1.   Background

This service report was prepared by the Energy Information Administration (EIA), in response to a May 2, 2006, request from Congressmen Tom Udall and Tom Petri (Appendix A).  A follow-up letter dated June 13, 2006, provided further guidance (Appendix B). These communications request an economic and industry analysis of the impacts that would result from enactment of H.R.5049, the Keep America Competitive Global Warming Policy Act.  

Bill Summary

Under H.R.5049, emissions of greenhouse gases (GHG) would be regulated through a market-based emission allowance program.  A fixed number of tradable allowances would be issued to establish a cap on emissions, but with additional allowances created and sold at a “safety-valve” price to limit the potential cost of the program. 

The bill states that the allowance program would begin 3 years after enactment and that the Environmental Protection Agency (EPA) would establish the number of the allowances, or cap, based on emissions over the prior 3 years.   The follow-up letter to the analysis request specified that the assumed cap should go into effect in 2009 and be based on projected emissions for 2009 from the reference case of EIA’s Annual Energy Outlook 2006 (AEO2006).²   In the absence of the cap, energy-related carbon dioxide (CO2) emissions in the reference case are projected to grow from 5,900 million metric tons in 2004 to 6,281 million metric tons in 2009, and to 8,114 million metric tons in 2030.  Under the cap, the emissions reduction needed to comply with the cap would become more stringent over time as the economy and energy consumption grow, suggesting a rising cost of compliance over time that would eventually trigger the safety-valve price for allowances.

The safety-valve price is initially set to $25 nominal per metric ton of carbon equivalent, or $6.82 per metric ton carbon dioxide equivalent.  The safety-valve price increases each year at a percentage equal to the growth in the Consumer Price Index—All Urban (CPI), plus an increment of either 1 or 2 percentage points, with the 2 percentage point increase contingent on whether five developing countries with the greatest emissions have adopted comparable emissions control actions.   

The bill calls for fossil energy suppliers, including producers and importers, to submit allowances for carbon dioxide emissions associated with the fuels sold.  Targeting suppliers, rather than intermediate or final consumers, is intended to simplify the administration of the program.   In addition to energy-related CO2, the bill also regulates emissions of the other GHGs:  nitrous oxide, methane, and the fluorinated gases (hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride).  The bill exempts emission sources where measurement or estimation is deemed infeasible by the EPA. 

In the follow-up letter to the analysis request, EIA was asked to assume coverage applies to energy-related CO2 and those gases for which available information on abatement costs was available, similar to its other recent studies on this issue.³  Emissions abatement cost curves for several classes of GHG sources have been provided by EPA and used by EIA in several of its recent analysis reports.⁴   These sources include the fluorinated gases, methane from coal mining, landfills, and natural gas systems, and nitrous oxide from adipic and nitric acid production.  By assumption, then, the uncovered sources include non-energy-related carbon dioxide, nitrous oxide emissions from agriculture and vehicles and methane emissions from agriculture and vehicles.  These uncovered sources represented 9 percent of the total greenhouse gases reported by EIA in 2004.

The AEO2006 projects energy-related CO2 emissions using the National Energy Modeling System⁵ (NEMS) through 2030.  For this analysis, the AEO2006 reference case emissions for energy-related CO2 emissions were augmented with baseline emissions projections for other GHGs to create a baseline for total GHG emissions and total covered emissions.  Projections for other GHG emissions are derived from an unpublished EPA “no-measures” case, developed by EPA for use in the U.S. Climate Action Report 2006.⁶   Based on this combined projection of covered GHGs in 2009, the assumed allowance cap is 6,956 million metric tons carbon dioxide equivalent and remains at that level thereafter. 

Section 7 of the bill establishes a program to credit increases in carbon sequestration from proposed projects that would not have been undertaken in the absence of the program.  Potential projects would include CO2 capture and storage and biogenic carbon sequestration projects, such as tree planting, forest management, and cropland tillage practices.  The owners of approved projects would be granted emission allowances equal to the amount of greenhouse gases sequestered, in carbon dioxide equivalence, adding to the pool of allowances available.

The bill calls for up to 10 percent of the emission allowances to be allocated for free to the oil, natural gas, and coal industries, which are required to submit allowances equal to the CO2 emissions from their fuel sales.  The rest of the allowances are allocated to State governments, the electric utility industry, energy-intensive industries, the Department of State, the Department of Energy, and the U.S. Treasury.  These recipients are presumed to sell their share of the allowances on the open market.  Proceeds would compensate affected parties and provide transition and low-income assistance, fund research and development programs, and raise government revenue. 

Methodology

The analysis of emission regulations of the bill was conducted with NEMS as used for the reference case projection in EIA’s Annual Energy Outlook 2006, with modifications to reflect the bill’s provisions.   NEMS endogenously calculates energy-related CO2 emissions.  The cost of using each fossil fuel includes the costs associated with the GHG allowances needed to cover the emissions produced when the fuel is used.   These price adjustments influence energy demand and energy-related CO2 emissions.  The GHG allowance price also determines the reductions in the emissions of other GHGs based on abatement cost relationships supplied by EPA and used in previous EIA studies, as discussed above.  NEMS solves for the allowance price such that the emissions target is achieved or else the price reaches the safety-valve level.  If the safety-valve price is attained, covered GHG emissions can exceed the target, as unlimited additional allowances can be purchased at the safety-valve price.

The Macroeconomic Activity Module (MAM) interacts with the energy supply, demand, and conversion modules of NEMS to solve for an energy-economy equilibrium.  In an iterative process within NEMS, MAM reacts to changes in energy prices and consumption, solving for the effect on macroeconomic and industry level variables such as real GDP, the unemployment rate, inflation, and real industrial output.  These economic impacts, in turn, feed back into the energy sectors of NEMS.  The cycle is repeated until an integrated solution is obtained.  The economic impacts of the legislation stem partly from its impact on energy prices and its effects on production, imports, and exports of energy goods and services.  In addition, the sale of the GHG allowances generates revenue streams to the government, private, and international sectors.  The MAM represents the revenue streams accruing to these sectors based on the allowance allocations specified in the bill.  Together, these energy-related price, quantity, and revenue allocation effects impact on the aggregate level of prices, output, and employment within the economy.

Policy Cases

Three principal analysis variations on the bill are presented in this report and referred to as the H.R.5049A, H.R.5049B, and H.R.5049C policy cases.

The H.R.5049A case represents the emission regulation policy with the reference case assumptions and assumes the nominal safety-valve price escalates at a rate matching the  projected change in the CPI reported in the AEO2006, plus an increment of 1 percentage point per year.   The H.R.5049B case is similar to the H.R.5049A case but assumes a 2 percentage point  increment to the CPI for the safety-valve escalation rate. 

The H.R.5049C is similar to the H.R.5049A case but varies a key assumption concerning abatement cost curves for non-CO2 gases provided by EPA, which indicate that substantial emissions reductions are economical at very low GHG allowance prices based on engineering cost analyses.  However, the operation of real-world behavioral factors could significantly reduce the market response to the opportunities identified by EPA.   The H.R.5049C case assumes 50 percent lower abatement response for the non-CO2 gases than the H.R.5049A case. 

A fourth case, the No-Safety case, simulates a hypothetical version of the bill without its safety-valve provision.  The case is mentioned briefly to highlight the importance of the safety valve in limiting the potential economic impacts.

Uncertainty

NEMS, like all models, is a simplified representation of reality.  The projections are dependent on the data, methodologies, model structure, and assumptions.  Since many of the events that shape energy markets cannot be anticipated (including severe weather, technological breakthroughs, and geopolitical developments), energy markets are subject to uncertainty.  Moreover, future developments in technologies, demographics, and resources cannot be foreseen with certainty.  Nevertheless, well-formulated models are useful in analyzing complex policies, because they ensure consistency in accounting and represent key interrelationships, albeit imperfectly, to provide insights. 

EIA’s projections are not statements of what will happen, but what might happen, given technological and demographic trends and current policies and regulations.  EIA’s reference case is based on current laws and regulations.  Thus, it provides a policy-neutral starting point that can be used to analyze energy policy initiatives.  EIA does not propose, advocate, or speculate on future legislative or regulatory changes within its reference case.  Laws and regulations are generally assumed to remain as currently enacted or in force (including sunset or expiration provisions); however, the impacts of scheduled regulatory changes, when clearly defined, are reflected. 

This report, like other EIA analyses of energy and environmental policy proposals, focuses on the impacts of those proposals on energy choices made by consumers in all sectors and the implications of those decisions for the economy.  This focus is consistent with EIA’s statutory mission and expertise.  The study does not account for any possible health or environmental benefits that might be associated with curtailing GHG emissions.

Notes and Sources