Background

This report responds to a request from Senators Bingaman, Landrieu, Murkowski, Specter, Salazar, and Lugar for an analysis of a proposal that would regulate emissions of greenhouse gases (GHGs) through a national allowance cap-and-trade system.  Under this proposal, suppliers of fossil fuel and other covered sources of GHGs would be required to submit government-issued allowances based on the emissions of their respective products.  The gases covered in this analysis of the proposal include energy-related carbon dioxide, methane from coal mining, nitrous oxide from nitric acid and adipic acid production, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride.¹

The program would establish annual emissions caps based on targeted reductions in greenhouse gas intensity, defined as emissions per dollar of Gross Domestic Product (GDP).   The targeted reduction in GHG intensity would be 2.6 percent annually between 2012 and 2021, then increase to 3.0 percent per year beginning in 2022.  To limit its potential cost, the program includes a “safety-valve” provision that allows regulated entities to pay a pre-established emissions fee in lieu of submitting an allowance.  The safety-valve price is initially set at $7 (in nominal dollars) per metric ton of carbon dioxide equivalent (MMTCO2e) in 2012 and increases each year by 5 percent over the projected rate of inflation, as measured by the projected increase in the implicit GDP price deflator.  In 2004 dollars, the safety valve rises from $5.89 in 2012 to $14.18 in 2030.

The proposal calls for initially allocating 90 percent of the allowances for free to various affected groups, but the proportion of allowances to be auctioned grows from 10 percent in 2012 to 38 percent in 2030.  The revenue from the auctions and any safety-valve payments are accumulated into a “Climate Change Trust Fund,” capped at $50 billion, to provide incentives and pay for research, development, and deployment of technologies to reduce greenhouse gas emissions.  The U.S. Treasury would retain any revenue collected in excess of the $50-billion limit.

As specified in the request for the analysis, EIA considered both a Phased Auction case, which allocates allowances as specified in the proposal, and a Full Auction case, in which all allowances are assumed to be auctioned beginning in 2012.  Because they share the same emissions targets and safety valve prices, the energy sector impacts in the Phased and Full Auction cases are very similar.  The only areas where the impacts in the two cases differ are for electricity prices and the economic impacts associated with collection and use of revenue from the sale of allowances.  Several additional sensitivity cases examine the impacts of higher and lower safety valves and limiting the use of emission reduction credits, or offsets, from non-covered entities.  The proposal and its variants were modeled using the National Energy Modeling System and compared to the reference case projections from the Annual Energy Outlook 2006 (AEO2006).²

The analysis presented in this report builds on previous EIA analyses addressing GHG limitation, including earlier EIA reports requested by Senator Bingaman³, Senator Salazar⁴, and Senators Inhofe, McCain, and Lieberman.⁵  All of the analysis cases incorporate the economic and technology assumptions used in the AEO2006 reference case.  While increased expenditures for research and development (R&D) resulting from the creation of the Climate Change Trust Fund are expected to lead to some technology improvements, a statistically reliable relationship between the level of R&D spending for specific technologies and the impacts of those expenditures has not been developed.  Furthermore, the impact of Federal R&D is also difficult to assess, because the levels of private sector R&D expenditures usually are unknown and often far exceed R&D spending by the Federal Government.

However, the recent reports for Senators Bingaman and Salazar include additional sensitivity analyses on the assumptions made regarding the availability of GHG emissions reductions outside the energy sector and the pace of advances in technology used to produce and consume energy.  The report for Senators Inhofe, McCain, and Lieberman also examines the economic implications of possible alternative approaches to recycling revenues collected by government under a cap-and-trade program in which significant amounts of government revenue is collected from allowance auctions.  Alternative assumptions in these areas can have a major impact on the results obtained, and the insights from those prior sensitivity cases would also be applicable to the proposal analyzed this report.  Readers interested in how the results reported below might be affected by different assumptions in these areas are encouraged to review the earlier reports. 

The modeled impacts of the proposal are summarized below.  Reported results apply for the $7 Phased Auction case, unless otherwise stated.  Energy and allowance prices are reported in 2004 dollars for compatibility with AEO2006.  Macroeconomic time series such as GDP and consumption expenditures are reported in 2000 chain-weighted dollars to maintain consistency with standard reports of U.S. economic statistics.  Projections of the aggregate value of allowances and auction revenues and fiscal impacts on the budget surplus are reported in nominal dollars, as are deposits relating to the Climate Change Trust Fund.

• The proposal leads to lower GHG emissions than in the reference case, but the intensity reduction targets are not fully achieved after 2025. Some regulated entities would opt to make safety-valve payments beginning in 2026, the year in which the market value of allowances is projected to reach the safety-valve level (Table ES1).  With the higher safety-valve prices in the $9 Phased Auction sensitivity case, the intensity targets are attained through 2029.

• Relative to the reference case, covered GHG emissions less offsets⁶ are 562 MMTCO₂e (7.4 percent) lower in 2020 and 1,259 MMTCO2e (14.4 percent) lower in 2030 in the Phased Auction case.  Covered GHG emissions grow by 24 percent between 2004 and 2030, about half the increase in the reference case.

• In the early years of the program, when allowance prices are relatively low, reductions in GHG emissions outside the energy sector are the predominant source of emissions reductions.  In 2020, reductions of GHGs other than energy-related CO2, estimated based on information provided by the Environmental Protection Agency, account for nearly 66 percent of the total reductions.  By 2030, however, the higher allowance prices lead to a significant shift in energy decisions, particularly in the electricity sector, and the reduction in energy-related CO2 emissions account for almost 58 percent of total GHG emissions reductions.

• An allowance allocation incentive for carbon sequestration, available only in the Phased Auction case, is projected to result in an additional emissions impact of 296 MMTCO2e in 2020 and 311 MMTCO2e in 2030, or about 4 percent of covered emissions.

• In 2004 dollars, the allowance prices rise from just over $3.70 per metric tons CO2 equivalent in 2012 to the safety valve price of $14.18 metric tons CO2 equivalent in 2030.

• The cost of GHG allowances is passed through to consumers, raising the price of fossil fuels charged and providing an incentive to lower energy use and shift away from fossil fuels, particularly in the electric power sector.

• When allowance costs are included, the average delivered price of coal to power plants in 2020 increases from $1.39 per million Btu in the reference case to $2.06, an increase of 48 percent.  By 2030 the change grows from $1.51 per million Btu in the reference case to $2.73 per million Btu, an increase of 81 percent.

• Electricity prices are somewhat lower in the Phased Auction case than in the Full Auction case because the Phased Auction provides a portion of the allowances to the electric power sector for free, a benefit that is passed on to ratepayers where the recipients are subject to cost-of-service regulation.  Electricity prices in 2020 are 3.6 and 5.6 percent higher than in the reference case in the Phased and Full Auction cases, respectively.  In 2030, electricity prices are 11 and 13 percent above the reference case level.  Electricity price impacts are likely to vary across states and regions due to differences in State regulatory regimes and in the fuel mix used for generation in each area.

• Relative to the reference case, annual per household energy expenditures in 2020 are 2.6 percent ($41) higher in the Phased Auction case and 3.6 percent ($58) higher in the Full Auction case.  By 2030, projected annual per household energy expenditures range from 7.0 percent to 8.1 percent ($118 to $136) higher in the two cases.  The difference primarily reflects the lower electricity prices in the Phased Auction case.

• Coal use is projected to continue to grow, but at a much slower rate than in the reference case.  Total energy from coal increases by 23 percent between 2004 and 2030, less than half the 53-percent increase projected in the reference case over the same time period.

• The proposal significantly boosts nuclear capacity additions and generation. The projected 47-gigawatt increase in nuclear capacity between 2004 and 2030 allows nuclear to continue to provide about 20 percent of the Nation’s electricity in 2030. In the reference case, nuclear capacity increases by only 9 gigawatts between 2005 and 2030.

• The proposal also adds significantly to renewable generation.  In the reference case, renewable generation is projected to increase from 358 billion kilowatthours in 2004 to 559 billion kilowatthours in 2030.  In the Phased Auction case, renewable generation increases to 572 billion kilowatthours by 2020 and 823 billion kilowatthours by 2030.  Most of the increase in renewable generation is expected to be from non-hydroelectric renewable generators, mainly biomass and wind.

• Retail gasoline prices in 2030 are $0.11 per gallon higher in 2030 compared to the AEO2006 reference case, leading to modest changes in vehicle purchase and travel decisions.  The transportation sector provides only a small amount of emissions reduction.

• While the Phased Auction and Full Auction cases have similar energy market impacts, the macroeconomic impacts of the two cases differ because of differences in the revenue flows associated with emission allowances. 

• In the Phased Auction case, the $50-billion cap (nominal dollars) on the maximum cumulative deposits to the Climate Change Trust Fund is reached in 2017, and all subsequent revenues from allowance sales or safety valve payments go to the U.S. Treasury.  This leads to a $59-billion reduction in the Federal deficit by 2030.  However, in the Full Auction case, the revenues flowing to the government are much larger, resulting in a $200-billion reduction in the Federal deficit in 2030.

• In the Phased Auction case, wholesale energy prices rise steadily and, by 2030, are approximately 12 percent above the reference case levels (after inflation).  This translates into 8-percent higher energy prices at the consumer level by 2030 and a 1-percent increase in the All-Urban Consumer Price Index (CPI) above the reference case level.

• In the Phased Auction case, discounted total GDP (in 2000 dollars) over the 2009-2030 time period is $232 billion (0.10 percent) lower than in the reference case, while discounted real consumer spending is $236 billion (0.14 percent) lower.  In 2030, in the Phased Auction case, real GDP is projected to be $59 billion (0.26 percent) lower than in the reference case, while aggregate consumption expenditures, which relate more directly to impacts on consumers, are $55 billion (0.36 percent) lower.  The reductions in GDP and consumption reflect the rise in energy prices and the resulting decline in personal disposable income.

• While higher energy costs and lower consumption expenditures tend to discourage investment, many provisions of the bill help to support investment activity. The value of allowances allocated to States is substantial, and some portion of the allowance revenue would likely result in increased investment.  In addition, the portion of the allowances allocated to the private sector generates funds which would help spur private investment in energy saving technologies.

• GDP and consumption impacts in the Full Auction case are substantially larger than those in the Phased Auction case.  Relative to the reference case, discounted total GDP (in 2000 dollars) over the 2009-2030 time period in the Full Auction case is $462 billion (0.19 percent lower), while discounted real consumer spending is $483 billion (0.29 percent) lower.  In 2030, projected real GDP in the Full Auction case is $94 billion (0.41 percent) lower than in the reference case, while aggregate consumption is $106 billion (0.69 percent) lower, almost twice the estimated consumption loss in the Phased Auction case.  These results reflect the substantially higher level of auction revenues under the Full Auction case, which, by assumption, are not re-circulated into the economy beyond the $50 billion in expenditures from the Climate Change Trust Fund.  Because these estimated impacts could change significantly under alternative revenue recycling assumptions, these results do not imply a general conclusion that a Phased Auction will necessarily result in lesser impacts on GDP and consumption than a Full Auction.

Notes

Table ES1