pdf).

ABSTRACT

This study uses a general equilibrium model to compare environmental and economic outcomes of two policies: (1) a tax credit of 10 percent of the price of household capital that is 20 percent more energy efficient than its unsubsidized counterpart, assuming half of new household investment qualifies for the credit; and (2) a tax starting at $30 ($2007) per metric ton of CO2 rising five percent annually. By 2040, the carbon tax and tax credit reduce emissions by about 60 1.5 percent, respectively. Assuming other countries impose no carbon price, we find that although the carbon tax reduces U.S. GDP, it improves U.S. household welfare because it reduces world fuel prices, strengthens U.S. terms of trade, and makes imports cheaper. The revenue neutral tax credit reduces welfare but boosts U.S. GDP growth slightly at first. Both policies have similar impacts on the federal budget, but of opposite signs.

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Publication: International Association for Energy Economics

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Subsidizing Energy Efficient Household Capital: How Does It Compare to a Carbon Tax?

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Mon, 25 Oct 2010 16:48:00 -0400

Abstract
Current U.S. law offers a variety of tax credits for different kinds of energy efficient household capital. This study uses an intertemporal general equilibrium model to compare the environmental and economic performance of two policies: (1) a tax credit of 10 percent of the price of household capital that is 20 percent more energy efficient than its unsubsidized counterpart, assuming half of new household investment qualifies for the credit; and (2) a tax starting at $30 ($2007) per metric ton of carbon dioxide (CO2) and rising 5 percent (inflation adjusted) each year. By 2040, the carbon tax reduces emissions by 60 percent while the investment tax credit for energy-efficient capital reduces emissions by about 1.5 percent. Under the assumption that other countries do not adopt a price on carbon, we find that although the carbon tax reduces U.S. GDP, it improves the welfare of U.S. households because it reduces the world price of fuels, strengthens U.S. terms of trade, and makes imported goods cheaper. The revenue neutral tax credit reduces welfare but boosts U.S. GDP growth slightly in the first few years. Both policies have similar impacts on the federal budget, but of opposite signs.

1. Introduction
Proponents of ambitious climate policy often support imposing both a price on carbon and “complementary policies” to provide incentives for the deployment of energy-efficient and low carbon technologies. Current U.S. law offers an extensive variety of tax benefits for certain kinds of energy production and conservation, including incentives for renewable electricity production, energy efficient household investments, and bio-fuel production. The U.S. Congress expressed its continued enthusiasm for these measures in the American Recovery and Reinvestment Act of 2009 (Recovery Act), which extended many consumer energy-related tax incentives as part of the fiscal stimulus package.

In particular, the Recovery Act expanded two energy-related tax credits for households: the non-business energy property credit and the residential energy efficient property credit. The non-business energy property credit equals 30 percent of homeowner expenditure on eligible investments, up to a maximum tax credit of $1,500 over 2009 and 2010. The capital and labor costs of certain high-efficiency heating and air conditioning systems, water heaters and stoves that burn biomass qualify, as does the capital (but not labor) cost of certain energy-efficient windows, doors, insulation and roofs. The residential energy efficient property credit equals 30 percent of the installed costs of solar electric systems, solar hot water heaters, geothermal heat pumps, wind turbines, and fuel cell systems.

Another potential expansion of subsidies for energy efficiency appears in HOME STAR, a bill designed to strengthen short-term incentives for energy efficiency improvements in residential buildings. This proposal would establish a $6 billion rebate program for energyefficient appliances, building mechanical systems and insulation, and whole-home energy efficiency retrofits. The program targets energy efficiency measures that would achieve an energy efficiency gain of 20 percent.

One key goal of subsidies for energy efficiency investments is to reduce electricity generation and thereby reduce carbon dioxide emissions and other air pollutants. Some analyses suggest that increasing energy efficiency is a relatively low, possibly negative, cost way to abate greenhouse gas emissions and other air pollutants as well. However, adoption rates for energy efficient technologies fall short of levels that many believe are justified by the potential return on such investments. For example, the rates of return households apparently require for investments in energy efficiency are considerably higher than the rates of return used by electric utilities when investing in new generation. That difference in rates of return has spurred the development of utility-based demand side management (DSM) programs which often include subsidies for household energy efficiency. A growing economic literature explores this “energy-efficiency gap.”

Regardless of the net benefits from investments in energy efficient capital, recent expansions in policies to promote those investments raises the question of how much they reduce carbon emissions and how they compare to policies that target carbon more directly. This paper uses an intertemporal general equilibrium model called G-Cubed to compare and contrast the environmental and economic performance in the United States of a tax credit for energy efficient household capital and an economy-wide price signal on carbon from fossil fuels used in the energy sector. We choose the tax credit and carbon tax rates of those policies so that they have roughly comparable fiscal impact on the US government; that is, if the policies were implemented together, the revenue from the carbon tax would offset most of the reduction in revenue associated with the tax credit. When examining the policies individually, we use a lump sum tax or rebate in order to hold federal spending and the budget deficit constant. A tax credit for energy-efficient household capital reduces its relative price to homeowners and induces them to invest more. As household capital turns over, the energy saving properties of the policy accrue along with the aggregate tax expenditure up to the point where households have adopted all the energy efficient capital that is cost-effective at the subsidized rate. Unless market conditions evolve to the contrary, the government must sustain the subsidy to prevent households from reverting to purchasing relatively lower efficiency capital. As a result, it will have permanent effects throughout the economy. By raising the rate of return on household capital relative to capital in other sectors, the subsidy permanently shifts the economy’s overall portfolio of physical capital.

The empirical evidence on the effects of investment tax credits is limited and pertains primarily to the effect of tax credits on investment levels and energy savings. Gillingham et al. (2006) summarize the literature on tax credits to promote energy efficiency. Hassett and Metcalf (1995) show that a 10 percentage point change in the tax price for energy investment would lead to a 24 percent increase in the probability of energy conservation investment. The degree to which households and firms anticipate policies can significantly affect the results, particularly in the early years of the policy. For example, if households anticipate a subsidy to capital then they will delay acquiring capital they would otherwise purchase in order to take advantage of the subsidy later. Similarly, Hassett and Metcalf (1995) and others point out that tax credits are unlikely to be efficient tools for reducing carbon emissions. Consumers who would have purchased energy efficient capital in the absence of the subsidy receive a windfall, and unless the subsidy is perceived to be permanent, the effect could be to induce an intertemporal substitution in investments more than a net increase. This intertemporal substitution can be an important real-world policy effect, and it is captured in the G-Cubed model via forward-looking behavior on the part of households and other investors.

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Comparing Climate Commitments: A Model-Based Analysis of the Copenhagen Accord

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Thu, 27 May 2010 00:00:00 -0400

Executive Summary: The political accord struck by world leaders at the United Nations negotiations in Copenhagen in December 2009 allows participating countries to express their greenhouse gas commitments in a variety of ways. For example, developed countries promised different percent emissions reductions relative to different base years by 2020. China and India committed to reducing their emissions per unit of gross domestic product (GDP) relative to 2005 by 40 and 20 percent respectively. Such flexibility promotes consensus by allowing each country to use its preferred commitment formulation. However, the disparate approaches and widely varying baseline trends across different economies complicate comparing the likely emissions reductions and economic efforts required to achieve the commitments.

This paper provides such a comparison by analyzing the Copenhagen targets using the GCubed model of the global economy. We begin by formulating a no-policy baseline projection for major world economies. We then model the Copenhagen Accord’s economy-wide commitments, with a focus on fossil-fuel-related CO2. We show how different formulations make the same targets appear quite different in stringency, and we estimate and compare the likely economic and environmental performance of major emitters’ Copenhagen targets. The analysis also explores the spillover effects of emission reductions efforts on countries that did not adopt economy-wide emissions targets at Copenhagen.

We emphasize that this work is not a policy analysis or a prediction about how countries will actually achieve their commitments. Rather, it offers a way of standardizing and comparing heterogeneous proposals with an eye towards assessing their relative environmental and economic consequences.

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Around the Halls: Copenhagen Climate Change Conference

Adele Morris, Emmanuel Asmah, Nathan Hultman and Peter J. Wilcoxen — Wed, 09 Dec 2009 08:44:00 -0500

Experts from the Global Economy and Development program analyze the talks at the 15th U.N. climate change conference in Copenhagen and provide comments on the key areas that will likely be addressed, including the status of U.S. climate legislation, low-carbon energy technologies, and financing for Africa.

Learn more about climate change policy and the governing bodies and agreements »

In this edition:

Adele Morris: COP15 and U.S. Climate Legislation »
Nathan Hultman: Climate Change and Low-Carbon Innovation »
Emmanuel Asmah: Climate Change, Africa, and Its Vulnerable Nations »
Peter J. Wilcoxen: Copenhagen and the Global Community »

How will the current state of U.S. climate legislation impact negotiations in Copenhagen? And, following COP15, how will the negotiations affect next steps for U.S. legislation?
Adele Morris, Fellow and Policy Director for Climate and Energy Economics, Global Economy and Development

President Obama is being as forthcoming as he possibly can in the climate talks without having legal authority to implement an economy-wide constraint on greenhouse gas emissions. He needs new authority to pursue his target of emissions reductions in the “range of 17 percent” relative to 2005 levels. Although the EPA just finalized its finding that greenhouse gases are dangerous, which is an important step toward using the Clean Air Act (CAA) to control greenhouse emissions, the existing authority is ill-suited to controlling climate change in a low-cost way. Probably the most effective way the EPA can use the CAA is to credibly threaten costly regulation to prompt Congress to enact a new, more efficient climate law.

With whatever comes out of Copenhagen, the ball really stays in Congress’ court. Congress isn’t bound by administration promises abroad, and it appears to be a steep climb in the Senate to pass legislation to meet the president’s goal. Indeed, if the U.S. delegation caves in to demands by the Europeans and others for even more stringent U.S. commitments, the Copenhagen agreement could flop domestically. Thus the president is seeking the slim intersection of what is achievable in the negotiations and what is implementable at home. We’ll see over the coming months whether that intersection exists.

What type of low-carbon projects are appropriate for developing countries, and how can they be financed?
Nathan Hultman, Nonresident Fellow, Global Economy and Development

While popular attention has focused almost exclusively on the the allocation of emissions targets across countries, the Copenhagen conference is also about much more: establishing new and effective approaches to technological innovation, improving international carbon market operations, establishing sound mechanisms for advanced developing countries to make concrete commitments on low-carbon energy infrastructure, setting new procedures for reducing deforestation, and initiating new funding for helping the poorest countries adapt to likely climate changes. The key emitting countries have already made specific and concrete proposals across all these areas, including quantitative targets from China, India, and the U.S. As such, while a complete and final agreement on targets may be unlikely at Copenhagen, substantial resolution of multiple climate goals is more likely now than at any other time in the past.

As we look at the anticipated growth of emissions over the coming decades, it is clear that the large emerging economies—China, India, and Brazil to name a few—are of fundamental importance. Their emissions might be expected, absent any action, to grow faster and far more substantially than other countries’. As such, innovative approaches to reducing this rate of growth are essential as part of a global climate policy. These countries are embracing the challenge, setting forth ambitious energy policy goals and emissions intensity targets, but international support can provide additional assistance. For this reason, expansion and improvement of international carbon markets—such as those established under the Clean Development Mechanism—is a key task of the Copenhagen meeting. In addition, concrete agreements on technology cooperation, creative international approaches to technological innovation, and honest treatment of intellectual property rights can provide the basis for unleashing these countries' vigorous entrepreneurial engines to implement those low-carbon energy technologies that are best suited to their own development contexts.

With climate change already affecting African farmers, food productivity and prices, how can leaders at Copenhagen protect Africa's vulnerable nations?
Emmanuel Asmah, Africa Research Fellow, Africa Growth Initiative, Global Economy and Development

Although Africa only contributes between two to five percent of greenhouse gas emissions worldwide, it faces some of the greatest threats from climate change: floods and droughts further imperil agricultural production and food security, water availability, and threaten coastal cities and towns. Mitigation and adaptation costs are especially high for Africa, while most African countries do not have the technological, financial, or human resources available to combat these effects. Developed countries, which have emitted the greatest share of greenhouse gases currently in the climate system, should demonstrate more commitment to reducing emissions to the levels that mitigate global warming effects.

More than rhetoric, African countries desperately need a quantifiable and binding commitment by the wealthy nations to support efforts by African governments to 1) transform agriculture through technology transfer, and 2) provide financial aid and capacity building for mitigation activities. This will be an important signal by world leaders at the forthcoming Copenhagen conference that they are committed to addressing the food security and poverty effects from climate change. A further commitment to reward African governments that demonstrate sound agricultural practices and innovative policies to reduce deforestation and land degradation will be a bigger step in the right direction.

What can the leaders in Copenhagen do to move the global community toward effective climate action?
Peter J. Wilcoxen, Nonresident Senior Fellow, Global Economy and Development

The Copenhagen climate conference could break a long-standing deadlock in international climate policy. Climate negotiations since 1996 have taken a top-down approach focused on setting internationally-enforceable national targets and timetables for emissions reductions. That has lead to years of stalemate because it demands that national governments cede control of their energy sectors to new international institutions. Countries with large emissions or rapid economic development have been reluctant to do so.

Copenhagen could lead the way toward a much more effective and practical climate policy as long as negotiators are willing to move toward a more flexible approach with a greater role for carbon prices. A successful treaty would work from the bottom up: enhancing, encouraging and extending the wide diversity of policies currently undertaken at regional or national levels.

For the bottom-up approach to work, provisions are needed that would allow carbon prices (including the price equivalent of regulatory policies) to complement or replace emissions targets as a recognized means of compliance. Prices provide an excellent measure of the stringency of alternative policies and would provide a clear standard for comparison across countries. Treaty language addressing prices would also help ensure that the treaty achieves the goal of “comparability of effort” established during the 2007 Bali negotiations.

A good approach would be to include a “price collar” that allows each country to set specified upper and lower limits on carbon prices within its borders—including an initial price floor and ceiling per ton of carbon-equivalent emissions, and an annual real growth rate for both. The floor would eliminate the incentive for countries to negotiate very lax emissions targets, and the ceiling would provide a politically crucial mechanism to contain costs. A price collar would provide much greater predictability about the returns to investments that reduce emissions. It would help the policy weather future economic turbulence, and would accommodate developing countries like China that are uncomfortable with hard emissions caps.

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Achieving Comparable Efforts through Carbon Price Agreements

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Tue, 01 Dec 2009 00:00:00 -0500

The United Nations Framework Convention on Climate Change (UNFCCC)’s 2007 Bali Plan of Action calls for the next agreement to ensure the “comparability of efforts” across developed countries while “taking into account differences in their national circumstances.” Trends in national emissions and economic growth vary widely between countries, as do year-to- year fluctuations around those trends. This means that achieving similar reductions relative to historical base years can require very different levels of efforts in different countries. These differences have greatly hampered climate cooperation because it means that commitments that are similar in effort look inequitable. Further, divergent underlying trends make it difficult to know the effort that any particular commitment will require. The failure of the G- 8 to set a base year for its agreed 80 percent reduction of emissions by 2050 illustrates the contention in formulating even collective targets.

The presumption that binding commitments can take only the form of a percentage reduction relative to historical levels has dimmed the long term prospects for stabilizing the climate, not least because it alienates rapidly industrializing countries such as China and India. Parties could negotiate emissions levels rather than reductions relative to base years, but even then they are not assured of comparable efforts because many things that affect the burden of achieving the target can happen between the year of negotiation and the commitment period. The recent financial crisis and global economic downturn are clear reminders of the volatility in the underlying economic environment in which parties make these emissions commitments. Additional uncertainties include unanticipated economic growth, technology breakthroughs, prices for renewable energy and natural gas (a lower-emitting alternative to coal), and political instability. To properly protect the climate, the international regime should endure through any number of economic and political fluctuations.

A Price Collar for Major Economies
Here we offer a way forward. Parties could break the stalemate around hard targets and ensure the comparability of efforts by supplementing commitments on emissions with commitments for price signals on carbon. Under our proposal, all major parties would need to show at least a minimum level of effort regardless of whether they achieve their emissions target, and they would be allowed to exceed their target if they were unable to achieve it in spite of undertaking a high level of effort.

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Publication: The Harvard Project on International Climate Agreements

G‐20 and Climate Change: Achieving Comparable Effort Through a Carbon Price Collar

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Thu, 17 Sep 2009 00:00:00 -0400

The below is one in a series of recommendations to G-20 leaders on how to construct their policies so that the world economy progressively gains in strength while the long-run health of public finances does not threaten the recovery process.

Climate negotiations are currently at the forefront of global policy debates. Leaders at the G-20 Summit in Pittsburgh should focus on the challenges associated with the negotiations, how the recent economic crisis has aff ected countries on meeting emission targets, and how to move global climate policy forward. If effective, these discussions could be infl uential in implementing coordinated policy agreements at the 15th annual United Nations climate change conference in Copenhagen in December.

Policy Considerations

The key to advancing global climate policy is in the United Nations Framework Convention on Climate Change (UNFCCC) 2007 Bali Plan of Action. The Plan highlights the need to ensure the “comparability of efforts” across developed countries while “taking into account differences in their national circumstances.” Implementing these goals will require a modified approach to the negotiations that goes well beyond the Kyoto paradigm. The Kyoto Protocol focused on establishing national emissions targets measured as percentage reductions relative to a specified base year. However, differences in economic conditions can easily mean that countries with similar targets will experience very different costs, violating the goal of comparable effort. Indeed, variations in economic growth among developed countries between the Kyoto base year (1990) and the date at which it was to go into effect (2008) have led to large differences in emissions growth and, consequently, in the costs of meeting the Kyoto targets. To ensure comparability of effort, the new agreement implemented in Copenhagen will need to address costs directly. A transparent and robust method for doing so would be to include upper and lower bounds on the price of carbon dioxide emissions, a policy often described as a “price collar.”

Expanding the agreement to include a price collar would have additional benefits as well. It would provide a path for rapidly industrializing countries such as China and India to take on gradually increasing commitments without fearing that their growth will be stifled. It would also help stabilize the agreement in the face of major economic disturbances such as the recent financial crisis and global economic downturn. The agreement will need to endure through many economic and political crises, and a price collar would help it do so.

A collar would supplement the emissions targets already under negotiation. It would require that each party undertake at least a specified minimum level of abatement effort, even if the country’s target could be achieved with less. In addition, each party would be allowed to exceed its target if it could show that it was unable to comply in spite of undertaking a high level of effort. Specifically, in addition to a cumulative emissions target for the 2013 to 2020 period, major economies would agree on three things, known collectively as the “price collar”:

A starting floor price on a ton of carbon dioxide- equivalent emissions for 2013;
A starting price ceiling on a ton of carbon dioxide- equivalent emissions for 2013; and
An annual rate of growth in the price floor and ceiling that reflects the real rate of interest, such as 4 percent.

To be in compliance, each party would demonstrate: (1) that it had imposed a price on carbon-equivalent emissions no lower than the floor over most or all of the commitment period, and (2) that its cumulative emissions were no higher than its announced target OR that its price on emissions had reached the ceiling for an appropriate proportion of the commitment period given the extent of its excess emissions.

This approach has several advantages. The ceiling allows each party to comply even if its target turns out to be unexpectedly stringent and impractical to achieve. The floor ensures that no party’s commitment is unduly lax; it reduces the incentive for parties to negotiate overly-generous targets; and it limits the downside risk for investors in low-carbon technologies by guaranteeing a minimum payoff per ton of emissions avoided. Both aspects of the collar help to reduce the risks faced by investors, which will accelerate the development and diffusion of new technology.

A price collar also accommodates developing countries like China that are uncomfortable with hard emissions caps but might be open to imposing a carbon tax. Such countries could adopt a price floor— possibly without an emissions target at first, or with a low price ceiling—and then gradually transition to commitments more like those of industrialized countries.

Several implementation details would need to be negotiated, including guidelines for demonstrating compliance with the price collar. This would include methods of verifying the carbon price and the extent to which the price was effective. Emissions above the cap would need to be accompanied by an appropriate duration of prices at the ceiling and allowances transacted at that price.

The price collar could be implemented by each party in a manner most suitable for its domestic economy. A tax or cap-and-trade system would provide a transparent carbon price. However, regulatory measures could also be used via provisions for calculating an equivalent carbon price. For example, countries could calculate a shadow price on emissions analogous to the way the World Trade Organization converts trade protection policies into tariff equivalents. Parties could include existing fossil energy taxes when determining their compliance with the price floor, but such credit would have to be net of any subsidies to fossil energy or other greenhouse gas emitting activities. Each party would control any revenues generated by its domestic climate policy.

Some environmentalists are uncomfortable with a price collar because they believe that any limit on carbon prices would undermine the effectiveness of the agreement. However, without a price collar, parties to an agreement may be reluctant to undertake aggressive policies and may insist on loose caps, or none at all, rather than risk excessive stringency or non-compliance. Moreover, without a price ceiling, volatile macroeconomic conditions may cause countries to abandon the agreement entirely, a considerably worse outcome than allowing them to exceed their targets briefly.

Action Items for the G-20 Summit

Focusing exclusively on reductions from historical emissions has greatly hampered climate negotiations to date, especially in regard to the role of developing countries where uncertainty about future growth and abatement costs is greatest. Combining a clear cumulative emissions target with a price collar would balance the environmental objective with the need to ensure that commitments remain comparable and feasible. Further, the price collar can ease major developing countries into the system by allowing them to adopt only a price floor in the early years. The G-20 Summit is the right group of countries meeting at the right time to steer global climate negotiations in a direction of comparable effort implemented through a price collar rather than by focusing on emissions targets alone.

Note: This paper is a shortened version of W. J. McKibbin, A. Morris and P. Wilcoxen (2009) “A Copenhagen Collar: Achieving Comparable Effort through Carbon Price Agreements” published by the Brookings Institution. The views expressed in the paper are those of the authors and should not be interpreted as reflecting the views of any of the above collaborators or of the institutions with which the authors are affiliated.

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G-20 Summit: Recovering from the Crisis

Thu, 17 Sep 2009 14:50:00 -0400

As the outlook for the world economy has improved since the London Summit last April, the G-20 leaders will meet again in Pittsburgh on September 24. There is the prospect of financial and economic recovery—albeit fragile—and the question is how to ensure that it is sustainable. While it is too early to withdraw the substantial fiscal stimulus and monetary easing, the task that G-20 leaders have to confront now is one of coordinating the composition and timing of their policies so that the world economy progressively gains in strength while the long-run health of public finances does not threaten the recovery process.

To enhance global coordination and to implement effective financial recovery policies, Brookings experts provide recommendations on how the G-20 can overcome current global governance and economic challenges.

Introduction » (PDF)
by Kemal Derviş, Vice President and Director, Global Economy and Development

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Articles

The G-20 and the World Economy: Sink or Swim » (PDF)
Eswar Prasad recommends that the G-20 maintain momentum on reforming the international institutions and advance international regulatory reform for the betterment of the overall global economy.

Confronting the Protectionism Spawned by the Crisis » (PDF)
Chad P. Bown makes the case for re-affirming the G-20 economies’ commitment to the World Trade Organization and curbing trade-restricting policies created by the crisis.

The G-20 and IMF: Their Future Roles in the International Monetary System » (PDF)
Domenico Lombardi proposes that the G-20 should focus on supporting effective measures to reform the International Monetary Fund.

To the G-20: Don’t Overlook Africa During the Recovery » (PDF)
Ernest Aryeetey, Mwangi Kimenyi and John Page assess the impact of the financial crisis on Africa and urge the G-20 leaders to support African economic recovery and growth.

Welcome to the New Era of G-20 Global Leadership » (PDF)
Colin Bradford and Johannes Linn assess the effectiveness of the G-20 summits and how to move the G-20 forward as the global steering body.

International Financial Redesign: A Latin American Perspective » (PDF)
Mauricio Cárdenas calls for international financial regulatory reform in order to address Latin America’s need for greater financial development and to prevent future crises.

The G-20 and Climate Change: Achieving Comparable Effort Through a Carbon Price Collar » (PDF)
Warwick McKibbin, Adele Morris and Peter Wilcoxen propose G-20 leaders to focus on the challenges associated with climate change negotiations leading up to the United Nations climate conference in December.

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A Copenhagen Collar: Achieving Comparable Effort Through Carbon Price Agreements

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Fri, 28 Aug 2009 12:00:00 -0400

Editor's Note: This paper will be included in a forthcoming report, to be released in early fall of 2009. The report will further highlight key recommendations to enact globally accepted policies to effectively tackle climate change and protect those most affected.

Abstract

The global financial crisis proves how unforeseen macroeconomic conditions can affect policies aimed at reducing and stabilizing greenhouse gas emissions. It has made voters uneasy about potential climate policy that could raise energy costs and unemployment. To improve the political stability of any policy agreement emerging from this December’s annual meeting on the U.N. Framework Convention on Climate Change (UNFCCC) in Copenhagen, and to ensure the comparability of commitments and ease the inclusion of developing countries, the authors propose that the UNFCCC supplement emissions targets with a price collar. This paper outlines an example that shows that a price collar can have a negligible expected impact on the outcome that matters most for the climate—increasing emissions.

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Consequences of Alternative U.S. Cap-and-Trade Policies: Controlling Both Emissions and Costs

Yiyong Cai, Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Mon, 27 Jul 2009 00:00:00 -0400

Executive Summary

The U.S. Congress continues to debate a potential cap-and-trade program for the control of greenhouse gas emissions. The economic effects of such a bill remain in dispute, with some arguing that a cap-and-trade program would create jobs and improve economic growth and others arguing that the program would shift jobs overseas and hit households with large energy price increases. This report applies a state-of-the art global economic model to the question and offers insights to policy-makers about how to design the program to achieve long-run environmental goals at minimum cost and with low risk to the economy.

The report analyzes a range of possible cap-and-trade policies for the United States. The seven policy scenarios we analyze meet similar long run environmental objectives, but differ in their emissions trajectories and costs. The first policy we analyze hits the emissions targets proposed by the Obama administration. The second hits the targets in an early “discussion draft” version of the bill proposed by Representatives Henry Waxman and Edward Markey. We modeled both of these approaches as annual caps on U.S. emissions that decline linearly over the lifetime of the policy to reach in 2050 an emissions level that is 83 percent below 2005 levels.

We consider two additional policies that would achieve much the same long-run environmental goals as the first two policies but which minimize the cost. Finally, we present three policies that augment the Obama administration’s target proposal with three different cost-containment mechanisms.

We show that the first two policies, the Obama administration and Waxman-Markey discussion draft targets, produce modest long-term effects on U.S. gross domestic product (GDP) and consumption. The two approaches produce slightly higher overall costs and quite different emissions trajectories than the cost-minimizing alternatives. Compared with the linear emissions trajectories, the cost-minimizing approaches result in relatively steep cuts in the early years, less steep declines in the middle years, and steeper cuts from about 2035 to 2050. The accumulated effect on GDP of each of the four carbon controls through 2050 is roughly equivalent to reaching 2050’s reference GDP in 2051 rather than 2050.

Finally, our results also show that adding a price ceiling or price collar can provide security against future events that would adversely affect an emissions permit market without unduly compromising the policy’s effectiveness in reducing emissions. The report concludes that a policy similar to the Obama proposal, augmented by a price collar or safety value, could achieve very significant long-term reductions in emissions while imposing a firm upper bound on compliance costs.

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Time for a Price Collar on Carbon

Warwick J. McKibbin, Adele Morris and Peter J. Wilcoxen — Fri, 24 Jul 2009 10:30:00 -0400

Senate leaders intend to take up the narrowly passed House climate and energy measure soon, with the hope of having a bill signed into law before December’s international climate negotiations in Copenhagen. The goal is to make Americans face the societal costs of carbon emissions and oil use. But might the costs of limiting carbon emissions — especially during a recession — sink this legislation?

As proposed, the House cap-and-trade system would set a quantity target on emissions and allow the market to determine the price of carbon — but with a price floor. Given that a key political vulnerability of the program is its economic effect on American households, sponsors of a Senate cap-and-trade bill could strengthen its prospects by imposing a price ceiling, in effect establishing a price collar.

By preventing the policy from being either unexpectedly lax or unexpectedly stringent, a price collar protects both investors in green technologies and households and preserves strong incentives to abate. The price floor proposed in the House bill would start in 2012 at $10 per ton of carbon dioxide equivalent and rise by 5 percent annually. Our research suggests that adding a ceiling starting at $35 per ton and increasing both the floor and the ceiling by 4 percent per year would increase cumulative emissions over the period from 2010 to 2050 by about 6 billion metric tons, or about 4 percent relative to a policy without a price ceiling.

In exchange, adding the ceiling would allow the Senate to jettison the reserve auction, rein in offsets and possibly raise more federal revenue, both by selling allowances if the ceiling is triggered and by setting a higher reserve price for auctioned allowances if the floor price is triggered.

With these changes, the resulting bill would be simpler and more transparent and would provide clear evidence that worst-case economic costs would be limited.

The price ceiling could work like the “safety valve” included in a 2007 bill introduced by Sens. Jeff Bingaman (D-N.M.) and Arlen Specter (D-PA), which would have allowed the government to sell additional emissions allowances if permit prices rose above a preset ceiling. A safety valve limits the worst-case costs of a cap-and-trade policy, so it would improve the bill’s prospects with moderate senators by guaranteeing that compliance costs would not be excessive.

Environmental groups may be reluctant to support a price collar, but they should remember that the stakes are very high: A bill that fails in the Senate or promptly collapses after enactment will do nothing at all to control emissions. If a price collar helps build a 60-vote majority in the Senate, the expected effect on emissions is well worthwhile.

Any climate bill will have to include cost containment provisions of some kind in order to have a realistic chance of passing. The House bill, for example, includes an allowance reserve, which operates a bit like a limited safety valve by holding back 1 percent to 3 percent of each year’s allowances for auction during periods of high allowance prices. However, the approach merely moves stringency from one year to another without actually limiting the overall cost.

The bill also includes billions of tons of potential offset credits for emissions reductions in U.S. sectors not covered by the cap-and-trade system and for certain reductions in other countries. Offsets allow U.S. emitters to exceed the cap cheaply while obscuring the actual effect on the environment.

As the cap-and-trade effort heads to the Senate for Round Two, there are mechanisms that could take this over the finish line. Ideally, cost containment should be transparent: It should be clear how it would affect domestic costs and what the consequences would be for U.S. and global emissions. It should also be credible: It must operate in a way that households and firms will perceive as economically and politically sustainable over the long run.

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Publication: Politico

The Economic Impact of Climate Change Reduction Strategies

Mon, 08 Jun 2009 10:30:00 -0400

Event Information

June 8, 2009
10:30 AM - 12:00 PM EDT

Falk Auditorium
The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

President Barack Obama has made energy and climate policy a top priority for his administration while expectations for U.S. leadership in the international climate negotiations run high. Meanwhile, the current state of the global economy will have an impact, affecting both the development of new technologies necessary to meet reduction targets and U.S. policy negotiations to reduce greenhouse gas emissions.

On June 8, the Brookings Institution hosted a preview of a forthcoming report on the economic impact of climate change reduction strategies by Brookings experts Warwick McKibbin, Adele Morris and Peter Wilcoxen. They analyzed the economic and environmental effects of potential U.S. greenhouse gas cap-and-trade programs, including emissions reduction scenarios that are broadly consistent with the targets proposed by the Obama administration and key committees in the House of Representatives. They also examined whether modest short-term targets can be consistent with cost-minimizing attainment of ambitious long-run goals.

Kemal Derviş, vice president and director of the Global Economy and Development program at Brookings, provided introductory remarks. David Goldston, columnist with Nature, moderated the discussion.

Related report: Consequences of Alternative U.S. Cap-and-Trade Policies: Controlling Both Emissions and Costs

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Moderator

David Goldston

Columnist, Nature

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Expecting the Unexpected: Macroeconomic Volatility and Climate Policy

Adele Morris, Peter J. Wilcoxen and Warwick J. McKibbin — Sun, 30 Nov 2008 12:00:00 -0500

Abstract

To estimate the emissions reductions and costs of a climate policy, analysts usually compare a policy scenario with a baseline scenario of future economic conditions without the policy. Both scenarios require assumptions about the future course of numerous factors such as population growth, technical change, and non-climate policies like taxes. The results are only reliable to the extent that the future turns out to be reasonably close to the assumptions that went into the model. In this paper we examine the effects of unanticipated macroeconomic shocks to growth in developing countries or a global financial crisis on the performance of three climate policy regimes: a globally-harmonized carbon tax; a global cap and trade system; and the McKibbin-Wilcoxen hybrid. We use the G-Cubed dynamic general equilibrium model to explore how the shocks would affect emissions, prices, incomes, and wealth under each regime. We consider how the different climate policies tend to increase or decrease the shock’s effect in the global economy and draw inferences about which policy approaches might better withstand such shocks. We find that a global cap and trade regime significantly changes the way growth shocks would otherwise be transmitted between regions while price-based systems such as a global carbon tax or a hybrid policy do not. Moreover, in the case of a financial meltdown, a price based system enables significant emissions reductions at low economic cost whereas a quantity target base system loses the opportunity for low cost emission reduction reductions because the target is fixed.

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Towards a Realistic Global Climate Agreement

Warwick J. McKibbin and Peter J. Wilcoxen — Sun, 30 Nov 2008 12:00:00 -0500

INTRODUCTION

As a mechanism for controlling climate change, the Kyoto Protocol has not been a success. Over the decade from its signing in 1997 to the beginning of its first commitment period in 2008, greenhouse gas emissions in the industrial countries subject to targets under the protocol did not fall as the protocol intended. Instead, emissions in many countries rose rapidly. It is now abundantly clear that as a group, the countries bound by the protocol have little chance of achieving their Kyoto targets by the end of the first commitment period in 2012. Moreover, emissions have increased substantially as well in countries such as China, which were not bound by the protocol but which will eventually have to be part of any serious climate change regime.

Although the protocol has not been effective at reducing emissions, it has been very effective at demonstrating a few important lessons about the form future international climate agreements should take. As negotiations begin in earnest on a successor agreement to take effect in 2012, it is important to learn from experience with the Kyoto Protocol in order to avoid making the same mistakes over again and to design a more durable post-2012 international agreement.

The first lesson is that a rigid system of targets and timetables for emissions reductions is difficult to negotiate because it pushes participants into a zero sum game. To reach a given target for global greenhouse gas concentrations, for example, countries must negotiate over shares of a fixed budget of future global emissions. A looser target for one country would have to be matched by a tighter target for another. It is clear that this has been an important obstacle for much of the history of negotiations conducted under the auspices of the United National Framework Convention on Climate Change, not just the Kyoto Protocol. From the beginning, developing countries have refused to participate in dividing up a fixed emissions budget. Not only that, but many observers have argued that if such a budget were ever to be divided, it should be done on the basis of population rather than the historical emissions which were the basis of the Kyoto Protocol.

A second lesson is that it is difficult for countries to commit themselves to achieving specified emissions targets when the costs of doing so are large and uncertain. At its core, the targets and timetables approach requires each participant to achieve its national emissions target regardless of the cost of doing so. Countries facing potentially high costs either refused to ratify the protocol, such as the United States, or simply failed to achieve their targets. Countries on track to meet their obligations were able to do so because of historical events largely unrelated to climate policy, such as German reunification, the Thatcher government’s reform of coal mining in Britain, or the collapse of the Russian economy in the early 1990’s.

The third lesson is perhaps the most important of all: even countries earnestly engaged in a targets and timetables process may be unable to meet their targets due to unforeseen events. Two excellent examples are New Zealand and Canada. No one anticipated during the 1997 negotiations that a decade later New Zealand would be facing a dramatic rise in Asian demand for beef and diary products. The impact on increasing methane emissions in New Zealand has been so large that it has completely offset the reductions New Zealand was able to achieve in the earlier 1990’s via reduced methane from declining numbers of sheep and improved sinks of carbon due to growth in forestry. Similarly, no one expected that Canada would find its tar sand deposits so valuable that extraction would be viable at oil prices reached two years ago let alone at current world oil prices.

One reason there has been so much interest in a targets and timetables strategy has been a widespread misunderstanding about the precision of scientific knowledge regarding the climate. It is widely agreed among atmospheric scientists that atmospheric concentrations of greenhouse gases are rising rapidly, and that emissions should be reduced.1 However, there is little agreement about how much emissions should be cut in any given year, and there is no guarantee that stabilizing at any particular concentration will eliminate the risk of dangerous climate change. Yet it is often implied that climate science translates directly into a specific emissions target and a fixed emissions budget.2 On the contrary, however, the uncertainties still remaining in the science are important and should be a core consideration in the design of climate policy.

All of the lessons above illustrate problems inherent in the targets and timetables approach. First, it forces countries into confrontations during negotiations over shares of a fixed global emissions budget. Second, committing to achieve a rigid emissions target is difficult for countries facing uncertain and potentially very high costs. Third, unexpected events can force even well-intentioned participants into non-compliance. In the face of these problems, some observers have argued that the solution is more of the same: a broader protocol with tighter targets and deeper cuts. However, there is little reason to expect the outcome to be any different, and in the mean time emissions will continue to rise. A better approach would be to recognize that focusing on targets and timetables has undermined the ultimate goal of actual emissions reductions, and that it is critical to move negotiations in a new direction. The Hokkaido Summit to be held in Japan this year is an important opportunity to make that shift, and to move the focus of climate change negotiations in a more realistic direction.

In this paper, we discuss an alternative framework for international climate policy, the McKibbin-Wilcoxen Hybrid3—an approach that focuses on coordinated actions rather than mandated, inflexible outcomes. Rather than committing to achieve specified emissions targets, participating countries would agree to adopt coordinated actions that are clear, measurable and enforceable within national borders. Because it does not start from a fixed emissions target (although an emissions budget does guide the design of the actions we propose), the Hybrid avoids all three of the problems discussed above. Shifting to an approach based on agreed actions, rather than specific emissions outcomes, will be a critical step in the evolution of climate negotiations. It will also make national policy actions more feasible than fixed targets, since a target would be little more than a hopeful pledge given how little is known for certain about the costs of reducing emissions.

Moreover, a framework based on common actions rather than common targets is particularly useful for accommodating the needs of developing countries. Developing countries face even greater uncertainty about their future economic growth prospects and future emissions paths than developed countries, and certainly do not want to undermine their development prospects by committing to an excessively stringent emissions target.

To illustrate the differences between the targets and timetables approach and one based on the Hybrid, we present a number of numerical simulations of the world economy using the G-Cubed global economic model. We focus particular attention on two of the problems with targets and timetables: the high stakes involved in negotiating over emissions budgets, and the risks stemming from uncertainty about costs. We first show that the outcome of a Kyoto-style targets and timetables policy with global emissions trading depends significantly on the allocation scheme for the emissions targets. We present one set of results using an allocation based on historical emissions and another set of results based on an equal per capita allocation. The results show how different the national costs of the policy will be depending on how emissions rights are allocated. We then examine the performance of the Kyoto-style allocation under one source of uncertainty: the rate of growth in developing countries, particularly China and India.

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Exploring China’s Growth and the International Climate Framework

Peter J. Wilcoxen, Warwick J. McKibbin and Wing Thye. Woo — Mon, 21 Jul 2008 12:00:00 -0400

Abstract

Under reasonable assumptions, China could achieve parity in living standard with Western Europe by 2100, and India by 2150. Climate change, however, may be a key obstacle preventing such a convergence. The business-as-usual (BAU) growth path of the world economy might increase concentrations of atmospheric greenhouse gases to unsafe levels and cause significant negative environmental feedback before China achieves parity in living standards with the OECD countries. We use a dynamic multi-country general equilibrium model (the G-Cubed Model) to project a realistic BAU trajectory of carbon dioxide (CO^₂) emissions, and we find it to be even above the CO^₂ emissions from the high-growth scenario estimated by the Energy Information Agency in 2007. This outcome is a reminder that it has been usual so far to underestimate the growth in China energy consumption.

We compare the merits of the different market-based CO^₂ reduction mechanisms like a carbon tax, a cap-and-trade scheme, and the McKibbin-Wilcoxen Hybrid (MWH) approach. Unexpected developments cause the different CO^₂ reduction mechanisms to create very different costs. Both the international carbon tax and the MWH approach are more economically efficient responses to uncertainty than the cap-and-trade scheme of the Kyoto Protocol. We use the G-Cubed Model to study the economic outcomes under each CO^₂ reduction mechanism, and under the deployment of advanced green energy.

The reduction of CO^₂ emissions would only delay, not stop, the increase in CO^₂ concentrations toward the “danger level.” As the only long-term solution is likely to be shifting to non-fossil emitting energy, it is important to combine a market-based CO^₂ reduction mechanism with an ambitious program to accelerate the development of green technology. Such a program would probably have a higher chance of success if some important parts of it were based on international collaboration. We conclude the paper with recommendations about the form of future international climate agreements and how China could be encouraged to participate.

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Climate Change Policy: The New Australian Approach

Thu, 21 Jun 2007 13:00:00 -0400

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June 21, 2007
1:00 PM - 2:00 PM EDT

Falk Auditorium
The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

In an attempt to steer the global debate on the post-Kyoto strategy for climate policy, Australian Prime Minister John Howard recently announced that Australia will adopt an innovative permit trading system for greenhouse gases by 2012, basing his recommendation on a recent report by the Prime Ministerial Task Group on Emissions Trading. That new system puts Australia in the forefront of "cap and trade" regimes, now being proposed by several U.S. presidential candidates.

Brookings hosted a discussion on the Australian government's recent climate change discussions and proposed policies with Warwick McKibbin and Peter Wilcoxen, whose climate change blueprint shaped the task force recommendations. Lael Brainard, vice president and director of Global Economy and Development, introduced and moderated.

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