Environmental Valuation & Cost-Benefit News

Link: http://www.cbo.gov/ftpdocs/103xx/doc10327/06-19-CapTradeCosts.htm

... Reducing emissions of greenhouse gases (GHGs) would moderate the damage associated with climate change and, especially, the risk of significant damage, but doing so would also impose costs on the economy. In the case of carbon dioxide (CO2)—which accounts for 85 percent of U.S. GHG emissions—higher costs would stem from the fact that most economic activity is based on fossil fuels, which contain carbon and, when burned, release it in the form of that gas.

H.R. 2454, the American Clean Energy and Security Act of 2009, as reported by the House Committee on Energy and Commerce on May 21, 2009, would create a cap-and-trade program for GHG emissions, an incentive-based approach for regulating the quantity of emissions. (The bill would also make a number of other significant changes in climate and energy policy.) The legislation would set a limit (the cap) on total emissions over the 2012–2050 period and would require regulated entities to hold rights, or allowances, to emit greenhouse gases. After allowances were initially distributed, entities would be free to buy and sell them (the trade part of the program).

This analysis examines the average cost per household that would result from implementing the GHG cap-and-trade program under H.R. 2454, as well as how that cost would be spread among households with different levels of income.1 The analysis does not include the effects of other aspects of the bill, such as federal efforts to speed the development of new technologies and to increase energy efficiency by specifying standards or subsidizing energy-saving investments.

Reducing emissions to the level required by the cap would be accomplished mainly by stemming demand for carbon-based energy by increasing its price. Those higher prices, in turn, would reduce households’ purchasing power. At the same time, the distribution of emission allowances would improve households’ financial situation. The net financial impact of the program on households in different income brackets would depend in large part on how many allowances were sold (versus given away), how the free allowances were allocated, and how any proceeds from selling allowances were used. That net impact would reflect both the added costs that households experienced because of higher prices and the share of the allowance value that they received in the form of benefit payments, rebates, tax decreases or credits, wages, and returns on their investments.

The incidence of the gains and losses associated with the cap-and-trade program in H.R. 2454 would vary from year to year because the distribution of the allowance value would change over the life of the program. In the initial years of the program, the bulk of allowances would be distributed at no cost to various entities that would be affected by the constraint on emissions. Most of those free allocations would be phased out over time, and by 2035, roughly 70 percent of the allowances would be sold by the federal government, with a large share of revenues returned to households on a per capita basis. This analysis focuses on the effect of the legislation in the year 2020, a point at which the cap would have been in effect for eight years (giving the economy time to adjust) and at which the allocation of allowances would be representative of the situation prior to the phase-down of free allowances. The incidence of gains and losses would be considerably different once the free allocation of allowances had mostly ended....

On that basis, the Congressional Budget Office (CBO) estimates that the net annual economywide cost of the cap-and-trade program in 2020 would be $22 billion—or about $175 per household. That figure includes the cost of restructuring the production and use of energy and of payments made to foreign entities under the program, but it does not include the economic benefits and other benefits of the reduction in GHG emissions and the associated slowing of climate change. CBO could not determine the incidence of certain pieces (including both costs and benefits) that represent, on net, about 8 percent of the total. For the remaining portion of the net cost, households in the lowest income quintile would see an average net benefit of about $40 in 2020, while households in the highest income quintile would see a net cost of $245. Added costs for households in the second lowest quintile would be about $40 that year; in the middle quintile, about $235; and in the fourth quintile, about $340. Overall net costs would average 0.2 percent of households’ after-tax income.
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H.R. 2454 would establish two cap-and-trade programs, one for six GHGs (mostly CO2) and one for a seventh GHG, hydrofluorocarbons (HFCs). The first program, the focus of this analysis, is generally referred to as the GHG cap-and-trade program.

H.R. 2454 would set limits on GHG emissions for each year. Regulated entities could comply with the policy in some combination of three ways:
* By reducing their emissions,
* By holding an allowance for each ton of GHGs that they emitted, or
* By acquiring an “offset credit” for their emissions.

Offset credits would be generated by firms that were not covered by the cap but that reduced their emissions or took actions to store emissions in trees and soil, using methods that would be approved by the Environmental Protection Agency. The bill would allow firms to use a significant quantity of offset credits— generated in the United States and overseas, with a maximum quantity for each specified in the legislation—toward compliance with the cap. Most of those offset credits would be generated by changes in agricultural and forestry practices. To the extent that acquiring offset credits was cheaper than undertaking more emission reductions, allowing firms to comply with offset credits would lower compliance costs overall.

CBO estimates that the price of an allowance, which would permit one ton of GHG emissions measured in CO2 equivalents, in 2020 would be $28. H.R. 2454 would require the federal government to sell a portion of the allowances and distribute the remainder to specified entities at no cost. The portions of allowances that were sold and distributed for free would vary from year to year. This analysis focuses on the year 2020, when 17 percent of the allowances would be sold by the government and the remaining 83 percent would be given away. Entities that received allowances could sell them or use them to meet their compliance obligations.
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The GHG cap-and-trade program established under H.R. 2454 would impose costs on U.S. households and provide some financial benefits, as well as the benefits associated with any changes in the climate that would be avoided as a result of the legislation. ... The costs would be incurred through higher prices for the goods and services that households consumed, and the incidence of those costs would be determined primarily by households’ consumption patterns. In the aggregate, most of those costs would be offset by income or other benefits provided to households as a result of the distribution of the value of the emission allowances. The legislation would influence how much of that value was conveyed to various households by specifying how to allocate the allowances. For example, H.R. 2454 would direct some of that value to low-income households by specifying that 15 percent of the allowance value be used to provide energy rebates and tax credits for such households.

Gross compliance costs would consist of the cost of emission allowances, the cost of both domestic and international offset credits, and the resource costs incurred in order to reduce the use of fossil fuels:
* The cost of the allowances. The cost of acquiring allowances would become a cost of doing business. In most cases, the firms required to hold the allowances would not bear that cost; rather, they would pass it onto their customers in the form of higher prices.
* The cost of both domestic and international offset credits. Like the cost for allowances, the cost of acquiring offset credits would be passed on by firms to their customers in the form of higher prices.
* The resource costs associated with reducing emissions. The resource costs would include the value of the additional resources (including nonmonetized resources, such as time) required to reduce emissions—for example, by generating electricity from natural gas rather than from coal, by making improvements in energy efficiency, or by changing behavior to save energy (by carpooling, for example).

According to CBO’s estimates, the gross cost of complying with the GHG cap-and-trade program delineated in H.R. 2454 would be about $110 billion in 2020 (measured in terms of 2010 levels of consumption and income), or about $890 per household. Of that gross cost, 96 percent would be the cost of acquiring allowances or offset credits. The reminder would be the resource costs associated with reducing emissions.

...Firms would generally pass the cost of reducing their emissions—or of acquiring offset credits or emission allowances—on to their customers, and their customers’ customers. (Indeed, assuming that higher costs are passed into prices is customary in distributional analyses.) Households and governments would bear those costs through their consumption of goods and services. Because households account for the bulk of spending, they would bear most of the costs. The federal government and state and local governments would bear the remainder (an estimated 13 percent) through their spending on goods and services.

The distribution of the gross cost of complying with the policy would be quite different if the price level did not increase as a result of the cap—if, for example, the Federal Reserve adjusted monetary policy to prevent such an increase. In that case, the compliance costs would fall on workers and investors in the form of lower wages and profits. Under that alternative assumption, the gross cost of the program would fall more heavily on high-income households than is indicated in this analysis because the distribution of wages and profits is more tilted toward higher-income households than is the distribution of expenditures.
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Although households and governments would pay for the cost of the allowances—generally in the form of higher prices—those allowances would have value and would be a source of income. The ultimate effects of the cap-and-trade program on U.S. households would depend crucially on policymakers’ decisions about how to allocate that value. Under H.R. 2454, allowances would be allocated among businesses, households, and governments, and the value of most of those allowances would ultimately be conveyed to households in various ways.

Under H.R. 2454, about 30 percent of the allowance value—$28 billion—would be allocated in a fairly direct manner to U.S. households to compensate them for their increased expenditures. That relief to households would include the 15 percent of the allowance value set aside for a low-income energy rebate and a tax credit for households receiving benefits through the Supplemental Nutrition Assistance Program or through the Medicare Part D low-income subsidy, and for households not participating in those programs but with income below certain thresholds. It would also include about $14 billion in allowances given to companies that distribute electricity and natural gas, with instructions to pass those benefits on to residential customers.

Roughly 50 percent of the allowance value—$47 billion—would be directed to U.S. businesses to offset their increased costs. That amount includes about $14 billion provided to what are termed emission-intensive trade-exposed industries (which would be less able to pass their compliance costs on to their customers than would other industries facing less international competition) and oil refiners. It also includes $27 billion worth of allowances that would be given to local distributers of electricity and natural gas, with instructions to pass those savings on to commercial and industrial customers (as distinct from the amount passed on to residential customers noted in the previous paragraph). The value of the allowances received by businesses would ultimately accrue to households in the form of increased returns on their investments.

About 10 percent of the allowance value would be allocated to the federal government and to state governments to spend within the United States (not accounting for the amount used to fund the energy rebate and tax credit). For example, the bill would direct a portion of the allowance value to be spent encouraging the development of particular technologies (such as electricity generation that includes carbon capture and storage) and improvements in energy efficiency. The value of those allowances allocated to governments would ultimately be passed on to households in the form of higher wages, increased returns on their investments, or lower energy costs.

Finally, H.R. 2454 would direct the federal government to spend 7 percent of the allowance value overseas, funding efforts to prevent deforestation in developing countries, to encourage the adoption of more efficient technologies, and to assist developing countries in adapting to climate change. The value the allowances spent overseas would impose a net cost on U.S. households: They would bear the cost of the allowances but would not receive the value.... In contrast, the other allowance allocations would not impose a net cost on U.S. households taken as a whole: Households would bear costs but ultimately would receive equivalent benefits.

Some additional transfers of income and additional costs would result from the GHG cap-and-trade program under H.R. 2454 but are not reflected in the gross compliance costs and the disposition of the allowance value discussed above. Those additional transfers would total about $14 billion, but they would also add close to $12 billion to the government’s costs, which ultimately would be borne by households through higher taxes or reduced government spending. They would include the following:
* The value of the rebates and tax credits for low-income households that exceeded the 15 percent of the allowance value that the bill would set aside to pay for them. The cost of the rebates and credits would exceed that allowance value by $2.8 billion, CBO and the Joint Committee on Taxation (JCT) estimate. That amount would add to the sums received by households but would also increase the cost to the government.
* Increases in government benefit payments that are pegged to the consumer price index, such as Social Security benefits. Under the assumption that the costs of compliance are passed through to consumers in higher prices and that the Federal Reserve does not take action to offset those price increases, the rise in the consumer price index would trigger increased cost-of-living benefits in indexed programs....
* Reduced federal income taxes. Because the federal income tax system is largely indexed to the consumer price index, an increase in consumer prices with no increase in nominal incomes would also reduce federal income taxes. That effect would increase households’ after-tax income but would also add to the federal deficit. In combination, the effect of price changes on the government’s indexed benefit payments and income tax receipts would convey an estimated $8.7 billion to households.
* The net income received by providers of domestic offset credits. Covered entities would spend an estimated $5.5 billion purchasing domestic offset credits to comply with the cap. Suppliers of offset credits would receive that amount in gross income but would incur costs to generate them. The additional net income of suppliers of domestic offset credits would be an estimated $2.7 billion.

Taking into the account the gross cost associated with complying with the cap ($110 billion); the allowance value that would flow back to U.S. households ($85 billion), both in the form of direct relief and indirectly through allocations to businesses and governments (all of which would eventually benefit households in people’s various roles as consumers, workers, shareholders, and taxpayers); and the additional transfers and costs discussed above (providing net benefits of $2.7 billion), the net economywide cost of the GHG cap-and-trade program would be about $22 billion—or about $175 per household. Four factors account for that net cost:
* The purchase of international offset credits (about $8 billion),
* The cost of producing domestic offset credits (about $3 billion),
* The resource costs associated with reducing emissions (about $5 billion), and
* The allowance value that would be directed overseas (about $6 billion).

Each of those components represents costs that would be incurred by U.S. households as a result of the cap-and-trade program but would not be offset by income resulting from the value of the allowances or from additional payments (such as increases in Social Security benefits) that would be triggered by the program.
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The measure of costs described above reflects the costs that would occur once the economy had adjusted to the change in the relative prices of goods and services. It does not include the costs that some current investors and workers in sectors of the economy that produce energy and energy-intensive goods and services would incur as the economy moved away from the use of fossil fuels. To be sure, increased production of energy from non-fossil-fuel sources (such as wind or solar) and a shift to more energy-efficient production processes would create jobs and profit opportunities as well....

The magnitude of transitional costs would also be affected by international trade, especially for goods or services that embody large amounts of GHG emissions.
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Estimates of the average net cost to households under H.R. 2454 do not reveal the wide range of effects that the cap-and-trade program would have on households in different income brackets, different sectors of the economy, and different regions of the country. In order to provide greater insight into some of those variations, CBO estimated the effect of the GHG cap-and-trade program on the average household in each fifth (quintile) of the population arrayed by income.
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Taking account of households’ share of the gross compliance cost and resource costs and the relief that would flow to households either through direct rebates and transfers or indirectly through the allocation of allowances, CBO estimates that households in the lowest income quintile would see an average net benefit of about $40, while households in the highest income quintile would see a net cost of approximately $245. Households in the second lowest quintile would see added costs of about $40 on average, those in the middle quintile would see an increase in costs of about $235, and those in the fourth quintile would pay about an additional $340 per year. Overall, costs for households would average 0.2 percent of their average after-tax income.
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The database for the analysis was constructed by statistically matching income information from the Statistics of Income data from the Internal Revenue Service, households’ characteristics from the Current Population Survey reported by the Bureau of the Census, and data on households’ expenditures from the Consumer Expenditure Survey by the Bureau of Labor Statistics. The data are from 2006, the latest year for which information from all three sources was available, and thus reflect the patterns of income and consumption in that year. The data were adjusted to 2010 levels by the estimated overall growth in population and income.

The estimated price increases for specific goods and services come from a model of the U.S. economy that relates final prices of goods to the costs of production inputs. Gross costs have been distributed to households on the basis of their consumption of those goods and services.

CBO allocated households to quintiles on the basis of a comprehensive measure of household income that accounts for cash and noncash income and adjusts for household size....

For this analysis, CBO did not allocate to households in various income categories $7.2 billion of net costs incurred by federal, state, and local governments and $5.5 billion of the value of allowances allocated to businesses because there is no clear basis for identifying which households would either bear those costs or benefit from the value of those allowances. With those items excluded, the gross cost would come to approximately $770 per household, compared with the total gross cost of $890 per household (as reported in Table 1); the net cost used in this distributional analysis would come to $165 per household, compared with the overall net cost of $175.
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The largest part of the gross cost of the program would stem from holding allowances and purchasing offsets. Those costs would become a cost of additional production for firms subject to the cap on emissions, which they would generally pass on to their customers in the form of higher prices. The prices of goods and services throughout the economy would rise on the basis of the CO2 emissions associated with their production and consumption. Goods and services resulting in greater emissions would have larger price increases; for example, the price of electricity would increase more than the price of food.

Another portion of the gross cost is the resource costs of implementing the legislation. Those resource costs would include expenditures that firms and households made to reduce their emissions (for example, by generating electricity from natural gas rather than from coal or by installing insulation) as well as inconvenience costs (from driving less, for instance). CBO reports all of those costs in dollar values and has assumed that households would bear those costs in proportion to their consumption of goods and services that result in CO2 emissions. Thus, households that consumed relatively large shares of fossil-fuel-intensive goods and services prior to the policy would bear the cost of either reducing those emissions or purchasing allowances and offset credits. The average resource cost accounts for only about $35 of the average gross cost increase of $770 per household.

The gross cost would be largest in absolute terms for the average household in the highest income quintile. High-income households consume more goods and services than do lower-income households; consequently, they would experience a greater increase in expenditures as those prices rose as a result of the cap on emissions. In total, households in the highest income quintile would bear an estimated 36 percent of the gross cost associated with the cap, and their annual expenditures would increase by about $1,380, on average. In contrast, expenditures would increase by an estimated $425 for households in the bottom quintile, without any offsetting cost decreases or income transfers taken into account.

Although the increase in out-of-pocket expenditures because of the higher prices would be substantially larger for high-income households than for low-income households, they would impose a larger burden—measured as a share of income—on low-income households. That increased cost would account for 2.5 percent of after-tax income for the average household in the lowest income quintile, compared with 0.7 percent of after-tax income for the average household in the highest quintile. That difference occurs for two reasons: Lower-income households consume a larger fraction of their income, and energy-intensive goods and services make up a larger share of lower-income households’ expenditures.
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About 31 percent of the allowance value would be allocated in a fairly direct manner to U. S. households to compensate them for their increased expenditures (see Table 1). Some of that relief is expected to be allocated across most households in the form of a rebate on their bills for heating and cooling their homes. Other relief would be directed at low-income households in the form of an energy rebate or a tax credit. By CBO’s estimates, 25 percent of the direct relief to households would go to households in the lowest income quintile and 50 percent to households in the two lowest quintiles combined. On average, the amount of direct relief would offset 94 percent of the additional expenses that households in the lowest quintile incurred. In contrast, the direct relief received by households in the highest quintile would offset only 18 percent of their added costs.
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H.R. 2454 would direct about 51 percent of the allowance value to businesses. In addition, net income would accrue to producers of domestic offsets. CBO assumes that transfers to businesses (either in the form of allowances or cash) would lead to higher profits.9 That result would be likely to occur in cases in which the transfers reduced the fixed costs associated with producing a good or providing a service. In general, businesses change prices in response to changes in their variable production costs (costs that increase in proportion to the quantity of goods or services provided) but not in response to changes in their fixed costs. That assumption was also used by CBO and JCT in estimating of the amount of the energy rebate and tax credit that would be provided to low-income households.10 Increased profits, net of taxes, were allocated to households according to their holdings of equities, which were estimated from the Federal Reserve’s Survey of Consumer Finances....

CBO estimates that about 63 percent of the allowance value conveyed to businesses would ultimately flow to households in the highest income quintile.11 On average, that relief would offset $885 of the additional expenses of those households resulting from the higher prices. In contrast, households in the lowest income quintile would receive only an estimated 5 percent of the relief targeted to businesses—an average of $65 per household.
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In total, federal, state and local governments account for roughly 14 percent of CO2 emissions through the goods and services that they purchase. As a result, governments would incur roughly 14 percent of the gross compliance costs (the costs of purchasing allowances and offsets and of reducing emissions), amounting to about $15 billion. The federal government would also incur additional costs of about $12 billion to pay for the rebate for low-income households and the energy tax credit in excess of the allowance value allocated for those benefits, and to account for the costs of higher benefits and lower taxes because of increases in the consumer price index. The incidence of these costs would depend on the manner in which governments chose to cover them. For example, if governments chose to increase taxes, the cost would fall on households on the basis of their share of federal, state, and local taxes. In contrast, if governments chose to cover the additional expenses by cutting back on the services that they provide, the cost would fall on households that no longer received those services. As a result of the uncertainty about the incidence of governments’ gross compliance costs and certain other costs, CBO did not distribute those costs....

On the other side of the ledger are a nearly equivalent amount of allowances and other benefits that were not allocated to households in this analysis. Those include about 11 percent of the allowance value that is directed to be spent by federal and state governments in a manner that does not have a clear incidence. For example, $5 billion would be given to state governments to fund increases in energy efficiency and the use of renewable energy. The federal government would also receive additional taxes from the allowances allocated to businesses and the income received by producers of domestic offsets. ... CBO did not allocate those additional government receipts for this analysis. CBO also did not allocate the estimated $5.5 billion of the allowance value provided to businesses through subsidies for capturing and storing CO2 emissions from electricity generation and developing advanced auto technologies because of similar uncertainty about the incidence of those benefits across households.
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Douglas W. Elmendorf, Director
U.S. Congressional Budget Office (CBO) www.CBO.gov
June 19, 2009