[Economic Report of the President (2010)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 9

TRANSFORMING THE ENERGY SECTOR AND ADDRESSING
CLIMATE CHANGE


The President has called climate change ``one of the defining
challenges of our time''. If steps are not taken to reduce atmospheric
concentrations of carbon dioxide (CO2) and other greenhouse gases,
scientists project that the world could face a significant increase in
the global average surface temperature. Projections indicate that CO2
concentrations may double from pre-industrial levels as early as 2050,
and that the higher concentraï¿½tions are associated with a likely long-
run temperature increase of 2 to 4.5 ï¿½C (3.6 to 8.1 ï¿½F). With
temperatures at that level, climate change will lead to a range of
negative impacts, including increased mortality rates, reduced
agricultural yields in many parts of the world, and rising sea
levels that could inundate low-lying coastal areas.
The planet has not experienced such rapid warming on a global scale
in many thousands of years, and never as a result of emissions from
human activity. By far the largest contribution
to this warming comes from carbon-intensive fossil fuels, which the
world depends on for cooking, heating and cooling homes and offices,
transportation, generating electricity, and manufacturing products
such as cement and steel.
The potential for significant damages if emissions from these
activities are not curbed makes it crucial for the world to transform
the energy sector. This transformation will entail developing entirely
new industries and making major changes in the way energy is produced,
distributed, and used. New technologies will be developed and new
jobs created. The United States can play a leadership role in these
efforts and become a world leader in clean energy technologies.
The transformation to a clean energy economy will also reduce our
Nation's dependence on oil and improve national security, and could
reduce other pollutants in addition to greenhouse gases.
As this transformation unfolds, two market failures provide a
motivation for government policy. First, greenhouse gas emissions are
a classic example of a negative externality. As emitters of greenhouse
gases contribute to climate change, they impose costs on others that
are not taken into account when making decisions about how to produce
and consume energy-intensive goods. Second, the development of new
technologies has positive externalities. As discussed in Chapter 10,
the developers of new technologies generally capture much less than
the full benefit of their ideas
to consumers,firms, and future innovators, and thus underinvest in
research and development.
This diagnosis of the market failures underlying climate change
provides clear guidance about the role of policy in the area. First,
policy should take steps to ensure that the market provides the
correct signals to greenhouse gas emitters about the full cost of
their emissions. Second, policy should actively promote the
development of new technologies. One way to accomplish these goals is
through a market-based approach to reducing greenhouse gases combined
with government incentives to promote research and development of new
clean energy technologies. Once policy has ensured that markets are
providing the correct signals and incentives, the operation of market
forces can find the most effective and efficient paths to the clean
energy economy. The Administration's policies in this area are guided
by these principles.

Greenhouse Gas Emissions, Climate, and Economic Well-Being

The world's dependence on carbon-intensive fuels is projected to
continue to increase global average temperature as greenhouse gas
emisï¿½sions build in the atmosphere. These emissions are particularly
problematic because many are long-lived: for instance, it will take a
century for slightly more than half of the carbon dioxide now in the
atmosphere to be naturally removed. The atmospheric buildup of
greenhouse gases since the start of the industrial revolution has
already raised average global temperature by roughly 0.8 ï¿½C (1.4 ï¿½F).
If the concentrations of all greenhouse gases and aerosols resulting
from human activity could somehow be kept constant at current levels,
the temperature would still go up about another 0.4 ï¿½C (0.7 ï¿½F) by
the end of the century. It is important to note that the overall
impact of today's emissions would be even higher were it not
for the offsetting net cooling effect of increases in atmospheric
aerosols such as particulate matter caused by the incomplete
combustion of fossil fuels in coal-fired power plants.
But keeping atmospheric concentrations constant at today's level is
virtually impossible. Any additional greenhouse gas emissions
contribute to atmospheric concentrations. And because of projected
economic growth, particularly in developing countries, greenhouse gas
emissions will continue to grow. Moreover, the sources of atmospheric
aerosols that have partly offset the greenhouse warming experienced so
far are not likely to grow apace because governments around the world
are taking actions to curb these emissions to improve public health
and control acid rain.
Greenhouse Gases
The principal long-lived greenhouse gases whose concentrations have
been affected by human activity are carbon dioxide, methane, nitrous
oxide, and halocarbons. Sulfur hexafluoride, though emitted in smaller
quantities, is also a very potent greenhouse gas. All have increased
significantly from pre-industrial levels. Carbon dioxide is emitted
when fossil fuel is burned to heat and cool homes, fuel vehicles, and
manufacture products such as cement and steel. Deforestation also
releases carbon dioxide stored in trees and soil. The primary sources
of methane and nitrous oxide are agricultural practices, natural gas
use, and landfills. Halocarbons originate from refrigï¿½eration and
industrial processes, while sulfur hexafluoride emissions mainly stem
from electrical and industrial applications.
The pre-industrial atmospheric concentration of carbon dioxide was
about 280 parts per million (ppm), meaning that 280 out of every
million molecules of gas in the atmosphere were carbon dioxide. As of
December 2009,its concentration had increased to about 387 ppm.
Taking into account other long-lived greenhouse gases would result
in a higher warming potential, but the net cooling effect of
aerosols that have been added by humans to the atmosphere nearly
cancels the effect of those other gases. Thus, the overall effect
of human activity on the atmosphere to date is (coincidentally)
about the same as that of the carbon dioxide increase alone.
A variety of models project that, absent climate policy,
atmospheric concentrations of carbon dioxide will continue to grow,
reaching levels ranging from 610 to 1030 ppm by 2100 (Figure 9-1).
When the warming effects of other long-lived greenhouse gases are
included, this range is equivalent to 830 to 1530 ppm.
The breadth of the range reflects uncertainty about future energy
supply, energy demand, and the future behavior of the carbon cycleï¿½1A\1\
ï¿½1A\1\ Underlying uncertainty about future energy supply is uncertainty
regarding the costs and penetration rates of technology, and resource
availability. Uncertainty about future energy demand is driven by
uncertainty regarding growth in population, gross domestic product,
and energy efficiency.



Temperature Change
The implications of large increases in greenhouse gas concentrations
for temperature change are quite serious. There is a consensus among
scientists that a doubling of COï¿½1A\2\ concentrations (or any equivalent
combination of greenhouse gases) above the pre-industrial level of
280 ppm is likely to increase global average surface temperature by
2 to 4.5 ï¿½C (3.6 to 8.1 ï¿½F), with a best estimate of about 3 ï¿½C
(5.4 ï¿½F).2 Given much higher projections of greenhouse gas
concentrations by the end of the century, a recent study projects
that the global average temperature in 2100 is likely to be 4.2 to
8.1 ï¿½C (7.6 to 14.6 ï¿½F) above pre-industrial levels, absent effective
policies to reduce emissions (Webster et al. 2009).
\2\ï¿½1AThese values express what is likely to happenin equilibrium.
Average surface temperature does not reach a new equilibrium for some
decades after any given increase in the concentration of heat-trapping
gases because of the large thermal inertia of the oceans.

Increases in global average temperature mask variability by region.
For instance, absent effective policy to reduce greenhouse gas
emissions, mid-continent temperature increases are likely to be about
30 to 60 percent higher than the global average, while increases in
parts of the far North (for instance, parts of Alaska, northern
Canada, and Russia) are expected to be double the global average. The
power of the strongest hurricanes and typhoons is likely to grow, as
are the frequency and intensity of extreme weather events such as
heatwaves,heavy precipitation, floods, and droughts. One study, for
example, estimates that the number of days that mean temperature
(calculated as the average of the daily minimum and daily maximum)
in the United States will exceed 90 ï¿½F will increase from about one
day a year between 1968 and 2002 to over 20 days a year by the end
of the century (Deschï¿½nes and Greenstone 2008).
As the increase in global average temperature warms seawater and
expands its volume, sea levels are projected to rise. Melting glaciers
also contribute to sea-level rise. Sea level has already risen about
0.6 feet since 1900; it is projected to rise another 0.6 to 1.9 feet
because of volume expanï¿½sion and glacial melt by the end of the
century. These estimates exclude possible rapid ice loss from the
Greenland and Antarctic ice sheets, events that are highly uncertain
but that could cause another 2 feet or more of sea level rise by 2100.
Without expensive adaptation, low-lying land in coastal areas around
the world could become permanently flooded as a result.

Impact on Economic Well-Being
Although predicting future economic impacts associated with
increases in global average temperature involves a large degree of
uncertainty, these economic effects are likely to be significant and
largely negative, and to vary substantially by region. Even for
countries that may be less vulnerable, large negative economic
impacts in other regions will inevitably jeopardize their security
and well-being. For instance, the temperature extremes and other
changes in climate patterns associated with global average
temperature increases of 2 ï¿½C (3.6 ï¿½F) or more are projected to
increase mortality rates and reduce agricultural productivity in many
regions, threaten the health and sustainability of many ecosystems,
and necessitate expensive measures to adapt to these changes. Box 9-1
discusses recent research on projected physical and economic impacts
in the United States. Some regions of the world are expected to be
particularly hard-hit. For example, low-lying and island countries
are especially vulnerable to sea-level rise. Further, developing
countries, especially those outside moderate temperature zones, may
be especially poorly equipped to confront temperature changes.
Recent research, for example, suggests that India may experience
substantial declines in agricultural yields and increases in
mortality rates (Guiteras 2009; Burgess et al. 2009).
These projected changes are predicated on likely increases in global
mean temperature. Particularly worrisome is the possibility of much
greater temperature change, should more extreme projections prove
accurate. Although more drastic increases are less likely, their
consequences could be devastating. For example, the costs of climate
change are expected to grow nonlinearly (that is, more rapidly) as
temperatures rise (Box 9-2).
In the United States, continued reliance on petroleum-based fuels
poses challenges that go beyond climate change. It makes the economy
susceptible to potentially costly spikes in crude oil prices and
imposes significant national security costs. A panel of retired senior
military officers and national security experts concluded that
unabated climate change may act as a ``threat multiplier'' to foment
further instability in some of the world's most unstable regions (CNA
Corporation 2007). Fossil fuel consumption is also associated with
other forms of pollution that harm human health, such as particulate,
sulfur dioxide, and mercury emissions from coal-powered electricity
generation.

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Box 9-1: Climate Change in the United States and Potential Impacts

The average temperature in the United States has risen more than
1 ï¿½C (2 ï¿½F) over the past 50 years. However, this increase masks
considerable regional variation. For instance, the temperature
increase in Alaska has been more than twice the U.S. average. By the
end of the century, the United Nations Intergovernmental Panel on
Climate Change projects that average continental U.S. temperatures
will increase by another 1.5 to 4.5 ï¿½C (about 2.7 to 8.1 ï¿½F) absent
climate policy (Intergovernmental Panel on Climate Change 2007).
Greater increases are possible, depending in part on how fast
emissions rise over time. Climate change will likely bring substantial
changes to water resources, energy supply, transportation,
agriculture, ecosystems, and public health. Potential effects on U.S.
water availability and agriculture are described below (Karl, Melillo,
and Peterson 2009).
Precipitation already has increased an average of 5 percent over the
past 50 years, with increases of up to 25 percent in parts of the
Northeast and Midwest and decreases of up to 20 percent in parts of
the Southeast.In the future, these trends will likely be amplified. The
amount of rain falling in the heaviest downpours has increased an
average of 20 percent over the past century, a trend that is expected
to continue. In addition, Atlantic hurricanes and the strongest cold-
season storms in the North are likely to become more powerful. In
recent decades, the West has seen more droughts, greater wildfire
frequency, and a longer fire season. Increases in temperature and
reductions in rainfall frequency will likely exacerbate future
droughts and wildfires.
Although warmer temperatures may extend the growing season in the
United States for many crops, large increases in temperature also may
harm growth and yields. One study finds that yields are relatively
unaffected by changes in mean temperature, but that they are
vulnerable to an increase in the number of very hot days (Schlenker and Roberts 2009).
That said, another study finds that expected changes in temperature
in the United States will have a relatively small impact on overall
agricultural profits (Deschï¿½nes and Greenstone 2007). Neither study
accounts for the possible increase in yields from elevated carbon
dioxide levels or the possible decrease in yields from increased
pests, weeds, and disease.
Climate change is also likely to bring increased weather uncertainty.
Extreme weather events-droughts and downpours-may have
catastrophic effects on crops in some years. Growing crops in warmer
climates requires more water, which will be particularly challenging
in regions such as the Southeast that will likely face decreased
water availability.
American farmers have substantial capacity for innovation and are
already taking steps to adapt to climate change. For instance, they
are changing planting dates and adopting crop varieties with greater
resistance to heat or drought. They can also undertake more elaborate
change. In areas projected to become hotter and drier, some farmers
have returned to dryland farming (instead of irrigation) to help the
soil absorb more moisï¿½ture from the rain. How well the private sector
can adapt to the effects of climate change and at what cost is still
an open question.

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Box 9-2: Expected Consumption Loss Associated with
Temperature Increase

One major uncertainty regarding climate change is the relationship
between temperature change and living standards, usually measured as
total consumption. The highly respected PAGE model produces an
estimate of this relationship (see Box 9-2 figure). Specifically, it
reports the expected decline in consumption as a fraction of GDP in
the year 2100. The range of these estimates is represented by the
dotted lines that represent the 5th and 95th percentile of the damage
estimates. The range reflects uncertainty about the sensitivity of the
climate system to increased greenhouse gas concentrations, the
probability of catastrophic events, and several other factors.
The figure reveals that the projected losses for the most likely
range of temperature changes are relatively modest. For example, at
the Intergovernmental Panel on Climate Change's most likely
temperature increase of 3 ï¿½C for a doubling of CO2 concentration
(concentrations in 2100 are likely to be higher), the projected
decline is 1.5 percent of GDP.
The projected relationship between temperature changes and consumption
losses is nonlinear-that is, the projected losses grow more rapidly
as temperature increases. For example, while the projected loss for
the first 3ï¿½C is 1.5percent, the loss at 6ï¿½C is five times higher.
And the estimated loss associated with an increase of 9 ï¿½C is about
20 percent with a 90 percent confidence interval of 8 to 38 percent.
These large losses at higher temperatures reflect the increased
probability of especially harmful events, such as large-scale changes
in ice sheets or vegetation, or releases of methane from thawing
permafrost and warming oceans. Overall, it is evident that policy
based on the most likely outcomes may not adequately protect society
because such estimates fail to reflect the harms at higher
temperatures.




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Jump-Starting the Transition to Clean Energy

To make the transition to a clean energy economy, the United States
and the rest of the world need to reduce their reliance on carbon-
intensive fossil fuels. The American Reinvestment and Recovery Act of
2009 provides a jump-start to this transition by providing about $60
billion in direct
spending and $30billionin tax credits (Council of Economic Advisers
2010). These Recovery Act investments were carefully chosen and
provide a soup-to-nuts approach across a spectrum of energy-related
activities, ranging from taking advantage of existing opportunities
to improve energy efficiency to investing in innovative high-
technology solutions that are currently little more than ideas.
These investments will help create a new generation of jobs, reduce
dependence on oil, enhance national security, and protect the world
from the dangers of climate change. Ultimately, the investments will
put the United States on a path to becoming a global leader in clean
energy.

Recovery Act Investments in Clean Energy
A market-based approach to reducing greenhouse gases (discussed in
detail later) will provide incentives for research and development
(R&D) into new clean energy technologies as firms search for ever
cheaper ways to
address the negative externality associated with their emissions.
However,as already described,there is a separate externality in the
area of R&D. Because
it is difficult for the person or firm doing research to capture all
of there turns,
the private market supplies too little R&D-particularly for more
basic forms of R&D,less so as ideas move toward demonstration and
deployment. In this case, government R&D policies can complement the
use of a market-based approach to reducing greenhouse gas emissions
and yield large benefits to society. A policy that broadly
incentivizes energy R&D is more likely to maximize social returns
than a narrow one targeted at a specific technology because it
allows the market, rather than the government, to pick winners.
Likewise, funding efforts in support of basic R&D are less likely to
crowd out private investment because differences between private and
social returns to innovation are largest for basic R&D.
In its 2011 proposed budget, the Administration has stated a
commitï¿½ment to fund R&D as part of its comprehensive approach to
transform the way we use and produce energy while addressing climate
change. The Recovery Act investments begun in 2009 are a first step in
this clean energy transformation.
They fall in to eight categories that are briefly described here.
Energy Efficiency. The Recovery Act promotes energy efficiency
through investments that reduce energy consumption in many sectors
of the economy. For instance, the Act appropriates $5 billion to the
Weatherization Assistance Program to pay up to $6,500 per dwelling
unit for energy efficiency retrofits in low-income homes. The Recovery
Act also appropriates $3.2 billion to the Energy Efficiency and
Conservation Block Grant program, most of which will go to U.S.states,
territories, local governments, and Indian tribes to fund projects
that improve energy efficiency, reduce energy use, and lower fossil
fuel emissions.
Renewable Generation. The Recovery Act investments in renewable
energy generation also are leading to the installation of wind
turbines, solar panels, and other renewable energy sources. The Energy
Information Administration projects that the fraction of the Nation's
electricity generï¿½ated from renewable energy, excluding conventional
hydroelectric power, will grow from 3 percent in 2008 to almost 7
percent in 2012 in large part because of the renewal of Federal tax
credits and the funding of new loan guarantees for renewable energy
through the Recovery Act (Department of Energy 2009a).
Grid Modernization. As the United States transitions to greater use
of intermittent renewable energy sources such as wind and solar, the
Recovery Act is financing the construction of new transmission lines
that can support electricity generated by renewable energy. The Act is
also investing in new technologies that will improve electricity
storage capabilities and the monitoring of electricity use through
``smart grid'' devices, such as sophisticated electric meters. These
investments will improve the reliability, flexibility, and efficiency
of the Nation's electricity grid.
Advanced Vehicles and Fuels Technologies. The Recovery Act is
funding research on and deployment of the next generation of
automobile batteries, advanced biofuels, plug-in hybrids, and
all-electric vehicles, as well as the necessary support
infrastructure. These efforts are expected to reduce the Nation's
dependence on oil in the transportation sector.
Traditional Transit and High-Speed Rail. Grants from the Recovery
Act also will help upgrade the reliability and service of public
transit and conventional intercity railroad systems. For example,
$8 billion is going to improve existing, or build new, high-speed
rail in 100-to 600-mile intercity corridors. Investments in high-
speed rail and public transit will increase energy efficiency by
improving both access and reliability, thus making it possible for
more people to switch to rail or public transit from autos or other
less energy-efficient forms of transportation.
Carbon Capture and Storage. One approach to limiting greenhouse gas
emissions is to capture and store carbon from fossil-fuel combustion
to keep it from entering the atmosphere. The abundance of coal
reserves in the United States makes developing such technologies and
overcoming barriers to their use a particular priority. For instance, technology to capture carbon dioxide emissions has been used in
industrial applications but has not been used on a commercial scale
to capture emissions from power generation. Likewise, although some
carbon has been stored deep in the ocean or underground in depleted
oil reservoirs, questions remain about the permanence of these and
other types of storage. The Recovery Act is funding crucial research, development, and demonstration of these technologies.
Innovation and Job Training. The Recovery Act is also investing in
the science and technology needed to build the foundation for the
clean energy economy. For instance, a total of $400 million has been
allocated to the Advanced Research Projects Agency-Energy (ARPA-E)
program, which funds creative new research ideas aimed at accelerating
the pace of innovaï¿½tion in advanced energy technologies that would not
be funded by industry because of technical or financial uncertainty.
The Recovery Act also helps fund the training of workers for jobs in
the energy efficiency and clean energy industries of the future.
Clean Energy Equipment Manufacturing. The Recovery Act investments
are increasing the Nation's capacity to manufacture wind turbines,
solar panels, electric vehicles, batteries, and other clean energy
components domestically. As the United States transitions away from
fossil fuels, demand for advanced energy products will grow, and these
investments in clean energy will help American manufacturers
participate in supplying the needed goods.
Total Recovery Act Energy Investments. The Recovery Act is investing
in 56 projects and activities that are related to transitioning the
economy to clean energy. Forty-five are spending provisions with a
total appropriation of $60.7 billion, and another 11 are tax
incentives that the Office of Tax Analysis estimates will cost $29.5
billion through fiscal year 2019, for a total investment of over $90
billion. In some cases, a relatively small amount of Federal
investment leverages a larger amount of non-Federal support.
Throughout this section, only the expected subsidy cost of the Federal
investment is counted toward the appropriation.ï¿½1A\3\
The largest clean energy investments from the Recovery Act go to
renewable energy generation and transmission, energy efficiency, and
transit. Figure 9-2 illustrates how this $90 billion investment is
distributed across the eight categories of projects described above,
along with a ninth ï¿½otherï¿½ category containing programs that do not
fit elsewhere.
ï¿½1A\3\ Because of the public nature of the Bonneville and Western Area
Power Administrations, the accounting of clean energy investments
described here measures the projected drawdown of the borrowing
authority to these agencies as the Recovery Act appropriation.



Because most of the clean energy investments involve grants and
contracts that require that proposals be reviewed before funds are
expended, not all of the money appropriated for these investments
could be spent immediately. Thus, as with the Recovery Act more
generally, only a portion of the appropriation has been spent.
Over $31billion has been obligated and over $5 billion has been
outlayed through the end of 2009.ï¿½1A\4\
ï¿½1A\4\ Obligated means that the money is available to recipients once
they make expenditures, and outlayed means the government has
reimbursed recipients for their expenditures. Energy related tax
reductions to date are included in the totals obligated and out
layed by the end of 2009.


Short-Run Macroeconomic Effects of the Clean Energy Investments
Using a macroeconomic model, the Council of Economic Advisers (CEA)
estimates that the approximately $90 billion of Recovery Act
investï¿½ments will save or create about 720,000 job-years by the end of
2012 (a job-year is one job for one year). Projects in the renewable
energy generation and transmission, energy efficiency, and transit
categories create the most job-years. Approximately two-thirds of the
job-years represent work on clean energy projects, either by workers
employed directly on the projects or by workers at suppliers to the
projects. These macroeconomic benefits make it clear that the
Administration has made a tremendous down payment on the clean energy
transformation.

Other Domestic Actions to Mitigate Climate Change

In his first year in office, the President took several other
significant and concrete steps to transform the energy sector and
address climate change. Significantly, the Environmental Protection
Agency (EPA) issued two findings in December 2009. The first finding
was that six greenhouse gases endanger public health and welfare. The
second finding was that the
emissions of these greenhouse gases from motor vehicles cause or
contribute to pollution that threatens public health and welfare.
These findings do not in and of themselves trigger any requirements
for emitters, but they lay the foundation for regulating greenhouse
gas emissions.
Following up on these findings, the Administration has proposed the
first mandatory greenhouse gas emission standards for new passenger
vehicles. The standards are expected to be finalized in the spring
of 2010. By model year 2016, new cars and light trucks sold in the
United States will be required to meet a fleet-wide tailpipe
emissions limit equivalent to a standard of about 35.5 miles per
gallon if met entirely through fuel economy improvements. The EPA
estimates that these standards will save about 36 billion gallons of
fuel and reduce vehicle greenhouse gas emissions by about 760
million metric tons in CO2-equivalent terms over the lifetime of the
vehicles.
The Administration also proposed renewable fuel standards consistent
with the Energy Independence and Security Act (EISA), which requires
that a minimum volume of renewable fuel be added to gasoline sold in
the United States. Renewable fuels are derived from bio-based
feedstocks such ascorn, soy, sugarcane, or cellulose that have fewer
life-cycle greenhouse gas emissions than the gasoline or diesel they
replace. When fully implemented, the standards will increase the
volume of renewable fuel blended into gasoline from 9 billion
gallons in 2008 to 36 billion gallons by 2022.
The Administration also has been proactive in establishing minimum
energy efficiency standards for a wide variety of consumer products
and commercial equipment. For instance, standards were proposed or
finalized in 2009 for microwave ovens, dishwashers, small electric
motors, lighting, vending machines, residential water heaters, and
commercial clothes washers, among others. Overall, these actions will
reduce energy consumpï¿½tion and, in turn, greenhouse gas emissions. The
Energy Information Administration's 2009 Annual Energy Outlook
projected that by 2030, higher fuel economy and lighting efficiency
standards will contribute to lowering energy use per capita by 10
percent, compared with fairly stable energy use per capita between
1980 and 2008 (Department of Energy 2009b).
The 2010 Annual Energy Outlook highlights appliance and building
efficiency standards as one reason for lower projected carbon
dioxide emisï¿½sions growth, underscoring the benefits of these
regulations (Department of Energy 2009a).
Beginning in 2010, the United States will begin collecting
comprehensive high-quality data on greenhouse gases from large
emitters in many sectors of the economy (for instance, electricity
generators and cement producers).
When fully implemented, this program will cover about 85 percent of
U.S. emissions. The information supplied will provide a basis for
formulating policy on how best to reduce emissions in the future. It
will also be a valuable tool to allow industry to track emissions over
time. Specifically, these data will make it possible for industry and
government to identify the cheapest ways to reduce greenhouse gas
emissions.
Finally, the President issued an Executive Order requiring Federal
agencies tosetand meetaggressive goals for greenhouse gas emission
reducï¿½tions. Importantly, agencies are instructed to pursue
reductions that lower energy expenses and save taxpayers money.

Market-Based Approaches to Advance the Clean Energy Transformation
and Address Climate Change

Greenhouse gas emissions, as noted, are a classic example of a
negative externality. Emitters of greenhouse gases contribute to
climate change, thus imposing a cost on others that is not accounted
for when making decisions about how to produce and consume energy-
intensive goods. For this reason, policymakers should ensure that
the market provides the correct signals to greenhouse-gas emitters
about the full cost of their emissions. Once policy has ensured that
markets are providing the correct signals and incentives, the
operation of market forces can find the most effective and efficient
paths to the clean energy economy. The President has included a
market-based cap-and-trade approach in his 2010 and 2011 budgets as
a way to accomplish this goal. This section describes the basics of
this approach, including several potential ways to minimize
compliance costs. It then discusses a specific proposal consistent
with the President's goals for reducing greenhouse gas emissions.

Cap-and-Trade Program Basics
A cap-and-trade approach sets a limit on, or caps, total annual
aggregate greenhouse gas emissions and then divides the cap into
emission allowances. These allowances are allocated to firms through
some combination of an auction and free allocation.ï¿½1A\5\ Firms may
trade the allowances among themselves but are required to hold an
allowance for each ton of greenhouse gas they emit. The aggregate cap
limits the number of allowances available, ensuring their scarcity
and thus establishing a price in the market for allowances. In this
way, a cap-and-trade approach provides certainty in the quantity of
emission reductions but allows the price of allowances to fluctuate
with changes in the demand and supply.
ï¿½1A\5\ In his fiscal year 2011 proposed budget, the President supports
using allowance revenue to compensate vulnerable families,
communities, and businesses during the transition to the clean energy
economy, as well as in support of clean energy technologies and
adapting to the impacts of climate change.
Creating a market for greenhouse gas emissions gives firms
flexibility in how they reduce emissions.Absent other regulatory
requirements, a firm subject to the cap can choose to comply by
changing its input mix (for instance, switching from coal to natural
gas), modifying the underlying technology used in production (using
more energy-efficient equipment, for example), or purchasing
allowances from other entities with lower abatement costs. Such
flexibility reaps rewards. A cap-and-trade program induces firms to
seek out and exploit the lowest-cost ways of cutting emissions. It
takes advantage of the profit motive and leverages private sector
imagination and ingenuity to find ways to lower emissions.
Cap-and-trade programs already have proven successful. The United
States has been using a cap-and-trade approach to reduce sulfur
dioxide (SO2) emissions since 1995. One study found that using a cap-
and-trade approach instead of a performance standard to reduce sulfur
dioxide emisï¿½sions caused some firms to move away from putting
scrubbers on their smokestacks to cheaper ways of meeting the cap,
such as by blending different fuels (Burtraw and Palmer 2004). As a
result, compliance costs of the SO2 cap-and-trade program have been
dramatically lower than predicted.
Finally, a cap-and-trade approach promotes innovation. A carbon
price will give firms the certainty they need to make riskier long-
term investments that could identify novel and substantially cheaper
ways to reduce emissions. Evidence shows that pricing sulfur dioxide
emissions through a cap-and-trade approach has produced patentable
innovations as firms search for ever cheaper ways to abate (Burtraw
and Szambelan 2009).
In the case of greenhouse gases, possible innovations range from new
techniques to capture and store carbon generated by coal-burning
electricity plants, to carbon-eating trees and algae, to the
development of new types of renewable fuels. Indeed, such
innovation-and the opportunity it provides to make the United States
a world leader in clean energy technologies-is a key motivation for
the Administration's energy and climate policies.
Ways to Contain Costs in an Effective Cap-and-Trade System
There are a wide variety of ways to contain costs within a cap-
and trade framework. For instance, cap-and-trade programs may
incorporate banking and borrowing of emission allowances over time,
set ceilings or floors on allowance prices, or permit the use of
offsets as ways to smooth the costs of compliance over time. A brief
review of these mechanisms follows.
Banking and Borrowing. A cap-and-trade approach can be designed to
give polluters flexibility in the timing of emission reductions
through banking and borrowing. To limit allowance price volatility,
sources can make greater reductions early if it is cheaper to do so
and bank their allowï¿½ances for future use. Likewise, firms can manage
costs by borrowing against future reductions, allowing them to emit
more today in return for more drastic reductions later.
Evidence shows that banking has played a particularly powerful role
in helping firms to hedge uncertainty in the costs of the SO2 cap-and-
trade program over time. Anticipating that the cap originally set in
1995 would become more stringent in 2000, firms began to bank
allowances for future use soon after the system was put in place. By
1999, almost 70 percent of available allowances in the market had been
banked. Once the more strinï¿½gent cap was in place, the banked
allowances were drawn down to meet the cap, with about a 40 percent
decrease in the size of the allowance bank between 2000 and 2005
(Environmental Protection Agency 2006).
In contrast, the inability of firms to bank or borrow in Southern
California's nitrous oxide market played a significant role in
increased price volatility during the State's electricity crisis in
2000 when firms met soaring demand for electricity by running old,
dirty generators. One study found that the absence of banking and
borrowing was an important contribï¿½uting factor to the roughly tenfold
increase in the price of nitrous oxide allowances, resulting in power
plants subject to the cap eventually seeking exemption from the
program (Ellerman, Joskow, and Harrison 2003).
Price Ceilings or Floors. While banking and borrowing allow firms to
smooth costs over time, they may not guard against unexpected and
potentially longer-lasting changes in allowance prices caused by such
factors as a recession or economic boom, fuel price fluctuations, or
unexpected variation in the pace of technological development.
Consequently, cap-and-trade systems often include protections against
prices that are deemed too high. For example, in the Northeast's
greenhouse gas trading system, allowance prices above certain
thresholds trigger additional flexibilities that reduce compliance
costs.ï¿½1A\6\
ï¿½1A\6\ Above $7 per ton (in 2005 dollars), a firm can cover up to 5
percent of its emissions with domestic offsets, up from 3.3 percent.
At $10 per ton (in 2005 dollars plus a 2 percent increase per year),
this amount increases to 10 percent of emissions and may include
international offsets.

Another way for a cap-and-trade program to mitigate the effects of
unexpected changes would be to specify an upper or lower limit, or
both, on allowance prices. An upper limit protects firms and
consumers from unexpectedly high prices. When the price reaches the
upper limit, additional allowances are sold to prevent further
escalation.
Alower limit on allowance prices ensures that cheap abatement
opportunities continue to be pursued. For example, cap-and-trade
legislation recently passed by the U.S. House of Representatives
reserves a small share of allowances to be auctioned if the price
rises above a predetermined threshold and also sets a minimum price
for allowances that are auctioned. One study finds that, for a given
cumulative emissions reduction, a combined price ceiling and floor
can reduce costs by almost 20 percent compared with a cap-and-trade
program without any cost-containment mechanisms (Fell and
Morgenstern 2009). On the other hand, it is possible that a floor
or ceiling can cause total emissions to differ from the legislated
cap.
Offsets. Offsets also can be an important cost-containment feature
of a cap-and-trade program. Offsets are credits generated by reducing
emissions in a sector outside the program; they can be purchased by a
firm subject to the cap to meet its compliance obligations. Because
greenhouse gases are global pollutants-they cause the same damage no
matter where they are emitted-offsets offer the appealing prospect of
achieving specified emissions reductions at a lower cost.
The purchase of offsets from the forestry and agricultural sectors
could play a potentially important role in reducing the compliance
costs of firms subject to the cap (Kinderman et al. 2008;
Environmental Protection Agency 2009). And under some cap-and-trade
programs, domestic firms may purchase international offsets to meet
their compliance obligations. This possibility may encourage a
foreign country to build a solar powerplant rather than a coal plant
so that it can sell the offsets in the U.S. market.
Despite these important advantages, however, it is crucial that the
claimed reductions from offsets be real-otherwise the system will
effectively provide payments without actually reducing emissions.
Indeed, Europe's experience with a project-based approach to
international offsets suggests that concerns about the environmental
integrity of claimed emissions reductions are well founded
(Box 9-3)ï¿½1A.\7\ If offsets are going to be included as part of a
cap-and-trade program, substantial investments in rigorous
monitoring methods, such as combining remote sensing with on-the-
ground monitoring, to verify greenhouse gas reductions are crucial.
ï¿½1A\7\ Cap-and-trade programs that allow project-level offsets are
particularly susceptible to crediting activity that would have
occurred anyway or that is replaced by high-carbon activities
elsewhere (leakage). One way to reduce the potential for leakage is a
sector-or country-based framework, in which sectors or governments
receive credit in exchange for implementing policies to reduce
emissions. The legislation passed by the U.S. House of Representatives
includes a sector-based approach to international offsets.
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Box 9-3: The European Union's Experience with Emissions Trading

One of the pillars of the President's proposed response to climate
change is a cap-and-trade system to reduce U.S. emissions of
greenhouse gases. The European Union's Emission Trading Scheme(ETS),
the world's first mandatory cap-and-trade program for carbon dioxide
emissions, was launched in 2005 to meet emission reduction targets
agreed to under the Kyoto Protocol. The first phase of the ETS-from
2005 to 2007-applied to several high-emitting industrial sectors,
including power generation, in 25 countries and covered just over 40
percent of all European Union (EU) emissions. Although data
limitations and uncertainty over baseline emissions preclude
researchers from assessing the precise magnitude of the reductions,
one estimate suggests that the ETS reduced EU emissions by about 4
percent in 2005 and 2006 relative to what the level would have been
in its absence. Because of the flexibility offered under the
cap-and-trade program, these reductions occurred where it was
cheapest to achieve them. That said, the ETS offers three important
cautionary lessons as the United States explores how best to
implement its own cap-and-trade system.
One lesson is the importance of carefully establishing a baseline
for current and future emissions, so that the price sends an
accurate signal to firms regarding how much to abate and innovate
based on the expected futur evalue of reductions. During the first
phase of the ETS, EUcountries allocated allowances based on
firms' estimates of their historic emissions. In April 2006, when
monitoring data became available, the data showed that actual
emissions were already below the cap. Allowance prices immediately
fell from about ï¿½30 ($38) per metric ton to less than ï¿½10 ($13) before
settling at ï¿½15-ï¿½20 ($19-$25) for the next few months.
The EU experience also demonstrates that distributing nearly all
allowances to industry at no cost can lead to large windfall profits.
The European Union distributed nearly 100 percent of allowances free
to firms subject to the cap in Phase 1 and only auctioned a small
portion of allowances for Phase 2 (2008-12). One estimate
(Point Carbon Advisory Services 2008) suggests that during Phase 2,
electricity generators in Germany will reap the highest windfall
profits of all participating EU countries, on the order of
ï¿½14 billion to ï¿½34 billion ($20 billion to $49 billion).
In countries with low-greenhouse-gas emitters, electricity
generators are expected to benefit less. For instance, in Spain,
windfall profits are estimated to be about ï¿½1 billion to ï¿½4 billion
($1 billion to $6 billion). In Phase 3 (2013-20), the European Union
plans to auction the majority of allowances.
Finally, it is important to ensure that any offsets from domestic and
international sources reflect real reductions. Otherwise, they may
endanger the environmental integrity of the cap. The ETS allows
limited use of project-based international offsets from the United
Nations' Clean Development Mechanism (CDM) in place of domestic
emission reductions. Are view of a random sample of offset project
proposals in the CDM program from 2004 to 2007 estimated that
``additionality'' was unlikely or questionable for roughly 40
percent of registered projects, representing 20 percent of emissions
reductions, meaning they would have occurred anyway (Schneider 2007).
Although the CDM has worked to improve its accounting procedures over
time, the EU's experience demonstrates the importance of designing
an offsets program carefully.
--------------------------------------------------------------------
Coverage of Gases and Industries
Although carbon dioxide made up about 83 percent of U.S. greenhouse
emissions in 2008, a cap-and-trade approach that gives firms
flexibility in where they reduce emissions, both in terms of the
greenhouse gas and the economic sector, can lower firms' compliance
costs. One study found that achieving an emission goal by cutting
both methane and carbon dioxide emissions rather than carbon dioxide
alone could reduce firms' abatement costs in the United States by
over 25 percent in the medium run (Hayhoe et al. 1999).
Costs are also affected by the number of industries covered by the
cap, with the general principle being that greater coverage lowers the
marginal cost of emissions reductions. A recent study comparing
alternative ways to achieve a 5 percent reduction in emissions found
that the cap-and-trade program's costs to the economy were twice as
large when manufacturing was excluded as they were under an
economy-wide approach (Pizer et al. 2006).
The American Clean Energy and Security Act
In June 2009, the U.S.House of Representatives passed legislation-
the American Clean Energy and Security Act (ACES)-that includes a
cap-and-trade program consistent with the President's goal of
reducing greenhouse gas emissions by more than 80 percent by 2050,
and the Senate is currently engaged in a bipartisan effort to
develop a bill.
Projected Climate Benefits. Based on two analyses of the ACES
legislation, U.S. actions would reduce cumulative greenhouse gas
emissions by approximately 110 billion to 150 billion metric tons in
CO2-equivalents by 2050 (Paltsev et al. 2009; Environmental Protection
Agency 2009). The EPA estimates that emission reductions of this
magnitude, when combined with comparable action by other countries
consistent with reducing world emissions by 50 percent in 2050, is
expected to limit warming in 2100 to less than 2 ï¿½C (3.6 ï¿½F) relative
to the pre-industrial global average temperature, with a likely range
of about 1.0 to 2.5 ï¿½C (1.8 to 4.5 ï¿½F).
To derive the possible benefits associated with the U.S.
contribution to these emission reductions, the CEA calculates that
the ACES will result in approximately $1.6trillion to $2.0trillion
of avoided global damages in present value terms between 2012 and
2050 (in 2005 dollars).ï¿½1A\8\ The value of avoided damages includes
such benefits as lower mortality rates, higher agricultural yields,
money saved on adaptation measures, and the reduced likelihood of
small-probability but high-impact catastrophic events. Further, the
benefits will be significantly larger if U.S.policy induces other
countries to undertake reductions in greenhouse gas emissions.
ï¿½1A\8\ The CEA uses estimates of the projected decline in emissions
between 2012 and 2050 based on the President's proposed reductions
in emissions and uses the central estimate of $20 a ton for a
unit of carbon dioxide emitted in 2007(in 2007 dollars)
that was recently developed as an interim value for regulatory
analyses (Department of Energy 2009c). Additionally, it assumes that
the benefit of reducing one additional ton of carbon dioxide grows
at 3 percent over time and that future damages from current
emissions are discounted using an average of 5 percent. Several
Federal agencies have used these values in recent proposed
rulemakings but have requested comment prior to the final
rulemaking, so these estimates may be revised.
Projected Economic Costs. The estimated cost of meeting the caps
outlined in the ACES legislation is relatively small. Recent research
suggests that the ACES will result in a loss of consumption on the
order of 1 to 2 percent in 2050 (Environmental Protection Agency 2009;
Paltsev et al. 2009). On a per household basis, the average annual
consumption loss would be between $80 and $400 a year between 2012
and 2050 (in 2005 dollars).

International Action on Climate Change Is Needed

Greenhouse gas emissions impose global risks. As a result, just as
U.S. efforts to reduce emissions benefit other countries, actions that
other countries take to mitigate emissions benefit the United States.
Given the global nature of the problem and the declining U.S. share of
greenhouse gas emissions, U.S. actions alone to reduce those emissions
are insufficient to mitigate the most serious risks from climate
change.
Developing countries such as China and India are responsible for a
growing proportion of emissions because of their heavy reliance on
carbon-intensive fuels, such as coal (Figure 9-3). In 1992, China's
carbon dioxide emissions from fossil fuel combustion were half those
of the United States and represented 12 percent of global emissions.
By 2008, China's carbon dioxide emissions represented 22 percent of
global emissions from fossil fuels, exceeding the U.S. share of 19
percent and the European share of 15 percent. China's share of global
emissions is projected to grow to about 29 percent by 2030 absent new
emission mitigation policies. By contrast, the U.S. share of global
emissions is projected to fall to about 15 percent by 2030 even
absent new emission mitigation policy. Thus, cooperation by both



past and future contributors to emissions will be required to
stabilize the atmospheric concentrations of greenhouse gases.
In keeping with this goal, the Administration has actively pursued
partnerships with major developed and emerging economies to advance
efforts to reduce greenhouse gas emissions and promote economic
development that lowers emission intensity.
Partnerships with Major Developed and Emerging Economies
The President has worked to further a series of international
agreements to address climate change. For example, he launched the
Major Economies Forum on Energy and Climate to engage 17 developed and
emerging economies in a dialogue on climate change. In July, the
leaders of these countries agreed that greenhouse gas emissions should
peak in develï¿½oped and developing countries alike, and recognized the
scientific view that the increase in global average temperature above
pre-industrial levels ought not to exceed 2 ï¿½C (3.6 ï¿½F). They also
agreed to coordinate and dramatically increase investment in
research, development, and deployment of low-carbon energy
technologies with a goal of doubling such investment by 2015.
Finally, the leaders agreed to mobilize financial resources in
support of mitigation and adaptation activities, recognizing that
the group should be responsive to developing-country needs in this
area.
Also in July, leaders from the Group of Eight (G-8) countries
agreed to undertake robust aggregate and individual medium-term
emission reductions consistent with the objective of cutting global
emissions by at least 50 percent by 2050. Additionally, under the
Montreal Protocol, the United States jointly proposed with Canada
and Mexico to phase down emissions of hydrofluorocarbons, a potent
greenhouse gas used in refrigeration, fire suppression, and other
industrial activities. This action alone would achieve about 10
percent of the greenhouse gas emission reductions needed to meet the
agreed G-8 goal of a 50 percent reduction by 2050.
In December, the Administration worked with major emerging economies,
including Brazil, China, India, and South Africa, developed countries,
and other regions around the world to secure agreement on the
Copenhagen Accord. For the first time, the international community
established a long-term goal to limit warming of global average
temperature to no more than 2 ï¿½C (3.6 ï¿½F). Also for the first time,
all major economies agreed to take action to address climate change.
Under the Accord, both developed and major emerging economies are in
the process of submitting their emission mitigation commitments and
actions to reduce greenhouse gas emissions.
Every two years, developing countries will report on emission
mitigation efforts, which will be subject to international
consultation and analysis under clearly defined guidelines.
Establishing transparent review of developed and developing country
mitigation activities will help ensure that countries stand behind
their commitments.
Furthermore, under the Accord, in the context of meaningful
mitigation actions and transparency, developed countries committed
to a goal of jointly mobilizing $100billion a year in funding from a
variety of private and public sources for developing countries by
2020. This funding will build on an immediate effort by developed
countries to support forestry, adaptation, and emissions mitigation
with funding approaching $30 billion sometime in the 2010 to 2012
timeframe. There will be a special focus on directing this funding
to the poorest and most vulnerable developing countries.

Phasing Out Fossil Fuel Subsidies
The United States also spearheaded an agreement in September to
phase out fossil fuel subsidies among G-20 countries, a goal
seconded by countries in the Asian-Pacific Economic Cooperation
(APEC) in November. The G-20 also called on all nations to phase out
such subsidies worldwide. Fossil fuel subsidies are particularly
large in non-OECD countries, such as India and Russia. Twenty of the
largest non-OECD governments spent about $300 billion on fossil fuel
subsidies in 2007. Together, this coordinated action to reduce
subsidies can free up resources, especially in developing countries,
to target other social needs such as public health and education.
One model estimates that eliminating fossil fuel subsidies in the
major non-OECD countries alone would reduce greenhouse gas emissions
by more than 7 billion metric tons of CO2-equivalent, enough to
fulfill almost 15 percent of the agreed-upon G-8 goal of reducing
global emisï¿½sions by 50 percent by 2050 (Organisation for Economic
Co-operation and Development 2009).
In the United States, these subsidies-including tax credits,
deductions, expensing practices, and exemptions-are worth about $44
billion in tax revenues between 2010 and 2019. Their elimination will
help put cleaner fuels, such as those derived from renewable sources,
on a more equal footing and reduce wasteful consumption of fossil-fuel
based energy caused by underpricing. Proper pricing of fossil fuels
will also help reduce reliance on petroleum, thus enhancing energy
security and aiding in the achievement of climate mitigation goals.

Conclusion

Today's economy is dependent on carbon-intensive fuels that are
directly linked to an increase in global average temperature.
Continued reliance on these fuels will have a range of negative
impacts, including increased mortality rates, reduced agricultural
productivity in many locations, higher sea levels, and the need for
costly adaptation efforts. For these reasons, a clean energy
transformation is essential.
Through his comprehensive plan, the President has set the country on
course to achieve this goal. He has taken several significant and
concrete steps to transform the energy sector and address climate
change through the American Reinvestment and Recovery Act and through
targeted regulaï¿½tion. To address externalities associated with
greenhouse gas emissions, the President has proposed a market-based
cap-and-trade approach. These combined efforts will stimulate the
research and development necessary to advance new clean energy
technologies. Because of the global nature of the climate change
problem, the Administration is also actively pursuing partnerships
with other countries to advance efforts to transition the world to
clean energy and reduce greenhouse gas emissions.