[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]


 
                    COUNTING THE CHANGE: ACCOUNTING 
                       FOR THE FISCAL IMPACTS OF 
                      CONTROLLING CARBON EMISSIONS 

=======================================================================

                                HEARING

                               before the

                        COMMITTEE ON THE BUDGET
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                               __________

            HEARING HELD IN WASHINGTON, DC, NOVEMBER 1, 2007

                               __________

                           Serial No. 110-24

                               __________

           Printed for the use of the Committee on the Budget


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                        COMMITTEE ON THE BUDGET

             JOHN M. SPRATT, Jr., South Carolina, Chairman
ROSA L. DeLAURO, Connecticut,        PAUL RYAN, Wisconsin,
CHET EDWARDS, Texas                    Ranking Minority Member
JIM COOPER, Tennessee                J. GRESHAM BARRETT, South Carolina
THOMAS H. ALLEN, Maine               JO BONNER, Alabama
ALLYSON Y. SCHWARTZ, Pennsylvania    SCOTT GARRETT, New Jersey
MARCY KAPTUR, Ohio                   MARIO DIAZ-BALART, Florida
XAVIER BECERRA, California           JEB HENSARLING, Texas
LLOYD DOGGETT, Texas                 DANIEL E. LUNGREN, California
EARL BLUMENAUER, Oregon              MICHAEL K. SIMPSON, Idaho
MARION BERRY, Arkansas               PATRICK T. McHENRY, North Carolina
ALLEN BOYD, Florida                  CONNIE MACK, Florida
JAMES P. McGOVERN, Massachusetts     K. MICHAEL CONAWAY, Texas
NIKI TSONGAS, Massachusetts          JOHN CAMPBELL, California
ROBERT E. ANDREWS, New Jersey        PATRICK J. TIBERI, Ohio
ROBERT C. ``BOBBY'' SCOTT, Virginia  JON C. PORTER, Nevada
BOB ETHERIDGE, North Carolina        RODNEY ALEXANDER, Louisiana
DARLENE HOOLEY, Oregon               ADRIAN SMITH, Nebraska
BRIAN BAIRD, Washington              [Vacancy]
DENNIS MOORE, Kansas
TIMOTHY H. BISHOP, New York
GWEN MOORE, Wisconsin

                           Professional Staff

            Thomas S. Kahn, Staff Director and Chief Counsel
           Patrick L. Knudsen, Acting Minority Chief of Staff
















                            C O N T E N T S

                                                                   Page
Hearing held in Washington, DC, November 1, 2007.................     1

Statement of:
    Hon. John M. Spratt, Jr., Chairman, House Committee on the 
      Budget.....................................................     1
    Hon. Paul Ryan, ranking minority member, House Committee on 
      the Budget.................................................     2
    Hon. Norman D. Dicks, a Representative in Congress from the 
      State of Washington, prepared statement of.................     3
    Peter R. Orszag, Director, Congressional Budget Office.......     6
        Prepared statement of....................................     9
    David Doniger, Climate Center policy director, Natural 
      Resources Defense Council..................................    18
        Prepared statement of....................................    21
    Robert Greenstein, executive director, Center on Budget and 
      Policy Priorities..........................................    27
        Prepared statement of....................................    29
    Anne E. Smith, Ph.D., vice president, CRA International......    35
        Prepared statement of....................................    37


                    COUNTING THE CHANGE: ACCOUNTING
                       FOR THE FISCAL IMPACTS OF
                      CONTROLLING CARBON EMISSIONS

                              ----------                              


                       THURSDAY, NOVEMBER 1, 2007

                          House of Representatives,
                                   Committee on the Budget,
                                                    Washington, DC.
    The committee met, pursuant to call, at 12:04 p.m. in room 
210, Cannon House Office Building, Hon. John Spratt [chairman 
of the committee] presiding.
    Present: Representatives Spratt, Doggett, Tsongas, Hooley, 
Moore of Kansas, Moore of Wisconsin, Ryan, Garrett, Lungren, 
Campell, and Smith.
    Chairman Spratt. I will call the meeting to order and 
welcome our witnesses and other participants to the Budget 
Committee's hearing on the fiscal considerations of controlling 
carbon emissions. Before going any further, let me announce and 
introduce our most recent addition, Niki Tsongas, recently 
elected from the Fifth District of Massachusetts, the widow of 
Paul Tsongas. And we are delighted to have you.
    The steering committee of our party has appointed her to 
this position. She hasn't been confirmed yet on the House 
floor. Oh, she was. I beg your pardon. You are a full-fledged 
Member. We are glad to have you this morning to participate.
    The concentration of greenhouse gases, carbon dioxide in 
particular, has gradually increased in the atmosphere over the 
last century, and is widely believed to be contributing to the 
warming of our climate. In light of the damages of climate 
change, there is gathering momentum in the Congress for 
legislation that uses market-based mechanisms to limit and 
eventually to lower emissions of greenhouse gases resulting 
mainly from the burning of fossil fuels, coal, oil, and natural 
gas.
    In fact, the Senate Committee on Environment and Public 
Works is holding a subcommittee markup of the Lieberman-Warner 
bill on the subject today.
    As Congress considers systems for control of carbon 
emissions, this committee, the Budget Committee, needs to 
consider budgetary issues to be resolved in implementing any 
such system. Our consideration of these issues is not meant to 
impede implementation of controls, but it is an important part 
of working out what assistance should look like and include, if 
and when Congress adopts one.
    The most prominent option is a cap-and-trade program for 
carbon dioxide emissions. Cap-and-trade programs would 
establish an overall limit on greenhouse gas emissions, 
declining over time, but allowing producers to buy and sell 
allowances or permits as needed. By capping emissions, but 
allowing trading, a new and highly valuable commodity would be 
created: the right to emit CO2. How this commodity is allocated 
and treated in the budget is a vitally important topic for the 
Budget Committee to consider.
    Today's topic is not only important, it is complex, and we 
are fortunate to have some lucid witnesses on the subject. My 
chief of staff took that word out and put ``outstanding,'' but 
I am putting ``lucid'' here because we put great stock in that. 
We have asked you here to come and explain it to us from your 
different viewpoints.
    Dr. Peter Orszag, who is the Director of CBO, will lead; 
followed by David Doniger, Policy Director for the National 
Resources Defense Council; followed by Bob Greenstein, 
Executive Director of the Center on Budget and Policy 
Priorities; and, finally, Anne Smith, who is the Vice President 
of CRA International.
    Before turning to our witnesses for their testimony, let me 
ask Mr. Ryan, our Ranking Member, for any opening statement 
that he may wish to make. Mr. Ryan.
    Mr. Ryan. I thank you, Chairman. Before I make my opening 
statement, I simply want to recognize something that is pretty 
important here. Today is your birthday. I simply want to say 
happy birthday.
    Chairman Spratt. Thank you, sir. I hope we couldn't put 
that on the record.
    Mr. Ryan. I wasn't going to say what birthday it is.
    Thanks for holding this hearing. There seems to be broad 
agreement that carbon dioxide and other greenhouse gases are 
accumulating in the Earth's atmosphere. There also seems to be 
broad agreement that man is creating carbon dioxide emissions, 
primarily through the combustion of fossil fuels such as coal, 
oil, and natural gas. There is far less agreement, however, 
about what this may mean for the planet's climate over time.
    While this is very clearly a worthy debate, the Budget 
Committee isn't the place for weighing the science of global 
warming. We will leave that to the other committees with 
expertise over that issue. What this committee can and should 
do, though, is examine the economic and budgetary implications 
associated with different approaches to reducing carbon 
emissions. We all want to be good stewards of the planet. So if 
keeping our planet healthy means we must reduce carbon 
emissions, Congress and the public have got to recognize that 
there are going to be tradeoffs involved.
    First, any increases in regulations and costs imposed on 
energy producers will be passed on to consumers directly in the 
form of higher prices. And those with lower incomes will be hit 
the hardest.
    Second, the rise in energy costs will have a suppressing 
effect on economic growth. And without a strong and growing 
economy, our options for addressing environmental challenges in 
the future will become extremely limited.
    I note some have suggested Congress create yet another 
mandatory program to help consumers offset the higher energy 
prices that would result from regulating carbon emissions, but 
we already have an unsustainable rate of entitlement growth. We 
should not keep making promises we simply can't keep.
    Finally, we also must recognize the international 
dimensions of this issue. According to the Congressional 
Research Service, the United States currently accounts for 
about 20 percent of global carbon emissions, and our share of 
emissions is expected to fall in the decade ahead as countries 
such as China and India continue their rapid growth. So in 
short, we are not going to fix anything simply through our 
actions alone. It must be a global worldwide effort.
    We should also start to look beyond the government mandates 
to reduce carbon emissions. We have got to look toward research 
and development from both the government and private sector. In 
short, I think we need to spend a little less time writing 
government mandates and a little more time advancing cleaner 
methods of producing energy America needs. And with that, Mr. 
Chairman, I thank you for holding this hearing.
    Chairman Spratt. Thank you, Mr. Ryan.
    Chairman Spratt. And just one housekeeping detail before we 
move on with the testimony. First of all, I ask unanimous 
consent that we include in the record for this hearing, 
testimony which has been submitted by Representative Norm Dicks 
of Washington. I also ask unanimous consent that all members be 
allowed to submit a statement at this time, at this point in 
the record. If there is no objection, it is so ordered.
    [The prepared statement of Mr. Dicks follows:]

    Prepared Statement of Hon. Norman D. Dicks, a Representative in 
                 Congress From the State of Washington

    Mister Chairman, Mister Ranking Member, and Members of the Budget 
Committee: thank you for holding this important hearing to examine 
impacts of proposals to address climate change, and for the opportunity 
to submit testimony for the record.
    I believe that climate change is the emerging issue of our time. 
Climate change could alter the face of our planet in ways we cannot yet 
fully comprehend, and I believe it is our responsibility not only to do 
as much as possible to halt or slow it, but also to do everything in 
our power to protect the earth's living resources from its impacts so 
that future generations will be able to appreciate and benefit from 
them as we and past generations have done. While it is not the specific 
focus of this hearing today, as Chairman of the Interior, Environment 
and Related Agencies Appropriations Subcommittee, I wish to highlight 
for the Budget Committee the impending crisis faced by our federal 
natural resource management agencies as the impacts of climate change 
on our nation's wildlife and ecosystems continue to grow. My testimony 
also recommends that the Budget Committee support dedicated funding 
from revenues that may be generated from comprehensive climate change 
legislation for a balanced program to support our federal natural 
resource management agencies in navigating this crisis.
    Our nation's wildlife is one critically important resource that is 
particularly vulnerable to climate change, and it is also a resource 
that is a fundamental part of America's history and character. 
Conservation of wildlife and wildlife habitat is a core value shared by 
all Americans.
    America's wildlife is vital to our nation for many reasons. 
Wildlife conservation provides economic, social, educational, 
recreational, emotional and spiritual benefits. The economic value of 
hunting, fishing, and wildlife-associated recreation alone is estimated 
to contribute $100 billion annually to the U.S. economy. Wildlife 
habitat, including forests, grasslands, riparian lands, wetlands, 
rivers and other water bodies, is an essential component of the 
American landscape, and is protected and valued by federal, state, and 
local governments, tribes, private landowners, and conservation 
organizations.
    Unfortunately, it is becoming increasingly apparent that the effect 
of climate change on wildlife will be profound. Reports from the 
Intergovernmental Panel on Climate Change (IPCC) have made clear that 
global warming is occurring, that it is exacerbated by human activity, 
and that it will have devastating impacts on wildlife and wildlife 
habitat. Wildlife is already suffering from massive changes in habitat, 
particularly in the arctic, and shifts in ranges and timing of 
migration and breeding cycles. Continued global warming could lead to 
large-scale species extinctions. These impacts add to and compound the 
adverse effects wildlife and its habitat already suffer from land 
development, energy development, road construction, and other human 
activities, and from other threats such as invasive species and 
disease.
    A U.S. Geological Survey Study released in September points to one 
particularly tragic and unthinkable consequence--there will be no polar 
bears in Alaska within the next 50 years due to a drastic decline in 
Arctic sea ice by mid-century. And polar bears are not the only animal 
that relies on Arctic sea ice. We can expect that many other ice-
reliant creatures will also be in jeopardy.
    According to the IPCC, global warming and associated sea level rise 
will continue for centuries due to the time-scales associated with 
climate processes and feedbacks, even if greenhouse gas concentrations 
are stabilized now or in the very near future. I believe that, as a 
nation, we must craft responses and mechanisms now to help wildlife 
navigate the looming bottleneck of complex threats caused by global 
warming, so that wildlife populations can survive to reap the benefits 
from reductions in greenhouse gas emissions undertaken now.
    As Chairman of the House Interior and Environment Appropriations 
Subcommittee, I have held hearings to assess the impacts of climate 
change on federally protected resources. Officials from federal 
agencies with responsibility for managing our national wildlife 
refuges, forests, parks, monuments, other public lands, and fish and 
wildlife already are seeing impacts from climate change out on the 
ground that make a compelling case for a national response.
    All of the Interior Department and Forest Service officials who 
testified expressed concern over the current and future impacts of 
global warming on the natural resources they are entrusted to protect 
and maintain for the American people. Their task is overwhelming. As 
Deputy Secretary of Interior, Lynn Scarlett, stated: ``Perhaps no 
subject relevant to managers of public lands and waters is as complex 
and multi-faceted as climate change.''
    Spectacular American treasures are at risk. Everglades National 
Park lies entirely at or near sea level. Park Superintendent Dan 
Kimball told my subcommittee that if IPCC sea level rise projections of 
7 to 23 inches hold true by century's end, 10% to 50% of Everglades 
National Park's freshwater marsh would be impacted and transformed by 
salt water intrusion.
    Glacier National Park has lost 73% of its glaciers. Point Reyes 
National Seashore, one of 74 coastal national park units, has witnessed 
seal haul-outs and endangered bird nesting areas washed out by rising 
seas, changes to offshore krill populations that have devastated sea 
bird populations, and reductions in fog patterns affecting forest and 
scrub species dependent on fog moisture.
    Sam Hamilton, Regional Director of the Southeast Region of the U.S. 
Fish and Wildlife Service testified that there are more than 160 
coastal national wildlife refuges threatened by sea level rise. Places 
like Pea Island National Wildlife Refuge on North Carolina's Outer 
Banks are losing chunks of marsh and beach to the ocean every year. 
Hamilton also warned that the incredible biological diversity of U.S. 
coral reefs, including reefs within national wildlife refuges, has 
already been impacted by warming-induced coral bleaching events. 
Hamilton added:
    ``As wildlife managers, we have managed around and through weather 
patterns like drought, which occur annually and can last years. 
However, now we are beginning to face growing certainty that these 
recent observations are not part of an annual or even decadal change in 
weather pattern, but are potentially linked to a long-term change in 
the climate system itself. If so, the implications for wildlife and 
fisheries management are consequential.''
    The Bureau of Land Management (BLM) is very concerned that exotic, 
noxious weeds like cheatgrass and red brome, will benefit from higher 
concentrations of carbon dioxide and further out-compete native species 
in the Great Basin and other parts of the West. These weeds are largely 
responsible for the increase in damaging wildfires in sagebrush 
habitats. Combined with an increase in woody vegetation, also 
stimulated by global warming, the risk of wildfires will much 
magnified, impacting human population centers, wildlife, grazing, and 
other uses of the public lands.
    The BLM has also seen direct evidence of desertification as a 
result of an increase in the frequency and duration of drought. 
Reductions in water availability have directly affected plant and 
animal communities. According to Ron Huntsinger, the National Science 
Coordinator of the BLM, ``The overall results of these changes are more 
fragile ecosystems, a greater susceptibility to the outbreak of attacks 
by parasites and diseases, increased vulnerability to wildlife fire and 
erosion, and an overall reduction in carrying capacity of the land.''
    These are just some of the impacts of global warming presented by 
federal agency officials to my subcommittee. These impacts have been 
documented first hand by our federal resource managers.
    Based on this overwhelming evidence, it is obvious that, to 
conserve our wildlife and ecosystems in the face of the far-reaching 
effects of global warming, there is a need for a coordinated, national 
response that includes a strategy based on sound scientific information 
to ensure that impacts on wildlife and ecosystems that span government 
jurisdictions are effectively addressed and to ensure that federal 
funds are provided and prudently committed.
    That is why I introduced the ``Global Warming Wildlife Survival 
Act,'' H.R. 2338. The bill takes a first step in ensuring that our 
nation is using all possible means to help America's wildlife navigate 
the global warming bottleneck.
    I introduced this along with my friends and colleagues, Jay Inslee 
of Washington and Jim Saxton of New Jersey. I also am deeply grateful 
to my friend and colleague, the Chairman of the House Natural Resources 
Committee Nick Rahall of West Virginia and his staff for working with 
me to develop the ``Survival Act'' and for including it in his 
comprehensive legislation, the ``Energy Policy Reform and 
Revitalization Act'' that passed the House of Representatives as part 
of H.R. 3221, Speaker Pelosi's ``New Direction for Energy Independence 
Act'' just before the August recess. Senator Sheldon Whitehouse of 
Rhode Island recently introduced a similar version of the bill, S. 
2204.
    The ``Global Warming Wildlife Survival Act'' has four elements:
     First, it includes a Congressional declaration of national 
policy recognizing that global warming is having profound impacts on 
wildlife and its habitat and committing the federal government, in 
cooperation with partners, to use all practicable means to assist 
wildlife in adapting to and surviving the effects of global warming.
     Second, the bill requires development of a national 
strategy for assisting wildlife impacted by global warming developed by 
the Secretary of the Interior, in consultation with other relevant 
federal agencies, state and local governments, tribes, and other 
partners. A committee of scientists is established to advise the 
Secretary in development of the National Strategy. The Secretaries of 
the Interior, Agriculture and Commerce are charged with implementing 
the National Strategy on federal lands and in conservation programs 
they administer.
     Third, the bill will support improved science capacity for 
federal agencies to respond to global warming, including establishment 
of a National Global Warming and Wildlife Science Center in the United 
State Geological Survey, and enhanced science capacity in federal land 
management and wildlife agencies.
     Finally, the bill directs strategic allocation of funding 
for implementation of the National Strategy and state and tribal 
actions to enhance wildlife resilience to global warming. The Act 
allocates federal funding to implement the National Strategy--45% to 
federal land management agencies, 25% to federally-funded and 
implemented fish and wildlife programs, and 30% to states through the 
State and Tribal Wildlife Grants Program created by our subcommittee in 
the FY 2001 Interior appropriations bill as a mechanism to facilitate 
comprehensive wildlife conservation in each state and as an upstream 
solution to help conserve species before they decline to the point 
where they need Endangered Species Act protection.
    The ``Survival Act'' will help to ensure that the pressing needs 
faced by our natural resource management agencies and programs that 
help wildlife and wildlife habitat are addressed strategically, based 
on a foundation of sound scientific information, and that funding is 
allocated among the federal agencies and the states in the most 
efficient way possible.
    As Members of the Budget Committee, you surely can understand that, 
as an appropriator, and considering the pressures on the federal 
budget, I would call for a new program only if it were critically 
needed. In the face of the overwhelming evidence already before us 
showing significant impacts on wildlife borne out by observations of 
the federal natural resource agencies on the ground, it is apparent 
that we are behind the curve in addressing this crisis and that we must 
move quickly to start to deal with this now before it is too late.
    Also, as an appropriator, I believe that any new program must be 
carefully and solidly structured. And the ``Survival Act'' program 
meets that test by building on and better coordinating many existing 
federal, state and tribal conservation programs around the problem of 
climate change. The framework established in the ``Survival Act'' is a 
strong one in which the components complement one another.
    Recently, two new reports have been released that underscore the 
need for the measures included in the ``Survival Act.'' A report 
released by the Government Accountability Office (GAO), ``Climate 
Change: Agencies Should Develop Guidance for Addressing the Effects on 
Federal Land and Water Resources'' evaluated how federal resources 
management agencies are dealing with the impacts of climate change and 
federal lands. The GAO found that the federal land and wildlife 
management agencies lack the capacity and guidance to effectively 
respond to the impacts of global warming on our federal lands and 
wildlife. On the heels of the GAO report, the National Academy of 
Sciences (NAS) released a report, ``Evaluating Progress of the U.S. 
Climate Change Science Program: Methods and Preliminary Results.'' The 
NAS report found that the government is failing to monitor global 
warming's impacts at a regional level, which is the scale of study 
necessary to inform sound policy choices. The ``Survival Act'' directly 
responds to both the GAO and NAS findings by giving our natural 
resource managers the national policy direction and mandate, as well as 
the scientific capacity, to plan for, and respond to, global warming 
impacts on wildlife and its habitat.
    Of primary interest to the Budget Committee, it is my firm belief 
that there ultimately should be dedicated funding for the program 
established in the ``Survival Act.'' Today's hearing examines proposals 
to address global warming that will likely generate new sources of 
funding for the federal government. Although the ``Global Warming 
Wildlife Survival Act'' as it currently stands merely authorizes 
funding to implement the provisions of the bill, I believe that a 
portion of any revenues that will be generated by upcoming climate 
change legislation should be specifically dedicated to implement the 
provisions of the ``Global Warming Wildlife Survival Act'' and I urge 
the Budget Committee to support me in ensuring this outcome.
    As the Chairman of the Interior and Environment Appropriations 
Subcommittee that has jurisdiction over our natural resource management 
agencies, I can say that my subcommittee allocation is already woefully 
stressed even to deal with the current pressing needs of the agencies 
and programs under its jurisdiction. Our federal land management 
agencies already have tremendous backlogs for operations and 
maintenance of our national wildlife refuges, parks, forests and other 
public lands. This situation has been greatly exacerbated by the past 6 
years of Bush administration budgets and prior Congresses. Hundreds of 
important biologist positions have been cut, and the agencies' budgets 
are far below what they have needed just to keep up with inflation. 
These programs have been starved to the point where they are on life 
support. It became apparent in the hearings on global warming held by 
the subcommittee that the land management agencies are already seeing 
broad changes from climate change out on the ground, but that they have 
few, if any, resources to deal with these changes. With these 
increasing impacts, our Subcommittee allocation and agency budgets will 
be stressed beyond the breaking point. I greatly appreciate the work of 
Chairman Spratt and the Budget Committee to provide increases for FY 
2008 in Function 300, natural resources and environment funding, as a 
significant first step in addressing the current shortfalls. However, 
it will be crucial, if we are to help our nation's wildlife and 
ecosystems navigate the global warming bottleneck, to infuse dedicated 
new funding into our efforts to address this crisis, and I ask the 
Budget Committee's support in working with me to make this happen.
    Mr. Chairman and Members of the Committee, this is a great nation 
with a unique and irreplaceable natural heritage. Even though we face 
challenges today on many fronts both internationally and nationally, I 
believe we are a great enough nation not to allow our nation's 
magnificent wildlife to fall to the ravages of climate change that we 
ourselves have created. I sincerely hope that by starting now we will 
be able to hold our wildlife losses to the absolute minimum, and that 
the lion's share of our rich wildlife heritage will survive to benefit 
our grandchildren and future generations just as it has benefited us. 
Again, thank you for the opportunity to provide my views to the 
Committee.

    Chairman Spratt. Dr. Orszag, thank you for coming. You can 
proceed with your testimony. The floor is yours.

            STATEMENT OF PETER R. ORSZAG, DIRECTOR,
                  CONGRESSIONAL BUDGET OFFICE

    Mr. Orszag. Thank you very much, Mr. Chairman, Mr. Ryan, 
members of the committee. Global climate change is one of the 
Nation's most significant long-term problems. The accumulation 
of greenhouse gases, especially carbon dioxide, will impose 
economic and social costs, including through rising sea levels, 
altering agricultural zones, and increasing the severity of 
storms and droughts. There is furthermore some risk those costs 
could be catastrophic. For example, if the thermohaline 
circulation stopped or if there were a breakdown of the west 
Antarctic ice sheet.
    In effect, we are conducting an experiment with potentially 
quite dangerous consequences and no backup plan. Mitigating 
those risks requires some reduction in carbon dioxide and other 
greenhouse gas emissions, which can be thought of as an 
insurance policy against the severe risks or the severe costs 
that could be entailed in the further accumulation of 
greenhouse gases in the atmosphere.
    Most analysis suggests that this insurance is worth 
purchasing; that is, a well-designed policy to reduce emissions 
would produce larger benefits than costs. There would, however, 
be costs as the economy adapted to lower emissions levels. 
Those costs would be much higher under a command-and-control 
type of approach in which there were, for example, technology 
standards that were imposed or other rigid approaches to 
reducing emissions. And they would be lower under an incentive-
based approach in which the power of markets were used to seek 
out the lowest cost possible reductions.
    There are two basic incentive-based approaches to reducing 
emissions, a carbon tax and a cap-and-trade system. A tax is 
generally the more efficient approach for two reasons:
    First, it allows reductions to occur in the years in which 
they are cheapest to undertake. A reduction of a ton of 
emissions this year is not that much different for the climate 
ultimately than a reduction next year, but the cost of those 
reductions could vary significantly from year to year depending 
upon the weather, economic conditions, the development of 
technology, and other factors. A rigid cap each year does not 
allow you to undertake the emission reductions in the cheapest 
year. A tax does. In addition, a tax provides price certainty 
to households and to firms, and there can be benefits 
associated with that certainty. A cap-and-trade system, 
however, can be made relatively more efficient through various 
design features; for example including a safety valve that is a 
maximum price at which permits would be sold. The government 
would stand ready to sell permits at some price, and that would 
put a cap on the price risk or the potential cost of the 
permits. And also banking and borrowing, which would allow 
emissions to be basically shifted across years and help address 
that year-to-year variability that I mentioned before.
    Under cap-and-trade, the mechanism for taking emissions 
down to the cap level is an increase in the price for carbon-
intensive goods and services. And it is very important to 
recognize that a price increase is absolutely essential to 
having the cap system work. That is the mechanism through which 
reductions occur, because when you price carbon-intensive goods 
more, there is shifting towards less carbon-intensive 
activities and production processes.
    The size of the price increase would depend on things 
including the technology available, but especially including 
the stringency of the cap. The more that you try to reduce 
emissions, the higher the price increase. It is also important 
to recognize that that price increase would occur regardless of 
whether the permits were sold to firms or households or were 
given away to them at no cost.
    It is sometimes thought that if you gave the permits away 
to firms, the ultimate price increases would not occur. And 
that is not likely to be correct. It is not what has occurred 
in the European Union where permits were allocated at no cost 
and there were price increases that varied from country to 
country. And it is not what we would expect to occur in the 
United States either. Those price increases by themselves are 
regressive, because low-income households consume a larger 
share of their income in the form of energy than higher-income 
households, so the price increases for carbon-intensive goods 
and services impose a relatively larger burden on low-income 
households than higher-income households. But the overall 
distributional impact of the policy will depend not only on 
that effect, but also, very importantly, on how the value of 
the allowances themselves are allocated.
    We estimate that the allowances would be worth somewhere 
between $50 and $300 billion a year by the year 2020. And what 
policymakers decide to do with those allowances could have a 
very big effect on the overall distributional consequences of a 
cap-and-trade system. In particular, if the permits were 
allocated at no cost to firms, the firms would obtain that $50 
to $300 billion.
    And just to put that in context, profits for U.S. producers 
of oil, gas and coal over the last 10 years have averaged less 
than $70 billion a year. So relative to existing profits, those 
permits would be extraordinarily valuable.
    Furthermore, allocating the permits in that way would 
exacerbate the regressivity of the underlying policy because 
the shareholders in those firms tend to be disproportionately 
higher-income households.
    The alternative is to auction the permits, in which case 
the $50 to $300 billion a year could be used to reduce the 
deficit or used to reduce other taxes. This approach could 
attenuate the distributional effects if the money was used to 
cushion the blow, especially for the poor, and it could also 
potentially reduce the macroeconomic consequences if some of 
those funds were used to reduce other distortionary taxes, 
including the individual income tax marginal rates and 
corporate income tax marginal rates. In particular, because 
giving the permits away to producers would disproportionately 
benefit high-income households and would preclude the 
possibility of using the allowance value to reduce the 
macroeconomic costs, such a strategy would appear to rank low 
from both a distributional and efficiency perspective.
    The final part of my testimony addresses the scoring of 
cap-and-trade systems under our role as the Congressional 
Budget Office and the budget scoring process. This is an 
important topic, but has received little attention to date. If 
the permits were auctioned, it is fairly clear that the revenue 
collected would be scored as revenue. And then depending on 
what was done with those funds, there may or may not be an 
outlay associated with the activity.
    If the permits were given away, however, the scoring is 
less clear. There is a solid case to be made that given the 
depth and liquidity of the secondary market in these permits 
that giving a firm or a household permits worth a hundred 
dollars which they could immediately transform into cash is 
effectively equivalent to giving that firm or household $100 in 
cash. And therefore giving away a permit should be scored as an 
outlay and a corresponding revenue with no net effect on the 
budget deficit.
    That kind of treatment would put on equal footing two 
transactions that economists believe are equivalent. Selling 
the permits for a hundred dollars and then giving a hundred 
dollars to particular firms and households, or simply giving a 
hundred dollars' worth of permits to those same firms or 
households, which they can then immediately and easily 
transform into cash.
    On the other hand, existing scoring--for example for the 
sulfur dioxide program--does not treat permits that are given 
away at no cost in this manner, and the Federal budget remains 
a primarily cash-based thing. And the transactions involved in 
giving away permits are not cash, they are just quasi-cash 
transactions.
    This scoring issue is something that CBO will be examining 
over the coming months as cap-and-trade proposals move through 
committee and we are forced to decide one way or the other how 
to score permits that are given away.
    Thank you very much, Mr. Chairman.
    Chairman Spratt. Thank you, Dr. Orszag.
    [The prepared statement of Peter R. Orszag follows:]

            Prepared Statement of Peter R. Orszag, Director,
                      Congressional Budget Office

    Mr. Chairman, Congressman Ryan, and Members of the Committee, thank 
you for the invitation to discuss issues related to reducing U.S. 
emissions of greenhouse gases, most prominently carbon dioxide (CO2).
    Global climate change is one of the nation's most significant long-
term policy challenges. Human activities are producing increasingly 
large quantities of greenhouse gases, particularly CO2. The 
accumulation of those gases in the atmosphere is expected to have 
potentially serious and costly effects on regional climates throughout 
the world. The magnitude of such damage remains highly uncertain. But 
there is growing recognition that some degree of risk exists for the 
damage to be large and perhaps even catastrophic.
    Reducing greenhouse-gas emissions would be beneficial in limiting 
the degree of damage associated with climate change, especially the 
risk of significant damage. However, decreasing those emissions would 
also impose costs on the economy--in the case of CO2, because much 
economic activity is based on fossil fuels, which release carbon in the 
form of carbon dioxide when they are burned. Most analyses suggest that 
a carefully designed program to begin lowering CO2 emissions would 
produce greater benefits than costs.
    The specific policy approach adopted to reduce emissions can have 
significant effects on the costs involved and on their distribution. In 
particular, an incentive-based approach for curbing CO2 emissions is 
substantially more economically efficient than alternative ``command-
and-control'' policies, which might dictate specific technologies or 
set standards for particular products or producers. An incentive-based 
approach to lowering CO2 emissions could be implemented in two main 
ways: by regulating the price of those emissions (for example, by 
taxing emissions) or by adopting a market-based system to regulate the 
quantity of emissions (for example, by establishing a ``cap-and-trade'' 
program for them). Either approach would raise the price for consuming 
goods and services that result in CO2 emissions. Those price increases 
could provide an effective financial incentive for firms and households 
throughout the economy to take actions that would decrease emissions.
    My testimony makes the following key points about those issues:
     The risk of potentially catastrophic damage from climate 
change can justify taking action to reduce that risk in much the same 
way that the hazards we all face as individuals motivate us to buy 
insurance. Some of society's resources may best be devoted to 
addressing climate change even if the most severe risks ultimately do 
not materialize.
     Although both a tax on emissions and a cap-and-trade 
system use the power of markets to achieve their desired results, a tax 
is generally the more efficient approach. The efficiency of a cap-and-
trade program can be enhanced, how ever, through various design 
mechanisms, such as a ``safety valve'' that would allow additional 
emission allowances to be sold when the price of an allowance exceeded 
a specified level.
     Under a cap-and-trade program, a key decision for 
policymakers is whether to sell emission allowances or to give them 
away. The value of those allowances would probably be substantial: 
Under the range of cap-and-trade policies now being considered by the 
Congress, the annual value of emission allowances would be roughly $50 
billion to $300 billion by 2020 (measured in 2006 dollars). More-
stringent caps would result in higher total allowance values.
     Policymakers' decisions about how to allocate the 
allowances could have significant effects on the overall economic cost 
of capping CO2 emissions, as well as on the distribution of gains and 
losses among U.S. households. Giving allowances away to companies that 
supply fossil fuels or that use large quantities of fossil fuels in 
their production processes could create ``windfall'' profits for those 
firms. The reason is that the cap-and-trade program would still result 
in higher prices for consumers and households but would not impose 
additional costs on those firms. Even if the companies received 
allowances for free, they would still raise prices to their customers 
because the cost of using an emission allowance for production--rather 
than selling it to another firm--would be embodied in the prices that 
they would charge for their goods and services. The resulting price 
increases would disproportionately affect people at the lower end of 
the income scale.
     If the government chose to sell emission allowances, it 
could use the revenue to offset the disproportionate economic burden 
that higher prices would impose on low-income households. Selling 
allowances could also significantly lessen the macroeconomic impact of 
a CO2 cap. Evidence suggests that the macroeconomic cost of a 15 
percent cut in U.S. emissions (not counting any benefits from 
mitigating climate change) might be more than twice as large if policy-
makers gave allowances away than if they sold the allowances and used 
the revenue to lower current taxes on labor or capital that discourage 
economic activity, such as income or payroll taxes.
     The budgetary treatment of a federal cap-and-trade system 
for CO2 emissions is an important topic that has received relatively 
little attention. If the federal government sold emission allowances, 
the proceeds would clearly be scored as federal receipts. The 
appropriate treatment of allowances issued at no charge is less clear. 
There is a solid case to be made that even allowances that were given 
away by the government should be reflected in the budgetary scoring 
process--specifically, that the value of any allowances initially 
distributed at no cost to the recipients should be scored as both 
revenues and outlays, with no net effect on the budget deficit. A 
different perspective would suggest that issuing allowances at no 
charge should be viewed as a straightforward regulatory action, with no 
direct budgetary consequences.
           the benefits of reducing greenhouse-gas emissions
    Human activities--industry, transportation, power generation, and 
land use--produce large quantities of greenhouse gases. Those gases are 
accumulating in the atmosphere more rapidly than natural processes can 
remove them. Atmospheric concentrations of CO2, for example, have risen 
from 280 parts per million in the preindustrial era to about 380 parts 
per million today. The result of that and other greenhouse-gas 
accumulation has been a gradual warming of the global climate: Average 
temperatures have already increased by about 0.8 C (1.4 F).
    Under a business-as-usual case, the total stock of greenhouse gases 
in the atmosphere would rise significantly, and estimates suggest that 
the global climate could warm by at least another 2 C to 6 C (4 F to 11 
F) over the coming century. Such warming would impose economic and 
social costs--for example, by raising sea levels, altering agricultural 
zones, and increasing the severity of storms and droughts. At the 
higher end of the range of projections, the amount of warming to come 
would be at least as great as the amount that has occurred since the 
depths of the last ice age and could produce unexpected, rapid, and 
very costly changes in the Earth's climate. Some experts think that the 
effects of climate change could be modest, especially if society is 
ingenious in adapting to the change. However, other experts are 
concerned that rising concentrations of greenhouse gases could produce 
much more severe consequences for the global and U.S. economies than 
have generally been projected--as well as other costs, such as mass 
species extinction, that are difficult to quantify in economic terms.
    Curbing greenhouse-gas emissions would help reduce not only the 
expected costs of future global climate change but also the chances of 
irreversible or potentially catastrophic damage. The Congressional 
Budget Office (CBO) has no basis to judge the scientific merits of the 
more extreme outcomes. But in general, the possibility of such extreme 
costs provides an economic motivation for additional action to moderate 
the growth of emissions--and, potentially, to reduce emissions to very 
low levels in the longer run. Individuals take actions, such as 
mitigating risky behavior or buying insurance, to reduce their harm 
from extreme events. Similarly, societies or governments do and should 
take actions to avoid catastrophic collective harm. The difficulty for 
policymakers is determining the appropriate cost to be paid today to 
reduce what may be a small risk of a potentially catastrophic event in 
the future.\1\
            incentive-based approaches to reducing emissions
    Any effort to limit CO2 emissions would have two principal effects: 
It would produce long-term economic benefits by avoiding some future 
climate-related damage, and it would impose immediate economic costs by 
reducing the use of fossil fuels. Most analyses suggest that a 
carefully designed program to begin lowering CO2 emissions would 
produce greater benefits than costs.
    Employing incentive-based policies to reduce CO2 emissions would be 
much more cost-effective than using more-restrictive command-and-
control approaches (such as imposing technology standards on 
electricity generators). Command-andcontrol approaches rely on 
policymakers to determine where or how emissions should be cut. 
Incentive-based policies, by contrast, use the power of markets to 
identify the least expensive sources of emission reductions. Thus, they 
can better reflect technological advances, differences between 
industries or companies in the ability to make low-cost emission 
reductions, and changes in market conditions.
    The two main incentive-based approaches to reducing CO2 emissions 
are to tax such emissions or to establish a cap-and-trade program for 
them. Under a tax, a levy would be imposed on CO2 emissions or on the 
carbon content of goods (which is ultimately released in the form of 
CO2). Under a cap-and-trade program, policymakers would set a limit 
(the cap) on total emissions during some period and would require 
regulated entities to hold rights, or allowances, to the emissions 
permitted under that cap. After allowances were initially distributed, 
entities would be free to buy and sell them (the trade part of the 
program). Reducing emissions to the level required by the cap would be 
accomplished mainly by stemming demand for carbon-based energy through 
increasing its price.\2\ The size of the required price increase would 
depend on the extent to which emissions had to be reduced--larger 
reductions would require larger price increases to reduce demand 
sufficiently.
            efficiency advantages of a tax on co2 emissions
    Although both types of incentive-based approaches are significantly 
more efficient than command-and-control policies, studies typically 
find that over the next several decades, a well-designed tax would 
yield higher net benefits than a capand-trade approach. A tax creates 
relative certainty about the cost of emission reductions each year, 
because firms will undertake such reductions until the cost of 
decreasing emissions by another ton just equals the tax on an 
additional ton of emissions. A cap-and-trade program, by contrast, 
creates relative certainty about the quantity of emission reductions 
each year, because the cap limits total annual emissions. In terms of 
the impact on the climate, however, it does not matter greatly whether 
a given cut in emissions occurs in one year or the next.\3\ From that 
perspective, a tax has an important advantage: It allows emission 
reductions to take place in years when they are relatively cheap. 
Various factors can affect the cost of emission reductions from year to 
year, including the weather, the level of economic activity, and the 
availability of new low-carbon technologies (such as improvements in 
wind-power technology). By shifting emission-reduction efforts into 
years when they are relatively less expensive, a tax can allow the same 
cumulative reduction to occur over many years at lower cost than can a 
cap-and-trade program with specified annual emission levels. In 
addition, by avoiding the potential volatility of allowance prices that 
might result from a rigid annual cap, a tax could be less disruptive 
for affected companies.
    The relative advantages of a tax and a cap-and-trade program could 
change over time, however. For example, because a cap creates relative 
certainty about the level of emissions, it could become more efficient 
than a tax if additional emissions were likely to trigger a sharp 
increase in damage, or if new technologies offered the opportunity to 
make extremely large cuts in emissions at a low and fairly constant 
cost. Analysts who have tried to define more precisely the conditions 
under which a cap would be more efficient than a tax have found those 
conditions to be quite narrow and not likely to be relevant in the near 
term. Specifically, scientists would need to have fairly precise 
knowledge about the level of an emissions threshold--beyond which 
additional emissions would trigger a sharp increase in total global 
damage--and such a threshold would have to be sufficiently close that 
policymakers would want to make very large cuts in emissions each year 
to avoid crossing it.\4\ In the absence of those conditions, a tax 
offers a more efficient approach for reaching a multiyear emission-
reduction target.
           enhancing the efficiency of a cap-and-trade system
    Although a tax is a more efficient policy in the near term, the 
efficiency of a capand-trade approach can be enhanced by various design 
features. In addition, some participants in the policy discussion 
believe that analytical comparisons of a tax and a cap-and-trade system 
ignore the idea that policymakers may be more inclined to set a tight 
cap than a correspondingly high tax.\5\
    Policymakers could capture some of the efficiency advantages of a 
tax, while maintaining the structure of a cap-and-trade program, by 
adding features that would help keep the price of allowances in line 
with the anticipated benefits of emission cuts. For example, a price 
cap--typically referred to as a safety valve--and a price floor could 
keep the price of allowances from climbing too far above or falling too 
far below the anticipated benefits of emission reductions. The 
government could implement a safety valve by agreeing to sell as many 
allowances as firms wanted to buy at a specified price. (If the safety 
valve was triggered, emissions would exceed the level of the cap.) A 
price floor could be implemented if policymakers decided to sell a 
significant fraction of the allowances in an auction and set an auction 
reserve price. Alternatively, rather than setting a price floor, 
policymakers could allow firms to ``bank'' allowances when the cost of 
reducing emissions was low and to use those allowances in the future 
when costs were higher. Banking would keep the price of allowances from 
falling too low, provided that prices were expected to be higher in the 
future.
    The effects of a cap-and-trade system would also depend 
substantially on whether the allowances were sold or issued at no cost, 
as discussed below.
       the distributional consequences of a cap-and-trade program
    By establishing a cap-and-trade program, policymakers would create 
a new commodity: the right to emit CO2. The emission allowances--each 
of which would represent the right to emit, say, one ton of CO2--would 
have substantial value. Based on a review of the existing literature 
and the range of CO2 policies now being debated, CBO estimates that the 
value of those allowances could total between $50 billion and $300 
billion annually (in 2006 dollars) by 2020. The actual value would 
depend on various factors, including the stringency of the cap (which 
would need to grow tighter over the years to keep CO2 from continuing 
to accumulate), the possibility of offsetting CO2 emissions through 
carbon sequestration or international allowance trading, and other 
features of the specific policy selected.\6\
    Policymakers would need to decide how to allocate the allowances 
that would correspond to each year's CO2 cap. One option would be to 
have the government capture their value by selling the allowances, as 
it does with licenses to use the electromagnetic spectrum. Another 
possibility would be to give the allowances to energy producers or some 
energy users at no charge. The European Union has used that second 
approach in its 2-year-old cap-and-trade program for CO2 emissions, and 
nearly all of the allowances issued under the 12-year-old U.S. cap-and-
trade program for sulfur dioxide emissions (which contribute to acid 
rain) are distributed in that way. Policymakers' decision about whether 
to sell the allowances or to give them away would have significant 
implications for the distribution of gains and losses among U.S. 
households and for the overall cost of the policy.
    The ultimate distributional impact of a cap-and-trade program would 
be the net effect of two distinct components: the distribution of the 
cost of the program (including the cost of paying for the allowances) 
and the distribution of the allowances' value (because someone will pay 
for them, someone will benefit from their value). Market forces would 
determine who bore the costs of a cap-and-trade program, but 
policymakers would determine who received the allowance value. The 
ultimate effect could be either progressive or regressive.
       market forces would determine who bore the costs of a cap
    Obtaining allowances--or taking steps to cut emissions to avoid the 
need for such allowances--would become a cost of doing business for 
firms that were subject to the CO2 cap. However, those firms would not 
ultimately bear most of the costs of the allowances. Instead, they 
would pass along most such costs to their customers (and their 
customers' customers) in the form of higher prices. By attaching a cost 
to CO2 emissions, a cap-and-trade program would thus lead to price 
increases for energy and energy-intensive goods and services that 
contribute the most to those emissions. Such price increases stem from 
the restriction on emissions and would occur regardless of whether the 
government sold emission allowances or gave them away. Indeed, the 
price increases would be essential to the success of a capand-trade 
program because they would be the most important mechanism through 
which businesses and households were encouraged to make investments and 
behavioral changes that reduced CO2 emissions.
    The rise in prices for energy and energy-intensive goods and 
services would impose a larger burden, relative to income, on low-
income households than on high-income households. For example, not 
incorporating any benefits to households from lessening climate change, 
CBO estimated that the price increases resulting from a 15 percent cut 
in CO2 emissions would cost the average household in the lowest one-
fifth of the income distribution about 3.3 percent of its income but 
the average household in the top quintile about 1.7 percent of its 
income (see Table 1).\7\


    The higher prices that would result from a cap on CO2 emissions 
would reduce demand for energy and energy-intensive goods and services. 
Thus, those price increases would create losses for some current 
investors and workers in the sectors that produce such goods and 
services. Investors could see their stock values decline, and workers 
could face the risk of unemployment as jobs in those sectors were cut. 
Stock losses would tend to be widely dispersed among investors, because 
shareholders typically have diversified portfolios. In contrast, the 
costs borne by existing workers would probably be concentrated among 
relatively few households and, by extension, their communities.
 policymakers would determine who received the value of the allowances
    Although the price increases triggered by a cap-and-trade program 
for CO2 emissions would be regressive, the policy's ultimate 
distributional effect would depend on policymakers' decisions about how 
to allocate the emission allowances. As noted above, those allowances 
would be worth tens or hundreds of billions of dollars per year. Who 
received that value would depend on how the allowances were 
distributed.
    Lawmakers could more than offset the price increases experienced by 
low-income households or the costs imposed on workers in particular 
sectors by providing for the sale of some or all of the allowances and 
using the revenue to pay compensation. For example, CBO examined the 
ultimate distributional effects of a cap-andtrade program that would 
reduce U.S. CO2 emissions by 15 percent and concluded that lower-income 
households could be better off (even without including any benefits 
from reducing climate change) as a result of the policy if the 
government chose to sell the allowances and used the revenue to pay an 
equal lump-sum rebate to every household in the United States. In that 
case, the size of the rebate would be larger than the average increase 
in low-income households' spending on energy and energy-intensive 
goods.\8\ Such a strategy would increase average income for households 
in the lowest income quintile by 1.8 percent (see the top panel of 
Figure 1). At the same time, average income for households in the top 
quintile would fall by 0.7 percent, CBO estimates.


    Conversely, giving all or most of the allowances to energy 
producers to offset the potential losses of investors in those 
industries--as was done in the cap-and-trade program for sulfur dioxide 
emissions--would exacerbate the regressivity of the price increases. On 
average, the value of the CO2 allowances that producers would receive 
would more than compensate them for any decline in profits caused by a 
drop in the demand for energy and energy-intensive goods and services 
that cause emissions. As a result, the companies that received 
allowances could experience ``windfall'' profits, with the government 
regaining only part of that windfall through corporate income taxes. 
For example, one study suggested that if emissions were reduced by 23 
percent and all of the allowances were distributed for free to 
producers in the oil, natural gas, and coal sectors, stock values would 
double for oil and gas producers and increase more than sevenfold for 
coal producers, compared with projected values in the absence of a 
cap.\9\ If emissions were instead reduced by 15 percent, as in the 
scenario discussed above, profits in those sectors would rise several 
fold. For example, in 2000, CBO examined the effects of reducing 
emissions from 1998 levels and estimated that under a 15 percent cut, 
the value of allowances would be 10 times as large as coal, oil, and 
natural gas producers' combined profits in 1998 and more than double 
their profits in 2006.\10\ Because the additional profits would not 
depend on how much a company produced, they would be unlikely to 
prevent the declines in production and resulting job losses that would 
stem from the price increases.
    In addition, those profits would accrue to shareholders, who are 
primarily from higher-income households, and would more than offset 
those households' increased spending on energy and energy-intensive 
goods and services. Low-income households, by contrast, would benefit 
little if allowances were given to energy producers for free, and they 
would still bear a disproportionate burden from price increases. Thus, 
giving away allowances would be significantly regressive, making 
higher-income households better off as a result of the cap-and-trade 
policy while making lower-income households worse off (see the top 
panel of Figure 2, which, like Table 1 and Figure 1, does not 
incorporate the benefits of reducing climate change). That regressive 
outcome could occur even if the government used its share of the 
allowance value--received through corporate income taxes on the 
windfall profits--to provide lump-sum rebates to households.


    Giving away all of the allowances and using the government's 
regained share of their value to reduce corporate tax rates would be 
particularly regressive. In that scenario (once again not including any 
benefits from reducing climate change), average household income would 
fall by 3.0 percent in the lowest quintile and rise by 1.9 percent in 
the highest quintile. However, that approach would help lessen the 
macroeconomic cost of the cap on CO2 emissions.
           reducing the overall economic impact of a co2 cap
    The ways in which lawmakers could allocate the revenue from selling 
emission allowances would affect not only the distributional 
consequences but also the total economic cost of a cap-and-trade 
policy. For instance, the government could use the revenue from 
auctioning allowances to reduce existing taxes that tend to dampen 
economic activity--primarily, taxes on labor, capital, or personal 
income. Research indicates that a CO2 cap would exacerbate the economic 
effects of such taxes: The higher prices caused by the cap would lower 
real (inflation-adjusted) wages and real returns on capital, which 
would be equivalent to raising marginal tax rates on those sources of 
income. Using the allowance value to reduce such taxes could help 
mitigate that adverse effect of the cap. Alternatively, policy-makers 
could choose to use the revenue from auctioning allowances to reduce 
the federal deficit. If that reduction lessened the need for future tax 
increases, the end result could be similar to dedicating the revenue to 
cutting existing taxes.
    The decision about whether or not to sell the allowances and use 
the proceeds in ways that would benefit the economy could have a 
significant impact. For example, researchers estimate that the 
efficiency cost of a 15 percent cut in emissions could be reduced by 
more than half if the government sold allowances and used the revenue 
to lower corporate income taxes, rather than devoting it to providing 
lump-sum rebates to households (see the bottom panel of Figure 1). The 
efficiency cost of a policy reflects the economic losses that occur 
because prices in the economy are distorted in ways that do not reflect 
the (nonenvironmental) resources used in their production. That cost 
includes decreases in the productive use of labor and capital as well 
as costs (both monetary and nonmonetary) associated with reducing 
emissions. To provide perspective on the magnitude of such efficiency 
costs, they are depicted as a share of gross domestic product.
    Giving the allowances away to producers, by contrast, would largely 
prevent the government from using the allowance value in ways that 
would lower the cap's total cost to the economy. For example, as 
indicated in the bottom panels of Figures 1 and 2, selling the 
allowances and using the revenue to reduce existing taxes that 
discourage economic activity would entail only about half the 
efficiency cost of giving the allowances away and devoting any revenue 
that the government regained (through the corporate income tax) to 
reducing those types of taxes.
       the federal budgetary treatment of a cap-and-trade program
    The budgetary treatment of a federal cap-and-trade program for 
carbon dioxide is an important topic, although it has received little 
attention. Auctioning off allowances would clearly generate receipts 
for the federal government, and those amounts would be recorded as 
revenues or as offsetting receipts (reductions in outlays) in the 
federal budget. For example, if the government conducted an auction of 
cap-and-trade allowances and received $100 for them, the $100 would be 
recorded in the federal budget as a receipt.
    The appropriate treatment of allowances issued at no charge is less 
clear, however. A solid case can be made that even allowances that are 
given away by the government should be reflected in the federal 
budgetary scoring process--specifically, the scoring should show, as 
both revenues and outlays, the value of any allowances distributed at 
no cost to the recipients. If the allowances given away by the 
government were worth $100, the budgetary scoring process would record 
the $100 as both a revenue and an outlay.\11\ The net effect on the 
budget deficit or surplus would be zero, since the value of such 
allowances would increase revenues and outlays by the same amount.
    Several considerations motivate that type of approach to scoring 
CO2 allowances. The government is essential to the existence of the 
allowances and is responsible for their readily realizable monetary 
value through its enforcement of the cap on emissions. (The allowances 
would trade in a liquid secondary market, since firms or households 
could buy and sell them, and thus they would be similar to cash.) In 
addition, that type of scoring approach best illuminates the trade-offs 
between different policy choices. Distributing allowances at no charge 
to specific firms or individuals is, in effect, equivalent to 
collecting revenue from an auction of the allowances and then 
distributing the auction proceeds to those firms or individuals. In 
other words, the government could either raise $100 by selling 
allowances and then give that amount in cash to particular businesses 
and individuals, or it could simply give $100 worth of allowances to 
those businesses and individuals, who could immediately and easily 
transform the allowances into cash through the secondary market. 
Treating allowances that were issued at no charge as both a revenue and 
an outlay would mean that those two equivalent transactions were 
reflected in parallel ways in the scoring process.
    A different perspective would suggest that issuing allowances at no 
charge should be viewed as a straightforward regulatory act, with no 
direct budgetary consequences. That perspective stresses that the 
federal budget is primarily a cash-based concept, and granting 
allowances at no cost involves no cash transaction between the 
government and the private sector. That approach would be the same as 
the one now applied to the Environmental Protection Agency's issuance 
of emission allowances for sulfur dioxide.
    As legislative proposals to create a cap-and-trade system for CO2 
emissions are introduced in coming months, CBO will evaluate those 
approaches to scoring such proposals.
                                endnotes
    \1\ For more discussion of policy choices in the face of 
catastrophic costs, see Cass R. Sunstein, Worst-Case Scenarios 
(Cambridge, Mass.: Harvard University Press, 2007).
    \2\ Emissions could also be reduced to some extent through ``carbon 
sequestration''--the capture and long-term storage of CO2 emissions 
underground (geological sequestration) or in vegetation or soil 
(biological sequestration). For more information, see Congressional 
Budget Office, The Potential for Carbon Sequestration in the United 
States (September 2007).
    \3\ Although it is difficult to measure, the long-term cumulative 
nature of climate change implies that the benefit of emitting one less 
ton of CO2 in a given year--referred to as the marginal benefit--is 
roughly constant. In other words, the benefit in terms of averted 
climate damage from each additional ton of emissions reduced is roughly 
the same as the benefit from the previous ton of emissions reduced, and 
shifting the reductions from one year to another does not materially 
affect the ultimate impact on the climate. In contrast, the cost of 
emitting one less ton of CO2 in a given year--the marginal cost--tends 
to increase with successive emission reductions. The reason is that the 
least expensive reductions are made first and progressively more-
expensive cuts would then have to be made to meet increasingly 
ambitious targets for emission reductions.
    \4\ See William A. Pizer, Climate Change Catastrophes, Discussion 
Paper 03-31 (Washington, D.C.: Resources for the Future, May 2003).
    \5\ Some analysts also suggest that a cap-and-trade program could 
be more politically acceptable than a tax because distributing the 
allowances for free could provide a method of directly compensating 
producers in the most affected industries. See Robert N. Stavins, 
AU.S.Cap-and-Trade System to Address Global Climate Change (Washington, 
D.C.: Brookings Institution, October 2007). The revenues from a tax 
could be used in a similar fashion, however.
    \6\ For information about carbon sequestration, see footnote 2.
    \7\ Those calculations are based on cash income, which excludes in-
kind transfers and accrued but still unrealized income. CBO could have 
presented results based on alternative measures of income, such as 
adjusted family income, which adjusts for family size. Using that 
measure would alter the quantitative results slightly but would not 
affect the conclusions of the analysis in any qualitative way. The 
numbers are based on an analysis that CBO conducted using 1998 data; 
see Congressional Budget Office, Who Gains and Who Pays Under Carbon 
Allowance Trading? The Distributional Effects of Alternative Policy 
Designs (June 2000). In an updated analysis, the qualitative findings 
would be unlikely to change, but the quantitative results could be 
significantly different because of various factors, including changes 
in the distribution of income and in marginal tax rates.
    \8\ One researcher has suggested that an environmental tax credit 
based on earnings could offer another means of reducing the regressive 
effects of the price increases that would result from a tax or cap on 
CO2 emissions. See Gilbert E. Metcalf, A Proposal for a U.S. Carbon Tax 
Swap (Washington, D.C.: Brookings Institution, October 2007).
    \9\ Lawrence H. Goulder, Mitigating the Adverse Impacts of CO2 
Abatement Policies on Energy-Intensive Industries, Discussion Paper 02-
22 (Washington, D.C.: Resources for the Future, March 2002), Table 3.
    \10\ Specifically, CBO estimated that the value of those allowances 
would total $155 billion (in 2006 dollars). By comparison, profits for 
U.S. producers of oil, natural gas, and coal totaled $13.5 billion in 
1998 (in 2006 dollars). Those companies' total profits were 
substantially higher in 2006: $174 billion.
    \11\ The value of allowances that were given away could be 
estimated either from the prices of any allowances that were auctioned 
or from the prices at which allowances were subsequently bought and 
sold by firms.

    Chairman Spratt. Let me add to the housekeeping details, 
previously the typical stipulation that all of your statements 
will be made part of the record so that you can summarize them 
as you see fit.
    Now we will go next to Mr. Doniger.

  STATEMENT OF DAVID DONIGER, CLIMATE CENTER POLICY DIRECTOR, 
               NATURAL RESOURCES DEFENSE COUNCIL

    Mr. Doniger. I thank you very much, Mr. Chairman and Mr. 
Ryan, for the opportunity to testify. I am David Doniger. I am 
the Policy Director of the Climate Center at the Natural 
Resources Defense Council. I am here on behalf of our 1.2 
million members and supporters across the country.
    A discussion about global warming, in my view, needs to 
start very briefly with some words on the urgency. And I wonder 
if I could have the slide shown.
    [Slide.]
    Mr. Doniger. We are already suffering dangerous impacts 
from global warming. We used to think it was off in the future. 
It is upon us now. There is a strong consensus in the 
Intergovernmental Panel on Climate Change, that won a Nobel 
prize recently, that global warming is occurring, it is human-
caused, it is within our power to control. The picture here 
shows the loss of Arctic ice at the summertime minimum since 
1979. Forty percent of the Arctic ice has melted away this past 
year in comparison with 1979.
    As Peter mentioned, we have the danger that the Greenland 
ice sheet and the Antarctic ice sheet would melt, triggering 
over a longer period very, very large sea level rises, 21 feet 
from either one of those melting.
    We have the expectation of more wildfires like the ones 
that have been suffered in California. I am not here to say 
whether that was or was not definitively caused by global 
warming, but it is of the kind that we will see more of, 
because there will be stronger droughts occurring as a result 
of global warming. There will also be stronger hurricanes like 
of the kind we saw hit New Orleans in Hurricane Katrina. The 
Centers for Disease Control, when it isn't being censored, 
acknowledges that there are public health impacts.
    I would point out as well that apart from the warming 
impact, the oceans are soaking up a great deal of carbon 
dioxide. This is increasing the acidity of the oceans. And 
scientists are now predicting that coral and shellfish may lose 
the ability to lay down shells as a result of the changing 
acidity of the oceans.
    In our view, we need to hold the future temperature 
increase--we have already had about a degree Fahrenheit already 
occur this past century--we need to hold the future increase 
under two degrees more Fahrenheit in order to avoid the worst 
effects of global warming. And this will take a declining cap 
on the emissions imposed here in the U.S. by our industrial 
partners, and eventually as well by developing countries.
    In the U.S. we need a cap that would be reducing emissions 
by 2020 on the order of 15 percent, and on the order of 80 
percent by 2050. That is the sort of specifications that Mr. 
Dingell--at least at the strong end of the range that he is 
talking about. There is a bill approaching that that was just 
marked up by Senators Lieberman and Warner in the subcommittee 
in the Senate this morning.
    My next point is that we can afford this, but it gets much 
harder if we delay. If I could have the second slide.
    [Slide.]
    Mr. Doniger. The first point I would make before really 
referring to that slide is that estimates of the cost of these 
kinds of programs show that the actual effect on a growing 
gross domestic product is quite minimal.
    I will submit a study for the record that was just done by 
the Duke University Nicholas Institute that shows that by 2030 
if we don't have a program, we will have GDP growth on the 
order of 112 percent. If we do have a declining cap like the 
Lieberman and Warner proposal, the growth would be 111.5 
percent. And by 2050, 238 percent growth expected. If you have 
a climate change program that might be 236.5 percent. Very 
small differences in our growth. But the longer we wait--and 
this is what this slide illustrates--the harder it is to meet 
these kinds of targets. Because you ramp-up the emissions to a 
higher point, and that means the ramp-down has to be much 
steeper in a shorter period of time. So a slow start means a 
crash finish.
    And that is why we think it is so important for Congress to 
act to pass this kind of legislation without further delay. A 
cap-and-trade program with complementary policies such as 
performance standards for efficiency and incentives to help 
achieve these standards and move new technologies is, we 
believe, the most efficient and effective way to meet carbon 
limits needed to curb this kind of serious impact. And I 
believe there are tools to smooth out the costs, to control the 
costs, such as banking and borrowing which Dr. Orszag 
mentioned.
    We are, however, opposed to including a safety valve. The 
fundamental problem with a safety valve, as that term has come 
to be used, is that it breaks the cap. You just keep bringing 
more allowances, and we don't achieve the environmental 
protection objectives that are needed.
    One or two other points. The key thing is to look at these 
allowances, as Dr. Orszag has said, as a public asset, 
something that should be used for public purposes. Those can 
include promoting new technologies such as renewable energy and 
a faster deployment of efficiency, technologies to promote the 
faster takeup of carbon capture and storage by coal-burning 
facilities, to retool Detroit to help make vehicles that fit 
the profile we need for a carbon-constrained world, to have 
greener buildings and lower energy-consuming appliances, and to 
rebuild electricity companies' demand-side management programs 
to reduce energy. These are some of the technology-oriented 
uses that can be made of the value of the allowances.
    There is another dimension which I know Bob Greenstein will 
talk about in greater detail, but with our full support, that 
one needs to use a very large, probably the largest part of the 
value of these allowances to protect low- and moderate-income 
people who will be seeing the cost increases associated with 
the cap.
    There are vulnerable workers and communities in certain 
other industries which deserve to have some assistance. There 
is a need for spending to protect and restore ecosystems on 
land and in other coastal and ocean resources.
    My last point is, though, I would urge a distinction 
between ends and means, between the public purpose of the 
allowances and the tool of auctions. Auctions is a very good 
tool, but not the only tool available to achieve the public 
purposes that I have been describing. Some of these purposes 
can be achieved by having allowances go by formula towards 
certain objectives.
    For example, the Tax Code already includes production tax 
credits for wind energy, for example. That can also be funded, 
or similar things can be funded with a production allowance 
credit. Perhaps a certain number of allowances go to a coal-
burning utility that stores the carbon safely geologically 
underground. A certain number of allowances would go to the 
makers of super-efficient vehicles or super-efficient 
appliances. These can be done by formula. They can also be done 
by raising the money through an auction and spending the money 
out by spending formulas.
    The key thing in using all these tools is the need for 
stability, for dedicated resources that are stably allocated 
for multiple years; because the investors, the marketplace, 
needs to have clarity not only coming from the cap, but clarity 
about how the allowances are going to be allocated so that 
smart investment decisions can be made.
    And to go back to the production tax credit example for a 
moment, the wind energy industry has suffered because the tax 
credit in that instance has come on again and off again several 
times. So you have booms and busts which are triggered by the 
presence or absence of that tax credit. Stability is important. 
And in that sense, direct allocation, directed spending, tax 
incentives on a multiyear basis are, in our view, preferred 
over using the annual appropriations process to achieve these 
purposes.
    I would be happy to answer questions. Thank you.
    Chairman Spratt. Thank you, Mr. Doniger.
    [The prepared statement of David Doniger follows:]

 Prepared Statement of David Doniger, Climate Center Policy Director, 
                   Natural Resources Defense Council

    Thank you for the opportunity to testify today regarding the 
impacts of global warming legislation on the federal budget and the 
U.S. economy. My name is David Doniger. I am policy director of the 
Climate Center at the Natural Resources Defense Council (NRDC). NRDC is 
a national, nonprofit organization of scientists, lawyers and 
environmental specialists dedicated to protecting public health and the 
environment. Founded in 1970, NRDC has more than 1.2 million members 
and online activists nationwide, served from offices in New York, 
Washington, Los Angeles and San Francisco, Chicago and Beijing.
    Our discussion of the impacts of global warming legislation must 
begin with a reminder of why this legislation is so badly needed. 
Action to curb the pollution that is driving global warming has already 
been delayed too long. Every day we learn more about the ways in which 
global warming is already damaging our planet and its ability to 
sustain us. As described in a full page story in the October 22nd 
Washington Post, dramatic new satellite pictures show that summertime 
arctic ice has declined by 40 percent since 1979 (Figure 1). The UN 
Intergovernmental Panel on Climate Change found that 11 of the past 12 
years are among the 12 hottest years on record. The Greenland and West 
Antarctic ice sheets are losing mass at accelerating rates. Rising sea 
surface temperatures correlate strongly with increases in the number of 
Category 4 and 5 hurricanes like Hurricane Katrina that devastated New 
Orleans. More wildfires like the disaster that just hit California, 
more heat waves, and more droughts and floods are predicted to occur as 
global warming continues unabated. Our own Centers for Disease 
Control--when not censored by the White House--calls global warming a 
threat to public health. Our oceans are warming and becoming more 
acidic, threatening the survival of corals and shellfish. Everywhere 
one looks, the impacts of a disrupted climate are confronting us.
                                figure 1


    The reality of global warming is now a recognized fact throughout 
the world. Earlier this year, the United Nations Intergovernmental 
Panel on Climate Change (IPCC) concluded that warming of the earth is 
``unequivocal'' and that with 90 percent certainty, humans are causing 
most of the observed warming. At about the same time, major businesses, 
including many of the world's largest companies in diverse industry 
sectors, banded together with environmental organizations, including 
NRDC, under the umbrella of the U.S. Climate Action Partnership (USCAP) 
to call for mandatory legislation that would reduce emissions by 60-80 
percent by 2050. In April, the United States Supreme Court ruled that 
greenhouse gases are air pollutants subject to control under the Clean 
Air Act.
    In the past year, stories about global warming have appeared on the 
covers of Time, Newsweek and Sports Illustrated. And recent polls show 
very high levels of concern about global warming. For instance, a 
recent opinion poll conducted by the Yale University Climate Center 
indicates that 62 percent of Americans believe that life on earth will 
continue without major disruptions, only if society takes immediate and 
drastic action to reduce global warming Finally, just this month, the 
Nobel Peace Prize was awarded jointly to Al Gore and to the IPCC for 
their work on global warming. Global warming has come of age as an 
issue of supreme importance.
    Climate scientists now warn that we must act now to begin making 
serious emission reductions if we are to avoid truly dangerous global 
warming pollution concentrations. Because carbon dioxide and some other 
global warming pollutants remain in the atmosphere for many decades, 
centuries, or even longer, the climate change impacts from pollution 
released today will continue throughout the 21st century and beyond. 
Failure to pursue significant reductions in global warming pollution 
now will make the job much harder in the future--both the job of 
stabilizing atmospheric pollution concentrations and the job of 
avoiding the worst impacts of a climate gone haywire.
    Since the start of the industrial revolution, carbon dioxide 
concentrations have risen from about 280 parts per million (ppm) to 
more than 380 ppm today, and global average temperatures have risen by 
more than one degree Fahrenheit over the last century. A growing body 
of scientific opinion has formed that we face extreme dangers if global 
average temperatures are allowed to increase by more than another 2 
degrees Fahrenheit from today's levels. We may be able to stay within 
this envelope if atmospheric concentrations of CO2 and other global 
warming gases are kept from exceeding 450 ppm CO2-equivalent and then 
rapidly reduced. However, this will require us to halt U.S. emissions 
growth within the next few years and then cut emissions by 
approximately 80% over the next 50 years.
    This goal is ambitious, but achievable. It can be done through an 
annual rate of emissions reductions that ramps up to about a 4% 
reduction per year. (See Figure 2.) But if we delay and emissions 
continue to grow at or near the business-as-usual trajectory for 
another 10 years, the job will become much harder. In such a case, the 
annual emission reduction rate needed to stay on the 450 ppm path would 
double to 8% per year. In short, a slow start means a crash finish, 
with steeper and more disruptive cuts in emissions required for each 
year of delay.
                                figure 2


    It is critical to recognize that continued investments in old 
technology will ``lock in'' high carbon emissions for many decades to 
come. This is particularly so for the next generation of coal-fired 
power plants. Power plant investments are large and long-lasting. A 
single plant costs around $2 billion and will operate for 60 years or 
more. If we decide to do it, the United States and other nations could 
build and operate new coal plants that return their CO2 to the ground 
instead of polluting the atmosphere. With every month of delay we lose 
a piece of that opportunity and commit ourselves to 60 years of 
emissions. The International Energy Agency (IEA) forecasts that more 
than 20 trillion dollars will be spent globally on new energy 
technologies between now and 2030. How this money is invested over the 
next decade, and whether we will have the proper policies in place to 
drive investment into cleaner technologies, which can produce energy 
from zero and low carbon sources, or that can capture and dispose of 
carbon emissions, will determine whether we can realistically avoid the 
worst effects of global warming.
    We have the solutions--cleaner energy sources, new vehicle 
technologies and industrial processes and enhanced energy efficiency. 
We just lack the policy framework to push business investments in the 
right direction and to get these solutions in the hands of consumers.
    Congress is beginning to respond. Many bills to cap and reduce 
global warming pollution have been introduced in the House and Senate 
this year. The strongest of these bills--H.R. 1590, sponsored by Rep. 
Henry Waxman and a bipartisan group of 142 other members, and S. 309, 
co-sponsored by Senators Bernie Sanders and Barbara Boxer and 19 other 
members--would reduce U.S. emissions 80 percent by 2050. The committees 
of jurisdiction are also working hard on serious legislation. In the 
Senate, the Environment and Public Works Committee is taking up the 
bipartisan America's Climate Security Act, S. 2191, co-sponsored by 
Senators Joseph Lieberman and John Warner, a cap-and-trade bill that 
would cut the global warming pollution from three key sectors--electric 
power, transportation, and industry--15 percent by 2020 and 70 percent 
by 2050, with additional policies to reduce emissions from other 
sources. Here in the House, Energy and Commerce Chairman John Dingell 
and Subcommittee Chairman Rick Boucher have started the legislative 
process by circulating a white paper on the scope of a cap-and-trade 
program to reduce U.S. global warming pollution 60-80 percent by 
2050.\1\
---------------------------------------------------------------------------
    \1\ http://energycommerce.house.gov/Climate--Change/White--
Paper.100307.pdf
---------------------------------------------------------------------------
    NRDC believes a declining emissions cap and an emissions allowance 
trading system--combined with complementary policies such as 
performance and efficiency standards and incentives for new power 
plants, vehicles, appliances, buildings, and renewable sources of 
electricity and motor fuel--is the most environmentally effective and 
economically efficient approach to curbing global warming pollution. (I 
would note that a final energy bill containing the best of the House 
and Senate provisions would enact some of the most important of these 
performance and efficiency standards, including the House's renewable 
electricity standard and the Senate's CAFE standard, and would be a 
down-payment on global warming.)
    Under a cap-and-trade system, Congress creates a limited number of 
emissions ``allowances'' in an amount equal to the intended emissions 
cap. The cap, and the number of allowances, declines each year. Each 
entity that Congress designates--for example, power plants, oil 
refiners, major industries--must acquire and then turn in one allowance 
for each ton of CO2 (or the equivalent amount of another greenhouse 
gas) that it emits, or that will be emitted when its products (like 
gasoline or refrigerants) are burned or released to the atmosphere. 
Tradable allowances can also be bought or sold. A cap-and-trade system 
thereby harnesses the marketplace to achieve the necessary pollution 
reductions and meet the cap at the lowest cost. Firms with low 
pollution control costs will make the most reductions, and firms with 
highest costs will make the least.
    Analyzing a predecessor to the Lieberman-Warner bill, the 
Environmental Protection Agency found that reducing global warming 
pollution will have an imperceptible affect on economic output overall. 
If that bill were enacted, EPA found consumption of goods and services 
by U.S. households would increase 103% between 2005 and 2030, which is 
virtually indistinguishable from the 105% increase projected without 
the legislation.\2\ Household consumption, of course, is not the same 
as welfare. It does not include the value we place on reducing the risk 
of catastrophic storms, preserving our favorite beaches and alpine 
meadows, and preventing polar bears and countless other species from 
being driven to extinction.
---------------------------------------------------------------------------
    \2\ EPA, Analysis of The Climate Stewardship and Innovation Act of 
2007, S. 280 in 110th Congress, July 16, 2007, http://www.epa.gov/
climatechange/downloads/s280fullbrief.pdf
---------------------------------------------------------------------------
    Some have expressed the view that even these modest costs are too 
high, and that legislation should include a feature--often called a 
``safety-valve''--to artificially limit the operation of the 
marketplace. The fundamental problem with the safety valve is that it 
breaks the cap without ever making up for the excess emissions. Simply 
put, the cap doesn't decline as needed or, worse, keeps growing. In 
addition to breaking the U.S. cap, a safety valve also would prevent 
U.S. participation in international trading systems. If trading were 
allowed between the U.S. and other capped nations, a major distortion 
would occur. Firms in other countries (acting directly or through 
brokers) would seek to purchase the artificially lower-priced U.S. 
allowances. Their demand would almost immediately drive the U.S. 
allowance price to the safety valve level, triggering the ``printing'' 
of more American allowances. The net result would be to flood the world 
market with far more allowances--and far less emission reduction--than 
anticipated.
    Although NRDC believes that the primary and most effective cost 
containment device in any mandatory legislation will be the cap-and-
trade system itself, NRDC also supports other means of providing 
flexibility. Banking has long been a feature of cap and trade systems. 
We also support provisions allowing firms to borrow allowances with 
appropriate interest and payback guarantees. Banking and borrowing can 
smooth out unpredictable year-to-year volatility.
    As members of this committee are aware, one must pay close 
attention to the equity of major national policies, as well as their 
efficiency. In this regard, a cap-and-trade system requires careful 
attention to how the emissions allowances are allocated, and for what 
purposes. Even though the overall economic cost of curbing global 
warming will be modest, the value of the pollution allowances created 
by a cap-and-trade law will be much higher: The best estimates of their 
value lie between $50 billion and $100 billion per year.
    NRDC believes these pollution allowances are a public trust and a 
public asset. They represent permission to use the atmosphere, which 
belongs to all of us, to dispose of global warming pollution. As such, 
they are not a private resource owned by historical emitters and such 
emitters do not have a permanent right to free allowances. The value of 
the allowances should be used for public purposes, including promoting 
clean energy solutions, protecting the poor and other consumers, 
ensuring a just transition for workers in affected industries, and 
preventing human and ecosystem impacts both here and abroad, especially 
where they can lead to conflicts and threats to security.
    If one looks back over the past few years of debate over global 
warming legislation, one can see a marked shift in thinking about 
allowance allocation. Five years ago, the common assumption was that 
all of the emissions allowances should simply be given away--
grandfathered--to historical polluters. This is what was done with the 
much smaller pool of allowances for sulfur dioxide in the 1990 Clean 
Air Act amendments which established the cap-and-trade program to curb 
acid rain. The acid rain program has been extremely successful at 
meeting its environmental target at much lower cost than predicted. But 
the grandfathering approach to allowance allocation chosen in 1990 is 
not appropriate for a global warming program adopted now.
    Economic studies have established that in the case of global 
warming, 100 percent grandfathering would result in vastly enriching 
the regulated entities. The Congressional Budget Office has summarized 
this literature as follows:
    Researchers generally conclude that less than 15 percent of the 
allowance value would be necessary to offset net losses in stock values 
in both ``upstream'' industries (such as suppliers of coal, natural 
gas, and petroleum) and energy-intensive ``downstream'' industries 
(such as electricity generators, petroleum refiners, and metal and 
machinery manufacturers). The reason is that the cost of holding the 
allowances would generally be reflected in the prices that producers 
charged, regardless of whether those producers had to buy the 
allowances or were given them for free.\3\
---------------------------------------------------------------------------
    \3\ CBO, Trade-Offs in Allocating Allowances for CO2 Emission, 
April 25, 2007, p.5, http://www.cbo.gov/ftpdocs/80xx/doc8027/04-25-
Cap--Trade.pdf
---------------------------------------------------------------------------
    It follows that if more than about 15 percent of the allowances are 
given away to polluters for free, there will be a large transfer of 
wealth to them at the expense of consumers. And as CBO further found 
the impact would be disproportionate for poor consumers, who have the 
least income and who must devote a larger percentage of their income 
than others for energy-related costs.
    These insights have been borne out in real experience. The European 
Union deserves great credit for moving forward with a cap-and-trade 
program for a large fraction of their emissions in 2005, even before 
their obligations under the Kyoto Protocol take effect in 2008. But 
they have made some start-up mistakes--an experience they are learning 
from and we should too. Specifically, they grandfathered 100 percent of 
their allowances to electric power companies. Predictably, the electric 
companies raised electricity prices to reflect the value of those 
allowances, even though they received the allowances for free. From 
these price increases the firms reaped several billion dollars in 
windfall profits.
    In the other direction, a group of U.S. states in the northeast 
have established the ``Regional Greenhouse Gas Initiative,'' a cap-and-
trade program for electric power in that region. All of these states so 
far have chosen to auction their allowances and use them for promoting 
energy efficiency and other public purposes. For example, Governor 
Spitzer announced last week that New York will auction 100 percent of 
its CO2 allowances and use the proceeds from the auction to fund energy 
efficiency programs and renewable energy projects.
    As a result of these insights and experiences, there is more and 
more acceptance that the bulk of the allowances must go to public 
purposes, not private enrichment. Still, the battle is not yet entirely 
won. In this body, there are some who still speak of grandfathering 
nearly all of the allowances. And in the Senate, while the Lieberman-
Warner bill eventually devotes most allowances to a variety of public 
purposes--promoting clean energy solutions, protecting the poor and 
other consumers, ensuring a just transition for workers in affected 
industries, and preventing human and ecosystem impacts both here and 
abroad, especially where they can lead to conflicts and threats to 
security--it still grandfathers too many allowances to power companies 
and industries at the outset and takes too long to phase out that 
grandfathering. We are working cooperatively with the sponsors and 
others to improve their bill.
    Note that in this discussion I generally have said ``public 
purposes'' rather than ``auction.'' I put it this way in order to focus 
on the ends before the means. It is possible to directly and 
efficiently allocate allowances to achieve many of the public purposes 
to which they should be put. Here are some examples found in bills 
introduced either in this or prior Congresses:
     Promoting renewable energy: Congress could write 
legislation that includes an appropriate formula for allocating bonus 
allowances to firms that produce electricity from wind or other 
renewables. The recipient would sell the allowances into the 
marketplace to realize their value. The incentive would function just 
like the current production tax credit for wind: the developer of a new 
wind farm would receive incentive revenue in proportion to its 
electricity output.
     Encouraging Carbon Capture and Storage: Congress could 
include a bonus allowance formula to encourage power companies to adopt 
carbon capture and storage technology. As above, the power company 
would receive incentive revenue from selling the allowances in the 
marketplace.
     Retooling the Auto Industry: To help domestic automakers 
retool and reposition for a changing market, Congress could establish 
an allowance allocation formula that functioned like a consumer rebate 
to encourage the purchase of low-emitting vehicles.
     Greening Buildings, Equipment, and Appliances: Likewise, 
allowance formulae could be written to promote faster deployment of 
highly energy-efficient appliances and construction of highly energy-
efficient buildings.
     Demand-Side Management and Climate Rebates: Allowances 
also could be allocated to local electric and gas distribution 
utilities on condition that the proceeds from selling them into the 
marketplace are used to fund energy efficiency and rebate programs for 
their consumers.
    These same objectives could be achieved, of course, by auctioning 
the allowances and using the revenue to support tax credits, directed 
spending, or appropriations aimed at the same results. Direct 
allocation of allowances for these public purposes, however, has the 
advantage that it can be accomplished in a single piece of legislation. 
It can also create incentives that planners and investors will see as 
stable and predictable over multi-year periods. To achieve the same 
degree of stability and effectiveness through an auction approach, it 
would be critical to put the allowance revenue into a dedicated trust 
fund mechanism that is sheltered from the uncertainties introduced by 
annual appropriations.
    There are some public purposes, however, that can be more 
effectively and efficiently pursued through such measures as tax 
credits or programs administered by federal or state agencies. For 
example, as Robert Greenstein of the Center on Budget and Policy 
Priorities will elaborate, in order to protect low-income consumers 
from a disproportionate distributional impact, the most effective and 
efficient approach may be a combination of (1) raising the Earned 
Income Tax Credit, and (2) delivering climate rebates through the 
electronic benefits card already used to deliver benefits to poor 
Americans. Likewise, an efficient way to deliver a climate rebate to 
moderate-income consumers would be through an increase in the standard 
deduction for income taxes.
    Another example of an important public purpose is transition 
assistance for workers and communities that otherwise would be 
disproportionately affected by a climate program. Assistance programs 
provided through government agencies could be funded by statutorily 
directing a certain percentage of auction revenues.
    Likewise, programs to protect our nation's health and our land and 
ocean resources, which are already suffering serious global warming 
impacts, could be funded with auction revenues. Indeed, a dedicated 
trust fund for the protection of ocean resources was a recommendation 
of the non partisan Pew Oceans Commission in 2003.\4\
---------------------------------------------------------------------------
    \4\ http://www.pewtrusts.org/our--work.aspx?category=130.
---------------------------------------------------------------------------
    Whether the means to achieve these public purposes is direct 
allowance allocation or the use of auction revenues, it is important to 
put things on a stable footing. Allocation formulae, tax credits, and 
dedicated funding can provide such stability. These are preferable to 
year-to-year appropriations, which introduce more uncertainty. Whether 
one is thinking of technology investors or low-income beneficiaries, 
there is significant value in establishing stable and predictable 
incentives and benefits.
    Finally, while the resources that can be made available in a cap-
and-trade program to fight global warming may seem significant, so are 
the public needs associated with the program--promoting new technology, 
protecting low- and moderate-income citizens, providing transition 
assistance for workers and communities, and addressing both domestic 
and international adaptation needs. Therefore, regardless of other 
chronic budget needs that could make a claim to these resources, it is 
critically important given the magnitude of the threat from global 
warming that the top priority for their use be the success of this 
program.
    Let me briefly mention a couple of additional issues in designing a 
national cap-and-trade system. Some contend we should do nothing until 
China and India agree to act. To the contrary, the best way to bring 
China and India on board is to take leadership. We are the world's most 
powerful economy. We are responsible for more of the global warming 
pollution now in the atmosphere than any other country. We have the 
most technological know-how. The best way to get global action is to 
start acting at home, and to negotiate reciprocal action from other 
countries.
    We've done this before. Twenty years ago, in 1987, industrial 
nations took the lead in a binding treaty to phase-out ozone-depleting 
CFCs. In just three years, in 1990, developing countries came on board. 
Led by China and India, they accepted binding limits on their own CFC 
production. Since then we've marched together--developed and 
developing--ever since, and have already eliminated 95 percent of the 
ozone-depleting chemicals. Just this past September, China and India 
agree to a new round of mandatory cuts in ozone-depleting chemicals. 
What's missing on global warming is our leadership. We are the only 
major industrial country that has refused to limit its own emissions. 
It's time to act.
    At the same time, Congress can design legislation to encourage 
other nations to join in action to reduce greenhouse gas emissions, and 
to protect American businesses and workers from unfair competition if 
specific nations decline to cooperate. Under a proposal advanced by 
American Electric Power and the International Brotherhood of Electrical 
Workers, the United States legislation would instruct the President to 
negotiate for ``comparable'' emissions reductions from other emitting 
countries within 8 years of enactment. Countries failing to make such 
commitments would be required to submit greenhouse gas allowances for 
certain carbon intensive products. NRDC supports this provision, while 
bearing in mind that the U.S., as the world's greatest contributor to 
the burden of global warming pollution already in the atmosphere, needs 
to show leadership in meeting the global warming challenge.
    Thank you for the opportunity to testify and I would be pleased to 
answer any questions that you may have.

    Chairman Spratt. And now Bob Greenstein.

 STATEMENT OF ROBERT GREENSTEIN, EXECUTIVE DIRECTOR, CENTER ON 
                  BUDGET AND POLICY PRIORITIES

    Mr. Greenstein. Thank you, Mr. Chairman. My focus will be 
on the potential effects of climate change legislation on the 
Federal budget and the budgets of American families, especially 
those of modest means.
    Our analysis indicates that Congress can develop climate 
change policy that is environmentally sound, fiscally 
responsible, and that treats low-income families equitably. But 
to do so, the policy has to be well designed. Our analysis of 
these issues is summed up, to a significant degree, in four 
sets of numbers that I would now like to discuss. The first 
number is $750 to $950 a year. That is the average increase in 
energy-related costs for households in the poorest fifth of the 
population from a relatively modest reduction, 15 percent, in 
emissions.
    As Dr. Orszag noted, effective policies to reduce emissions 
work in part by raising prices for fossil fuel energy products. 
And that will raise prices to consumers for a wide array of 
items from heating fuel, to gasoline, electricity, food, mass 
transit, and various other products and services with energy 
inputs.
    As Dr. Orszag also noted, households--and I think Mr. Ryan 
also noted--households with limited incomes will be affected 
the most since they spend a larger share of their incomes on 
energy-related products than more affluent households do. And 
it should be noted that lower-income households also have less 
ability to afford investments that can reduce their energy 
consumption, like buying a new, more fuel-efficient car or 
replacing your heating and cooling system with a new one.
    This means that if climate change legislation is passed but 
nothing is done to protect people of modest means, many of them 
will slip into poverty. Those who are poor will become poorer, 
and the trend towards widening income inequality will be 
aggravated: $750 to $950 a year is a particularly large number 
when you reflect on the fact that the average income of 
households in the bottom fifth of the population is a little 
more than $13,000 a year.
    Figure number two you have already heard from Peter Orszag, 
$50 billion to $300 billion a year, which is the Congressional 
Budget Office's estimate of the resources potentially generated 
by climate change policies that could be used to assist low-
income consumers and address a range of other climate change-
related needs. In other words, this would be the amount that 
would be raised if the government auctioned off permits under a 
cap-and-trade system, because it is the expected value of the 
permits that would be created.
    Figure number three is approximately 14 percent. This is 
the share of the auction proceeds that we estimated would be 
needed to fully offset the increased energy costs faced by low-
income consumers and provide some relief to moderate-income 
consumers as well.
    In my written testimony I set forth a series of 
principles--we elaborate on them more in our paper that is on 
our Web site--for how to effectively and efficiently, without 
new bureaucracies or big administrative costs, provide this 
kind of relief so that we would fully offset the impact on the 
poorest 20 percent of people and provide some relief to many 
hard-pressed families in the next 20 percent as well. We 
estimate that that could be done with 14 percent, that is one-
seventh of the resources that would be generated by auctioning 
off all the permits in a cap-and-trade system. And because the 
resources would come from the revenues, the new system created, 
it would not increase the deficit or put any pressure on the 
budget. It would be part of the self-contained system that 
climate change legislation created.
    Of course, there are other legitimate claims that arise on 
the budget from climate change legislation as well. Beside the 
need to protect vulnerable population, these include basic 
research into alternative energy resources, as Mr. Doniger 
noted, assistance for workers and communities that depend upon 
the coal industry and other industries that will be most 
affected by the shift to a less carbon-intensive economy.
    In addition, I want to note, of particular interest to this 
committee I would think, higher energy prices will raise costs 
to Federal, State, and local governments. They consume energy-
related products. For example, the single largest consumer of 
energy in the United States is the U.S. Department of Defense, 
not surprisingly. What that means is that if those costs are 
not offset, either the Federal deficit will rise or government 
services will have to be reduced or taxes raised.
    But this too can readily be addressed. If one auctions off 
the lion's share of the permits, one can take the appropriate 
fraction of the permits, or the proceeds from an appropriate 
fraction of the permits, use them to offset these costs so that 
the net effect on the Federal Government is a deficit-neutral 
effect.
    My fourth and final number, and could you put up the blue 
slide at this point, the one called Well-Designed Climate--
thank you very much.
    [Slide.]
    Mr. Greenstein. My final number is also from the 
Congressional Budget Office. And this is 15 percent, actually, 
technically, a little less than 15 percent. This is the share 
of the potential resources from auctioning off permits that the 
Congressional Budget Office, based on a thorough review of the 
literature in the field, estimates is needed to compensate 
energy companies and other emitters for financial losses due to 
climate change.
    This indicates that about 85 percent of the permits could 
safely be auctioned, a quite sufficient amount to meet the 
legitimate budgetary needs and to avoid increases in poverty, 
increases in deficits to fund the necessary basic research into 
alternative energy sources and so forth.
    So the real bottom line here, as we see it, is the need to 
ensure that needed legislation to address global warming that 
uses a cap-and-trade system if it does, auctions off the bulk 
of the allowances, gives away those needed to make emitters 
whole, but auctions off the rest rather than giving away more 
than is needed to make emitters whole by giving too many of 
them away free to energy companies.
    Again, CBO's estimate of the evidence is about 15 percent 
would be needed to make--offset the effects on energy 
companies. And I believe the term CBO has used is ``windfall'' 
gains for what would result if significantly more than that 
amount were given away free to the companies.
    I looked yesterday at a recent piece written by Greg 
Mankiw, the former Chairman of President Bush's Council of 
Economic Advisors, one of the Nation's most distinguished 
economists. Dr. Mankiw, in this piece, notes that if you had a 
cap-and-trade system that gave away to the energy companies 
more than was needed to offset their costs, what you basically 
would be doing would be to establish a very large program of--
Dr. Mankiw's term--``corporate welfare.''
    I would also note, and I will be very brief here because 
Dr. Orszag already really covered this, that the main argument 
one sometimes hears for giving away more of the permits is the 
claim, well, if you give them away, prices to consumers won't 
go up; but if you auction them off, they will. As Dr. Orszag 
has noted, that belief is simply not correct. It defies the 
basic laws of supply and demand. And I doubt that many, if any, 
economists, regardless of where they are on the political 
spectrum, would subscribe to that view. So in conclusion, well-
designed climate change policy can generate sufficient 
resources to meet legitimate budgetary claims that arise from 
the policy. If we do a cap-and-trade policy, that means it is 
necessary to auction off most of the permits. If that is done, 
the proceeds can be used to avoid increasing poverty, 
increasing deficits or debt, and also allowing resources to 
fund alternative energy, shield coal mining communities, and 
the like. The key, again, making sure that we auction off the 
appropriate share of the permits rather than failing to meet 
budgetary needs, failing to meet the needs of low-income 
families, and erecting a new program of corporate welfare 
instead.
    Chairman Spratt. Thank you, Mr. Greenstein.
    [The prepared statement of Robert Greenstein follows:]

      Prepared Statement of Robert Greenstein, Executive Director,
                 Center on Budget and Policy Priorities

    Effective action to reduce greenhouse gas emissions is necessary to 
prevent costly and potentially catastrophic environmental and economic 
damages from climate change. The Center on Budget and Policy Priorities 
is not making recommendations about how much we need to reduce 
emissions; that is not our area of expertise and we leave those 
recommendations to experts in environmental policy. Instead, our focus 
is on how climate change legislation might affect 1) the budgets of 
American families, especially those of modest means; and 2) the federal 
budget.
    Our analysis indicates that Congress can develop climate change 
policy that is environmentally and economically sound and fiscally 
responsible, and that treats low-income families equitably, avoiding 
increases in poverty and hardship. To achieve these objectives, 
however, the policy has to be well designed. This means the policy must 
generate sufficient budget resources to address the requirements and 
challenges of sound climate-change policy--including the resources 
needed to offset the direct impact of those policies on the federal 
budget--and must cushion the impact on vulnerable populations, 
especially people with low incomes.
four key numbers on climate policy, the budget, and low-income families
    Our analysis of the effects of climate-change policy on the federal 
budget and the budgets of low-income households can be summed up in 
four key sets of numbers.
1. $750--$950 per year: the average increase in energy-related costs 
        for the poorest fifth of the population from a modest (15 
        percent) emissions reduction
    Effective policies to reduce greenhouse-gas emissions work in part 
by raising the prices of fossil-fuel energy products to encourage 
energy efficiency and the substitution of clean energy sources for 
fossil fuel. This is essential to prevent extensive environmental and 
economic damage from climate change. However, it will raise costs to 
consumers for a wide array of products and services, from gasoline and 
electricity to food, mass transit, and other products or services with 
significant energy inputs.
    Households with limited incomes will be affected the most by those 
higher prices, since they spend a larger share of their incomes on 
energy-related products and services than more affluent households do. 
They also are less able to afford investments that can reduce their 
energy consumption, such as buying a more efficient car or a new 
heating and cooling system. If nothing is done to protect people of 
limited means, many more of them will slip into poverty, those who are 
poor will become poorer, and the trend toward widening income 
inequality will be aggravated.
    $750 to $950 per year is our estimate of how much, if left to fend 
for themselves, average families in the poorest 20 percent of the 
population would have to come up with to cover the increased costs 
arising from a 15 percent reduction in emissions.\1\ This is a group 
whose average income is only modestly over $13,000 a year, and our 
$750-$950 estimate already takes into account increases in cost of 
living adjustments that they may receive, such as through the annual 
Social Security COLA, as a result of higher energy costs. Moreover, the 
15 percent reduction in emissions, which is what CBO uses in its 
analysis, is relatively modest by the standards of current proposals. 
It is 15 percent below business-as-usual levels (what emissions would 
be if there were no restrictions), not 15 percent below the 1990 or 
2005 levels that are often used as benchmarks in legislative proposals. 
Those benchmarks themselves are well below business-as-usual levels.
---------------------------------------------------------------------------
    \1\ The Congressional Budget Office has provided a figure of $680 
for the average increase in cost for the bottom 20 percent of 
households. It should be noted that the $680 figure is for the fifth of 
households with the lowest incomes, not the poorest fifth of the U.S. 
population. There is an important difference. If one simply ranks 
households by income, regardless of household size, then the bottom 
fifth of households disproportionately consists of one- and two-person 
households, and as a result, includes significantly less than one-fifth 
of the people in the United States. Moreover, the bottom fifth of 
households, if measured in this manner, includes many small households 
that are not poor (i.e., that are above the poverty line), while 
missing many larger households that are poor. (The poverty line is 
adjusted by household size.) The $680 figure for the bottom fifth of 
households is measured in this manner. CBO has also developed a 
standard methodology to address this household-size problem when 
dividing households into income quintiles (or income ``fifths '') and 
uses that methodology in most of the work it conducts on income 
distribution issues. We use the CBO size-adjustment methodology here to 
allow us to examine the poorest fifth of the population, rather than 
the bottom fifth of households irrespective of household size. This 
produces a figure of $750 to $950 for the poorest fifth of the U.S. 
population.
---------------------------------------------------------------------------
2. $50 billion to $300 billion per year: resources potentially 
        generated by climate-change policies to help low-income 
        consumers and to address other climate-change-related needs
    Fortunately, the same climate-change measures that generate higher 
energy-related costs can also generate substantial resources to cover 
those costs. CBO estimates that various recent proposals to limit 
greenhouse-gas emissions by establishing a cap-and-trade system would 
create a valuable resource--emission permits--that would be worth $50 
billion to $300 billion per year by 2020, depending on the specifics of 
each proposal. That is how much revenue the government could expect to 
raise if it auctioned off all of the permits. It is also how much 
revenue the government could expect to raise if a carbon tax with a 
similar effect on limiting emissions were used instead of a cap-and-
trade approach.
3. Approximately 14 percent: share of auction proceeds or carbon tax 
        revenues needed to fully offset the increased energy-related 
        costs faced by low-income consumers
    The amount of revenue the government could raise by auctioning off 
all of the permits in a cap-and-trade system is far more than what 
would be needed to protect low-income consumers from higher energy-
related prices arising from climate-change legislation. We estimate 
that a program designed according to the principles laid out later in 
this testimony, which would fully offset the impact on the poorest 20 
percent of people and also provide some relief to many hard-pressed 
working families in the next 20 percent, could be fully funded with 
approximately 14 percent of the resources that would be generated by 
auctioning off all the allowances in a cap-and-trade system, or by a 
carbon tax.
    The specific dollar amounts in our first two sets of numbers--$750 
to $950 per year of added costs for low-income consumers and $50 to 
$300 billion per year of potential revenue are tied to specific 
emissions targets, but the 14 percent figure is not. When the emissions 
target is looser (and hence the emissions reduction is smaller)--as it 
would be in the early years of most proposals--the dollar amount of 
revenue that could be raised would be lower, but so too would be the 
increase in energy prices and the amount of added costs that households 
would face. As the cap tightens and larger emissions reductions are 
called for, the added costs to households increase, but so too does the 
potential revenue that would be available to offset those costs. In 
each case, the revenue needed to protect low-income consumers would be 
about 14 percent of the revenue that could be generated.
4. Less than 15 percent: share of potential budget resources needed to 
        fully compensate energy companies and other emitters for 
        financial losses due to climate-change policies
    Although the resources that can be generated by sound climate-
change policies are substantial, so too are the budget claims arising 
from those policies. Besides the need to protect vulnerable 
populations, those claims include basic research into alternative 
energy sources, assistance for workers and communities that depend on 
the coal industry and other industries most affected by the shift to a 
less carbon-intensive economy, and other needs. In addition, higher 
energy prices will drive up the cost to federal, state, and local 
governments of providing many important services and benefits. Unless 
these costs are offset, government services will have to be reduced or 
taxes raised, or the federal deficit will rise.
    In a cap-and-trade system, making sure there are adequate budget 
resources requires that most of the emission allowances are auctioned 
off, not given away for free to energy companies and other emitters due 
to misconceptions about the financial losses they would incur. One 
misconception is that those losses would be very large. CBO's review of 
the evidence, however, concludes that less than 15 percent of the total 
value of the allowances would be sufficient to offset the net financial 
losses of companies affected by policies to restrict emissions. More 
than that would simply create what CBO has called ``windfall profits'' 
for companies receiving the free allowances.
    A related misconception about cap-and-trade may also contribute to 
the belief that large numbers of emission allowances should be given 
away to energy companies and other industrial emitters. This is the 
mistaken belief that energy prices will not rise if the allowances are 
given away. That belief is not correct; it flies in the face of the 
basic law of supply and demand. A cap on emissions will limit the 
amount of energy produced from fossil fuels. Regardless of whether the 
government gives away or sells the allowances, market forces will raise 
the price of fossil-fuel energy to the point where the amount demanded 
will fall to equal the amount supplied. Either way, energy companies 
will be able to sell their products at the higher price. The increase 
in prices is the source of windfall profits for the companies that 
receive allowances for free but are able to charge the higher price.
    There are legitimate policy issues around the choice between a 
carbon tax and a cap-and-trade mechanism. But we should not let 
misconceptions cloud the debate or create false choices. Here is how 
Harvard economist Greg Mankiw, who served as Chairman of President 
Bush's Council of Economic Advisers, has characterized a cap-and-trade 
mechanism under which the allowances are given away:
    Economists recognize that a cap-and-trade system [in which the 
allowances are given away to emitters] is equivalent to a tax on carbon 
emissions with the tax revenue rebated to existing carbon emitters, 
such as energy companies. That is, Cap-and-trade [under which the 
allowances are given away to emitters] = Carbon tax + Corporate 
welfare.\2\
---------------------------------------------------------------------------
    \2\ Greg Mankiw, ``Greg Mankiw's Blog: Random Observations for 
Students of Economics,'' August 2, 2007.
---------------------------------------------------------------------------
avoiding regressive outcomes while meeting other climate-related budget 
                               priorities
    The policies needed to reduce greenhouse-gas emissions would, by 
themselves, result in regressive changes in energy prices. But they 
also can generate substantial revenue that could be used to offset 
those regressive impacts. Our analysis, like that of CBO, shows that 
the potential revenue from auctioning off emission allowances under a 
cap-and-trade system could yield more than enough revenue to offset the 
losses likely to be experienced by low- and moderate-income families 
and by workers in the industries hit hardest by the adjustment to a 
less carbon-intensive economy. The revenue could be sufficient both to 
address these issues and to meet various other legitimate purposes 
arising from the legislation as well (see figure 1).


    In contrast, giving away a substantial fraction of emission 
allowances to existing energy producers would do almost nothing to 
compensate low- and moderate-income families for their losses. A very 
large percentage of the benefits of such a giveaway would go to 
shareholders of the energy companies, most of whom have high incomes, 
while little revenue would be available to mitigate the effects on 
those least well-off.
    Addressing regressivity and adjustment costs would not be the only 
claims on the resources that could be generated by a cap-and-trade 
system or carbon tax. Governments at all levels would pay more for the 
energy and energy-related products that they consume directly. For 
example, the Defense Department is the single largest consumer of 
energy in the United States. In addition, there would be impacts on 
living costs and economic activity, which, while modest in the overall 
economy, could nevertheless trigger increases in automatic cost-of-
living adjustments in Social Security and other benefit programs and 
some modest reductions in tax revenues. These issues can be addressed--
and any increases in deficits and debt avoided--by using a share of the 
allowances to offset such tax and expenditure changes. (Note: action to 
reduce the damages from climate change should have positive effects on 
the budget over the longer run, by reducing government expenditures for 
such things as natural disasters, crop failures, and disease epidemics. 
In other words, in the absence of effective climate-change policies, 
natural events are likely to occur sooner or later that entail large 
federal costs and throw the budget farther out of whack.)
    In addition, although higher energy prices would create strong 
incentives for energy conservation and for investment in clean-energy 
technologies, there will be claims for additional subsidies to 
encourage a wide variety of activities in the name of combating climate 
change. In many cases (including various types of basic alternative 
energy research), such investments can be a valuable complement to the 
market incentives provided by a cap-and-trade system or carbon tax. 
Such spending will be wasteful, however, if it merely subsidizes 
activity that would take place anyway or that is not well focused on 
reducing greenhouse-gas emissions.
    Finally, economic analysis suggests that if there are instances 
where existing taxes have some disincentive effects that may dampen 
economic activity, receipts from cap-and-trade auctions or a carbon tax 
could be used to reduce those taxes. This, in turn, would lower any 
economic cost of restricting greenhouse-gas emissions. For example, CBO 
reports that the changes in economic activity required to achieve a 15 
percent reduction in greenhouse-gas emissions would result in economic 
losses equivalent to roughly one-half of one percent of GDP in 2010 if 
the all the allowances were given away. If, however, all of the 
emission allowances were auctioned off and the proceeds were used to 
cut payroll taxes or corporate income taxes, that loss could be cut 
substantially. At the same time, CBO points out that using all of the 
auction proceeds exclusively to reduce net economic costs would itself 
come at a price, because those proceeds would not be available to 
address the regressive effects of increases in consumer costs or to 
make investments in basic research on clean technologies.
    It should be noted, that these calculations of net economic loss do 
not take into account the substantial benefits that may arise from 
avoiding environmental and economic damages from climate change. 
Economic costs of the magnitude that have been reasonably estimated 
appear to be a modest price to pay to achieve the important goal of 
reducing greenhouse-gas emissions. In a well-designed climate-change 
policy, these are necessary costs for achieving the benefits of reduced 
greenhouse-gas emissions. They do not ``harm'' the public any more than 
expenditures on antibiotics to fight a serious infection ``harm'' a 
patient. Moreover, these ``side effects'' in terms of economic 
performance are modest (analogous to losing a day or two of work a year 
due to the antibiotic treatment in order to avoid greater harm from 
failing to treat the infection).
    To return to the trade-off between reducing net economic costs and 
equitable treatment of families facing higher costs, CBO has found that 
using the proceeds from auctions exclusively for tax cuts would offset 
only a very modest fraction of the impact of higher energy costs on 
low-and moderate-income households, and that cutting corporate taxes 
would be highly regressive. With all of the auction receipts used for 
either a payroll tax cut or a reduction in corporate income taxes, the 
poorest 20 percent of households would have the largest net losses (as 
a share of income) while the richest 20 percent of households would end 
up with tax cuts that exceeded their increase in energy costs. (It also 
should be noted that analyses by CBO and others find that reducing 
long-term budget deficits would do substantially more to boost the 
economy over time than cutting taxes and have a far less regressive 
impact.)
    While there are tradeoffs between economic efficiency and fairness 
in the design of climate-change policy, one policy that fails to 
measure up on either ground is giving away a substantial fraction of 
the permits to existing emitters. As CBO has explained,
    Because giving allowances to energy producers would 
disproportionately benefit higher-income households and would preclude 
the possibility of using the allowance value to reduce taxes on capital 
and labor, such a strategy would appear to rate low from both a 
distributional and an efficiency perspective.\3\
---------------------------------------------------------------------------
    \3\ Congressional Budget Office, letter to Senator Jeff Bingaman, 
Chairman, Committee on Energy and Natural Resources, United States 
Senate, July 9, 2007, pp. 3-4.
---------------------------------------------------------------------------
    If lawmakers capture the necessary revenue and make wise choices 
among competing claims in designing climate-change policy, they can 
achieve the economic and environmental benefits from reducing 
greenhouse-gas emissions while addressing the impact of higher prices 
on low-income consumers and other legitimate new claims on available 
resources. (It might even be possible to achieve some modest deficit 
reduction, which would be valuable at a time when, as this Committee 
well knows, the pressures on the federal budget will be increasing.)
    If, however, lawmakers give away too many emissions rights to 
existing emitters, as a number of the bills currently pending in 
Congress would do, they will fail to capture sufficient resources to 
meet these needs, while conferring windfall profits on energy companies 
and other emitters. This latter course would risk large increases in 
deficits and debt (already on course to reach unsustainable levels in 
future decades), significant increases in poverty and hardship, and a 
further widening of the gap between rich and poor.
designing climate-change legislation that shields low-income households 
                  from increased poverty and hardship
    Making sure that sufficient resources are available to shield low-
income households from increased poverty and hardship is crucial in the 
design of climate-change policies. But it is only the first step needed 
to avoid increases in poverty. It also is vital to use the resources 
made available for this purpose in a way that is effective in reaching 
low-income households, efficient (with low administrative costs), and 
consistent with energy conservation goals. At this early stage of the 
debate, no climate-change legislation introduced on Capitol Hill meets 
this goal, although there is a growing interest among a number of 
lawmakers in finding effective ways to protect low-income people from 
increased costs.
    To shield vulnerable households from higher energy costs in a 
manner that is both effective and efficient, we recommend that 
policymakers follow these six basic principles.
    1. Fully protect the most vulnerable households. Climate-change 
legislation should not make poor families poorer or push more people 
into poverty. To avoid that outcome, climate rebates should be designed 
to fully offset higher energy-related costs for low-income families. A 
good place to start is by fully protecting households in the bottom 
fifth of the income spectrum--those with average incomes of $13,000--or 
less than $27,000 for a family of three. Families at modestly higher 
income levels that struggle to make ends meet will need some help, as 
well, in coping with higher bills.
    2. Use mechanisms that reach all or nearly all low-income 
households. Some low-income households work for low wages and could 
receive their climate rebate through the tax code, such as through an 
increase in the Earned Income Tax Credit. But others are elderly, 
unemployed (especially during recessions), or have serious 
disabilities. Climate rebates need to reach all of them.
    Fortunately, policymakers can tap existing mechanisms to reach the 
large number of low-income households that cannot be reached through a 
tax rebate mechanism because their incomes are so low they are not 
required to file a federal income tax return. For example, ``climate-
change rebates'' could be provided through the electronic benefit 
transfer (EBT) systems that state human service agencies use to provide 
assistance to many poor people. Policymakers could fill any remaining 
gaps, and provide weatherization assistance, through some increases in 
the Low Income Home Energy Assistance Program.
    3. Minimize red tape. Funds set aside for low-income consumers 
should go to intended beneficiaries, not to administrative costs or 
profits. Accordingly, policymakers should provide assistance as much as 
possible through existing, proven delivery mechanisms rather than new 
public or private bureaucracies.
    4. Don't focus solely on utility bills. For households in the 
bottom fifth of the population, higher home energy costs will account 
for less than half of the hit on their budgets from increased energy 
prices. And about 20 percent of the households in the bottom fifth have 
their utility bills reflected in their rent, so they pay for utilities 
only indirectly, through the rents their landlords charge. Policymakers 
should structure ``climate-change rebates'' so they can also help low-
income families with these rent increases, as well as higher prices for 
gasoline and other products and services that are sensitive to energy 
costs.
    5. Adjust for family size. Larger households should receive more 
help than smaller households because they have higher expenses. 
Families with several children will generally consume more energy, and 
consequently face larger burdens from increased energy costs, than 
individuals living alone. Many other forms of assistance vary by 
household size; this one should as well.
    6. Adjust relief to reflect changing needs. Assistance for low-
income consumers should be smaller in the beginning, when a cap-and-
trade system or carbon tax is just phasing in and the impact on energy-
related prices is less substantial, and larger when the system is fully 
in place.
                               conclusion
    The economic and distributional effects of climate-change policy 
will generate major new claims on the federal budget, especially the 
need to offset the regressive impact of higher energy prices. But a 
well designed climate-change policy can also generate significant 
resources that can be used to avoid regressive outcomes and address 
other legitimate budgetary claims that arise from the new policy. 
Policymakers need to recognize the importance of generating adequate 
revenue and addressing fairness concerns to avoid ending up with a 
policy that increases poverty and further widens gaps between rich and 
poor, increases deficits and debt, or both.

    Chairman Spratt. Now, Dr. Smith.

       STATEMENT OF ANNE E. SMITH, Ph.D., VICE PRESIDENT,
                       CRA INTERNATIONAL

    Ms. Smith. Mr. Chairman, members of the committee, thank 
you for inviting me to participate in today's hearing. I am 
Anne Smith. I am a vice president at CRA International. My 
testimony today reflects my own research and opinions, and not 
any positions of my company, CRA.
    Today you have heard a lot about alternative methods for 
allocating allowances under cap-and-trade schemes. And 
allocations are extremely important, but they are also greatly 
misunderstood. For instance, many people seem to be saying that 
the very large value associated with the allowances can 
outweigh the costs of a carbon cap, and it cannot. Any policy 
that cuts carbon emissions will always impose a net cost on 
society. And there are only two ways that different types of 
allocation rules could even help reduce that net cost on 
society. And neither one is being seriously considered by the 
Congress at this moment.
    The first of these ways would be to use the auction 
revenues, rather than allocating some of the allowances, to 
reduce the drag on the economy that comes from income taxes. 
CBO has talked about this possibility. And I just want to 
emphasize that they made the statement, and it is true, that 
the benefit in the reduction on the drag on the economy that 
would come from this approach requires reducing marginal income 
tax rates, which is highly unpopular politically because it is 
regressive. If you don't reduce the marginal income tax rates 
you don't get the benefit in reducing the cost of the policy on 
the economy. So in contrast, giving tax rebates to households 
or increasing their tax deductions, that will not reduce the 
policy's net societal costs, although it will change the 
distribution of the impacts of that policy.
    The second way in which allocation values could be used to 
reduce the net costs of a carbon policy would be to promote the 
invention of new, advanced low-carbon technologies. Most of the 
allocations proposed so far for supporting technology are just 
subsidies, deployment subsidies, for instance, and 
demonstration project funding. These do not improve the 
incentives for breakthrough technology research and 
development. And that is what is needed in order for those uses 
of allocations to cut the policy's net costs.
    So the other types of allocation schemes that are being 
discussed will only change the distribution of the policy 
costs, and they will not reduce those costs. And it is 
important to recognize that the net cost of any of these hard-
cap bills that are currently being discussed in the Congress 
are quite large. For example, I have estimated that the current 
set of bills for hard caps would generate the following impacts 
by 2020 compared to a case with no carbon limits: Net losses of 
between $1,000 and $1,500 per year in the average household's 
real spending power. Net reductions of 2 to 4 million jobs. And 
reductions in the U.S. GDP of between $300 billion and $500 
billion in 2020, which represents a drop of 1.5 percent to 2.5 
percent. Of course, that drop in GDP would cause a 
corresponding 1.5 percent to 2.5 percent drop in government 
revenues approximately. Keep in mind these costs keep rising 
after 2020.
    These economic impacts are substantial enough to warrant a 
serious discussion about how to meet the proposed emissions 
targets as cost-effectively as possible.
    Before discussing a couple of ways that we can do this, I 
would like to note a couple of other misunderstandings about 
allocations that I frequently hear and have heard today. First, 
assertions that businesses require no more than 15 percent of 
the allowances to compensate them for their profitability 
losses due to carbon cap are misleading. We have just seen that 
in Mr. Greenstein's testimony. It also appears in some form 
similar to that in the CBO's written statement.
    I am one of the three researchers whose analyses are cited 
in support of that 15 percent rule, and I disagree with this 
oversimplification. In my written statement I describe four 
specific reasons why the actual percentage that businesses 
would require under a real-world carbon cap would be larger 
than 15 percent, in some cases much larger.
    Another misunderstanding is the view that allocations can 
protect U.S. companies whose products compete in international 
markets. As carbon price levels rise, more and more of these 
types of businesses will cease production in the U.S. no matter 
what their allocation is. However, as they close their 
operations here in the U.S., their emissions will simply 
reappear in another country, one that doesn't have a carbon cap 
of a similar magnitude. This is called ``leakage.'' And even 
fully compensating allocations to these companies cannot stop 
it. Short of global cooperation on emissions limits, the only 
way to stop leakage with a cap-and-trade would be through 
border tax adjustments, but these may not be legal under 
international trade agreements in a cap-and-trade application. 
If border tax adjustments are not put in place at the same time 
that a cap is imposed, in the same time period, the only 
alternative for minimizing this perverse leakage phenomenon 
would be to place a reasonable ceiling on the price of 
allowances. This is the idea of the safety valve that has been 
mentioned in other testimony today.
    An allowance price ceiling would have some important 
additional economic merits besides helping protect against 
unreasonable amounts of leakage. Prices in all cap-and-trade 
programs are notoriously volatile, and volatility in carbon 
prices will translate into volatility in economic performance 
generally.
    Even the government should prefer to see stable allowance 
prices. For example, would large variability in any auction 
revenues that are going to be used to fund technology 
deployment programs be of any value when they need long-term 
stable funding?
    Mr. Doniger spoke of the need for projects like these to 
have stable funding. But if it is funded through auction 
revenues, this funding may not be stable at all if the prices 
that can be returned in those auctions are quite volatile. Even 
if the auction revenues were to be simply rebated to citizens, 
would either the government or the citizens prefer to have 
variability in the size of their rebate checks?
    So in closing, be aware that cap-and-trade schemes are not 
the only market-based policy option, as Dr. Orszag said at the 
beginning of his testimony. Other options, such as a carbon 
tax, may be more suitable to the challenge of reducing carbon 
to the proposed levels that we are looking at without excessive 
damages to our economy.
    Thank you for this time. I have a longer written statement 
that I request be submitted into the record.
    Chairman Spratt. Thank you very much. As.
    [The prepared statement of Anne E. Smith follows:]

      Prepared Statement of Anne E. Smith, Ph.D., Vice President,
                           CRA International

    Mr. Chairman and Members of the Committee: Thank you for your 
invitation to participate in today's hearing. I am Anne Smith, and I am 
a Vice President of CRA International. Starting with my Ph.D. thesis in 
economics at Stanford University, I have spent the past twenty-five 
years assessing the most cost-effective ways to design policies for 
managing environmental risks, including cap-and-trade systems. For the 
past fifteen years I have focused my attention on the design of 
policies to address climate change risks, and have prepared many 
analyses of the economic impact of climate polices. I thank you for the 
opportunity to share my findings and climate policy design insights 
with you. My written and oral testimonies reflect my own research and 
opinions, and do not represent any positions of my company, CRA 
International.
    The topic of today's hearing is the fiscal impacts of controlling 
carbon emissions. Much of the discussion these impacts revolves around 
options for how the government can shift the economic burden of a cap-
and-trade system on greenhouse gases through alternative formulas for 
allocating the capped allowances. When a market-based approach to 
greenhouse gas emissions control is implemented, a very large amount of 
wealth in the form of the allowances will be created, even while the 
policy also forces net resource costs on society. No one should be 
surprised by the intensity of interest focused on how that wealth might 
be distributed because any single interest group could be made far 
wealthier under a carbon cap-and-trade program than not--if it can get 
the ``right'' kind of allocation assigned to it. Without denying the 
great importance of the allocations decisions, I would like to make a 
number of observations about the resource costs and economic impacts of 
such policies that policymaker's should not lose sight of when 
contemplating greenhouse gas emissions legislation.
          minimizing the policy's cost versus sharing its cost
    The total value of allowance allocations will always be less than 
the total cost of a carbon cap: the policy will always have a net cost.
    The total resource cost of an emissions limit is the sum of the 
expenditures that emitters will make in order to physically reduce 
their emissions from what they would otherwise have been. Under a 
market-based system, a limit is placed on emissions, and regulated 
emitters are required to pay for every ton that they emit. If the 
policy is a cap-and-trade system without any free allocations, emitters 
do this by buying as many allowances as they emit in a year, and 
rendering those allowances to the government. Because there are not as 
many allowances as there would be emissions (at least in the 
aggregate), emitters also are forced to reduce their emissions. Thus, 
there are two expenditures that emitters incur: (1) they spend money to 
reduce emissions down to the level of the cap and (2) they pay for 
allowances to cover all of their emissions that remain after the 
controls have been applied.
    In aggregate over all emitters, the second component of total 
expenditures by emitters is simply the value of the allowance pool that 
is created by the government when it sets up a cap-and-trade system. 
Therefore, the entire wealth that government will have to allocate is 
only equal to the second component of the emitters' costs. The 
government can give that entire value back to the companies by making a 
free allocation of 100% of the allowances to emitters, but that leaves 
companies still incurring the first cost component--the real resource 
cost associated with actually reducing emissions, which is the real net 
cost to society.
    The wealth associated with the allowances can be very large 
compared to the real resource costs of the cap. For example, if 
emissions without a cap are 100 tons and a 10% reduction is required by 
establishing a cap at 90 tons, the cost of controls (and hence the 
market value of the 90 tons of allowances) might be $20/ton of CO2. In 
that case, the real resource cost of reducing 10 tons of emissions 
would be less than $200 whereas the market value of the pool of 90 
allowances would be $1800. However, even if the government gave all the 
allowances to the emitters, it would only reduce emitters' expenditures 
from $2000 (i.e. the sum of $200 for emissions controls and $1800 to 
buy allowances for their remaining emissions) down to the net societal 
resource cost $200.\1\
    The net resource cost is therefore an inescapable fact of an 
emissions limit via a cap-and-trade program that cannot be eliminated 
through any allocation formula that may be devised. All that an 
allocation scheme can do is alter the companies and individual 
consumers that end up bearing the burden of that resource cost. An 
excessive amount of focus on who will gain the value in the allocations 
can cause policymakers to lose sight of the fact that they are creating 
a new cost to society that should be evaluated in the context of 
overall societal budget priorities.
    The net cost of a carbon cap of the stringencies now being 
discussed in the Congress would be very substantial.
    A large number of proposals have circulated in recent months that 
entail hard caps on US greenhouse gas emissions reaching reductions of 
about 75%to 90% from projected ``business as usual'' emissions by 2050. 
These current hard cap proposals vary in their specific timing and 
stringency, but all of them would impose significant costs on the US 
economy even in the near term, if implemented. I have performed 
economic impact analyses of many different levels and types of 
emissions limits using CRA International's general equilibrium model of 
the US economy called ``MRN-NEEM.'' My analyses indicate that the 
current set of proposals in the Congress for hard caps on greenhouse 
gas emissions would impose real resource costs to the US economy of the 
following general magnitude:
     Net losses in the average household's real spending of 
$1000 to over $1500 per year by 2020.
     Net reductions in jobs by 2020 of 2 million to 4 million.
     Reductions in US gross domestic product (GDP) of $300 
billion to $500 billion (i.e., a reduction of 1.5% to 2.5%) from a case 
with no carbon limits, by 2020.
    Needless to say, a drop in GDP implies a reduction in government 
revenues too--also roughly on the order of 1.5% to 2.5% by 2020. The 
costs of these proposals are projected to increase continuously up to 
2020, and are only somewhat lower in their very first year of 
implementation. Further, these costs are projected to continuously 
increase in the decades beyond 2020, because the reductions they 
require by 2020 are small compared to those that would be mandated by 
2050 in these Bills.
    These economic impacts are substantial enough that they warrant a 
very serious discussion about priorities for the spending of our 
society's resources. There is no question that achieving significant 
reductions in greenhouse gas emissions will be very costly, and it is 
therefore important to strive to minimize those costs. That cannot be 
done by focusing solely on how to allocate allowances. The design of 
the program itself is what matters, which requires taking care to 
ensure the following attributes in a cap-and-trade system:
     A cap that comprehensively covers all types of emissions 
sources.
     A policy that protects against leakage of emissions to 
economically competing nations.
     A supportive set of policies that provide effective 
incentives for research and development on breakthroughs in 
technologies that produce low-carbon energy.
     A cap stringency that is timed to match the availability 
of new, low-carbon technologies.
     A policy that offers businesses price certainty for 
planning major new investments in new technologies.
     Provisions in the policy to limit the costs that it will 
impose on the economy overall if emissions reductions turn out to be 
more expensive to achieve than currently anticipated.
     A policy that will deliver even larger emissions 
reductions if they turn out to be less expensive to achieve than 
currently anticipated.
    None of these attributes are easy to design into a greenhouse gas 
policy, and none of the hard cap proposals that are currently being 
discussed in the Congress have sufficiently addressed these needs. 
Their projected costs (described above) are thus probably unnecessarily 
high for achieving their stated emissions goals. I will discuss several 
of these points in more detail below, after a few more comments about 
allocations.
    There are very many claimants to the value associated with the 
allowance allocations.
    The costs of greenhouse gas reductions will directly increase the 
costs of companies that are emitters targeted by a regulation. These 
companies are thus the traditional and natural claimants on the 
allocations. However, in the case of greenhouse emissions limits, many 
of those emitters' costs will be passed on to consumers. This will 
occur through multiple routes. Energy prices will increase. The costs 
of most goods and services will increase because they can only be 
produced by using energy. Some companies will be forced out of 
business, with attending consumer costs of making job transitions. 
Energy cost impacts will be regressive, and affect the poor 
disproportionately. All of these impacts create additional groups in 
society that also can make a valid claim for a share of the wealth 
associated with the allowance pool. Finally, in addition to the claims 
from industry, businesses, workers, and representatives of the socio-
economically disadvantaged, government must also contend with its own 
needs. Government needs to support a massive increase in energy 
research and development. Government also needs to grapple with likely 
declines in its traditional tax revenues due to the costs, reduced 
profits and reduced household incomes that the policy imposes on its 
tax base.
    Clearly, policymakers face an unusually complex situation where 
almost every group in the economy has a reasonable claim for some share 
of the allowance value. This becomes an outright dilemma when one 
realizes that there will never be enough allowance value to cover all 
of the claims. When the net resource costs of the policy are so large, 
policymakers should focus should be on creating the most cost-effective 
policy possible; an emphasis on allocations rules does not further this 
goal.
    Alternative allocation formulas being proposed would not reduce the 
overall societal cost of a cap-and-trade policy.
    As I have described above, the value associated with the allowance 
pool that would be created under a cap-and-trade scheme is a 
``transferable'' amount of wealth. By allocating that wealth in 
different ways, the cost burden of the policy can be adjusted across 
the many players in the economy. That is, the allocation formula just 
splits the same pie in different ways. If one group is handed a pie 
slice that is larger than its slice of resource costs, that group will 
be better off. But because the total pie of transferable wealth is 
smaller than the total pie of expenditures that emitters must incur, a 
larger allocation for one group inevitably means that another group 
will be less well off. Almost all of the alternative allocation 
formulas being discussed would merely alter how the pie is sliced, and 
not how large the pie is.
    There are only two alternative uses of the allowance value that 
would actually reduce the net economic burden of a greenhouse gas 
policy, and neither one receives very much attention in current bills 
in the Congress:
    1. It is often stated that giving away free allowances reduces the 
opportunity for the government to enhance economic activity by lowering 
the economic distortions of existing taxes. If the allowances could 
instead be auctioned and the new revenues to the US government used to 
reduce these existing ``tax distortions,'' then there would be a 
generalized benefit to the economy that could partially offset the 
newly imposed economic cost of the emissions reductions. However, not a 
single one of the many policy proposals that have been introduced in 
Congress has proposed to use the auction revenues in the manner 
necessary to gain this offsetting economic benefit. It requires 
specifically that the auction revenues be used to reduce the marginal 
tax rate on either the personal income tax or on corporate tax rates. 
Several analyses have found that this could reduce the net impact to 
the economy of a cap by as much as 50%.\2\ However, it is highly 
unpopular politically because of its expected regressive nature.\3\ (In 
fact, reduction of marginal payroll tax rates would have much less 
beneficial impact than reduction of marginal personal income tax rates, 
and even less than if the marginal corporate income tax rates are 
reduced, each of which would be increasingly regressive.) While 
economists agree that reduction of marginal income tax rates would be 
an excellent way to reduce the net economic impact of a policy, 
policymakers seem incapable of implementing the right form of tax rate 
reductions to claim policy cost reduction as a justification for 
auctioning a larger share of permits. Rebate checks to households, 
reductions in average tax rates, and other forms of tax reductions 
called ``lump sum'' do not accomplish any such policy cost reduction.
    2. It is widely accepted that another way to reduce the cost of a 
greenhouse gas cap would be to reduce the costs of, and to speed the 
time of commercial availability, of new and advanced low-carbon 
technologies. This might be accomplished through government policies 
that offer greater and more cost-effective incentives for targeted and 
successful research and development in energy technologies. Most of the 
recent carbon policy proposals attempt to direct some of the allowance 
value towards technology development, and this is a positive 
development. However, most of these proposals' provisions are limited 
to subsidies and demonstration project funding. They still give 
insufficient attention to how to actually improve the incentives for 
both public and private researchers to effectively target their efforts 
towards new, breakthrough technologies. Far more effort needs to go 
into designing these research and development initiatives before one 
can argue that allocating a larger share of allowances or auction 
revenues to fund technology programs will have much effect in reducing 
the cost of the associated cap.
     clarification of some issues regarding allocations to emitters
    Assertions that emitting businesses require ``less than 15%'' of 
the allowances to compensate them for their losses due to a carbon cap 
costs are misleading, and incorrect in most cases.
    A common assertion within greenhouse policy circles is that only a 
small fraction of the total allowances need be given to emitters to 
offset their profit losses. The Congressional Budget Office (CBO) has 
characterized this ``small fraction'' as less than 15%.\4\ I am one of 
the researchers whose analyses are cited in support of CBO's statement. 
I would like to identify several problems with that are associated with 
this type of oversimplifying summary statement.\5\
     Phase out of allocations over time. The small percentages 
of allowances that modeling studies find would offset sectoral average 
profitability losses are calculated assuming that the free allocation 
percentage will remain constant permanently (i.e., infinitely) into the 
future. In real application (and in all present policy proposals), the 
allocations are not permanent, but are phased out; yet the policy's 
impacts only continue to increase over time. If an allocation is to be 
phased out over time, the percentage share that achieves the same 
degree of compensation is higher. For example, an 8% perpetual 
allocation would need to become a 54% allocation per year if it were to 
end after ten years.\6\ It would need to be in the range of 50% or more 
in the first year, if it were to be phased out gradually over 20 or 
more years.
     Compensation estimated only for average sectoral impacts. 
The estimates of a percentage of allocation that would compensate 
``businesses'' is actually based on a model that does not consider 
individual businesses, but only entire aggregate sectors, such as the 
``energy-intensive industries'' sector or ``the electricity 
generating'' sector. There will, in fact, be both winners and losers in 
any large aggregated sector, and these models cannot distinguish 
between them. Instead, the share of allocation estimated to compensate 
the entire sector on average assumes the winning companies' gains 
within a sector can be netted against the losses of the losing 
companies. This is like saying that profitability increases to wind 
farmers and nuclear generators due to a cap will be taken from them and 
given to coal generators. Then, any remaining net losses to coal 
generators would be compensated by free allocations to that sector. If 
one of the modeled sectors had an equal balance of winners and losers, 
the model would estimate a zero need for any allocations to that 
sector--clearly that would be insufficient to compensate companies 
facing profitability losses within that sector. In one case where the 
analysts were able estimate the allocations needed to compensate each 
individual business rather than the sectoral average, the analysis 
found that that actual compensation of every individual business would 
require a 33% allocation to that sector, even though the analysis 
indicated a 0% allocation need when estimated on the typical sectoral 
average basis.\7\
     Compensation estimates largely ignore how trade exposure 
reduces abilities to pass costs through to customers. One of the 
reasons that some businesses may be able to be compensated for their 
profit reductions under a carbon policy is that they can actually pass 
a large share of their cost on to the consumer. That is, impacts to 
their profits are not as large as their increased compliance 
expenditures. The economy-wide models that have been used to assess how 
many allocations are needed to compensate sectors are not detailed 
enough to address the degree to which different sectors are able to 
pass costs through in their product prices, and they tend to overstate 
the pass-though. In particular, if parts of some sectors are highly 
exposed to competition from international competitors, they have 
exceptionally little ability to raise prices, because they will lose 
market share to foreign producers. However, when aggregated with a 
variety of other types of businesses in a ``sectoral model,'' their 
actual vulnerability to cost increases is averaged away. The model will 
assume they can achieve an average degree of price pass-through, and 
thus understate the profitability impacts of the very highly trade-
exposed within each sector. Those types of companies would require 
larger allocations than the modeling exercises have estimated.
     Comprehensiveness of cap's coverage. The modeling 
exercises have modeled idealized caps that would be applied uniformly 
to all emissions in the US. However, if a real-world cap were to only 
apply to about 50% of the emissions, while non-market policies and 
measures would be applied to the remaining sources, then the economic 
impacts of the policy would be the same or higher, but there would only 
be half as many allowances (and half as much allowance value) available 
to allocate. The amount of value needed to offset profitability impacts 
would be the same, but in this case, achieving that amount of 
compensation would require allocation of twice as large of a percentage 
of the allowance pool (because it is half as large). The bottom line is 
that as the comprehensiveness of the cap is lowered, the percentage of 
the allowances needed to achieve the same level of compensation rises.
    The above set of bullets points identify many limitations in the 
ability of models to address the question of fair compensation. The 
ideal solution would be to develop more disaggregated models to refine 
the estimates. Unfortunately, there are limits to what any models can 
do, due to lack of the necessary disaggregated data. In the end, there 
are no available analytical methods for determining allocations of 
allowances to individual companies throughout all sectors of the 
economy that would equitably mitigate the financial impacts of the 
policy.
    The available analyses do suggest that not all companies would 
require a 100% allocation in order to be compensated. However, any rule 
of thumb based on the quantitative results of these analyses (such as 
``less than 15% '') probably understates the true aggregate need when 
several of the real-world features of climate policies are taken into 
account. Such simplistic rules also clearly are not correct at the 
level of individual businesses, some of which will benefit without any 
allocation, and others of which may not be compensated even with a 100% 
allocation.
    Domestic companies whose products compete in international markets 
are likely to be driven out of business no matter what allocation they 
receive.
    A generous allocation could increase the shareholder value of a 
company that is unable to increase its prices due to competition in 
international markets (i.e., a ``trade exposed'' industry). However, it 
will do this in a perverse way that policymakers need to be aware of. 
As the price of allowances rises, a company that cannot raise its 
product prices will experience falling margins. If that company is also 
granted free allocations, it can use them to offset some of the costs, 
and thus maintain profitability. However, this will only be true for a 
range of lower allowance prices. For every type of company that cannot 
pass costs through, there will be an allowance price level at which the 
company would be able to make more money by selling its allowance 
allocation than by using those allocations to continue to produce its 
usual product. When allowance prices reach that level, the company will 
cease production, and become a seller of allowances instead. The 
shareholders may be satisfied with their financial situation, and use 
the proceeds of their allowance sales to invest in some different 
business venture that can be profitable in the carbon-constrained 
world. However, from the vantage point of the US economy, there will be 
premature retirement of the existing productive assets in our trade-
exposed sector, and reductions in the economic activities associated 
with those sectors.
    This is hardly fits the image that some may have of the notion of 
achieving compensating allocations for the businesses. Yes, the losses 
in profitability are offset for the affected shareholders, but this 
goes hand in hand with plant closures and loss of key economic sectors. 
Given that the cause of the closures is international competition, 
these lost US manufacturing activities would be replaced by foreign 
manufacturing: global emissions will not fall but the US economy will 
still pay the price.
    This perverse outcome of climate policy is called ``leakage'' 
because the policy is rendered ineffective environmentally when it 
causes emissions to ``leak'' across national borders. Emissions from 
any part of the globe have comparable impacts on climate risks, as they 
all first accumulate together in the global atmosphere to have their 
combined and joint effect on the global greenhouse effect. On the one 
hand, this offers important flexibility to reduce emissions anywhere in 
the globe that has cost-effective opportunities to do so, and not to 
confine domestic efforts to actions within US borders. On the other 
hand, it also means that any GHG cap we impose domestically, and its 
attending domestic reductions, may be undermined by offsetting 
emissions increases in nations that do not have comparable caps on 
their own economies. Large sums of money could be spent with no actual 
global environmental benefit. US economic output and jobs leak to other 
countries as well.
    Leakage has often been talked about in very general terms. 
Estimates of leakage due to a US domestic policy are suggested in the 
range of about 10-15%, meaning that for every 10 tons that is reduced 
in the US, 1 ton is just emitted elsewhere in the world. This may sound 
like a relatively small price to pay in order to get a net 9 tons of 
reduction from US action. The difficulty with this view, however, is 
that leakage is not a phenomenon that applies to every ton of emissions 
reduction. Instead, there may be almost no leakage associated with 
controls on emissions that are not trade-exposed (e.g., personal and 
commercial transportation, electricity generation, and services), but 
nearly 100% leakage associated with controls on emissions in sectors 
that are trade-exposed (e.g., many of the energy-intensive 
manufacturing processes such as cement, iron and steel, chemicals, 
transportation equipment manufacturing, textiles, etc.) Concentrated 
economic impacts on specific sectors that offer no benefit in terms of 
global emissions reduction make no sense as a matter of policy design. 
The possibility that the shareholders could be made whole is not a 
relevant argument to allow this to happen.
    The potential severity of the impacts to trade-exposed industries 
appears not yet fully appreciated by policy analysts or policymakers. 
Most of the attention on estimating climate policy impacts has been 
focused on transportation and electricity generation, which are among 
the least concerned with potential leakage. The potential plight of the 
trade-exposed industries has been mostly thought to be something that 
could be dealt with through compensating allocations. While that might 
solve the concerns of some of the shareholders of those businesses, 
policymakers should closely examine whether they are prepared to face 
the economic impacts of reduced exports, increased imports, and losses 
of domestic output of many important elements of the US manufacturing 
base.
             some options for reducing net economic impacts
    I noted in the first section that there are a few attributes of a 
greenhouse gas policy that would be important to keeping the policy's 
economic impacts in an acceptable and politically sustainable range. I 
believe that these require at least as much attention in designing a 
policy as the question of how to allocate allowances. This section 
provides some discussion of several of those attributes.
    Policymakers should focus on how to limit US emissions without 
creating leakage.
    As I noted in the last section of these comments, leakage is a 
serious concern for some portions of the economy, and not one that can 
be addressed satisfactorily with some free allocations to the trade-
exposed sectors. There are two ways to mitigate leakage without 
exempting trade-exposed sectors from an emissions cap:
    1. The first is to impose domestic emissions limits only as part of 
a global agreement among all nations that compete with our products, or 
which might start to compete once a policy offers them a greater cost 
advantage than they have now. Clearly, the present policy proposals in 
the Congress would not accomplish this.
    2. The second is to find ways to remove the competitive advantages 
of competitors at our borders, through ``border tax adjustments.'' 
Border tax adjustments are allowed only under very special 
circumstances under the rules of the World Trade Organization.
    The legality of obtaining effective border tax adjustments in the 
case of a cap-and-trade system is quite questionable at present.\8\ 
While a proposal to do so has been circulated by American Electric 
Power and the International Brotherhood of Electrical Workers (the 
``AEP-IBEW'' proposal), it appears to have dubious chances of success 
in limiting leakage due to a cap-and-trade proposal. The AEP-IBEW 
proposal contains quite a complex set of provisions, each aimed at 
addressing one of several hurdles that would be faced in order to 
achieve the ultimate goal of equalizing costs of imports at the US 
border in a WTO-compliant manner. Each element of the proposal would be 
open to legal challenge, leaving multiple potential ways that the 
approach could fail to provide the intended protection from leakage. 
Most critical in my mind, however, is that these many steps require 
time to accomplish. As embodied in the bill of Senators Bingaman and 
Specter, the imposition of leakage protection from the AEP-IBEW scheme 
might not be possible until 2020. Given that the cap in that policy 
would start in 2012, this would imply up to eight years during which US 
trade-exposed manufacturers would be facing competitive pressures, 
eroded ability to profitably continue in business, and experiencing 
leakage. Delays of this sort in obtaining that coverage are not 
acceptable for the businesses that face rapidly responding markets.
    The AEP-IBEW proposal for obtaining WTO-compliant leakage 
protection was crafted to work with a cap-and-trade form of proposal. 
Interestingly, the prospects of successfully and immediately 
implementing border tax adjustments are considered to be much greater 
in the case of a greenhouse gas tax than in the case of cap-and-
trade.\9\ Those having a hand in creating a climate policy for the US 
should become much more familiar with the intricacies of WTO rules, and 
the likelihood of successfully creating immediate and durable 
protection from leakage under different types of greenhouse gas policy 
designs. This needs to be sorted out before and not after a greenhouse 
gas policy is enacted.
    In the absence of a clear mechanism for preventing leakage with a 
cap-and-trade system, the only alternative for keeping economic impacts 
within acceptable bounds is to place a ceiling on the cost of 
allowances.
    The higher the price of permits under the domestic cap, the more 
serious ``leakage'' is likely to be if there are no border tax 
adjustments in place. Thus, potential for leakage provides an important 
reason for directly ensuring that the price of permits that may occur 
under a domestic GHG cap-and-trade program will remain relatively low. 
The only way to design a domestic cap-and-trade program to address this 
international competitiveness risk is simply to keep the carbon price 
low enough that such losses remain within acceptable bounds. This, 
naturally, limits the amount of domestic emissions reductions that will 
be achieved as well. Until international competitiveness issues are 
resolved (either through coordinated action or a system of border tax 
adjustments) ambitions to make significant reductions through any 
domestic cap-and-trade program will be thwarted, or else highly 
disruptive to key parts of our economy. This also implies that any 
domestic cap-and-trade program that is implemented in advance of 
internationally coordinated efforts should be designed with clearly 
defined permit price caps.
    An allowance price ceiling has important additional merits for 
businesses and government.
    Prices in all previous and existing cap-and-trade programs have 
exhibited substantial volatility, and this can be expected of GHGs as 
well.\10\ Price volatility, however, is likely to have much greater 
generalized economic impacts with a CO2 cap than for caps on SO2 and 
NOx. CO2 is a chemical that is an essential product during the 
extraction of energy from any fossil fuel. As long as fossil fuels are 
a key element of our energy system (which they are now, and will remain 
for many years even under very stringent caps), any change in the price 
placed on GHG emissions will alter the cost of doing business 
throughout the economy. This is because all parts of the economy 
require use of energy to one degree or another.
    In contrast, under the Title IV SO2 cap, a fluctuating SO2 permit 
price would only affect emissions from coal-fired electricity 
generation. In deregulated electricity markets, coal-fired electricity 
does not always affect the wholesale price of electricity, and even 
significant fluctuations in SO2 permit prices might have almost no 
effect on electricity prices. Even in regulated electricity markets, 
the impact of the SO2 price on the cost of all electricity generation 
would be diluted by the unaffected costs of all other sources of 
generation before it reached customers. Also in contrast to an economy-
wide GHG cap, no other sources of energy in the economy are affected at 
all by SO2 price changes. Finally, under the Title IV SO2 cap, price 
variations during the past year that range from $400/ton to $1500/ton 
(the range observed in the past year under Title IV) have a modest 
effect on the majority of coal-fired units that are already either 
scrubbed or burning low-sulfur coal. Such units might see the cost 
adder due to its SO2 emissions vary between 7% and 26% of its base 
operating cost,\11\ and (as noted) the impact on consumer's cost of 
electricity would be much smaller, if anything.
    Variation of CO2 prices such as that observed in the EU ETS market 
over the past two years (approximately $2/ton to $35/ton) would cause 
all coal-fired units to see additional costs varying between about 10% 
and 175% of their base operating costs. Further, even gas-fired units 
would experience absolute cost increases equal to about half those of 
the coal-fired units.\12\ Since gas-fired units do frequently set the 
wholesale market price of electricity, consumer electricity prices 
would also vary markedly with the price of GHG permits. Retrofits would 
not be available to attenuate these costs (at least, not until even 
higher permit price levels would be achieved and sustained at those 
levels.) At the same time, all other key energy demands in the economy 
(e.g., for transportation, industrial process heat, building heating 
and air conditioning, etc.) would also experience similar fluctuations 
with varying GHG permit prices. Clearly, the effect on the economy 
could be disruptive.
    These are not just theoretical calculations. The EU's statistics 
bureau, Eurostat, reports that electricity prices rose significantly 
throughout the EU in 2005. Household rates rose by 5% on average over 
all 25 EU countries, and industrial rates rose by 16% on average.\13\ 
The high prices of GHG permits under the EU ETS during that period is 
widely viewed as having contributed to this price increase, and indeed, 
wholesale electricity prices have fluctuated in step with the wide 
swings in ETS permit prices. It is not clear yet how or whether the 
wide variations in permit prices may begin to contribute to the 
variation in economic activity. However, it should also be noted that 
the EU ETS does not cover all sources of GHGs, or even a majority of 
sources of CO2 emissions in the EU. (This may dampen the impacts of CO2 
permit price volatility on the EU economy, but is also a widely 
observed flaw in that cap-and-trade system's potential to produce 
sufficient cuts in GHG emissions necessary for the EU to meet its GHG 
targets.)
    To sum up, price uncertainty and price volatility will impose 
impacts in the case of GHG emissions limits that are completely 
different in scale and scope from those under previous emissions 
trading programs. Their potential to increase variability in overall 
economic activity thus should be viewed as a core concern in designing 
a GHG cap-and-trade program. At the same time, the nature of climate 
change risks associated with GHG emissions is such that it is possible 
to design price-stability into a GHG cap-and-trade program without 
undermining its environmental effectiveness. In the case of a stock 
pollutant such as greenhouse gases, there is no need to absorb high 
costs in return for great specificity in achieving each year's 
emissions cap.\14\ Economists widely agree that the cost to businesses 
of managing the price uncertainty of a hard cap is not worth the 
greater certainty on what greenhouse gas emissions will be from year to 
year.
    Businesses clearly prefer having reliable allowance price 
expectations, but even governments would probably prefer some stability 
in the year to year revenue streams from an auction. For example, would 
large variability and uncertainty in allowance auction revenues be of 
any use if those revenues are intended to fund important technology-
related projects that have long-term funding needs? Even if the 
revenues would simply be rebated to citizens, would either the 
government or the citizens find any value in such uncertainty in the 
size of the rebate checks?
    There are various ways to provide much greater price certainty 
under a cap-and-trade program, although none have been used in any 
trading programs to date. One of the simplest concepts that has gained 
substantial attention for GHGs has been called a ``safety valve.'' 
Unfortunately, this term has begun to be used loosely (e.g., under the 
rules of the Regional Greenhouse Gas Initiative, and in California's 
AB32 program) for a variety of mechanisms that do not actually provide 
the price certainty originally intended. To be quite specific, the cap-
and-trade program mechanism that provides the requisite price cap is 
one where the government offers to issue any number of additional 
permits to regulated companies at a pre-specified and fixed price per 
permit. This price is set low enough that it is not considered 
punitive, but rather as an assurance by the government that it would 
not consider control costs above that level to be desirable as a normal 
course of events.\15\ This is the mechanism that has been incorporated 
into the bill of Senators Bingaman and Specter.
    Because regulated entities know that they need not ever pay more 
for a permit than the established safety valve price, it functions as a 
price ceiling. No company would ever pay more to purchase a regular 
permit in the emissions market if it knows that it can always obtain 
sufficient permits at that price from the government, if necessary. 
Permit prices may fluctuate at levels below the safety valve price, but 
by judicious selection of an appropriate safety valve price, policy 
makers can ensure that these variations would not rise to a level that 
might be viewed as potentially harmful to the economy at large. If the 
safety valve price is hit on an occasional basis under a cap, then the 
goal of achieving long-term reductions in emissions is not harmed, 
given that the primary environmental risk of GHG emissions is a long-
term, cumulative one. If the safety valve price is hit on a perpetual 
basis, this suggests an important need for policy makers to consider 
how we should address the evidence that meeting targets that are more 
difficult than hoped; however, this policy deliberation will be 
possible without the urgent need to throw ``band-aid'' solutions onto 
the cap-and-trade program, and with concrete evidence of the degree of 
economic pain that is associated with the initially-established maximum 
permit price. A higher price might then be deemed acceptable, but if 
not, the safety valve will have helped us avoid the greater pain of 
learning that fact through a hard cap approach.
    Aversion to the idea of a price ceiling has been widespread among 
parties that prefer hard caps at any cost over a long-run policy that 
offers price certainty in exchange for some flexibility in year to year 
emissions outcomes. Recently, a proposal for a ``Carbon Market 
Efficiency Board'' (CMEB) was released that was supposed to offer an 
alternative to the price ceiling approach.\16\ This concept has since 
been incorporated into the bill of Senators Lieberman and Warner. This 
CMEB proposal provides no cost certainty at all, and it explicitly 
states that it does not wish to diminish allowance price volatility: 
``The cost relieve measures are not intended to relieve brief price 
spikes that are part of normal, healthy market volatility.'' \17\ The 
proposal goes on to assert that `` 'volatility' in price is expected 
and even desirable.'' \18\ As I have noted above, volatility creates 
unnecessary planning and management costs to businesses, and should be 
eliminated if possible without harming one's objectives for reducing 
emissions within acceptable cost bounds. This is entirely possible in 
the case of a market that is entirely the result of regulation, such as 
an allowance market. The CMEB proposal does not meet the objectives of 
providing price certainty or policy cost containment.
                      thinking outside of the cap
    Almost everybody considers it as a foregone conclusion that cap-
and-trade is the only option for achieving cost-effective reductions in 
greenhouse gas emissions. However, in efforts to secure a greater share 
of the allowance values for non-industry interests, and in efforts to 
raise government funds for supporting research, and even in efforts to 
raise government revenues to reduce other taxes, there is growing 
pressure for a large share of the allowances to be auctioned. In the 
limit, however, an auction works just like a tax--except that the level 
of the tax is unknown in advance of passing the legislation, and will 
probably remain highly variable over time even after implementation of 
the legislation. This price uncertainty is not a helpful element to 
achieving reductions at lowest possible cost to the economy.
    If we find ourselves shifting into a world where auctions 
predominate, one must ask: why not simply apply a tax? All parties--
public and private--would benefit from the much greater price 
certainty, reduced administrative and strategic planning effort. Often 
expressed concerns with manipulation of allowance markets (for both the 
auction and the secondary markets) would also be eliminated. Further, 
as CBO has demonstrated in one of its issue briefs, the tax approach 
can outperform either a hard cap or a cap with a price ceiling in terms 
of cost-benefit outcomes.\19\
    Thus, it may be wise for policymakers to take time to consider more 
closely alternatives to the cap-and-trade approach for greenhouse 
gases. Cap-and-trade is not the only form of market-based policy 
option, and others may be more suitable for the challenge of reducing 
greenhouse gases to levels that are being proposed without excessive 
damages to our economy.
    With those central points in mind, I want to close by noting that 
even a highly effective and efficient market-based approach for GHGs 
will have a serious limitation that should not be forgotten. An 
adequate national climate policy must consist of more than a system of 
efficient GHG controls. Actual stabilization of climate change risks 
will require that GHGs be reduced to nearly zero levels. Although this 
goal may be possible to achieve at some point in the later part of this 
century, it can only be done through truly revolutionary technological 
progress and the resulting changes in the structure of how our energy 
systems.
    Hoffert et al. report that ``the most effective way to reduce CO2 
emissions with economic growth and equity is to develop revolutionary 
changes in the technology of energy production, distribution, storage 
and conversion.'' \20\ They identify an entire portfolio of 
technologies requiring intensive R&D, suggesting that the solution will 
lie in achieving advances in many categories of research. They conclude 
that developing a sufficient supply of technologies to enable near-zero 
carbon intensity on a global scale will require basic science and 
fundamental breakthroughs in multiple disciplines. Therefore, Herculean 
technological improvements beyond those that are already projected and 
accounted for in cost models appear to be the only hope for achieving 
meaningful reduction of climate change risks. By inference, no cap-and-
trade system should be placed into law that does not simultaneously 
incorporate specific provisions that directly support a substantially 
enhanced focus on energy technology R&D.
    Placing a price on carbon emissions, as a cap-and-trade program 
would do, would affect the pattern of private sector R&D. However, this 
so-called ``induced-innovation effect'' would be small. Economic 
analysis shows that market forces produce a less than socially optimal 
quantity of R&D. Once a private sector innovator demonstrates the 
feasibility and profitability of a new technology, competitors are 
likely to imitate it. Copycats can escape the high fixed costs required 
to make the original discovery. Therefore, they may gain market share 
by undercutting the innovator's prices. In that case, the initial 
developer may fail to realize much financial gain. Foreseeing this 
competitive outcome, firms avoid investment in many R&D projects that, 
at the level of society as a whole, would yield net benefits.\21\
    The task of developing new carbon-free energy sources is likely to 
be especially incompatible with the private sector's incentives. With 
no large emissions-free energy sources lying just over the 
technological horizon, successful innovation in this area will require 
unusually high risks and long lead times. As Hoffert et al. pointed 
out, developing the needed technologies will entail breakthroughs in 
basic science, placing much of the most essential R&D results beyond 
the boundaries of patent protection. These are precisely the conditions 
under which for-profit firms are least likely to rely on R&D as an 
approach to problem-solving. Thus, greenhouse gas caps on their own 
would insufficiently increase private sector R&D directed toward 
technological solutions to abatement.
    Market-based policies can very effectively stimulate incremental 
innovation and deployment into the market place of emerging new 
technologies. They cannot, however, stimulate the kinds of 
technological progress necessary to enable meaningful emissions 
reductions later on. Realistically, then, government must play an 
important role in creating the correct private sector incentives for 
climate-related R&D, as well as in providing direct funding to support 
such activity. This role must be built into any cap-and-trade policy, 
in order to avoid establishing an emissions policy that cannot fulfill 
expectations, and to avoid wasteful diversion of key resources for the 
requisite forms of R&D.
    Merely establishing cap and trade cannot meet the crucially 
important need for enhanced emphasis on basic research rather than 
additional subsidies for specific technologies that are already far 
along in the development process. It also does not clearly define 
government's role or an appropriate division of labor or risk between 
the public and private sectors in the development of new technologies, 
whether as commercialization and incremental improvement of existing 
low-carbon technologies, or R&D for new, breakthrough technologies. 
Creating an effective R&D program will not be easy, but it ultimately 
has to happen if climate risks are to be reduced. The difficult 
decisions are how much to spend now, and how to design programs to 
stimulate R&D that avoid mistakes of the past.
    In conclusion, the current policy debate about how to impose near-
term controls through cap-and-trade programs is encouraging policy 
makers to neglect much more important, more urgently needed actions for 
reducing climate change risks. The top priority for climate change 
policy should be a greatly expanded government-funded research and 
development (R&D) program, along with concerted efforts to reduce 
barriers to technology transfer to key developing countries. Neither of 
these will be easy to accomplish effectively, yet they are receiving 
minimal attention by policy makers.
                                endnotes
    \1\ Emitting companies may be able to pass some of these two cost 
components on to their customers, and so directly-regulated companies 
could be given more compensation than the cost that their shareholders 
bear if all of the allowances were allocated to them alone. However, 
this only means that a part of the net cost has been spread to other, 
non-regulated parties, including consumers. They, in turn, would 
require their share of the allowance allocation to be compensated for 
the part of the cost that was passed to them. There is not enough value 
in the allowances to cover all costs to regulated companies if they 
cannot pass those costs on, and neither can that value cover all the 
incurred costs even if they are passed through to customers and spread 
throughout the entire economy.
    \2\ For a review of the literature and specific analytical 
examples, see A. E. Smith, M. T. Ross and W. D. Montgomery, 
Implications of Trading Implementation Design for Equity-Efficiency 
Trade-offs in Carbon Permit Allocations, Charles River Associates 
Working Paper, December 2002.
    \3\ Congressional Budget Office, Trade-offs in Allocating 
Allowances for CO2 Emissions, Economic and Budget Issue Brief, April 
25, 2007, Figure 1.
    \4\ Congressional Budget Office, op. cit., p. 5.
    \5\ The points are further explained in my paper (Smith, Ross and 
Montgomery, op cit.). The CBO does acknowledge some of the following, 
but the caveats noted by CBO are not usually noticed, although they are 
extremely important to how this research is applied to actual policy 
design.
    \6\ Smith, Ross and Montgomery, op cit., p. 54.
    \7\ Congressional Budget Office, op. cit., p. 5, footnote 15.
    \8\ J. Pauwelyn, U.S. Federal Climate Policy and Competitiveness 
Concerns: The Limits and Options of International Trade Law, Nicholas 
Institute for Environmental Policy Solutions Working Paper NI WP 07-02, 
April 2007.
    \9\ Ibid.
    \10\ Some have argued that banking reduces price volatility. While 
it may reduce it, it certainly does not eliminate it. For example, the 
Title IV SO2 market has experienced high volatility over the past two 
years, even though it has a large bank already in place. During 2005, 
SO2 permit prices rose from about $600/ton to above $1600/ton, then 
plummeted to below $400/ton by the beginning of 2007. Additionally, 
banking offers little price stability at all during the start up of a 
new cap, simply because no bank yet exists, and this initial-period 
volatility can be very large if the first-period cap requires a 
substantial amount of reduction and/or has a relatively brief 
regulatory lead time. The experience of the first year in the NOx cap 
of the Ozone Transport Region of the northeastern U.S. is a classic 
example.
    \11\ By ``base'' operating cost, I mean the cost of generating a 
unit of electricity before accounting for the emissions price. The 
majority of this cost is the cost of the fuel.
    \12\ However, the percentage increase in the base operating cost 
would be much smaller (i.e., about 30% compared to 175%) because 
natural gas is so much more expensive than coal.
    \13\ Eurostat, ``News Release--July 14, 2006'' (Revised version 93/
2006), available at http:/ec.europa.eu/eurostat
    \14\ Richard G. Newell and William A. Pizer 2003, ``Regulating 
Stock Externalities Under Uncertainty,'' Journal of Environmental 
Economics and Management, Vol. 45, pp. 416-432.
    \15\ Outside of the U.S., further confusion about the notion of a 
``safety valve'' has been created by application of this term to the 
traditional notion of a penalty for noncompliance. The EU ETS has a 
penalty for noncompliance that is (Euro) 40/ton CO2 in Phase I and will 
be (Euro) 100/ton in Phase II, starting in 2008. This is often 
described as a price cap, but its very high level relative to the price 
at which the cap is expected to be met makes it extremely ineffective. 
Further, its role as a penalty rather than as an additional compliance 
mechanism clearly would undermine the willingness of companies to 
resort to its use for planning purposes. The same confusion of penalty 
and safety valve appeared in the proposal for an Australian emissions 
trading scheme released in 2007 by Australia's National Emissions 
Trading Taskforce. The notion of a ``safety valve'' should be clearly 
separated from the role of a noncompliance penalty, with the former 
being set at a price that is considered an acceptable level of policy 
implementation cost, and the latter being set at a much higher level 
that is considered ``punitive'' and not acceptable as an indicator of 
the cost of meeting the policy goals.
    \16\ ``Cost Containment for the Carbon Market: A Proposal,'' 
developed in consultation with the Nicholas Institute of Environmental 
Policy Solutions, Duke University, July 24, 2007. Available: http://
www.nicholas.duke.edu/institute/carboncosts/carboncosts.pdf.
    \17\ Ibid., p. 3.
    \18\ Ibid., p. 7.
    \19\ Congressional Budget Office, Limiting Carbon Dioxide 
Emissions: Prices Versus Caps., Economic and Budget Issue Brief, March 
15, 2005.
    \20\ M. I. Hoffert et al., ``Advanced Technology Paths to Global 
Climate Stability: Energy for a Greenhouse Planet'' Science, Vol. 298, 
Nov.1, 2002, p. 981.
    \21\ These points are developed in a more rigorous fashion in W. D. 
Montgomery and Anne E. Smith ``Price, Quantity and Technology 
Strategies for Climate Change Policy,'' in M. Schlesinger et al (eds.) 
Human-Induced Climate Change: An Interdisciplinary Assessment, 
Cambridge University Press, 2007.

    Chairman Spratt. I listened to the testimony of all of you. 
You seem to be attributing great dexterity to the invisible 
hand that moves through a very substantial market, the entirety 
of the United States. What mechanism would you employ to 
administer and facilitate the operation of this system we are 
talking about, a cap-and-trade system? It obviously can't be 
turned over just to the marketplace, it has to have some kind 
of overseer and administrator, it seems to me, to be operative. 
We will start with Dr. Orszag.
    Mr. Orszag. Let me make two points about administration. 
The first is that you could impose a cap-and-trade system at 
different parts of the production process, if you will, either 
upstream--that is, you know, at the point of an oil or natural 
gas or a coal firm--or downstream, in the form of the goods and 
services that are actually then bought by households. It is 
almost universally viewed by analysts that an upstream approach 
would be much more administratively efficient because you have 
to then monitor many fewer potential sources. So that is the 
first point.
    The second point is it is difficult to see how a system 
of--a cap-and-trade system could be effectively undertaken in 
the United States without at its heart the Federal Government 
playing an important role in monitoring and enforcement. And 
that actually then speaks to the scoring issue that I was 
mentioning. In addition to the allowances being very cash like, 
it is also the case that the Federal Government will have to be 
at the heart of enforcing and monitoring how the allowances are 
used and whether firms are exceeding their allowances and what 
have you.
    Chairman Spratt. Mr. Doniger.
    Mr. Doniger. Thank you, Mr. Chairman.
    If I could add, of all the kinds of pollution regulatory 
programs, the cap-and-trade system is the most economical to 
administer. Everything that Mr. Orszag said is true, but it is 
a much simpler system than traditional command-and-control 
systems.
    For example, the Environmental Protection Agency 
administers the acid rain cap-and-trade program, and I don't 
remember the exact number, but it is with a couple of dozen 
employees as opposed to the more command-and-control portions 
of the clean air program, which involves hundreds of people. 
And the fundamental thing, as Dr. Orszag said, is that you have 
to have systems of monitoring emissions and reporting those 
emissions and then making sure that the submission of 
allowances is made by a company in the number which it owes.
    In the acid rain program there is almost perfect 
compliance. There is a system of monitors in the stacks of the 
major power plants in this country that gives hour-by-hour 
readings of four pollutants--excuse me, three pollutants, one 
of which is carbon dioxide. So we already have under the Clean 
Air Act all the data necessary to implement this program for 
the electric power industry. And there is equally good data on 
the amount of fuel that moves through refineries.
    Various other statistics are already out there and 
collected by government agencies from which you can either 
directly measure or infer the amount of CO2 that is released 
there, or will be released, when the fuel is burned by 
households or by cars or whatever.
    So the system is actually quite economical. It does depend 
on there being a penalty which is larger than the market price. 
So most of these bills have, as a rule of thumb, that the 
penalty for not submitting allowances is on the order of three 
times the price of an allowance. And that is why you get such 
ready compliance, because it always makes sense for a company 
to turn in the number of allowances it owes rather than----
    Chairman Spratt. Is this a self-certifying system, then?
    Mr. Doniger. No, at least with the acid rain program and a 
couple of other programs of the same nature, companies file 
reports, there is a violation of law to mislead, there are 
extensive records which are kept which are quite good at 
preventing that kind of misleading. But you do need a 
government authority and the EPA or another agency which has 
the power and the resources to check and audit, and when it 
finds problems, go after violators. But it is a very economical 
system compared to many other kinds of pollution control 
systems.
    Chairman Spratt. Mr. Greenstein, you have been around the 
government a long time. What NRDC is proposing is a slight 
increase over time, less in previous--I think it is up to 450 
million ppm or whatever it is, and then it drops down by 80 
percent over the next 50 years. Can that be accomplished, in 
your view, without some sort of strong oversight by the Federal 
Government?
    Mr. Greenstein. I am not an expert on these aspects of 
environmental policy. My testimony really focuses on the areas 
we know: fiscal policy and distributional effects on low-income 
households. The only thing I would note on this front is that 
if the Congress enacts legislation that phases various things 
in over time, you probably want to design it in a way that 
minimizes the potential for future Congresses to undo the 
phasing in of the controls over time.
    Having said that, certainly both the economic price and the 
political difficulty of going in one fell swoop to the full 
degree of reduction in emissions one would like to achieve 
would make that impossible. I don't think there is any 
alternative but to phase in the reductions in emissions over 
time. Given that there is no alternative to do that, I think it 
means one designs the legislation in a way to try to maximize 
the potential for the reductions to stay in place and to 
minimize the potential for future policymakers to undo them 
before the goal is reached.
    Chairman Spratt. Dr. Smith, what do you propose for the 
oversight, administration, and implementation?
    Ms. Smith. If you are going to have a cap-and-trade system, 
you definitely need to have sound monitoring and sound 
enforcement. I don't think you need any sort of oversight board 
to interfere in the marketplace per se, and you definitely 
would not need that if you had a safety valve price. But I do 
want to comment that Mr. Doniger said that of all the types of 
emissions regulations that are possible, cap-and-trade is the 
easiest to administer. And this is simply not true.
    A carbon tax would be far simpler to administer. There 
would be no auctions. There would be no volatility to worry 
about. There would be far fewer worries about possible market 
manipulation that could occur. You would still need to have the 
enforcement and the monitoring, of course, but the issues would 
be much simpler. And the analogy to the SO2 market for a CO2 
market is actually a very poor one. The SO2 market applied to a 
few thousand individual electricity-generating units, all of 
which were already highly overseen by regulators in the first 
place in a very uniform market. With CO2 we are looking at 
thousands of more sources, all sorts of sectors of the economy, 
encompassing other types of gases than CO2. And even CO2 
sequestration activities, which are taking CO2 out of the 
atmosphere, rather than emitting, all of these make for a far 
more complicated sort of marketplace to monitor and enforce.
    Chairman Spratt. In your testimony, and this is my last 
question, but you do raise a difference between your viewpoint 
and Mr. Doniger's and Dr. Orszag's. That is, you question the 
assertion that emitting businesses would require less than 15 
percent of the allowances to compensate for losses due to the 
carbon caps. You call these misleading, and maybe even suggest 
you have been miscited. Would you like to explain to us why you 
think the 15 percent is misleading?
    Ms. Smith. Certainly. I will say that that literature does 
demonstrate that you don't necessarily need to give 100 percent 
of the allocations to businesses in order to compensate their 
profitability losses. The 15 percent is the oversimplification, 
and the suggestion that it is a very small percent. For 
instance, the models that have produced that number have always 
assumed that the allocation would be a permanent, infinite 
horizon allocation, year over year, all the way into the 
future. As you probably are aware, most real-world applications 
of cap-and-trade for CO2 involve a phaseout of those 
allocations, perhaps as short as 10 years as one amendment over 
on the Senate side says today. With a phaseout like that, you 
are going to get less value from your allocations because you 
will get them over a shorter period of time. But you have to 
nevertheless achieve the same amount of compensation because 
the costs go on forever and they continue to rise.
    So if the allocation has to perform the compensation in a 
short period of time the percent will rise. It is just a very 
simple piece of algebra. And we saw, for instance, in our 
analysis that an 8 percent allocation, if it were to be a 
constant allocation just for 10 years and then phase out, would 
require rising up to about 50 percent allocation in order to 
achieve the exact same amount of compensation to the exact same 
businesses with the exact same policy. So that is one important 
area.
    Another one is that the percent, whatever it is, 15 percent 
or 50 percent, in the case of that other estimate, is based on 
the average of a sectoral impact. And there are many businesses 
in a sector. And these models work with very, very aggregated 
sectors. One sector is the entire electricity-generating 
sector, rather than all types of generators, some of which emit 
carbon and some don't. Another is all of the energy-intensive 
sectors, which include many, many diverse types of 
manufacturing all into one because they all happen to use a lot 
of energy in their production processes. They have very 
different marketplaces. Some of them may benefit under a carbon 
market and some may lose. If you try to estimate what the 
impact would be to the sector on average, you may find that you 
need no compensation, zero percent. But in fact if you say, 
well, if you look behind those numbers you find that that has 
assumed that you have taken the profits from the winning 
companies, compensated the losing companies in the sector with 
those profits that they will never get their hands on, and then 
only say what do we need in addition to further offset the 
overall sectoral losses?
    So in one analysis we found a zero percent needed 
allocation to compensate a group of businesses. Actually, if 
you looked at the need to compensate each of the individual 
losers, without taking profits away from the winners, it 
translated into 30 percent allocations. So those are two very 
critical ones.
    Also the models are very poor at estimating whether certain 
companies can actually pass their costs through to customers. 
The models assume a good deal of price pass-through. And that 
is simply not the case for some kinds of businesses, 
particularly those that are exposed to trade competition from 
foreign imports or exports. If they can't pass it through, they 
need a larger allocation to be made whole. Because part of the 
reason you don't need to give a hundred percent of the 
allocation to businesses is because a lot of the business costs 
do get passed through to the consumer. And that will happen.
    As we said, prices of energy will go up, and it will get 
passed through in many cases to consumers as higher costs of 
goods and services.
    Chairman Spratt. Dr. Orszag, would you like to respond 
briefly?
    Mr. Orszag. Sure. I would first note that the paper that 
talks about this from CBO was issued under my predecessor, 
Douglas Holtz-Eakin. I have reviewed that. I think that the 
depiction therein is entirely accurate. It does distinguish 
between net effects on the sector and compensating individual 
firms. And I don't think there was anything misleading at all 
in CBO's presentation.
    I would also note a deeper question, though, which is in 
many discussions of compensation for losses there is a level of 
aggregation that is undertaken. Mr. Greenstein, for example, 
talked about compensating low-income households. That was an 
average across all sorts of low-income households, some of whom 
will lose more and some of whom will lose less. If you 
compensate low-income households, on average, you are not going 
to hit each individual household exactly, nor do I think it is 
even possible for you to do so. So it is often the case in this 
kind of setting, that there is a level of aggregation done and 
an impossibility of reaching in and compensating each 
individual household or each individual firm for the effects 
imposed on them. If you tried to do that, I think you would 
wind up with a bigger administrative mess than administering 
the cap-and-trade program itself.
    Chairman Spratt. Thank you very much. Now, Mr. Doniger, did 
you want to say something?
    Mr. Doniger. Just one quick point. The whole premise that 
the company's shareholders need to be compensated is based on 
an assumption that this program is coming and hitting them as a 
surprise. But we have known for a long time that global warming 
is a problem. And smart investors have known that there were 
risks associated in holding positions in companies with a lot 
of carbon exposure. I am not sure that it is--I am not saying 
that we oppose using a share of the allowance proceeds for some 
sort of transitional assistance to companies in the fossil fuel 
industry. I am not saying that NRDC completely opposes that.
    But I do think that it shouldn't be taken as a given that 
they are owed this, because like everybody else, they have been 
on notice that global warming is a problem and legislation is 
coming.
    Chairman Spratt. Thank you, sir. Mr. Ryan.
    Mr. Greenstein. One quick point also, since I was also 
accused, my testimony along with Dr. Orszag's, of being a 
little misleading here. As Dr. Orszag said, our estimate of a 
14 percent of the allowances to offset the effects on low-
income households, there would be winners and losers in that. 
If I tried to give you an estimate of how to do something you 
could administer that identified every single low-income 
household in the United States and made them whole, it would 
cost more, but that is not feasible. And it doesn't occur to me 
that it has been the policy over time of the U.S. Government 
every time it institutes a new policy in any area to try to 
identify every individual firm in the United States that may be 
affected by a change in policy or regulation and fully 
compensate it. It is not feasible.
    The other point is it certainly is true that if you phase 
out the allocation of permits to energy companies after 
something like 10 years, then your initial percentage would 
need to be higher than 15 percent. The 15 percent figure that 
CBO talked about, and we are just citing their figure, is a 
steady-state figure. You can do 15 percent in perpetuity or you 
can do a somewhat higher percentage initially and phase it down 
to zero over time. There is nothing misleading there. You just 
take your choice on how you do it.
    Chairman Spratt. Mr. Ryan.
    Mr. Ryan. Thank you, Chairman. This is a good hearing and a 
good debate, and something we need to do a lot more of. 
Unfortunately, some of us are on Ways and Means, we are in the 
middle of a markup, we have amendments coming up, so we are 
going to be coming and going. I guess this debate shows you 
that, you know, modeling is a crude science still. And these 
sectors-wide, aggregate-wide, economy-wide models are tough and 
crude and difficult to measure.
    And so when we put in place policies that are so 
prescriptive, it is really difficult to measure the outcomes. 
And so that is why I want to get into the debate about if we do 
cap-and-trade, and we don't have a safety valve on leakage, 
then what are the consequences? If we do have a safety valve, 
then we still lose emissions, either way you go, because of 
foreign competition.
    It seems to me going down the cap-and-trade route, and if 
we take Mr. Doniger's recommendation and don't have any price 
protection, don't have a safety valve, then you will have a lot 
of leakage, at which planetarily-wise you are going to have a 
reduction in your goals. But if you do have leakage protection, 
or you do allow leakage--I mean if you do allow a price 
ceiling, then you are going to have--you are going to reduce 
your goals either way. So the point is why don't we have more 
discussion about a carbon tax instead of a cap-and-trade? If we 
are going to spend all of our time building a big mouse trap to 
try and reach the goal of cap-and-trade, isn't a better, more 
efficient, less economically damaging route a tax?
    I think the Mankiw article that I think, Bob, you 
mentioned, which I agree, if you just take benefits out of the 
economy and give to a few, you are clearly giving something 
that is more valuable. Corporate welfare is probably a good way 
of describing it. But at the same time, think Greg also 
mentioned we maybe ought to look at a tax that is 
international. And therefore you can have global adjustments, 
border adjustments.
    So here is my quick question to everybody. And then, Peter, 
I have a scoring question I want to ask you, and then I will 
turn it over. Those of you who are advocating cap-and-trade, 
why is it that you think this is so much better than a tax if, 
given we have to do all of these things to try and police a 
cap-and-trade, would seem to me are going to escape us and we 
will not meet our goals?
    Mr. Doniger. Could I take the first whack at that?
    Mr. Ryan. Sure.
    Mr. Doniger. First of all, let me go back to the beginning. 
There is a distinction to be made between the volatility 
problem, prices going up and down year to year, and the long-
term cost. The volatility problem, in my experience in talking 
with people from the industries, is the thing that really kills 
people. If their costs are predictable, they can adjust to 
them.
    So how do you avoid volatility? Well, the primary way to 
avoid volatility in a cap and trade program is with banking, 
which means that if prices are low in a year, you control more 
and you save up the allowances and borrowing. If costs are 
high, you can borrow from the future under an interest-based 
repayment. And that can have the capacity to smooth out this 
year-to-year volatility.
    If you had the ability during the spike in natural gas 
prices to have borrowed and used natural gas that wouldn't be 
pumped from the ground until 2020, it would have dampened the 
price of 2006 natural gas.
    You can do that with allowances because you can shift them 
in time. So I don't think the volatility problem is as serious 
a problem or it has a cure without going to the safety valve.
    The second point I would make is that your question and Dr. 
Smith's observation assumes a very long period in which the 
United States is doing its thing on global warming all by 
itself and other countries are not coming along. Well, first of 
all, except for Australia, the rest of the industrial world is 
already ahead of us and we would be joining them rather than 
leading them.
    Secondly, there are provisions in several of the bills to 
create more leverage for bargaining with key developing 
countries by proposing that there should be border pollution 
purchase requirements like a board of tax adjustment if after a 
number of years key countries don't have comparable control 
requirements.
    As someone who has worked in the international negotiations 
as well as the domestic arena, I think the time actually has 
come where the developing countries are ready to respond if and 
when we lead. So it will come together in the next 5 to 10 
years, and you won't have that sort of thing.
    The last point on the tax, what the atmosphere sees is the 
number of tons that go into it. That is what causes global 
warming. So we need, in my opinion, a direct limit on the 
amount of pollution that goes into the atmosphere. When you use 
a tax approach, you are guessing at how much response there 
will be in terms of what pollution levels will go in. And it is 
not easy to write a tax. Everyone has their own different 
provisions and subprovisions and loopholes and this's and 
that's. It is not any less complicated than writing a cap and 
trade program, and you have to keep adjusting the amounts to 
get the results you want.
    Mr. Ryan. I would simply say, constructing a border 
adjustment regime on a cap and trade program that is WTO 
compliant I think would be a lot more difficult than if you did 
it on a tax. We did DSC and FSC and all of these iterations, 
and now ETI, and now where are we. We have had a hard time just 
with existing trade law and tax policy complying with WTO. I 
think there is a case to be made that this would be very 
difficult. Because we are worldwide and the rest of the 
countries are territorial our tax regimes are different. We 
would have a very hard time, I would think, constructing a WTO 
compliant border adjustability regime under a cap and trade 
program than if we did in our tax system.
    And I know you are not a tax guy, I think the other folks 
here are. But go ahead, Bob.
    And then one just quick question, Peter, I want to ask you 
about scoring.
    Mr. Greenstein. It seems to me one way to think of this is 
think of three alternatives, carbon tax, cap and trade; the 
third alternative is doing nothing, sticking with what we have 
now.
    Now, clearly, by far the worst alternative is doing 
nothing. The difference between that and either cap and trade 
or a carbon tax is vastly greater than the difference between a 
carbon tax and a cap and trade.
    So I would agree with you that if we could either do a cap 
and trade or a carbon tax, I would prefer a carbon tax. My 
concern is that the political system I think would have a 
real--all of you and your colleagues--a much harder time 
enacting a carbon tax than a cap and trade system. I wish that 
weren't true. That certainly is true today; maybe it won't be 
true in a couple years.
    Mr. Ryan. Right. But politics aside, in theory in the 
policy vacuum you are saying the carbon tax is the better way 
to go than a cap and trade?
    Mr. Greenstein. In a policy vacuum, I would prefer a carbon 
tax. But I have a very strong fear that if one tried to move 
it, those who advocated it would be immediately attacked as tax 
increasers and the whole thing would fall apart and we would 
end up with nothing. So in the ideal world with no politics, I 
would prefer a carbon tax. But I don't want to let the perfect 
be the enemy of the good.
    Ms. Smith. I first want to point out, banking is not a way 
to reduce volatility. There is an enormous amount of banking 
allowed and used in the SO2 cap, and yet we have seen huge 
volatility in that market. Just in the past couple years, 
prices rose in the space of 12 months from $400 per ton of SO2 
up to $1,500 a ton, and then plummeted back down to the range 
of about $500 a ton.
    And you have hit it on the mark about the tax. For the WTO 
compliance, a tax allows a much easier and immediate, without 
delay, implementation of border tax adjustment that would be 
WTO compliant or very likely to much, more likely than anything 
that has been proposed around the cap and trade schemes. Taxes 
may be complicated to implement into law, to enact into law and 
write, but I think we are seeing that cap and trade is 
complicated to enact and write into law. Just have a look at 
the length of the Lieberman-Warner bill. But once you get it 
implemented, and it is pretty easy to know if it is a simple 
one or not. Once you get it implemented, then you have all the 
benefits of simplicity associated with the tax in addition to 
the international trade side of it.
    Mr. Ryan. Okay, Peter. Answer that question, then I will 
tack this out at the end. Your written testimony, you go into 
sort of scoring rules that you are going to put down. If we 
send you a bill, one that auctions how we score that, if we 
send a bill that does not auction, that gives the allowances 
away, how is that going to be scored?
    Mr. Orszag. Let me answer that question first. As my 
written testimony notes, if you auction the permits, that would 
be scored as a revenue. If you gave the permits away, there is 
a solid case to be made that that should be scored as a revenue 
and a corresponding outlay with no net effect on the deficit. 
That would be a departure from the way that the sulfur dioxide 
program, for example, was scored, and it would be a departure 
from the fact that the budget is primarily cash based.
    On the other hand, again, there is a very solid argument to 
be made that that would be the most insightful scoring to put 
equivalent transactions on an equal footing in the scoring 
process.
    Mr. Ryan. You can't be a two-handed economist when you are 
CBO Director though. You will have to make a decision.
    Mr. Orszag. Within a very short period of time, we will 
have to make a decision.
    Mr. Ryan. And you have yet to do that?
    Mr. Orszag. We have not yet formally done that. Again, I 
would just say there is a solid case to be made for treating 
the permits that are given away as both a revenue and an 
outlay.
    Mr. Ryan. So no net effect?
    Mr. Orszag. No net effect on the budget. However, the 
benefit of that kind of approach is it would make it 
transparent what was happening. And in particular, again, 
repeating the equivalents, giving someone permits worth $100 
that they can immediately turn around and sell for cash is 
effectively equivalent to selling the permits for $100 and then 
giving that person or firm $100 in cash. Scoring the permits 
that are given away as a revenue and an outlay would make those 
equivalent transactions equivalent in the scoring process. And 
for transparency and so that policymakers can evaluate the 
tradeoffs clearly, there is a solid case to be made for that 
kind of scoring.
    Mr. Ryan. Then, because I know you do tax as you dabble 
there, isn't it easier for us to concoct a border adjustability 
regime that is WTO compliant based on a tax versus a cap and 
trade system? And give me your take on the efficiencies of 
achieving the end goal between the two.
    Mr. Orszag. First, as my testimony makes clear, a tax is 
generally more efficient than a cap and trade system. You can 
make a cap and trade system sort of approach the efficiency of 
a tax by changing its design features. So, banking and 
borrowing and then a safety valve, as you noted. And so, 
relatively speaking, a tax is more efficient, but a cap and 
trade can approach the efficiency of a tax with design features 
that I mentioned.
    On the border tax adjustments and WTO compatibility, I 
would say the area of adjustments in a cap and trade system at 
the border has ambiguities associated with it. Before I joined 
CBO, I had done some work in the area. And I would just say 
that is a particularly complicated area in which I wouldn't 
want to make predictions about what exactly is or is not WTO 
compliant.
    Mr. Ryan. Thank you.
    Mr. Spratt. Ms. Tsongas, welcome. Do you have any 
questions?
    Ms. Tsongas. I don't, but I have enjoyed your testimony. 
This is clearly an issue we have to face, and there is no time 
to waste.
    Mr. Spratt. Mr. Smith.
    Mr. Smith of Nebraska. Thank you very much for your time 
here. I know that it gets to be a challenge balancing science 
and politics and economics, and I appreciate your efforts.
    In trying to read up on so much of this, it has been 
interesting to see, and especially for my district, a large 
producer of livestock. And I have read about the impacts of 
high corn prices, not only high corn prices on the prices in 
livestock, but across the food spectrum, if you will, around 
the world.
    Here are pluses and minuses along the way. But especially 
the criticisms of the livestock industry and relating to 
carbon, would situations be considered, Mr. Orszag, if you 
don't mind; with a cap and trade system would the increased 
costs of food production be considered in this equation?
    Mr. Orszag. There would be a variety of effects that would 
be spread out across different sectors, and the agricultural 
sector in particular would experience effects. I would also 
note, the agricultural sector would be one of the sectors most 
affected by a change in climate, so you also need to weigh the 
costs and benefits.
    And beyond that, I would just point out that your example 
might be a particularly salient one to return to the scoring 
issue. Handing a farmer a permit worth $100 that the farmer 
then turns around and sells for cash of $100 is really similar 
to handing that farmer $100 in cash.
    So you are right to identify your district and the 
agricultural sector in particular as a key sector in climate 
change. It is often noted that methane emissions are tied to 
the agricultural sector, and that is one of the greenhouse 
gases. And there would be important effects that are part of 
all of these models that strive as best they can to identify 
potential impacts on particular sectors.
    Mr. Smith of Nebraska. Go ahead.
    Mr. Doniger. May I add a couple points? First, that most 
cap and trade bills don't suggest they would actually control 
the emissions from most agricultural activities. But the change 
in the markets for energy means that there will be even larger 
opportunities for farm-based energy production. And this is 
apart from allocation subsidies or other subsidies. It just 
becomes more valuable to make wind energy, to recover methane 
natural gas from the wastes of livestock production, to grow, 
we would hope, cellulosic products, not the corn but the 
stocks, switchgrasses and so on, and turn those into ethanol. 
So you get an increase in farm-related energy markets just from 
the imposition of a cap. And there can also be, inside the 
distribution of the allowances there can be incentives to make 
some of those technologies come forward faster.
    Mr. Smith of Nebraska. Dr. Smith.
    Ms. Smith. I would like to also point out agriculture is 
one of the most energy intensive forms of manufacturing we have 
in the U.S. It is up there with other energy intense sectors. 
Cost of energy, when it rises, will raise the cost of farming. 
There is no question, though, that there may be some 
opportunities if the world is shifting towards biomass-based 
ethanol and use of land for forestry. There will be higher 
rises and changes in markets for land as well as change in 
markets for the crops off of the land, and I think it creates 
much uncertainty. There could be some upside for farmers, but 
it could also be a pretty disruptive time. At the same time, 
all the input prices are changing.
    Mr. Smith of Nebraska. I think you might have been reading 
a transcript of some conversations I had with constituents. I 
appreciate your bringing that up, because agricultural 
producers, their greatest concern right now is the cost of 
energy. And with the direct impact that a cap and trade system 
would probably have on the energy costs, it would even 
exacerbate the problem that I see.
    When we look at the larger issue, again, are we confident 
that those who would be most impacted across the border, 
whether it is individuals, whether it is companies, whether it 
is those on fixed income paying their utility bills, that we 
can truly address all those? I know that is an ambiguous 
question; but I am fearful that there might be some unintended 
consequences along the way.
    If Mr. Greenstein would respond.
    Mr. Greenstein. Sort of following up on an earlier comment 
I made. If the question is, could we identify every individual 
firm or elderly person on a fixed income, or a farmer, and 
fully offset the impact, no, we can't do it for each individual 
one. We have never done that for any big policy the 
governmenthas ever implemented.
    What we can do, though, is we can identify the priority 
needs. And if we auction off the lion's share of the permits, 
the resources are there. One can design in an efficient manner 
how to provide the assistance in those areas.
    Now, clearly you are not going to be able to fully offset 
the impact on everyone. If you took every consumer at all 
income levels and fully offset the cost on all of them, you 
wouldn't have money for basic research, or you might not have 
enough to go deeper in the coal mining communities. You make 
some choices. But the amount of revenue that can be raised, 
whether it be through auctioning permits or a carbon tax, as 
Mr. Ryan suggested, is sufficient that Congress could identify 
all the priority needs it needed to address, and it could on 
average fully address the needs in each of those areas, whether 
it be energy companies, people on fixed incomes, low income 
consumers, or the like.
    Mr. Orszag. Mr. Smith, let me just add that it is not 
possible to compensate each individual household or each 
individual firm precisely because there is an overall economic 
cost to acting. That overall economic cost means it is not--I 
don't want to call it a fool's quest, but it is not possible to 
compensate everyone for the effects because there is some net 
cost. However, that cost has to be weighed against the benefit 
of purchasing insurance against climate change, basically.
    And so attempts to fully compensate everyone for the 
economic costs involved are not going to succeed almost by 
definition, but the net cost that sort of will be there needs 
to be weighed against the benefit of reducing the risk of 
potentially catastrophic climate change.
    Ms. Smith. I would like to add, I completely agree. There 
was a net cost that was my starting point. The different forms 
of allocations can maybe help find a way to smooth out where 
the impacts are, but there is no way to make everybody better 
off even if you get a fully smooth and equitable sort of 
distribution.
    But I also want to point out, yes, we need to try to weigh 
the costs against the benefits, and we need to look at the 
costs that I just reported in my statement. Those are the net 
costs after accounting for all the recycling of all the 
benefits associated with the revenues from the allocations. And 
so the net average cost to the household for the kinds of hard 
cap bills that we are looking at, without accounting for the 
uncertainty of volatilities, is in the range of $1,000 to 
$1,500 a year. That is what needs to be compared against the 
benefit from the climate.
    Mr. Orszag. So it is not net-net.
    Mr. Smith of Nebraska. Thank you, Mr. Chairman. I really 
want to thank the witnesses here today. This has been very 
interesting and I think a very productive debate. Thank you.
    Mr. Spratt. Thank you, Mr. Smith.
    One final question of Ms. Smith. Would you take just a 
minute and explain to what extent that CRA's analyses, your 
analyses take into account the economic benefits of imposing 
climate control, particularly with respect to avoiding 
environmental harm and even catastrophic consequences?
    Ms. Smith. As I just said, those are the costs that need to 
be evaluated against the benefits. So they do not include the 
environmental benefits; instead, they provide you a sense of 
what you would be spending for different emissions targets. And 
then one can ask, what do we gain from those emission targets?
    I would just take a moment to mention that some of these 
catastrophic changes, if they are happening now, will not--the 
risk of them will not be changed by any of these carbon 
policies. We can change the amount of future warming that might 
occur with deep cuts on a global basis, but the kinds of 
changes we are talking about in those cap and trade programs 
that the U.S. is undertaking would not be able to avert any 
catastrophic losses that are already in the works. They don't 
make enough change in the climate forecast.
    Mr. Spratt. Mr. Doniger.
    Mr. Doniger. Thank you, Congressman. First, what we are 
sketching out is the U.S. part of a balanced world program to 
cut back the global warming pollution not yet in the 
atmosphere. And the IPCC and many other analysts see 
increasingly dire future consequences as the temperature goes 
up.
    If we had it in our power, we would keep the temperature 
from going up at all, but there is some increase coming from 
the pollution already in the bank, already in the air, and from 
the activities that we need to turn around that won't be turned 
around overnight.
    So the goal, at least from the environmental community, is 
to draw as much as we can a bright line against letting the 
temperature increase over where we are now go on a global 
average up another 2 degrees Fahrenheit or more than that.
    It is true, as Dr. Smith said, that there are impacts 
occurring now, and it is unfortunately true, that have resulted 
from the global warming pollution already in the atmosphere, 
changing the frequency of droughts and storms and some of the 
other bad events. Not every fire, not every hurricane obviously 
is caused by global warming, but you are changing the number of 
dots on the dice and changing the outcome as we roll the future 
climate dice.
    We have no alternative but to cut back emissions now in 
order to stave off the impacts we have not yet committed to. If 
we just keep letting it go, it just gets worse and worse.
    Mr. Spratt. Mr. Greenstein?
    Mr. Greenstein. I was just going to say we need numbers to 
help guide us in work, especially those of us who deal with the 
budgets. One problem we sometimes run into is for things that 
we do not have enough data to quantify, we run the risk of 
ignoring or acting like there is zero. In this case, the thing 
we can't quantify is the economic damage, and you could--how 
you would average it per household of doing nothing.
    Now, think of the--let me be clear. I am not an expert on 
Hurricane Katrina. I don't know to what degree that was climate 
change related. But for sake of illustration, suppose over the 
next 50 years there were a series of events like that that 
could have been averted if we took strong action to address 
climate change. The potential economic impacts of those would 
be very large. And if we knew the number we could quantify it 
per household. We can't do it because we can't possibly predict 
what that is. We can't come up with a number. But it doesn't 
mean the number is zero. And there is a very substantial chance 
that that number is substantially larger than all the numbers 
we are talking about here today of the potential effect per 
household because of what would be relatively modest impacts on 
the economy.
    Mr. Spratt. Mr. Smith.
    Mr. Smith of Nebraska. I know you are not scientists, but 
we are trying to balance all of this right here. If those who 
would wish to state on a scale of 1 to 100 the certainty of 
reversing global warming with a cap and trade program.
    Mr. Doniger. Let me take the first cut at this. The 
analysis by the IPCC scientists, the Intergovernment Panel on 
Climate Change, and by others is that the kind of emission 
reduction pathway that I am talking about, 15 percent reduction 
by 2020, 80 percent reduction in the U.S. by 2050. If matched 
by other developed countries, and there is a lot of those 
countries that are ahead of us, and if not exactly the same 
action but proportionate action is taken in moderating 
emissions growth in developing countries and ultimately to 
reduce it, that sketches out a budget, an atmospheric carbon 
budget that is consistent with avoiding the 2-degree increase 
or worse that I described. And that is the physics, that is the 
budget of the atmosphere that we are bringing to this economic 
budget hearing.
    Mr. Smith of Nebraska. Anyone else wishing to respond?
    Ms. Smith. There is no question, if we were to stop the 
growth of the CO2 emissions and the other greenhouse gases 
going through the future and through this century, that we 
would reduce the amount of warming that will occur otherwise. 
But we are not going to reverse the warming that is occurring 
now without waiting another century or so.
    So there is a certain amount that is committed. It is not 
going to get reversed. Then the question is, with these 
expenditures, what will we do in the way of reducing further 
growth? There is a serious issue here where we don't have 
developing countries involved and their emissions aren't being 
reined in, and there is nothing on a hard cap in the U.S. that 
actually brings them into the fold. In fact, they have more and 
more incentive not to come into the fold as we put tighter and 
tighter caps on ourselves unilaterally because they gain 
competitive advantages over it.
    So the real issue is, can we get a globally coordinated 
reduction in those greenhouse gas emissions? And just putting a 
cap on the U.S. emissions and in bearing these costs in the 
near term isn't going to accomplish that.
    That doesn't mean that we shouldn't try to take some action 
in the U.S. to start to put in effect a cost effective climate 
policy that will start to move us in the direction of getting 
towards zero emissions over the next century. And by ``us,'' I 
mean the whole globe. And that is the other point I have been 
making, is that these policies are more costly than they need 
to be in order to get us on that long-term, centuries long 
action to prevent more greenhouse gas increase than is 
desirable.
    Mr. Orszag. Could I just add one thought, which is I think 
too much of the discussion about future climate change has 
focused on the expected outcome, the range of say 2 to 6 
degrees Celsius, for example, and too little on what economists 
call the tail, the small probability of really bad things 
happening. And I would think that more attention, even though 
they are extraordinarily difficult to quantify or even know 
what the risk is, more attention to that risk would be 
beneficial in evaluating the pros and cons of moving forward 
rather than just the sort of expected outcomes, because there 
is an important element of insurance here against that kind of 
catastrophic risk.
    Mr. Smith of Nebraska. Thank you.
    Mr. Spratt. Thank you, Mr. Smith.
    Now, I believe that concludes the hearing. I have one final 
detail. Any members who did not have the opportunity to ask 
questions, I ask unanimous consent they be given 7 days to 
submit questions for the record. Without objection, so ordered.
    Thank you very much for your testimony and your lively 
presentation. We appreciate it, and we have learned a lot. 
Thank you.
    [Whereupon, at 1:30 p.m., the committee was adjourned.]

                                  
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