Review of Economic Arguments Against AB32. W. Michael Hanemann, Ph.D. California Climate Change Center University of California, Berkeley.

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1 Review of Economic Arguments Against AB32 W. Michael Hanemann, Ph.D. California Climate Change Center University of California, Berkeley August 2006 This note reviews economic concerns articulated by opponents of Assembly Bill 32, as outlined in the recent report by Dr. Margo Thorning 1 and also the document sent to Secretary Linda Adams of CalEPA by SEE California on July 31, I have reviewed both documents in the light of what we learned from the analyses conducted for the report I co-edited with Professor Alex Farrell 2 as well as on the basis of my own professional and academic experience with economic modeling, including my experience as a member of the US EPA Science Advisory Board s Second Generation (Economic) Model Advisory Panel. Between them, the two reports I reviewed make a number of economic statements that I believe are unfounded and incorrect. In short these are: Voluntary action is preferable. The available evidence suggests that voluntary action will be insufficient to substantially reduce greenhouse gas (GHG) emissions. Economic theory suggests that externalities like GHGs will not be reduced by the polluter without policy action. A cap on carbon is a cap on growth. This is only true if technology does not change, but California s history has proven this to be a false assumption. The emissions intensity of the state s economy has declined substantially over the past three decades, in large part due to efficiency gains spurred by its policy action. AB32 will cause job loss. Our own analysis, and that of the state s Climate Action Team, suggests that California can meet the AB32 limits while accelerating economic and job growth. In arguing the reverse, Dr. Thorning cites a 1998 macroeconomic analysis that is not a reliable indication of the economic impact of AB32. For example, the study estimates impacts for a program that requires 7% deeper emissions reductions in about one-half the time of AB32. AB32 will simply export emissions to other states and countries. Leakage of emissions can be controlled through good policy design, such as imposing emission limits on all electricity sold in the state, including that imported from other parts of the country. The technologies do not exist. Our analysis finds, consistent with the Climate Action Team, that existing technologies can accomplish the emission reduction requirements set by AB32 for Thorning, California Climate Change Policy: Is AB32 a Cost-Effective Approach? Washington, DC: American Council for Capital Formation, June 15, Hanemann and Farrell, Managing Greenhouse Gas Emissions in California, California Climate Change Center, UC Berkeley, January

2 A more detailed point-by-point critique follows: 1. The Voluntary Approach Will Allow Emission Intensity to Be Reduced in a Cost- Effective Way. Now Is the Time to Provide Incentives for Companies to Voluntarily Undertake Additional CO2 Intensity Reducing Investments. As a matter of basic economic principle, there is every reason to believe that a voluntary approach will be inadequate to accomplish reductions in greenhouse gas (GHG) emissions that are economically justified. From an economic perspective, GHG emissions are a pollutant because of the adverse effects they generate. In economic parlance, they create a negative externality because they impose costs on others that are ignored by the party creating the emission. The polluter pays principle states that (i) under a voluntary approach, a polluter does not have an adequate incentive to control his harmful emissions, and (ii) a satisfactory outcome can be secured when the polluter is forced to become responsible for his emissions and to either control them or pay for they damage they cause. This principle applies to GHG emissions as to other pollutants. Our empirical economic analysis of GHG emissions in California shows clearly that a voluntary approach will absolutely not be adequate to provide the GHG emission reductions that are needed to meet the targets established by AB32 for California. In arguing for the infeasibility of the AB32 targets, Dr. Thorning points to the fact that there has been only a small reduction in per capita GHG emissions in California over the period Over this period, there has been only a voluntary approach to GHG reduction, and the limited accomplishment over the period is precisely why we need some form of mandatory approach now. 2. A Cap on Carbon is a Cap on Growth. This statement is not correct. A more accurate statement would be: A cap on carbon is a cap on growth with business as usual. But, if one is willing to permit a deviation from business as usual, the statement is incorrect, as our experience in California shows. Economic growth can be combined with lowered carbon emissions provided that one reduces the emission intensity of production i.e., the amount of carbon or GHG emissions per unit of goods and services produced. The statement above would be correct only if the emission intensity of California production were fixed, but this is not the case. In fact, the carbon emission intensity of the California economy has declined greatly over the past three decades, to the point that California now has one of the lowest emission intensities of any state. Our analysis, and those of many other researchers, indicates that substantial opportunities exist to continue, and indeed accelerate, this trend in the future. The major factor underlying the decline in carbon emission intensity in California has been the continuing increase in energy efficiency, which has kept per capita energy consumption in California virtually constant for the past three decades despite robust 2

3 economic growth. The improvement in energy efficiency in California did not come about spontaneously: it was triggered by specific regulations that California had adopted, especially in the 1970s and 1980s, especially the regulation of energy efficiency for appliances and buildings. If California now regulates GHG emissions, our past experience shows that this will trigger a comparable improvement in the carbon emission intensity of the California economy. 3. AB 32 is likely to cause net job loss and leakage of industry to states and countries which do not have mandatory emission caps. Leakage is certainly an important consideration, but it can be controlled if one designs a carbon policy that recognizes this. The key is to include the out of state carbon emissions embodied in the major goods and services sold in California when imposing a cap for example, include the use of fossil fuels to generate the electricity that California imports from out of state. This was well recognized by the Climate Action Team in its report earlier this year, and it is incorporated in AB32. By controlling leakage of carbon emissions, we greatly reduce the likelihood of jobs leaking out of state. Our own economic analysis clearly indicates that it is possible to reduce GHG emissions to meet the AB32 target for 2020 while still maintaining economic growth in California. Dr. Thorning cites a 1998 macroeconomic analysis conducted by an economic consulting company then known as DRI/WEFA, and now known as Global Insight, which showed that California would lose income and jobs from meeting the Kyoto Protocol study. This is not what we found in our recent analysis using the new BEAR model of the California economy. There are multiple reasons why the 1998 DRI/WEFA analysis cited by Dr. Thorning cannot be taken as a reliable indication of the economic impact of AB 32. First, the emission reduction considered by DRI/WEFA is somewhat different from that called for in AB32. The DRI/WEFA analysis focused on a reduction on emissions to 7% below the 1990 level, while AB32 calls for a reduction just to the 1990 level. Second, and more important, the DRI/WEFA analysis assumed a shorter period of adjustment than is provided for by AB32. The DRI/WEFA focused on a policy goal of meeting an emission reduction target by the period , while AB32 allows a significantly longer period of adjustment to meet a target by It is a well established economic fact, with a longer period of adjustment, the economic cost is greatly reduced. Third, Dr. Thorning has exercised a degree of selectivity in her choice of economic model. The DRI/WEFA analysis is one of about 20 economic models that been used to assess the national economic impact of Kyoto on the US economy. 3 Most of the other studies showed a lower economic impact than the DRI/WEFA. This fact is well known to Dr. Thorning. In testimony she delivered to US Senate Governmental Affairs Committee in July 2001, she presented the results of 8 national economic models, of which the 3 T. Barker and P. Elkins, The Costs of Kyoto for the US Economy The Energy Journal, Vol 25, No. 3 (2004)

4 DRI/WEFA showed the second highest economic impact; most of the others showed impacts that were half as large or smaller. Why do different economic models show different results? Several studies have investigated this question; they find that the single most important factor is sectoral disaggregation. Specifically, highly aggregated macroeconomic models yield substantially higher economic costs than disaggregated general equilibrium (GE) models. 4 This is especially true of the DRI/WEFA model. Compared to the BEAR model used in our own analysis and the EDRAM model used by the Climate Action Team, both of which are GE models, the DRI/WEFA model has far fewer industrial sectors and it assumes a more rigid production function with less scope for substitution among inputs. The combined result of the sectoral aggregation and the restricted elasticity of substitution is that the model understates the economic opportunities for achieving a reduction in emission intensity through (1) intra-sectoral and inter-sectoral emission trading, and (2) input substitution. 5 Both of these features lead to an overestimate of the economic cost of a statewide cap on GHG emissions in California. Finally, and most importantly, the DRI/WEFA has no provision for energy saving policies such as the California Energy Commission s building efficiency standards and the standards for vehicle tailpipe emissions of greenhouse gasses promulgated by the California Air Resources Board in its implementation of AB Energy saving improvements like these reduce costs for California consumers and, rather than lowering GDP, they generate positive economic growth. If these had been incorporated into the DRI/WEFA analysis, they would have greatly lowered the overall cost for California. An authoritative assessment of the economic literature on this topic by a leading macroeconomic expert concludes as follows: [T]he high-cost estimates from this literature are either misleading or they demonstrate (1) the costs of making policy mistakes, for example, by too hasty, unexpected action, or sub-optimal use of the revenues; (2) the costs of policies that do not include the use of the Kyoto flexible mechanisms; and/or (3) how a selection of worst-case assumptions and parameters can accumulate to give high costs. Taking all the literature into account, the macroeconomic costs of greenhouse gas mitigation of the kind envisaged by the Kyoto commitments is likely to be insignificant in the US, provided that the policies are 4 Barker and Elkins (2004). J. P. Weyant and J. N. Hill, Introduction and Overview. The Costs of the Kyoto Protocol: A Multi-Model Evaluation. Special Issue of The Energy Journal (1999). R. Repetto and D. Austin, The Costs of Climate Protection: a Guide for the Perplexed. World Resources Institute, Washington DC, Other factors that inflate the cost estimate include the failure to allow adequately for emission trading and the assumption of a limited degree of substitution in production technology. Both are features of the DRI/WEFA model. 5 That the lack of sectoral disaggregation is a drawback of the DRI/WEFA model is explicitly acknowledged by DOE in the 1998 DOE/EIA Report Impacts of the Kyoto Protocol on US Energy Markets and Economic Activity. This states: to investigate a system of allocated (emission) permits would require an energy and macroeconomic modeling structure with a highly detailed sectoral breakout beyond those represented in the NEMS and DRI models. (p. 120).. 4

5 expected, long-term, and well-designed. 6 designed. In my view, this is how AB 32 has been 4. The technologies simply do not exist to reduce total emissions over next 14 years. This is incorrect. The analysis by the Climate Action Team identifies existing technologies that can accomplish the emission reduction target set by AB32 for Our own assessment leads to the same conclusion. We find that it is possible to meet the AB32 target using existing technology. We also believe that the setting of this target and the enactment of AB32 will create an economic climate that stimulates the development of some new technologies and will lower the cost even further by the time 2020 is reached. Some Concluding Observations It is interesting to note what Global Insight, the company on whose economic report Dr. Thorning relied so heavily, is saying to its clients about climate change. We quote from recent Global Insight presentation, The Global Climate Change Forum. After noting that global climate change is one of the major issues of our time, Global Insight states that The Problem is Not Intractable, and it proceeds to list a variety of viable options for reducing carbon emissions, providing numerous examples of mitigation options by sector for vehicles and transportation, buildings, manufacturing, electric power, and agriculture and forestry. Interestingly, many of these are options used by the Climate Action Team in its report. Global Insight then goes on to state: Transition Target Must Be Established.Initial inaction will prevent the attainment of longer term goals at reasonable cost. This is, indeed, the same as our own conclusion in our report on Managing Greenhouse Gas Emissions in California. It is unfortunate that Dr.Thorning relied so heavily on the 1998 study by DRI/WEFA and ignored what this company is saying to its clients now. 6 Barker and Elkins (2004, p 69). 5