[Senate Hearing 111-222]
[From the U.S. Government Publishing Office]



 
                                                        S. Hrg. 111-222

                     GREENHOUSE GAS TRADING PROGRAM
=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                      ENERGY AND NATURAL RESOURCES
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   TO

EXPLORE POTENTIAL COSTS AND PRICE VOLATILITY IN THE ENERGY SECTOR AS A 
   RESULT OF A GREENHOUSE GAS TRADING PROGRAM AND WAYS TO REDUCE OR 
                          CONTAIN THOSE COSTS

                               __________

                           SEPTEMBER 15, 2009



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              JEFF BINGAMAN, New Mexico, Chairman

BYRON L. DORGAN, North Dakota        LISA MURKOWSKI, Alaska
RON WYDEN, Oregon                    RICHARD BURR, North Carolina
TIM JOHNSON, South Dakota            JOHN BARRASSO, Wyoming
MARY L. LANDRIEU, Louisiana          SAM BROWNBACK, Kansas
MARIA CANTWELL, Washington           JAMES E. RISCH, Idaho
ROBERT MENENDEZ, New Jersey          JOHN McCAIN, Arizona
BLANCHE L. LINCOLN, Arkansas         ROBERT F. BENNETT, Utah
BERNARD SANDERS, Vermont             JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   JEFF SESSIONS, Alabama
DEBBIE STABENOW, Michigan            BOB CORKER, Tennessee
MARK UDALL, Colorado
JEANNE SHAHEEN, New Hampshire

                    Robert M. Simon, Staff Director
                      Sam E. Fowler, Chief Counsel
               McKie Campbell, Republican Staff Director
               Karen K. Billups, Republican Chief Counsel
                            C O N T E N T S

                              ----------                              

                               STATEMENTS

                                                                   Page

Bingaman, Hon. Jeff, U.S. Senator From New Mexico................     1
Claussen, Eileen, President, Pew Center on Global Climate Change, 
  Arlington, VA..................................................     9
Grumet, Jason, President, Bipartisan Policy Center...............    43
Mason, Joseph R., Ph.D., Professor, Louisiana State University, 
  Baton Rouge, LA................................................    23
Murkowski, Hon. Lisa, U.S. Senator From Alaska...................     3
Wara, Michael, Assistant Professor, Stanford Law School, Faculty 
  Fellow, Program on Energy and Sustainable Development, Center 
  Fellow, Woods Institute for the Environment, Palo Alto, CA.....    14
Yacobucci, Brent, Specialist in Energy and Environmental Policy, 
  Congressional Research Service.................................     5

                               APPENDIXES
                               Appendix I

Responses to additional questions................................    75

                              Appendix II

Additional material submitted for the record.....................   109


                     GREENHOUSE GAS TRADING PROGRAM

                              ----------                              


                      TUESDAY, SEPTEMBER 15, 2009

                                       U.S. Senate,
                 Committee on Energy and Natural Resources,
                                                    Washington, DC.
    The committee met, pursuant to notice, at 2:35 p.m. in room 
SD-366, Dirksen Senate Office Building, Hon. Senator Jeff 
Bingaman, chairman, presiding.

OPENING STATEMENT OF HON. JEFF BINGAMAN, U.S. SENATOR FROM NEW 
                             MEXICO

    The Chairman. Ok, why don't we get started? Let me just 
advise members. We have, in addition to the hearing that we've 
got our witnesses for today, we have three pending nominations 
that we hope to deal with in a business meeting.
    My hope is if we get 12 members here at some point during 
our hearing we would interrupt the hearing long enough to go 
ahead and deal with those nominations in a business meeting. 
Until that happens why don't we go right ahead with the 
hearing.
    Global climate change is one of the most consequential and 
difficult problems that we face in this Congress. It's a 
problem of vast scale that obviously requires a solution of 
vast scale. More precisely it requires that we find a way to 
reinvent our energy infrastructure.
    Many members are currently absorbed by the health care 
debate, but it is important to continue to make progress on 
this issue as well. This week in our Energy Committee we will 
have two hearings on the issue of energy and climate change 
legislation.
    Today we will receive testimony on the topic of containing 
costs in a greenhouse gas emissions market. Thursday we'll 
learn about economic analyses and what models could tell us 
about the expected impacts of energy and climate legislation.
    Many members of the committee have expressed an interest in 
climate legislation and its impacts on the energy sector. So I 
believe it's important that the committee do its part to help 
the full Senate understand this connection, and having 
available the most current and credible information on key 
issues in the energy climate connection is a constructive step 
that this committee can take in moving forward on the issue.
    The discussion this week will revolve around the 
implementation of a cap and trade program for greenhouse gases. 
The primary goal of any such program must be to achieve our 
environmental objectives with the least possible disruption to 
our economy. As we contemplate cap and trade, we need to ensure 
that the costs of carbon permits do not become either 
excessively high or excessively volatile.
    At today's hearing we will receive testimony on policy 
options to avoid these types of unexpected and potentially 
dangerous costs. I'm very pleased with the bipartisan approach 
we've been able to take in the committee in putting the energy 
legislation together that we reported several months ago. We 
reported a bill that contained important incentives and 
programs for clean and efficient energy. I very much hope we 
can see those provisions enacted into law.
    At the same time I'm dedicated to doing what I can to enact 
effective greenhouse gas legislation. I have worked, as have 
several members of this committee, to help craft legislation in 
previous Congresses that would help us to achieve this result. 
Senator Murkowski co-sponsored a bill that Senator Specter and 
I introduced in the last Congress.
    I thought that was a contribution to the discussion. 
Failure to act on the issue does carry real costs both for the 
global environment and for the economy. The search for 
effective legislative proposals to avoid climate change 
involves avoiding the costs of global warming without imposing 
other unintended costs that would have few benefits and could 
even have negative impacts on our society. So we need to 
provide assurances that the costs of a cap and trade system 
will not go out of control either because of excessive prices 
or because of excessive volatility.
    Today's hearing is to explore some of the mechanisms that 
can be used to address these concerns. Let me defer to Senator 
Murkowski. Then I'll introduce the various witnesses, and we'll 
hear from the panel.
    Go right ahead.
    [The prepared statement of Senator Bunning follows:]

   Prepared Statement of Hon. Jim Bunning, U.S. Senator From Kentucky
    Thank you Mr. Chairman. I look forward to the hearing today to 
discuss some of the financial issues involved through enacting a cap 
and trade program.
    I think it is made clear in the testimony today that we need to be 
careful of moving too quickly in addressing climate change.
    I have long said that I do not support imposing mandatory caps on 
emissions. I believe in providing incentives for new technology, moving 
to lower emission technologies and improving energy efficiency.
    These immediate-impact policies accomplish the goals of a cap and 
trade program with less complication and potential opportunity for 
market manipulation.
    Under a cap and trade program the federal government would be 
forced to oversee yet another area of financial transactions through 
the trading of carbon credits. This is at a time when we are struggling 
to maintain an effective banking system.
    Supporters of cap and trade argue that they can impose cost 
containment mechanisms--such as offiets or price collars--to lower the 
financial risks and costs of implementing such a program. These 
proposals, however, are unworkable and unrealistic.
    Instead of focusing on ways to mitigate the negative costs of 
imposing a cap and trade system, Congress should instead focus on 
policies that provide incentives for businesses so they can create jobs 
and grow.
    Make no mistake. Cap and trade is an anti-growth proposal that will 
hurt American industries and American families more than it will help 
them.
    At a time when our country is struggling to come out of our longest 
and deepest economic downturn since the Great Depression, enacting a 
regressive energy tax is reckless and irresponsible.
    I thank the witnesses for appearing before the committee today and 
appreciate their comments. I look forward to continuing the 
conversation on this issue and discussing the entire scope of the cost 
of enacting climate change legislation.

        STATEMENT OF HON. LISA MURKOWSKI, U.S. SENATOR 
                          FROM ALASKA

    Senator Murkowski. Thank you, Mr. Chairman. I appreciate 
your scheduling this hearing. I hope this will be the first of 
many constructive discussions on the issue of climate change 
here in the committee.
    Effectively dealing with the issues that we're here to 
discuss, cost containment and price volatility in a cap and 
trade market, is clearly essential to any legislation that has 
a chance of passing. Chairman Bingaman, you have mentioned the 
importance of many of these factors last year. They played a 
significant role in the legislation that you mentioned that I 
had agreed to co-sponsor.
    But as we saw in the floor debate that followed it became 
clear that perhaps not everyone agreed with us. Provisions to 
contain costs and volatility were largely absent from the 
measure that was brought up, the Boxer/Lieberman/Warner bill. 
In my opinion, by failing to address those concerns the failure 
of that bill was all but guaranteed.
    Today it's become even more important to control the cost 
of climate legislation. We've got millions of Americans that 
are struggling to find work, to pay mortgages and getting 
through a rough economy. We must make sure that climate 
policies do not add to their burdens.
    I think it's disappointing, at least with the legislation 
that we saw coming out of the House of Representatives, that 
some in Congress have failed to learn this lesson from this 
summer. That's really about the only explanation that I have 
with the bill that passed the House, by seven votes on the 26th 
of June. Instead of lightening the load for Americans it asks 
Americans to shoulder more, oblivious to how difficult life may 
be for so many families.
    Let me list just a few of the impacts of the House bill, 
which are projected by the Energy Information Administration. 
This is again, on the House bill.
    By 2030, the House bill could cost as much as $1,870 per 
household.
    Raise diesel prices by 44 percent.
    Raise electricity prices by 77 percent.
    May reduce domestic employment by up to 2.3 million people.
    I appreciate that there are other numbers from other 
entities that put the impact at different levels. But I also 
understand why so many folks have written and called to express 
their opposition to the House bill. I think they have every 
reason to be nervous about the impact it may have to them and 
to their families.
    It would take money that many Americans don't have.
    Impose prices that many can't afford.
    Destroy the jobs that our country so desperately needs.
    In my opinion, the principle reason why estimates of the 
House bill's price tag are so high is that the sponsors did 
little to limit the costs and reduce market volatility. They 
relied, I think to an irresponsible degree, on international 
offsets that would give the appearance of cost containment. 
They utilized a strategic reserve concept that is flawed.
    The House bill strategic reserve provision allows for the 
introduction of additional allowances into the market if prices 
spike to 60 percent above the 3-year rolling average. While 
this may be marginally useful for blunting massive short term 
run ups in allowance prices. It doesn't do anything to contain 
sustained high prices. Furthermore the protections that kick in 
over a 3-year period will be of little use if allowance prices 
bring our economy to its knees in the first or second year of 
the program.
    Now these are specific issues, problems, contained within a 
very large, a massive bill, a 1,400 page bill. There are many 
other issues that must be addressed and debated. I'm happy that 
we'll be able to do so in an objective way here in this 
committee.
    We need to recognize that steps to contain costs and limit 
volatility will not be enough to fix the House bill. Those 
concerns are just the tip of the iceberg. There's far more and 
far larger problems that lurk beneath the surface.
    We must resolve these issues in a fair, transparent, and 
effective manner. For now they simply make clear that we have 
got a great deal of work ahead. A great amount of work needs to 
be done before climate legislation has a chance of passage in 
the Senate.
    As the climate debate continues I would encourage my 
colleagues to keep a couple things in mind.
    First, climate change is certainly an important issue and 
one that must be addressed. The people of our country and 
certainly in my State of Alaska, are feeling the impacts. I 
believe that those impacts will only worsen in the years ahead.
    Second, I think we need to avoid what has happened in the 
House. The Senate debate should be about more than who will 
receive free allowances or bonus allowances or exemptions. We 
need to consider all of our options in an even handed and 
thoughtful way. Our goal should be good policy, not politics.
    For now looking at ways to reduce the costs and price 
volatility that may result from climate change legislation is a 
good starting point. It's very clear that a policy as 
comprehensive as cap and trade could impose a tremendous burden 
on families, consumers and businesses, especially if it's not 
designed properly. So I view this hearing, Mr. Chairman, and 
those we have scheduled to be an essential part of the sound 
process that can result in sound policy decisions.
    I look forward to the testimony from the witnesses and the 
questions that we'll be able to ask.
    The Chairman. Thank you very much. Let me introduce the 
witnesses.
    First, Mr. Brent Yacobucci, who is a specialist in energy 
and environment policy with the Congressional Research Service. 
Mr. Yacobucci is going to make a short presentation about some 
of the different mechanisms that have been put forward or 
suggested as ways to deal with this problem; sort of give us a 
little short tutorial.
    Second will be Eileen Claussen, who is President of the Pew 
Center on Global Climate Change and has spent a lot of time on 
this issue.
    Dr. Michael Wara, who is a professor of law at Stanford Law 
School. Thank you for being here.
    Dr. Joseph Mason, who is a professor at Louisiana State 
University in Baton Rouge.
    Mr. Jason Grumet, who is a familiar witness to us here and 
was very helpful to us in our deliberations on this issue here 
for the last several Congresses.
    So Mr. Yacobucci, why don't you go ahead? If each of you 
could take about 6 minutes and give us a summary of the main 
points you think we need to understand. Then we will have 
questions.

    STATEMENT OF BRENT YACOBUCCI, SPECIALIST IN ENERGY AND 
      ENVIRONMENTAL POLICY, CONGRESSIONAL RESEARCH SERVICE

    Mr. Yacobucci. Good afternoon. My name is Brent Yacobucci. 
On behalf of the Congressional Research Service, I would like 
to thank the chair and ranking member for the invitation to 
testify here today.
    I've been asked by the committee to help frame the subject 
of the hearing first by describing some of the concepts that 
will be discussed. Second by relating those to H.R. 2454, the 
American Clean Energy and Security Act of 2009 as passed by the 
House of Representatives. I should note that CRS takes no 
position on legislation. In the interest of time I will forgo a 
discussion of the basic fundamentals of the cap and trade 
system.
    Under cap and trade the term cost containment has two 
components.
    First, mechanisms designed to limit or contain the overall 
cost of the program to a socially acceptable level.
    Second, mechanisms designed to limit short term volatility 
in the allowance market created by the system.
    While the two components are complementary, policies to 
achieve them may differ and may even conflict. A critical 
policy decision is whether the maintenance of the program's 
overall cap is paramount or whether there are conditions under 
which policy concerns may require a relaxation of the cap. 
Shifting allowances across time is a key technique to limit 
short term volatility while maintaining the cap.
    Mechanisms to achieve this time shifting include banking, 
borrowing, multiyear compliance periods and a strategic 
allowance reserve auction. H.R. 2454 includes all four to some 
degree. Banking of allowances is unlimited while the bill 
allows entities with free allocations to borrow allowances from 
the coming year. However the bill places a substantial rate of 
borrowing beyond that first year.
    H.R. 2454 also contains a strategic allowance reserve. 
Under this mechanism a portion of emissions allowances from 
each year is placed in a reserve. These allowances are then 
available to covered entities at a minimum reserve price. A 
price set considerably higher than the average allowance price.
    With a strategic reserve firms have the option of tapping 
into an emergency supply of allowances. However this supply is 
limited as the reserve is created by shifting emissions 
allowances from later years. The effect on volatility would 
depend on the size of the reserve, demand for the allowances 
and the trigger price.
    It should be noted that there is uncertainty on how 
effectively time shifting will work. Many studies suggest that 
it should have some mitigating effect. But data from existing 
programs have not fully validated the effectiveness of the 
primary mechanism, banking.
    On the other side of the coin attempting to prevent 
volatility at the lower limit of allowance prices have 
generally involved setting a reserve price for any allowance 
auctions. The bill's quarterly allowance auctions contain such 
a reserve price. So far the techniques I've discussed are aimed 
at limiting volatility, not long run costs of the program.
    A key technique for limiting the overall cost to the 
program is to effectively expand the supply of allowances 
through the use of offsets. H.R. 2454 allows a generous offset 
supply, up to one billion tons each, of domestic and 
international offsets every year. Further expanding the offset 
supply would likely lower long term costs.
    According to the Congressional Budget Office doubling the 
supply of international offsets allowed under the bill lowers 
allowance prices by 30 percent or more. Conversely most studies 
of H.R. 2454 find that eliminating international offsets raises 
the price of allowances by more than half. H.R. 2454's offset 
supply is fixed.
    Another alternative would be to establish a flexible offset 
supply like that established by the regional greenhouse gas 
initiative. Under this mechanism the availability of offsets 
expands as the allowance price increases effectively increasing 
allowance supply. Whether this approach would work under H.R. 
2454 is unclear as its offset limits are already quite generous 
and indeed some analyses of the bill suggest that the limits 
may never be met.
    If one decides that there are conditions where the 
reduction requirement should be modified possible mechanisms 
generally include an alternative means of compliance or a 
suspension of the cap under certain conditions. The former, 
commonly called a safety valve, essentially allows covered 
entities to make a cash payment in lieu of submitting 
allowances. If the allowance price is above the safety valve 
price entities would find it cost effective to make the 
alternative payment rather than by allowances on the market, 
thus a ceiling is placed on allowance prices.
    While H.R. 2454's cap and trade program does not contain 
such a safety valve, its renewable electricity standard does. 
In lieu of meeting the RES requirement retail electricity 
suppliers may submit a payment to their State which the State 
then uses to encourage renewable energy development. Such an 
approach could be used for the cap and trade program as well 
where any safety valve payments could be used to purchase 
additional offsets or to do develop new, low carbon energy 
technology.
    Arguably the most comprehensive cost containment scheme 
would be a price collar that combined a reserve price auction 
to help establish a price floor with a safety valve to set a 
price ceiling. Such a price collar might operate to cutoff the 
peaks and valleys of the allowance price curve. Developing a 
cost containment scheme to address overall costs and short term 
allowance price volatility will require consensus on acceptable 
costs, acceptable volatility and acceptable environmental 
protection. A key policy decision is whether the cap must be 
maintained at all times or if policies may allow emissions to 
exceed the cap under certain conditions.
    Thank you for inviting me to appear. I will be pleased to 
address any questions you may have.
    [The prepared statement of Mr. Yacobucci follows:]

    prepared statement of brent yacobucci, specialist in energy and 
          environmental policy, congressional research service
    Good afternoon Chairman, Ranking Member, and Members of the 
Committee. My name is Brent Yacobucci. On behalf of the Congressional 
Research Service (CRS), I would like to thank the Committee for its 
invitation to testify here today. I have been asked by the Committee to 
help frame the subject of the hearing, first by providing an 
explanation for some of the terms and concepts that will be discussed, 
and second by relating those to H.R. 2454, the American Clean Energy 
and Security Act of 2009, as passed by the House of Representatives on 
June 26, 2009. I should note that CRS takes no position on this or any 
other legislation. In the interest of time I will forego a discussion 
of the basic fundamentals of a cap-and-trade system to limit emissions.
    In a cap-and-trade system, the term ``cost containment'' has two 
components (as suggested by the title of the hearing). The first 
involves mechanisms designed to limit or contain the potential cost of 
the program to a socially acceptable level. The second involves 
mechanisms designed to prevent or dampen potential short-term 
volatility in the allowance market created by the system. While the two 
components of cost containment are complimentary, the mechanisms 
involved in achieving them may differ and even conflict.
    A critical policy decision that one is faced with in determining 
any appropriate cost containment mechanism is whether maintenance of 
the program's overall cap is paramount, or whether there are conditions 
under which economic or energy policy concerns may mandate a change in 
the reduction system (at least temporarily). One may decide the cap 
must be maintained at any economic cost for a variety of reasons, 
including the need to send a consistent signal to the allowance market, 
a consistent signal to innovators of new technology, and to achieve the 
tonnage mandated. Likewise, a variety of economic and energy policy 
reasons can be posited for allowing those concerns to trump the cap in 
specific situations, including economic disruption, timetable to deploy 
emerging technology, and unforeseen international events.
            limiting upward price volatility--time shifting
    Shifting allowances across time is a key technique for maintaining 
the cap within any cost containment mechanism designed to prevent or 
dampen short-term volatility in the allowance market. Mechanisms to 
achieve this time-shifting include banking, borrowing, multi-year 
compliance periods, and a strategic allowance reserve auction 
(effectively a form of emergency borrowing). H.R. 2454 includes all 
four to some degree. Banking of allowances under H.R. 2454 is 
unlimited. Borrowing from future allocations of allowances under H.R. 
2454 is free for the first year (effectively creating a two-year 
compliance period for those entities receiving allowance allocations), 
but places a substantial rate on borrowing beyond that first year.
    H.R. 2454 also contains a strategic allowance reserve. Under this 
mechanism, a portion of emissions allowances from each year is placed 
in a reserve. These allowances are then available to covered entities 
at a minimum reserve price--a price set considerably higher than the 
average allowance price projected under H.R. 2454. With a strategic 
reserve, firms have the option of tapping into an emergency supply of 
allowances. However, this supply is limited, as the reserve was created 
by shifting emission allowances from later years. The effect on 
mitigating price volatility would depend on the size of the reserve, 
demand for the allowances, and the trigger price.
    It should be noted that there is uncertainty on how effectively 
these mechanisms will work. Many studies have been conducted on them 
(particularly on banking) suggesting that they should have some 
mitigating effect. However, data from existing programs have not fully 
validated the effectiveness of the primary mechanism-banking.
              limiting downward volatility--reserve prices
    On the other side of the coin, attempting to prevent volatility at 
the lower limit of allowance prices while maintaining the cap has 
generally involved setting a reserve price for any allowance auctions. 
H.R. 2454's quarterly allowance auctions contain such a reserve price: 
$10 in 2012 (2009$), rising at 5% (in real terms) annually thereafter.
      long-run cost control under the cap--expanded offset supply
    So far, the techniques I have discussed are aimed at limiting 
volatility, not long-run costs of the program. A key technique for 
limiting the overall cost of the program is to effectively expand the 
supply of allowances through the use of offsets--reductions made by 
entities not covered by the cap. H.R. 2454 allows a very generous 
offset supply, up to 1 billion tons of domestic and one billion tons of 
international offsets each year. Further expanding offset supply would 
likely lower long-term costs. According to the Congressional Budget 
Office, doubling the supply of international offsets allowed under the 
bill lowers allowance prices by 30% or more. Conversely, most studies 
of H.R. 2454 find that eliminating international offsets raises the 
price of allowances by more than half.
    H.R. 2454's offset supply is fixed. Another alternative would be to 
establish a flexible offset supply like that established by the 
Regional Greenhouse Gas Initiative. Under this mechanism the 
availability of offsets expands as the allowance price increases, 
effectively increasing allowance supply. Whether this approach would 
work under H.R. 2454 is unclear as its offset limits are already quite 
generous, and indeed, some analyses of H.R. 2454 suggest that the 
limits may never be met.
  alternative compliance outside of the cap--safety valves and price 
                                collars
    If one decides that there are conditions where the reduction 
requirement should be modified, the mechanisms involved generally 
incorporate an alternative means of compliance, or suspension of the 
reduction requirement at a specific trigger price. The former, commonly 
called a safety valve, essentially allows covered entities to make a 
cash payment in lieu of submitting allowances. If the allowance price 
is above the safety valve price, entities would find it cost-effective 
to make the alternative payment rather than buy allowances on the 
market. Thus, a ceiling is placed on allowance costs.
    While H.R. 2454's cap-and-trade program does not contain such a 
safety valve, its renewable electricity standard does. In lieu of 
meeting the RES requirement, retail electricity suppliers may submit a 
payment to their state, which the state then uses to encourage 
renewable energy development. Such an approach could be used for the 
cap-and-trade program where any safety valve payments could be used to 
purchase offsets or to develop new low-carbon energy technologies.
    As suggested earlier, combinations of these mechanisms are 
possible. Outside of a carbon tax (which would be the ultimate form of 
cost containment) arguably the most comprehensive cost containment 
scheme would be a price collar that combined a reserve price auction to 
help establish a price floor, with a safety valve to set a price 
ceiling. The attached figure* shows how such a price collar might 
operate to cut off the peaks and valleys of the allowance price curve. 
However, developing a cost-containment scheme to address overall costs 
and short-term allowance price volatility will require consensus on 
acceptable costs, acceptable volatility, and acceptable environmental 
protection.
---------------------------------------------------------------------------
    * Graphic has been retained in committee files.
---------------------------------------------------------------------------
                               conclusion
    To conclude, cost containment in a cap-and-trade system generally 
implies one of two things, either limiting volatility in allowance 
markets, or limiting the overall cost of the program over its life. 
Different policy tools may be needed to address these two objectives. 
Further, cost control options can either maintain overall emissions at 
or below the cap or limit costs by allowing emissions to rise above the 
level of the cap.
    Thank you for inviting me to appear. I will be pleased to address 
any questions you may have.

    The Chairman. Thank you very much.
    Ms. Claussen, please go right ahead.

 STATEMENT OF EILEEN CLAUSSEN, PRESIDENT, PEW CENTER ON GLOBAL 
                 CLIMATE CHANGE, ARLINGTON, VA

    Ms. Claussen. Mr. Chairman, Senator Murkowski, members of 
the committee, thank you for the opportunity to testify here 
today. My name is Eileen Claussen. I'm the President of the Pew 
Center on Global Climate Change. We are founding members of the 
U.S. Climate Action Partnership, a coalition of 25 leading 
businesses and five environmental organizations that have come 
together to call on the Federal Government to quickly enact 
strong national legislation to require significant reductions 
of greenhouse gas emissions.
    Let me start by thanking you, Mr. Chairman, not only for 
holding this hearing, but for your years of leadership on the 
climate issue and in particular on the issue of cost 
containment. I hope that you will see in the work of the Pew 
Center and USCAP, an effort to build on your leadership in a 
positive way. The Pew Center has long supported enactment of an 
economy wide, greenhouse gas cap and trade bill as a primary 
measure for reducing U.S. greenhouse gas emissions.
    A cap and trade program provides an excellent division of 
responsibilities. Government establishes the public policy 
objective to reduce emissions by a certain amount in a given 
year. Businesses decide how to meet the objective as cost 
effectively as possible.
    The Pew Center believes, as does USCAP that the most 
powerful way to contain costs is a robust cap and trade 
program. Cap and trade minimizes cost because it provides 
industry the flexibility to reduce emissions at the lowest 
possible cost. It also provides a powerful incentive for 
industry to invent and commercialize the innovative clean 
energy technologies that will help us to achieve our climate 
protection goals.
    That said. There are legitimate concerns that greenhouse 
gas allowance prices may either get too low or too high or be 
excessively volatile. Let me talk in particular about the 
second and third concerns.
    We know from a wide range of economic analyses that two 
factors are critical to avoid excessively high prices, the 
availability of offsets and the availability of low carbon 
technologies including carbon capture and storage and nuclear 
power. Recent economic modeling by the EIA suggests that 
barring the use of international offsets in a cap and trade 
program would increase allowance prices by 65 percent. We would 
recommend being restrictive on the quality of offsets while 
being liberal on quantity.
    We want to make sure that offsets meet or exceed standards 
for what qualifies while at the same time ensuring that there 
are adequate quantities available to support lower allowance 
prices. The potential for cost reductions is especially large 
from international offsets where there are huge opportunities 
for achieving low cost emission reductions while assisting poor 
countries to develop in more sustainable ways. We would 
recommend that agencies start now even in advance of 
legislation to lay the ground work for an effective offset 
program.
    Economic modeling studies show that the availability of key 
technologies such as CCS and nuclear power also play an 
important role in reducing the costs of climate protection. For 
example, EIA's modeling projects that when critical technology 
is not available, compliance costs could be 10 percent higher. 
We recommend combining a cap and trade program with increased 
funding and incentives for technology research development and 
deployment since the price signal for a cap and trade program 
alone may not be adequate to drive the low carbon innovation 
that we need.
    To avoid excessive allowance price volatility we recommend 
that Congress provide as much ``when'' flexibility as possible 
in the cap and trade program. The legislation should allow 
banking of offsets and allowances, along with a multiyear 
compliance period and multiyear allocations. It is clear from 
past cap and trade programs that banking and multiyear 
compliance periods are extremely effective tools for smoothing 
out price fluctuations.
    However we must also understand that some price 
fluctuations are inevitable and under some circumstances even 
desirable. For example, one particular advantage of a cap and 
trade over a tax is that if the overall economy turns down so 
will allowance prices. Reducing the economic costs of 
compliance under a tax regime further government intervention 
would be required to make similar adjustments.
    If allowance prices spike to a high level and stay there 
one obvious response would be simply to make additional 
allowances available thus bringing down the price. The 
fundamental issue is how to do this without breaking the cap on 
greenhouse gas emissions and therefore undermining the 
environmental integrity of the program. USCAP recommends an 
approach that meets both of these objectives.
    It makes additional allowances available to drive down 
excessive prices but does so by creating a pool of allowances 
that does not break the long term cap. This would be done by 
creating a strategic reserve pool that would be filled with a 
combination of offsets and allowances borrowed from future 
years. Both of which would ensure that the integrity of the cap 
is maintained over time.
    I want to stress that the strategic reserve would perform 
much the same function as a price cap, but without undermining 
the environmental integrity of the program. It would provide 
additional supply into the market to reduce allowance prices, 
increase certainty about market price, function automatically 
by means of regularly scheduled auctions and be adjusted to 
accommodate economic conditions. Neither a price cap nor a 
strategic reserve would provide perfect cost certainty. But 
with the strategic reserve the environmental outcome would be 
much more assured.
    Climate legislation is critical to both our future economic 
prosperity and our environmental well being. I am convinced 
that if we draw from experience to enact measures that reward 
innovation and limit costs, we will provide once again, that no 
challenge is beyond our reach. Thank you very much.
    [The prepared statement of Ms. Claussen follows:]

Prepared Statement of Eileen Claussen, President, Pew Center on Global 
                     Climate Change, Arlington, VA
    Mr. Chairman, Sen. Murkowski, Members of the Committee, thank you 
for the opportunity to testify on how we can best design climate 
legislation to contain costs and minimize greenhouse gas allowance 
price volatility. My name is Eileen Claussen, and I am the President of 
the Pew Center on Global Climate Change.
    The Pew Center on Global Climate Change is an independent non-
profit, non-partisan organization dedicated to advancing practical and 
effective solutions and policies to address global climate change. Our 
work is informed by our Business Environmental Leadership Council 
(BELC), a group of 44 major companies, most in the Fortune 500, that 
work with the Center to educate opinion leaders on climate change 
risks, challenges, and solutions. The Pew Center is also a founding 
member of the U. S. Climate Action Partnership (USCAP), a coalition of 
25 leading businesses and five environmental organizations that have 
come together to call on the federal government to quickly enact strong 
national legislation to require significant reductions of greenhouse 
gas (GHG) emissions.
    The Pew Center has long supported enactment of an economy-wide GHG 
cap-and-trade bill as a primary measure for reducing U.S. GHG 
emissions. A cap-and-trade program provides an excellent division of 
responsibilities: Government establishes the public policy objective--
to reduce emissions by a certain amount in a given year--and businesses 
decide how to meet that objective as cost effectively as possible. The 
Pew Center believes, as does USCAP, that the most powerful way to 
contain costs is a robust cap-and-trade program. It is clear from 
economic theory, from our experience with the U.S. acid rain program, 
and from a vast body of economic modeling analysis, that cap-and-trade 
will dramatically reduce the costs of reducing GHG emissions compared 
to traditional command-and-control regulatory approaches. Cap-and-trade 
minimizes cost because it provides industry the flexibility to reduce 
emissions at the lowest possible cost. It also provides a powerful 
incentive for industry to invent and commercialize the innovative clean 
energy technologies that will help us to achieve our climate protection 
goals.
    That said, there are legitimate concerns that GHG allowance prices 
may get either too low or too high, or be excessively volatile. Too low 
a price could undermine long-term investments critical to moving to 
clean energy economy. Too high a price could cause economic harm. Too 
volatile a price could create risk and uncertainty for businesses.
    Let us talk about each of these problems in turn.
                    avoiding excessively low prices
    While we would all like to keep the costs of reducing GHG emissions 
low, allowance prices that fall too low would discourage long-term 
capital investments in critical new clean energy technologies. In order 
to keep prices from going too low, we believe Congress should establish 
a minimum reserve price for the auction of allowances. We believe the 
reserve price that could accomplish this policy objective is 
approximately $10 per ton at the outset of the program. This price 
should escalate over time at a rate greater than inflation and then 
flatten out, for example, by 2025. The reserve price should be reviewed 
over time to determine whether it should be adjusted, stay the same, or 
be phased out by the program's administrator.
                    avoiding excessively high prices
    We know from a wide range of economic analyses that two factors are 
critical to avoid excessively high prices--the availability of 
significant quantities of domestic and international offsets and the 
availability of clean technologies, including carbon capture and 
storage (CCS) and nuclear power.
1. The Critical Role of Offsets
    Recent economic modeling by the Energy Information Administration 
(EIA) suggests that barring the use of international offsets in a cap-
and-trade program would increase allowance prices by 65 percent. 
(Modeling by the Environmental Protection Agency (EPA) similarly 
projects a price increase of 89 percent without international offsets.) 
These results are fully consistent with modeling being done by other 
organizations. Restricting offsets would lead to higher allowance 
prices and larger impacts on the overall economy.
    We would recommend being restrictive on the quality of offsets, 
while being liberal on quantity. We want to make sure that offsets meet 
or exceed standards for what qualifies, while at the same time ensuring 
that there are adequate quantities available to support lower allowance 
prices. The potential for cost reductions is especially large from 
international offsets, where there are huge opportunities for achieving 
low-cost emission reductions while assisting poor countries to develop 
in more sustainable ways.
    To be an effective cost containment measure and an effective 
environmental policy tool, however, safeguards must be in place to 
ensure that all such reductions are environmentally additional, 
verifiable, permanent, measurable, and enforceable. We recommend the 
following:

   The offset program administrator (which could be, for 
        example, the EPA, the U.S. Department of Agriculture (USDA), or 
        a joint effort of the two agencies) should be directed to 
        establish an offset program using a standards-based approach 
        within 18 months of enactment. Under a standards-based 
        approach, rules should identify specific categories of offsets 
        that are eligible to qualify, along with clear procedures to 
        achieve certification, and clear guidance to offset providers 
        about how they can meet the standards. The eligible categories 
        of offsets should be added to or modified over time based on 
        experience, and standards should be periodically updated to 
        ensure environmental integrity.
   The program administrator(s) should be directed to establish 
        a transparent process for evaluating and approving high-quality 
        international offsets. These offsets would be approved during 
        the early years of the program, with a schedule to assure that 
        over time developing countries are encouraged to move as 
        rapidly as possible to curb their emissions through national or 
        sector emission reduction commitments, while ensuring that the 
        overall quantities of offsets and international allowances are 
        adequate for cost containment.

    We recommend the following approach for managing the amount of 
offsets used:

   Set an overall upper level limit on the use of offsets for 
        compliance in any year of 1.5 billion metric tons domestic and 
        1.5 billion metric tons international offsets and specifying 
        that initially 2 billion metric tons of offsets in total would 
        be allowed.
   Allow the program administer (e.g., EPA, USDA or a Carbon 
        Market Board) to increase the upper limit of offsets to 3 
        billion metric tons per year, should additional cost 
        containment be needed. In making this adjustment to the annual 
        offset limit, the program administrator should take into 
        account the number of banked offsets in the private sector, the 
        degree to which the criteria for offset quality described above 
        have been effectively implemented, the potential supply of 
        offsets in the market and the size of the ``strategic reserve 
        pool'' described later in this testimony.

    While there is an inherent tension between striving to ensure 
adequate offset availability and offset quality, we believe it is in 
the best interest of all parties to ensure that a balance is reached. 
This balance will be easier to achieve if agencies start now--even in 
advance of legislation--to begin laying the groundwork for a GHG offset 
program. Early efforts of agency personnel could include assessing 
existing protocols and existing offset programs, starting work on new 
protocols, and identifying experts for advisory roles. With respect to 
international offsets, our international agencies could begin to work 
with developing countries to improve their emission inventories, 
develop forestry plans and generally engage in reforms currently being 
discussed within the existing international offset mechanisms (i.e., 
the Kyoto Protocol's Clean Development Mechanism (CDM) and Joint 
Implementation (JI) programs).
    Some have criticized these existing international offset 
mechanisms, especially CDM, and without a doubt, there has been and is 
room for improvement. Work is now underway to fix many of the problems 
that have been identified, including streamlining the very bureaucratic 
(and, some would argue, overly rigorous) process. We believe, for 
example, that movement by the CDM's Executive Board toward more 
standardized protocols and a more efficient project review process are 
good steps forward. U.S. engagement could only make this tool better 
and more efficient.
2. Accelerating Technology Development
    Economic modeling studies also show that the timely availability 
and reasonable costs of key technologies, such as CCS and nuclear 
power, play an important role in determining the costs of climate 
protection. For example, EIA's modeling projects that when critical 
technology is not available, compliance costs could be 10 percent 
higher. EPA's modeling shows that when the use of nuclear power is 
constrained, compliance costs increase by 15 percent. Both demonstrate 
the need to accelerate technological innovation. We recommend doing 
this by combining a cap-and-trade program with increased funding and 
incentives for research, development and deployment (RD&D), since the 
price signal from a cap-and-trade program alone may not be adequate to 
drive the low-carbon innovation that we need. Numerous studies indicate 
that a combination of ``market push'' (such as RD&D) and ``market 
pull'' (such as capand-trade) are much more cost-effective in tandem 
than they are by themselves. For example, a Pew Center study written by 
Dr. Lawrence H. Goulder of Stanford University finds that it can be up 
to 10 times cheaper to push and pull technology in tandem than relying 
on either push or pull by itself. We strongly recommend measures to 
support development and deployment of CCS technology and clean vehicle 
technologies, to facilitate expansion of nuclear power and renewable 
technologies, and to create a new energy technology deployment 
administration.
                       avoiding price volatility
    To avoid excessive allowance price volatility, we recommend that 
Congress provide as much ``when'' flexibility as possible in the cap-
and-trade program. The legislation should allow banking of offsets and 
allowances, along with a multi-year compliance period and multi-year 
allocations. It is clear from past cap-and-trade programs that banking 
and multi-year compliance periods are extremely effective tools for 
smoothing out price fluctuations. Banking allows firms the ability to 
save their offsets and allowances for future use. It also promotes 
near-term reductions as firms seek to do more so they can save their 
allowances for a day when prices might be higher. The absence of 
banking between the initial ``learning phase'' of the EU's Emissions 
Trading Program (2005--2007) and the current five year phase was one of 
the main reasons the EU allowance prices crashed as the learning period 
came to a close at the end of 2007. While this limit on banking between 
the two periods was intended to keep problems from the learning phase 
from spilling over into the current phase, it also clearly illustrated 
how not having banking can impact the price of allowances. Notably, 
today, the EU program does allow banking between the current phase and 
the next.
    The EU also has effective multi-year compliance, as does the 
Regional Greenhouse Gas Initiative (RGGI) trading program that has been 
established by ten northeastern U.S. states. Giving firms a compliance 
obligation that covers more than one year at a time means that firms do 
not have to turn in their allowances and offsets yearly. The EU 
essentially has a two year compliance window, while RGGI has a three 
year window. Multi-year compliance adds ``when'' flexibility, which in-
turn can help control price volatility.
    With regard to multi-year allocation, EPA in the Acid Rain Program 
allocated 30 years worth of allowances at the beginning of the program. 
I do not believe that we need to allocate allowances that far into the 
future at the beginning of a climate program, but we certainly need to 
allocate enough (maybe 5 or 10 years worth) to provide sufficient 
market liquidity. Markets just getting started tend to have a more 
price volatility, in part because people are uncertain about whether 
there is going to be adequate liquidity (supply and demand) in the 
market. Having more allowances in circulation, even if they cannot be 
used for compliance before their vintage year, will help provide market 
liquidity, increase certainty and dampen price volatility.
    We must, however, also understand that some price fluctuations are 
inevitable and, under some circumstances, even desirable. Changes in 
allowance prices would result from changes in supply and demand for 
allowances, which in turn could be affected by how fast or slow the 
economy grows, by shifts in the relative prices of fuels, and even by 
short-term fluctuations in the weather. One particular advantage of a 
cap-and-trade over a tax is that if the overall economy turns down, so 
will allowance prices, reducing the economic costs of compliance. Under 
a tax regime, further government intervention would be required to make 
similar adjustments.
                    insurance against higher prices
    The smart design of a domestic cap-and-trade regime, including the 
mechanisms described above (offsets, banking, multi-year compliance and 
multi-year allocation), along with proper incentives to spur 
technological change, should go a long way to minimizing the economic 
costs of climate protection. Nonetheless, given the uncertainties that 
remain (rate and costs of new technologies, availability of offsets, 
the extent that increased energy efficiency can be mobilized), and 
especially given the large role energy plays in our economy, it is also 
critical to include additional safeguards to insure that GHG allowance 
prices will not be excessively high.
    If allowance prices spike to a high level and stay there, one 
obvious response would be simply to make additional allowances 
available, thus bringing down the price. The fundamental issue is how 
to do this without breaking the cap on GHG emissions and therefore 
undermining the environmental integrity of the program. USCAP 
recommends an approach that meets both of these objectives--it makes 
additional allowances available to drive down excessive prices, but 
does so by creating a pool of allowances that does not break the long-
term cap. This would be done by creating a ``strategic reserve pool'' 
that would be filled with a combination of offsets and allowances 
borrowed from future years, both of which would insure that the 
integrity of the cap is maintained over time.
    The offsets in the pool would include both domestic and 
international offsets that meet high quality standards and would be 
certified by the U.S. government. We would envision that the pool would 
also include ``forest carbon tons,'' offsets generated from avoided 
tropical deforestation. The allowances in the pool would be borrowed by 
the program administrator from future compliance periods. If the 
borrowed allowances were not used, the emissions cap over time would 
stay fixed; if they were used, future emission reduction targets would 
be made more stringent.
    To serve as an insurance mechanism against sustained high prices, 
offsets and allowances in the strategic reserve pool would be released 
into the market when allowance prices exceed a specific threshold 
price. This threshold price should be set at a level that is low enough 
to prevent undue economic harm from excessively high allowance prices 
but that is high enough to encourage technology transformation, 
including the deployment of CCS and nuclear power. Figure 1* 
illustrates how the strategic reserve would essentially bend the 
emissions cap over time, even while it maintains the program's 
environmental objectives.
---------------------------------------------------------------------------
    * Graph has been retained in committee files.
---------------------------------------------------------------------------
    The USCAP Blueprint recommends that a Carbon Market Board decide 
the threshold price, but USCAP is currently discussing the possibility 
of recommending a specified threshold price in the legislation, 
instead. The Blueprint also contains details on how the offsets and 
allowances would be brought into the strategic reserve, how the 
strategic reserve would be replenished, what rules would be established 
for auctioning off strategic reserve allowances, and what role a 
program administrator, like the Carbon Market Board, could play. 
Business as Usual Emissions The green line indicates the emissions 
goals of the program. The orange line shows how borrowing allowances 
from future years to fill the strategic reserve--if needed to dampen 
high allowance prices--bends the emissions trajectory but does not 
change the cumulative amount of emissions allowed under the cap.
    I want to stress that the strategic reserve would perform much the 
same function as a price cap (also sometimes called a ``safety 
valve''), but without undermining the environmental integrity of the 
program. It would provide additional supply into the market to reduce 
allowance prices; increase certainty about market price; function 
automatically by means of regularly scheduled auctions; and be adjusted 
to accommodate economic conditions. Neither a price cap nor a strategic 
reserve would provide perfect cost certainty, but with the strategic 
reserve the environmental outcome would be assured.
                               conclusion
    Climate legislation is critical to both our future economic 
prosperity and our environmental well-being. I am convinced that if we 
draw from experience to enact measures that reward innovation and limit 
costs, we will prove once again that no challenge is beyond our reach.
    Thank you. I look forward to your questions.

    The Chairman. Thank you very much.
    Dr. Wara, go right ahead.

 STATEMENT OF MICHAEL WARA, ASSISTANT PROFESSOR, STANFORD LAW 
   SCHOOL, FACULTY FELLOW, PROGRAM ON ENERGY AND SUSTAINABLE 
      DEVELOPMENT, CENTER FELLOW, WOODS INSTITUTE FOR THE 
                   ENVIRONMENT, PALO ALTO, CA

    Mr. Wara. Thank you very much, Senator Bingaman and Senator 
Murkowski and other members of the committee for inviting me to 
testify today. My name is Michael Wara. I'm an Assistant 
Professor at Stanford Law School. My research focuses on 
existing emissions trading markets, especially the largest 
offset market in existence today, the Clean Development 
Mechanism.
    In my written testimony today I hope to drive home two key 
conclusions.
    Offsets have not and most likely cannot provide both 
effective cost control and environmental integrity.
    Second, a price collar can provide superior cost control 
that is both effective, transparent and importantly, easily 
administrable while at the same time essentially providing many 
of the benefits to uncapped sectors that offsets provide.
    I think a key concern when contemplating climate 
legislation, especially legislation that conceives a time table 
out to 2050, is ensuring that we enact a durable program. My 
belief is that a safety valve or price collar can provide a 
much more durable program than offsets. Experience with the 
largest existing carbon offset program in the world, the Clean 
Development Mechanism, or CDM, suggests that environmental 
integrity while possible in theory is very difficult to achieve 
in practice, even with the best intentioned and well resourced 
regulators.
    The key problem at the heart of all offset programs, 
including the CDM and a future offset program under the 
American Clean Energy and Security Act is operationalizing the 
determination of what's called in offset jargon, the emissions 
baseline. Essentially what would have happened in the absence 
of the incentive created by a carbon offset market. In practice 
the CDM has been unable to accomplish this objective in a cost 
effective way or at in large enough quantity to produce a 
reliable supply of offsets.
    This is especially true. This problem is especially 
difficult to resolve in heavily regulated sectors of the 
economy such as the energy sector in China, a place where my 
research is focused or within the United States potentially in 
the forestry sector, a portion of the economy that is heavily 
regulated by other environmental laws. In addition the CDM has 
illustrated despite good intentions and a focus on 
environmental integrity it's very difficult to produce a large 
supply of credits. Large enough in this case to supply 
effective cost control for governments that are seeking to 
comply the Kyoto Protocol and perhaps more relevantly, for the 
EU emissions trading scheme which is a large, not economy wide, 
but covers a substantial fraction of the European Union's 
economy especially the electricity sector and heavy industry.
    This is important as we think about an ACES or ACES like 
bill because the offset markets contemplated by that bill would 
have to be 20 to 50 times larger than the Clean Development 
Mechanism while at the same time requiring greater 
environmental integrity. To the credit of the House, there are 
significant important provisions in the bill that would 
strengthen the environmental integrity of the offset program 
created under ACES relative to the CDM. ACES is extraordinarily 
dependent on offsets. It's more or less four times as many 
offsets are allowed under ACES as are allowed under the EU 
emissions trading currently.
    That translates into according to EPA modeling, that more 
than half of the reductions prior to 2030 derived from a system 
come from offsets rather than from emissions reductions by what 
are called covered entities or sectors covered by the cap. As 
has been mentioned earlier prices increase in the allowance 
market nearly two fold. If has occurred under the CDM offset 
supply is limited.
    More importantly real offsets, offsets that are actually an 
offset system that's actually implemented in the real world 
places in significant doubt the promised theoretical benefit of 
an offset system. That is to have your cake and eat it too. 
Have cost control on the impact to the U.S. economy and also 
certainty as to the quantity. Because we don't know, because we 
don't have in practice a very difficult time even with the best 
intentions and with the best resources in determining what 
would or would not have happened anyway under an offset system 
quantity certainty is placed in significant doubt.
    A price collar or symmetric safety valve sets, as has been 
described, a firm price, both a minimum and a maximum price for 
allowances. It provides superior cost certainty on both the 
high end for firm space and compliance and importantly the low 
end for firms that seek to innovate and supply new technologies 
to the market. Funds raised from a safety valve could be used 
to accomplish many of the environmental benefits of an offset 
system.
    That is they could be used to fund reductions in uncapped 
sectors. That might actually create substantial benefits for 
uncapped sectors in that a fund approach to those emissions 
reductions would create greater flexibility in terms of how 
emissions reductions are created and accomplished domestically 
for Ag and forestry. Also internationally allow that fund to 
access key strategies such as energy efficiency in buildings, 
appliances and heavy industry that are difficult to monetize by 
a carbon offset market.
    So in conclusion, I would urge the committee to consider a 
price collar alongside or instead of offsets as a cost 
containment strategy in implementing an effective and cost and 
durable U.S. climate policy. Thank you.
    [The prepared statement of Mr. Wara follows:]

 Prepared Statement of Michael Wara, Assistant Professor, Stanford Law 
School, Faculty Fellow, Program on Energy and Sustainable Development, 
   Center Fellow, Woods Institute for the Environment, Palo Alto, CA
                      1. introduction and summary
    Mr. Chairman and members of the committee, I am honored to appear 
before you to testify on the potential role of carbon offsets as a cost 
containment mechanism for a US greenhouse gas emissions trading market. 
Overall, I believe that offsets hold limited promise, both as a cost 
control mechanism and as a method for reducing emissions beyond the 
sectors covered by a cap-and-trade scheme. Alternative cost-containment 
measures, such as a symmetric safety valve with revenues dedicated to a 
climate trust fund, are more likely to supply many of the hoped for 
benefits of with fewer of the risks associated with their use. This is 
especially likely to be the case for the cap and trade system proposed 
in Title III of the American Clean Energy and Security Act of 2009 
(ACES)\1\. The ACES's cap and trade system depends very heavily on the 
provision of unprecedented numbers of offsets from both domestic and 
international programs for cost containment ,while at the same time 
requiring that these systems meet exacting environmental standards. My 
research focuses on the implementation and function of the only 
existing compliance grade carbon offset market, the Kyoto Protocol's 
Clean Development Mechanism (CDM). Detailed analysis of this large and 
growing carbon offset market suggests that these twin objectives for an 
ACES offset market, of copious offset supply and high environmental 
integrity, are likely to be fundamentally incompatible.
---------------------------------------------------------------------------
    \1\ The American Clean Energy and Security Act, H.R. 2454, 111th 
Cong. (2009).
---------------------------------------------------------------------------
    In this testimony, I will address several key lessons learned from 
the international experience with carbon offsets under the Kyoto 
Protocol so far. I will then describe the relevance of these lessons to 
the offsets program contemplated by ACES. Finally, I will describe an 
alternative cost-containment mechanism, a symmetric safety valve or 
price collar, combined with a climate trust fund. Based on experience 
with carbon offsets so far, a price-collar is likely to provide far 
more reliable cost-containment than carbon offsets. I conclude the 
following:

          (1) There has been and will continue to be substantial 
        crediting of businessasusual behavior within the CDM. This is 
        particularly true for sectors such as electricity generation 
        that are highly regulated by developing country governments. 
        This crediting of counterfeit emissions reductions is likely to 
        be a hallmark of any real offset program. The crux of the 
        problem is the inability in practice to tell which of the many 
        applicants for carbon offsets are telling a genuine story 
        regarding emissions reductions and which would have installed 
        cleaner technology even in the absence of the carbon market.
          (2) The CDM has yet to perform as a reliable costcontainment 
        strategy. Actual issuance of offsets has been far lower than 
        predicted because of concerns about environmental integrity. 
        These concerns have led of necessity to an elaborate and time 
        consuming regulatory process. The impact of this failure to 
        produce offsets has been largely hidden by the reduction in 
        demand for permits due to the global recession.
          (3) Realworld implementation of an offset market of the scale 
        contemplated by ACES could not avoid the CDM's pitfalls. ACES 
        as passed requires an offset market and regulatory structure of 
        between 10 and 50 times the size of the current CDM. While 
        there are process efficiencies that a US system could realize, 
        the potential for crediting business-as-usual behavior, for 
        uncertain offset supply, or both, is substantial. In practice 
        as opposed to theory, both effective cost control and certainty 
        as to emissions levels are impossible to achieve under such a 
        system.
          (4) A symmetric safety valve or price collar that includes 
        both a price floor and a price ceiling for emissions allowances 
        is preferable to offsets as a costcontrol option. A price 
        collar would be simple to administer, would not require an 
        elaborate regulatory system to administer, and would produce 
        certainty ex-post as to the actual level of emissions under the 
        cap. Offsets will deliver none of these. A price-collar would 
        keep costs within the ACES emissions trading market 
        commensurate with expectations. By doing so it would help to 
        ensure the ongoing support of constituencies essential for an 
        enduring and stable climate policy. Finally and most 
        importantly, a price collar would provide a guaranteed minimum 
        return for clean-tech innovators seeking to displace older 
        fossil generation. This guaranteed return ould increase the 
        provision of new and innovative technologies to the US economy. 
        By doing so, it would also increase the number of green jobs 
        created by a US climate program, and help to position the US as 
        a leader in the global energy revolution.
          (5) A price collar would produce substantial revenues via the 
        sale of extra permits. These funds could be used to produce 
        many of the environmental benefits promised by offsets. While 
        use of the safety valve would increase the level of emissions 
        under the cap, the revenue could be directed into a Climate 
        Trust Fund. This fund could accomplish many of the emission 
        reduction objectives of an offset program and do so more 
        costeffectively. By allowing for increased flexibility and by 
        reducing the rents captured by offset producers a Climate Trust 
        Fund would quite possibly produce greater reductions from 
        uncapped sources than would be possible under a carbon offset 
        system.
 2. crediting of business-as-usual activities in the clean development 
                               mechanism
    The environmental integrity and costeffectiveness of a carbon 
offset system depend on the ability to rapidly, reliably, and cheaply 
determine how entities seeking carbon offsets would have behaved in the 
absence of the financial incentives created by emissions trading. The 
``business-as-usual'' or baseline scenario can then be compared to what 
actually happens. Any reduction in emissions from the baseline to 
reality can then be credited with offsets. Offsets must, if they are to 
be effective, result in changed behavior. If not, then the result is 
that emissions do not fall either under the cap (where the offset is 
used as an alternative compliance tool) or outside the cap (where 
emissions remain unchanged relative to the baseline scenario). If an 
offset system performs perfectly, total uncapped and capped emissions 
remain unchanged. For every ton reduced outside the cap, one ton is 
emitted by a covered entity inside the cap. Of course, no offsets 
market is likely to work perfectly; in practice, a balance must be 
struck between the over-crediting of business-as-usual behavior and the 
under-crediting of real reductions. But even evaluating this type-1 
versus type-2 error requires some ability to objectively determine the 
counterfactual baseline scenario. In too many contexts, this has proven 
impossible to do in real offset systems.
    The Clean Development Mechanism of the Kyoto Protocol (CDM) is the 
largest carbon offset market in the world, both in terms of volume of 
credits and value transacted. The CDM is also the world's first 
compliance grade carbon offset market. Firms covered by cap-and-trade 
regimes, most notably the European Union's Emissions Trading Scheme (EU 
ETS), can use CDM offsets in lieu of allowances for compliance. The CDM 
was conceived with the twin goals of lowering compliance costs for 
parties to the Kyoto Protocol and assisting in the financing of 
sustainable development. The performance of the CDM holds important 
lessons for an analogous compliance grade carbon offset system proposed 
for the US.
    The CDM has evolved through time as it has both grown in size, from 
just a few emission reduction projects to more than four thousand, and 
in complexity, from just a few project types to over one hundred. 
During this growth process, the regulators of the CDM have learned by 
doing and have improved practices. These improvements have been made 
mainly with the intention of insuring greater environmental integrity. 
Both anecdotal and systematic evidence suggests that substantial 
crediting of businessasusual projects continues to occur. The root 
cause of the problem appears to be an inability to reliably determine 
the baseline scenario for a particular project or class of projects.
    The problems in the CDM have been greatest in sectors and countries 
where government regulation plays an important role in economic 
activity. In China where more than half of all CDM credits originate, 
this is most evident in the energy sector. The Chinese energy sector, 
because of its strategic importance, remains largely state controlled 
and in many cases, state owned. The basic problem for the CDM is that 
state mandates and subsidy programs, along with a complicated and 
nontransparent interaction between state owned banks, state owned 
utilities, and financial and energy regulators, already strongly favor 
the construction of renewable and natural-gas fired energy production. 
Some small fraction of the new capacity added is no doubt caused by the 
additional finance provided by CDM. However, in practice, almost all 
new plants in the wind, hydro, and natural gas sectors apply for and 
receive credit under the CDM for emissions reductions (see Figure 
1*)\2\ \3\
---------------------------------------------------------------------------
    * Figures have been retained in committee files.
    \2\ See, Michael Wara and David Victor, A Realistic Policy on 
International Carbon Offsets, Stanford Program on Energy and 
Sustainable Development Working Paper #74 (2008), at http://
pesd.stanford.edu/people/michaelwara
    \3\ Hydro and wind CDM applications exceed new capacity additions 
in part because some plants applying for credit in 2007 were built 
earlier and in part because some plants that applying for credit 
experienced construction delays. Data Sources: National Development and 
Reform Council; International Gas Union; International Energy Agency; 
Jorgen Fenhann, UNEP-Riso Centre, CDM-JI Pipeline Database.
---------------------------------------------------------------------------
    The problem for the CDM has been that in practice, there is no 
straightforward way to determine whose behavior has been altered 
because of offsets and therefore who should receive them. CDM 
regulators have been forced to add layers of bureaucracy in an 
ultimately futile effort to determine which of the many applicants are 
telling a genuine story regarding emissions reductions and which would 
have installed cleaner technology even in the absence of the carbon 
market. As a result, there are lingering uncertainties as to the 
quality of credits that have been and are being issued by the CDM.
    CDM offsets are ultimately bought for use as alternative compliance 
in a cap-andtrade system. The impact of their uncertainty quality 
creates uncertainty as to the quantity of emission reductions produced 
by the overall program of cap, trade, and offset. In the EU ETS, this 
uncertainty has turned out to be less than anticipated because of the 
global recession causing a fall in demand for electric power and hence 
for allowances and offsets. The fall in demand, combined with free 
allocation of allowances to emitters has resulted in relatively little 
use of offsets.\4\ Even so, approximately one third of the reduction 
between the cap in 2007 and the cap in 2008 was covered by CDM offsets. 
To the extent that these offsets are of doubtful quality, we will never 
know whether a third of the reductions within covered sectors for the 
first year of the Kyoto Protocol were real or mere paper reductions. 
Unless ACES can somehow resolve the lingering uncertainty and criticism 
that has surrounded determination of baselines and consequent emissions 
reductions in offset programs, it will suffer the same fate. And ACES 
if enacted, would rely on offsets to a far greater extent than does the 
current EU ETS.
---------------------------------------------------------------------------
    \4\ 4 In 2008, the first year during which covered entities could 
use CDM offsets as alternative compliance in the EU ETS, just 82 
million offsets were surrendered, compared to a maximum allowed usage 
of 8% of the cap or approximately 150 million offsets. Data obtained 
from the European Commission Community Independent Transaction Log.
---------------------------------------------------------------------------
3. the clean development mechanism struggles to produce a large offset 
                                 supply
    Another surprise of the first 5 years of CDM operation has been the 
difficulty the system has had in producing large numbers of issued 
credits. Reliable supply of large volumes of offsets is a necessity for 
a cost-containment mechanism. The problem for CDM offsets has been that 
in order to maintain environmental integrity, a relatively complex 
regulatory system has been required. The CDM system works by first 
requiring that a project apply for registration, after which it 
operates, producing emission reductions. Reductions claimed by a 
project are then audited by an accredited third-party verifier. Only 
after this verification can an offset project owner apply for issuance 
of credits that can be used for compliance purposes. The ACES offset 
program is designed to operate in a similar fashion.\5\
---------------------------------------------------------------------------
    \5\ ACES supra note 1, Sec. Sec.  735, 736.
---------------------------------------------------------------------------
    In practice in the CDM, this process has proven fraught with delay 
such that the number of issued credits is far lower than had been 
expected or has been promised in offset project application documents. 
Estimates vary depending on methodologies used to assess project and 
country risk, but expected deliveries of CDM credits were on the order 
of billions of tons. To the end of date, in 5 years, the program has 
produced just over 300 million offsets (See Figure 2)\6\. Further, the 
rate of issuance, which increased through the early phases of the 
program, has recently stabilized at about 12 million offsets per month 
(See Figure 3). At this rate, the CDM will issue just 800 million tons 
of offsets by the end of the Kyoto Protocol compliance period in 2012. 
This slow rate of issuance has been caused largely by the need to 
carefully check issuance requests prior to issuance because of concerns 
about environmental integrity. Because each request and audit trail 
must be checked individually before approval, this is not an area where 
significant economies of scale have been found. Instead, issuance has 
emerged as perhaps the most significant bottleneck in the CDM process.
---------------------------------------------------------------------------
    \6\ Data compiled by the author from the CDM issuance database, at 
http://cdm.unfccc.int/issuance/index.html.
---------------------------------------------------------------------------
    Furthermore, the composition of the projects generating credits is 
strongly biased towards those that generate large numbers of credits. 
This reduces the number of requests for issuance that must be reviewed 
by the CDM. Thus the current rate of issuance is probably 
unrealistically fast relative to the entire universe of offset 
projects. Shown in red in Figure 2 are the industrial gas capture 
projects, which have generated more than 70% of the issued credits to 
date. These offset projects capture high global warming potential gases 
at industrial facilities. Because each ton of high GWP gas is worth 
between 310 and 11,700 times a ton of carbon dioxide, these projects 
generate enormous volumes of credits. Industrial gas projects greatly 
simplify the workload for the CDM, since a few large issuances from 
these projects make up most of the issuance request throughput. 
Unfortunately, these are unlikely to be representative of either the 
future of the CDM or of any other large offset system. Because these 
projects are highly profitable, there is essentially complete global 
participation on the part of the eligible industries.\7\ The remainder 
of projects in the CDM portfolio or in any other potential offset 
portfolio will be significantly smaller in scale and so require 
proportionately more work on the part of regulators to process.\8\
---------------------------------------------------------------------------
    \7\ Indeed, these projects are so profitable that the carbon 
offsets produced by them are worth substantially more than the 
underlying products--most notably refrigerant gases for mobile air 
conditioners--being produced by the polluting industries. See, Michael 
Wara, The Performance and Potential of the Clean Development Mechanism, 
55 UCLA Law Review 1759 (2008), available at http://pesd.stanford.edu/
people/michaelwara.
    \8\ Ibid.
---------------------------------------------------------------------------
    Whatever the ultimate issuance rate achieved by the CDM, one thing 
the system has made clear is that actually producing compliance grade 
offsets is a complex and time consuming regulatory undertaking. 
Building the regulatory apparatus for the CDM has proven quite 
challenging, especially as concerns about quality have caused greater 
scrutiny to be applied to each project registration and request for 
issuance. This scrutiny takes time and leads to delays and hence a 
slower than anticipated production rate of offsets. Luckily for those 
nations and firms otherwise dependent on the CDM for cost containment 
of their Kyoto Protocol compliance obligation, the global recession, by 
reducing economic activity, substantially lowered emissions.\9\ This in 
turn has greatly reduced the need for
---------------------------------------------------------------------------
    \9\ The United States is a useful point of reference in this regard 
since it did not ratify the Kyoto Protocol and so is not trying to 
reduce emissions in order to comply. During 2008 and 2009, the EIA 
estimates that offsets and the costs of not having them, averting what 
could have been a compliance crisis.
---------------------------------------------------------------------------
              4. implications of the cdm example for aces
    The CDM is the carbon offset system about which we know the most. 
But how relevant is experience gained under the Kyoto Protocol to the 
ACES offset program? I believe that the lessons presented above, of 
difficulty telling good from bad credits, and of the challenges of 
producing adequate supplies of credits, are likely to be highly 
relevant to an offset program of the scale contemplated by ACES.
    No offsets system, including the CDM or ACES, can avoid the problem 
of establishing emissions baselines against which actual emissions are 
judged. The CDM has illustrated the difficulty of this task. By 2020, 
the ACES offset program would likely be approximately 20 times the size 
of the current CDM, if measured in terms of issuance rate (See figure 
3).\10\ Extrapolating from the relatively small size of the CDM to the 
much larger ACES program is necessarily uncertain. This is especially 
the case because ACES contains provisions for both a large 
international forestry offsets program\11\ as well as a large domestic 
agricultural and forestry offsets program.\12\ Also, ACES incorporates 
numerous provisions aimed at improving the quality of its offsets 
program compared to the CDM.\13\ Nevertheless, the fundamental 
conceptual and administrative challenges that have confronted the CDM 
are unlikely to be absent from an ACES or ACES-like offset program. 
Such a program will struggle to create offsets of undisputed high 
quality because of difficult baseline determination problems, both in 
domestic agricultural and forestry settings and in the international 
regime. Finally, it will have to confront the reality that its 
rulemakings are potentially subject to challenge in court. The CDM 
Executive Board faces no such scrutiny of its decisions, or potential 
source of delay, in its implementation.
---------------------------------------------------------------------------
    \10\ See, Environmental Protection Agency, EPA Analysis of the 
American Clean Energy and Security Act of 2009: HR 2454 in the 111th 
Congress (Jun 23, 2009);
    \11\ ACES supra note 1, Sec. Sec. 751-756.
    \12\ ACES supra note 1, Sec. Sec. 501-511.
    \13\ ACES supra note 1, Sec. Sec. 731, 739, 509, 531.
---------------------------------------------------------------------------
    In addition, the ACES capandtrade program is, far more than the EU 
ETS, dependent on offsets both for costcontrol and for environmental 
effectiveness. Most analyses of the bill indicate that allowance prices 
will approximately double in the absence of a ready supply of 
offsets.\14\ In its analyses of the bill, EPA estimates that less than 
50% of emission reductions that occur due to its enactment will be in 
capped sectors prior to 2030 (See Figure 4). That is, the majority of 
the bill's environmental impact hinges on the offsets program having 
superb environmental quality. If not, then emissions will occur under 
the cap and be covered by offset credits that due not represent real 
world reductions. In order to accomplish this objective, the ACES 
offset program, both international and domestic, will have to 
accomplish a far higher level of environmental oversight than has 
proven possible, even with the best intentions, within the CDM.
---------------------------------------------------------------------------
    \14\ EPA supra note 9; Congressional Budget Office, Economic and 
Budget Issue Brief: The Use of Offsets to Reduce Greenhouse Gases 
(August 3, 2009); Energy Information Administration, Energy Market and 
Economic Impacts of H.R. 2454, the American Clean Energy and Security 
Act of 2009 (Aug. 4, 2009).
---------------------------------------------------------------------------
    In order to avoid chronic shortages of credits, and consequently 
very high allowance prices for covered entities, USDA and EPA will have 
to accomplish more stringent environmental review of offsets at a much 
faster rate than the CDM--at least 20 times the speed of the current 
CDM. All economic analyses of the bill suggest that its' costs will 
nearly double if offset supply is significantly constrained or 
delayed.\15\ Failure to accomplish this issuance rate might both cause 
undue harm to the US economy and undermine long-term support for the 
ACES program. In the event that offset supply proves lower than 
expected under ACES, the EPA and USDA will come under tremendous 
pressure to lower standards in order to increase the rate of supply of 
new offsets into the US emissions trading market. The dependence of 
ACES on offsets thus exposes it to significant risks. Either that 
insufficient offset supply will drive a reduction in standards or, if 
the regulator is unwilling to increase supply in this way (or cannot on 
the timescale the health of the US economy demands) the undermining of 
political support for continued implementation.
---------------------------------------------------------------------------
    \15\ Ibid.
---------------------------------------------------------------------------
     the advantages of a price collar over offsets for cost-control
    A price collar or symmetric safety valve sets a reliable and simple 
upper and lower bound on allowance prices in a cap and trade system. A 
price collar places a hard and certain limit beyond which US permit 
prices would not fluctuate. These trigger points would increase each 
year at a predetermined rate in excess of inflation over the life of 
the program. Operating such a system would be relatively 
straightforward compared to the complexity of a high quality offsets 
system. If allowance prices exceeded the price ceiling, the government 
would sell allowances into the market until the price fell below the 
ceiling. All allowance auctions would be held with a reserve price such 
that no allowances would enter the market at a price below the floor. 
If an exogenous shock caused prices in the secondary market for 
allowances to fall below the floor, the government could respond by 
reducing the number of allowances released for auction at regularly 
scheduled intervals until the price stabilized at the desired level.
    The history of emissions trading schemes indicates that ex ante 
predictions of permit prices are generally inaccurate and biased toward 
overestimation of cost. Experience with cap-and-trade programs to date 
indicates that a lower bound on prices is as important as an upper 
bound. The US Acid Rain Trading Program (ARTP), the Regional Clean Air 
Incentives Market (RECLAIM), and the EU ETS have, more often than not, 
exhibited prices far below marginal abatement costs predicted prior to 
their enactment. In the ARTP case, this was because abatement costs 
were in fact far lower than predicted. For RECLAIM, the problem was 
early overallocation of allowances. In the EU ETS case, this was 
because of over-allocation in the first phase of trading (2005-2007) 
and due to recession in the second (2008-present). All three emissions 
trading markets have also experienced relatively brief periods of very 
high prices. The truth is that because we don't know with much 
certainty what marginal abatement costs will be under cap and trade, 
what fuel prices will be, and the future trajectory of GDP, it is 
impossible to predict with any accuracy or precision what allowance 
prices will be. Pretending otherwise is a misuse of the models used to 
estimate differences between policy outcomes.\16\
---------------------------------------------------------------------------
    \16\ The computed general equilibrium and energy system models used 
to estimate future allowance price and program costs are likely far 
more reliable at estimating differences between policies than absolute 
costs. For example, estimates of the difference between a case with 
offsets and without offsets is likely more informative than an estimate 
of the absolute cost of either.
---------------------------------------------------------------------------
    A symmetric safety valve provides reliable costcontainment for 
covered entities planning for compliance with a capandtrade system. In 
theory, offsets provide a solution for firms worried about the costs of 
compliance with cap-andtrade. In practice as described above, the 
biggest carbon offset market has been unable to provide either cost-
containment or the environmental integrity required to ensure quantity 
certainty. Further, there is little reason to believe that the causes 
of this failure can be avoided under ACES. In contrast, a safety valve, 
because it responds directly to the price of allowances, provides far 
greater certainty that costs will not exceed a particular level during 
any given compliance period. Especially under a program like ACES that 
provides emissions targets until the mid-twentyfirst century, such cost 
certainty allows for sound long-term investment planning on the part of 
vertically integrated utilities and merchant generators. In Europe 
under the EU ETS, it has proven very difficult for utilities to plan 
for new generation when there is tremendous uncertainty as to the 
carbon price. Such planning certainty is an important policy objective 
of any US climate program and a key prerequisite to charting a secure, 
clean, and low-carbon US energy future.
    A symmetric safety valve will also provide a reliable minimum price 
for allowances that will enable firms to confidently make investments 
in new pollution reduction technologies. The history of cap-and-trade 
programs is as much a story of prices that fell below expectation as 
above. This result has led the clean-tech start-ups that create and 
venture capital firms that fund new energy technologies to ignore 
carbon prices when planning and investing. A price collar that provides 
long-term certainty as to the minimum price of allowances in a US cap-
and-trade would allow the innovative firms to count on a certain level 
of advantage relative to traditional fossil generation technologies. 
Providing this minimum certainty would allow startups to more fully 
capitalize on the societal benefits that their new low-carbon 
technologies will provide. As a consequence, a price floor would 
increase the provision of these technologies to the US economy, 
increase the number of green jobs created by a US climate program, and 
help to position the US as a leader in the global energy revolution.
    While a price collar does not provide absolute certainty of 
emissions limits, neither would a realworld carbon offset system. It's 
important to emphasize what is not given up in the choice of cost-
containment strategy. The main criticism of symmetric safety-valve 
proposals is that they do not provide quantity certainty for climate 
policy.\17\ That is, they do not pretend to provide certainty as to the 
level of pollution that will be allowed in any given year. As has been 
shown above, offset systems promise to provide this certainty, but in 
practice fail to do so. Thus the choice between quantity certainty 
under a cap, trade, and offset system like ACES and quantity 
uncertainty under cap-and-trade with a price collar is in reality, a 
false choice--neither approach can provide both cost containment and 
certainty as to the maximum pollution level. In fact, given the low 
allowance price history of emissions trading programs, it is at least 
likely that a price collar would provide superior environmental results 
due to its ability to reduce the supply of allowances when prices fall 
too far.
---------------------------------------------------------------------------
    \17\ A lack of quantity certainty is also the major criticism of 
carbon taxes.
---------------------------------------------------------------------------
 6. revenues from a price collar could fund additional cost-effective 
                               reductions
    In the event that prices within a US capandtrade program exceed 
expectations and so trigger the safety valve, revenues raised from the 
auction of extra allowances could be used to accomplish many of the 
benefits promised by offsets. One of the key benefits of offsets is 
that they extend incentives to reduce emissions beyond the scope of 
sectors covered by the cap. Offsets create a potential financial 
benefit for reductions in uncapped sectors, such as agriculture, or 
uncapped jurisdictions, such as Brazil, to reduce GHG pollution even 
though they are not required to do so. This benefit need not be 
sacrificed just because offsets are not relied upon for cost-
containment. The simple solution is to dedicate revenues raised by the 
price collar to reductions outside of the cap.
    Any revenues generated by a safety valve should be deposited into a 
Climate Trust Fund (CTF) dedicated to reducing emissions outside of the 
cap. Such a trust fund could be utilized as a source of funding to 
assist the agricultural and forestry sectors in reducing their 
emissions or to assist developing countries in doing the same. These 
goals might be accomplished via payment for the cost of particular 
activities that are known to result in lowered emissions or via open 
requests for proposal for emission reduction activities.
    Administration of an agricultural and forestry emissions reduction 
program by a CTF would be far simpler than via offsets. The two great 
challenges of administering an agricultural offset program are 
measurement and permanence. A CTF administered system, because it is 
not linked to an emissions trading market greatly simplifies both. 
Measurement of carbon emissions of similar accuracy and precision to 
covered sources is difficult and costly to accomplish on farms and in 
forests. At the same time, permanence looms large for sequestration 
based offsets because reversals threaten the integrity of the cap. In 
contrast, a CTF could handle both issues more flexibly and could more 
realistically shape an emissions reduction program to fit the needs and 
capabilities of both US farms and forests. A CTF would enable society 
to capture greater benefits from the contributions that farms and 
forests have to make towards reducing emissions while also simplifying 
the process of farmers and foresters gaining credit for their actions.
    Administration of a CTF would allow for far greater 
costeffectiveness in an international emissions reduction program. One 
of the major criticisms leveled at the CDM has been that most of the 
reductions in GHG emissions it has produced could have been had at far 
lower prices.\18\ Careful study of the emission reduction opportunities 
available at lowest cost in developing countries shows that these are 
accessible via good regulatory design and effective implementation in 
areas like building standards, industrial efficiency, and appliance 
energy efficiency.\19\ These are areas that are typically inaccessible 
to carbon offsets because regulations are part of the emissions 
baseline, because results are nearly impossible to quantify with 
sufficient certainty for offset creation, and because there is unclear 
title to the emissions reductions. A CTF could more easily realize 
these key emission reduction strategies, available at a cost far below 
the likely price of emissions in the US capand-trade market, without 
concern for what was or was not a part of the regulatory baseline. 
Indeed, the goal of a CTF would be to shape this baseline in ways that 
drive large-scale change. Further, a CTF, because not tied to an 
emissions trading market, would be free to grasp such low-cost 
solutions without the need for strict quantification and clarity of 
ownership. In sum, a CTF, freed from the strictures of an offset 
market, could produce greater reductions at lower cost.
---------------------------------------------------------------------------
    \18\ See, Michael Wara, Is the Global Carbon Market Working?, 445 
Nature 559 (Feb. 8, 2007).
    \19\ See, McKinsey & Company, Pathways to a Low Carbon Economy 
(Jan. 2009).
---------------------------------------------------------------------------
                             7. conclusions
    A price collar will provide superior cost-containment for a US cap-
and-trade system compared to offsets along a wide variety of 
dimensions.
    Experience with the CDM has shown that large compliance grade 
offset markets fail to provide either adequate environmental integrity 
or a sufficient supply of offsets. The former results in substantial 
doubt as to the reality of reductions promised by the cap on emissions; 
the latter in significant cost uncertainty for the program.
    A symmetric safety valve, by creating certainty as to the range of 
possible allowance prices allows firms to plan for a worst case 
compliance situation while allowing new technologies to fully 
capitalize on a minimum guaranteed return from the carbon market. It 
also insures that if estimates of program costs turn out to be lower 
than expected, extra emissions reductions can be wrung from the capped 
sectors. This insures that the political calculus of costs and benefits 
central to the enactment of the program is in fact realized in 
practice.
    Revenues raised from the safety valve, assuming that it is 
employed, invested via a Climate Trust Fund, could be used to create a 
domestic agricultural and forest GHG pollution reduction program that 
better matches the needs and capabilities of these sectors. These funds 
could also be used to access the very low-cost emission reduction 
opportunities available from energy efficiency of buildings, 
appliances, and industry in the developing world.

    The Chairman. Thank you very much.
    Dr. Mason, go right ahead.

STATEMENT OF JOSEPH R. MASON, PH.D., PROFESSOR, LOUISIANA STATE 
                  UNIVERSITY, BATON ROUGE, LA

    Mr. Mason. Thank you, Chairman Bingaman, Senator Murkowski 
and members of the committee for inviting me to testify today.
    The two major schools of thought among academics studying 
how to limit climate change are delineated primarily by whether 
policymakers should control either the quantity of carbon 
emissions via cap and trade policies or the price of carbon 
emissions via taxes. Theoretical economic models have been 
developed to support cap and trade. But those models of cap and 
trade dominate taxation only when optimal banking and borrowing 
are assumed to occur.
    The problem is that the economists advocating such banking 
and borrowing strategies are public choice economists, not 
monetary or financial economists. In practice banking and 
borrowing is implemented even at a relatively well understood 
realm of monetary policy is rarely optimal. Monetary policy 
uses tools like discount window borrowing, reserve requirements 
and quantity constraints to manipulate the supply of 
contraction order to affect economic growth.
    Analogous policy tools are proposed for carbon permits. But 
contemporary carbon market proposals rarely acknowledge the 
limits of those policy tools which are described in more detail 
in my longer written testimony which I'd like to ask to be 
included in the record. For the moment let's clarify. Borrowing 
doesn't work for monetary policy. So why should it be expected 
to work for carbon contracts.
    The clearest advice that's ever been given for managing 
discount window borrowing in the banking sector is Bagehot's 
Rule which suggests that liquidity crises should be addressed 
by ``lending freely at a penalty rate.'' Of course 
operationalizing Bagehot's Rule in monetary policy has been 
tricky. What constitutes a crisis? What constitutes lending 
freely? What's a penalty rate?
    Environmental authors therefore routinely make it seem like 
they can freely adopt a readymade policy that has in fact not 
yet been invented for hundreds of years. Reserve requirements 
help stabilize banks, but are not used to actively manipulate 
monetary policy. The problem is that reserve requirement 
manipulations require every bank, irrespective of its 
resources, to expand or more importantly contract reserves by a 
fixed amount to meet policy goals.
    Seeing reserve policy is too blunt the Federal Reserve 
moved away from actively using reserve requirements for policy 
purposes in the 1950s. Reserve requirements are not considered 
a realistic central bank policy tool. Are probably too heavy 
handed for environmental policy as well.
    Open market operations are the current vanguard of monetary 
policy. But the effects and limits of open market operations 
are still largely unknown. Modern central banks influence 
markets primarily by purchasing and selling key market 
instrument, thereby affecting the supply of money and 
secondarily the price that is interest rates.
    The supply of money related to consumption demand is the 
most important for driving economic growth, the ultimate target 
variable of monetary policy. If money that is injected through 
open market operations however is merely absorbed by investment 
or speculative demand it doesn't drive growth as directly as 
does consumption. When the money is merely held in excess 
reserves equivalent to stuffing money in the mattress the link 
between open market operations and economic growth breaks down 
completely which can create a liquidity trap.
    Academic proposal for carbon market designs have 
acknowledged difficulties dealing with these competing demands 
even if they haven't yet formally adopted the vocabulary of 
monetary economics. For instance the ability to bank carbon 
permits may create a political problem akin to ``undo wealth 
accumulation'' or ``hoarding'' when some firms have a large 
residual supply of permits on hold.
    The second, some say greater problem, is that firms with 
large banked permit resources could corner markets and drive up 
prices.
    The risk lies in the way that some authors think of 
rectifying the problems. The simplest proposals call for an 
expiration date on the permits much like how Zimbabwe and other 
dysfunctional developing countries impose expiration dates on 
their currencies. Others suggest imposing more stringent 
project requirements on firms with greater wealth in terms of 
these banked permits.
    Even environmental authors like Murray Newell and Pizer 
admit that permit demand function is largely unknown. ``There's 
little evidence concerning how large of an allowance banked 
firms might accumulate. It could in fact be much larger than 1 
year's worth of allowances. How fast they might spend it down 
and in turn how much this might affect any future tightening of 
a cap.'' Those are crucial unknowns for a system that will be 
so inextricably tied to U.S. economic growth.
    At the end of the day the situation is even more simple. 
Manipulating carbon permit supply via something that has at 
times been called a carbon market efficiency board that is 
charged with restraining emissions without unduly harming 
economic growth necessarily decreases the benefit certainty 
that is the hallmark of cap and trade. Without that benefit 
certainty the convoluted carbon permit market design and risk 
of market collapse is both theoretically and practically 
unnecessary because at the extreme if the carbon market 
efficiency board works. They peg the price of carbon while 
allowing benefits to fluctuate you get exactly the same result 
that you'd get from a carbon tax.
    So there's no need to develop this plethora of complex 
institutions to get the same result. In fact, worse yet, 
history is rife with examples that suggest borrowing economic 
institutions from one setting for use in another and rarely 
works. So I expect similar outcomes for central bank features 
applied to nascent carbon markets, especially when a tax can 
achieve the same goal of price certainty. Thank you.
    [The prepared statement of Mr. Mason follows:]
  Prepared Statement of Joseph R. Mason, Ph.D., Professor, Louisiana 
                   State University, Baton Rouge, LA
     the economic policy risks of cap and trade markets for carbon 
  emissions: a monetary economist's view of cap and trade market and 
                 carbon market efficiency board designs
                                Abstract
    The two major schools of thought among academics studying how to 
limit climate change are delineated primarily by whether policymakers 
should control (1) the quantity of emissions via cap and trade policies 
or (2) the price of carbon emissions via direct taxation. The lack of 
theoretical ``fit'' between carbon pollutants and cap and trade, 
however, has given rise to notions of a management board design that 
can manipulate the carbon market to achieve the economic ideal. The 
idea is that something like a central bank, most recently referred to 
as a ``Carbon Market Efficiency Board,'' in the U.S., can manipulate 
contract supply, smoothing price volatility and dynamically adjusting 
carbon permit supply to policy goals. But manipulating carbon permit 
supply via a Carbon Market Efficiency Board that is charged with 
restraining emissions without unduly harming economic growth 
necessarily decreases the benefit certainty that is the hallmark of cap 
and trade. Without that benefit certainty, the convoluted carbon permit 
market design and risk of market collapse is both theoretically and 
practically unnecessary. At the extreme, the Carbon Market Efficiency 
Board pegs the price of carbon while allowing benefits to fluctuate, 
which is exactly the result of a carbon tax.
    Recent scholarship on climate change begins with the assumption 
that some adjustment mechanism is needed to limit carbon emissions.\1\ 
There are two major schools of thought among academics studying how to 
limit climate change.\2\ They are delineated primarily by whether 
policy-makers should control (1) the quantity or (2) the price of 
carbon emissions. The first school is commonly associated with command-
and-control ``cap and trade'' policies, whereas the second school is 
usually associated with incentive-based carbon taxes.\3\
---------------------------------------------------------------------------
    \1\ Related research has also been conducted to examine the 
political development of environmental regulation, the interaction 
between state and federal pollution control policies, and avenues of 
future positive research. See, e.g., Robert W. Hahn, Sheila M. 
Olmstead, & Robert N. Stavins, Environmental Regulation During the 
1990s: A Retrospective Analysis, 27 Harvard Environmental L. Rev. 377 
(2003) (discussing the political and economic development of thought on 
environmental policies during the 1990s); Meghan McGuinness & A. Denny 
Ellerman, ``The Effects of Interactions between Federal and State 
Climate Policies,'' Center for Energy and Environmental Policy Research 
Working Paper, May 2008 (exploring the interplay between state and 
federal policymaking); Robert W. Hahn & Robert N. Stavins, Economic 
Incentives for Environmental Protection: Integrating Theory and 
Practice, 82 AEA Papers and Proceedings 464 (1992) (exploring avenues 
of research).
    \2\ Weitzman's seminal work was among the first to examine the 
dichotomy between price-based and quantity-based pollution regulations. 
See Martin L. Weitzman, Prices vs. Quantities, 41 Rev. Econ. Studies 
477 (1974).
    \3\ A discussion of both the cap and trade and tax approaches to 
pollution abatement is available in William J. Baumol & Wallace E. 
Oates, The Theory of Environmental Policy (Cambridge University Press, 
2d ed. 1988).
---------------------------------------------------------------------------
    Cap and trade, as its name suggests, focuses on achieving an 
absolute cap on carbon emissions using special tradable carbon 
emissions permits. Policymakers control the total number of permits, so 
that total emissions can be set by fiat. Many policymakers and 
environmental theorists believe that cap and trade provides ``benefit 
certainty'' because it achieves a hard cap on carbon emissions.\4\
---------------------------------------------------------------------------
    \4\ See Reuven S. Avi-Yonah & David M. Uhlmann, Combating Global 
Climate Change: Why a Carbon Tax Is a Better Response to Global Warming 
Than Cap and Trade, 28 Stanford Environmental L. J. 3, 8 (2009), and 
Robert N. Stavins, Addressing Climate Change with a Comprehensive U.S. 
Cap and Trade System, 24 Oxford Rev. Econ. Policy 2 (2008). For related 
work, see Nicholas Brozovic, Prices vs. Quantities Reconsidered, 
University of California Working Paper, Sept. 12, 2002; James K. Boyce 
& Matthew Riddle, Cap and Dividend: How to Curb Global Warming while 
Protecting the Incomes of American Families, Political Economy Research 
Institute Working Paper, Nov. 2007; Sergey Paltsev, John M. Reilly, 
Henry D. Jacoby, Angelo C. Gurgel, Gilbert E. Metcalf, Andrei P. 
Sokolov, & Jennifer F. Holak, Assessment of U.S. Cap and Trade 
Proposals, MIT Global Science Policy Change Report No. 146, Apr. 2007; 
Richard G. Newell, Adam B. Jaffe, & Robert N. Stavins, The Effects of 
Economic and Policy Incentives on Carbon Mitigation Technologies, 28 
Energy Econ. 563 (2006).
---------------------------------------------------------------------------
    The primary alternative to the cap and trade scheme is the flat 
``carbon tax'' proposal, which sets a stable positive price for carbon 
emissions. Proponents believe that this price based mechanism provides 
greater policymaking flexibility.\5\ The ``price certainty'' arising 
from a carbon tax would allow businesses to plan efficiently, because 
an increase in the tax rate beyond any foreseen adjustment would 
require a vote in Congress that would adjust only slowly, better 
smoothing business investment plans, employment, and economic 
growth.\6\
---------------------------------------------------------------------------
    \5\ William D. Nordhaus, A Question of Balance: Economic Modeling 
of Global Warming 202 (2008). Karen Palmer, Dallas Burtraw, & Danny 
Kahn, Simple Rules for Targeting CO2 Allowance Allocations 
to Compensate Firms, Resources for the Future Discussion Paper 06-27, 
June 2006, at 8 (``This part argues that both a carbon tax and a cap 
and trade system incorporate the necessary carbon price signal, with a 
tax offering `price certainty' and cap and trade offering ``benefit 
certainty,'' but asserts that a carbon tax would be simpler to 
implement, more transparent, and less vulnerable to abuse.'').
    \6\ See Avi-Yonah & Uhlmann, supra at 42.
---------------------------------------------------------------------------
    The economic debate has led researchers to theoretically describe 
conditions under which a cap and trade approach is more efficient than 
a carbon tax.\7\ Section I describes the economic foundations of cap 
and trade. While cap and trade can work for some pollutants, 
applications to carbon are less than ideal.
---------------------------------------------------------------------------
    \7\ Roberton C. Williams III, Prices vs. Quantities vs. Tradable 
Quantities, NBER Working Paper 9283, Oct. 2002.
---------------------------------------------------------------------------
    Section II goes on to introduce the experience with cap and trade 
using carbon contracts to date. Even though active markets for such 
contracts have begun to trade in Europe, the contract mechanisms and 
price dynamics do not fit any traditional financial economic contract 
design. Uncertainty about the nature of the contracts has therefore led 
to tremendous price volatility on European markets that threatens the 
viability of that system.
    Environmental researchers and public policy economists have more 
recently argued that the lack of theoretical ``fit'' between carbon 
pollutants and cap and trade and the problems with European carbon 
price volatility can be overcome by implementing a management board 
design. The idea is that something like a central bank, most recently 
referred to as a ``Carbon Market Efficiency Board,'' in the U.S., can 
manipulate contract supply, smoothing price volatility and dynamically 
adjusting carbon permit supply to policy goals. Section III, therefore, 
frankly discusses problems of managing central bank policy that are 
still unresolved after hundreds of years of monetary economics research 
and policy application. Hence, manipulating carbon permits' supply to 
restrain emissions without harming economic growth necessarily 
undermines the benefit certainty that is the hallmark of cap and trade 
policy, decreasing cap and trade efficiencies to levels no better 
than--and perhaps worse than--a simple carbon tax. Section IV provides 
a summary and a policy recommendation of a carbon tax as the most 
effective and efficient approach to pollution abatement.
 i. cap and trade policy vastly oversimplifies a tremendously complex 
                      market-based economic theory
    Economists first suggested cap and trade as an alternative to 
levying usage taxes to curb privately beneficial but socially 
undesirable action. In economic terms, the goal of both measures is to 
curb a recognized and measurable externality.\8\
---------------------------------------------------------------------------
    \8\ Harvey S. Rosen, Public Finance 56 (McGraw-Hill Irwin 7th ed, 
2005). See also Paul A. Samuelson, The Pure Theory of Public 
Expenditure, 36 Rev. Econ. Stat. 387-89 (1954), and Baumol & Oates, 
Environmental Policy, supra at 14-20.
---------------------------------------------------------------------------
    Public finance, and more specifically the sub-discipline of 
environmental economics, defines the theoretical optimality of the 
choice between cap and trade and abatement taxes. The optimal level of 
emissions is found in Figure 1* at the intersection of the marginal 
costs with the marginal benefits of pollution abatement. Figure 1 
graphically depicts the intersection of these two curves and the 
resulting socially optimal equilibrium in the market.
---------------------------------------------------------------------------
    * Figures 1-4 have been retained in committee files.
---------------------------------------------------------------------------
    In Figure 1, the horizontal axis indicates the amount by which 
emissions are reduced relative to their unregulated level, while the 
vertical axis represents the value society derives from reduced 
emissions measured in dollars. The curve labeled MB represents that 
marginal benefit to society of pollution abatement--that is, the 
additional value to society derived from an incremental increase in 
pollution abatement above and beyond the pollution that has already 
been eliminated up to that point. The curve has a downward slope 
because ``the greater the degree of purity of air or water that has 
already been achieved, the less the marginal benefit of a further 
`unit' of purification.''\9\ The curve labeled MAC represents the 
scarce resources society must expend to precipitate an incremental 
increase in pollution abatement above and beyond the pollution that has 
already been eliminated up to that point. The curve has an upward slope 
``because of the rising cost of further abatement as the zero emissions 
point is approached.''\10\ The optimal level of pollution abatement is 
represented graphically at the point where the MAC curve and the MB 
curve intersect. Conceptually, this point is optimal because at this 
level of pollution abatement, represented by Q*, society has maximized 
the value of abatement relative to the cost of using society's scarce 
resources to further cleanse the environment, represented by P*.
---------------------------------------------------------------------------
    \9\ Baumol & Oates, Environmental Policy, supra at 59.
    \10\ Id.
---------------------------------------------------------------------------
    An important point to note about the result presented in Figure 1 
is that the optimal outcome can be achieved either through cap and 
trade or through a pollution charge. Specifically, capping the amount 
of emissions that can be produced at Q* results in the equality of 
marginal abatement costs and the marginal benefits of abatement. On the 
other hand, by creating a charge of P* for every unit of carbon that is 
emitted, producers have incentive to reduce emissions by Q* units of 
carbon. Specifically, because P* lies above the cost of reducing 
emissions for all points to the left of Q*, it is less costly to simply 
reduce pollutants by Q* than to pay the tax. Therefore, an emissions 
charge of P* has the same effect on the market as an emissions cap that 
results in emissions abatement of Q*.
    In reality, once P or Q is set as a policy variable, MAC and MB can 
fluctuate, similar to supply and demand curves. Hence, when setting P, 
Q may fluctuate due to market and other economic forces. Similarly, 
setting Q will result in P fluctuating due to similar influences. 
Setting either costs (P) or benefits (Q) with certainty is key to the 
environmental debate around carbon policy.
    It is not clear, from a purely theoretical basis, whether cost 
certainty or benefit certainty is more important in the carbon 
abatement debate. Some scholars have argued that a focus on benefit 
certainty is superior because it puts the emphasis on the environment 
rather than on the economics.\11\ But it could also be argued that the 
benefits of any policy to reduce greenhouse gas emissions are 
worldwide, while the cost of any policy adopted by the United States 
will be confined to the United States.\12\ Moreover, small taxes can 
have disproportionately large effects on economic behavior. As a 
result, a cap and trade system may, with perfect hindsight, be 
overkill, were a moderate tax on emissions found to achieve substantial 
effect.\13\
---------------------------------------------------------------------------
    \11\ Baumol & Oates, Environmental Policy, supra at 74.
    \12\ Avi-Yonah & Uhlmann, supra at 36.
    \13\ The Federal Reserve's policy toward daylight overdrafts 
provides an example of how a small change in policy can have a dramatic 
effect on economic activity. A daylight overdraft occurs when a bank 
transfers funds that exceed its reserve balance at a Federal Reserve 
Bank early in the day and then eliminates the overdraft before the end 
of the banking day. In this manner, daylight overdrafts serve as 
intraday credit for banks. To curb daylight overdrafts, the Fed imposed 
a small fee on this activity in 1994. Originally, the Fed planned to 
double this fee in 1995 and increase it again in 1996. However, the Fed 
ultimately decided to increase the fee by 50 percent in 1995 and then 
monitor activity for two years before taking further action. (Heidi 
Willmann Richards, Daylight Overdraft Fees and the Federal Reserve's 
Payment System Risk Policy, Federal Reserve Bulletin (Dec. 1995)). No 
additional increases were made, as the small fee sufficiently reduced 
overdrafts to manageable levels.
      Another example of the implementation of a small cost by 
policymakers resulting in a dramatic shift in economic behavior exists 
within the design of spectrum auctions in the United States. In early 
auctions, the Federal Communications Commission did not apply a fee to 
bid withdrawals that occurred during the auction. As a result, 
withdrawals were frequent, as bidders used them to signal one another 
in an effort to divide up the market at low prices. To curb this 
activity, the FCC imposed a relatively small fee on withdrawals. The 
result was a dramatic decline in the number of withdrawals in spectrum 
auctions. (For example, there were more than 780 withdrawals during the 
FCC DEF block auction in 1996. By contrast, there were only 16 
withdrawals during the AWS-1 auction in 2006, which occurred years 
after the FCC imposed only a small fee on withdrawals. Data on prior 
FCC auctions is downloadable from the FCC's website at http://
wireless.fcc.gov/auctions/default.htm?job=auctions_home.) The 
experience in FCC auctions again shows that the imposition of only 
small costs on an activity that is deemed undesirable can have large 
effects on the market. Such examples suggest that imposing a usage tax 
on carbon emissions rather than cap and trade may have immediate and 
profound effects on emissions while helping policymakers better 
understand the effect of environmental policy on economic behavior.
---------------------------------------------------------------------------
    The negative consequences of environmental advocates capturing cap 
and trade programs are likely to be exacerbated by Wall Street 
investment firms. A recent article in Environment: Yale Magazine quotes 
Peter Fusaro, an energy consultant, who notes the climate change 
finance sector includes 90 hedge funds and 80 private equity funds, in 
addition to a large number of venture capitalists. Fusaro maintains, 
``It's the most complex financial market ever created.'' Fusaro counts 
38 distinct markets in the United States dealing in everything from 
acid rain emissions permits to California's mobile emissions reductions 
credits--that is, credits for reducing tailpipe exhaust. Mutual funds 
and ETFs (exchange-traded funds) specializing in climate change issues 
have sprung up in Europe and the United States. Nonetheless, in 2007, 
$64 billion in assets was traded on the global carbon market, and in 
2008 that number was projected to exceed $100 billion.\14\
---------------------------------------------------------------------------
    \14\ See Richard Conniff, Wall Street's Carbon Conversion, 
Environment: Yale Magazine 7 (2008).
---------------------------------------------------------------------------
    Of course, there is nothing wrong with financial firms profiting 
from making markets for stocks, bonds, and other valuable commodities. 
However, when a market is created and operated according to government 
fiat, it is all but certain that vested interests, financial firms that 
operate and make markets in this case, will lobby for socially 
inefficient provisions that increase their profits to the detriment of 
society as a whole. This phenomenon, where well-coordinated interest 
groups manipulate government programs meant to provide for the common 
good, is known as public choice theory.\15\
---------------------------------------------------------------------------
    \15\ See, e.g., generally Mancur Olson, The Logic of Collective 
Action (Harvard University Press Revised ed. 1971); James M. Buchanan & 
Gordon Tullock, The Calculus of Consent: Logical Foundations of 
Constitutional Democracy (University of Michigan Press 1962).
---------------------------------------------------------------------------
    As far as cap and trade proposals are concerned, both Wall Street 
investment firms and environmentalists have similar goals--to restrict 
the number of carbon permits such that marginal cost to society of 
pollution abatement exceeds its social benefit. Environmentalists' 
motivations are obvious. What is less apparent in the emotion of the 
environmental debate is the fact that financial firms that make markets 
for tradable pollution permits will be able to make higher commissions 
the scarcer the permits are. An alliance between environmentalists and 
Wall Street presents a particularly intractable problem as far as 
public choice theory is concerned.
    The empirical evidence indicates that these public choice concerns 
are well-founded. Indeed, two companies infamously associated with 
corporate malfeasance and financial manipulation, Enron and AIG, both 
lobbied for cap and trade programs so that they could reap profits by 
making markets for the permits.\16\ In 2007, Martin Sullivan, CEO of 
AIG at the time, explained that the firm would seek to ``help shape a 
broad-based cap and trade legislative proposal, bringing to this 
critical endeavor a unique business perspective on the business 
opportunities and risks that climate change poses for our 
industry.''\17\ Although systematic academic analysis of nascent cap 
and trade programs is only beginning, the initial results suggest that 
special interests have succeeded in ``capturing'' the European program. 
Looking at the greenhouse gas (GHG) market, a recent article in the 
journal Energy Policy concluded ``Here, we find that the dominant 
interest groups indeed influenced the final design of an EU GHG 
market.''\18\
---------------------------------------------------------------------------
    \16\ See Phil Kerpen, Cap and Trade for AIG?, Washington Times, 
Mar. 25, 2009, available at http://washingtontimes.com/news/2009/mar/
25/cap-and-trade-for-aig.
    \17\ Id.
    \18\ See Peter Markussen & Gert Tinggaard Svedsen, Industry 
Lobbying and the Political Economy of GHG Trade in the European Union, 
33 Energy Policy 245 (2005).
---------------------------------------------------------------------------
    ii. cap and trade contracts are susceptible to numerous pricing 
                 anomalies that remain to be understood
    A significant problem with cap and trade that has become apparent 
in recent years is that carbon prices under cap and trade systems have 
been far more volatile than originally envisioned. Part of the problem 
is related to carbon permit demand that fluctuates with weather 
conditions that are highly correlated with electric power generation. 
Furthermore, although monetizing and trading in various assets and 
commodities often helps to improve economic efficiency, financial 
market applications created additional volatility in carbon permits.
    The underlying problem is that ill-understood pricing anomalies in 
the price of carbon credits have undermined the ability of the market 
to properly internalize both short-and long-term price dynamics. As a 
result, a firm's incentives to invest significantly in newer, cleaner 
technologies for the long-term are undermined when prices of emissions 
credits are extremely volatile and therefore cloud longterm price 
signals in the short-term.
    This section summarizes the European experience with cap and trade 
and reviews the complexity of emissions credit valuation and resulting 
pricing anomalies. As a whole, exhibited anomalies are the result of 
both weather and political uncertainties as well as idiosyncrasies in 
the carbon permit contract.
    The European Union provides a wealth of information and data on 
markets that have developed from cap and trade programs. In the 
European Union's Emissions Trading Scheme (``EU ETS''), both cash and 
futures contracts are traded in a variety of markets. While trade with 
EU Allowances (EUAs) began in 2003, the official EU ETS began in 2005. 
Prices before 2005 are therefore forward prices on a not-yet-traded 
underlying asset. In the ``pre-2005'' period, the traded volume was 
quite low, at some days even zero as the highest bidder price was 
smaller than the lowest seller price. Daily EUA prices between August 
27, 2003, and December 29, 2004, before agreement on EU-ETS, were 
generally stable. The price during this entire period was stable during 
any small time window, and fluctuated between 7 and 13 Euros over the 
entire 18-month period, with bid-ask spreads were quite large, often 
exceeding 4 Euros. By contrast, prices between early 2005 and December 
29, 2006, fluctuated greatly. Prices spiked at nearly 30 Euros in July 
2005 and again in April 2006, and fell to lows of about 6 Euros by 
December 2006.\19\
---------------------------------------------------------------------------
    \19\ Eva Benz & Stefan Truck, Modeling the Price Dynamics of 
CO2 Emission Allowances, 31 Energy Economics 11 (2009).
---------------------------------------------------------------------------
    A review of daily EUA prices shows that prices were increasingly 
volatile after 2004. Figure 2 displays daily price and traded volume of 
futures contracts for December 2009 settlements between February 2006 
and December 2008. The data in Figure 2 first confirms that the price 
of carbon futures fell significantly during 2006. The price then rose 
through 2007 and the first half of 2008, but plummeted after July 2008.
    Important drivers of the market seem to be a combination of short-
run weather and political policy announcements rather than any long-
term economic fundamentals. Before the EU Parliament agreed on the 
introduction of the EU ETS in July 2003 and before the first 
suggestions for National Allocation Plans (NAPs) were published at the 
end of 2003, prices were stable. Both announcements led to an increase 
in prices. Because of the initially generous allocation of allowances 
to the countries, prices calmed down again between February and March 
2004. Reviewing and accepting the NAPs in the second half of the year, 
prices increased to about 9 Euros. As the main framework of the trading 
scheme became defined, the price determinants became more fundamental 
after January 2005.\20\
---------------------------------------------------------------------------
    \20\ Id. at 11-12.
---------------------------------------------------------------------------
    Chief among those fundamentals, however, is the weather. For 
example, prices fell due to mild weather and high supply of wind energy 
from Scandinavia and North Germany. At the end of January 2005, cold 
weather and high gas and oil prices in the United Kingdom coupled with 
low coal prices resulted in a strong price increase of EUAs.\21\ This 
effect was magnified by a dry summer in July 2005 in Southwestern 
Europe. Low rainfall depleted reserves and prevented full utilization 
of hydroelectric plants. The lack of cooling water for nuclear power 
plants resulted in greater utilization of high-emission-producing 
assets, which therefore increased the demand for carbon permits. By 
July 2005, prices peaked at 29.15 Euros. During the last four months of 
2005, prices fell to 22 Euros. By March 2006, however, prices again 
increased to approximately 27 Euros, due to a long and cold winter 
between 2005 and 2006.\22\
---------------------------------------------------------------------------
    \21\ PointCarbon, Carbon Market Monitor 2005 Review, Jan. 2006, 
available at: http://www.pointcarbon.com/research/carbonmarketresearch/
monitor/.
    \22\ Benz & Truck, supra at 12.
---------------------------------------------------------------------------
    May 2006 marked completion of the first full cycle of the EU ETS. 
By April 2006, however, it was apparent that a surplus of allowances of 
approximately 10 percent existed. As a consequence, EUA prices fell by 
60 percent within one week, amid fears that emissions prices would drop 
to zero. The EUA market recovered during the summer of 2006 as the 
industrial sector began selling EUAs to utilities investors as a dry, 
hot European summer increased the demand for high-emissions assets.\23\
---------------------------------------------------------------------------
    \23\ Id. at 12-13.
---------------------------------------------------------------------------
    The European experience outlined above is important because the 
primary purpose of a cap and trade-based carbon market is to provide 
long-term incentives for firms to invest in clean-air technologies. 
Such technologies--nuclear assets or clean-air coal assets, for 
example--are extremely costly to build, and they are large base-load 
units that are technologically intensive. Private investment in these 
types of assets only makes sense if the long-term benefits of the 
investment are clear. With carbon permit prices fluctuating wildly, 
long-term signals regarding the carbon-reducing benefits of investment 
in clean-air technology are clouded at best and nonexistent at worst. 
Therefore, it is not apparent that a cap and trade system resulting in 
a market for carbon permits is helpful in aligning private interests 
with policymakers' long-term goals: the dissemination of technologies 
that will reduce carbon emissions.
    In fact, numerous asset pricing anomalies can be expected to 
continue to frustrate long-term pricing signals in a market for carbon 
emissions, in addition to the volatility arising from weather and 
politics.
A. While Carbon Permits Are Usually Thought of as a Commodity Contract 
        Because the Deliverable Is a Factor of Production, Price 
        Dynamics of the Contracts Are Not Those Expected for 
        Commodities
    In many ways, cap and trade emissions contracts are commodity 
contracts. A commodity contract is a contract to deliver a raw product 
or primary input such as food, metal, or energy. In the case of cap and 
trade contracts, the deliverable is carbon emissions, which is a 
primary input for production. Emission allowances are classified as 
``normal'' factors of production. Since the allowances are used for 
production, they are removed from the market as they are consumed. 
Therefore, the right to emit carbon can be compared with other 
commodities that are traditionally used as factor inputs in production, 
and standard commodity pricing models can be applied to the carbon 
emissions market.\24\
---------------------------------------------------------------------------
    \24\ Id. at 4-15.
---------------------------------------------------------------------------
    Commodity markets work on a spot and a futures basis. The spot 
market is the market for immediate delivery of the commodity. The 
futures market is the market for delivering the commodity at some point 
in the future. The futures market is a derivatives market, meaning that 
its value is derived from the current spot market for the underlying 
asset. The spot and futures market for the EU's current cap and trade 
contracts exists on a number of different commodity exchanges.\25\ 
Empirical data from these exchanges can show whether the real-world 
pricing of cap and trade contracts conforms to price behavior of other 
commodities possessing similar characteristics.
---------------------------------------------------------------------------
    \25\ Marc S. Paolella & Luca Taschini, An Econometric Analysis of 
Emission Trading Allowances, Swiss Finance Institute Research Paper 
Series (2006) at 5-6.


    The conditions just described are the result of what are commonly 
referred to as arbitrage conditions. If, for instance, the futures 
price was above the spot price plus storage, arbitrageurs could sell 
futures and buy on the spot market, storing the commodity for future 
delivery at a risk-less profit. The opposite also generally holds true.
    But in the case of carbon emissions, the optimal level of emissions 
is stochastic, so that a firm's demand for emissions allowance 
contracts is also stochastic.\26\ Because of these uncertainties and 
costs, a firm benefits from holding an inventory of the commodity to 
hedge against any unexpected higher prices. Therefore, allowances for 
different vintages will have different spot prices at a given point in 
time.
---------------------------------------------------------------------------
    \26\ Id. at 13-14.
    
    
    In other words, the convenience yield is sufficiently large such 
that the future price is less than the spot price. In addition, the 
future price decreases as time to maturity increases.\27\
---------------------------------------------------------------------------
    \27\ Id. at 14-15.
---------------------------------------------------------------------------
    The opposite of a backwardation structure is contango--spot prices 
are less than futures prices. Empirical evidence from the EU carbon 
market shows that the carbon futures market illustrates characteristics 
not of backwardation, but of contango, where spot prices are less than 
futures prices.\28\ But the financial economics literature suggests 
that commodities with contango structures usually have readily 
available inventories that are easily accessed and stored and stable 
supply and demand functions. Those conditions contradict the 
performance of carbon markets to date. Even if cap and trade contracts 
have no cost of storage and are easily accessed, levels of supply and 
demand for carbon emissions are not easily predicted. In addition, the 
level of inventories for cap and trade contracts is dependent on 
current emission levels, which are stochastic and unpredictable.
---------------------------------------------------------------------------
    \28\ Id. at 15.
---------------------------------------------------------------------------
    Because the empirically observed convenience yield for cap and 
trade contracts does not conform to standard finance theory for 
commodities, a price analysis based on a historically consistent theory 
of future-spot parity is probably not very useful.\29\
---------------------------------------------------------------------------
    \29\ Id.; S. Truck, S. Borak, W. Hardle, & R. Weron, Convenience 
Yields for CO2 Emission Allowance Future Contracts, School 
of Economics and Finance, Queensland University of Technology, 
Brisbane, Australia (2006).
---------------------------------------------------------------------------
B. While Carbon Permits Can Be Considered an Option Contract Because 
        the Producer Can Choose Whether to Use the Allowances in Any 
        Given Settlement Period, Price Dynamics of the Contracts Are 
        Not Those Expected for Typical Options
    A futures contract only allows for delivery at a specific date in 
the future. A carbon contract can be used for production at any time 
until expiration. A carbon cap and trade contract may therefore be more 
like an option than a future.\30\ An option is a contract between a 
buyer and a seller that gives the buyer the right, but not the 
obligation, to buy or sell an asset at a specified price on or before a 
specified date. The option to buy an asset is known as a call option, 
and the right to sell an asset is known as a put option. In the context 
of a carbon market, an emissions contract would be similar to a put 
option, because it allows the contract holder to exercise a right to 
emit carbon during a specific time period.
---------------------------------------------------------------------------
    \30\ For a primer on financial options, see John Hull, Options, 
Futures, and Other Derivatives 6 (Prentice Hall, 6th ed. 2006).
---------------------------------------------------------------------------
    A multi-period cap and trade contract can be characterized as a 
sequence of European put options (options that can be exercised at a 
specific expiration date in the future) that come into effect 
sequentially through the life of a contract. The decision of when to 
exercise each put option is characterized as a real option, optimal-
stopping-time problem, similar to the problem of early exercise on an 
American option. Consistent with common intuition, early exercise is 
optimal only when the holder's demand for emissions increases.
    One of the most common models to price options is the Black-Scholes 
model. According to the Black-Scholes valuation model, the value p of a 
European put on a non-dividend-paying asset is estimated by:


    The Black-Scholes model is commonly applied to stock options. Since 
contracts give holders a put option to produce emissions until a given 
maturity date, the Black-Scholes model could similarly be applied to a 
cap and trade contract. This option can be traded, just as a stock can, 
and a market participant could value the put option using the Black-
Scholes model. However, the Black-Scholes model has numerous shortcuts 
and anomalies that limit its use in valuing even common stock options.
    Characteristics of the carbon market will most likely reveal 
further complications to the usefulness of the BlackScholes model. The 
Black-Scholes model for valuing options already contains many important 
limitations. First, the model is only used to value an option if it 
will be exercised at expiration (European options). Therefore, it 
cannot value American options, which can be exercised at any point in 
time before expiration. Second, the model also assumes that the return 
on the underlying asset is normally distributed, which may not be the 
case for carbon emissions, and has certainly not been the case for 
stocks. (Historically, stock market returns have been skewed or 
leptokurtic--exhibiting more returns in the ``tails'' of the 
distribution than would be found in a normal distribution.)\31\ Third, 
the model assumes a constant discount rate, even though the discount 
rate could change over the life of the contract. Fourth, the model 
assumes a constant volatility of the underlying asset, which market 
experience has already shown to vary substantially over time.
---------------------------------------------------------------------------
    \31\ See, e.g., B. Mandelbrot, The Variation of Certain Speculative 
Prices, 36 Journal of Business 394-419 (1963); E. F. Fama, The Behavior 
of Stock Market Prices, 38 Journal of Business 34-105 (1965); P. 
Theodossiou, Financial Data and the Skewed Generalized T Distribution, 
44 Management Science 1650-1661 (1998).
---------------------------------------------------------------------------
    The empirical literature testing the accuracy of the BlackScholes 
model is enormous. Although most studies confirm that market prices 
generally are close to the estimates resulting from Black-Scholes, 
several anomalies have been found. For example, because of the model's 
assumption of normally distributed returns when returns are in fact 
skewed or leptokurtic, Black-Scholes generally undervalues deep in-the-
money call options (or out-of-the-money put options) and overvalues 
deep out-of-the money call options.\32\ Figure 3 illustrates the 
difference between the normal distribution assumed by the Black-Scholes 
model and a skewed leptokurtic distribution that is commonly observed 
in stock returns.
---------------------------------------------------------------------------
    \32\ M. Rubinstein, Implied Binomial Trees, 49 Journal of Finance 
771-818 (1994).
---------------------------------------------------------------------------
    As Figure 3 shows, ``distribution B''--that is, the skewed 
distribution with thick tails--is asymmetric, which leads to deviations 
from outcomes common to the normal distribution. For example, if both 
tails in the distribution of asset returns are thinner than a normal 
distribution, then the Black-Scholes model overprices out-of-the-money 
and in-the-money calls and puts. If the left tail is fatter, and the 
right tail is thinner, then the Black-Scholes model overprices out-of-
the-money calls and in-the-money puts, and it underprices out-of-the-
money puts and in-the-money calls. If the left tail is thinner, and the 
right tail is fatter, then the Black-Scholes model overprices out-of-
the-money puts and in-the-money calls, and it underprices in-themoney 
puts and out-of-the-money calls. If both tails are fatter, then the 
Black-Scholes model underprices out-ofthe-money and in-the-money calls 
and puts.
    Several alternatives to the Black-Scholes model exist, but they 
each have their own problems. For example, Geske's compound option 
model treats the equity in a firm as a call option on the value of the 
firm, making the option an option on an option. A second alternative 
model is the displaced diffusion model, which values an option based on 
the volatility of the percentage of risky assets held by the firm. A 
third alternative, the constant elasticity of variance model, assumes 
that volatility of a firm's value is a function of its fixed costs, and 
the volatility of firm value increases when stock prices drop. Each of 
these three alternative models, however, overprices out-of-the-money 
calls and in-themoney puts, and underprices out-of-the-money puts and 
in-the-money calls.
    Other alternatives include the pure jump model, which assumes stock 
prices do not change continuously but jump randomly, and the jump 
diffusion model, which puts jumps together with geometric Brownian 
motion (also called a ``random walk''). However, the pure jump model 
overprices out-of-themoney puts and in-the-money calls, and underprices 
in-themoney puts and out-of-the-money calls. The jump diffusion model 
underprices out-of-the-money and in-the-money calls and puts.
    In addition to the established anomalies of Black-Scholes and other 
models in pricing stock options, the market for carbon emissions has 
its own anomalies that complicate the valuation of cap and trade 
contracts as options. As discussed above, cap and trade contracts leave 
holders with the risk of having too few abatement options at the end of 
the commitment term when they may need those options. On the other 
hand, a firm that holds more permits than it expects to need may still 
hold onto the surplus because those permits have some option value, 
given that purchasing options in the future may be costly. Illiquidity 
arises endogenously from the fact that firms cannot emit without having 
permits and thus fear that they may face a market squeeze at the end of 
the year. The combination of the general anomalies of commodities, and 
options valuation models with the anomalies in the carbon emissions 
market have the capacity to seriously complicate the valuation analysis 
of a cap and trade market.
C. Exhibited Characteristics of Carbon Permit Prices Confirm That They 
        Are Tremendously Complex Financial Contracts So That Financial 
        Economics Is Unlikely to Find the True Value of ``Cap and 
        Trade'' Permits
    Emission allowance prices have exhibited periods of high 
volatility, arising in part due to the correlation between 
CO2 emissions and external events such as seasonal changes 
and environmental disasters. Those external factors increase the 
difficulty of modeling emission allowance values, making it difficult 
for market participants to plan ahead for their future carbon 
emissions.
    Figure 4 shows the daily allowance spot prices for sulfur dioxide 
(SO2) from 1999 through May 2006. These allowances are 
traded on the over-the-counter market as well as through the Chicago 
Climate Exchange.\33\ Producers of SO2 emissions have been 
granted allowance permits through the United States Acid Rain Program 
since 1995.\34\ The spot price for SO2, at least from June 
2003 until November 2005, could be consistent with a stochastic mean-
reverting process with a constant positive drift, as desired by the 
stated cap and trade policy. The enormous price drop after November 
2005, however, indicates that an assumption that the SO2 cap 
and trade market was working correctly and that the policy was 
responsible for the gradual upward trend in price movement would most 
likely have been very wrong.\35\
---------------------------------------------------------------------------
    \33\ Marc S. Paolella & Luca Taschini, An Econometric Analysis of 
Emission Trading Allowances, Swiss Finance Institute Research Paper 
Series (2006), at 5.
    \34\ Id. at 2.
    \35\ Id. at 7-8.
---------------------------------------------------------------------------
    Studies of the European markets for CO2 allowances have 
also shown the difficulty in using cap and trade for risk-management 
purposes. In a paper discussing an optimal design for emission 
allowance derivatives, two financial economists from Universitat 
Karlsruhe note that political and regulatory uncertainties, weather, 
and fuel prices were the most important and most volatile factors 
affecting allowance prices, according to surveyed market 
participants.\36\ Weather changes (such as temperature, rainfall, and 
wind speed), fuel prices, and economic growth all affect CO2 
production levels. Unexpected events, such as power plant breakdowns or 
environmental disasters that shock the supply and demand balance for 
CO2, and changes in fuel spreads shock the demand and supply 
side of CO2 allowances and consequently market prices.\37\
---------------------------------------------------------------------------
    \36\ Marliese Uhrig-Homburg & Michael Wagner, Success Chances and 
Optimal Design of Derivatives on CO2 Emission Certificates 
(2006), at 23.
    \37\ Eva Benz & Stefan Truck, Modeling the Price Dynamics of 
CO2 Emission Allowances, 31 Energy Econ. 4, 6 (January 
2009).
---------------------------------------------------------------------------
    For example, energy consumption (and hence CO2 
emissions) increases with cold weather. Non-CO2 power 
generation is affected by rainfall and wind speed. In addition, the 
relative costs of coal, oil, and natural gas affect the decision to 
move forward with CO2 abatement projects, and fuel switching 
costs can be high. These sources of price uncertainty have a short-or 
medium-term impact on liquidity, which in turn affects the volatility 
of emission allowance prices.\38\ In addition, the prohibition on 
banking emission allowances between distinct phases of the EU ETS 
significantly affects futures pricing in that market.\39\
---------------------------------------------------------------------------
    \38\ Id.
    \39\ George Daskalakisa, Dimitris Psychoyiosb, & Raphael N. 
Markellosa, Modeling CO2 emission allowance prices and 
derivatives: Evidence from the European trading scheme, J. Banking Fin. 
(forthcoming 2009).
---------------------------------------------------------------------------
    As a result of the complex fundamental dynamics, forecasting models 
based on fundamentals and future-spot parity of CO2 yield 
implausible results due to market complexity and to the particular 
behavior of the allowances, such as inconsistent behavior of 
CO2 allowance convenience yield.\40\ Other studies have also 
shown that CO2 emission allowance prices are nonstationary 
and exhibit abrupt discontinuous shifts, short periods of high 
volatility, with heavy tails in the distribution.\41\ One study 
analyzing the dynamic behavior of CO2 emission allowance 
spot prices for the European emissions market demonstrates that a steep 
price increase will occur when the end of the trading period is 
approaching, in contrast to a smooth approach to spot prices 
demonstrated in typical commodity markets.\42\
---------------------------------------------------------------------------
    \40\ Marc S. Paolella & Luca Taschini, An Econometric Analysis of 
Emission Trading Allowances, Swiss Finance Institute Research Paper 
Series N06--26, 2006.
    \41\ George Daskalakisa, Dimitris Psychoyiosb, & Raphael N. 
Markellosa, Modeling CO2 emission allowance prices and 
derivatives: Evidence from the European trading scheme, J. Banking Fin. 
(forthcoming 2009).
    \42\ Jan Seifert, Marliese Uhrig-Homburg, & Michael Wagner, Dynamic 
behavior of CO2 Spot Prices, 56 J. Envtl Econ. & Mgmt. 180 
(2008).
---------------------------------------------------------------------------
    The institutional and financial characteristics described above 
make the choice of a proper statistical model crucial (albeit perhaps 
impossible) for purposes of risk management and carbon permit 
securities valuation. Given the interrelationship of carbon prices with 
both fundamental and policy variables, emission allowance prices and 
returns will exhibit different periods of behavior that include price 
spikes, volatility spikes, and heteroskedastic returns. The 
``jumpiness'' of price series necessitates using not only traditional 
time series models, but jump and jump-diffusion models to analyze the 
statistical properties of the series.\43\
---------------------------------------------------------------------------
    \43\ Eva Benz & Stefan Truck, Modeling the Price Dynamics of 
CO2 Emission Allowances, 31 Energy Econ. 4, 14 (January 
2009).
---------------------------------------------------------------------------
    The dynamics discussed above are not limited to the EU. In addition 
to the EU cap and trade emission allowances, which are government-
issued offsets that are limited in supply, other ``low cost'' emission 
credits that will assist the countries that are signatories to the 
Kyoto protocol in meeting their emission reduction targets include 
Certified Emission Reductions (CERs) and Emission Reduction Units 
(ERUs). CERs are created from projects in developing countries such as 
Brazil, Mexico, China, and India that reduce greenhouse gas, whereas 
ERUs are allowances that have been allocated to mainly Eastern European 
countries that have already met their emission reduction targets. CERs 
and ERUs are both fully fungible with the EU emission allowances and 
can therefore be banked and traded within the EU ETS. According to an 
early 2006 report, some project developers had already sold forward 
their CERs for delivery in 2006 and 2007, while others were banking 
their CERs until the price became more favorable.\44\
---------------------------------------------------------------------------
    \44\ Ronald S. Borod & Madeleine Tan, Carbon: Is It Just Hot or Is 
It a New Asset Class?, 9 INTL. Securitization & Fin. Rep. 11 (February 
15, 2006).
---------------------------------------------------------------------------
    An important lesson from the EU's experience with CERs and ERUs is 
the arbitrage opportunities that have arisen due to the significant 
price difference between EU allowances and CERs. Funds and other 
entities finance energy projects that result in CERs. Then, those 
entities aggregate the CERs that are produced and create pools of 
carbon credits that are diversified across projects and countries.\45\ 
These arbitrage opportunities mitigate both credit and country risk, 
but further complicate efforts to price emission allowance contracts 
alone.
---------------------------------------------------------------------------
    \45\ Id.
---------------------------------------------------------------------------
    Given the number of pricing anomalies that exist in financial 
markets, and the fact that carbon permits would share properties, at 
least in part, with many financial assets whose prices exhibit 
similar--but not identical--anomalies, valuations driven by financial 
markets are unlikely to uncover the true price of carbon permits in the 
multiple sources of statistical noise in market prices. Should a market 
for carbon permits in the United States emerge, one can be sure that 
investors will use the most innovative--and therefore untested--
valuation techniques available to value and to trade what would be, 
arguably, one of the most important contracts in the economy and the 
environment. Although uncertainty may surround the value of such 
contracts ex ante, one can be sure that market participants will soon 
discover weaknesses in either the contract terms or the market 
structure and will seek to exploit any arbitrage opportunities that 
present themselves. Consequently, the nascent market will have to be 
monitored closely and carefully regulated. Market regulation itself, 
however, is far from efficient and fraught with difficulties.
iii. managing the supply of carbon permits is like central banking, and 
          central bank policy has not been working well lately
    Theoretical mathematical and economic models have been designed to 
show that a cap and trade program with sufficient banking and borrowing 
can, in principle, deliver a better outcome than taxing emissions. This 
conclusion has been recognized to some degree in papers that extended 
the prior work on optimal carbon permit banking and borrowing. More 
recently, public policy work for Resources for the Future by Richard 
Newell et al. (2005) showed how inter-temporal banking and borrowing 
would allow firms to smooth abatement costs across time, offsetting the 
traditional disadvantage of cap and trade relative to taxes.\46\
---------------------------------------------------------------------------
    \46\ Richard Newell, William Pizer, & Jiangfeng Zhang, Managing 
Permit Markets to Stabilize Prices, 31 Environ. & Resource Econ. 133-57 
(2005).
---------------------------------------------------------------------------
    The results of Newell et al. (2005) in particular, however, rely 
crucially on several mechanisms borrowed directly from central bank 
policy. Using those features, Newell et al. (2005) claim to have 
written a theoretical economic model that, for the first time, 
suggested cap and trade (with appropriate dynamic modifications adopted 
from central bank theory) can achieve greater economic efficiency than 
tax-based approaches.\47\
---------------------------------------------------------------------------
    \47\ Id. at 149 (``We demonstrate that permit systems incorporating 
banking, borrowing, and adjustments to the quantity of outstanding 
permits can replicate price-based regulation. The methods do not 
require any monetary transfers between the government and the regulated 
firms, thereby avoiding a politically unattractive aspect of price-
based policies.'').
---------------------------------------------------------------------------
    As a result, most recent carbon market development proposals now 
routinely borrow institutional features from central bank design and 
organization that are thought to be able to effectively regulate and 
constrain carbon markets to achieve environmentalists' objectives. It 
is those institutional features, working optimally according to 
assumptions embedded in the economic models, which generate the models' 
efficiency gains over straight carbon taxes. The problem is that--as 
demonstrated in markets today--central bank policy rarely achieves 
those ideal efficiencies because central banking is far more 
complicated than it looks. In fact, given the theoretical and practical 
difficulties of central bank policy and application, Newell et al. 
(2005), style carbon market manipulation is more likely to undermine 
the benefit certainty that is the hallmark of cap and trade policy, 
decreasing cap and trade efficiencies to levels no better than--and 
perhaps worse than (depending on political volatility)--a simple carbon 
tax.
    Like carbon contracts, money is a necessary input to production, 
and can be used to store value for the future and as a source of 
income. The fundamental source of value for both carbon contracts and 
money lies in the necessity of their use as a production input by 
government fiat. Hence, it makes sense to think of carbon permit supply 
management in the same light as managing a fiat money supply.
    The section below shows that monetary theory--the branch of 
economics that concerns itself with attempting to achieve the 
simultaneous objectives of maintaining a valuable fiat currency without 
stifling economic growth, typically through central bank operations--
separates three sources of demand for money: consuming, investing and 
speculating. Those demands are analogous to the uses of carbon permits 
as inputs to production, savings for future production, and options on 
expanding production in the future.
    Those three demands create great complexity in monetary system 
design. Traditionally, three common ways of addressing the different 
needs are through discount window operations, reserve requirements, and 
manipulating the supply of fiat contracts. Contemporary carbon market 
proposals also include such features, but rarely acknowledge the limits 
to economists' knowledge with regard to best practices and 
effectiveness.
    Last, therefore, I discuss the central bank's role in monetary 
policy, actively monitoring hitherto unknown dimensions of the economy 
in attempts to smooth economic growth by manipulating the money supply 
to stabilize the relative value of the fiat contract against the 
production, investment, and speculative demands for the contract. While 
it is one thing for a central bank to try to operate such a system with 
a relatively-well-established instrument called money, whose supply can 
be both expanded and contracted over time, it is quite unreasonable to 
expect to efficiently manage innovative financially engineered markets 
of financial instruments with a long-term objective of decreasing 
supply and maintain reasonable economic efficiency in the short-term 
without substantial and sometimes repeated economic disruption.
    The section stresses throughout how little is really known by 
economists about monetary theory and central banking, even after 
hundreds of years of academic research and policy application. Indeed, 
the current credit crisis is a manifestation of those limits to 
knowledge. Hence, the section proposes that applying the principles and 
practices of monetary economics to a new fiat instrument with unknown 
properties can have crucially important unintended consequences. While 
it may make sense to experiment with carbon market design in a 
relatively constrained application in order to learn how to harness 
that market, reducing carbon emissions can best be attained in the 
short-term through taxes rather than cap and trade policies.
A. Productive Use, Investment Use, and Speculative Use of Contracts 
        Will Compete for Limited Supply of Contracts
    Money is thought of as having three distinct uses whose relative 
importance varies over time: consumption use, investment use, and 
speculative use. First, and most straightforward, money is used to buy 
things, that is, for consumption. A carbon contract can only buy one 
thing, carbon emissions, but the analogy is still apt.
    The second use of money is to store consumption potential over time 
and, more powerfully, until a time when that potential may be greater 
than today. Such activity is commonly called investment, and carbon 
permit holders can invest similarly when schemes involve banking 
provisions. Sometimes economies suffer from too much investment, that 
is, too little consumption. Some monies, typically in developing 
countries, may therefore have expiration dates to get consumers to use 
them more quickly. Usually, however, trade (legitimate or illegitimate) 
in different financial contracts can smooth individual inter-temporal 
consumption preferences despite such restrictions.
    Investment differs from speculation in that investment targets some 
goal of future consumption. Speculation, in contrast, merely attempts 
to realize the maximum value of exchange either inter-temporally or 
across contracts of different types. If contracts are either mispriced 
or expected to be of far greater value in different times or places, 
speculators may demand some fraction of the contracts to take advantage 
of those relationships. Speculators have no use of the contracts for 
their own purposes, but may rent them from others to take advantage of 
speculative opportunities, creating leverage. While such activity is 
harder to observe with money (since money is fungible), it may be 
easier to identify among carbon permit holders with no emissions needs.
    That fungibility is an advantage to fiat money over carbon permits. 
The ``hard'' carbon permit value makes the contract more vulnerable to 
demand shocks than the ``soft'' fiat money contract--just as money 
backed by gold was more difficult to defend than fiat currency. This is 
an important point, because what is envisioned as a tightly controlled 
supply of carbon permits will not just be used for consumption 
(producing carbon this period) but also for investment (producing 
carbon next period) and speculation (betting on the price of carbon).
    Academic proposals for carbon market designs have acknowledged 
difficulties dealing with competing demands, even if they have not yet 
formally adopted the vocabulary of monetary economics. For instance, 
the ability to bank carbon permits may create a political problem akin 
to ``undue wealth accumulation'' or ``hoarding'' when some firms have a 
large residual supply of permits on hold. The second, some say greater, 
problem is that firms with large banked permit resources could corner 
markets and drive up prices. The risk lies in the way some authors 
think of rectifying the problems. The most simple proposals call for an 
expiration date on the permits, much like Zimbabwe (annual inflation 
last year of roughly 10,000 percent), and other dysfunctional 
developing countries impose expiration dates on their currency. Others 
suggest imposing more stringent project requirements on firms with 
greater ``wealth'' in terms of banked permits. Nevertheless, authors 
admit that the permit demand function is largely unknown, noting 
``...there is little evidence concerning how large of an allowance bank 
firms might accumulate (it could, in fact, be much larger than one 
year's worth of allowances), how fast they might spend it down, and in 
turn how much this might affect any future tightening of the cap.''\48\
---------------------------------------------------------------------------
    \48\ See Brian C. Murray, Richard G. Newell & William A. Pizer, 
Balancing Cost and Emissions Certainty, Resources for the Future 
Discussion Paper (2008) at 10.
---------------------------------------------------------------------------
B. Typical Ways of Managing the Competing Demands for Money Are Not at 
        All Straightforward in Practice
    Typical proposals maintain that uncertainties about the permit 
demand function can be addressed through a central bank ``discount 
window'' equivalent, imposing a ``reserve requirement'' on permit 
holders, or regularly intervening in permit markets to dynamically 
manipulate permit supplies in a manner similar to open-market 
operations. While such features appear attractive at face value, closer 
inspection quickly reveals the well-known--within the field of monetary 
economics--problems associated with using these tools to manipulate the 
money supply and how much more complex and potentially intractable the 
problems would be if implemented with carbon permits.
            1. Discount windows do not work for the money supply, so 
                    why should they be expected to work for carbon 
                    contracts?
    Accepted approaches to carbon permit supply management have evolved 
to allow some form of borrowing if permit costs are unexpectedly high 
or supply is otherwise unavailable. Notwithstanding the fact that such 
policies are generally frowned upon by staunch environmentalists who 
want emissions limits treated as rigid constraints, the question 
becomes when to intervene and how many permits to offer. Those are 
precisely the questions that have confounded monetary theory for 
hundreds of years.
    The clearest advice that has been given for managing such discount 
window applications is Bagehot's rule, which suggests that liquidity 
crises should be addressed by ``lending freely at a penalty rate.'' The 
idea is that financial market crises are accompanied by liquidity 
difficulties arising when investors cannot sort out weak firms from 
strong ones. Firms that are otherwise sound but lack temporary 
liquidity can, therefore, be helped through discount window lending by 
a monetary authority that has inside information about firm conditions. 
The carbon permit problem would be similar, if firms did not hold 
enough reserve permits to meet production requirements, say, in a cold 
winter. Hence, the policy approach is argued to be similar, as well.
    Of course, operationalizing Bagehot's rule in central banking has 
been tricky. What constitutes a crisis? What constitutes lending 
``freely''? What is a penalty rate? Environmental authors are feeling 
their way around such policy problems, effectively reinventing the 
wheel. Some suggest allowing the regulator to ``...react to specific 
high-permit-price circumstances by making special allocations.'' Far 
from applying the penalty rate, however, such authors suggest the 
regulator ``...give away some volume of additional permits, thereby 
lowering permit prices,'' which is like a central bank dropping 
interest rates to zero. Of course, it would be desirable to only 
facilitate a temporary increase in permits (similar to facilitating 
only a temporary increase in the money supply to avoid inflation), 
leading some to suggest the permits be loaned instead of sold.\49\ All 
the approaches will be applied in a highly politicized environment, 
detracting--perhaps substantially--from economic efficiency.
---------------------------------------------------------------------------
    \49\ Newell, Pizer, & Zhang, supra at 148.
---------------------------------------------------------------------------
    Moreover, the environmental debate ignores the fact that the 
importance of central bank discount window policy has waned 
considerably over recent decades. While discount window lending can 
help smooth typical small fluctuations in currency demand, discount 
window lending is not an advantageous way to address crises where 
solvency difficulties are often paramount, since more credit does not 
help firms become less insolvent. Similarly, additional subsidized 
permits will only help insolvent environmentally value-destroying firms 
hold on a little longer at the margin and will destabilize the carbon 
regulatory authority. Hence, after hundreds of years of 
experimentation, the discount window lies largely unused for 
significant policy purposes. The carbon market equivalent similarly 
holds little promise.
            2. Reserve requirements help stabilize banks but are not 
                    used to actively manipulate monetary policy
    Environmentalists have also come to advocate central bank reserve 
requirements as not only a means of smoothing permit demand, but also 
manipulating permit supply. As with other central bank applications, 
the principle is deceptively simple. Firms that use carbon permits to 
some substantial degree are required to hold a quantity of unused 
permits to accommodate normal production demand, perhaps based on a 
certain percentage of the allocation or based on a certain percentage 
of last year's emissions. ``These reserves would be roughly analogous 
to the reserve requirement that the Federal Reserve places on banks, 
whereby they are required to always hold and not loan out certain 
percentage of deposits. As with the Fed's reserve requirement, firms 
not meeting the permit reserve requirement could be allowed to borrow 
from the regulatory authority in order to meet it.''\50\
---------------------------------------------------------------------------
    \50\ Id. at 147.
---------------------------------------------------------------------------
    Again, problems arise when environmentalists read too much into 
central bank policy, unaware of the pitfalls that such policy options 
have demonstrated over the history of practical application. Some 
environmentalists suggest the reserves give ``...the regulator an 
additional policy lever to stabilize permit prices by influencing the 
effective amount of permits in circulation, in the same manner that the 
Fed can adjust reserve requirements to influence the interest rate. 
Raising the reserve requirement, for example, would lower the effective 
amount of permits available in the market, thereby raising the permit 
price. Lowering the reserve requirement would have the opposite effect. 
The regulator could take this action any time it saw prices deviating 
from the target.''\51\
---------------------------------------------------------------------------
    \51\ Id.
---------------------------------------------------------------------------
    Central bankers long ago, however, accepted that reserve 
requirements were too heavy-handed to be used as a policy tool. In the 
monetary world, reserve requirement manipulations required every bank, 
irrespective of its resources, to expand or--more importantly--contract 
reserves by a fixed amount to meet policy goals. Such broad policy is 
obviously detrimental to institutions with even idiosyncratically 
temporarily low reserves, penalizing such banks for what may be 
advantageous use of capital. Hence, the Federal Reserve moved away from 
actively using reserve requirements for policy purposes in the 1950s. 
While undergraduate textbooks still correctly teach that central banks 
still have the authority to change reserve requirements, reserve 
requirements are not considered a realistic central bank policy tool 
and are probably too heavy-handed for environmental policy, as well.
            3. Open market operations are the current vanguard of 
                    monetary policy, but the effects and limits of open 
                    market operations are still largely unknown
    Modern central banks influence markets primarily by purchasing and 
selling key market instruments, thereby affecting the supply of money 
and, secondarily, the price (interest rates). While overall supply is 
affected by open market operations, however, the supply of money 
related to consumption demand is most important for driving economic 
growth, the ultimate target variable of monetary policy. If money that 
is injected through open market operations is merely absorbed by 
investment or speculative demand, it is transformed back into 
securities and therefore does not drive growth as directly as does 
consumption. When the money injected is merely held in excess reserves 
(equivalent to ``stuffing money in the mattress''), the link between 
open market operations and economic growth breaks down completely. To 
the extent such preference shifts are understood in monetary economics, 
the field refers to the conditions as a breakdown in the credit channel 
of monetary policy transmission, which can create a liquidity trap.\52\
---------------------------------------------------------------------------
    \52\ See, for instance, Ben S. Bernanke, Nonmonetary Effects of the 
Financial Crisis in the Propagation of the Great Depression, 73 Am. 
Econ. Rev. 257-76 (1983).
---------------------------------------------------------------------------
    A similar phenomenon can be imagined for carbon open market 
operations, where productive, investment, and speculative demand are 
more closely tied to the target variable of economic growth. If 
productive users do not receive permits sold through open market 
operations--whether because productive users do not desire such permits 
or because speculators desire those permits more highly than productive 
users (who value the permits at the marginal cost of fuel substitution 
or production cutbacks)--the link between carbon permits and production 
will be broken.
    Breaking a carbon market ``liquidity trap'' may involve increasing 
the supply of carbon permits dramatically. When the Federal Reserve 
embarks upon such action, it runs the risk of inflation. When the 
carbon market regulator embarks upon such action, it runs the risk of 
obviating the long-term carbon emissions restrictions it seeks to 
impose. Both invoke vast unknowns in the economics of engineering and 
manipulating markets for public benefit. Both are potentially damaging 
and even reckless, both economically and politically.
            4. Regulatory credibility and optimal policy consistency 
                    are not easily obtained
    Since the early days of Kydland and Prescott (1977) and many 
authors who followed, the risks that central banks assume in generating 
policy credibility, consistency, and openness have become well-
known.\53\ With central banks, such considerations arise out of 
investor concern for inflation and economic growth. With carbon 
markets, similar considerations can be expected to arise with respect 
to long-term carbon emissions goals and economic growth.
---------------------------------------------------------------------------
    \53\ Finn E. Kydland & Edward C. Prescott, Rules Rather Than 
Discretion: The Inconsistency of Optimal Plans, 85 J. of Pol. Econ. 
473-91 (1977).
---------------------------------------------------------------------------
    The main problem with central banks is that credibility, 
consistency, and openness are only measurable against long-term 
economic growth, which may take several years to evolve from any given 
policy shift. With applications to carbon markets, credibility must be 
maintained with respect to not only long-term economic growth but also 
long-long-term carbon emissions reduction targets, which may take 
decades to measure.
    The issue of credibility is central to academic discussions of 
whether central banks should set policy on the basis of rules or 
subjective judgment. Rules are attractive because investors can 
transparently weigh whether the central bank intends to meet their 
long-run policy goals by observing whether the central bank is 
following the rule to which it has committed.\54\ The rule therefore 
helps investors filter through the noise of short-term economic 
fluctuations to determine policymakers' credibility.
---------------------------------------------------------------------------
    \54\ Id. Rules are credible precisely because they impose 
discipline in the face of economic upheavals. Inflexible rules 
regarding gold parity of the dollar and other worldwide currencies 
certainly helped cause the Great Depression. While inflation--dropping 
the rule--helped spur recovery in every country, each inflated with the 
objective of reestablishing pre-Depression gold parity sometime in the 
future. It was not until 1973 that countries moved to fiat currencies 
(not based on gold), and recent crises in Latin America and Asia remind 
us that economists' understanding of the relationship between rules and 
credibility is still in formative stages.
---------------------------------------------------------------------------
    Rules, however, do not fit every situation. Hence, central banks 
prefer to have discretion over how to address idiosyncratic issues 
affecting short-term economic growth. Discretion can also be used, 
however, to eviscerate policy goals. Hence, rules are stronger than 
discretion in establishing central bank credibility. Once credibility 
is established, however, mature central banks can usually be trusted to 
undertake some level of more discretionary and effective short-term 
policymaking.
    Of course, setting rules precisely in the context of specific 
policy questions can be difficult. Monetary theorists have struggled 
with growth rules, inflation rules, and other monetary policy target 
rules. The well-published Taylor Rule is one example of an outside 
metric that is used to judge deviation from steady-state policy in a 
discretionary central bank.
    What rules would an environmental regulator set? The simplest 
relates to the benefit certainty that is thought to be the hallmark of 
cap and trade: reduce carbon emissions over time. In the short-term, 
however, holding tightly to such a rule may impose substantial costs on 
economic growth. Furthermore, according to the now-famous Lucas 
critique, once traders figure out rules, they act accordingly. As with 
developing country central banks, the regulator may therefore be 
attacked by speculators buying contracts in hopes of driving prices up. 
As long as regulators hold tightly to their rules, speculators gain. 
Hence, while the regulator seeks to establish credibility, the 
speculator seeks to push prices to levels that break the regulators' 
resource constraints. Such was the case in the Asian and Latin American 
crises of the 1990s and George Soros' speculation against the British 
Pound in 1992.
    Once the regulator deviates from its rule, it must once again 
establish credibility. After the crises of the 1990s, more countries 
adopted other sorts of currency pegs and floating pegs to allow rule-
based policy with greater degrees of discretion to guard against 
speculative incursions. Some countries maintained their rules-based 
policies and defended them through capital controls, prohibiting 
exchange between foreign and domestic currency in times of necessity. 
Overall, however, the problem of establishing central bank credibility 
has not yet been solved in monetary economics, and policy-makers 
seeking to apply central bank paradigms to carbon markets should expect 
similar difficulties.
    Once credibility is established, central banks are still not free 
to do as they wish. Policy inconsistency has been shown by many authors 
to be as disruptive as any financial crisis. The regulator cannot set a 
discretionary paradigm or an operating target and then change it 
without expecting economic disruption as businesses and investors try 
to understand the new ``rules of the game.'' In fact, modern central 
bank policy has changed significantly across recent decades, and those 
changes have sometimes caused tremendous disruptions. Central banks 
have struggled over appropriate operating target variables for some 
time now, and ongoing financial innovation perpetuates the struggle.
    Policy inconsistency was related to the 1970s stagflationary 
episode. In the 1970s, the Federal Reserve implemented monetary policy 
by targeting the federal funds rate. Interest rates rose dramatically, 
however, during the 1970s. The Federal Reserve responded to interest 
rate increases by increasing the money supply, which led to 
historically high levels of inflation (e.g., over 10 percent in the 
summer of 1979). With rapidly rising inflation, Paul Volcker (chairman 
of the Federal Reserve Board at the time) felt that interest rate 
targets were not doing an appropriate job in constraining the demand 
for money (and the inflationary side of the economy). Thus, on October 
6, 1979, the Federal Reserve chose to completely refocus its monetary 
policy, moving away from interest rate targets toward targeting the 
money supply itself, and in particular bank reserves--so-called non-
borrowed reserves, which are the difference between total reserves and 
reserves borrowed through the discount window.
    Growth in the money supply, however, did not turn out to be any 
easier to control. For example, the Federal Reserve missed its M1 
growth rate targets in each of the first three years in which reserve 
targeting was used. Further, in contrast to expectations, volatility in 
the money supply growth rate grew as well. In October 1982, the Federal 
Reserve abandoned its policy of targeting non-borrowed reserves for a 
policy of targeting borrowed reserves (those reserves banks borrow from 
the Fed's discount window).
    The borrowed reserve targeting system lasted from October 1982 
until 1993, when the Federal Reserve announced that it would no longer 
target bank reserves and money supply growth at all. At this time, the 
Federal Reserve announced that it would again use interest rates--the 
federal funds rate--as the main target variable to guide monetary 
policy (initially setting the target rate at a constant 3 percent). 
Under the current regime, and contrary to previous tradition such as in 
the 1970s, the Federal Reserve now announces whether the federal funds 
rate target has been increased, decreased, or left unchanged after 
every FOMC meeting--previously, the federal funds rate change had been 
kept secret.
    Some signs of policy inconsistency have already shown up in 
European carbon markets. The trading period break between 2007 and 
2008, institutionalized in first-generation carbon contracts, 
prohibited continuous spot trading between the two trading periods. The 
result has been two separate markets over time, and the potential EU 
ETS transition into a third trading period would create further 
disruption. According to European writers, the break has made 
``...planning or risk management a lot more difficult for companies 
active in the EU ETS. Policy makers should thus think about a smoother 
transition into a potential third trading period. ''\55\
---------------------------------------------------------------------------
    \55\ See Marliese Uhrig-Homburg & Michael Wagner, Futures Price 
Dynamics of CO2 Emission Certificates.
---------------------------------------------------------------------------
    In summary, therefore, central bank operating paradigms are not as 
simple as they seem. The Federal Reserve retains one of the most 
impressive staffs of economists worldwide not because the governors are 
fans of economic research, but because that research is necessary to 
guide monetary policy on a path through great unknowns. That is also 
why the governance structure of the Federal Reserve is constructed to 
provide consistent policy across long periods of time, so that 
knowledge and experience can potentially be buffered from political 
demands across time.
C. A Carbon Market Efficiency Board modeled on central bank operations 
        will operate with all the above constraints plus additional 
        uncertainties and political interference
    Policies to date have suggested that the supply of carbon permits 
be constrained to meet environmental goals. Problems arise, however, 
when considering that--as with monetary policy--the price of those 
contracts will be left to vary widely in response to market conditions. 
Indeed, analysis in the previous sections showed that we have already 
seen incredible price volatility in European markets, obviating efforts 
to push carbon prices to levels that will stimulate green investment.
    A further advantage of money market manipulation over carbon market 
manipulation is that there is no intended fixed constraint on money 
supply or consumption that can be used to influence economic growth. In 
fact, the U.S. is unique among countries worldwide in that roughly two-
thirds of the money supply is estimated to be held outside the country. 
Hence, there is no worry about running into a hard constraint on the 
amount of money necessary to facilitate consumption while accommodating 
investment and speculative demands. Whereas central bankers are allowed 
to raise the money supply above a prespecified ceiling, the stated 
ideal is for carbon permit supply to remain constrained, which--adding 
complexity--will be decreased over time.
    More importantly, even central banks have learned over time that 
they can target either the price of money (interest rates) or the 
quantity of money, but not both. If the money supply is the target, 
variable interest rates must be allowed to fluctuate. By contrast, if 
an interest rate (such as the fed funds rate) is the target, then the 
money supply must be allowed to fluctuate relatively freely.
    In summary, carbon permit supply will need to be dynamically 
controlled to adjust for numerous unobservable influences, just like 
the money supply. If investment or speculative demand rises, there will 
be fewer permits available for production. If, on the other hand, 
investment or speculative demand falls, carbon overproduction may 
result. Hence, managing a carbon permit market will be far more complex 
than managing the money supply, which--indeed--is already tremendously 
complex, leading to cyclical booms and busts that remain the focus of 
an entire body of economic research.
    Managing a carbon permit market will therefore rely even more 
crucially on economists who can staff a Carbon Market Efficiency Board 
with the courage to stanch booms and the talent to mitigate busts, much 
as the Federal Reserve is expected to accomplish today. According to 
environmental researchers, all policy proposals ``...run into a barrier 
of establishing some type of management board to manage the reserve 
allocations and otherwise administer the program.''\56\ It is that 
board that is crucially responsible for the dynamic optimality of the 
implemented cap and trade solution over a carbon tax alternative.
---------------------------------------------------------------------------
    \56\ See Murray, Newell, & Pizer, supra at 21.
---------------------------------------------------------------------------
    Like a central bank, the important issues would be the precise 
governing mandate for such a board, the tools available to it, and the 
degree to which it operated subject to legislated rules versus having 
complete discretion. Even the Federal Reserve faces multiple 
conflicting goals, including seeking ``to promote effectively the goals 
of maximum employment, stable prices, and moderate long-term interest 
rates.'' In steady-state economic growth, those goals all work in 
tandem. But in economic booms and busts, the goals may conflict with 
one another. For instance, the only way to bring high inflation down is 
to restrain economic growth, resulting in higher unemployment. In such 
a situation, ``those responsible for monetary policy face a dilemma and 
must decide whether to focus on defusing price pressures or on 
cushioning the loss of employment and output.''\57\
---------------------------------------------------------------------------
    \57\ See Purposes and Functions of the Federal Reserve, available 
at http://federalreserve.gov/pf/pdf/pf_complete.pdf, at 15.
---------------------------------------------------------------------------
    A Carbon Market Efficiency Board is expected to face similar 
conflicts, at once protecting the environment and containing costs to 
firms of doing so. The board will therefore have to not only maintain, 
but define, an appropriate balance of ``contract demand'' and 
``contract supply,'' which will take considerable time and resources in 
an environment of great political and economic demands. Even the 
Federal Reserve was politically captured during its first 40 years of 
existence to serve the Treasury by keeping interest rates low, 
ultimately being released from such duty only in the Treasury-Federal 
Reserve Accord of 1951.
    But what of the Carbon Market Efficiency Board's mandate to 
restrict carbon emissions and contain costs to preserve economic 
growth? Balancing both long-run costs and long-run growth makes the 
Federal Reserve's job look simple, in comparison. When both emissions 
and economic growth targets are long-term, the management of the two 
takes on an air of supposition beyond even that managed by central 
banks. Operationalizing the Carbon Market Efficiency Board's mandate 
will require settling on a measure of emissions among the vast number 
of possibilities, as well as settling on a measure of costs. Like a 
central bank, unable to directly measure either, the board will have to 
choose target variables it thinks are related--to one extent or 
another--to the ultimate policy variable and manage to those targets 
while trying to make sense of the targets' relationship to the ultimate 
policy measure.
    None of this is new: central banks still struggle with a proper 
definition of economic growth, since classic measures like GDP, for 
instance, exclude services and other key segments of productive 
activity. Central banks also struggle with the definition of inflation, 
relying on CPI and PPI measures that--classically now that we have 
experienced another asset bubble--exclude financial market prices and 
housing prices. With greater integration of financial markets and 
commercial banks, central banks are not even sure anymore what money 
is. Indeed, those uncertainties are why economies still experience 
financial crises, recessions, and depressions. With theoretical 
economic certainty, there would be no credit crisis, nor 10,000 percent 
annual inflation in Zimbabwe, nor any of the booms and crashes that 
inexorably repeat themselves through history.
    Instead of certainty, modern economies rely on central bank 
representatives who are thought to be wizened individuals with industry 
knowledge and economic backgrounds that can help them make creative and 
meaningful policy even where economic theory falls short. Members of 
the Federal Reserve Board of Governors are chosen in a manner that 
attempts to balance conflicting interests, coming from diverse 
backgrounds such as banking, monetary economics, and law, with 
practitioners and academics represented in the mix. Furthermore, the 
governors can rely upon a staff of some of the best economists in the 
world to undertake market and economic studies that help create strong 
central banking principles that serve as guideposts to our ever-
evolving understanding of central banking and its relationships with 
markets and the economy. The diverse board composition and economic 
might are crucial to a well functioning central bank because, even 
after hundreds of years, central banking is still more art than 
science. We would expect no less in the present (infant) application of 
a Carbon Market Efficiency Board.
    In summary, in adopting a cap and trade system we are hinging 
economic growth on a complex contract and a convoluted market design, 
both of which have yet to be tested in the real world. In theory, 
therefore, cap and trade systems predicated upon a market stabilized by 
a Carbon Market Efficiency Board may be able to generate efficiency 
levels greater than a flat tax. In practice, however, cap and trade 
plans that rely crucially upon idealized applications of central bank 
operations with an unlimited supply of benevolent governors and a full 
and complete understanding of market characteristics and functions are 
rare, at best. Practical difficulties, therefore, will detract 
significantly from the theoretically ideal benefit certainty thought to 
be conferred under a cap and trade system for the foreseeable future. 
With such policy uncertainty, it is hard to imagine a Carbon Market 
Efficiency Board will be more efficient than a carbon tax, which is--in 
effect--the ultimate policy rule.
               iv. policy recommendations and conclusions
    The crux of current greenhouse gas emissions policy debates is 
whether to implement a cap and trade system or a carbon tax. 
Economically, the question comes down to which program provides the 
most effective means of catalyzing pollution abatement while limiting 
economic distortions.
    Based on economic research and the available empirical evidence, 
the most efficient policy approach would be to impose a carbon tax on 
all coal, natural gas, and oil produced domestically or imported into 
the United States. While both a carbon tax and a cap and trade system 
achieve the same goals in theory, a carbon tax would be simpler to 
implement, more transparent, and less vulnerable to manipulation or 
malfeasance.\58\
---------------------------------------------------------------------------
    \58\ Avi-Yonah & Uhlmann at 4-6.
---------------------------------------------------------------------------
    The present paper shows myriad benefits associated with 
implementing a carbon tax over a cap and trade program. In terms of 
simplicity of administration, carbon taxes are both easier to enforce 
and can more readily be adjusted if the policy is too weak or too 
aggressive. A carbon tax also reduces the time lag between the 
promulgation of a pollution target and its achievement, as a tax can be 
administered immediately. A cap and trade system, in contrast, requires 
extensive administrative and market infrastructure that will take 
decades to develop.
    Additionally, a carbon tax would result in an immediate revenue 
inflow, as it would rely on the existing federal tax structure for 
collection. This revenue could then be used to promote further 
environmental protection in the form of research grants for the 
development of alternative energy sources, which are not forthcoming 
from carbon permit market revenues. Carbon tax revenues could also be 
used to offset any regressive effects of the carbon tax, especially 
where small businesses will be adversely affected by additional 
production costs in a positive-carbon price world.\59\
---------------------------------------------------------------------------
    \59\ Id at 4-5.
---------------------------------------------------------------------------
    The most important drawback of cap and trade programs is that they 
do not work in practice. The tradable permits program initiated by the 
European Union has been subject to administrative folly and 
disappointing results. On the other hand, carbon taxes have been 
successfully introduced in a growing number of countries, including 
Canada, Denmark, Finland, Italy, and the Netherlands.\60\ The 
simplicity and efficiency of carbon taxes render their use less ripe 
for regulatory capture than a cap and trade program.
---------------------------------------------------------------------------
    \60\ Id at 33.
---------------------------------------------------------------------------
    Nevertheless, if policymakers decide to ignore the clear benefits 
of a carbon tax and opt to implement a cap and trade program instead, 
the most direct route to preventing speculative abuse and protecting 
economic growth is to guard the market through attentive monitoring and 
regulation. The carbon market regulator--referred to in U.S. proposals 
as the Carbon Market Efficiency Board--must have the power to stanch 
speculative abuses and attempts to corner the market, whether by 
domestic or foreign traders, by requiring market participants to be 
registered with the board and giving the board adequate powers to 
rescind registration in cases of domestic or international abuse.
    The board also must have macro-prudential authority to play a 
substantial role in decisions about how to value and report carbon 
contract holdings for accounting purposes in order to ensure sufficient 
transparency in financial statements of businesses that use the 
contracts for production, investment, and speculation. The board must 
have the power to provide an adequate stock of carbon contracts to 
``lean against the wind'' of global warming while ensuring economic 
growth and employment.
    Last, the board must have the power to change the terms of the 
carbon contracts if the original design proves flawed or ineffective. 
Alternative contract designs, such as a carbon fee or tax structure, 
may yet prove superior, and transition may be necessary if the present 
``cap and trade'' carbon contract proves crucially flawed. Just like 
the Federal Reserve can choose its monetary policy tools and targets, 
limiting the Carbon Market Efficiency Board to one tool or target may 
ultimately prevent it from accomplishing the task for which it is 
established: cutting carbon emissions and helping the environment.
    Proposed U.S. cap and trade policies are attempting to implement 
something far different from the original cap and trade theory using 
complex financial contracts and convoluted market designs to mitigate 
price uncertainty at the cost of the benefit certainty that is the 
hallmark of cap and trade. But such mechanisms and designs will not 
only substantially reduce the policy's impact on the environment; they 
may also pose significant risks to U.S. economic growth and 
competitiveness. In a world where economic outcomes are couched in 
uncertainty and the optimal level of pollution abatement cannot be 
established with precision, a carbon tax provides the flexibility 
policymakers need to grapple with the problems presented by climate 
change.
    In summary, manipulating carbon permit supply via a Carbon Market 
Efficiency Board that is charged with restraining emissions without 
unduly harming economic growth necessarily decreases the benefit 
certainty that is the hallmark of cap and trade. Without that benefit 
certainty, the convoluted carbon permit market design and risk of 
market collapse is both theoretically and practically unnecessary. A 
carbon tax confers far greater economic efficiency than an ill-defined, 
unstable, and environmentalist--and Wall Street--driven cap and trade 
market design.

    The Chairman. Thank you very much.
    Jason, you're the cleanup batter here. Go right ahead.

 STATEMENT OF JASON GRUMET, PRESIDENT, BIPARTISAN POLICY CENTER

    Mr. Grumet. I'll do my best, Senator.
    Chairman Bingaman, Senator Murkowski and the rest of the 
committee, it is really a pleasure to be here on behalf of the 
Bipartisan Policy Center. The BPC was formed a few years ago by 
former Senate Majority Leaders Daschle, Dole, Baker and 
Mitchell with the goal of providing both the motivation and the 
infrastructure to encourage some meaningful bipartisan 
engagement. Our interest is not the esoteric desire that you 
all play nice together, but rather the view that truly durable 
change is going to require a different kind of collective 
engagement that involves all members of this Congress.
    I will admit that some have fairly noted recently that our 
efforts to change the debate have been subtle at best. But we 
do believe that we are going to have a more collective and 
collaborative mood here. I really think that there's no better 
place to start than with this committee.
    As you point out, Mr. Chairman, not only did you mark up 
bipartisan legislation this year. But in 2005 and 2007 this 
committee brought forward bipartisan legislation that passed 
with 74 and 86 votes respectively. So it my great hope that 
this committee will take an even more active role in the weeks 
ahead. I'm going to focus principally on costs and then say a 
few words on offsets.
    On costs our flagship project, the National Commission on 
Energy Policy has long held that providing predictable and 
transparent cost containment is one of the absolute keys to 
moving climate legislation through the Congress. In 2004 we 
offered recommendations that provided a simple safety valve. 
Again, you know, not an abstract idea. But like Congress, many 
members of our group have dramatically different views on the 
expected and predicted costs of a climate program.
    Senator Murkowski, you point out that very modest 
differences of views about offset availability or natural gas 
prices or the speed and the price of new technologies lead even 
our national governmental institutions to reach broadly 
different conclusions on the costs of the same program. So the 
benefit of a cost cap is that it essentially allows people to 
agree to disagree. If the prices are low as many would hope 
then the presence of a cost cap is of no accord.
    If prices in fact are much higher than people predicted 
well then, you want a cost cap because you don't want to have 
the potential damage to the economy. In broad strokes I think 
the combination of a cap and a price cap or collar really 
provides the best elements of both the tax proposal and a cap 
and trade program. That's why we think it really is the obvious 
way forward.
    Now while this issue remains controversial. I think there 
is clearly a different mood in the Senate about a price cap 
then there has been before. I think that's very encouraging.
    I also want to note though that our positions have evolved 
over the last few years. We now support and believe in the 
value of having a price floor as well as a price ceiling, 
having that collar. We have also generally comfortable with the 
numbers for that collar, if it was a true collar in the House 
bill. The idea of a $10 floor and a $28 ceiling for reasons I'm 
happy to elaborate on seem, you know, within the realm of good 
reason.
    Also we are now supportive of a well designed, strategic 
reserve. As Ms. Claussen pointed out, that has much of the 
benefits of a true cost cap. At the same time does provide over 
the course of the 50 year program an expectation of having the 
complete emission reductions realized.
    I should say that with regard to a strategic reserve we 
think it has to be simple, straight forward and easily 
understandable. Have published a paper where we make some 
recommendations as to how we think you can in fact, improve 
upon the House legislation in that regard. Because we think it 
does, because of the 3-year running average, really have a 
fluctuating price that doesn't provide the predictability that 
we think is important both to the Congress and to the market.
    A final thought on cost containment. We share the very 
broad desire that there be aggressive oversight of this market. 
Understand that this real anxiety many of you must have at this 
moment in our Nation's history of creating a new market that 
may have, you know, one to $2 billion of value.
    An important benefit of a price collar is that combined 
with the reforms that are generally being proposed by the 
Administration for all commodities you can dramatically reduce 
the price volatility. In doing so, dramatically reduce the 
potential for market manipulation and the potential for undue 
profits. Recognize that there are some who are calling 
essentially for cap without trade and others who are arguing 
for a very prescriptive controls on who can participate in the 
marketplace and what instruments are allowed.
    We would urge great caution in going down those paths. They 
are truly a return toward a command to control regulatory style 
that I think we have learned over years is not the most cost 
effective way to move forward. Hope that having a true price 
collar we can in fact allow the market to work, but bounded by 
those publicly intended floor and ceiling price.
    Finally on offsets, I can be very brief because I'm very 
much in accord with on our paper that we released today is very 
much in accord with what Professor Wara suggested. Though, I 
think our Energy Commission is more optimistic than Dr. Wara 
about the long term opportunities for emissions offsets to play 
a meaningful role under a truly global regime. We strongly 
share the view that there is just tremendous uncertainty in how 
this market will mature.
    I think of emission offsets like I think of any of the kind 
of breakthrough technologies, advanced nuclear, carbon capture 
and sequestration and dramatic increases of renewables. Many of 
these are going to work profoundly well. But it's going to take 
some time. It's very hard to predict.
    I think it's much more likely that in the early years we 
will see about 100 million tons of international offsets, much 
more like anything we'll see that number than the 1 billion to 
1 \1/2\ billion that's contemplated in the ACES bill. You know, 
the European Union collectively right now after 6 years has 
about a 300 million ton program going forward. I think that's 
probably the high water mark for what we could imagine.
    So in closing I guess, Chairman Bingaman, Senator 
Murkowski, I just want to acknowledge on behalf of this entire 
committee that you have worked together. You have held 
workshops and numerous hearings that really try to understand 
and address the key obstacles and concerns that have served as 
barriers to moving legislation through the Congress. As I 
reflect on the broad political dynamic right now I would assume 
I want to close by saying we need you and are very hopeful that 
we'll have opportunities to work with this committee going 
forward. Thank you.
    [The prepared statement of Mr. Grumet follows:]

   Prepared Statement of Jason Grumet, President, Bipartisan Policy 
                                Center,
    Chairman Bingaman, Ranking Member Murkowski and members of the 
Committee, thank you for the opportunity to testify today.
    I am pleased to be here on behalf of the Bipartisan Policy Center 
(BPC), which was founded by four former majority leaders, Senators Tom 
Daschle, Bob Dole, Howard Baker and George Mitchell. BPC was created to 
help provide the motivation and infrastructure to forge the bipartisan 
consensus we believe is necessary for durable change. The model of 
principled, bipartisan compromise we pioneered with the National 
Commission on Energy Policy (NCEP) later came to serve as the founding 
idea for the Bipartisan Policy Center. Launched in 2007, the BPC has 
projects underway that address a broad suite of issues, including 
energy, national security, health care, transportation, financial 
services and science. The BPC's mission is to develop and promote 
solutions that can attract the public support and political momentum to 
achieve real progress.
    Bipartisan policy is of course very familiar to this Committee. You 
have historically worked in a truly bipartisan way to pass legislation, 
including the 2005 and 2007 energy bills that combine enhanced energy 
security with meaningful greenhouse gas emissions reductions.
    BPC's flagship project, the National Commission on Energy Policy, 
was formed in 2001 to bring together a diverse group of 20 nationally 
recognized energy experts to address critical energy policy issues.
    In 2004 and 2007, the Commission released reports proposing 
detailed bipartisan strategies to meet our nation's energy challenges. 
Since then the Commission has undertaken a wide array of projects and 
analyses to inform the national energy and climate change debates. 
Recent reports seek to address the legitimate concerns of rate payers, 
business, organized labor, agriculture and energy intensive industries.
    The major remaining recommendation from our 2004 and 2007 reports 
that Congress has not yet enacted is an economy-wide cap and trade 
program that, in combination with other complementary measures and 
commensurate international action, will help prevent the most damaging 
potential consequences of global climate change.
    In furtherance of our efforts to educate the public on critical 
design elements of such a program, the Commission has recently released 
two papers pertinent to this hearing: ``Managing Economic Risk'' and 
``Domestic and International Offsets.'' These papers accompany my 
testimony and I ask that they be accepted as part of the record.*
---------------------------------------------------------------------------
    * Documents have been retained in committee files.
---------------------------------------------------------------------------
    The Commission's principles for an effective economy-wide cap and 
trade program are clear: under a well-designed climate bill, emission 
limits would initially be modest and ramp up in a gradual and 
predictable way over multiple years, with effective mechanisms in place 
from the outset to (a) guard against high or excessively volatile 
allowance prices and (b) protect low-income households and trade-
sensitive/energy-intensive businesses. This approach will provide time 
and a favorable investment environment for robust low-carbon technology 
alternatives to become available, thereby reducing climate-related 
costs to the economy. It will also help ensure that the transition to a 
low-carbon economy provides a steady impetus for the creation of 
durable new industries and employment opportunities with minimal 
regional economic dislocation.
    We believe that Congress must act to address climate change as soon 
as possible-urgency must take precedence over competing views of 
perfection. In our mind, there is no question that, left unchecked, 
climate change will compound environmental and economic as well as 
national security risks to the United States and its citizens.
    Many will argue that with a struggling economy this is exactly the 
wrong time to tackle climate change. Last year some argued against 
acting on the basis of $4 gasoline prices. Once an economic recovery 
takes hold, arguments will again center on China, India, and other 
developing nations or the lack of perfected clean energy technologies. 
There will always be an excuse to avoid confronting the single biggest 
environmental challenge of our generation, but the longer we delay 
acting the more costly the eventual solution.
    If anything, our current predicament--a recession caused in part by 
rising energy prices and a nascent recovery threatened by the next 
increase in energy prices--illustrates the danger of drifting along 
with the status quo. In the long run, the policies we need to address 
global warming are also the policies we need to regain control of our 
energy destiny. And with appropriate cost containment mechanisms and 
allocation designs we can be confident that the energy security and 
economic impacts of any climate policy we adopt now are manageable in 
the near term and positively beneficial in the medium and long-term.
              controlling costs in a cap and trade program
    Since the cap-and-trade debate began, the ability to form a 
meaningful consensus has been hampered by disagreements over the 
projected costs of compliance. Taken together, even moderately 
different views on the cost of new technologies, the speed at which 
they will deploy, the availability of offset credits, and the macro-
economic response to a price on greenhouse gas emissions can lead to 
dramatically different estimates. Such disparities point to the 
inherent difficulty of making predictions about the future, 
particularly when it involves complex social, economic, and 
technological factors. As a result, the debate over compliance costs 
remains a formidable barrier to forging a legislative consensus.
    For several years, we have advocated for a price ceiling that would 
set a maximum cap on the price of allowances. The initial price for 
this cap should be set in statute and increase by 5% annually above 
inflation. We reached this agreement to address the fact that members 
of our Commission, like Members of Congress, have substantially 
different expectations about the costs of compliance. The inclusion of 
a price ceiling enables people to essentially ``agree to disagree'' 
while collectively moving forward in support of a cap-and-trade 
program. If compliance costs are low, as many advocates believe, then 
the presence of a price ceiling is of no accord. Conversely, if prices 
are substantially higher than forecasted, the price cap limits costs 
while new technologies are developed that are capable of achieving 
lower-cost reductions.
    Recently, the Commission also embraced the adoption of a price 
floor. Just as some are concerned about potential high costs, others 
fear that allowance prices could dip so low that the program will fail 
to provide a meaningful incentive for technology advancement and 
innovation. They argue that low natural gas prices, significant volumes 
of cheap offsets, or slower-than-expected economic growth could lead to 
extremely low allowance prices. Setting a price floor provides more 
consistent financial incentives for sustained investment in low-carbon 
technologies that can reduce compliance costs in the long run. Rather 
than being subject to boom-bust cycles when allowance prices fall, new 
low-carbon technologies would be assured a certain level of market 
stability. Together, a price ceiling and floor-or ``price 
collar''.substantially reduces the uncertainty about the costs of a 
climate program.
    There are two basic approaches to determining where to set the 
initial floor and ceiling prices. One approach is to examine economic 
modeling of the projected price of a reduction target and set the 
collar levels at a certain percentage above and below these 
projections. The other approach is to examine the impact of different 
price levels on key factors like electricity prices, gasoline prices, 
coal production and set the ceiling at a level that prevents costs from 
reaching unacceptable levels. NCEP believes that the $10 floor and $28 
ceiling set in the Waxman Markey bill for year one are in line with 
both of the above approaches. EPA's projected 2015 cost for the Waxman-
Markey bill is $13-$15 per ton. The proposed $28 ceiling is therefore 
double the midpoint in EPA's projection.
    As an alternative approach, a price floor could be coupled with a 
``strategic allowance reserve'' that would, in effect, create a price 
ceiling by making additional allowances available through an auction 
that begins at a specified price. The allowance reserve would be 
similar to a price ceiling, except that instead of providing a 
potentially unlimited number of allowances at the predetermined price, 
the reserve would contain a limited number of allowances borrowed from 
the future that would eventually be paid back. If allowances in the 
reserve were used, they could be replaced either by using the proceeds 
from the reserve auction to purchase offset credits or by tightening 
emission targets in later years. While the Commission continues to 
believe that a simple price ceiling coupled with a minimum price floor 
is the most straightforward approach to managing economic risks in a 
cap-and-trade program, a well-designed strategic allowance reserve and 
price floor offer many of the same benefits and may better ensure that 
all of the contemplated emission reductions are achieved over the life 
of the program.
    To be effective as a mechanism for managing economic risk, however, 
the allowance reserve must be structured to reduce uncertainty, not add 
to it. In our paper, we suggest several modifications to the reserve 
provision in the Waxman-Markey bill that would make this cost 
containment mechanism more predictable and effective. For example, we 
recommend changing the mechanism by which the strategic reserve auction 
price is set so that the price would rise over time in a transparent, 
pre-determined fashion (just as we have recommended for a simple price 
ceiling). We also suggest a larger strategic reserve and that the 
government be directed to use reserve auction revenues to pay back 
allowances borrowed from future years.
    With respect to the price floor there has been less debate. Most 
who face potential burdens under the program would accept a $10 
allowance price and technology advocates seem comfortable that this 
price would provide sufficient incentives for long term technology 
development.
    Overall, a price floor coupled with a price cap, or a robust, well-
designed reserve auction mechanism could be extremely useful for 
increasing public confidence in a new greenhouse gas allowance market. 
These mechanisms will limit volatility, making prices more predictable 
and transparent. While the presence of a price collar could change the 
market dynamics, we view these changes as improving both the 
functioning and public support for the program.
    Finally, to the extent that the Committee is concerned about the 
potential for emission credit traders to reap substantial profits at an 
undesirable cost to the average consumer, reducing volatility 
substantially reduces the ability of market participants to reap 
unreasonable profits from this new market. While NCEP shares concerns 
stated by many on this Committee that there must be aggressive market 
oversight, we believe that the adoption of a price collar would 
substantially reduce the need for adopting specific restrictions on 
market participants and trading instruments beyond the requirements the 
Administration is proposing for all commodities. The presence of a 
price collar ensures that there will be a functioning trading market to 
achieve compliance at lower costs.
    In short, we believe that a climate bill must have price certainty. 
It is our view that simplifying and strengthening the cost containment 
provisions in the House legislation with the modest and important 
revisions I mentioned is critical to building a bipartisan consensus 
for meaningful action this year.
                                offsets
    I would also like to briefly discuss the role of offsets in 
managing the program costs. EPA's analysis of Waxman-Markey assumes the 
immediate availability of substantial international offset credits (up 
to 1.5 billion tons). While the inclusion of offsets as an alternative 
compliance option gives emissions sources greater flexibility and can 
reduce short-and long-term costs, it also introduces an additional 
source of uncertainty since numerous difficult-to-predict 
administrative and environmental factors will affect the supply of 
offset credits and ultimately allowance prices. We are fully supportive 
of a robust offset market and hope that they are abundant, inexpensive, 
and represent real, verifiable emission reductions. However, we should 
not rely on them as our primary cost-containment mechanism. There is 
too much uncertainty about the quantity and quality of international 
offsets to feel confident about their adequacy in managing economic 
risk in the critical early years of a cap-and-trade program. The price 
collar mitigates uncertainty about the availability of offsets (just 
like it does with uncertainty around technology deployment). To the 
extent that offsets are plentiful, costs will stay below the cap. 
Conversely, in the event that sufficient offsets do not materialize 
quickly enough, the price cap (or robust strategic reserve auction) 
will be the tool that controls cost. In short, offsets are a 
complementary cost control measure, not a substitute for effective cost 
control.
    It is simply impossible to predict with accuracy how many offsets 
will be available in the early years of a U.S. cap-and-trade program. 
This is particularly true for international offsets. The number of 
these offsets used for compliance will depend on a variety of factors, 
including rules for ``additionality,'' administrative procedures for 
reviewing projects, policies in host countries, and the ability to 
negotiate agreements for broader, sectoral offsets. Based on past 
experience with offset programs, however, we would expect the 
international offset market to ramp up slowly compared to some of the 
more optimistic estimates associated with recent House-passed climate 
legislation. For example, consider the Clean Development Mechanism 
(CDM) set up under the Kyoto Protocol to promote greenhouse gas 
abatement activities in developing countries. From its inception in 
2004 through May 2009, the CDM has registered projects that now yield a 
total of roughly 300 million metric tons of carbon dioxide-equivalent 
offset credits annually. We therefore believe it is unlikely that U.S. 
purchases of international offsets would exceed 300 million tons of 
carbon dioxide-equivalent credit per year during the first several 
years of the program, and while this estimate may be conservative over 
the long term, the five-fold increase (1.5 billion ton limit) 
contemplated by the Waxman-Markey bill seems unrealistic. The inclusion 
of a price ceiling or a robust allowance auction reserve in the early 
years of a cap-and-trade program for greenhouse gas emissions would 
ease the pressure for short-term reliance on international offsets as 
the primary mechanism for managing program-related economic risks. 
This, in turn, should make it less likely that there will be design and 
implementation decisions that prioritize quick approval of large 
quantities of offset credits over the objectives of maintaining 
environmental integrity and promoting the strategic engagement of 
developing countries.
    Regarding domestic offsets, we believe there should be a ``set-
aside'' program that dedicates a percentage of allowances-say 2 percent 
to 5 percent-to reward eligible agricultural sequestration practices. 
Using emission permits to, in essence, ``insure'' new and innovative 
sequestration activities will make it possible to create a more 
streamlined approach than under a traditional offset regime. This can 
be used to reward early action and promote experimentation while 
avoiding burdensome administration and accounting rules and reducing 
uncertainty as new measurement and verification protocols are being 
developed.
    By reducing the pressure to process huge numbers of offsets in the 
early years of a cap and trade program, the cost containment mechanisms 
and soil carbon set-aside will help preserve the integrity, and 
ultimately the viability of international and domestic offset 
provisions. Past offset programs have shown that even a small number of 
imperfectly documented offset credits can significantly undermine 
confidence in the emerging offset market. There is every reason to 
expect continued controversy, critical media attention, and a high 
degree of scrutiny by NGO's and oversight bodies. This dynamic has the 
potential to stifle innovation and slow the learning that is needed to 
realize the full potential of domestic and international offsets.
    In addition to reducing costs, an international offsets program 
should engage developing countries in ways that induce more significant 
commitments on greenhouse gas emissions. The Commission believes that 
the development of sectoral offset programs and ``offset aggregator'' 
institutions are potentially important innovations and should be 
explored as part of a U.S. climate program. At the same time, these 
approaches raise a number of questions and may take time to develop. 
Thus, we do not support an approach that would rely solely on these 
types of mechanisms at the beginning of the program and believe that a 
robust project-based offset program should go forward while sectoral or 
aggregated offset options are being developed.
    Finally, the Commission recommends that Congress establish 
guidelines for an international offsets program and authorize the 
appropriate federal agencies to periodically review and, if necessary, 
modify the details of program design and implementation to be 
responsive to evolving economic, policy, and diplomatic developments.
    While we can all agree that U.S. action alone cannot solve a global 
problem, it is equally true that we have no hope of securing effective 
and equitable global action absent U.S. leadership. The key is to 
design a program that protects our economy, strengthens our security 
and encourages innovation in both the production of low carbon energy 
and sequestration of carbon emissions domestically and abroad.
    Thank you for this opportunity to testify.

    The Chairman. Thank you very much. Thank you all for your 
excellent testimony. I'll start with 5 minutes of questions and 
then Senator Murkowski and other members I'm sure will have 
questions as well.
    Let me ask about this issue of international forestry 
projects. That's one issue that was given a lot of attention in 
the House passed bill. I guess I'd be interested in anyone's 
view as to whether or not this is an opportunity for very major 
numbers of offsets in the future.
    Large quantities of offsets can be obtained from this 
source? What are the challenges that we face if we rely upon 
that? I'm just not clear. Dr. Wara, did you have a thought 
about that?
    Mr. Wara. Yes. I think I see forestry offsets, 
international forestry offsets as being a potential long term 
source. But there are really two significant obstacles to that 
coming to pass.
    The first is developing some mutually agreed upon, 
relatively objective framework for determining deforestation 
baselines. That remains a challenge. Without that we won't know 
really, how to quantify the offsets.
    The second perhaps more fundamental and more long term 
challenge is solidifying property rights regimes in the key 
developing countries that would sell us these forestry offsets. 
In many of those countries currently the environmental laws are 
not enforced, especially with respect to the illegal logging. 
There's an inability to exclude many parties from land that is 
in theory owned by a particular land owner.
    All of that uncertainty with respect to both property 
ownership and use creates a tremendous uncertainty as to 
permanence and also as to quite frankly, who owns the offset to 
be sold. Resolving those issues is complicated and is delicate, 
political process in any country. I think it will take time for 
the major developing countries, especially Brazil and Indonesia 
to get to the point where their land title regime is mature 
enough to allow for large scale forestry offsets.
    The Chairman. Jason, did you have a comment on this?
    Mr. Grumet. Just briefly. I very much agree that it is 
extremely challenging. I do think that this is the most hopeful 
area for significant international offsets.
    I think the ability in a government to government fashion 
to have a big package that looks at tens of thousands, hundreds 
of thousands of acres as opposed to having U.S. corporations 
entering into private agreements with other individuals and 
assuming that those will all somehow become aggregated. I think 
it's relatively much more promising approach. I agree that it's 
not going to be available in the next, you know, 12 to 36 
months.
    The Chairman. Ok. Eileen, did you have a comment on that?
    Ms. Claussen. Yes. I mean, I think I agree in principle 
that there are real challenges here. That these will most 
likely be of greatest value in the not immediate future.
    But I do think they are a real possibility for the future. 
I think they can play an important role. One of the things that 
strikes me in, for example, Dr. Wara's comments on the CDM 
which I think are actually really useful to contemplate is that 
we, the United States, who are usually the most analytical in 
these international fora in trying to put real numbers and real 
analysis on the table have not really been involved.
    I think that if we were involved, the United States, a lot 
of the things that have been done quite as well as we might 
have expected would actually have been dealt with. I really do 
believe that if we engage in a constructive way on the 
international forestry thing as part of a regime we can have an 
enormous influence on making sure that the offsets that are 
there are real, verifiable and something that we can count on.
    The Chairman. Let me ask. You referred to the problem of 
establishing a deforestation baseline. I believe that was the 
phrase that you used, Dr. Wara.
    My impression is that in Europe they have not, as far as 
their offset policy there, they have not been willing to 
recognize agricultural offsets to some extent the same kind of 
concerns about the difficulty of establishing a baseline. The 
difficulty of getting agreement on how you quantify the value 
of the so-called offset or the changed telling practices or 
whatever it is that's being done in the agricultural sector. I 
don't hear much discussion of that?
    I didn't hear much discussion of that in the House when 
they were passing their bill. I think there's a lot of 
expectation in this country that a substantial amount of our 
domestic offsets are going to be from agricultural sources. Is 
this a real problem? Are the Europeans seeing ghosts here or 
are we too Pollyannaish about our ability to do this?
    Mr. Wara. I think that agricultural offsets will be 
challenging to do well. Some of the toughest problems have to 
do with quantification. A field is not a smokestack and 
emissions trading works best when you have a smokestack that 
you can put a continuous emissions monitoring device on and 
monitor the flow of gas.
    Fields just are not amenable to that treatment. So and are 
sensitive to things like the history of land use, climate 
practice, or I'm sorry, the history of the weather on the site, 
soil type, lots of variables that are tough to monitor and 
practice and quantify. So there's a quantification issue.
    But there's also the fact that we have a currently existing 
subsidy program within the U.S. that funds conservation 
tillage. In fact the numbers that I have heard are that 52 
percent of agricultural land in the U.S. is currently under 
conservation tillage. So deciding what the appropriate 
conservation tillage baseline and level of crediting should be 
under an offset program that's conservative and concerned with 
additionality will be challenging.
    The Chairman. Senator Murkowski.
    Senator Murkowski. Thank you, Mr. Chairman. Listening to 
this conversation about offsets it just strikes me. No wonder 
the people I talk to back home are just scratching their head 
saying, so tell me what is it that is contained in this House 
bill and how it works? Recognizing that at least with the House 
measure so much of their cost containment revolves around this 
issue of offsets.
    We sit here talking about what is a real offset and what is 
a theoretical offset or something that may materialize in the 
future and recognizing that we acknowledge there is a finite 
amount of offsets and how this all plays in. Again, you can 
talk to people and they can understand it if it's real. But if 
it's something that we're hoping is going to materialize.
    This is the basis for our policy. When it comes to the 
issue of cost containment, which I think we all agree is 
something that we must be focused on. This is a big issue.
    I wanted to ask and it may be nothing more than has been 
provided. Jason, you mentioned it and Dr. Mason, you certainly 
alluded to it in your testimony.
    The issue of manipulation, Robert Shapiro said as a former 
Under Secretary in the Clinton administration. Many others have 
suggested that we're on the verge of creating a new trillion 
dollar market and financial assets that will be securitized, 
derivitized and speculated by Wall Street like the mortgage 
back securities market and the concern regarding structure in 
such a way that we don't see market manipulation that many are 
concerned about. You suggested, Dr. Mason, in your opinion the 
best way to avoid it was just a straight up tax. Was I correct 
in hearing that?
    Mr. Mason. Yes, I suggested that if we really go all the 
way toward stabilizing prices we've effectively already adopted 
a tax and avoided this problem of market manipulation and 
deeper crite financial market or carbon market crises that may 
pose a problem for economic development. Just even that 
something as simple on the subject of offsets we're today 
seeing a crisis and a verification structure for offset 
markets. That's already occurring, if you think of that as 
something like the problems that we solve with rating agencies 
leading up to the financial crisis.
    So knowing what we know today to go further into that 
market without assurances and institutional preconditions that 
can provide better verification would be, in my opinion, 
reckless. But worse yet I think that Dr. Wara also mentioned 
property rights are crucial to these markets. If an individual 
in a country doesn't truly have the property rights or stable 
property rights that allow them to sell a meaningful offset, 
again you run into a similar problem.
    Last, the types of countries that we're talking about are 
developing countries that often have political instability. 
While we like to think that people have the best intentions and 
we certainly do in this room. We cannot assume that worldwide 
and all regimes and all states of the world.
    I can think of, right now, just as happens with typical 
sovereign risk, where a country will seize oil fields or other 
industrial capacity of a country's ability to effective seize 
their offsets, create a scenic crisis on the order of what we 
saw say with AIG with credit default swaps where the cost of 
removing these offsets suddenly from the system will be 
prohibitive and will command a bailout from the U.S. 
Government. It's not unthinkable. In fact we should think 
through some of these incentives, these ways to gain the system 
now so that we don't have our backs against the wall of these 
ways to gain the system of like unexpectedly later on.
    Senator Murkowski. Are we thinking it through, Mr. Grumet? 
Would you like to respond? I was just given an article here. 
The headline of an article I have is ``Carbon Trading Market 
Hit as U.N. Suspends Clean Energy Auditor,'' which is certainly 
in line with what we're discussing.
    Mr. Grumet. So, I'll try to give you a brief response to 
what is admittedly a very complicated topic.
    First of all there's no question that a tax would be much 
easier to implement and reduce the potential--well there will 
be some tax evasion. But reduce the potential for market 
manipulation. I think a number of folks on this committee have 
voiced a lot of support for a tax.
    What has yet to happen is building any kind of real 
political coalition around that idea. I think if there was a 
strong, meaningful, bipartisan, political coalition advancing a 
serious tax proposal it would garner a lot of steam. But 
there's a lot of people who don't think that's likely to 
happen.
    In the absence of that the price collar is actually a 
pretty elegant solution. It provides, you know, a tax provides 
a point estimate and a collar provides a bit of a band. But as 
Senator Cantwell is--and very much appreciate your legislative 
efforts and others have pointed out. If you reduce the volume 
of that volatility, you reduce the potential for the 
malfeasance. So I think it is a significant, but not complete 
solution.
    Senator Murkowski. Thank you, Mr. Chairman.
    The Chairman. Senator Cantwell.
    Senator Cantwell. Thank you, Mr. Chairman. Dr. Mason, your 
comments are almost music to my ears. Because I think this 
committee has had many, many hearings about manipulation of 
energy markets and to have someone who can actually provide 
research about the activities of what's going on in the 
European trading I think is the specificity we need.
    I think with Enron it took somebody really getting a tape 
that said, you know, let's get Grandma Milly. Then everybody 
really realized that there was manipulation of energy markets. 
I think your specificity gives us some understanding that these 
markets really are very vulnerable.
    In fact I guess I was going to start with Mr. Grumet and 
others to talk about the price collar. But I did want to ask 
you because obviously, I mean, we are seeing a system that is 
just inherent with special interests when you have the trading 
that's been involved in Europe. Your point is it's, you know, 
if you're going to get to the point of removing those, and I 
don't know if you think where Europe is going today whether 
they're talking about doing that is the right direction. But 
then you get to the point of providing predictability a 
different way.
    So I guess I'm asking if there's any way to avoid those 
special interests if you have a trading system?
    Mr. Mason. I don't think there's any way to avoid the 
special interests. We all know how political systems work. Of 
course, they do their best to make themselves heard.
    In my mind the best you can do is insulate both political 
processes and market processes from those with overt interests 
and buffer those as good as you can. In that respect when I 
hear talk about collars and bands around prices my mind, as a 
financial economist, goes to the stories of countries 
attempting to convert their currencies into the Euro, of which 
Britain was one. As Britain attempted to decrease the 
volatility of the pound relative to the Euro into a tight band, 
the speculator intervened and pushed them off of that band.
    So when you try to hold to tight bands in fact you 
incentivize speculators to put your back to the wall to see how 
much money you're going to put up to stay in that band and try 
to break a country's reserves and their pledge of maintaining 
that rule. That's the problem with any rule. We've seen that 
time and time again.
    But one more point I'd like to make just on the subject of 
a tax is I think one of the main obstacles----
    Senator Cantwell. Just price certainty, price 
predictability. There's lots of ways to get a price 
predictability, but----
    Mr. Mason. Yes, I'm going to call it a tax now just for 
colloquial reasons. But a set price so to speak is that many 
have thought that that set price has to fully internalize the 
costs of the externality. What a lot of research in taxation 
has been showing is it's sometimes just a nominal user fee can 
get you 80 percent of the way there without trying to fully 
price the externality and getting into this tax stickiness 
problem that Eileen brought up where you'd have to reduce the 
tax to accommodate economic difficulties and so on and so 
forth.
    So I'd like to just say I think a system could be a lot 
simpler and get a lot of the effect today.
    Senator Cantwell. I couldn't agree more.
    Mr. Grumet. Just a quick point to your original question.
    Senator Cantwell. Can I throw out too, for you and Dr. 
Wara? Could you talk about the floor? You were talking about a 
price collar and the benefit of that.
    But can you talk about the benefit of a floor for emerging 
technologies because to me that it what, I mean, this is what 
we should be doing. I mean we're not going to get the 
investment. We can't subsidize our way to this transition. So 
having a floor is critical to helping us get all the type of 
investment that we want to see in various technologies.
    Mr. Grumet. So my initial thought just on this question of 
special interests is that my hunch is there are a number of 
special interests that those of you around the table don't 
really want to reward. Right? It's the Wall Street folks who 
have arbitrage credits and you know, Wall Street, not Main 
Street.
    But the market actually provides incentives for a lot of 
other special interests like technology innovators. People who 
think because there's a market out there they can invent a new 
product and achieve reductions more cheaply and garner credits. 
So there is a larger frame of the market which in the acid rain 
program and other places we've seen be very effective. So my 
only suggestion is to try very hard to find that balance where 
we kind of clamp down on what we want to avoid without stifling 
and going right back to a command and control program.
    On the point of the floor just like there is uncertainty 
about the upward price there is tremendous uncertainty about 
the low price. You know, there are those who say that because 
we are going to have a painful and ongoing recession which will 
limit economic activity. There was a report today that 
emissions have gone down more in the last year than in any year 
before. Of course, not for the reasons any of you desire.
    But if you combine that with very significant low cost 
natural gas and the possibility of significant influx of 
offsets. So if you put those three ideas together you could 
have, you know, permit prices in the $2 or $3 range. So as you 
point out you don't want to guess wrong low just like you don't 
want to guess wrong high.
    The $10 number, to my knowledge, has not, it's been a 
little more art than science. It is a number that most people 
believe will in fact motivate technology. A number that's low 
enough that just about everybody would in the kind of emitting 
community would be thrilled if it stopped there.
    There may be more math behind it. But it seems to be a 
number that people have kind of rallied around. You know, we're 
quite comfortable with it.
    Senator Cantwell. Dr. Wara.
    Mr. Wara. The key issue as I see it. The reason to have a 
price floor is to provide a number that innovative firms can 
take to the bank or in the case of the firms that I work most 
closely with to the venture fund. Right now when clean tech 
firms, even firms that plan significant operations in Europe.
    So firms that operate in an environment where there is a 
carbon price. When they try to raise funding rounds the 
experienced and most knowledgeable venture funds force them to 
justify their business case with a carbon price of zero. That 
is because the venture funds do not believe there's any 
predictability to the carbon price. They recognize that 
actually the real world experience of cap and trade markets has 
been that the downside price risk is greater than the upside 
price risk.
    In practice many emission trading markets have produced 
lower prices than predicted ex ante. Firms that are planning 
investments in technologies that are innovative and disruptive 
are thinking about that risk when they make their decisions.
    Senator Cantwell. Thank you, Mr. Chairman.
    The Chairman. Thank you.
    Senator Corker.
    Senator Corker. Mr. Chairman, thank you. I'll tell you 
what. This has been an outstanding hearing.
    I thank you for having these great panelists. I wish every 
American could have listened to the 30 minutes of testimony 
each of you gave. I think it points to, especially in this time 
of tremendous distrust of Washington, that we've earned fairly, 
this whole Rube Goldberg notion of creating this vehicle to 
basically not be straight with the American people is 
interesting to hear.
    I thank all of you for your testimony. I think every one of 
you are being 100 percent honest. I think all of you basically 
talked about price volatility other than CRS giving us 
definitions.
    I do wonder and I guess I'll start with Eileen, who's been 
certainly a leader in this cause. Why is it you think that 
climate change activists don't have the courage just to be 
straight with the American people? Say this is about raising 
the price of carbon and setting a carbon price and everybody 
understanding that?
    I mean wouldn't that build good will among the American 
people to at least be honest? Wouldn't it do away with the 
issue of the green technology piece where in essence we have 
ethanol folks in here talking about they can't compete because 
the price of oil has dropped. The whole issue of having a floor 
on the price of carbon certainly would cause those technology 
folks, the special interest that you like to reward, not the 
special interest that have come up here and sat at the table 
and calls the Waxman-Markey bill to be highly beneficial to 
their bottom line that maybe are not innovators.
    But I just would ask the question. Why don't--is this just 
sort of a romance and they want a date with the idea? They 
don't really want to marry the issue? What is the answer to 
that?
    Ms. Claussen. I'm sorry. I'm not sure I can answer your 
question. I'm in favor of telling the truth and being straight 
with the American people and with Members of Congress on what 
we're actually doing here and why we are doing it.
    Senator Corker. But you--but it is to raise the price--
raising the price of carbon----
    Ms. Claussen. You don't get the technology that you need to 
solve the problem.
    Senator Corker. Would a carbon tax instead of all these 
folks sitting around the table and some people making money off 
of it, if they have good lobbyists and some people not, if they 
don't. Would that not be a better approach for those who are 
climate change activists?
    Ms. Claussen. I mean I happen to think that there's 
difficulty with the tax because I don't know exactly where to 
set the level of the tax. I myself would prefer that the market 
set the level which you would get under a cap and trade 
program. So I mean if you designed a good enough tax at a high 
enough level to get the result. I would probably end up by 
saying let's pass it.
    But I would rather the market set the price rather than----
    Senator Corker. But this is----
    Ms. Claussen. Those in Washington set the price.
    Senator Corker. What's been discussed in the House is not a 
market. I mean, my gosh, anytime you have offsets, Dr. Wara 
mentioned that 50 percent of the reductions through 2030 are 
with offsets. That's not a market. That's like an Alice in 
Wonderland, make believe kind of thing.
    Ms. Claussen. I guess I'm not, as you know, not negative on 
offsets. There are--I mean what is an offset? It's really an 
unregulated sector.
    So if you decide that you're going to regulate the large 
emitters there are lots of smaller emitters who I think should 
be part of this as well. One way to bring them in rather than 
with command and control regulation which actually is a little 
bit in the Waxman-Markey bill. I mean there are standards there 
for smaller sources is to actually allow them to be offsets.
    So if for example you have a small methane source which you 
can verify, which could be real. I don't actually have a 
problem with using that because it would reduce emissions of 
greenhouse gases.
    Senator Corker. Dr. Wara, how many of the offsets you're 
predicting 50 percent through 2030. I mean how much will those 
be international and how much of those will be domestic?
    Ms. Claussen. I mean the international----
    Senator Corker. Dr. Wara. I've only got a minute left.
    Ms. Claussen. Thank you.
    Senator Corker. Thank you for your mostly honesty.
    [Laughter.]
    Mr. Wara. It's important to emphasize that that's EPA's 
prediction. That's not my prediction.
    Senator Corker. Do you know how much of those will be 
international?
    Mr. Wara. The vast majority are international.
    Senator Corker. So I'd just like to point out to the 
committee what that means in code. Is thanks to CRS giving us 
these great definitions, is that we are transferring wealth out 
of this country to other countries around the world. An 
absolute transference of wealth from our companies, from our 
constituents, from our citizens, to people around the world at 
a high level to create some Rube Goldberg mechanism to really 
get around the fact that we're really trying to raise carbon 
prices.
    Instead of being honest with the American people where 
those revenues would actually stay in the country and actually 
could be used, I understand under certain schemes, just dollar 
for dollar to reduce another tax which it's amazing the 
President of France is actually advocating that. You have to 
give him credit for his directness and honesty. But we're not 
doing that.
    So I know my time is up. I hope we'll have the opportunity 
to pursue this further. But the whole issue of looking at 
safety valves and collars is in essence a way of creating a 
carbon tax. But you still have all these mechanisms where 
special interests are winning and our citizens are losing.
    So thank you, Mr. Chairman for an outstanding hearing. I 
hope many more.
    The Chairman. Senator Shaheen.
    Senator Shaheen. Thank you, Mr. Chairman. I guess I would--
I'm not sure that I would agree with Senator Corker that I wish 
the American public had been able to hear all of your testimony 
this afternoon. I think they would have gotten a little 
concerned about what's being proposed because I think as 
Senator Murkowski said that what we're talking about is a very 
complicated system. That's part of the challenge with trying to 
do this is that it is complicated and so it's hard to 
understand.
    But I would like to follow up on the previous questioning 
about how we set prices. I mean I appreciate and I think I 
share the point that part of setting up a cap and trade system 
is to try and establish a market. That the market is best able 
to set prices on carbon and on emissions.
    But how do we design this so that this price cap doesn't 
interfere with market dynamics? I don't know. Mr. Grumet?
    Mr. Grumet. I would start by saying that the interference 
of the price collar is salutary. In other words what we want to 
interfere with is difficult volatility that allows, you know, 
the market traders to reap significant profits that don't 
result in technology increases. We want to avoid the volatility 
that makes it harder for investors and large companies to plan 
forwards. I mean I think that this is an intervention. But it's 
just the kind of intervention we want, you know.
    The second part of your question I think implicitly is that 
well how much, you know, where should you set the price?
    Senator Shaheen. Right.
    Mr. Grumet. There's kind of two ways you could think about 
it. You can think about it from an emissions or a cost 
standpoint.
    You know, from an emissions standpoint the modeling that 
EPA did of the Waxman-Markey bill albeit I think under many 
circumstances somewhat optimistic suggests that a range of 
program prices from $13 to $15. So the midpoint, 14, double it 
for 28. So many would argue that you want to set the price 
ceiling at you know, two times the anticipated price of the 
program which I think is the reasonable way to go.
    The other way is to think from a cost standpoint. Look at 
if permit prices were at $20, if they were at $30, if they were 
at $40, where do you start to experience costs that you don't 
want to see in this country and pass onto your consumers? You 
know, we've done some analysis that is also a little technical.
    I wouldn't want to share it with the American public. But 
be happy to share it with you. That looks at what the costs 
would be on gasoline and electricity rates and other things at 
different prices. Our sense is that, you know, somewhere in the 
$25 to, you know, $30 range the prices are sustainable. You 
don't start to see the really egregious impacts that I think 
you would all be reluctant to embrace.
    So for those two reasons maybe they were brilliant. Maybe 
they were lucky. But $28 a ton seems pretty reasonable.
    Senator Shaheen. Ms. Claussen, did you want to add to that?
    Ms. Claussen. Yes, I'd like to answer it in a slightly 
different way because one of the reasons I don't like the 
safety valve or the upper limit. I mean I do support the lower 
limit. I mean for all the reasons about technology innovation 
is the same reason why I don't like the tax.
    If you have a hard cap and it's too low you lose the 
climate protection that you're after. If you have a hard cap 
and it's too high you end up with economic impacts that you 
don't like. So it's a guessing game for the Congress to figure 
out what the right level is.
    I mean that's one reason we like the strategic reserve 
better. Because you don't end up in that kind of a situation.
    Mr. Grumet. Can I just add to that. I'm more comfortable 
with the reserve too. I think you can apply those numbers to 
either. It's just a question of whether you want to pay back 
the future or deal with the present.
    Senator Shaheen. So as we're talking about setting a floor 
then as Senator Cantwell talked about. Where do we set the 
floor so that we incentivize new technologies? How do we make 
that determination?
    I mean I've had, we've had groups suggests that what is in 
the House bill is not a high enough floor to incentivize new 
technology. So again, how do we come up with that number?
    Mr. Grumet. I think there's some art and some science. If 
you talk to a number of technology investors I think they'll 
say something that a number of people have mentioned which is 
just the clarity that there is going to be a carbon price. It's 
going to be increasing each and every year which is something 
that we hadn't talked about. But I think most of us who support 
either a floor or a ceiling believe that there should be a 
ratchet at about 5 percent a year above inflation.
    So the simple knowledge that there is a price on carbon, 
that the full faith and credit of the United States is behind 
it and then it's going to be going up for the foreseeable 
future is probably as important as the precise number. But 
again, you know, having spoken to a number of technology 
investors, they've told us that a $10 floor that accelerates by 
5 percent over inflation a year would be very meaningful. I 
mean they'd like a $20 floor, a $30 floor even more. But that 
$10 would be helpful.
    Senator Shaheen. Isn't this though pretty critical because 
if we don't--if the number isn't high enough at the start don't 
we then lose the potential for the market to encourage those 
new, very new technologies that we're trying to develop? So how 
much time have we got to experiment with this?
    Mr. Grumet. All I'll say is this. I think that the relative 
comparison is to the current price floor which is Europe. So, 
you know, we've always felt that urgency is more important at 
this moment than perfection.
    So whether it's 8 or 15, I think that may ultimately just 
be a political decision. We would support just about whatever 
you come up with.
    Senator Shaheen. Ok. Yes.
    Mr. Mason.
    Mr. Mason. I'd just like to build upon a point. I think 
you're right to ask how much time do we have to consider this 
when the price is zero now. While we may risk getting the floor 
too low by moving with something like a simple call it a floor, 
a tax, we could raise that later on. But the time that we're 
dithering is time that could be spent building familiarity with 
the data and understanding the system better to build even a 
better system.
    My objection to cap and trade, and it's been touched upon 
in various elements of the discussion here. So I'd like to 
bring that out. I think and feel free to correct me if I'm 
wrong. I think I'm the only economist on the panel.
    Cap and trade was designed to work with a well identified 
externality problem. So if we have something in this room on 
this floor and we can decide we want one ton of that thing on 
this floor and we can measure that. We can set one ton as the 
cap and we can let the market price that.
    Part of the problem with carbon is we don't know what that 
amount is. So right from the get go we're violating some of the 
key economic assumptions behind the original theory that gave 
birth to cap and trade. Once we then start talking about well, 
we don't like this price or that price, then we're getting 
further away from the theory of cap and trade.
    While Ms. Claussen does bring up, cap and trade is the 
perfect way to control that one ton of the externality right on 
this floor here that's easily identifiable. It is indeed, 
theoretically the perfect way. I think that we're letting the 
perfect be the enemy of the good right here and that we could 
move forward very quickly with a simple capital charge that 
would get us off square one. Get us gathering data on the 
dynamics of the market so that maybe later on if the market was 
amenable we could get to that perfect.
    But right now with no data and no movement I find it very 
difficult to jump right to that end point.
    Senator Shaheen. Thank you. I know I've gone over my time. 
Thank you, Mr. Chairman.
    The Chairman. Thank you very much.
    Senator Stabenow.
    Senator Stabenow. Thank you very much, Mr. Chairman, on 
this really excellent panel and all of the work that you and 
our Ranking Member have been doing on this issue. Welcome to 
each of you, a lot of important information, a lot of questions 
that I have.
    First I do want to indicate and actually put into the 
record, Mr. Chairman, a letter I just received from the 
Secretary of the Department of Agriculture. Just indicating 
that they're--based on a letter I had sent with a number of 
colleagues about the involvement of the USDA in this process 
and what they were doing to develop their technical 
capabilities. They recently developed a climate change program 
office and their office of chief economists.
    Have indicated in the letter they're preparing to conduct a 
rigorous technical and science based process to develop 
guidelines for quantifying greenhouse gas benefits of 
agricultural and forestry practices. I think that one of the 
things that the panelists talked about was getting ahead of the 
curve by preparing and planning to be ready and so I really 
commend the Secretary for moving forward aggressively on that 
process.
    I think that one of the things that a panelist talked about 
was getting ahead of the curve by preparing and planning to be 
ready and so I really commend the Secretary for moving forward 
aggressively on that process. When we talk about this issue and 
I agree with many of the comments concerning a price collar. It 
makes sense to me that we need both a floor so there can be 
confidence investing in new technology which is absolutely 
critical. That we need to know that there is a floor for a 
number of reasons in tackling what is a global crisis and also 
a ceiling so that we have that framework.
    I guess from my perspective it makes sense also to have 
offsets. That I don't see those as mutually exclusive and would 
like comments related to that. Because both of those I think 
make sense to me.
    Dr. Wara, in your--I think you've often time been viewed as 
a critic of offsets. But when I've looked at your writings 
actually you talk about smart design choices which is exactly 
what I think we are trying to do and what the efforts in the 
House bill have been to deal with the deforestation guidelines 
and so on that you've talked about. You try to address that. We 
need to make sure that's done right, that these are quality 
offsets.
    But that it's important to do that. I think it's important 
to note that if we were to look at completely eliminating the 
offsets of a cap and trade program which some would say that 
incorporating them have environmental uncertainties. But also 
not incorporating any offsets has environmental uncertainties 
with it as well.
    It would seem to me that completely eliminating the use of 
offsets in favor of only a price collar would simply introduce 
another set of uncertainties. I would point to the CBO analysis 
of the House bill that found that with offsets that the House 
bill, the allowance price of $40 a ton by 2030, approximately 
1.8 billion tons in emission reductions would be achieved with 
offset projects. But without the offsets in the House bill the 
price would be $138 billion a ton. Yet we would have lost the 
1.8 billion in reductions.
    So I would like some comments about molding those two 
together. I understand and I share with my friend from 
Tennessee on the initial look at offsets, particularly 
international offsets. What that seems to be the reality is 
that this is a global crisis and a ton of carbon is a ton of 
carbon. That we benefit by the entire world.
    In fact I want as someone coming from a manufacturing State 
to make sure other countries are holding up their fair share so 
we're not losing jobs to them. So I think and we have to look 
at this as a global challenge for us. Offsets are really, in my 
judgment, a bridge to get to new technologies. They don't take 
the place of new technology and what needs to happen. But it 
helps us and our industries be able to get there.
    But I wonder if anyone might comment about offsets and the 
price collar and how they might fit together in a credible way.
    Mr. Wara.
    Mr. Wara. I think it's certainly possible to imagine a 
system design that involves both a price collar and offsets and 
would have one important advantage over an offsets only system. 
That is that in the current experience with offsets is that 
multiple constituencies favor low quality issuance. Those are 
both at the buyer--oh, I'm sorry the seller, the creator of the 
offset because they want to make more money. Which is 
completely rational and understandable.
    But also the buyer that is the regulated entities recognize 
that the greater supply of offsets, the lower their allowance 
price will be. So they also come to the table. Put pressure on 
the regulators to use their discretion which is substantial in 
the creation of offset methodologies to favor the creation of 
emission reduction credits rather than a more conservative 
approach that comes down on the areas where there is 
uncertainty and favor of environmental integrity instead of 
issuance.
    But so you could certainly imagine the political economy of 
that regulatory process being improved by a price collar. So 
that actually a domestic Ag and forestry offsets program I 
think would be strengthened by a price collar. It would provide 
greater incentives to the regulators to focus on quality and 
make sure that farmers and foresters were fully compensated for 
the emissions reductions they create, but not overcompensated 
which everyone I think, thinks is fair.
    Without the worry that those decisions would create another 
problem, a spike in allowance prices that would potentially 
call the durability of the program into question.
    Mr. Grumet. If I could just add a thought. We believe that 
they're absolutely complementary. In fact you have to have 
both.
    The kind of precise concern we have is the idea of using 
offsets principally as a cost containment mechanism. We have 
two concerns.
    One, that it either won't work, that you won't get enough 
offsets in early enough to in fact provide the cost reductions 
that you hoped. I think a lot of people agree there's just a 
lot of uncertainty about how many will come, how fast. The 
alternative which is something I think Dr. Wara was alluding to 
is that the tremendous pressure to bring offsets in will in 
fact force us or somehow convince us to bring in lower quality 
offsets.
    That we will start an offset program relying on it too 
heavily too soon and they'll be some things that investigative 
reporters point out just don't add up. Will actually undermine 
the mechanism before it has a chance to start. So I think it's 
a key issue just of using them for the right reason. We argue 
that if you have a cost collar then you should have unlimited 
offsets because we think then the system could function. It's 
in the absence of a cost collar that we think the pressures 
create a real potential for undermining the integrity.
    I won't continue but to say that we should talk about 
domestic offsets at some point because I think we've all spoken 
about international offsets. I think you've done a tremendous 
amount of work on the domestic issue. I think they're very 
different issues.
    Senator Stabenow. Thank you, Mr. Chairman. I realize I've 
gone over.
    The Chairman. Thank you.
    Senator Barrasso.
    Senator Barrasso. Thank you very much, Mr. Chairman. Dr. 
Mason, if I could. I'm very concerned that any, any tax and cap 
scheme is simply going to benefit the same Wall Street elite 
who got us into this financial mess that we find ourself in 
today.
    We don't have a bill yet on the Senate side. Yet we're 
already debating the ways to mitigate the price volatility that 
any cap and trade bill is going to cause. So whether we're 
talking about a safety valve or price collar as others have 
talked about, in reality the only people who are going to 
understand this whole new system are going to be the elite on 
Wall Street.
    I see you're smiling and nodding your head in agreement. I 
am concerned that a cap in tax is going to be a recipe for 
green collar crime, for greed and for abuse. I know Senator 
Murkowski just referenced an article that appeared in the 
Sunday Times in the UK. The article is entitled, ``Carbon 
Trading Market hit as U.N. suspends Clean Energy Auditor.''
    The article goes on to state, the legitimacy of the hundred 
billion dollar carbon trading market has been called into 
question after the world's largest auditor of clean energy 
projects was suspended by United Nations inspectors.
    The article goes on to say, SGS UK has its accreditation 
suspended last week after it was unable to prove its staff had 
properly vetted projects that were approved for the carbon 
trading scheme or even that they were qualified to do so.
    The article goes on to say, SGS, the second such company to 
be suspended. Norway's DNV was penalized last November for 
similar infractions.
    Dr. Wara, how are we not creating just another Enron type 
situation by creating such a carbon market in the Waxman-Markey 
bill or other cap and trade bills that may come to us in the 
Senate?
    Mr. Wara. I actually think the SGS suspension was a 
tremendous positive step on the part of the CDM executive 
board. That's because the auditors to date have been operating 
in an environment of relative impunity for their actions. 
Auditors, just like everyone else, respond to incentives. Part 
of the job of any offset regulator will be to create the right 
set of incentives for auditors.
    I think the CDM executive board took an important step when 
they suspended SGS. Was there behavior adequate? Absolutely 
not. It points to--I mean there's been systematic study of 
auditor behavior that suggests that it's inadequate under the 
CDM.
    But I think everyone who looks at the issue closely 
realizes that the solution is real penalties and real costs 
imposed on auditors for bad behavior. That hasn't been the case 
to date. It's starting to be the case. So that should actually 
help.
    Senator Barrasso. Then Dr. Mason, would you like to comment 
on that as well?
    Mr. Mason. This pattern of inappropriate auditor behavior 
is all too familiar from the financial crisis. It is something 
that is a possibility we could properly incentivize in a 
grander system that's described over 1,400 pages which to me 
undoubtedly leaves room for some holes for other incentive 
conflicts as well. I think you're right, those 1,400 pages will 
be scrutinized with the most effort by those with a financial 
incentive to do so.
    Those holes will be found. Those holes are the principle 
risk that I see in jumping with both feet into a cap and trade 
system today as our primary means of helping the environment. I 
think at the end of the day we're at risk of getting too little 
effect for the environment and placing too much risk on the 
U.S. economy.
    Senator Barrasso. Then that brings up the article that 
appeared in Climate Wire on September 9. The article was 
entitled, ``Lobbying: Chicago Climate Exchange Seeks DC Muscle 
on Climate Bill.'' In this article it talks about the thousands 
of dollars the Chicago Climate Exchange paid to hire advocates 
who come from ``influential positions within Congress and the 
executive branch.''
    I think Dr. Wara was quoted as saying that the Chicago 
Climate Exchange was ``concerned that rules for trading 
flourish and that the Exchange wanted to ensure that regulation 
of commodities isn't so strict.'' Did I quote you correctly 
there? I guess the question is why do we want lax rules for 
carbon commodity trading?
    Mr. Wara. To be honest I haven't seen the article. I do 
recall speaking with the reporter. But my sense and her concern 
was, you know, why would CCX be hiring lobbyists at this point?
    My thought on the issue was twofold.
    One, that they might be seeking to ensure that their offset 
methodologies are granted early action credit under a program, 
a U.S. program.
    Also that CCX is owned, at least I believe wholly by the 
European Climate Exchange. Is that correct?
    Senator Barrasso. I would encourage you to take a look at 
this article if you're Michael Wara, Law Professor at Stanford 
University. You're quoted as saying, ``They are concerned that 
rules for trading flourish. They want to ensure that regulation 
of commodities isn't so strict.''
    So I would----
    Mr. Wara. Isn't stricter than other commodities I think is 
the concern. The concern is that for instance, limitations 
would be placed upon who can participate in the market for 
emissions allowances or offsets. That, for instance the Wall 
Street firms that we have spoken a lot about today would be 
forbidden from participating.
    In practice and for example the acid rain trading program, 
investment banks have played an important role by being 
essentially suppliers of credit. People who can afford to 
pulled allowances for the day. When prices go up they sell 
them. They make a profit.
    But they also are essentially an important source of 
stability in the market. That's, I think, that's what I was 
referring to.
    Senator Barrasso. Thank you, Mr. Chairman.
    The Chairman. Senator Dorgan.
    Senator Dorgan. Thank you very much. Although I was not 
here for the testimony, I've had a chance to look at the 
submissions. I thank the panel for being here.
    This is a very complicated and difficult issue. I guess 
I've said publicly that I have problems with the trade side of 
cap and ``trade.'' Representatives from the Energy Information 
Administration sat at the table you are sitting at in a 
previous hearing. We spent $110 million funding this 
administration, that is staffed with about 400 people.
    We wanted to know from them how it was that the price of 
oil went from $40 a barrel to $147 a barrel on day trading. We 
asked them what was the cause of the price increase? The 
representatives from the Energy Information Administration sat 
there and didn't have the foggiest idea. They didn't have any 
idea what was the cause for the rise in oil prices.
    It was speculation in the market that caused the sharp rise 
in the price of oil. It's rather berserk in the sense that it 
had no relationship to supply and demand, it just went off the 
charts. It's interesting the discussion today about a price 
collar.
    I mean, I understand why you would never want to have a 
carbon trading market without a price collar. The discussion of 
a price collar itself demonstrates that the lack of confidence 
in a market for carbon. Otherwise there wouldn't be talk about 
a price collar.
    It seems to me that a price collar undermines the notion of 
having the market make the decision. I'm not someone who 
supports having the market make that decision because I think 
we should not be heading in the direction of creating a 
trillion dollar carbon securities market. The difference, Dr. 
Mason, in what you described as the product here, a ton of 
CO2, the difference between a carbon market and most 
markets is there will be a diminishing product year by year.
    So you create a product that diminishes and a very large 
securities market on which carbon is traded. There could be a 
point in the future where we make a decision that our energy 
prices on Thursday shall be developed by some investment banks 
and traders on Wednesday. So the price that we're going to pay 
the next day is consigned to the rolling seas of a carbon 
securities market in cap and trade. So I guess count me as--
well, you know how to count me after what I've just said.
    Let me ask you a question, Dr. Mason. I read the piece that 
you wrote expressing great skepticism about the trade piece of 
cap and trade. What is your sense of the size of the carbon 
market and the potential volatility of this market? I know that 
you've responded to others as well, but would you give me some 
more information?
    Mr. Mason. I think that the size estimates of a trillion 
are far south of the real size of the market. I think there's 
far more to be gained in this market than one trillion. As far 
as the volatility, I find it hard to see a market without 
market volatility.
    The discipline that we desire to arise from having a market 
price arises from the volatility in that price. I think we 
should admit that if we don't like price volatility than we 
don't like the market solution here because you can't have 
both. You can't have a market without market volatility.
    It's kind of like the approach that we've taken to the 
financial crisis where we like the upside volatility. But we 
don't like the downside volatility. So we let traders take away 
the profits and then we bail everybody out when the prices go 
through the floor.
    Here we're talking about kind of the opposite because it's 
carbon. We let traders take the profit from the low price, but 
we insulate them from somehow defined undue high prices. Make 
artificial restrictions that we will prevent Wall Street firms 
from transacting in these securities so as to staunch 
investment or undue trading. I have a home office you can use 
if we can call that a non Wall Street firm. I'll profit from 
this.
    I can set up a company and call it an energy company. Check 
off the right code on my tax form and I can trade. Is that the 
key to arbitrage in this market? This is what I find troubling.
    There's money to be had. There's numerous ways to arbitrage 
it.
    Senator Dorgan. Is there any doubt in your mind--and again 
I apologize for not asking the others their questions because 
you've raised a lot of questions. Is there doubt in your mind 
that, in a relatively short time, we'll have derivatives, 
synthetic derivatives, swaps, everything that comes with a 
carbon market and all of the carnival attractions and dramatic 
amount of risk that we've seen developed in other markets in 
the last decade or so?
    Mr. Mason. We have them. We have securitization of carbon 
credits in Europe already. Markets are everywhere working and 
efficient and creating new innovative products.
    My only problem is hanging a substantial amount of U.S. 
economic growth on those new innovative products.
    Senator Dorgan. Senator Corker asked the question--I don't 
know whether he would actually support this issue, but he asked 
the question about a carbon tax. Let me ask the question a 
different way, calling it a carbon fee.
    Would a carbon fee be a much more direct way of addressing 
the issue rather than creating the intricate devices that are 
described in the Waxman-Markey bill?
    Mr. Grumet. I think Senator if you could convince everyone 
else to also call it a carbon fee, it would be. I think the 
concern that our group reached was just a concern that has been 
very difficult over the last several years, certainly since the 
BTU tax experience to generate enthusiasm there. There's a 
practicality here.
    I think you do have to, you know, obviously ask from the 
first instance is this a problem that you really believe has 
urgency behind it? If there was the opportunity to quickly move 
a significant tax proposal I think you would see dramatic 
support. If you believe pragmatically that's not the case, then 
the question really is and you pointed out, do you want to go 
with the market based approach or a more command and control 
approach?
    You know, the argument is, despite all the concerns 
visceral that we've shared about the market, the government has 
got to fix that. Right? I mean you all have to do that not just 
for carbon. There's going to be legislation that I hope moves 
quickly that will dramatically place new constraints on 
commodities across the board.
    Senator Dorgan. I read the papers every day. It's a pretty 
pathetic record of the government fixing the markets or even 
addressing it. I live with the hope that you just described, 
but that's a triumph of hope over experience regrettably.
    Mr. Grumet. I think that may be fair. But I guess the 
question is if you believe this is a critical problem, do you 
want to accept the higher costs of a command and control 
approach which, you know, from an environmental standpoint it 
would justify or do you want to grapple with the very real 
challenges of a market.
    Senator Dorgan. Right.
    Mr. Grumet. The idea of a collar is just that you put 
training wheels on it while you figure it out.
    Senator Dorgan. No that's not the case. The idea of a price 
collar is to actually constrain the market in a way we don't 
typically do.
    Mr. Grumet. It's to try to balance the desire for the 
benefits of the market without tolerating very real concerns 
you point out.
    Senator Dorgan. I'm not advocating having a price collar or 
not having a price collar. I approach this issue saying that I 
don't support the ``trade'' side of cap and trade. I just said 
to the Chairman that I hope at some point we might have a 
hearing that evaluates what the range of alternatives are for 
capping carbon. There are more than you've mentioned.
    You mentioned a carbon fee or carbon tax. You mentioned 
command and control and cap and trade. But there are other 
options as well. We sort of moved right into this rut of one 
option. We're going down this direction and all we can really 
talk about is cap and trade. I think there's more to talk about 
frankly.
    The Chairman. Senator Bennett.
    Senator Bennett. Thank you very much, Mr. Chairman. I 
apologize to the panel that I was called out. I've been very 
interested in what you have to say. Most of the ground has been 
covered by the questions you've already been asked.
    So let me just re-emphasize a conclusion that I believe Dr. 
Mason is in the piece that came from you. Is this your piece? 
The highlight, you say on page 20, ``In adopting a cap and 
trade system we are hinging economic growth on a complex 
contract and a convoluted market design both of which have yet 
to be tested in the real world.''
    That's a pretty scary statement. I happen to believe it's 
true. So let me ask this question that I don't think has been 
asked that I keep coming back to in this whole debate. Has any 
cost benefit analysis been done on what we get if we do put, 
fill in the blank, in place?
    Fill in the blank, cap and trade, carbon tax, price collar, 
command and control, all of the terms that we get. Now what do 
we get in terms of actual, economic benefit from controlling 
greenhouse gas emissions?
    Mr. Wara. If I could respond to that, Senator?
    Senator Bennett. Sure.
    Mr. Wara. I hate to cite the work of another prominent law 
school. But NYU Law School recently came out with a report that 
attempted in the best fashion that they could because they're 
not the EPA to apply an approach, a cost benefit analysis 
approach, to the ACES bill. Their outcome, and it's just one, 
but I think it's one of the few that's been done that really 
looks at the benefit side of the ledger as well as the cost 
side of the ledger, indicated that ACES was a highly cost 
effective piece of legislation.
    There is significant uncertainties around the benefits of 
evaluating any piece of environmental legislation. I'd be the 
first to tell you that. But the work that's been done so far 
suggests that the U.S. would come out ahead on this bill.
    Senator Bennett. Alright.
    Ms. Claussen. Yes, let me answer it in a slightly different 
way. There have been lots of different economic analysis 
looking at the cost side of this. There are some lessons you 
can learn from all of that.
    Even where the inputs are different and the results are 
different, I think you can still take away a lot of things 
about how to make this less costly, how to do it an effective 
way. There is not the same level of analysis on the benefits 
side. There's a lot of stuff that's anecdotal. There's a lot of 
stuff that's region specific. But there is no either global or 
national assessment of the benefits looking at it in dollar 
terms.
    I mean, we've actually done a lot of work. We've brought in 
a lot of people to talk about how you might do it. While I 
believe based on the anecdotes and the work that has been done 
that if you do it in a relatively intelligent way, don't try to 
do too much too fast and so on and so on. The benefits far 
exceed the cost, but I don't think you can say we've got really 
good data on the benefit side that matches the quality of the 
data on the cost side.
    Mr. Yacobucci. Then Senator, it's just worth noting that on 
the benefits side those ranges of value if we're talking about 
$20 a ton or $30 a ton are the numbers that have been put out 
here. The range of benefits is anywhere from zero to hundreds 
of dollars a ton depending on whose analyses----
    Senator Bennett. A fairly wide delta, you're saying.
    Mr. Yacobucci. You could say that.
    Senator Bennett. Alright. Ok. I've tried to ask myself or 
tried to discover for myself what the environmental benefits 
are. Those become even more difficult to discover. Trying to 
turn it into temperature change you end up with projections of 
the amount of less warming that you would get in 100 years. You 
want to talk about a wide delta this is about as difficult as 
it can be.
    Every analysis I have seen says that the impact on 
temperature change is basically diminimus. Now is there any 
evidence to say, no? That's it's going to be dramatic if we do 
this?
    Mr. Grumet. Senator I guess--and this question comes up a 
lot. I think it's an important one. That analysis requires 
understanding kind of the dynamic nature of a global collective 
action problem. I think you could isolate the U.S.'s actions in 
the drug war and trying to fight poverty and trying to get rid 
of global extremism.
    Senator Bennett. Yes.
    Mr. Grumet. Terrorism and say the U.S. alone can't solve 
that problem. That is absolutely clear here. If you believe 
that U.S. action is a predicate for meaningful action by other 
countries that are big emitters and going to get bigger. You 
believe that the consequences of an action are potentially 
tremendously negative for our own population.
    Then that argues--and I think what Eileen correctly points 
out is an anecdotal way that we should get started. But I think 
one of the reasons that many of us are talking about the price 
collar is that we shouldn't be silly. We should get started in 
a way that we have confidence, is not going to undermine our 
own economic strength and hope that that gives us the authority 
to negotiate internationally.
    If it doesn't then I don't think you'll see many people 
advocating for second and third steps. But it's a, you know, 
probably unsatisfactory, but the most honest answer I can give 
you.
    Senator Bennett. No, it's very satisfactory because it is 
an honest answer. My fear is that we put this in place, 
discover that it does not produce any significant change around 
the world and then leaves us stuck with it. If that happens 
then the anecdotal evidence that is good for our economy better 
be right because we will have paid a very significant price.
    Yes.
    Ms. Claussen. Maybe I can just make one point. I think it 
is absolutely clear that without us taking some steps the rest 
of the world will not. It is more of a question as to whether 
if we do, will everyone else at a level that we think is 
important.
    But I think the opposite is absolutely true. If we don't 
take some steps in this there is no way that the rest of the 
world will do it. We will be faced with, I think, very serious 
impacts even if we can't quantify them all.
    Senator Bennett. Mr. Chairman, I had a brief discussion on 
this with people who are running the cap and trade in the 
United Kingdom. I sat in the room where they were trading 
carbon credits. It was about 20 pounds for a ton of carbon 
emissions, at about $35. Is that? Yes, that was the price.
    I said do you have any advice for us in America? He said, 
yes. Go slow and go small and described all of the difficulties 
that they had had. So----
    The Chairman. We're following that advice.
    Senator Bennett. Good. Thank you.
    [Laughter.]
    The Chairman. Senator Murkowski indicated she had another 
question or two and why don't we just have a very short 3 
minute round here. See if that doesn't satisfy everybody.
    Senator Murkowski.
    Senator Murkowski. Thank you, Mr. Chairman. I'll be very 
brief. As I've been talking to people back in my State and they 
bring up the issue of climate change and the cost and it always 
comes down to what it is going to cost.
    My constituents say the economy is in trouble right now. 
We're in the midst of some really serious economic times. We've 
had great discussion here about the price collar and 
particularly the price floor and how that will help to incent 
investments in technologies.
    But is there any allowance or any consideration of how this 
works when we have a strong economy, when we have the ability 
to invest in the technology. But do you think that there should 
be some allowance or recognition for economic recovery 
prioritizing that when we're in a time of economic recession, 
particularly when we're talking about the mechanism and a price 
floor. I direct that to you, Jason.
    Mr. Grumet. Senator, I think it is unmistakably clear that 
the recession has changed the debate here on Capitol Hill and 
as has the kind of implosion of our confidence in the markets. 
I mean I think we are having a very different discussion than 
we were having last year. A response that I think is wildly 
unhealthful politically, but I think somewhat important 
substantively is that this program if passed this year, by most 
estimations would take effect in 2014.
    The good people in the White House have told us basically 
today that the recession is waning. But if we're still stuck in 
2014, I would have a very strong confidence that you and your 
colleagues would be making a number of adjustments to the law. 
I think in some ways it is within of course, your prerogative 
to be adjusting this going forward.
    But I'm quite optimistic that by 2014 we'll be in much 
better economic shape. There are some, and you should, you 
know, speak not to me, but to the major energy companies who 
are arguing that the uncertainty in climate regulation 
legislation on top of the current uncertainty in capital 
markets generally is just making it impossible for them to get 
any investment, any liquidity. They would argue that while they 
don't want what they would call an overly onerous system, 
having some predictability going forward might in fact free up 
capital as opposed to constrain it.
    But when you go back home I don't think any of that is 
particularly helpful to you.
    Senator Murkowski. Our difficulties when we put in place a 
new system, a new regime, it's a new system. It's a regime and 
we live with it. That's what we're talking about here with the 
health care reform and the discussions there.
    This is not just about spending money like we did in the 
stimulus. This is a whole new system. So whether or not we 
build in that level of flexibility that allows for 
reprioritization, I don't know.
    Dr. Wara.
    Mr. Wara. I think the health care analogy is actually an 
apt one in this--thinking about this question as well in a 
sense that a big part of what motivates the health care 
discussion is that it's not as if we're starting from scratch. 
We have a system. It's evolving in a particular trajectory that 
some parts of our society have concluded is not a good one.
    Similarly EPA is charged with enforcing the Clean Air Act. 
It's looking very much like part of doing/accomplishing that 
mission is going to be regulating this new pollutant class that 
they have been charged with, greenhouse gases, under the 
existing statutory framework. So it's not as if there's nothing 
else there that is the alternative.
    You know, doing nothing is not the alternative. Doing 
something that I think most regulated entities and most 
economists who think about it believe would be far more costly 
is the alternative.
    Senator Murkowski. Thank you, Mr. Chairman.
    The Chairman. Senator Cantwell.
    Senator Cantwell. Thank you, Mr. Chairman. I want to go 
back to international offsets for a minute because I think my 
colleagues are talking about the complexity of the House bill 
in a way that--you know, I believe, Mr. Grumet, what you were 
saying about predictability and wanting to make the transition 
that we absolutely need to have that predictability. We need to 
make the transition.
    But it's my understanding that EPA's analysis of the House 
bill is that through 2050 we'd be spending $1.4 trillion on 
international offsets. I mean what could we be buying for $1.4 
trillion? Doesn't that offset just, I mean that's money that 
could instead go to helping us stimulate the investment that we 
need to see in green technology here in the United States 
instead of spending $1.4 trillion abroad?
    Mr. Grumet. I can't speak on behalf of everybody on the 
panel. But we think EPA's estimates are pretty unrealistic in 
terms of the volume of offsets. I think they are making as 
they, you know, kind of, good engineering judgments about what 
is the kind of theoretical volume of offsets.
    But what they're not dealing with, you know, is what I 
guess the oil industry calls the above ground risk. So in 
theory there are those lower cost reductions around the world. 
In practice I think you've heard Dr. Wara, myself and others 
say we think it's very unlikely that those will be captured.
    So EPA's analysis because they're presuming about a billion 
tons a year monetizes those then into about a trillion dollars. 
Our sense is that they're going to be a small fraction of that. 
So that the, you know, money going overseas would be a small 
fraction of that trillion.
    Senator Cantwell. Dr. Wara or Dr. Mason, would you like to 
comment on that?
    Mr. Mason. Thank you. It's interesting that you raise this 
question after some of the discussion of offsets and your 
earlier question about special interests. Because I'd just like 
to pose a puzzle to the committee of who owns the land that's 
producing much of the offsets from restrained deforestation in 
foreign countries?
    You have to remember other countries don't have property 
rights like we do. One of the problems in the Brazilian rain 
forest is the lack of a fee simple, structure of land 
ownership. When you don't have to pay property taxes on land, 
you own as much land as you can afford. You just keep it for 
whenever you might need it, so large companies own this land. 
Individuals don't have a chance to buy this.
    What you're doing is you're assigning them more value to 
the large companies. These are the special interests and 
they're foreign special interests at that. So I think that you 
may be missing an opportunity to impose a tax right now or a 
fee, if you will, to get immediate benefits. But also use at 
least a domestic offset system to lower costs of businesses to 
U.S. businesses meeting those tax demands.
    Where I come from in Louisiana I have to say, we are 
grinding up new growth cypress forests to pelletize the wood 
and ship it off to the EU to burn in power plants to help meet 
their carbon goals. Where does that make sense at all? I think 
that we could benefit from some of these offsets directly in 
Louisiana.
    Senator Cantwell. Thank you, Dr. Mason. You made my point 
better than I could.
    Thank you, Mr. Chairman. I know we're out of time. So I 
appreciate your indulgence.
    The Chairman. Thank you very much.
    Senator Corker.
    Senator Corker. Mr. Chairman, thank you. Again, I think all 
of you have been outstanding witnesses. I would say to the 
gentlemen about not having enough international offsets to meet 
the demand with trillions of dollars available.
    I assure you there are plenty of hucksters around this 
world that will figure out a way to take that in. As is 
existing today where in China people are doing projects that 
cost $100 million and charging $4 billion. So I assure you that 
with trillions of dollars running around there are hucksters 
all over this world that can figure out a way to benefit off of 
our taxpayers.
    But let me just ask this question. Would everybody agree in 
a perfect world that if in fact there ends up being some kind 
of regime to deal with carbon that the very best way to have a 
carbon regime would be for it to be revenue neutral so that 
there's no net, not one penny that comes out of the economy? 
That in the event there is a cap and trade, I would call it a 
scheme, or in the event there's a carbon tax that at least one 
principle we ought to adhere to is that not any of that leaves 
the economy that there are reductions or dividends or some 
other mechanism to put that same, exact amount of money back 
into American's pockets in the event that something like this 
is pursued.
    I'd love to have comments from all of you briefly.
    Mr. Grumet. Senator, I think that's exactly the right goal. 
It's simply a question of how you accomplish it since different 
people living in different regions with different lifestyles 
will experience different costs from that program. The 
challenge is how do you in fact, give the money back to people 
in a way that is in fact, equitable? So you're going to have to 
take a kind of rough justice approach.
    I think, you know, the effort in the utility sector to 
allocate the permits not to the companies, but to the local 
distribution companies moves in that direction because it has 
State regulators trying to push that money back into the 
pockets of rate payers. But the idea of cap and dividend and a 
number of those other ideas I think deserve real attention. If 
you can tax bad things like pollution and reduce taxes like on 
good things like labor and savings, you've done a good thing 
for the environment and the economy.
    Senator Corker. Dr. Mason.
    Mr. Mason. I would just like to say I'm in full agreement. 
My problem with cap and trade is that markets don't know 
boundaries. Taxes do.
    Senator Corker. That's right. In essence much of the flow 
would be to other countries.
    Mr. Mason. With markets you can't control where that flow 
goes.
    Senator Corker. Dr. Wara.
    Mr. Wara. I think how we distribute the revenue that is 
raised is a very complicated question that draws. It's a 
political question. Firms have some claim on those revenues 
because we want businesses to flourish as well as our 
taxpayers. Taxpayers also have a valid claim.
    I think one thing that's worth adding is that we're looking 
at the complexities here of an emissions trading scheme. Taxes 
have been talked about in a theoretical way today, but the 
reality of tax policy and tax law in this country is it is not 
simple. An important consideration and important benefit that 
an emissions trading scheme provides is a single price of 
carbon across the market.
    In practice, for carbon taxes around the world that have 
been implemented that has been a very tough goal to achieve. 
Different emitters get different rates. That's an important 
thing to bear in mind as we make this comparison.
    Ms. Claussen. I mean I like things that are simple. But I 
think this is not simple. For example I think some of the money 
that is raised here should be used for adaptation.
    I'm not just back to consumers. But to deal with the 
consequences of climate change which I'm not sure would fit 
into the way you said that. I really have to agree with Dr. 
Wara here on the complexities of a tax scheme,it's not as if 
you're going to not have people wanting to be exempted from the 
tax to pay a lower tax. It's not as if you're going to end up 
with a scheme where it's just, you know, a straight tax for a 
unit of carbon across the board.
    So I mean, I think it's fine if you want to explore a tax. 
But I think it's wrong to assume that the cap and trade is 
really complicated and the tax is going to be really simple. 
Because I don't think it will be.
    Senator Corker. I'll stop. I know my time is up. The 
Chairman has been very patient.
    It would appear to me that one of the ancillary goals of 
people who craft legislation like we saw in the House is 
though, to consume, to take money into government. Then make 
decisions on behalf of people. It does cause one to wonder 
about what the real goals, the true goals of much of this 
legislation is about.
    I mean the bill last year on the Senate floor was $6.8 
trillion if you just used present day carbon cost. It was the 
mother of all ear marks. I mean every bit of that money was 
pre-spent through the year 2048.
    So I just hope that there will be some clarity in this 
debate. I think that our Chairman has helped us with that 
today. I think each of you have been outstanding witnesses. I 
thank you.
    The Chairman. Senator Bennett.
    Senator Bennett. Thank you very much. Senator Corker 
covered most of the ground I had in mind. You talked Ms. 
Claussen about you want it to go for remediation or some kind 
of diminution of some good environmental purpose.
    Of course, that does take you in the direction that Senator 
Corker was talking about as an ear mark. As an appropriator I 
don't like trust funds because they begin to distort the 
appropriations process. Here's money coming into the 
government. We desperately need it for this purpose. But it has 
been blocked only for that purpose.
    That gets us back to the discussion of fees. I do like the 
Highway Trust Fund because the Highway Trust Fund is a user 
fee. The people who are using the highways are paying for 
repair of the highways. That's fair.
    But if now the people that are using the utilities or 
whatever it might be are seeing the money go for bike trails 
because everything else in remediation is properly funded. 
They've got so much money in the trust fund they have to find 
some way to spend it in an environmentally friendly way. It's 
not the best idea for the government to building bike trails.
    Ok. That's the theoretical problem. Let's take that to the 
other thing I was told when I was in Europe. As I looked at the 
cap and trade system there I discovered to my surprise that the 
only thing they were dealing with were utilities.
    I said, you don't have a transportation factor in here. In 
the United States everybody is excited about the automobile as 
being the No. 1 polluter and so on. They said, yeah, we only do 
carbon emissions on utilities. I said, why? He said that's the 
only place we have any accurate data. Everything else is a 
guess. Now talk about the impact on a marketplace if we do 
decide that we want to go where you don't have accurate data 
with respect to the polluters.
    I'll close it with this very, very targeted anecdote. I saw 
a bumper sticker on a very serious pickup truck. It said the 
carbon emissions from this pickup truck are offset by and then 
it gave a data base and a website.
    As somebody pointed out to me it may be that I said how 
much is he paying? How does he know what the emissions are from 
his truck? What is he buying? Someone said, he may have only 
bought a bumper sticker. So there is that situation.
    But talk about this question of accurate data and how do 
you come up with this. Yes?
    Ms. Claussen. Yes. Let me just make a quick point. I mean 
one of the reasons that the first phase of the EU system, I 
mean the experimental phase failed, is because in fact they 
didn't have good data. They over allocated.
    I mean, I think they figured out how to fix that. I think 
we're seeing real improvement there. But I think part of the 
problem is no data. It's really important that we have data 
from a reporting system in place so we actually know what we're 
doing.
    Mr. Wara. I'll respond to the----
    Senator Bennett. Are you comfortable with the present data 
level?
    Mr. Wara. I think actually we're doing something as a 
Nation that's very smart which is that EPA is currently in a 
rulemaking process to design a greenhouse gas reporting rule, 
so that we will have the data if and when we decide to 
implement a tax or a cap and trade. On the issue of mobile 
sources in Europe and the U.S. a big factor--a big reason, one 
main reason that they were not included in the cap and trade is 
the equivalent carbon tax or the gas tax in most European 
countries is several hundred dollars per ton carbon. I know the 
number for Germany is $228 per ton.
    So effectively because of the high gas taxes motor fuels 
are already facing a very high carbon price. In the U.S. the 
approach that's being taken in the current bill before Congress 
and at the State level is to regulate fuels at the refinery 
where there's real certainty at something called the rack. I'm 
not quite clear on what that is at a refinery, but at the rack, 
about the volume of petroleum, refined petroleum products that 
are being sold.
    It's there that we can get the good data we need to do this 
well. Certainly at the pickup truck we're not going to get that 
data. You're absolutely right.
    Senator Bennett. You do it at the refinery you're 
automatically raising the price at the pump to get to where the 
Germans are.
    Mr. Wara. Not even close to where the Germans are.
    Senator Bennett. But it's the same idea. You do it at the 
refinery you're raising the price of gasoline at the pump.
    Thank you, Mr. Chairman.
    The Chairman. Thank you all very much. I think it's been a 
very good hearing. Good testimony. We appreciate your taking 
time to talk with us.
    [Whereupon, at 4:45 p.m. the hearing was adjourned.]
                               APPENDIXES

                              ----------                              


                               Appendix I

                   Responses to Additional Questions

                              ----------                              

     Response of Brent Yacobucci to Question From Senator Bingaman
    Question 1. EPA projections have indicated that there will be a 
very limited supply of offsets coming from projects based in the U.S., 
and that the vast majority of the offset supply will be coming from 
overseas. Are there policy choices we can make to increase the supply 
of high-quality domestic offsets, so a greater amount of funds spent 
purchasing offsets stays in the U.S.?
    Answer. The supply of international vs. domestic offsets will 
largely be driven by two factors: 1) the total potential for 
sequestration and other offset projects; and 2) the cost of those 
projects. Even if offset projects are widely available within the 
United States, there may be little interest in pursuing those 
opportunities if the allowance price and/or the international offset 
price is low relative to the domestic project cost. Therefore, key to 
increasing the supply of domestic offsets is to reduce their overall 
cost, and their cost relative to emissions reductions from covered 
sources and from offset projects overseas. One possible option would be 
to provide supplemental financial incentives for the development of 
such domestic projects; however, amendments to offset provisions in 
proposed legislation would likely be necessary so that those incentives 
do not negate the additionality\1\ of the projects. A second option is 
to effectively raise the cost of international offsets. H.R. 2454 does 
this by discounting international offsets after 2017. After 2017, 1.25 
international offsets are needed in lieu of one ton of emissions--there 
is no such discounting for domestic offsets. Raising this discount rate 
or applying it early could make domestic offsets more competitive (by 
effectively raising the cost of international offsets). Other factors 
that could play a role include: 1) limiting the quantity of 
international offsets, thus creating more demand for domestic offsets; 
and 2) requiring less stringent verification or other protocols for 
domestic vs. international offsets.
---------------------------------------------------------------------------
    \1\ A key component of any offset program is that the projects 
awarded offsets be additional--i.e., they would not have been 
undertaken in the absence of the incentive provided by the offset. For 
example, actions taken to comply with other environmental laws (e.g., 
air quality or water quality regulations) would likely not be 
considered additional even if they had an ancillary greenhouse gas 
benefit because the project is not optional. Likewise, financial or 
other incentives above those provided by the offset program could 
negate the additionality of a particular project. Supporters of 
multiple incentives, including offsets, prefer to allow 
``stackability,'' that is, the ability to combine (``stack'') multiple 
incentives for the same project. For more information on offsets, see 
CRS Report RL34436, The Role of Offsets in a Greenhouse Gas Emissions 
Cap-and-Trade Program: Potential Benefits and Concerns, by Jonathan L. 
Ramseur.
---------------------------------------------------------------------------
    Responses of Brent Yacobucci to Questions From Senator Cantwell
    Question 1a. What role does the compliance period play in reducing 
price volatility?
    Question 1b. Are there any substantial differences in price 
volatility between rolling compliance periods and fixed compliance 
dates?
    Question 1c. To minimize price volatility, how much time should 
firms have between the emissions of greenhouse gases and the 
acquisition (and surrender) of allowances? One year or less? Two years? 
Three years? Five years?
    Answer. Allowing entities to spread their compliance over multiple 
years allows those firms to avoid purchasing allowances on the market 
when they perceive prices as temporarily high. A longer compliance 
period gives them more time to wait out perceived volatility in the 
market. There seems to be no consensus on how long that compliance 
period should be, or how much the length of the compliance period 
affects volatility. However, a period of at least a few years would 
seem necessary to mitigate against short-term allowance price shocks 
such as those driven by a hot summer (with greater demand for air 
conditioning) or a cold winter (with greater heating demand). For 
example, the Regional Greenhouse Gas Initiative (RGGI)\2\ employs a 
three-year compliance period, while the American Clean Energy and 
Security Act (H.R. 2454) effectively creates a rolling two-year 
compliance period for entities that would receive free allowances under 
the bill's allocation scheme. The current sulfur dioxide 
(SO2) cap-and-trade program established by the 1990 Clean 
Air Act Amendments has a one-year compliance period, and allows covered 
entities three months after the end of the year to settle their 
accounts.
---------------------------------------------------------------------------
    \2\ For more information on RGGI and other state and regional 
programs, see CRS Report RL33812, Climate Change: Action by States to 
Address Greenhouse Gas Emissions, by Jonathan L. Ramseur.
---------------------------------------------------------------------------
    Question 2a. What is a reasonable number of allowances, as a 
percentage of yearly emissions, that firms would be able to bank for 
future emissions and compliance dates?
    Question 2b. How long are firms likely to retain allowances for 
future use? Is there likely to be a limit to their willingness to keep 
these assets on their balance sheets?
    Answer. Various bills would allow different limits on the amount of 
allowances that could be banked, and for how long. H.R. 2454 would 
allow unlimited banking--i.e., entities could bank an unlimited\3\ 
number of allowances for as long as they choose. Experience with 
previous cap-and-trade systems shows that firms will bank allowances in 
early years when emissions reductions are inexpensive relative to 
expected future costs, and to spend those banked allowances later as 
costs rise. For example, under the SO2 cap-and-trade 
program, at its peak the total bank among all firms reached roughly 
one-and-one-half times annual emissions for covered entities (it has 
since declined). Covered entities are apparently comfortable banking 
allowances over long periods of time--at least a decade in the case of 
the SO2 program.
---------------------------------------------------------------------------
    \3\ H.R. 2454 gives the Federal Energy Regulatory Commission (FERC) 
the authority to establish position limits on allowance holdings. For 
example FERC could determine that no entity could hold more than 10% 
(or some other amount) of allowances in the market. However, it seems 
unlikely that an individual entity's banking decisions would be 
affected by such a position limit unless the limit were set at a very 
low level.
---------------------------------------------------------------------------
    Similarly, the Environmental Protection Agency's (EPA's) analysis 
of H.R. 2454 using its Intertemporal General Equilibrium Model (IGEM) 
found that the total allowance bank is projected to reach nearly 20 
billion allowances in 2029--roughly five times the allowance cap in 
that year.\4\ Under the various analyses of H.R. 2454, the number of 
allowances banked varies depending on expected compliance costs and 
allowance prices, as well as assumed discount rates--a lower discount 
rate results in greater banking, while a higher discount rate results 
in less banking.\5\
---------------------------------------------------------------------------
    \4\ EPA Analysis of the American Clean Energy and Security Act of 
2009: H.R. 2454 in the 111th Congress (June 23, 2009). EPA/IGEM ``Data 
Annex'' available on the EPA website at http://www.epa.gov/
climatechange/economics/ economicanalyses.html.
    \5\ Some analyses assume--as an input--that no banking occurs.
---------------------------------------------------------------------------
    Question 2c. To reach the 2050 emissions targets that scientists 
agree are necessary to avert catastrophic climate change, is there an 
affordable option at mid-century that does not incorporate either a 
significant amount of coal with carbon capture and sequestration 
technology or a substantial expansion of nuclear power?
    Answer. It is impossible to predict what technology development 
will occur to make different compliance options in the electric power 
sector affordable by the middle of the century. Analyses of H.R. 2454 
that assume carbon capture and storage (CCS) and new nuclear power are 
not substantially available by mid-century generally result in high 
consumption of natural gas--and to a lesser extent, renewable 
resources--for electric power generation. In limiting other options, 
those analyses generally result in significantly higher allowance 
prices, and overall costs to the economy.\6\
---------------------------------------------------------------------------
    \6\ For a comparison of different analyses of H.R. 2454, see CRS 
Report R40809, Climate Change: Costs and Benefits of the Capand-Trade 
Provisions of H.R. 2454, by Larry Parker and Brent D. Yacobucci.
---------------------------------------------------------------------------
    Question 3a. From a strictly economic viewpoint, how can the 
pathway of the emissions reductions or the trajectory of the cap's 
emissions reductions affect the costs of a climate policy?
    Question 3b. For a fixed amount of cumulative emissions, what might 
the optimal shape of that emissions pathway be?
    Answer. In terms of the environmental benefit from reductions, the 
trajectory of emissions reductions (i.e., the shape of the emissions 
curve) is arguably immaterial,\7\ what matters is the total aggregate 
emissions over time (i.e., the area under the emissions curve). There 
are generally two camps on the optimal shape of the emissions curve: 1) 
those who argue that the curve should be relatively steep early (and 
flatter later on) to force the development of technology more quickly, 
reducing overall compliance costs in the future; and 2) those who argue 
that it will take time for technology to develop, and that requiring 
fewer reductions early on will allow entities to delay reductions until 
more cost-effective options are available. To some degree, entities' 
individual decisions on banking reflect their view of technology. A 
firm that believes low-cost technology will be available in the future 
will be less likely to bank allowances early, while a firm that 
believes low-cost technology will not develop would be more likely to 
make early reductions and bank those for the future.
---------------------------------------------------------------------------
    \7\ The key exception is if there are ``tipping points'' beyond 
which changes become irreversible.
---------------------------------------------------------------------------
    Question 3c. Why do you regard the inclusion of a price floor as 
particularly important for investment in new energy technologies under 
a climate policy?
    Answer. CRS holds no position on this or any other policy. Those 
who support a price floor argue that, in the absence of a price floor, 
technology developers may be unwilling to invest due to the risk of an 
allowance price below the cost of the technology in question. A price 
floor allows technology developers certainty that their technology will 
always be competitive if it is less expensive than that floor. 
Opponents of a price floor tend to argue that it unnecessarily raises 
the cost of the program--if allowance prices are below expectations, 
that shows that the cap-and-trade system is working effectively and 
efficiently.
    Question 4. Since cap-and-trade programs are so inherently complex 
and far-reaching:

    a) How can we be sure that any scheme is workable and can be 
implemented by the executive branch?
    b) How great are the risks of unintended consequences--for the 
economy and the environment?
    c) What sort of growth are we likely to need in federal agencies, 
particularly EPA, if the House-passed bill became law?

    Answer. Like any other regulatory policy, the regulating agency 
will need budget and other resources to implement the policy. EPA has 
some history implementing cap-and-trade programs such as the 
SO2 program. While it is unclear how much additional 
capacity EPA or other government agencies will need, it could be 
significant. As CRS states in our report on H.R. 2454:

          Compared with the complexity of implementing a greenhouse gas 
        cap-and trade scheme, the SO2 program was simple. 
        Conceptually, a CO2 tradable permit program could 
        work similarly to the SO2 program. However, 
        significant differences exist between the acid rain process and 
        possible global warming factors that affect current abilities 
        to model responses. For example, the acid rain program involves 
        up to 3,000 new and existing electric generating units that 
        contribute two-thirds of the country's SO2. This 
        concentration of sources (and the fact that they are 
        stationary) makes the logistics of allowance trading 
        administratively manageable and enforceable. The imposition of 
        the allowance requirement is straightforward. The acid rain 
        program is a ``downstream'' program focused on the electric 
        utility industry. The allowance requirement is imposed at the 
        point of SO2 emissions so the participant has a 
        clear price signal to respond to. The basic dynamic of the 
        program is simple, although not necessarily predictable.
          A comprehensive greenhouse gas cap-and-trade program would 
        not be as straightforward to implement. Greenhouse gas 
        emissions sources are not concentrated. Although over 80% of 
        the greenhouse gases generated comes from fossil fuel 
        combustion, only about 34% comes from electricity generation. 
        Transportation accounts for about 28%, direct residential and 
        commercial use about 11%, agriculture about 7%, and direct 
        industrial use about 19%.\8\ Thus, small dispersed sources in 
        transportation, residential/commercial, agriculture, and the 
        industrial sectors are far more important in controlling 
        greenhouse gas emissions than they are in controlling 
        SO2 emissions. This greatly increases the economic 
        sectors and individual entities that may be required to reduce 
        emissions.\9\
---------------------------------------------------------------------------
    \8\ U.S. Environmental Protection Agency, U.S. Inventory of 
Greenhouse Gas Emissions and Sinks: 1990-2007 (April 15, 2009), p. ES-
14.
    \9\ CRS Report R40809, Climate Change: Costs and Benefits of the 
Cap-and-Trade Provisions of H.R. 2454, by Larry Parker and Brent D. 
Yacobucci, p. 17.

    To some degree, the potential complexity of H.R. 2454's program is 
limited through decisions made on the point of regulation. For example, 
instead of requiring emissions monitoring of over 200 million motor 
vehicles, the bill requires roughly 400 petroleum refiners and 
importers to report their emissions and submit allowances.\10\ In 
total, the Congressional Budget Office (CBO) estimates that roughly 
7,400 entities would be covered under H.R. 2454's cap-and-trade 
program.\11\
---------------------------------------------------------------------------
    \10\ CRS Report R40242, Carbon Tax and Greenhouse Gas Control: 
Options and Considerations for Congress, by Jonathan L. Ramseur and 
Larry Parker, Table 2, p. 31.
    \11\ CBO, Congressional Budget Office Cost Estimate: H.R. 2454 
American Clean Energy and Security Act of 2009, Washington, DC, June 5, 
2009, p. 4, http://www.cbo.gov/ftpdocs/102xx/doc10262/hr2454.pdf.
---------------------------------------------------------------------------
    To implement a program such as that in H.R. 2454, new government 
capabilities would likely include: monitoring and reporting of 
emissions from currently unmonitored sources (currently, only electric 
power plants are required to report their carbon dioxide emissions); a 
system for counting and awarding offsets under the cap-and-trade 
program (and certifying third-party verifiers); systems for determining 
the imbedded carbon content of imported goods; and procedures for 
determining that allowances allocated to non-covered entities are 
disposed of in accordance with the requirements of the bill.
    Question 5. Given the complexity and intricacy of some of these 
policy proposals, I am particularly concerned about the opportunities 
they might create for market manipulation, fraud, and for the 
development of arcane financial instruments that will lead us to the 
next major global financial crisis. Do you believe that these concerns 
are justified? How might opportunities for market manipulation be 
reduced through climate policy design?
    Answer. Currently emissions allowances (e.g., SO2 
allowances) are regulated as commodities. H.R. 2454 contains provisions 
to more stringently regulate all commodities (not just allowances).\12\ 
Provisions include limits on the amount of allowances any single entity 
can purchase at a given auction, a limitation that only covered 
entities may participate in strategic reserve auctions, and the 
authority for the FERC to set position limits on overall market 
holdings. Other broad commodity regulation provisions include a 
requirement that over-the-counter swaps and other derivative 
transactions be settled and cleared through a clearinghouse. Whether 
those provisions would be sufficient to prevent market manipulation is 
unclear.
---------------------------------------------------------------------------
    \12\ For more information on the regulation of allowances in a cap-
and-trade program, see CRS Report RL34488, Regulating a Carbon Market: 
Issues Raised By the European Carbon and U.S. Sulfur Dioxide Allowance 
Markets, by Mark Jickling and Larry Parker.
---------------------------------------------------------------------------
    Question 6. I understand that last December, the European Union 
made auctioning the default future allocation method for its emission 
trading system.

    a) Was that a tacit recognition that the best way to allocate 
carbon permits or emission allowances is by auction?
    b) What other ways is the European Commission working to correct 
the windfall and overallocation it experienced in the early years of 
the European emission trading system?
    c) What lessons can Congress learn from the European experience to 
avoid pitfalls in designing and implementing a carbon trading system?

    Answer. Currently, in the European Union's Emissions Trading Scheme 
(ETS), the vast majority of allowances are given to covered entities at 
no cost. In later periods, the EU has determined that a larger share of 
allowances will be auctioned.\13\ Problems encountered in the early 
phases of the ETS were largely driven by an over-allocation of 
allowances caused by poor data which overestimated the EU countries' 
emissions. Arguably, the key lesson from that experience is that good 
emissions monitoring data is necessary to implement the program.
---------------------------------------------------------------------------
    \13\ For more information, see CRS Report RL34488, Regulating a 
Carbon Market: Issues Raised By the European Carbon and U.S. Sulfur 
Dioxide Allowance Markets, by Mark Jickling and Larry Parker, and CRS 
Report RL34150, Climate Change and the EU Emissions Trading Scheme 
(ETS): Kyoto and Beyond, by Larry Parker.
---------------------------------------------------------------------------
    Question 7. One of my concerns is that, as far as I can tell, 
allowances that are given away under cap-and-trade could be sold on the 
secondary market at a price that would undercut the government auction 
reserve price.

    a) Is this accurate, and do you see this as a potential problem for 
energy investments under such price uncertainty?
    b) What happens if or when strategic allowance reserves run out in 
a cap-and-trade program?
    c) If a strategic reserve is used instead of an explicit price 
ceiling, then what happens if the strategic reserve is continually 
depleted? Do costs skyrocket at that point?

    Answer. If low prices in the secondary market undercut the reserve 
price in the primary market, then presumably firms would choose not to 
purchase allowances through the government auction. This seems unlikely 
to be sustained in the long run, as this would reduce total allowance 
supply since the number of new allowances entering the market would 
decline. Eventually the reduced supply of allowances should cause 
prices to rise above the reserve price, restoring demand for allowances 
from the primary auction.
    H.R. 2454 employs a strategic reserve as a sort of ``relief valve'' 
for allowance prices. If allowance prices run up too quickly, firms 
could tap into an additional supply of allowances at a relatively high 
reserve price. Under H.R. 2454, this emergency supply has been skimmed 
off the top of each year's allocation. Under a strategic reserve 
system, once the reserve has been depleted, its ability to mitigate 
against high allowance prices is eliminated. Thus, the strategic 
reserve is not an explicit price ceiling, and may be used to mitigate 
against volatile allowance prices, but is unlikely to affect the long-
run costs of the program.
                                 ______
                                 
 Response of Joseph R. Mason, Ph.D., to Question From Senator Bingaman
    Question 1. EPA projections have indicated that there will be a 
very limited supply of offsets coming from projects based in the U.S., 
and that the vast majority of the offset supply will be coming from 
overseas. Are there policy choices we can make to increase the supply 
of high-quality domestic offsets, so a greater amount of funds spent 
purchasing offsets stays in the U.S.?
    Answer. It is surprising to me that domestic offset opportunities 
are thought to be so limited compared to those available 
internationally. Necessary preconditions for genuine and reliable 
offsets lie in property rights of the country of origin, such that 
ownership of the rights can be perfected and recompense mandated in the 
event of violation of the offset contract. While we take such property 
rights for granted in the US, such property rights are relatively rare 
in developing countries targeted for offset supply.
    Many of the countries of origin for proposed and actual offsets 
such as China, India, and Brazil, are less politically stable than the 
US, have weaker ownership rights over intangibles such as offsets, and 
otherwise present contract rights, labor rights, and human rights 
challenges that make them poor candidates for offset earnings subsidies 
created in the largest carbon program in the world.
    International sourcing of offsets seems to be more of a development 
allocation that is designed to keep those countries from pursuing high-
carbon projects that can otherwise fuel their economic growth. Unlike 
even the traditional ``Dutch disease'' problem, however, it is doubtful 
in such unstable political environments that the gains from offsets 
will trickle down to economic development and growth even in the short 
term.
    Moreover, in the long term struggles for the cash flows in 
perpetuity can make political regimes ripe for conquest, both 
internally and externally. Internally, countries may rationally default 
on previously agreed offset deals in order to extract higher rents from 
developing countries that need those offsets for their carbon goals. 
Such strategies are akin to current too-big-to-fail problems in the 
financial industry, and present substantial holdup problems for US 
economic growth. Externally, military struggles for ``passive'' value 
can create further political instability in regions that are the 
proposed main sources of offsets.
    Those international dynamics, as well as the current economic and 
financial crisis, suggest that it may be wise to pursue more forcefully 
a credibly verifiable domestic offset supply that can provide a 
substantial share of offsets necessary for proposed policy. Such a 
policy can fuel domestic growth and conservation efforts, and will be 
necessary to provide an offset ``bank'' that can buffer shocks to 
international sources of offset supply, ranging from tsunamis, 
earthquakes, and forest fires, to military incursions to domestic 
unrest.
    In summary, it is imperative to construct a domestic offset system 
that can provide a sizeable portion of offset demand before pursuing a 
cap and trade policy relying crucially upon such terms.
    Responses of Joseph R. Mason, Ph.D., to Questions From Senator 
                               Murkowski
                        utilization of revenues
    Question 1. We should be honest about what a cap-and-trade program 
for reducing greenhouse gas emissions will do. Such a policy would 
essentially create a new form of currency and generate massive amounts 
of revenue through auctions, or financial largesse to be doled out in 
the form of free allowances.
    What do you think those revenues should be spent on and who should 
receive that money?
    Answer. As an economist, my reply is that it does not matter what 
the revenues are used for. Once the revenues are injected into the 
economy, they flow through individuals and financial institutions and 
feed economic growth. Along the way, they become available for 
investment in carbon-reducing technology or other projects valued by 
business and society.
    For example, let's say the revenues are dividended to taxpayers. 
Every individual recipient now has more money to spend or save. If 
individuals spend the money, it is (eventually) saved by the recipient 
of the funds in the chain of transactions. Savings is motivated into 
investment through the US financial system. A carbon project 
entrepreneur, needing investment funds, now goes to her bank to borrow 
and receives a lower interest rate resulting from the increased supply 
of funds available to be lent. The carbon entrepreneur, faced with 
favorable business prospects, is likely to face an advantage over a 
carbon producer, who now faces higher costs of production. Hence, the 
carbon entrepreneur is likely to have an advantage in the market, 
exactly as intended.
    If desired, tax or interest subsidies can be targeted to carbon 
technology projects to further incentivize investment. Nonetheless, the 
total economic effects of the revenues have already cascaded through 
the economy. Only if the new investment is less productive than the one 
that would occur take place if the money were returned to taxpayers, it 
would be a net economic negative. Of course, it is difficult to tell 
whether this is the case with any one policy. Hence, the system is best 
kept simple.
    As an individual, and recognizing the boundaries of economic 
theory, there exists a fairness criterion that must be addressed in the 
allocation. That is why, in economics, we refer to a ``helicopter 
drop'' of money into the economy. Hence, policy options run the gamut 
from dividending the funds to individual taxpayers (along what 
distributional criterion that must, again, satisfy a fairness test), 
funneling those to social programs, or targeting those to clean energy 
projects. Barring the identification of an obvious market failure that 
prevents a hyper-productive industry from receiving funding and using 
the funds to address that shortcoming, the economic effect is the same 
for any allocation: only the fairness criterion is important, no matter 
what the distribution.
                    transparency in compliance costs
    Question 2. Price volatility in any climate policy--outside of a 
carbon tax--is inevitable, and may not be reflected transparently in 
bills or fees, but embedded in the price at the pump, the grocery 
store, and elsewhere.
    Should we require these additional costs to be identified and 
printed on utility bills and elsewhere, so that consumers know exactly 
how much their contributing to climate change mitigation efforts?
    Answer. I see no economic value to requiring the additional costs 
to be identified and printed on utility bills and elsewhere.
    In contrast, such a requirement--multiplied by hundreds of millions 
of bills and receipts printed annually--will impose substantial 
compliance costs on firms with little obvious benefit. Just, for 
instance, multiply the average number of terminals at each gas station 
(as I recall, about twelve) by the number of gas stations (115,223 (in 
2008)) times the cost of the terminals (about $200 each) to get the 
cost of terminal replacement. The numbers are familiar to me because 
the industry went through a similar replacement when the credit card 
associations restricted the card number information from being printed 
in full on each receipt, necessitating such a change. The cost to a 
single large oil company for that change was in the billions of 
dollars. Compliance costs (do you have to report today's carbon price 
or an average, where do you get the data from, etc. . .) will add to 
that bill.
    Moreover, such policy will undoubtedly contribute to waste of ink 
and toner (which contain trace heavy metals) and paper (we want save 
the trees to produce the carbon) in ways that are contrary to the 
intent of environmental consciousness, in general, and carbon 
reduction, in particular.
                   susceptibility of offsets to fraud
    Question 3. A recent UK Telegraph article highlighted the value-
added tax (VAT) fraud that has recently occurred in their offset 
market. A total of 7 arrests were made and many more investigations 
into carbon credit fraud are underway.
    How can the United States prevent a similar type of fraud from 
occurring if we were to adopt a mandatory cap-and-trade program that 
includes widespread use of international offsets?
    Does the considerable volume (up to 1 billion tons per year, or 
more) envisioned by the House bill lend itself to an offset market that 
is even more difficult to control?
    What organization do you think is capable of regulating that large 
of a market?
    Answer. Good question. I recently had a dialog with one of the 
largest VAT refund firms in the world on just this topic. They view the 
issue of pursuing fraud in the growing market as a valuable business 
opportunity.
    As mentioned in my reply to Sen. Bingaman, China, India, and 
Brazil, the three main countries of origin for proposed and actual 
offsets, are generally less politically stable than the US, have weaker 
ownership rights over intangibles such as offsets, and otherwise 
present labor and human rights challenges that make them poor 
candidates for offset earnings subsidies created in the largest carbon 
program in the world.
    The undeveloped legal and political institutions in those countries 
are the lynchpin of an economically and environmentally meaningful role 
of offsets in US carbon policy. Hence, I would not expect to proceed 
without substantial frictions.
    More importantly, as you bring up here, there currently exists no 
international body of law that can settle sovereign contract disputes. 
We felt the effects of that shortcoming in the recent financial crisis, 
when the inability to pursue international assets of US firms in 
bankruptcy necessitated bailouts of several large international 
financial institutions. At best, treaties and agreements could 
eventually be worked out to cover some of the difficulties among 
developed countries, but developing countries would most likely 
abrogate treaty terms in the event of a shock sizeable enough to be of 
economic importance.
    Hence, we need to assume--even with treaties in place with 
developing countries--that there is no body of law to rely upon to 
enforce offset contracts in the event of a major dispute. Sovereigns 
default on debt and expropriate assets in other realms--to expect 
carbon offset markets to develop without similar shocks would be 
heroic.
                           transfer of wealth
    Question 4. The European Union's Emission Trading Scheme began 
implementation in 2005. In the first phase, emissions covered under the 
Scheme rose by 0.8% across the EU as a whole. Additionally, the price 
of carbon fell to almost zero.
    Since not all member countries had the same requirements, the 
European Scheme acted as a transfer of wealth. It simply forced 
countries with higher requirements to pay more to countries with lower 
requirements to purchase their credits.
    If the U.S. takes a `go at it alone' approach, are you concerned 
that the same transfer of wealth will occur from our American 
businesses to foreign entities as they purchase carbon credits?
    Answer. While I am not sure from the form of your question whether 
you are referring to requirements in terms of allocation levels, carbon 
limits, or initial price levels, I think I can get to the root of the 
economic principle that you seek.
    We would expect prices and permits to gravitate from where those 
are less valuable to where they are more valuable in the short term. In 
the long term, if factors of production (of which carbon permits are 
intended to be one) are inflexible, production may flow abroad, as 
well.
    But whether we are talking about production, financial flows, or 
carbon permits, all markets work to allocate products efficiently, 
defined as flowing from those who value the good relatively less to 
those who value the good relatively more. While international economics 
takes this flow as a fundamental condition of labor availability, 
resource allocations, and productivity (among other things), carbon 
policy inherently applies a value to abatement that is unobservable 
until held in comparison to that of other countries through the market 
mechanism. Get the value too low, and your carbon permits merely flow 
out of the country. Get the value too high, and others' permits flow to 
you. If we value carbon abatement ``too low'' in the US, we fully 
expect to fail to achieve the reduced domestic production of carbon 
that is sought under the policy.
Responses of Joseph R. Mason, Ph.D., to Questions From Senator Cantwell
    Question 1a. What role does the compliance period play in reducing 
price volatility?
    Question 1b. Are there any substantial differences in price 
volatility between rolling compliance periods and fixed compliance 
dates?
    Question 1c. To minimize price volatility, how much time should 
firms have between the emissions of greenhouse gases and the 
acquisition (and surrender) of allowances? One year or less? Two years? 
Three years? Five years?
    Answer. In my view, it is not the compliance period construct that 
reduces volatility so much as market liquidity. The compliance period, 
in contrast, is merely a method of restraining the costs of 
recordkeeping and regulatory compliance efforts. That said, real time 
compliance is the most economically efficient and meaningful, but also 
the most costly, compliance paradigm. Let me explain.
    The reason for my view of the relationship between price volatility 
and compliance lies in the fact that in order to meet compliance 
requirements firms will keep a stock or permits to meet expected 
production demand and then an ``excess'' reserve to meet unexpected 
demand. Excess reserve demand will be a function of price volatility, 
not a cause of that volatility. If volatility is high or markets are 
illiquid, excess reserve demand will be high. If volatility is low and 
or markets are liquid, excess reserve demand will be low.
    As for the efficiency of real-time compliance, longer compliance 
periods need to address the problem of what happens if a firm enters 
bankruptcy between the reporting and compliance deadlines? Such an 
occurrence (and one will occur, even intraday), will have to be dealt 
with by regulators and bankruptcy courts, especially since no one will 
lend to the bankruptcy entity for compliance and it may have sold its 
own permits to raise cash prior to default.
    In summary then, the compliance period should be as short as 
practical after the reporting period and has little to do with price 
volatility.
    Question 2a. What is a reasonable number of allowances, as a 
percentage of yearly emissions, that firms would be able to bank for 
future emissions and compliance dates?
    Question 2b. How long are firms likely to retain allowances for 
future use? Is there likely to be a limit to their willingness to keep 
these assets on their balance sheets?
    Answer. Similar to my response above, it is important to allow 
firms to bank excess reserves that meet their own needs and management 
preferences. Some firms will choose to manage permit needs 
aggressively, preferring to borrow to meet idiosyncratic needs when 
they arise. Others will choose to keep a large stock of reserves on 
hand. Choices of management styles will probably break down according 
to industry and economic conditions, varying over time as well as 
across the economy. One size of policy cannot, therefore, be expected 
to fit all.
    As for how long permits should remain valid, I don't think you want 
to force them to be used, but you may wish to know how may remain 
outstanding year to year. Hence, while you may wish to force last 
years' permits to be redeemed for this years', in my opinion you would 
want to reward, not punish, the firm for economizing on carbon output.
    Question 3. To reach the 2050 emissions targets that scientists 
agree are necessary to avert catastrophic climate change, is there an 
affordable option at mid-century that does not incorporate either a 
significant amount of coal with carbon capture and sequestration 
technology or a substantial expansion of nuclear power?
    Answer. I am not an expert in this area. My lay reading of the 
literature is that renewable such as wind, wave, and solar cannot make 
up a substantial portion of production assuming reasonable growth in 
productive capacity per installed unit or operation. I defer to the 
climate scientists for a more detailed and informed explanation.
    Question 4a. From a strictly economic viewpoint, how can the 
pathway of the emissions reductions or the trajectory of the cap's 
emissions reductions affect the costs of a climate policy?
    Question 4b. For a fixed amount of cumulative emissions, what might 
the optimal shape of that emissions pathway be?
    Answer. We know little about the projected pathway from an economic 
standpoint. Given what we know about the costs and availability of 
major carbon reducing tech (new nuclear capacity, carbon capture and 
storage) plus the time frame for turnover of capital we would expect a 
reduction curve that's flatter in the near term (i.e. less aggressive) 
and steeper in later years (i.e. past 2030) to be less costly overall.
    The whole point of cap and trade theory is to let the market decide 
the most efficient path, allowing markets to bid up permit prices to 
the highest marginal value of emissions, incentivizing firms that are 
best able to cheaply economize on emissions to rationally do so. The 
expense of carbon permits prevents additional investment where 
emissions are difficult to restrain, leading to reductions in carbon 
emissions from those most expensive sources. Without the market, only 
an omnipotent central planner can come close to the efficient path of 
adjustment in lieu of the market mechanism.
    Hence, cap and trade without the cap--that is cap and trade with an 
overlaid carbon market efficiency board used to manipulate prices--can 
only deviate from the most efficient path of adjustment, hindering the 
creative destruction created by market forces to stanch the creativity 
and mitigate the destruction, which effectively draws out the 
adjustment for longer than need be the case.
    Question 5. Why do you regard the inclusion of a price floor as 
particularly important for investment in new energy technologies under 
a climate policy?
    Answer. I think it is important to place a price on carbon 
emissions in order to even begin to price the externality of carbon 
emissions and nudge firms to investment decisions consistent with 
policy decisions. A tax, in this regard, is a price floor and works 
toward policy goals.
    Moreover, it appears that Europe is headed toward a hybrid tax and 
cap and trade system, whereby France is moving to set a tax-based floor 
in parallel with the existing cap and trade framework. It seems to me 
that, knowing what we know now about price volatility and market 
dynamics, if setting up a system today we would start with a nominal 
tax to set that floor and then gradually implement the cap and trade 
market structure on top of the tax overlay. That way you get immediate 
benefits and can learn about the intricacies of cap and trade in a 
controlled fashion as implementation proceeds. In a way, you don't have 
all of your climate change policy eggs in one basket, helping to ensure 
economically and environmentally meaningful results.
    Question 6. Since cap-and-trade programs are so inherently complex 
and far-reaching:

    a) How can we be sure that any scheme is workable and can be 
implemented by the executive branch?
    b) How great are the risks of unintended consequences--for the 
economy and the environment?
    c) What sort of growth are we likely to need in federal agencies, 
particularly EPA, if the House-passed bill became law?

    Answer. The first part of this question is exactly the point: we 
cannot be at all certain that the type of cap and trade-program we are 
developing will work at all, due in combination to the less-than-
perfect fitting externality that is carbon, the complexity and dynamics 
of the contract design, and the management of the carbon market 
efficiency board.
    We are discussing the issue of carbon emissions reductions because 
we believe such reductions are important to the environment. Hence, I 
think it is wisest to rely to various degrees on a mix of policies, 
weighing more on traditional taxes and less on innovative cap and trade 
schemes, to ensure an environmentally meaningful solution.
    The risks if a carbon market crisis are very real, and the costs of 
regulation of that market and its participants, as well as carbon 
emissions, is likely to be very high. Moreover, while much discussion 
has centered around how to distribute revenues from initial allocations 
of carbon permits, I do not recall any discussion of paying for 
monitoring and infrastructure needs before distributing revenues to the 
public.
    The costs of the regulation and monitoring system--which will span 
firms emitting carbon as well as carbon markets--are likely to dwarf 
those of something like the existing banking system, and those costs 
are likely to be incurred through multiple regulatory agencies, 
including but not limited to EPA. The reason for my opinion is that the 
system will require multiple layers of ``carbon examiners'' to verify 
monitoring technology, ``collections officers'' to verify the forms of 
payment for emissions, and ``market regulators'' to police trading 
market participants. All of those tasks will be carried out according 
to an, as yet, unknown body of regulatory rules that will have to be 
constructed and will evolve through decisionmaking with comment periods 
and review. We are creating an entire industry by government fiat, from 
the instruments of value through the mechanism of trade. That will not 
be cheap.
    Question 7. Given the complexity and intricacy of some of these 
policy proposals, I am particularly concerned about the opportunities 
they might create for market manipulation, fraud, and for the 
development of arcane financial instruments that will lead us to the 
next major global financial crisis. Do you believe that these concerns 
are justified? How might opportunities for market manipulation be 
reduced through climate policy design?
    Answer. While it is difficult to say a priori how market 
manipulation and fraud may evolve, one can be sure that millions of 
traders with dollars at stake will examine the contract and trading 
rules thoroughly and discover loopholes no relatively small (in 
comparison) set of policymakers can detect. The concerns are very 
justified, and a system will have to be set in place to police 
nefarious activity and modify the system quickly in response, where 
needed. Hence, even a carbon market efficiency board will not be a 
passive entity, merely looking after the permit supply, but passive in 
addressing market dynamics as they evolve.
    Question 8. I understand that last December, the European Union 
made auctioning the default future allocation method for its emission 
trading system.

    a) Was that a tacit recognition that the best way to allocate 
carbon permits or emission allowances is by auction?
    b) What other ways is the European Commission working to correct 
the windfall and overallocation it experienced in the early years of 
the European emission trading system?
    c) What lessons can Congress learn from the European experience to 
avoid pitfalls in designing and implementing a carbon trading system?

    Answer. As state previously, auction mechanisms or ``free'' 
allocations are equal in the mind of an economist, barring overt 
redistributional policy goals. To an economist, the money moves through 
the economy either way. The only difference being whether it starts in 
the hands of the government as a result of the auction or in the hands 
of businesses as a result of the ``free'' allocation.
    The windfall and overallocation problems are related to the 
inability to set a hard ``cap'' for the cap and trade to regulate. I 
reiterate, the essence of cap and trade is that cap--which forms 
benefit certainty--and the lack of price limits that discipline firms 
to work within the cap. Without agreed upon scientific evidence to 
properly identify the size of cap necessary in any one period or any 
one country to achieve long term environmental goals, there will always 
be debate about moving that cap, creating price volatility from the 
policy variance.
    Question 9. One of my concerns is that, as far as I can tell, 
allowances that are given away under cap-and-trade could be sold on the 
secondary market at a price that would undercut the government auction 
reserve price.

    a) Is this accurate, and do you see this as a potential problem for 
energy investments under such price uncertainty?
    b) What happens if or when strategic allowance reserves run out in 
a cap-and-trade program?
    c) If a strategic reserve is used instead of an explicit price 
ceiling, then what happens if the strategic reserve is continually 
depleted? Do costs skyrocket at that point?

    Answer. The concern you voice is nothing more than the difference 
between spot and future prices. The only permits that would sell on 
secondary markets are those not immediately needed for compliance. 
Until it is established that they are not needed, they must be 
``carried'' at a positive opportunity cost, the interest rate 
representing the cost of capital. Hence, the all-in futures price 
should be the spot price plus storage cost.
    Sometimes, as is common with commodities, the futures price is 
persistently more than the spot price plus storage, representing the 
``convenience yield'' of having the spot contract on hand if needed. 
This process, known as backwardation is a common characteristic of many 
commodities contracts where the underlying is a production input and 
seems to be the focus of your question. Such market conditions are 
normal for production inputs and should not be a concern.
    The opposite of a backwardation structure is contango--where 
futures prices are less than spot prices plus storage. Empirical 
evidence from the EU carbon market shows that the carbon futures market 
illustrates characteristics not of backwardation, but of contango But 
the financial economics literature suggests that commodities with 
contango structures usually have readily available inventories that are 
easily accessed and stored and stable supply and demand functions. 
Those conditions contradict the performance of carbon markets to date. 
Even if cap and trade contracts have no cost of storage and are easily 
accessed, levels of supply and demand for carbon emissions are not 
easily predicted. In addition, the level of inventories for cap and 
trade contracts is dependent on current emission levels and 
availability of offsets, which are stochastic and unpredictable.
    What happens when strategic reserves run out is a policy question. 
If more reserves are added, nothing need happen. If policy prevents 
reserves from being added, prices necessarily rise. Only uncertainty 
around the chosen policy path will dictate the degree of price 
volatility along the adjustment curve. That is why central banks often 
precommit to policy rules that can smooth adjustment in undue 
circumstances.
    Question 10. Under the House bill, I understand that the strategic 
reserve fund in H.R. 2454 is replenished using international forestry 
offsets. But with all of the other offsets proposed in the House bill 
are these likely to be available in sufficient numbers to rebuild the 
reserve, especially in the longer-term? What would this imply for cost 
control and for the overall viability of the cap-and-trade policy?
    Answer. If the system is implemented before sufficient offsets are 
available the lack of such offsets could induce substantial disruptive 
price dynamics. As discussed above, it is imperative to construct an 
offset system that can provide a sizeable portion of offset demand 
before pursuing a cap and trade policy relying crucially upon such 
terms.
    Question 11. Could you please summarize the pitfalls of carbon 
market design that you have observed in the EU ETS and other emissions 
trading systems that you would want to avoid in U.S. climate policy 
architecture?
    Answer. First, as discussed previously, it appears that price 
volatility and continued price pressures in Europe has resulted in its 
heading toward a hybrid tax and cap and trade system, whereby France is 
moving to set a tax-based floor on top of existing cap and trade 
framework. It seems to me that, knowing what we know now about price 
volatility and market dynamics, if setting up a system today we would 
start with a nominal tax to set that floor. Later, if desired, we could 
experiment with limited applications of a cap and trade market 
structure on top of the tax overlay. That way you get immediate 
benefits and can learn about the intricacies of cap and trade in a 
controlled fashion as implementation proceeds. In a way, you don't have 
all of your climate change policy eggs in one basket, helping to ensure 
economically and environmentally meaningful results.
    Second, our own experience with the SO2 system in the US 
has taught us the perils of policy uncertainty. When a court case 
challenged the validity of the system prices plummeted, only to rebound 
when the case upheld the existing policy approach. Nonetheless, the 
uncertainty led to a lengthy disruption in price dynamics in the 
market.
    Third, policy implementation periods and targets need to be linked 
to smooth implementation over time.
    Overall, however, the biggest lesson is that we really don't know 
what to expect, given the demonstration of contango price dynamics with 
policy and weather volatility, trending ever lower until necessitation 
a flat tax to maintain even the spectre of a reasonable user fee. The 
important thing to know is that there is still a lot we don't know.
    Question 12. Is it even possible to avoid creating a carbon market 
that is so vulnerable to manipulation?
    Answer. Probably not. The only markets traders don't try to 
manipulate are the ones that don't matter. Even if policymakers create 
the perfect market, there will always be fraud. We will have to stay 
forever vigilant to maintain this market if we are to see it confer 
meaningful economic and environmental benefits.
                                 ______
                                 
      Responses of Jason Grumet to Questions From Senator Bingaman
    Question 1a. In your testimony, you discuss using allowance revenue 
to directly fund offset projects and other projects that will reduce 
greenhouse gas emissions.
    Do you expect that this will deliver greater reductions at lower 
cost than through the use of an offsets market? In other words, are 
offsets necessarily the most cost-effective way to obtain reductions?
    Answer. Offsets reduce program costs and increase regulatory 
flexibility by allowing companies to take advantage of low-cost 
abatement opportunities outside the cap-and-trade system. Offsets are 
an effective way to obtain reductions. Domestic offsets also promote 
innovation in offset markets and ensure that money moves to agriculture 
and forestry projects even if the bureaucracy moves slower than hoped. 
However, any offsets program must balance the need for investor 
certainty, reasonable transaction costs, and administrative simplicity 
(all of which can affect offset price) with assurance that offset 
projects have environmental integrity.
    The crucial difference between offsets and allowance set-asides is 
that whereas offset credits are additional to the cap, set-aside 
allowances are taken from under the cap. Since set-aside allowances are 
already part of the cap, total emissions from regulated sources do not 
rise above the cap level under the set-aside approach. Conversely, in 
certain instances, offsets may allow regulated entities to increase 
their emissions.
    The advantage of a set-aside approach is that it would allow for a 
less rigorous demonstration of emissions reductions: while applicants 
for a share of the set-aside pool would still need to document 
emissions reductions commensurate with the quantity of allowances they 
wish to claim, there would be less pressure to precisely measure these 
reductions. Likewise, reliance on allowance set-asides rather than 
offset credits could allow for a less rigorous approach to issues like 
additionality and permanence.
    Question 1b. Are there certain types of projects that this method 
of funding is more suited to that an offsets market would not deliver?
    Answer. Many agricultural and forestry sequestration projects in 
the U.S. require complex carbon accounting. A cap-and-trade program 
that provides for both offset credits and set-aside allowances will 
give agricultural producers the flexibility to choose different levels 
of rigor in documenting emissions benefits and will help to deliver 
maximum economic and environmental benefits from low-cost mitigation 
opportunities in the agriculture sector. Offset credits should be 
available for agriculture-based mitigation projects--including soil 
carbon sequestration projects--that can meet rigorous standards for 
assuring measurement, additionality, and permanence. Set-aside 
allowances taken from under the cap provide a particularly effective 
mechanism for rewarding these types of projects that provide important 
carbon benefits, but that may have more difficulty meeting these tests, 
such as no-till practices undertaken before the cap-and-trade program 
goes into effect (so-called `early action' projects). A hybrid approach 
can respond effectively to the twin imperatives of (a) ensuring overall 
program integrity and (b) allowing for maximum participation by the 
agricultural sector.
    Question 2. EPA projections have indicated that there will be a 
very limited supply of offsets coming from projects based in the U.S., 
and that the vast majority of the offset supply will be coming from 
overseas. Are there policy choices we can make to increase the supply 
of high-quality domestic offsets, so a greater amount of funds spent 
purchasing offsets stays in the U.S.?
    Answer. Since offsets come from sources outside the cap, exempting 
more sectors from the cap would increase the potential supply of 
domestic offsets. But there are countervailing policy considerations 
that must be weighed against such an approach. EPA's analysis of H.R. 
2454 (Waxman-Markey) indicates that the majority of domestic offsets 
will come from domestic afforestation, forest management, utilization 
of animal waste methane, and other agricultural methane and nitrous 
oxide management strategies. Agriculture and forestry sector offsets 
share many of the inherent challenges of offsets in other sectors, and 
several additional ones.
    Dedicating--or ``setting aside''--a percentage of allowances from 
within the emissions cap or overall budget under a cap-and-trade 
program could allow the U.S. to essentially undertake a large-scale 
demonstration program aimed at resolving some of the issues specific to 
awarding offset credits for carbon sequestration in agricultural soils, 
while both allaying concerns about program integrity and creating new 
economic opportunities in rural communities. A variation on this 
approach would be to have provisions for both regular offset credits 
and set-aside allowances for soil carbon sequestration. Regular offset 
credits would only be available for soil carbon projects that can meet 
rigorous standards for measurement, additionality, and permanence. Set-
aside allowances that are taken from under the cap could reward 
projects that provide important carbon benefits, but that may have more 
difficulty meeting these tests. A requisite for awarding set-aside 
credits would be careful monitoring and evaluation so as to determine 
benefits with more confidence and learn from the experience.
     Responses of Jason Grumet to Questions From Senator Murkowski
                        utilization of revenues
    Question 1. We should be honest about what a cap-and-trade program 
for reducing greenhouse gas emissions will do. Such a policy would 
essentially create a new form of currency and generate massive amounts 
of revenue through auctions, or financial largesse to be doled out in 
the form of free allowances.
    What do you think those revenues should be spent on and who should 
receive that money?
    Answer. As you note, allowance allocation is a highly contentious 
issue in the climate debate due to the significant value of emission 
allowances at stake. Yet despite the intense debate, we believe it is 
possible to design an allocation program that includes an equitable 
distribution centered on the principle of mitigating economic harm. We 
believe that the focus of free allocations should be to help enable the 
transition by entities and communities to a lower carbon future.
    An allowance allocation program should:

   Protect households, especially low-and moderate-income 
        households, from adverse economic impacts as a result of higher 
        energy prices under a climate program;
   Support energy-intensive industries in making a viable 
        transition to a lower carbon footprint without resulting in the 
        significant export of jobs and emissions to our trade 
        competitors;
   Provide incentives for increased investment in the research, 
        development, and deployment efforts needed to advance critical 
        no-and low-carbon technologies and for investment in needed 
        adaptation measures;
   Phase out quickly, with most of the funds raised through the 
        allowance auctions then going to the general treasury.

    There are compelling arguments for using a portion of the allowance 
value (whether through a free allocation or the use of auction 
revenues) to compensate for the economic impacts on utilities and 
industry, in particular energy-intensive industries. These firms will 
undoubtedly bear a significant portion of the cost of the program, and 
mitigating energy price impacts in the early years of the program would 
allow firms needed time to invest in new capital and adjust to changes 
in relative energy prices. Allowances should be distributed to impacted 
sectors, including end-use consumers, according to relative cost 
burden. After the allocations have phased out, auction revenue could 
serve a similar purpose.
             effectiveness of regulation versus incentives
    Question 2. The bill sent over to us from the House not only caps 
emissions from sources emitting more than 25,000 tons annually, but 
imposes command-and-control style regulation of sources below that 
threshold.
    Do you think it is better to provide incentives for the reduction 
of these smaller emissions, through offset projects and other means, 
than to subject relatively insignificant sources to complicated and 
inflexible regulation?
    What ability would these newly regulated sources, under the House 
bill, have to contain costs?
    Answer. It is quite possible that there is a good economic/
environmental argument for excluding sources under 25,000 tons 
altogether. There are a couple of ways, however, to address sources 
smaller than 25,000 tons (but above 10,000 tons). Your 2007 Bingaman-
Murkowski-Specter cap and trade bill solved that problem by taking an 
upstream approach for regulating the carbon content of fuels.
    Another option is to lower the emissions threshold for stationary 
sources to 10,000 tons so those smaller sources would be able to trade 
allowances just like the larger sources, rather than being included 
under an EPA mandated command and control program. You can simply allow 
such sources to participate in the offset market.
               effectiveness of ldcs for cost containment
    Question 3. Under the auspices of cost containment, the House bill 
relies heavily on a requirement that savings associated with free 
allowances given to Local Distribution Companies be passed on to their 
customers. The Center for Budget Policy and Priorities has pointed out 
that more than 60% of the LDC customers are business, not residential 
consumers. And CBO has concluded that businesses receiving this relief 
as a fixed rebate on their bill would retain that relief as added 
profit, rather than pass it on to their own customers in the form of 
lower prices for their products.
    Do you believe this is a flawed approach to cost containment and, 
if so, how can we more explicitly limit the exposure of Americans to 
the costs of a cap-and-trade regime?
    Answer. NCEP supports a price collar (with either a hard price cap 
or a properly designed strategic allowance reserve) as a robust cost 
containment mechanism for overall program costs. As a related but 
separate provision, NCEP also supports use of allowance allocation to 
protect consumers from the economic impacts of higher energy costs. The 
value of allowances allocated to electricity LDCs can help offset 
higher energy costs without dampening incentives for efficiency and 
conservation. All classes of electricity consumers (households, 
business, and industrial entities) will experience price increases--
small businesses and U.S. manufacturers are particularly vulnerable--
and should receive the value of allocated allowances. You raise an 
important question with respect to LDC pass-through and we would 
encourage the Energy Committee to hold a hearing focused on how LDC 
allocations would work in practice.
    NCEP also supports added protection for low-and moderate-income 
families. The CBPP actually proposes several suggested mechanisms to 
reach these consumers, particularly those who would not benefit from 
tax rebates.
      Responses of Jason Grumet to Questions From Senator Cantwell
    Question 1a. What role does the compliance period play in reducing 
price volatility?
    Answer. In general, longer compliance periods for regulated 
entities could help marginally in reducing volatility, but should not 
be relied upon to play an integral role in reducing price volatility. A 
price collar or safety valve is a stronger means of reducing 
volatility.
    Question 1b. Are there any substantial differences in price 
volatility between rolling compliance periods and fixed compliance 
dates?
    Answer. Rolling compliance periods create the equivalent of 
banking, which would help to smooth volatility.
    Question 1c. To minimize price volatility, how much time should 
firms have between the emissions of greenhouse gases and the 
acquisition (and surrender) of allowances? One year or less? Two years? 
Three years? Five years?
    Answer. We fully support unlimited banking. We don't believe that 
drawing out the surrender time will have that great of an effect on 
volatility. The SO2 program has achieved success with a 
twelve month compliance period followed by a 90 day true up period. We 
strongly believe that a price collar or well-functioning strategic 
reserve would provide a more comprehensive solution to volatility.
    Question 2a. What is a reasonable number of allowances, as a 
percentage of yearly emissions, that firms would be able to bank for 
future emissions and compliance dates?
    Answer. We don't see a rationale for limiting banking, as a limit 
will simply discourage early action.
    Question 2b. How long are firms likely to retain allowances for 
future use? Is there likely to be a limit to their willingness to keep 
these assets on their balance sheets?
    Answer. A firm's willingness to hold future vintage allowances is 
based on its assessment of regulatory risk and the future supply/demand 
balance for the commodity. As long as a firm is confident in the long 
term sustainability of the climate program, there is no reason it 
should not be willing to keep allowances on its balance sheet.
    Question 3. To reach the 2050 emissions targets that scientists 
agree are necessary to avert catastrophic climate change, is there an 
affordable option at mid-century that does not incorporate either a 
significant amount of coal with carbon capture and sequestration 
technology or a substantial expansion of nuclear power?
    Answer. The role of a cap-and-trade program is not to pick 
technology winners, but to put a price on carbon that allows the market 
to make informed decisions about which technologies to deploy. It is 
impossible to predict exactly what technological breakthroughs may 
occur between now and mid century. Based on current knowledge, large 
amounts of nuclear or coal with carbon capture and sequestration, or a 
combination thereof, are likely necessary to achieve emissions goals 
while preserving abundant, affordable and reliable electricity.
    Question 4a. From a strictly economic viewpoint, how can the 
pathway of the emissions reductions or the trajectory of the cap's 
emissions reductions affect the costs of a climate policy?
    Answer. One of the reasons the Commission believes that U.S. action 
on climate change is needed now is that sustained inaction creates a 
situation whereby the emission cuts needed over the next few decades to 
avoid dangerous levels of warming must be that much deeper and 
costlier. Under a well-designed climate bill, emissions limits would be 
initially modest and ramp up in a gradual and predictable way over 
multiple years, with effective mechanisms in place from the outset to 
(a) guard against high or excessively volatile allowance prices and (b) 
protect low-income households and trade-sensitive, energy-intensive 
businesses. This approach will provide time and a favorable investment 
environment for robust low-carbon technology alternatives to become 
available, thereby reducing climate-related costs to the economy in the 
long run. It will also help ensure that the transition to a low-carbon 
economy provides a steady impetus for the creation of durable new 
industries and employment opportunities.
    Most importantly, a successful bill will deliver clarity about U.S. 
climate policy and certainty about carbon costs going forward. This is 
the critical issue for businesses attempting to make strategic 
investments in new energy technology and long-lived infrastructure. It 
is also the central priority from the standpoint of engaging major 
developing countries in a re-invigorated international process.
    Question 4b. For a fixed amount of cumulative emissions, what might 
the optimal shape of that emissions pathway be?
    Answer. Because it is cumulative global emissions that are 
critical, determining whether there is a single optimal shape of the 
emissions pathway from an economic perspective is complex. The 
Commission has long advocated beginning in a moderate and achievable 
manner to begin reducing emissions, which will provide more flexibility 
later on as uncertainties around necessary cumulative emissions limits 
are reduced. It will also send a clear signal to speed technology 
development and then steepen the slope as those technologies take hold.
    Question 5. Why do you regard the inclusion of a price floor as 
particularly important for investment in new energy technologies under 
a climate policy?
    Answer. Along with a cap on allowance prices at the high end, the 
Commission supports the concept of a floor, or lower limit, on 
allowance prices in case abatement costs prove significantly lower than 
expected. A price floor along with a price ceiling should be considered 
because allowance prices in past market-based regulatory programs have 
more often proved to be lower than expected, rather than higher than 
expected--in some cases because emissions budgets were inflated, in 
some cases because other factors (such as slower-than-expected economic 
growth) temporarily reduced demand for allowances.
    Some price stability at the low end, as well as at the high end, 
would assure that there are sufficient--and sufficiently consistent--
incentives for investment in low-carbon technologies over time (along 
with sufficient disincentives to new investment in long lived carbon-
intensive infrastructure). Combining a price floor with a price ceiling 
could thus be quite important to the successful development of new 
climate-friendly industries and could help ensure that artificially low 
prices in the short term don't lead to significantly higher costs in 
the long run, when deeper emission reductions are needed to achieve 
program goals.
    Question 6. Since cap-and-trade programs are so inherently complex 
and far-reaching:

    a) How can we be sure that any scheme is workable and can be 
implemented by the executive branch?

    Answer. It has been the Commission's considered view for some time 
that the benefits of prudent but imperfect action profoundly outweigh 
the arguments for further delay. Debate on the critical substantive 
issues has narrowed. In fact, viable solutions to six of the most 
contentious features of a national climate policy--cost-containment, 
state/federal harmonization, international participation and 
competitiveness, offsets, allowance allocation and revenue recycling, 
and market oversight--can be found in existing legislative proposals. 
We also have confidence in the ability of Congress to oversee the 
program and make necessary adjustments.

    b) How great are the risks of unintended consequences--for the 
economy and the environment?

    Answer. With appropriate program design and particularly cost 
control, the risks of considerable ecological and economic consequences 
from inaction are far larger than any risk from acting. In recent 
testimony before Congress, Dr. R.K. Pachauri, Chairman of the 
Intergovernmental Panel on Climate Change (IPCC), noted that evidence 
for warming of the climate system is now ``unequivocal'' and warned 
that ``[d]elayed emission reductions significantly constrain the 
opportunities to achieve lower stabilization levels and increase the 
risk of more severe climate change impacts.'' Already, experts warn 
that the more protective stabilization goals often discussed in recent 
years are moving rapidly out of reach. Moreover, the latest 
developments in climate science lend greater urgency to the case for 
action: effects on natural systems are already being observed and 
recent findings concerning the potential scope and magnitude of damages 
from future warming are increasingly worrisome.
    A diverse group of stakeholders that includes military experts, 
CEOs of major oil companies and electric utilities, labor leaders, 
state governments, religious leaders, sportsmen, and environmental 
advocates recognize that the intolerable (and probably far more costly) 
alternative to a clear federal policy is continued uncertainty, 
international paralysis, and reliance on highly imperfect regulatory 
mechanisms such as those triggered by EPA's recent finding that 
greenhouse gases endanger human health and welfare under the Clean Air 
Act.

    c) What sort of growth are we likely to need in federal agencies, 
particularly EPA, if the House-passed bill became law?

    Answer. In June, the Congressional Budget Office (CBO) estimated 
that fully funding federal agencies' administrative costs for 
implementing the House-passed bill would require gross appropriations 
totaling $540 million in 2010 and $8.2 billion over the 2010-2019 
period. Their estimate is based on historical information on how large 
regulatory programs have been implemented and on information provided 
by EPA, FERC and other federal agencies with significant administrative 
responsibilities under the House bill.
    Question 7. Given the complexity and intricacy of some of these 
policy proposals, I am particularly concerned about the opportunities 
they might create for market manipulation, fraud, and for the 
development of arcane financial instruments that will lead us to the 
next major global financial crisis. Do you believe that these concerns 
are justified? How might opportunities for market manipulation be 
reduced through climate policy design?
    Answer. We share your concerns about the need for market oversight 
and, in the coming months, NCEP will release a set of recommendations 
addressing this issue in detail. We believe It is possible to limit 
opportunities for market manipulation without implementing excessive 
regulations that compromise the efficiency of a cap-and-trade program. 
A carbon market shares both the benefits and potential pitfalls of 
financial markets in general. Therefore, carbon market controls will be 
addressed in the context of broader market reforms being considered 
today and, once created, may require additional regulatory oversight.
    The design of climate policy can significantly reduce the 
opportunity of market manipulation. NCEP strongly supports a robust 
cost containment mechanism--such as a price collar or strategic 
allowance reserve--that will limit price volatility in addition to 
controlling overall program costs. An upper and lower bound on 
allowance prices can limit opportunities for market speculation.
    Question 8. I understand that last December, the European Union 
made auctioning the default future allocation method for its emission 
trading system.

    a) Was that a tacit recognition that the best way to allocate 
carbon permits or emission allowances is by auction?

    Answer. The allocation approach taken in Europe--where national 
governments distributed nearly all allowances for free to entities 
directly regulated under the EU trading system--does not provide a good 
model for an economy-wide U.S. program. Rather, to address equity 
concerns and avoid excessive windfall profits in some industries, a 
much larger fraction of emissions allowances or permits should be 
auctioned. It is worth noting however that much like Europe's 
transition from phase 1 to phase 2, we propose beginning with a large 
allowance program and ending with a full auction.
    Given that both energy producers and the general public bear some 
burden under a greenhouse-gas trading program, an allocation approach 
that auctions all allowances and recycles the proceeds in the form of 
tax relief will have the overall effect of transferring some wealth 
from energy producers to the broader public (in this case taxpayers). 
Conversely, an allocation approach that gives all allowances for free 
to directly affected industries will have the overall effect of 
transferring some wealth from the broad public (in this case consumers) 
to those industries.
    An allocation that does both could end up leaving both groups 
roughly equally well off. In other words, compared to either a pure 
auction or pure grandfathering, a mixed strategy--in which some 
allowances are auctioned and others are given away for free--may create 
opportunities to realize broader public benefits while also addressing 
legitimate industry concerns about cost impacts. Moreover, a phased 
approach, wherein a substantial portion of allowances is grandfathered 
in the early years of program implementation but that share gradually 
diminishes in subsequent years to allow for a larger auction, may offer 
particular advantages in terms of creating a transition period for 
energy-intensive industries (especially those with a long-lived capital 
assets), while eventually securing the social welfare and efficiency-
maximizing benefits of an auction.

    b) What other ways is the European Commission working to correct 
the windfall and overallocation it experienced in the early years of 
the European emission trading system?

    Answer. The EU-ETS is proceeding in three stages:

    Phase 1, from 2005-2007, was a pilot phase, which was focused on 
generating data for establishing an accurate price on carbon, 
developing infrastructure such as emissions registries, and gaining 
valuable experience with regulating a carbon market.
    Phase 2, from 2008-2012, involves a tightening of the cap and fewer 
allocations to industry and the power sector. The price of carbon has 
fluctuated, but mainly mirrored global markets. To reduce the number of 
free allowances given to industry and power sectors, larger amounts of 
international offsets were made available.
    Phase 3, from 2013-2020, will involve moving toward a 20% emissions 
reduction goal for 2020. All utilities, unless they are at risk of 
carbon leakage, will face 100% auctioning.

    c) What lessons can Congress learn from the European experience to 
avoid pitfalls in designing and implementing a carbon trading system?

    Answer. One important lesson is the need for accurate emissions 
data so that over-or under-allocation of allowances does not occur. We 
have better data and a new reporting rule in the U.S., which should 
hopefully inoculate us from some of the troubles experienced in the 
first phase of Europe's program. Another lesson is that a trading 
system must provide enough certainty to allow technology investment. 
Third, the EU-ETS experience highlights the important effects of 
allowance allocation.
    Question 9. One of my concerns is that, as far as I can tell, 
allowances that are given away under cap-and-trade could be sold on the 
secondary market at a price that would undercut the government auction 
reserve price.

    a) Is this accurate, and do you see this as a potential problem for 
energy investments under such price uncertainty?

    Answer. Allowances (whether initially auctioned or freely 
allocated) can be traded on the secondary market at a price below the 
price floor but this would assume drastically lower prices than current 
projections. It would of course be good news if technological 
breakthroughs are so effective that regulations become unnecessary.
    However, this would have no long-term effect on the emissions price 
floor and thus does not present a significant problem for energy 
investment certainty. A price floor is enforced through the periodic 
regular auctions, where no allowances will be sold below the specified 
minimum price. If allowances are trading on a secondary market below 
the floor price, bids at the regular auction would not reach the floor 
price and allowances would not be sold. As long as there is a 
sufficient number of auctioned allowances, prices would rise again in 
response to the tightened supply of allowances in the market.

    b) What happens if or when strategic allowance reserves run out in 
a cap-and-trade program?
    c) If a strategic reserve is used instead of an explicit price 
ceiling, then what happens if the strategic reserve is continually 
depleted? Do costs skyrocket at that point?

    Answer. In our recent paper addressing economic risk in a cap-and-
trade program, NCEP made several suggestions to strengthen the design 
of the strategic allowance reserve included in the Waxman-Markey 
legislation. These recommendations address both the size of the reserve 
and the proposed mechanism to replenish the reserve.
    A strategic allowance reserve differs from an explicit price 
ceiling in that only a limited number of allowances are available at 
the trigger reserve allowance price. Therefore, there is no guarantee 
that the pool of strategic reserve allowances will not be depleted. If 
this pool is depleted, the prices can rise above the trigger reserve 
allowance price. We believe that roughly 6 billion tons of allowances 
should be available in the first ten years of the program. We are 
undertaking additional analysis regarding the reserve size required to 
manage long-and short-term cost concerns.
    The Waxman-Markey allowance reserve is structured to be replenished 
annually through government purchases of international forestry 
offsets. NCEP is uncertain about the availability of international 
offset credits, particularly in the early years of a program, and does 
not recommend that the size and effectiveness of the reserve be fully 
reliant on the offsets market. An alternative may be to have the 
government purchase offsets to ``pay back'' the allowances borrowed 
from future years.
                                 ______
                                 
     Response of Eileen Claussen to Question From Senator Bingaman
    Question 1. EPA projections have indicated that there will be a 
very limited supply of offsets coming from projects based in the U.S., 
and that the vast majority of the offset supply will be coming from 
overseas. Are there policy choices we can make to increase the supply 
of high-quality domestic offsets, so a greater amount of funds spent 
purchasing offsets stays in the U.S.?
    Answer. We believe it is important to encourage cost-effective 
domestic offset projects from uncapped and unregulated sectors, 
particularly in the early years of a cap-and-trade program. There are 
several policy choices that can be made to increase the availability of 
these domestic offsets.
    First and foremost, directing the administering agencies to start 
now to develop the foundation of an offset program in anticipation of 
legislation is important. Foundational issues which can be addressed in 
advance of program implementation include establishing:

   A clear and consistent definition of key GHG offset quality 
        criteria;
   A priority list of offset project types to be considered by 
        the program;
   A framework for methodology review and approval;
   A review and approval process of existing offset 
        methodologies;
   A scientific advisory board; and
   A review of the quality of offsets from existing programs.

    Some types of offsets projects are easier to do than others. 
Reducing emissions from coal mines, landfills, and natural gas systems 
provide some of the most readily-available offset opportunities. In 
fact, EPA has said that including these types of actions as offsets 
would increase the domestic offset supply by 45%. We recommend that 
these types of reductions be included as offset projects rather than 
utilizing the House proposed NSPS for small sources. In addition, 
another potential type of offset credit could be the ``destruction of 
Ozone Depleting Substances (ODS)''. In the House bill, these credits 
could only be used in the separate HFC cap, and not in the main capped 
system until an EPA review and finding after the market has already 
been operating for a number of years.
    Responses of Eileen Claussen to Questions From Senator Murkowski
                        utilization of revenues
    Question 1. We should be honest about what a cap-and-trade program 
for reducing greenhouse gas emissions will do. Such a policy would 
essentially create a new form of currency and generate massive amounts 
of revenue through auctions, or financial largesse to be doled out in 
the form of free allowances.
    What do you think those revenues should be spent on and who should 
receive that money?
    Answer. At the Pew Center, we use the term ``allowance value'' to 
mean the economic value of either auction revenues or free allowances. 
As part of USCAP, we believe that the distribution of allowance value 
should achieve the following overarching objectives:

   enable a smooth transition to a low-carbon economy by 
        providing financial relief to consumers and businesses who bear 
        the costs of climate change mitigation
   transform technology and the nation's workforce to support a 
        new energy economy by subsidizing the early deployment of 
        climate-friendly technologies and the creation of clean energy 
        jobs
   enhance our resilience and ability to adapt to climate 
        change impacts by funding adaptation planning and investment at 
        all levels of government.

    With regard to transition assistance we recommend helping those who 
actually bear the cost, and not those who can easily pass those costs 
on to others, and to concentrate assistance on those consumers and 
businesses who are the most vulnerable to the secondary price cost 
impacts effects of a cap, such as low-income consumers. We also 
recommend providing this assistance without undermining the cap-and 
and-trade program's incentive to reduce emissions. This free 
distribution of allowance values would be phased out over time.
    For example, we recommend providing allowance value to energy-
intensive, trade-exposed industries that cannot easily pass on their 
compliance costs due to lack of action by other countries whose 
businesses compete with ours. Such assistance should be structured so 
that it rewards improved environmental performance in comparison to a 
benchmark for each particular industry, and should be phased out as 
other nations adopt comparable climate policies. It is important to 
help such industries not only for competitiveness reasons, but also for 
environmental reasons--if compliance costs for such industries cause 
them to shift production overseas, we will ``leak'' not only economic 
activity, but also emissions, thus hurting the environmental integrity 
of the cap cap-and and-trade program.
    We also recommend providing assistance to regulated local electric 
and gas distribution companies, to condition that assistance on their 
providing relief to their customers, and to require that state Public 
Utility Commissions certify that the allowance value is indeed being 
used to help customers. Providing relief in this way takes advantage of 
existing business and institutional arrangements, creates incentives 
for utility-based energy efficiency programs, and tends to target more 
relief to regions that are harder hit by the program.
    With regard to technology transformation, we recommend providing 
allowance value to emerging technologies that are not sufficiently 
incentivized by the cap cap-and -trade program itself, such as energy 
efficiency and carbon capture and storage. With regard to workforce 
transformation we recommend providing both transition assistance for 
those who must change their jobs as well as support for businesses to 
create new jobs.
    Finally, we recommend proving support for activities to enhance 
both human and ecological resiliency to future climate change and for 
government at all levels to take steps to adapt to the impacts of 
climate change that we are already beginning to experience. This 
includes impacts on public health, infrastructure, fish and wildlife 
habitats, and other affected communities in the United States. In 
addition, we support the use of allowance value as a mechanism to 
promote international engagement and cooperation to help developing 
countries adapt to unavoidable climate change.
                        eligible offset projects
    Question 2a. There is a great variety of offset projects that can 
be undertaken, some more reliable than others. We risk creating an 
incentive for loosely constructed offset rules given the cost 
containment objectives we have and the extent to which some would have 
us rely upon offsets to meet it.
    Should there be a list of allowable offset project types spelled 
out in legislative text, or not?
    Answer. In order to ensure early supply, offset project developers 
need guidance on the types of offset projects that will be eligible to 
produce emission reductions and the standards that will be used to 
evaluate those projects. A positive list of eligible project types 
would help to provide developers with such guidance, and provide 
further incentive to invest in projects early on in the program.
    Question 2b. What standards should apply whether there is such a 
list or not?
    Answer. The Pew Center has published a Congressional brief on 
offsets, available at our website (http://www.pewclimate.org/policy-
brief/Offsets), and we are also a member of the Offset Quality 
Initiative, which has published a brief on this issue titled ``Ensuring 
Offset Quality: Integrating High Quality Greenhouse Gas Offsets Into 
North American Cap-and-Trade Policy'' (http://
www.offsetqualityinitiative.org/pdfs/
OQI_Ensuring_Offset_Quality_7_08.pdf). In those documents and 
elsewhere, the following criteria are often cited as essential to 
ensure that offsets are of high enough quality to be credibly included 
in a cap-and-trade program. Offsets should be:

   Real.--GHG emission reductions should represent actual 
        emission reductions and not simply be artifacts of incomplete 
        or inaccurate accounting.
   Measurable.--Emission reductions from offset projects must 
        be accurately quantified. In some cases direct measurement may 
        be difficult, but imprecise and/or unreliable accounting will 
        impinge on the integrity of the offset.
   Additional.--Offset project reductions must be shown to be 
        ``in addition to'' reductions that would have occurred without 
        the offset project or the incentives provided by offset 
        credits. This criterion is often considered not only the most 
        important attribute, but also the most difficult to determine. 
        To be considered additional, the revenue gained from selling 
        the project's emission reductions should be the main fiscal 
        incentive behind the project's implementation. Determining 
        additionality is an essential but imperfect process. No single 
        approach is the best for all project types. A standardized 
        methodology for this determination is usually considered the 
        best approach.
   Permanent.--Offset emission reductions can sometimes be 
        reversed either by human activity and/or by acts of nature (the 
        most common example being a forest fire). Because offset 
        credits in emission trading programs will be used for 
        compliance in lieu of an on-site reduction, it is important to 
        ensure that the offset credits either represent a permanent 
        reduction or contractually require replacement if they are 
        reversed. Alternatively, there are other mechanisms to address 
        permanence, including pooling, aggregation, and insurance. A 
        standardized methodology for this determination is usually 
        considered the best approach.
   Monitored.--Offset projects must be monitored to ensure that 
        emission reductions are occurring. Each project must have a 
        unique monitoring plan that defines how, when and by whom data 
        will be collected and emissions quantified. These plans should 
        be developed with experts familiar with the specifics of a 
        project and should use established standards.
   Independently Verified.--All GHG reductions should be 
        verified by either a third party or a government agency 
        according to accepted methodologies and regulations. Monitoring 
        reports issued after the emission reductions have occurred (ex-
        post) should be used as the basis for issuing offset credits. 
        For credibility purposes, verifier compensation should not in 
        any way depend on the outcome of the verifier's decisions.
   Measured From a Credible Baseline.--A credible baseline, or 
        ``without-project'' emissions, must be established in order to 
        measure an offset project's reductions. The difference between 
        this baseline case and the actual emissions level represents 
        the reductions achieved by the offset project, and determines 
        the amount of offset credits issued.
   Protected From Leakage.--Leakage is defined as an increase 
        in GHG emissions outside of the project's boundary that occurs 
        as a result of the project. For example, avoiding deforestation 
        through an offset project in one area could simply push the 
        deforestation (and resulting emissions) to a different region 
        or country. Leakage minimization through monitoring and 
        verification plans and protocols should be addressed in offset 
        program design. A standardized methodology for this 
        determination is usually considered the best approach.
   A Clear Property Right.--Clear and uncontested title to 
        offset credits is necessary, and transfer of ownership must be 
        unambiguous and documented. Once sold, the original owner must 
        cede all rights to claim future credit for the same reductions 
        in order to avoid double counting. Offset credits should be 
        serialized and accounted for in a registry or other approved 
        tracking system.
                  decertification of an offset project
    Question 3a. It is all but inevitable that at least some offset 
projects, if allowed as part of a climate program, will be exposed as 
flawed or useless as it relates to verifiable greenhouse gas 
reductions. Forests can burn down, fraud can take place, and countries 
could even nationalize these projects for their own financial gain. In 
the event that this occurs, a process of de-certification will need to 
be developed.
    How should such a process work, and under what circumstances should 
it be done?
    Answer. Changes in the overall program design, as well as details 
of assessment protocols for different project types, should be 
evaluated and incorporated regularly to ensure the environmental 
integrity and effectiveness of an offset mechanism. Policy and 
regulatory reviews should occur at long enough intervals to allow for 
investment certainty. Except under extreme circumstances, policy 
changes should not be applied retroactively or without ample warning, 
in order to avoid leaving market participants with stranded investments 
that were made in good faith under existing rules.
    Question 3b. Should we be concerned that the need to contain costs 
may provide an incentive to look the other way and fail to pursue de-
certification?
    Answer. A centralized authority that will administer and implement 
an offset program should be established, and decisions of this sort 
should be done by regulation, using a transparent process with public 
input. This authority should have the ability to make necessary 
decisions, such as those regarding any de-certifications, and should be 
capable of doing so in a timely and transparent fashion.
     difficulties of certifying international offsets and ensuring 
                               compliance
    Question 4. It is apparent that many difficulties ay emerge in 
attempting to develop an accurate tracking system for a worldwide 
carbon market. The House bill creates a litany of requirements that 
must be met before international offsets can be used. In order to host 
offset projects, a developing country must meet several criteria:

   They must negotiate a treaty with the U.S. to assure 
        certain, minimum requirements are met;
   They must establish an emissions baseline and set targets to 
        achieve zero net deforestation within 20 years;
   They must design offset projects to account for the 
        interests of communities, indigenous peoples, and vulnerable 
        groups with equitable profit-sharing; and
   The U.S. must certify the establishment and enforcement by 
        the host country of laws, processes and standards to assure 
        these rights.
   The developing country must develop a strategic plan for 
        addressing the drivers of deforestation and identify reforms to 
        national policies.

    There is nothing wrong with these criteria, per se, but they make 
timely availability of international offsets impossible. It is also 
unclear if foreign governments would acquiesce to these conditions or 
not.
    How do we ensure that American entities are buying legitimate 
carbon credits without creating an impenetrable, bureaucratic process 
like we've seen in the House bill? Is it even possible?
    Answer. The criteria above are challenging to meet but represent a 
core set of requirements that have developed over years of from 
international discussions aimed at making international offsets a 
reality. With respect specifically to international forestry, some key 
developing countries have, or are close to having, deforestation 
policies and the necessary institutional capacity to establish national 
baselines, change national policies, and move to net-zero deforestation 
over time. Deforestation accounts for approximately 20% of global 
emissions and putting domestic policies in place that drive private 
investment towards reducing international deforestation our planet 
benefit us all.
    Forestry projects, however, are not the only type of international 
offset project that are possible. Similar to domestic offsets, 
international offsets projects can be done in a number of categories 
outside of the forestry sector, including agriculture, energy fuel 
switching, and transportation--to name just a few. Measured against the 
same quality criteria as domestic offsets, i.e. additional, permanent, 
monitored, independently verified, and addressing leakage--
international offsets can be assessed by an international body if our 
program administrator determines that this international body has a 
thorough and credible assessment process. The role of international 
offsets in containing the cost of a cap-and-trade program is 
significant, as EPA modeling shows that without these offsets, costs 
may be as much as 89% higher. Therefore, it is crucial that 
international offsets be a part of our cap and trade system. It is also 
critical that international offsets be of high quality for our program 
and for others. U.S. involvement in the international process can help 
ensure this high quality and if it is not forthcoming we can require 
additional measures and be selective.
                  longevity of trees as carbon offsets
    Question 5. Scientists tell us that carbon dioxide remains in the 
atmosphere for roughly a century before it fades away. If a tree 
claimed as a source of offset credits were cut down even a few decades 
after that occurring, then the carbon credits it had produced would be 
environmentally worthless.
    How can anyone realistically ensure that a tree that creates a 
carbon offset credit isn't later destroyed anyway, particularly in 
foreign countries in which the U.S government has no say in the way 
those resources are managed?
    Answer. First, it is important to understand that a carbon offset 
credit is not tied directly to a particular tree in a forest. Forests 
generating offset credits may have trees dying and growing back at all 
times, and on the whole still be a net sink for carbon. The key is 
avoiding large scale degradation or deforestation over a reasonable 
period of time.
    The issue of permanence is a difficult one for offset projects but 
there are options to address reversals to ensure the environmental 
integrity of offset credits from forestry. One option would include 
establishing an offsets reserve. Here the offset Administrator could 
simply subtract and hold (from the credits that would have been issued 
for a project) a quantity of credits that account for the risk that the 
biological sink was destroyed. These ``reserve'' credits could then be 
retired if necessary to fully account for the tons of carbon that are 
no longer sequestered. Alternatively, the offset Administrator could 
create an insurance mechanism that provides dollars to purchase 
replacement carbon tons if a sink is destroyed.
    Other ways to address permanence could include discounting the 
credits that are issued for offset projects (reducing the value of the 
credit to reflect carbon that is measurably sequestered in a given 
year); explicitly requiring project developers to surrender credits in 
the event of reversals; and providing strong contractual and liability 
arrangements.
    Internationally, the same options to deal with permanence apply--
the key difference being that the U.S. government may not be the 
regulator. Depending on how the program is structured, the party 
responsible for issuing credits (and ensuring permanence) could be a 
multilateral organization (UN) or potentially the U.S. program 
administrator. In the international context we believe it is especially 
important to build robust measuring and monitoring capacity and good 
governance practices in developing countries as this can help prevent 
reversals from occurring in the first place. Moreover, encouraging such 
things as the development and implementation of strong, long-term 
contract design with liability provisions, effective authorities to 
implement and enforce forest governance, and clear incentives for 
landowners to maintain carbon stocks on their land will be important 
elements of any international carbon offset program.
    Responses of Eileen Claussen to Questions From Senator Cantwell
    Question 1a. What role does the compliance period play in reducing 
price volatility?
    Answer. Although only one factor, the length of the compliance 
period can affect volatility--a multiyear compliance period (say 24 
months instead of 12 months) would reduce price volatility by giving 
firms a greater number of allowances (2 yrs worth) and more time 
flexibility to deal with any short-term price fluctuations and the 
ability to optimize their reduction schedule and minimize their 
compliance costs over time
    Question 1b. Are there any substantial differences in price 
volatility between rolling compliance periods and fixed compliance 
dates?
    Answer. Market volatility in part depends on supply availability 
(see above answer). To the extent that a rolling compliance period 
gives greater flexibility to the program and access to greater supply, 
(in comparison to a fixed compliance period), the result should be less 
price volatility.
    Question 1c. To minimize price volatility, how much time should 
firms have between the emissions of greenhouse gases and the 
acquisition (and surrender) of allowances? One year or less? Two years? 
Three years? Five years?
    Answer. Time and experience with the program will improve (lessen) 
volatility but too many years between emissions and surrender of 
allowances may reduce the effectiveness of the program. We think that a 
multiyear year compliance period (e.g., 2-3 years) would decrease 
volatility. However, if the compliance window is too long, a scenario 
could arise in which large numbers of buyers are in the market for 
allowances at the same time (as the compliance deadline is reached). If 
firms have delayed taking action until the end of the long compliance 
period, the result could be a large temporary spike in the price of 
allowances, and potentially even an increased risk of non-compliance. 
In addition, we think that it is important to allow firms a short 
window of time or ``true-up'' period following the end of the 
compliance period, during which they can reassess their emissions 
compliance obligations and ensure that adequate surrender of allowances 
has occurred.
    Question 2a. What is a reasonable number of allowances, as a 
percentage of yearly emissions, that firms would be able to bank for 
future emissions and compliance dates?
    Answer. Firms should be able to bank all allowances not used in 
each period. There should be no limit. Banking is likely to be utilized 
by firms if they believe that the price of allowances or offsets will 
be higher in the future or that the quantity of available allowances 
will be lower. There is no reason to limit banking because it has 
multiple benefits: it reduces allowance price volatility, provides 
firms with the flexibility to optimally time their investments, and 
encourages early reductions.
    A significant benefit of this approach is that it motivates early 
action by encouraging sources to make larger emission reductions in the 
near-term than needed to satisfy compliance requirements, thereby 
advancing environmental objectives. In periods with relatively low 
allowance demand (e.g., a mild winter, an economic down turn, low 
technology costs), banking will prevent prices from falling too far, 
helping to alleviate volatility on the lower end and preserve 
incentives for innovation. Over the longer-term, this intertemporal 
flexibility results in lower economy wide impacts because firms are 
able to optimize their reduction schedules over time.
    Question 2b. How long are firms likely to retain allowances for 
future use? Is there likely to be a limit to their willingness to keep 
these assets on their balance sheets?
    Answer. As long as firms understand that there is a declining cap 
and expect prices to go up in the future, firms will make a calculation 
on the value of holding allowances or using them. As with any financial 
decision, a part of this calculation will be a discount or interest 
rate that allows firms to compare the value of an allowance today with 
the expected value in the future.
    Question 3. To reach the 2050 emissions targets that scientists 
agree are necessary to avert catastrophic climate change, is there an 
affordable option at mid-century that does not incorporate either a 
significant amount of coal with carbon capture and sequestration 
technology or a substantial expansion of nuclear power?
    Answer. Delaying the availability of new nuclear power and CCS will 
increase the cost of achieving mid-century GHG emission goals, though 
perhaps not to a level that is ``unaffordable.'' Multiple scenarios for 
future low-carbon U.S. and global energy systems that rely to varying 
extents on energy from new nuclear power and fossil fuels with carbon 
capture and storage (CCS) have been explored. If major low-carbon 
technologies prove technically, economically, or politically 
infeasible, the cost to society of achieving a given GHG emission 
reduction goal will be greater than in the case of a broader portfolio 
of mitigation options. A significant body of unbiased analyses 
indicates that a broad portfolio of low-carbon technology options is 
required to meet U.S. and global GHG emission reduction goals at the 
lowest cost to society. Below we discuss results from some of these 
analyses.
    The U.S. Energy Information Administration's (EIA) recent analysis 
of H.R. 2454, the American Clean Energy and Security Act (ACESA) [see 
http://www.eia.doe.gov/oiaf/servicerpt/hr2454/index.html] modeled a 
core ``Basic'' policy case and a sensitivity policy case (called the 
``Limited Alternatives'' case) that restricted the deployment of new 
nuclear power, coal with CCS, and biomass power generation to the very 
low levels projected under ``business as usual.'' EIA projected that 
severely limiting the deployment of these technologies increased the 
cost of complying with the GHG cap-and-trade program. In particular, 
cap-and-trade allowance prices were projected to be 14.5 percent higher 
in all years in the Limited Alternatives case. While the overall 
economy was projected to grow robustly in both policy cases, the GDP 
impact in 2030 of the Limited Alternatives case was projected to be 
more than 40 percent greater than that of the Basic policy case. When 
restricting new nuclear and CCS, EIA projected fewer GHG emission 
reductions from sources under the cap and a greater reliance on 
offsets. For electricity, compared to the Basic policy case, EIA 
projected lower total electricity demand in the Limited Alternatives 
case and a greater reliance on natural gas (generation almost 80 
percent greater in 2030) and renewables (13 percent greater generation 
in 2030), with national average electricity prices projected to be 
about 11 percent higher in 2030.
    A 2009 analysis from the Massachusetts Institute of Technology 
Joint Program on the Science and Policy of Global Change (Paltsev, 
Reilly, Jacoby, and Morris, 2009, The Cost of Climate Policy in the 
United States, MITJPSPGC Report 173) modeled a generic carbon emissions 
pricing policy (e.g., cap and trade) with an emission reduction pathway 
consistent with an 80 percent reduction below the 2008 emissions level 
by 2050. The researchers analyzed several technology scenarios out to 
2050 including one that assumed no nuclear or fossil fuel with CCS 
technology was available for deployment at all. The MIT report found 
that excluding nuclear and CCS as abatement options led to carbon 
prices that were 15-16 percent higher than in the core policy scenario 
across the model run years while the impact on aggregate economic 
welfare in 2050 was about 18 percent greater. The MIT researchers 
reported that:

          The exclusion of CCS and nuclear rule out two big low-carbon 
        options, which should make the task of achieving these goals 
        much harder. While excluding these options raises the cost 
        substantially the simulation results suggests it does not make 
        the target unachievable. Since raising the price of one option, 
        or even making some options unavailable, just leads to use of 
        other options, the cost impact is moderated. If neither 
        advanced nuclear nor the CCS technologies are available then 
        renewables and gas provide about two-thirds of the generation. 
        (p. 18-20)

    The MIT researchers also make the point, however, that extending 
the analysis timeframe beyond 2050 makes the heavy reliance on natural 
gas, which has lower GHG emissions than coal but is still a significant 
source of emissions, ``probably not tenable'' given that climate 
stabilization requires even greater emission reductions post-2050. The 
MIT analysis suggests that if the availability of new nuclear or CCS is 
delayed the cost of achieving mid-century GHG emission reductions may 
still be moderate or ``affordable'' but that if both of these 
technologies are forever precluded as economically, technically, or 
politically infeasible, achieving mid-century GHG emission reduction 
goals would likely prove much more costly.
    Question 4a. From a strictly economic viewpoint, how can the 
pathway of the emissions reductions or the trajectory of the cap's 
emissions reductions affect the costs of a climate policy?
    Answer. For a given cumulative emissions cap, the more rapid the 
reduction in emissions--in other words, the steeper the decline of the 
emissions trajectory--the higher the economic costs of climate policy. 
This is because early reductions will likely take place before advanced 
low-and zero-carbon technologies have been developed and deployed. 
Also, under the standard convention of discounting, the costs of 
emissions reduction occurring today are valued more than the equivalent 
reduction occurring at some point in the future.
    Question 4b. For a fixed amount of cumulative emissions, what might 
the optimal shape of that emissions pathway be?
    Answer. In general, a smoothly declining emissions trajectory leads 
to lower overall costs. The optimal shape of the emissions pathway will 
on the one hand take into account the likelihood that early reductions 
may increase costs (see 10a), but on the other hand, will need to 
ensure the technological feasibility of meeting the cumulative target. 
A trajectory that entails a later peaking point in emissions will make 
it more difficult to meet the cumulative emissions target. Delaying the 
timing of peak emissions will require greater annual reductions in 
years following the peaking point. If the peak occurs sufficiently late 
in the pathway, this may require negative emissions in some years.
    Question 5. Why do you regard the inclusion of a price floor as 
particularly important for investment in new energy technologies under 
a climate policy?
    Answer. A price floor is important because it ensures that the 
strength of the carbon price signal is maintained at a sufficient level 
to stimulate investment in new energy technologies. These investments 
are made with a long planning horizon. If the carbon price signal 
routinely falls to too low a level, this will create an uncertain 
return for long-term investments and decrease the likelihood that those 
investments are undertaken in a timely fashion.
    Question 6. Since cap-and-trade programs are so inherently complex 
and far-reaching:

          a) How can we be sure that any scheme is workable and can be 
        implemented by the executive branch?

    Answer. There is a growing body of national and international work 
supporting the case that the proposed cap-and-trade program can be 
successfully implemented. In the United States we have learned from the 
acid rain trading program the key ingredients to making trading work 
and believe it is possible to scale up that program to cover more 
sources and sectors as required to address greenhouse gas emissions. We 
have also watched closely and learned from the European Union's 
experience--from both the success they have had and the problems they 
have encountered. For example, one major problem they encountered in 
their initial trading period had to do with a lack of baseline 
emissions data for many sources. EPA is about to finalize a rule that 
will collect that data for the United States and make sure we avoid 
this problem.

          b) How great are the risks of unintended consequences--for 
        the economy and the environment?

    Answer. Allowance prices under a cap-and-trade program will be 
influenced by a wide range of factors including the rate of growth of 
our economy, the pace and costs of new technologies, how consumers and 
industry respond to putting a price on carbon, shifts in the relative 
prices of fuels, and even such factors as the weather. None of these 
can be predicted with certainty. Nonetheless, a cap-and-trade program 
can be designed to provide safeguards to prevent unintended 
consequences. Smart program design can avoid unintended economic 
consequences by allowing greater flexibility to minimize compliance 
costs through the use of banking, borrowing and multiyear compliance 
periods. In addition, a minimum allowance price provides needed 
certainty for those investing in new technologies. A strategic reserve 
can provide insurance against a spike in allowance prices while at the 
same time preserving the environmental integrity of the program.

          c) What sort of growth are we likely to need in federal 
        agencies, particularly EPA, if the House-passed bill became 
        law?

    Answer. We do not have and are not aware of any specific estimates 
of the added resources that would be required at EPA and other federal 
agencies for implementing the House-passed bill. We do believe, however 
a cap-and-trade program requires fewer agency resources than achieving 
similar reductions through traditional command and control regulations.
    Question 7. Given the complexity and intricacy of some of these 
policy proposals, I am particularly concerned about the opportunities 
they might create for market manipulation, fraud, and for the 
development of arcane financial instruments that will lead us to the 
next major global financial crisis. Do you believe that these concerns 
are justified? How might opportunities for market manipulation be 
reduced through climate policy design?
    Answer. At the heart of any successful cap-and-trade program is a 
well-functioning market for the trading of emission allowances and 
related financial instruments. The recent high-profile market crises 
highlight the critical need for appropriate market design, transparency 
and oversight. A number of lawmakers and the Administration have 
introduced proposals that would tighten oversight of commodity markets 
in an effort to reduce excessive risk taking, and more generally 
address what they view as weak spots in market regulation. These 
proposals would establish a legal framework for overseeing financial 
markets in general and by extension, carbon trading activity.
    As with any regulation, this oversight must strive for a balance 
between regulating and over-regulating. Policymakers should encourage 
transparency, seek to prevent excessive speculation that can drive 
large swings in commodity prices and further seek to restrain efforts 
to interfere with and manipulate market activity. We believe that these 
goals should be achieved in large part through tightening of regulation 
directed at financial markets as a whole and not by regulating carbon 
market separately. More extensive reporting by market participants 
(including those buying and selling carbon commodities), position 
limits and collateral requirements (which both can be used to reduce 
excessive risk taking), and even restrictions on who can buy and sell 
in a market are options that can be applied to ``exchange-based'' 
transactions (e.g., NYMEX, Green Exchange, et al.) and to some extent 
to transactions that occur between parties not through an exchange. We 
know that a carbon market can be a cost effective mechanism for 
reducing GHG emissions and spurring innovation in low carbon 
technologies, but like any financial market, they need oversight to 
ensure that they are effective and efficient.
    Question 8. I understand that last December, the European Union 
made auctioning the default future allocation method for its emission 
trading system.
    Answer. The EU plans to increase auctioning in Phase III (2013-
2020) of their GHG trading program with a move towards much greater 
auctioning over time. From 2013 onward, the EU anticipates that overall 
more than 50% of allowances will be auctioned but this percentage will 
vary by sector (and by country). Notably in the power sector, the 
intent is to have 100% auctioning by 2020. For industrial sectors not 
at high risk of carbon leakage (because of their carbon intensity and 
international competition) the intent is to have 20% of allowances 
auctioned in 2013, 70% by 2020, increasing to 100% by 2027. However, in 
the industrial sectors at high risk of carbon leakage, the intent is to 
give these companies free allocation equal to 100% of allowances needed 
by the best performers in each sector. The EU is now working on 
developing benchmarks for determining these allocation levels. Thus 
while there is a move toward more auctioning, less than 100% auction is 
anticipated.

          a) Was that a tacit recognition that the best way to allocate 
        carbon permits or emission allowances is by auction?

    Answer. The decision concerning the initial allocation of the 
emission allowances is very important to the design of a cap-and-trade 
program. However, this decision will not affect the environmental 
effectiveness of the program-this is primarily a distributional 
question. Therefore the important question that any government enacting 
a cap-and-trade system will have to grapple with is how to distribute 
the value associated with the allowances. In the U.S. Acid Rain 
program, policy makers distributed most of the allowances to regulated 
entities based on their historical fuel use multiplied by a benchmark 
emission rate. The EU decided to base allocations on historical 
emissions in the initial (trial) phase of their ETS. However, because 
good data on emissions were not yet available, more allowances were 
distributed than necessary to cover emissions and there were reports of 
excessive windfall profits, particularly in the electricity sector. In 
order to avoid these concerns, EU officials have decided to shift to a 
greater use of auction in Phase III (2013-2020) and to prohibit the use 
of free allowances in the electricity sector.
    Most of the U.S. domestic cap-and-trade proposals (including 
USCAP's Blueprint for Legislative Action) propose some free allocation 
of allowances in the early years of the program that phases out over 
time to an auction. The free allowances would initially be distributed 
to capped entities and consumers particularly disadvantaged by the 
secondary price impacts of a cap.

          b) What other ways is the European Commission working to 
        correct the windfall and overallocation it experienced in the 
        early years of the European emission trading system?

    Answer. Based on experience in the first phase, the EU commission 
made several modifications in the second phase (2008-2012) including a 
significant reduction in the cap and, less free allocation, both of 
which result in significantly fewer allowances issued to facilities. 
Current emission targets in the ongoing second phase are designed to 
reduce total emissions in covered sectors more than 6% below 2005 
levels by 2012. Going forward in the period 2013-2020, the target is 
20% below 1990 levels by 2020 (equivalent to 14% below 2005 levels by 
2020). The target can decrease to 30% below 1990 if other 
industrialized nations take comparable action.
    Likely the most significant issue that contributed to the allowance 
price collapse of the first phase of the program was that the EU did 
not have good emissions data prior to program start up and as a result 
they subsequently issued too many allowances.

          c) What lessons can Congress learn from the European 
        experience to avoid pitfalls in designing and implementing a 
        carbon trading system?

    Answer. The EU-ETS has succeeded in setting up the infrastructure, 
determining country specific and industry specific targets, defining 
the commodity, implementing a fairly consistent set of rules and 
verification requirements such that carbon trading of billions of 
allowances among 12,000 regulated facilities and other market players 
has become a reality. Carbon emissions in the EU now have a recognized 
price--which will go up and down as happens in all markets.
    The creation of this market though has not been free from 
difficulties and many lessons can be learned:

   First and foremost, the EU experience demonstrated the 
        importance of good data on which to base cap-setting and 
        allowance allocation decisions.
   Free allocation does not necessarily protect consumers from 
        price increases; allocation must be targeted to those who bear 
        the costs and not to those who can simply pass their costs on 
        to others.
   Allocation decisions do not impact the environmental outcome 
        of the program.
   The rapid development of carbon markets is facilitated by a 
        rapid dissemination of information about emissions and 
        allowance demand and price.
   Allowance price volatility can be dampened by including 
        allowance banking and borrowing and allocating allowances for 
        longer trading periods.
   The interaction between allowance allocation, allowance 
        markets, and the unsettled state of electricity sector 
        liberalization and regulation must be confronted as part of 
        program design to avoid mistakes and unintended consequences---
        especially where 50% of the electricity is generated with coal 
        as it is in the United States.

    Question 9a. One of my concerns is that, as far as I can tell, 
allowances that are given away under cap-and-trade could be sold on the 
secondary market at a price that would undercut the government auction 
reserve price.
    Is this accurate, and do you see this as a potential problem for 
energy investments under such price uncertainty?
    Answer. Prices in the secondary (as well as primary) market will 
reflect the overall state of supply and demand, decisions about banking 
and expectations about program duration and ambition. As long as 
program targets are expected to continually get more stringent, carbon 
prices would be expected to rise over time. As long as firms can bank 
unused allowances, future expectations about higher prices will ensure 
that price does not go too low.
    In the U.S. Acid Rain program, for example, concern about higher 
future prices actually pushed firms into earlier deployment of 
scrubbers than required by the program and resulted in a sizable 
``bank'' of SO2 allowances. Prices in this market did not go too low 
though because banking was allowed and firms expected the program to 
become more stringent (and they expected higher future prices).
    Question 9b. What happens if or when strategic allowance reserves 
run out in a cap-and-trade program?
    Answer. We do not expect a strategic reserve to run out if it is 
designed well; in particular if it includes sufficient quantities of 
both offsets and allowances borrowed from the future. If allowances and 
offsets in the strategic reserve were auctioned, the price would act as 
the distribution mechanism, meaning that the allowances would go to the 
highest bidder. Program flexibility, including ample offsets (domestic 
and international), the ability to borrow from future allocations, 
multiyear compliance and multiyear distribution of allowances, can help 
to contain the costs of a cap-and-trade program. The strategic reserve 
should act as an insurance against sustained higher price and to do so 
there must be sufficient supply in the reserve and there must be 
sufficient ability to ``borrow'' more from the future should the need 
arise.
    Question 9c. If a strategic reserve is used instead of an explicit 
price ceiling, then what happens if the strategic reserve is 
continually depleted? Do costs skyrocket at that point?
    Answer. See above.
                                 ______
                                 
      Responses of Michael Wara to Questions From Senator Bingaman
    Question 1a. In your testimony, you discuss using allowance revenue 
to directly fund offset projects and other projects that will reduce 
greenhouse gas emissions.
    Do you expect that this will deliver greater reductions at lower 
cost than through the use of an offsets market? In other words, are 
offsets necessarily the most cost-effective way to obtain reductions?
    Answer. Offsets are not necessarily the most cost-effective way to 
obtain reductions. This is true because of the additionality problem--
not all reductions that are paid for will be real, and because of the 
high transaction costs associated with producing offsets. It is also 
true because the price of offsets is set by the allowance price in the 
cap-and-trade market. The difference between allowance price and the 
costs of offset production (inframarginal rent) is captured by the 
offset producer (or offset value chain). Using a Carbon Truse Fund to 
reduce emissions outside the cap might in the net, produce lower costs 
per ton because a market mechanism, such as a reverse auction, could be 
used to disburse funds. This would keep most inframarginal rents for 
the fund while paying offset producers enough to induce them to produce 
reductions but no more. In addition, because the program would not be 
linked to the cap-and-trade, additionality concerns, while still 
present, would be less central and so transaction costs could be much 
lower. In combination, these two effects might lead to lower average 
costs per ton of CO2e reduced.
    Question 1b. Are there certain types of projects that this method 
of funding is more suited to that an offsets market would not deliver?
    Answer. Offsets are ill suited to delivering reductions that are 
achievable by improved policy design or implementation, by correction 
of market failure, or where differentiation of marginal from BAU 
projects is in practice impossible. An example of the first type of 
project is improved building standards that produce energy efficiency 
improvements in new construction. An example of the second is energy 
retrofits of rental housing. An example of the third is finance of 
renewable energy projects in China, where other policies are already 
supportive of new wind and solar builds and the energy tariff paid to 
generators is set by opaque agency decision rather than by markets or a 
public rate making procedure.
    Question 2. One primary benefit of an international offsets market 
is that it engages developing nations in the process of achieving 
global emissions reductions. Are there better ways to spend money 
internationally that could achieve even greater reductions and engage 
these nations in a similar manner?
    Answer. There are far better ways to spend these revenues that 
would both achieve reductions in global emissions and build greater 
levels of international cooperation on climate change. Some of the best 
examples of the type of work that could be funded by a Carbon Trust 
Fund are capacity building activities to promote energy efficiency. 
McKinsey has estimated that reductions from energy efficiency are 
enormous in developing countries, especially China, and assuming 
relatively conservative discount rates, will pay for themselves. 
Examples of small scale experiments in implementing these types of 
programs include the China Program of the Natural Resources Defense 
Council, the 1000 Enterprises Program in China, which grew out of a 
collaboration between one province and the Energy Foundation. These 
energy efficiency opportunities are the true low-hanging fruit but they 
do not make good offsets because ownership of the carbon reduction is 
unclear, because monitoring is difficult, and because additionality is 
hard to prove since they have a positive NPV.
    Question 3. EPA projections have indicated that there will be a 
very limited supply of offsets coming from projects based in the U.S., 
and that the vast majority of the offset supply will be coming from 
overseas. Are there policy choices we can make to increase the supply 
of high-quality domestic offsets, so a greater amount of funds spent 
purchasing offsets stays in the U.S.?
    Answer. Most US emissions are under the cap in the current US 
proposals. What is left--the 15.5% of GHG emissions not associated with 
fossil fuels--is relatively difficult to reduce using offsetting 
methods. Capturing a greater fraction of the revenue for domestic 
producers will be very tough because the best potential offset types 
also lend themselves to being capped--and so they are within the US 
under the current legislation. In contrast, these types of emission 
sources are uncapped in developing countries. This dynamic is likely to 
be exacerbated by relatively high environmental integrity in the 
offsets program. Indeed, the only way I can imagine the US capturing 
most of the offset revenue would be by largescale crediting of non-
additional agricultural or forest practices and/or overcrediting of 
same.
     Responses of Michael Wara to Questions From Senator Murkowski
                        utilization of revenues
    Question 1. We should be honest about what a cap-and-trade program 
for reducing greenhouse gas emissions will do. Such a policy would 
essentially create a new form of currency and generate massive amounts 
of revenue through auctions, or financial largesse to be doled out in 
the form of free allowances.
    What do you think those revenues should be spent on and who should 
receive that money?
    Answer. Ideally, this revenue would be used to reduce other 
distortionary taxes within the US system. Probably the lowest hanging 
fruit here would be the payroll tax. Using revenue from allowance 
auctions to offset payroll tax revenue would increase both the 
willingness of US firms to hire new workers and of the US labor force 
to work. Using a cap-and-trade (or carbon tax) to reduce other 
distortionary taxes, especially when these taxes directly reduce 
behaviors that we want more of in our economy, is the best use of 
revenues. This produces what my colleague Larry Goulder has famously 
called a ``double dividend.'' Society benefits both by avoiding climate 
changes and by increased rate of economic growth.
    A second best option would be to directly rebate these revenues to 
consumers (note that the LDC rebate in Waxman-Markey is not the same as 
this). Direct rebates of revenues raised by allowance auctions would at 
least not distort economic activity, would offset the costs of the 
program for at least the lower 40% of income earners in the US (see 
Dallas Burtraw's work on this issue for RFF), and would give citizens a 
direct incentive to reduce their energy consumption relative to the 
average.
    There is some justification for grants of free allowances to firms. 
Studies indicate that somewhere between 5 and 10% is required to fully 
compensate firms for the costs of a cap-and-trade program for 
greenhouse gases (again see Burtraw's work on this issue). Anything in 
excess of this value is windfall profit for shareholders that is 
produced by higher energy costs for everyone.
                    supply of international offsets
    Question 2. In the long-term, the supply of international offsets 
is finite. As these offsets become more important, there will be fewer 
of them. Furthermore, as time goes by, I suspect that a desire to see 
other countries take action will be hampered by Americans having used 
up many of the affordable offsets, and particularly in developing 
countries.
    Do you see this as a problem going forward, if we adopt an approach 
to cost containment that is similar to that contained in the House 
bill?
    Answer. I believe that the supply of international offsets may well 
be constrained both in the near term, by the administrative constraints 
in the system, and in the long term, by developing countries accepting 
caps. My understanding is that assumptions along these lines are built 
into the EPA supply curves that underlie its analysis of HR 2454. That 
being said, it is highly likely that a large number of so-called least 
developed countries will not accept caps for some time, potentially not 
before 2050. If these countries begin to develop at an accelerated 
rate, then it is possible that they might become important sources of 
offsets as the key source nations (China, India, Brazil) accept 
commitments that are similar to developed countries. In any case, you 
are absolutely right that the source nations for offsets will have to 
evolve over the length of the program if key developed countries are to 
accept caps.
       differentiating between international and domestic offsets
    Question 3. I am concerned that a full appreciation of the 
differences between international and domestic offsets has not sunk in 
with many of us involved in the climate change debate.
    Can you please elaborate on the similarities and differences 
between domestic and international offset projects, with an emphasis on 
the effectiveness of them, the availability of them, and the logistical 
issues associated with approving/monitoring them?
    Answer. International offsets typically come (with the exception of 
forestry) from sources that would be under the cap in the US. These 
offsets can be challenging to administer, as my testimony indicates, 
because telling the difference between crediting of business as usual 
and real reductions is challenging, even for well resources and 
intentioned regulators. Nevertheless, once baseline and additionality 
issues are resolved, monitoring and verification are generally 
relatively straightforward (this is the reason that these sources tend 
to be under the cap in a US program).
    Domestic offsets (and international forestry) face all of the 
challenges of baselines and additionality plus important monitoring and 
verification challenges. Accurately estimating the amount of carbon 
stored in soil or in a forest is simply not possible with the accuracy 
at which power plant emissions are measured. Furthermore, the risks of 
reversal are real and difficult, as yet, to quantify and hence insure 
against (although this should get better as we gain experience with 
these offsets). If anything however, domestic offsets, because of their 
sources, will be intrinsically more challenging than international 
offsets.
     difficulties of certifying international offsets and ensuring 
                               compliance
    Question 4. It is apparent that many difficulties may emerge in 
attempting to develop an accurate tracking system for a worldwide 
carbon market. The House bill creates a litany of requirements that 
must be met before international offsets can be used. In order to host 
offset projects, a developing country must meet several criteria:

   They must negotiate a treaty with the U.S. to assure 
        certain, minimum requirements are met;
   They must establish an emissions baseline and set targets to 
        achieve zero net deforestation within 20 years;
   They must design offset projects to account for the 
        interests of communities, indigenous peoples, and vulnerable 
        groups with equitable profit-sharing; and
   The U.S. must certify the establishment and enforcement by 
        the host country of laws, processes and standards to assure 
        these rights.
   The developing country must develop a strategic plan for 
        addressing the drivers of deforestation and identify reforms to 
        national policies.

    There is nothing wrong with these criteria, per se, but they make 
timely availability of international offsets impossible. It is also 
unclear if foreign governments would acquiesce to these conditions or 
not.
    How do we ensure that American entities are buying legitimate 
carbon credits without creating an impenetrable, bureaucratic process 
like we've seen in the House bill? Is it even possible?
    Answer. I would argue that there is no way to assure both adequate 
supply, or at least supply commensurate with expectations, and 
environmental integrity. Supply requires efficient, low-cost 
administrative practices; environmental integrity requires time-
consuming and costly analysis of each and every project.
                    veracity of forestry as offsets
    Question 5. When we look at the offset credits envisioned by so 
many here in Congress, it is difficult to get a clear picture of how it 
is all supposed to work. If a tree would have remained standing despite 
the enactment of climate legislation that allows offset credits, then 
any emission reduction attributed to that tree would be false. Despite 
that fact, just having ``bought'' it as an offset would allow the 
holder of an offset credit to put more greenhouse gases into the 
atmosphere.
    What should the burden of proof be for someone generating or 
selling offset credits that a tree really would have been cut down were 
it not for the sale of a carbon credit?
    Answer. Something approximating the clean and convincing evidence 
standard (the party with the burden must prove that the fact asserted 
is substantially more likely than not) seems appropriate for 
establishing that a credit is backed by a real reduction. It is my 
belief that this standard will be impossible to meet for individual 
projects for the reasons that you allude to but may be possible to meet 
for provincial or national programs that focus on deforestation rates 
across large areas.
                           transfer of wealth
    Question 6. The European Union's Emission Trading Scheme began 
implementation in 2005. In the first phase, emissions covered under the 
Scheme rose by 0.8% across the EU as a whole. Additionally, the price 
of carbon fell to almost zero.
    Since not all member countries had the same requirements, the 
European Scheme acted as a transfer of wealth. It simply forced 
countries with higher requirements to pay more to countries with lower 
requirements to purchase their credits.
    If the U.S. takes a `go at it alone' approach, are you concerned 
that the same transfer of wealth will occur from our American 
businesses to foreign entities as they purchase carbon credits?
    How can we prevent this from happening?
    Answer. The international transfers that would occur under a US 
system along the lines of HR 2454 would likely be substantial but it 
must be remembered that both sides benefit from trade in this 
circumstance. The presence of international credits lowers allowance 
price so that all domestic firms benefit while the seller of the offset 
receives revenue he would otherwise not have obtained.
    I am less concerned about the magnitude of wealth transfers under 
the bill than that the money we spend overseas be effective in reducing 
emissions rather than simply subsidize activities that would have 
occurred anyway.
              effective engagement of developing countries
    Question 7. You have said that you doubt the Clean Development 
Mechanism (CDM) is an effective means of engaging developing countries 
due to the CDM's general ineffectiveness and that it rewards exactly 
the opposite behavior.
    In your opinion, what is the best way to encourage these developing 
countries to participate in a global reduction of GHG?
    Answer. The best way to engage developing countries currently 
involved in the CDM in reducing emissions is to fund (via allowance 
allocation) investments in energy efficiency (industrial, buildings, 
appliances) and in the capacity to identify and implement domestic 
energy efficiency programs. This approach has the advantages that (1) 
the reductions produced are less expensive than in the CDM and (2) they 
are in the national interest of the developing countries and (3) they 
leverage funds by increasing developing country capacity to produce 
such reductions on its own.
          logistical hurdles to effective offset verification
    Question 8. The European Union's Clean Development Mechanism (CDM), 
has run into problems approving projects that qualify for credit. Not 
only is their Executive Board extremely under-staffed and forced to 
rely on third party verifiers, but it also would be very time consuming 
to properly investigate each request.
    Is there any way that this type of situation could be resolved if 
the U.S. were to implement a cap-and-trade system?
    Answer. The logistical hurdles to proper implementation of an 
international or a domestic offset program are substantial. The 
rulemakings will be protracted and contested. The actual implementation 
of the program will require substantial and sustained attention from 
whichever agencies (EPA/USAID/USDA) are tasked with implementation. In 
general, the stronger the environmental integrity of the program, the 
greater the scrutiny required by regulators, and the more challenging 
the logistical hurdles. My basic perspective is that US entry into the 
system will actually make this problem worse because US demand will be 
so large relative to current supply. That being said, there are 
certainly process reforms that the US might push for in an 
international program that would lead to reduced workload. One would be 
a greater reliance on benchmarking rather than project by project 
evaluation of additionality. This is only a good idea if benchmarks are 
set conservatively enough that they guarantee that the credits are 
real. A good proposal is to set benchmarks such that they undercredit 
projects but to provide the option for project developers to prove an 
additionality case that would then allow full crediting of reductions. 
Probably the most important way to reduce the workload, at least for 
EPA and other US implementing agencies, will be to implement sectoral 
programs that do not rely on any sort of project-by-project 
implementation. These programs have the potential to produce enormous 
numbers of credits that, so long as sector baselines are set 
conservatively, will be additional. Sectoral programs are still 5 to 10 
years away from being ready to grow to scale so this is really a medium 
term solution to the logistical issues that plague the current CDM.
      Responses of Michael Wara to Questions From Senator Cantwell
    Question 1a. What role does the compliance period play in reducing 
price volatility?
    Answer. Its important to distinguish between compliance period and 
banking. The ability to bank emissions across periods, provided that 
there are allowances to bank, can significantly reduce price 
volatility. This has been proven in the current EU ETS, where the 5-
year trading phase (thus allowing 5-year banking) has reduced the price 
volatility that otherwise would have occurred due to the recession. At 
the same time, there is no reason that banking can't coexist with 
relatively frequent compliance--annually or even subannually. For 
example, the EU requires annual compliance but allows banking for 5 
years during the current period. Frequent compliance in the US is 
important because environmental liabilities are given low priority in 
bankruptcy proceedings.
    Question 1b. Are there any substantial differences in price 
volatility between rolling compliance periods and fixed compliance 
dates?
    Answer. Without a model, I think this question is difficult to 
answer with any confidence. Also, it will depend on how effectively 
both physical and paper positions are communicated to the market. My 
suspicion is that rules on banking and/or borrowing would totally 
dominate as sources of volatility relative to the choice of a rolling 
or fixed compliance period. My major concern with a rolling compliance 
period would be the costs to firms and the regulator of compliance and 
enforcement.
    Question 1c. To minimize price volatility, how much time should 
firms have between the emissions of greenhouse gases and the 
acquisition (and surrender) of allowances? One year or less? Two years? 
Three years? Five years?
    Answer. For an industry covered by a cap-and-trade market, 
allowances are just like any other input used in the production 
process. It takes this much coal, that much payroll, and this many 
allowances to produce 1 megawatt hour of electricity, etc. Therefore, I 
think the most sensible option is to set relatively frequent true-ups 
for firms. The longest I would recommend is 1 year but I would 
encourage you to consider quarterly true up. This will force firms to 
think about and account for allowance costs as just another input in 
the production process, which is exactly how we want firms to respond 
to the incentives created by cap-and-trade. The danger with long 
periods between true-ups is that there will be volatility at the end of 
the period as covered entities scramble to acquire the needed 
allowances, and many derivatives contracts expire in a short time 
frame.
    Question 2a. What is a reasonable number of allowances, as a 
percentage of yearly emissions, that firms would be able to bank for 
future emissions and compliance dates?
    Answer. My belief is that there is no convincing justification for 
limiting firms ability to bank allowances. I would allow firms to bank 
as many allowances as they want to given their other choices regarding 
capital allocation.
    Question 2b. How long are firms likely to retain allowances for 
future use? Is there likely to be a limit to their willingness to keep 
these assets on their balance sheets?
    Answer. The honest answer is that it depends. It depends on the 
expectations that firms have about increases in the value of 
allowances, it depends on the firms' financial structure and state, it 
depends on firms' access to credit, it depends on who in the firms is 
responsible for compliance--energy firms with trading desks behave 
differently from industrial firms where environmental compliance 
departments are responsible for handling acquisitions and surrender of 
allowances.
    Question 3. To reach the 2050 emissions targets that scientists 
agree are necessary to avert catastrophic climate change, is there an 
affordable option at mid-century that does not incorporate either a 
significant amount of coal with carbon capture and sequestration 
technology or a substantial expansion of nuclear power?
    Answer. I don't think that we really know the answer to this 
question. It may be that new solar and wind technologies, combined with 
smart grid, will allow for us to achieve the deep reductions that will 
be required to avoid catastrophic climate change. On the other hand, if 
these new technologies do not emerge, then certainly nuclear and/or CCS 
will be required. Since we don't know what will work, we should set 
clear technology neutral incentives and fund research into all areas.
    Question 4a. From a strictly economic viewpoint, how can the 
pathway of the emissions reductions or the trajectory of the cap's 
emissions reductions affect the costs of a climate policy?
    Answer. The optimal pathways are those that start immediately but 
very gradually increase the level of effort to high levels at later 
stages of the program. The actual rate of reduction is subject to a 
number of uncertainties, most notably, the rate of technology 
development and deployment.
    Question 4b. For a fixed amount of cumulative emissions, what might 
the optimal shape of that emissions pathway be?
    Answer. The optimal shape will balance net present value of costs 
and benefits. In practice this is hard to do because both are quite 
uncertain. In practice, sending credible market signals may be more 
important than a theoretically optimal path. Credible commitment 
requires strong political support, long-term pathways that require 
immediate action now rather than deferring effort until late in the 
day, and some mechanism to insure that costs don't get out of control.
    Question 5. Why do you regard the inclusion of a price floor as 
particularly important for investment in new energy technologies under 
a climate policy?
    Answer. A price floor is particularly important under a cap-and-
trade approach in order to create a guaranteed rate of return for low-
carbon investments. Without some minimum but certain value for carbon, 
in the phase of the regulatory uncertainty that ultimately drives the 
carbon price, many firms have opted to assume a carbon price of $0 in 
their planning. Moreover, sources of debt or equity financing for these 
startups assume a price of zero in considering their financing 
proposals and business plans. Thus regulatory uncertainty leads to 
price uncertainty which leads to a barrier to investment. The way 
around this is to provide certainty on the low end of the carbon price 
spectrum. This proposal has the added advantage of potentially 
increasing the environmental performance of the program if there is a 
miscalculation on the part of the regulator as to how large the 
allocation should be (for this see EU ETS Phase 1).
    Question 6. Since cap-and-trade programs are so inherently complex 
and far-reaching:

          a) How can we be sure that any scheme is workable and can be 
        implemented by the executive branch?

    Answer. Cap and trade programs are not inherently more complex than 
traditional command and control regulation and might be much simpler. 
The key advantage, and one reason that EPA favors them, is that they 
avoid the complexity and contention associated with designing and 
implementing technology standards for each class of regulated 
polluters. They then also avoid the costs and contention of permitting 
each and every facility. All that is required is monitoring and 
reporting--and this would be required anyway under a command and 
control system. It is the optional offset component that adds the 
regulatory complexity. My own view is that the way to implement 
successful cap and trade is the way that the EPA has historically done 
it under the Acid Rain Trading Program--to do so without the inclusion 
of a complicated and administratively costly offsets program.

          b) How great are the risks of unintended consequences--for 
        the economy and the environment?

    Answer. Unintended consequences, both good and bad, are likely for 
a US cap and trade program, especially one as complex as that proposed 
under HR 2454. With so many different sources, actors, and interactions 
with other regulatory structures, both financial and environmental, 
predicting the performance of the system is impossible. This is not a 
bad thing. Unintended positive consequences--for instance discovery of 
low cost abatement opportunities--is a very positive effect of a system 
like the one proposed. The key to managing the negative unintended 
consequences is to create structures that can both detect and respond 
to them as they develop. The EU ETS does this very well for its cap-
and-trade system via periodic review and revision; the CDM less well, 
mostly because it is a creature of international law and multilateral 
agreement and so difficult to change without the consensus of nearly 
200 nation states. The US system design should focus on building both 
the detection mechanisms and the ability to respond to new information 
about unintended consequences into its structure. See my March, 2009 
testimony before House Energy and Commerce for more on this issue.

          c) What sort of growth are we likely to need in federal 
        agencies, particularly EPA, if the House-passed bill became 
        law?

    Answer. Substantial growth. The largest staffing demands will 
likely fall to EPA and USDA as they both develop and then implement and 
enforce the offset components of the bill. The cap-and-trade provisions 
will also require additional FTEs but will likely be less cumbersome in 
the long run, similar to the ARTP under the Clean Air Act, which 
relative to the number of sources regulated, is not terribly staff-
intensive.
    Question 7. Given the complexity and intricacy of some of these 
policy proposals, I am particularly concerned about the opportunities 
they might create for market manipulation, fraud, and for the 
development of arcane financial instruments that will lead us to the 
next major global financial crisis. Do you believe that these concerns 
are justified? How might opportunities for market manipulation be 
reduced through climate policy design?
    Answer. The concern that market participants might exploit 
weaknesses in the regulatory system to manipulate prices is potentially 
justified. The solution to this concern is to encourage participation 
in the markets by as many firms as possible and to insure, via well 
resourced and tough market oversight, that abuses do not occur.
    Question 8. I understand that last December, the European Union 
made auctioning the default future allocation method for its emission 
trading system.

          a) Was that a tacit recognition that the best way to allocate 
        carbon permits or emission allowances is by auction?

    Answer. The EU ETS has made auctioning the default allocation 
mechanism for electricity generators but not for industry. Industries 
that are subject to international competition will still receive 
substantial free allocation of allowances during Phase III of the EU 
ETS. Auctioning makes sense for sectors that can pass through the costs 
of permits to consumers--primarily electricity generators. For those 
who, either because of regulation or competition with firms in uncapped 
jurisdictions, cannot pass through costs, there is at least some 
justification for free allocation.

          b) What other ways is the European Commission working to 
        correct the windfall and overallocation it experienced in the 
        early years of the European emission trading system?

    Answer. It's important to distinguish between the windfall profits 
issue and the overallocaiton issue. Windfall profits are best corrected 
by reduced free allocation of permits. Overallocation in the EU ETS has 
been corrected by the European Commission in two ways. The first is by 
collection of better monitoring data. The key to successful startup of 
a cap-and-trade program is high quality data to base the first cap and 
allocation upon. After the first compliance deadline, good data is 
available via the reporting of covered installations. The second is by 
lowering the cap. Overallocation occurred partly because the cap was so 
close to business as usual emissions. Once the cap fell 8% in order to 
assist the EU in meeting its Kyoto Protocol obligations, overallocation 
was far less likely because permitted emissions were substantially 
below what they otherwise would have been. Overallocation will always 
be a possibility, even with excellent data, when the cap is set close 
to expected emissions, because variation in business activity can 
influence the actual level of emissions relative to what was expected. 
This is especially true when the cap is set far in advance of 
compliance.

          c) What lessons can Congress learn from the European 
        experience to avoid pitfalls in designing and implementing a 
        carbon trading system?

    Answer. I believe that the single most important lesson is to 
expect the unexpected. No system, however carefully thought out, is 
likely to avoid both positive and negative unintended consequences. The 
take away from this is that institutional structures that can learn 
from experience and implement mid-course correction are important to a 
good design for an emissions trading market.
    Question 9. One of my concerns is that, as far as I can tell, 
allowances that are given away under cap-and-trade could be sold on the 
secondary market at a price that would undercut the government auction 
reserve price.

          a) Is this accurate, and do you see this as a potential 
        problem for energy investments under such price uncertainty?

    Answer. This is possible; but in this circumstance, no allowances 
would be sold at auction until the market clearing price rose above the 
reserve price. Market expectations would likely price in this reduced 
supply, thus leading to higher prices in the spot market because of 
expectations of higher future prices.

          b) What happens if or when strategic allowance reserves run 
        out in a cap-and-trade program?

    Answer. It depends on the design of the strategic reserve. Under 
the Kerry-Boxer proposal, prices in the cap-and-trade would be allowed 
to rise above the price set for the strategic reserve once the reserve 
was depleted. Under a true safety-valve, since there would be no limit 
on the number of allowances that might be sold at the safety-valve 
price, this would not occur.

          c) If a strategic reserve is used instead of an explicit 
        price ceiling, then what happens if the strategic reserve is 
        continually depleted? Do costs skyrocket at that point?

    Answer. The strategic reserve is not intended to limit the long-run 
price of allowances. Instead, it is intended to reduce short-term price 
spikes in the allowance market. If the system as designed, produces a 
long-term price of abatement that is higher than the strategic reserve, 
then the reserve would be depleted relatively quickly and prices would 
rise to balance the supply of allowances (the cap) and their demand 
(the cost of abatement).
    Question 10. Under the House bill, I understand that the strategic 
reserve fund in H.R. 2454 is replenished using international forestry 
offsets. But with all of the other offsets proposed in the House bill 
are these likely to be available in sufficient numbers to rebuild the 
reserve, especially in the longer-term? What would this imply for cost 
control and for the overall viability of the cap-and-trade policy?
    Answer. My sense is that a large supply of strategic reserve 
forestry offset is unlikely to be available in the short-term. It will 
take 5 to 10 years to develop the necessary regulatory and enforcement 
infrastructure to bring a large supply of REDD credits to market. That 
being said, it's not clear that the strategic reserve will actually be 
needed in the near-term. By the time that the level of abatement under 
the cap might produce high enough carbon prices to trigger the reserve, 
I believe that there will likely be REDD credits available.
    Question 11. In your testimony you seem to suggest that a price 
collar with a dedicated climate trust fund to finance additional 
climate mitigation projects outside the cap could serve as a more 
effective cost control mechanism than an offset program, both in terms 
of price certainty and environmental integrity.

          a) Could you explain how you view these two mechanisms as 
        potential substitutes?

    Answer. Offsets serve to lower prices within the cap and to, if 
they work as intended, lead to cost-effective reductions outside the 
cap. A price-collar accomplished the first objective with greater 
certainty than offsets because it sets hard limits outside which the 
regulator will not allow prics to vary. A climate trust fund would 
accomplish the latter by creating incentives for those outside the cap 
to apply for funding to reduce emissions. Using a technique such as a 
reverse auction to select proposals for climate trust fund funding 
would insure that only cost-effective reductions occurred. By delinking 
the outside the cap reductions from those occurring inside the cap, the 
program would insure that if reductions outside the cap weren't real 
and/or permanent and/or verifiable, no harm to the cap would occur. To 
the extent that the safety valve was triggered, thus effectively 
raising the cap, the trust fund could be used to lower outside of cap 
emissions, thus counterbalancing the increase in emissions.

          b) Are additional emissions reductions through agricultural 
        and forestry projects, for example, more efficient as offsets 
        against the cap or as subsidized projects funded by a climate 
        trust fund that are outside of the cap?

    Answer. I believe that agriculture and forestry projects could be 
carried out more cost-effectively via a climate trust fund than via 
offsets. That is, more reductions could be generated for less money--
because farms and forests would be paid for the marginal cost of 
reductions outside the cap rather than for the marginal price inside 
the cap. Furthermore, because the transaction costs of a subsidy 
program would be lower than for compliance grade offsets, more of the 
revenues would go to the farmer or land owner actually producing the 
reduction, rather than being captured by lawyers, consultants, and 
brokers at other levels of the offset value chain. One recent study 
shows that just 31% of CDM revenues actually reach the entity producing 
the reduction while 69% are kept by other parties. Thus reductions 
could be more cost-effective AND farmers and land-owners might receive 
more revenue under a Climate Trust Fund.
    Question 12. Given the current state of the offset market, and the 
45 pages of requirements governing offsets in the House passed bill, do 
you think there will be sufficient offsets available -domestically and 
internationally-to contain costs under a cap-and-trade bill over the 
next 20 years?
    Answer. This is very difficult to predict at the present time--
before the rules governing offset creation have been written. That 
being said, my best guess is that the rules will be written to insure 
that there are sufficient offsets available. If this means sacrificing 
the environmental integrity of the program, my evaluation of the 
political economy of the offsets rule making process is that it will be 
sacrificed. There is simply too much discretion on the part of the 
agency writing the regulations and too much pressure to keep costs down 
to avoid this outcome.
    Question 13. I was struck by your testimony that we would need to 
process offsets 20 times faster than the CDM. How did you arrive at 
this conclusion?
    Answer. This estimate is based on the fact that the CDM currently 
issues approximately 10 million tons of offset credits per month or 
about 120 million credits per year. The US system, in order to issue 
2.4 billion tons per year (including for the 4/5 write down of 
international offsets), would need to issue 20 times this amount, 
including all of the additional regulatory process required to create 
higher environmental integrity than currently exists within the CDM.
                              Appendix II

              Additional Material Submitted for the Record

                              ----------                              

                         Department of Agriculture,
                                   Office of the Secretary,
                                Washington, DC, September 10, 2009.
Hon. Debbie Stabenow,
U.S. Senate, 133 Hart Senate Office Building, Washington, DC.
    Dear Senator Stabenow: Thank you for your letter of June 1, 2009, 
cosigned by your colleagues, in support of the Department of 
Agriculture's (USDA) efforts to encourage farmers, ranchers, and forest 
landowners to address climate change and provide ecosystem services. 
USDA is uniquely positioned to provide farmers, ranchers, and forest 
landowners with the information needed to evaluate their options and 
quantify the benefits of greenhouse gas reduction alternatives and 
other services. We also have the technical capabilities to construct a 
robust, environmentally sound system that ensures real and lasting 
greenhouse gas benefits.
    We are preparing to conduct a rigorous technical and science-based 
process to develop guidelines for quantifying the greenhouse gas 
benefits of agricultural and forestry practices. I have asked a newly 
formed Climate Change Program Office, within the Office of the Chief 
Economist, to coordinate this effort, working with the Natural 
Resources Conservation Service, the Agricultural Research Service, the 
Economic Research Service, the Forest Service, and the newly formed 
Office of Ecosystem Services and Markets.
    In 2006, we released guidance to farm and forest landowners to 
allow them to estimate their greenhouse gas footprints. This work 
relied on the support of the research and program agencies across USDA. 
We continue to work on this front and are developing user-friendly 
tools that can help farmers and landowners make these calculations. The 
Department of Energy adopted USDA's technical greenhouse gas methods 
for use in its Voluntary Greenhouse Gas Reporting Registry.
    Looking forward, we envision a process that can engage the public 
and the technical experts at every step to ensure that the most recent 
information is included and that there is high confidence in the 
emissions reductions produced through agricultural and forestry 
offsets.
    The specifics of the plan are being finalized. In general, our plan 
is that these methods will be stand-alone and will be designed to: 1) 
quantify the emissions and sinks associated with specific source 
categories; 2) quantify emission reductions and carbon sequestration 
from conservation and land management practices and technologies; 3) 
support the development of entity and farm-scale greenhouse gas 
inventories; 4) develop prototype reporting systems; and 5) ensure 
compatibility with any new Federal incentive-based or offset-based 
greenhouse gas reduction system to the extent possible.
    We would like to make these guidelines available for use in public 
and private registries and reporting systems. We plan to use them in 
assessing the performance of conservation and renewable energy 
programs. Finally, the guidelines will be prepared to facilitate their 
adoption and use in a Federal regulatory greenhouse gas offsets market 
The guidelines will be designed to provide reliable, real, verifiable, 
estimates of on-site greenhouse gas emissions, carbon storage, and 
carbon sequestration, They also will be designed so that they can be 
applied to quantify on-site greenhouse gas reductions and increases in 
carbon storage due to conservation and land management activities.
    Thank you again for your interest and commitment to working with 
USDA as we move forward on these important efforts. We will make every 
effort to keep your offices and staffs informed of our progress. Please 
do not hesitate to contact us if you have any questions or would like 
additional information, l am sending a similar letter to your 
colleagues.
            Sincerely,
                                         Thomas J. Vilsack,
                                                         Secretary.
                                 ______
                                 
 Statement of Roger Williams, Vice-President of Blue Source, LLC, and 
     Chair of Carbon Offset Providers Coalition, Salt Lake City, UT
                              introduction
    Mr. Chairman, my name is Roger Williams, and I am a vice-president 
of Blue Source, LLC based in Salt Lake City, Utah. I also serve as 
Chair of the Carbon Offset Providers Coalition (``COPC''). On behalf of 
Blue Source and the Carbon Offset Providers Coalition, I thank you, the 
Ranking Member, and the Committee for this opportunity to provide 
written testimony for the record of proceedings.
About Blue Source
    Blue Source is the oldest and largest investor and developer in the 
U.S. of projects that reduce greenhouse gas, promote domestic energy 
production, and construct the physical infrastructure that will be 
needed to transition to a clean energy economy. Over the last 10 years, 
Blue Source has created the largest portfolio of emission reduction 
credits and projects in North America. We have offices in Salt Lake, 
San Francisco, Houston, New York, Calgary (Alberta), and North 
Carolina, and employ over 30 environmental and business professionals. 
We are not environmentalists, but environmental capitalists, working at 
the intersection of the environment and business to solve global and 
local environmental problems through market mechanisms and capital 
investment in ecosystem services, primarily low-carbon clean energy 
infrastructure projects. We have two primary businesses.
    First, we have built an extensive portfolio of carbon credits 
representing over 100 million tons of greenhouse gas reductions. We 
invest in a wide variety of sustainable low-carbon projects such as 
geothermal, advanced transportation logistics, on-farm wastewater 
management, landfill gas energy, forestry management, and organic waste 
composting. We have developed the first protocols in numerous carbon 
categories and invested in over 20 project types in 48 states and 
Canada. Just one specific example is our coal mine methane project in 
the Powder River Basin of Wyoming, in which Blue Source provides the 
necessary working capital to support pre-draining of mine methane at a 
large surface mine. This project has reduced CO2e by 1.75 
million tons through the capture of otherwise wasted natural gas, which 
is then cleansed to pipeline quality and becomes a domestic clean 
energy resource. Blue Source has been very active in Federal and state 
carbon advocacy leadership, sharing our on-the-ground experience in 
environmental markets to help governments develop sensible market rules 
that encourage transformational changes in behavior that will 
accelerate America's progress to energy independence and a clean energy 
economy.
    Blue Source also has a project development business with over $1 
billion in available funds ready to deploy today in Carbon 
Infrastructure investments. For example, our management team has 
developed projects that gather approximately 340 million cubic feet per 
day (6.8 million metric tons per year) of industrial vent-stack-sourced 
carbon dioxide that delivers the CO2 to various sites for 
geologic sequestration. Instead of venting into the atmosphere, Blue 
Source projects are transporting these emissions to Enhanced Oil 
Recovery projects in Canada, Wyoming, Texas and New Mexico. Our newest 
project will take over 250,000 tons annually of waste carbon dioxide 
from the LaVeta gas processing project in Colorado, separate and 
compress the gas, and pipe it 16 miles to connect to the existing Sheep 
Mountain CO2 pipeline which supplies CO2 for 
enhanced oil recovery in the Permian Basin of Texas. These kinds of 
projects support increased domestic energy production, recover oil 
resources otherwise stranded underground, and directly reduce oil 
imports. Our blended engineering, finance and transactional skills make 
such projects possible through carbon finance where traditional 
economics and market barriers will not. We have 60+ projects in the 
pipeline and intend to be a key contributor to the development of a 
new, national CO2 ``carbon highway'' infrastructure. More 
information about our company is available at our website at 
www.bluesource.com and further examples of our projects are included in 
the addendum.
About the COPC
    The Carbon Offset Providers Coalition www.carbonoffsetproviders.org 
is an alliance of the leading companies in the carbon offset market, 
including those involved in financing, producing, generating, 
providing, aggregating and/or marketing greenhouse gas emission 
reductions for sale as offsets in existing and emerging voluntary and 
compliance greenhouse emission trading markets.
    COPC members offer their collective experience from hundreds of 
offset projects in the U.S. and abroad that have achieved millions of 
tons of greenhouse gas reduction. COPC members have been actively 
managing climate change for the last 15 years, and are leaders in 
reducing greenhouse gases in the United States through carbon offsets, 
renewable energy, and clean tech markets. In anticipation of greenhouse 
gas regulation--and encouraged by states such as California and federal 
agencies such as EPA--our members have invested tens of millions of 
dollars in hundreds of offset projects in nearly all 50 states here in 
the U.S. and in Canada and Mexico, which collectively have helped 
America significantly reduce its carbon footprint. Our members are 
ready to invest billions of dollars more if the right public policies, 
market signals, and legal certainty are provided.
    Many of these projects directly benefit farmers and the 
agricultural community by providing an additional revenue stream as 
payment for environmental services and greenhouse reductions achieved 
through advanced manure management, digesters and lagoon covers that 
generate green ``cow power,'' soil management techniques that improve 
soil carbon stocks, precision farming and fertilizer reduction, and 
land management and conservation.\1\ We do these projects not only as 
environmental investors, but also as participants, like Blue Source's 
CEO, Bill Townsend and his family, who are 4th generation Indiana 
farmers.
---------------------------------------------------------------------------
    \1\ U.S. Department of Agriculture, A Preliminary Analysis of the 
Effects of HR 2454 on U.S. Agriculture (July 22, 2009).
---------------------------------------------------------------------------
             the role of offsets in containing energy costs
    Blue Source and the COPC support a cap-and-trade approach that 
contains robust provisions for carbon offsets and low-carbon energy 
investments. Appropriately, most of the climate bills that have been 
considered in this Congress and the last have recognized the vital role 
that carbon offsets play in providing necessary cost containment and 
early investment in clean technology, carbon-reduction infrastructure 
and green jobs. Blue Source and COPC are ready and willing to invest in 
projects that serve this cost containment function, but we need 
investment certainty from Congress in order to do so. Both in the 
specific area of carbon offsets and the broader market for emissions 
allowances, the key to encouraging investment, managing cost and 
achieving price stability is for Congress to craft sensible and 
pragmatic regulatory structures support by clear and unambiguous market 
rules
            A. Carbon Offsets Have Been Shown to Significantly Lower 
                    the Costs of Cap-and-Trade and Provide Other Co-
                    Benefits
    Economic analyses by the U.S. Environmental Protection Agency 
(``EPA'') and others have shown that incentivizing a robust market in 
offset reductions (i.e., emissions reductions from diverse sources 
outside a mandatory cap) can effectively reduce the overall cost to 
American taxpayers and consumers of meeting the goals of global warming 
legislation. Conversely, failing to incentivize offsets could double 
the price of allowances and dramatically increase the cost of cost of 
cap-and-trade to American families.\2\ These studies have consistently 
shown that the cost of compliance with a greenhouse gas cap could be up 
to 96% higher if there is not sufficient investment in offset projects. 
Accordingly, offsets provide critical costcontainment and price 
stability by providing flexibility to covered industries to find the 
lowest available cost emissions reductions across a range of options. 
Greenhouse gas reduction opportunities are diverse and spread across 
the entire economy,\3\ and thus offset trading is the best means to tap 
these opportunities and create real change by overcoming market 
barriers, investment needs and misaligned incentives.
---------------------------------------------------------------------------
    \2\ Source: U.S.EPA Analysis of the American Clean Energy and 
Security Act of 2009 (H.R. 2454) (June 23, 2009); U.S.EPA Preliminary 
Analysis of the Waxman-Markey Discussion Draft, The American Clean 
Energy and Security Act of 2009 in the 111th Congress (Apr. 20, 2009); 
U.S.EPA, Analysis of the Low Carbon Economy Act of 2007 (Bingaman-
Specter, S. 1766) (Jan. 15, 2008); U.S.EPA, Analysis of the Climate 
Stewardship and Innovation Act of 2007 (McCain-Lieberman, S. 280) (July 
16, 2007).
    \3\ McKinsey & Company, Reducing U.S. Greenhouse Gas Emissions: How 
Much at What Cost, U.S. Greenhouse Gas Abatement Mapping Initiative 
(Dec. 2007).
---------------------------------------------------------------------------
    Jobs created by greenhouse gas emissions reductions projects are 
part of the 1.7 million jobs expected to be added by ACES.\4\ As just 
one example, EPA estimates that a typical landfill green energy 
project--many of which are made possible by carbon offset revenue 
funded by COPC members--increases national GDP by $14 million ($3 
million local benefit) and creates nearly 70 full-time equivalent green 
jobs.\5\ Landfill gas projects nationally generate 10.5 billion 
kilowatt hours of electricity and 79,000,000,000 cubic feet of biogas 
for direct use application--thereby displacing 177 million barrels of 
conventional oil.\6\
---------------------------------------------------------------------------
    \4\ Source: US House of Representatives, The American Clean Energy 
and Security Act of 2009: By the Numbers.
    \5\ Source: U.S. EPA Landfill Methane Outreach Program, An Overview 
of Landfill Gas Energy in the United States.
    \6\ Ibid.
---------------------------------------------------------------------------
    A great illustration is our Sarpy County Landfill project in 
Papillion, Nebraska, which captures 100,000 tons CO2e each 
year from fugitive methane gas. This municipal landfill opened in 1990 
and has 2.8 million tons of waste in place, but had no current revenue 
and was not required by EPA rules to capture landfill gas. Because the 
county did not have the money or access to financing or technical know-
how to install a collection system, methane from the landfill was 
seeping out into the atmosphere, adding to global warming. Blue Source 
partnered with the county to overcome these barriers by using carbon 
credits recognized by the California Climate Action Reserve to provide 
the necessary revenue to finance the gas collection project. The 
residents of Sarpy County also benefit from improved odor control which 
is expected to pave the way for economic and industrial development 
around the landfill. We are currently evaluating a supplemental biogas-
to-energy project that would sell green power to the Omaha Public Power 
District, which would further reduce greenhouse gas and fossil-fuel use 
from electric utilities.
    In addition to providing cost-containment and price moderation, by 
energizing innovation and market forces, offset projects provide an 
essential bridge to a low-carbon economy. Offset projects are already 
providing jobs and opportunity for the U.S. economy through a robust 
voluntary market. Such projects have provided important incentives and 
revenue to many corners of the economy, including family farmers and 
small businesses, and have already demonstrated their ability to bring 
about real, positive changes in the way America generates electricity 
(for example, renewable energy from wind, biomass, landfill gas and 
solar), grows crops (though advanced farming practices and manure 
management), and manufactures products (through cleaner, smarter 
industrial processes and pollution control). In addition to reducing 
carbon emissions, offsets have funded the development of commercially 
viable methods of sequestering carbon through tree planting, 
agricultural advances, and long-term storage in geologic formations.
    Offsets also deliver important co-benefits over and beyond 
combating global warming, including reduction of conventional air 
pollutants, improved water quality, and energy security that improve 
the lives of all Americans. Many offset projects directly benefit 
disadvantaged urban and rural communities, such as urban tree canopy 
projects that reduce ``heat island effect'' and beautify our inner 
cities. In addition, offset projects can incentivize the development 
and adoption of new, low-carbon technology developed by American 
industry and research institutions, which may be exported to the rest 
of the world.
    Finally, offsets provide critical flexibility to those heavy 
industry sectors covered under an emissions cap as they transition to a 
carbon-constrained economy. If properly incentivized, offset projects 
are available to begin achieving greenhouse gas reductions 
immediately--giving regulated industry time to phase in new technology 
and capital investment while avoiding premature retirement of assets 
that could result in unnecessary economic hardship and avoidable life-
cycle costs. In short, the potential of offset projects should be 
``unleashed'' to help attain the goal of mitigating climate change and 
achieving America's energy independence.
    Ironically, the gains achieved over the last 10 years through the 
voluntary carbon market are being seriously undermined by current 
federal legislative uncertainty, as investors who funded these projects 
in anticipation of federal action are now doubting whether Congress 
will provide the needed incentives. Accordingly, investment in low-
carbon projects is dropping as a result of weak market signals. The 
consequence is that there will be comparatively fewer greenhouse gas 
reductions this year, even though investment in greenhouse gas 
reductions ought to be growing, and could be growing with Congressional 
leadership.
            B. Congress Should Ensure Cost Containment Through Sensible 
                    Market Rules
    We congratulate the U.S. House of Representatives for passing the 
American Clean Energy and Security Act of 2009, H.R. 2454, and 
encourage the Senate to take up similar legislation as soon as 
possible. Although H.R. 2454 is a major step forward, the bill as 
currently drafted does not fully accomplish its goal of launching 
America onto a new low-carbon and clean energy pathway, particularly in 
the near term over the next 3-5 years, due to impracticalities in the 
way market rules are drafted which artificially constrict the 
effectiveness of the offset market and create ambiguities that may 
foreclose opportunities for cost-effective emission reductions. 
However, this vision can be achieved with a few simple but key changes 
to the bill, which will allow billions of dollars of now-ready 
investment to start flowing immediately into the U.S. economy through 
low-carbon and clean energy markets. The COPC has offered detailed 
comments on H.R. 2454 to address these concerns, which I have included 
in the addendum to my testimony.
---------------------------------------------------------------------------
    * Addendum has been retained in committee files.
---------------------------------------------------------------------------
    The central theme of these comments is that market rules need to be 
clear, predictable, and workable from an investment standpoint. The 
changes to H.R. 2454 proposed by Blue Source and the COPC will 
accomplish several important goals:

   The proposed changes will allow emission reduction projects, 
        such as collecting methane from livestock manure or landfills 
        for green energy, to continue capturing this methane under H.R. 
        2454's offsets program, without arbitrarily cutting off 
        projects that were built prior to 2009 (or in some cases 2001), 
        so that we don't tell the owners of these beneficial projects 
        (who risked their hard-earned capital) that they should abandon 
        or dismantle those projects.
   We encourage Congress to expressly recognize early emissions 
        reductions registered with the American Carbon Registry (ACR), 
        the Voluntary Carbon Standard (VCS), and the Climate Action 
        Reserve (CAR), as well as other state and federal programs. 
        These are nationally and internationally recognized, 
        effectively governed and operated offset registries which have 
        pedigrees of excellence with founding stakeholders such as: 
        Environmental Defense Fund who started ACR; the States of 
        Illinois and New Mexico, the City of Chicago and the Iowa Farm 
        Bureau which helped establish the Chicago Climate Exchange 
        (CCX); numerous industry, academic and nonprofit stakeholders 
        that collaborated to develop the VCS; and state-led legislative 
        initiatives that led to CAR and RGGI.
   The proposed changes will also allow early projects under 
        established offset programs to continue operation under their 
        original crediting period (which is usually 10 years) before 
        transitioning to EPA's offsets program. Otherwise, ACES will 
        unintentionally cause the forfeiture of millions of dollars of 
        existing project investments. No investors will put additional 
        money in a project that has only 3 years of confirmed economic 
        qualification, as is the case in H.R. 2454 as drafted. The 
        consequence is that investment is currently frozen and there 
        will be no gains in the battle against global warming for the 
        next 3-5 years until EPA has its program up and running.
   We have also proposed to allow covered industrial facilities 
        the opportunity to start making emissions reductions 
        investments now, instead of 5 years from now when compliance 
        obligations commence, and to be awarded tradable and bankable 
        credits for early reductions, without fear of being penalized 
        or losing transitional assistance.
   Our proposed changes will also give limited, one-time 
        recognition to those early actors that can prove that they 
        reduced emissions prior to enactment of this bill. To reward 
        these early movers, 5% of the allowances from the first year of 
        the allowance pool (only the first year) should be set aside 
        for pro rata distribution in recognition of this leadership, 
        vision, and early, higher risk investment in climate change 
        solutions that have shown that it is possible to tackle climate 
        change and helped make serious consideration of climate 
        legislation possible.

    In short, America needs policies that start tackling climate change 
now--not in 5 years--with protection of existing investments and clear 
incentives for continued investment in early reductions, not only for 
the sake of the climate, but for green jobs, economic stimulus, 
technology advancement, revenue for farmers, small businesses, and 
landowners, and myriad environmental benefits including cleaner air, 
cleaner water, and enhanced wildlife habitat. America needs policies 
that will bolster, maintain and protect the early action efforts of 
pioneering environmental entrepreneurs; and not so easily forget or set 
aside their contributions.
 achieving energy independence and climate goals through energy policy
    In addition to a cap-and-trade approach, energy policy is essential 
for promoting investment in the clean, low-carbon economy. We encourage 
this Committee to seriously consider progressive changes to current 
energy policy that will better recognize the value of U.S. domestic 
energy production, better manage our domestic energy resources, and at 
the same time significantly reduce carbon emissions. There are several 
enormous opportunities for domestic energy growth that need further 
incentive and policy support.
            A. Promote Domestic Energy Production Through Enhance Oil 
                    Recovery
    First, the United States has some 85 billion barrels of stranded, 
domestic, onshore oil that is physically recoverable only using 
enhanced oil recovery (``EOR''). EOR involves injecting carbon dioxide 
into depleted oil and gas wells to force previously unrecoverable oil 
to the surface. This volume of available oil production is equal to the 
approximately 17 years of current total imports of foreign oil, or 42 
years equivalent current U.S. production. The market value of this new 
production is projected to be $6 trillion at $70 per barrel, which will 
provide significant revenue to the U.S. Treasury. Today, EOR is 
produced primarily using underground CO2. The U.S. has less 
than 30% of the underground CO2 it needs to produce this 
oil, and at the same time, each day is venting billions of cubic feet 
of CO2 from industrial facilities as a byproduct--an 
enormous waste of resources which many believe is also a serious 
environmental hazard because of its contribution to global warming. 
Because CO2 injected during the EOR process can be sealed 
underground at the conclusion of production activities, EOR will also 
pave the way to commercially viable carbon capture and storage 
technologies that will allow hundreds of millions of tons of 
CO2 to be safely stored underground in perpetuity, and thus 
allow the U.S. to achieve real reductions in greenhouse gas emissions.
    Instead of using underground CO2, we need to provide 
meaningful incentives to capture ``ventstack'' CO2 and 
construct a ``carbon highway'' to transport the CO2 to EOR 
fields in order to expand domestic energy production and recover these 
otherwise stranded natural resources. This could be accomplished 
through a mix of new federal (and state, where necessary) tax and 
nontax incentives that are targeted towards companies that develop and 
finance EOR infrastructure for anthropogenic CO2. We applaud 
Congress for taking steps in this direction already by, for example: 
(1) the new Section 45Q CCS tax credit; (2) expansion of MLP rules to 
include the pipeline transport of anthropogenic CO2; and (3) 
the CCS-related stimulus dollars that have been provided recently, all 
of which include EOR.
    Those efforts, while admirable, are generally targeted towards 
industrial sources of CO2, not the companies that are 
building EOR infrastructure. And to the extent that entities other than 
industrial sources are eligible (i.e., pipelines/MLP), the incentives 
are proving to be insufficient to spark the needed capital flows. We 
thus propose that consideration be given to a new package of incentives 
that might include, for example, a new investment tax credit (``ITC'') 
for the construction of CO2-EOR infrastructure. That new 
ITC, in turn, should be eligible for the recently enacted ITC/grant 
conversion mechanism to accommodate the current state of the capital 
markets and corporate revenue positions. The amount of the new ITC 
should be set at a sufficient level to drive projects forward while 
recognizing the energy independence, trade balance, national security, 
and green energy production benefits that such projects would deliver 
to the Nation.
            B. Incentivize Renewable ``Energy'' Production of All 
                    Forms, Not Just Electricity
    An estimated 1.4 trillion cubic feet of uncaptured methane 
emissions leak into the atmosphere every year--an amount equal to 30% 
of annual imports of natural gas worth $4 trillion per year at gas 
prices of $3 per mmBtu. Of this amount, over 300 billion cubic feet (or 
about 8% of U.S. imports) escapes from landfills, coal mines, 
wastewater treatment facilities, and potential manure management 
projects annually. This ``biogas'' is a critically important energy 
resource that could be captured by projects funded with greenhouse gas 
carbon offsets, renewable energy certificates (RECs), and/or tax 
incentives; however, under most state and federal energy incentive 
programs, if a project doesn't generate energy in the form of 
electricity (i.e., if the biogas is instead used to generate heat, 
power, or vehicle fuel), there is no incentive under most state 
renewable electricity programs or the federal tax credit for renewable 
energy.
    Because biogas used in lieu of natural gas is as important to our 
domestic energy and environmental goals as the use of such gas to 
produce electricity, we need to define renewable energy more broadly to 
include productive use of such gas independent of electricity 
generation. Specifically, we recommend that Congress: (1) allow the 
production of such gas for beneficial use to receive the full spectrum 
of grant funding and tax benefits available to renewable energy, 
including reauthorizing the now-lapsed Section 29 biogas tax credit; 
(2) recognize the Btu value of biogas by expanding the current federal 
Renewable Fuel Standard (``RPS'') to include nontransportation 
biofuels; and (3) include in any federal Renewable Energy Standard 
(``RES''), such as that proposed in this Committee's S.1462, equal 
credit for non-electricity energy value from biogas or other renewable 
sources.
    In addition, Congress should recognize that methane biogas projects 
also deliver significant environment benefits due to the ``global 
warming potential'' of methane which is estimated to be between 21-25 
times more powerful than carbon dioxide in terms of climate change 
effects. In addition to the energy value of biogas projects, 
investments in the destruction of methane emissions should be given 
additional incentives to reflect this added environmental benefit. In 
absence of a cap-and-trade program, this could be achieved in the form 
of bonus credits under the federal RFS or proposed RES programs, 
similar to bonus credits given to cellulosic biofuels under the 
renewable fuels program.\7\
---------------------------------------------------------------------------
    \7\ See, e.g., 42 U.S.C. Sec.  7545(o)(4).
---------------------------------------------------------------------------
            C. Incentivize Energy Efficiency in the Use of Fuel
    The country needs additional incentives to accelerate energy 
efficiency, not just in the electricity sector, but also the efficient 
use of fuels used for heat, power, and transportation. Reducing fuel 
use is essentially the equivalent of expanding domestic energy 
production. If Congress passes a renewable energy standard, energy 
savings of all kinds (not just electricity) should receive a credit 
that would count toward renewable energy targets. Similarly, Congress 
should extend programs offering grants and other government support to 
electricity energy efficiency to cover fuel savings as well. In 
addition, the federal RFS program for transportation fuels should be 
amended to recognize avoided impacts thru vehicle fleet efficiency, 
advanced logistics, and other conservation measures.
    Thank you for the opportunity to submit this written testimony, and 
we would be delighted to provide further information to the Committee.

                                    

      
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