Dr. Janet Yellen, Chair, Council of Economic Advisers, Testimony Before the House Commerce Committee, Subcommittee on Energy and Power, Washington, DC, October 6, 1998


"Economics of Climate Change"

Thank you, Mr. Chairman. I appreciate having this opportunity to
discuss with you the economics of climate change and the
Administration's efforts to address this significant
environmental challenge. As you know, I have testified on this
topic before this committee on two prior occasions. In my first
appearance, prior to the Kyoto negotiations, I emphasized that if
flexible, market-based mechanisms are effectively used, the costs
of cutting greenhouse gas emissions would be significantly
reduced. Elaborating on this point, I stated in March of this
year that, in the Administration's view, the costs of achieving
our Kyoto target would be modest if we can succeed in
implementing international trading, joint implementation, and the
Clean Development Mechanism in an efficient manner and we achieve
meaningful developing country participation. A report released by
the Administration in July, entitled "The Kyoto Protocol and the
President's Policies to Address Climate Change: Administration
Economic Analysis" elaborates the assumptions and analysis
underlying this conclusion. In addition, the Stanford Energy
Modeling Forum has been coordinating an economic modeling
exercise of the Kyoto agreement, and the participating modelers,
who include academic, private sector and government analysts,
have made available some of their preliminary results. Today, I
will provide a brief summary of the Administration's Economic
Analysis and review several of the key findings of the Energy
Modeling Forum effort.

The Potential Impact of Climate Change

The Intergovernmental Panel on Climate Change (IPCC) concluded in
1995 that "the balance of evidence suggests that there is a
discernible human influence on global climate."  Current
concentrations of greenhouse gases have reached levels well above
those of preindustrial times. If growth in global emissions
continues unabated, the atmospheric concentration of carbon
dioxide (CO2) will likely double relative to its preindustrial
level by midway through the next century and continue to rise
thereafter. As a result of the increased concentration of CO2,
the IPCC estimates that global temperatures will increase by
between 2 to 6 degrees Fahrenheit in the next 100 years, with a
best guess of about 3.5 degrees Fahrenheit. Potential
consequences associated with this shift in climate include a rise
in sea levels, greater frequency of severe weather events, shifts
in agricultural growing conditions from changing weather
patterns, threats to human health from increased range and
incidence of diseases, changes in availability of freshwater
supplies, and damage to ecosystems and biodiversity. Further
discussion of the costs of climate change is contained in the
Administration Economic Analysis. [note 1]

The Kyoto Protocol and the Buenos Aires Conference of the Parties

Previously, Undersecretary Eizenstat and I appeared before this
committee to discuss the Kyoto Protocol and the Administration's
efforts to address the risks of climate change. In my testimony,
I described the many important flexibility mechanisms in the
Kyoto Protocol and explained how they would allow countries to
achieve cost-effectively the emissions targets established in
this agreement. These mechanisms, which permit what we have
termed "when", "what", and "where" flexibility in meeting the
Kyoto emissions targets, are described in detail in the
Administration Economic Analysis. Since securing international
emissions trading, the Clean Development Mechanism, and joint
implementation last year in Kyoto, the Administration has worked
in bilateral and multilateral arenas to promote understanding of
these mechanisms and to develop rules that will promote their
efficient operation. This work will continue in the talks in
Buenos Aires and beyond. While I will defer to the Department of
State for a discussion of the upcoming international
negotiations, I will reiterate that efficient implementation of
these flexibility mechanisms is critical to reducing the costs of
achieving the targets established in the Kyoto Protocol.

Costs of Action

In assessing the economic effects of the Kyoto Protocol, the
Administration has drawn on the insights of a wide range of
models and analysis. Examples include models of the energy sector
and economy over the next 25 years, such as the Stanford Energy
Modeling Forum, the Intergovernmental Panel on Climate Change's
review of the economic and social dimensions of climate change,
the work of the Organization for Economic Co-operation and
Development (OECD) on the economic dimensions and policy
responses to global warming, and the Administration's staff-level
interagency analysis. In addition, the Administration used other
tools, such as a meta-analysis, basic economic reasoning,
overviews of the domestic and international energy sectors,
statistics regarding energy efficiency and greenhouse gas
emissions, and economic indicators from World Bank, International
Energy Agency, and Energy Information Administration databases.

Assuming that effective mechanisms for international trading,
joint implementation, and the Clean Development Mechanism are
established, and assuming also that the United States achieves
meaningful participation of key developing countries, the
Administration's overall assessment is that the economic cost of
attaining the targets and timetables specified in the Kyoto
Protocol will be modest for the United States in aggregate and
for typical households. This conclusion is not entirely dependent
upon, but is fully consistent with, formal model results. The
Administration continues to believe that there are limitations to
relying on any single model to assess the economic impact of the
Kyoto Protocol. However, model results can further inform and
improve the understanding of the effects of climate change
policy. To complement the economic analysis of the
Administration's policy to address climate change, we have
conducted an illustrative assessment with a modified version of
the Second Generation Model (SGM). The results from the SGM
substantiate the conclusion that the economic effects of an
efficient, effective, and global policy to address the risks of
climate change will be modest.

An assessment using the SGM model that accounts for effective
trading and developing country participation yields permit price
estimates ranging between $14/ton and $23/ton, and direct
resource costs to the U.S. between $7 billion and $12
billion/year. The range reflects uncertainty about the extent of
Annex I participation in international trading.

Under the assumptions of the Administration's analysis, permit
prices in the range of $14/ton to $23/ton translate into energy
price increases at the household level between 3 and 5 percent.
Under these permit prices, fuel oil prices would increase about 5
to 9 percent, natural gas prices about 3 to 5 percent, gasoline
prices about 3 to 4 percent (or around 4 to 6 cents per gallon),
and electricity prices about 3 to 4 percent. This increase in
energy prices at the household level would raise the average
household's energy bill in ten years by between $70 and $110 per
year, although such predictions may not be observable because
they would be small relative to typical energy price changes, and
nearly fully offset by electricity price declines from federal
electricity restructuring. By 2008-2012, the anticipated 10
percent decline in electricity prices from restructuring is
projected to lead to expenditure reductions of about $90 per year
for the average household.

The illustrative modeling analysis does not account for several
key components of the Kyoto Protocol and the Administration's
policies to reduce greenhouse gas emissions. These include the
benefits of reducing net emissions through carbon sinks, the
Administration's electricity restructuring proposal, the
Administration's Climate Change Technology Initiative (R&D
funding and tax incentives in the FY 1999 budget), the
Administration's sectoral consultations to encourage and support
voluntary efforts by U.S. industry to undertake emissions
reductions, including the provision of credit for early action,
and the Administration's efforts to reduce federal energy use.
There are also ancillary benefits of reducing greenhouse gas
emissions -- in particular, the corresponding reductions in
conventional air pollutants like sulfur dioxide and fine
particulate matter. These benefits alone could produce savings
equal to about a quarter of the costs of meeting our Kyoto
target.

Since I last testified before this committee, the Administration
has released its proposed electricity restructuring legislation
and the supporting analysis of this proposal. The
Administration's proposed Comprehensive Electricity Competition
Act (CECA) is estimated to reduce greenhouse gas emissions by
about 25 to 40 million metric tons of carbon equivalent per year
by 2010.

Further, the electricity restructuring proposal provides
potential cost-savings in four areas: dispatch efficiency,
improved capital utilization, savings in capital additions and
cost reductions in fuel procurement, non-fuel operation and
maintenance expenses, and administrative and general expenses.
These four categories of savings are likely to reach or exceed
$20 billion annually. The Department of Energy's CECA supporting
analysis documents [note 2] contain further discussion of the
Administration's electricity restructuring proposal.

Recent Research on the Economics of Climate Change

Since I last appeared before this committee, many economists have
conducted and made available their analyses of the Kyoto
Protocol. I noted in both of my previous appearances that there
are limitations to relying on one or a small set of models and
that we were eager to see assessments of the Kyoto Protocol by
other models. In March, I indicated that the Energy Modeling
Forum (EMF) based at Stanford University, a long-running model
comparison exercise involving many of the leading climate and
energy models, would conduct full scale analyses of the Kyoto
Protocol. We have now received a compilation of the preliminary
analyses by the participating modeling teams.

EMF Kyoto Analyses

The Energy Modeling Forum comparison exercise of the Kyoto
Protocol has included ten modeling teams from the United States,
Europe, and Asia. In evaluating the Kyoto Protocol, all of the
participating teams used economic models that incorporate the
potential for international trading in greenhouse gas permits. By
explicitly incorporating international trading, these models can
evaluate the opportunities for cost-savings through trading among
Annex I nations and among Annex I and developing countries were
they to adopt emissions targets. Since the Kyoto Protocol enables
all countries with emissions targets to trade emissions
allowances among other countries with targets, these models are
well-suited to assess the economic implications of the
international trading component of the agreement.

While the EMF models can assess international trading, there are
several other flexibility mechanisms of the Kyoto Protocol that
they cannot, at present, readily assess. For example, these
models did not incorporate the effects of sinks. While several
modelers did assess the economic costs of achieving the Kyoto
targets with "off-line" assumptions about sink activity, none
incorporated an integrated energy-land use model. Further, most
of the modelers did not evaluate opportunities to reduce costs by
trading across greenhouse gases. These models are primarily
energy models and are focused on the economics of reducing carbon
emissions from fossil fuel combustion. Again, some modelers
analyzed the Protocol by making some "off-line" assumptions about
the potential reductions in non-carbon dioxide greenhouse gases,
but none employed a model with cost curves for these gases.
Finally, it should be noted that these models did not include
opportunities for emissions reduction through Administration
proposals, such as electricity restructuring or the Climate
Change Technology Initiative, that could lower greenhouse gas
permit prices.

The EMF results provide very useful context for the
Administration's economic analysis. First, the illustrative model
used by the Administration, the Second Generation Model of the
Pacific Northwest National Laboratory, tends to fall in the
middle of the range of this set of models in terms of U.S. permit
prices. [note 3] For example, under Annex I trading SGM generates
a permit price which is at the median of this set of models.
Under full global trading, the SGM permit price is just below the
median permit price. Second, the EMF exercise found that the
reduction in permit prices as trading expands from no trading to
Annex I trading to full global trading is robust. On average, the
EMF models found that Annex I trading would cut the U.S. permit
price by 53 percent relative to a no trading scenario. Of these
models, one estimated a 72 percent reduction in the permit price
under Annex I trading. In full global trading, the permit price
would be, on average, 80 percent lower than the no trading price.
Several models estimated permit price reductions of about 90
percent.

Analyses of Trading Constraints

In addition to the modeling of various efficient international
trading scenarios, several EMF modeling teams have considered the
impact of constraints on the opportunity to buy or sell emissions
allowances in an international market. While the United States is
unambiguously opposed to trading restrictions, several parties to
the agreement have indicated support for some form of a trading
constraint, for example, by setting a limit on the amount a party
can purchase through the trading system. Trading restrictions
would generate no benefit for the global climate while they could
significantly increase the costs of achieving the Kyoto targets.

Before describing the economic costs of trading constraints, I
would like to explain why such constraints yield no climate
benefits. Regardless of where an emission reduction occurs, it
has the same effect on total emissions and the same effect on the
climate. A ton reduced in New York generates the same climate
benefit as a ton reduced in Berlin. In proposing trading
constraints, some have focused on countries such as Russia, that
will have emissions below their Kyoto targets during the
commitment period because of the decline in their economic output
associated with the transition to market economies. If trading
constraints are established that restrict the ability of Russia
to sell permits (or restrict the opportunity for other Annex I
countries to buy Russian permits), then emissions during the
first commitment period would be lower than in the absence of
such constraints. However, Russia would simply bank its
allowances and use these allowances in a subsequent commitment
period when its emissions exceed its target. While a trading
constraint might lower emissions during the first commitment
period, the cumulative emissions over several commitment periods
from Annex I countries would be the same with and without the
trading constraint. Given the long residence times of greenhouse
gases (on the order of a 100 or more years), the cumulative
effect is what is most relevant in terms of changes in the global
climate.

To provide a sense of the economic implications of trading
constraints, I would like to share with you two examples from
work done by EMF modeling teams. First, consider a trading
constraint that mandates that at least two-thirds of the
emissions reductions necessary for a country to achieve its Kyoto
target must occur through domestic actions. Evaluating this
trading constraint with the EPPA model based at the Massachusetts
Institute of Technology, the permit price for the United States
is almost four times higher with the constraint than under an
unconstrained global trading system. It is important to note that
the effects of this constraint are even more pronounced for the
European Union and for Japan. The permit price for the EU would
be more than five times higher than the unconstrained global
trading permit price, and the Japanese permit price would be
thirteen times higher. As these results indicate, the trading
constraint would result in each country experiencing a different
marginal cost of abatement, and there would be no common permit
price for a ton of carbon equivalent. Since the constraint
restricts opportunities for countries like the United States,
Japan, and members of the EU to buy emissions allowances, the
competitive price for emission allowances from countries like
Russia would fall below the unconstrained level.

Second, consider a trading constraint that mandates that
acquisitions of permits through international trading could not
exceed 10 percent of a country's emissions allocation. For
example, the U.S. target is approximately 1.5 billion tons of
carbon equivalent on an annualized basis. Under this trading
constraint, the United States, or private firms in the United
States, could not purchase more than 150 million tons on an
annual basis from other countries. Assessing this trading
constraint with the Second Generation Model based at the Pacific
Northwest National Laboratory, the permit price for the United
States would more than triple relative to the unconstrained
global trading permit price. For the EU, the permit price would
nearly double, and for Japan, the permit price would be eleven
times as high as the unconstrained global price.

While trading constraints increase greenhouse gas permit prices
(and subsequently, energy prices) in the United States, the
European Union, and Japan, they also reduce the gains from trade
by the countries likely to be sellers of emissions allowances.
For example, Russia and large developing countries that adopt
emissions growth targets and participate in international
trading, e.g., China and India, would sell fewer emissions
allowances at lower international permit prices under such
trading constraints than in an unconstrained global trading
environment. Such restrictions lessen the benefits of
participation by developing countries in international trading.

Developing Country Participation

While no non-Annex I country has yet adopted a binding emissions
target, economic and environmental benefits would accrue if some
developing countries do so. Setting a target below the business
as usual emissions level for the commitment period would generate
climate benefits by reducing global emissions below what they
would otherwise have been. In addition, if the target is set not
too far below the business as usual emissions level, the
participation of the country in a global trading system would
produce economic benefits or "gains from trade" for both the
developing country and its trading partners. Emissions trading by
developing countries would occur only if they chose to undertake
emissions reductions above and beyond their commitments --
reductions that would generate trading extra income for them as
long as their marginal abatement cost is below the world trading
price for greenhouse gas permits. Many of the EMF models reveal
that, for large developing countries, like China, such excess
reductions would indeed be profitable, so that these countries
would export allowances and gain from trade. Developing countries
would also reap ancillary benefits of reducing conventional air
pollutants, which may be substantial. Benefits from trading would
also accrue to Annex I countries. Annex I countries (and private
firms in these countries), who would purchase these emissions
allowances in the world market, would achieve their targets at
lower cost than without the participation of the developing
countries. However, it should be noted that the more stringent
the target for the developing country, the lower the gains from
trade both for that country and for Annex I countries such as the
United States. Indeed, an extremely stringent target could
conceivably make the developing country a net importer of
emissions allowances, and raise the international trading price
for a greenhouse gas permit. Still, these models illustrate the
potential to create targets that simultaneously make the
environment, the developing country, and Annex I countries all
better off.

Conclusion

The Administration's overall conclusion is that the economic
impact of the Protocol will be modest under the conditions we
have identified in our economic analysis. The purpose of this
testimony has been to summarize the analysis we have presented in
the Administration Economic Analysis on climate change and to
provide a brief update of recent modeling efforts outside of the
government.

I look forward to continuing to work with members of this
committee, as well as with other interested parties, in further
analyzing the Kyoto Protocol and evaluating the net effects of
reducing greenhouse gas emissions. It is my hope that economic
analysis will continue to play a key role in designing policies
in this area.

I welcome your questions.

Endnotes:

1/ Please refer to the attached paper copy or
http://www.whitehouse.gov/WH/New/html/kyoto.pdf for a PDF version
of this document.
2/ Please refer to the attached paper copy or
http://www.doe.gov/ceca/ceca.htm for the PDF version of the
supporting analysis.
3/ Please note that the version of SGM used in EMF differs from
the analysis conducted by the Administration because the EMF
version does not include cost curves for non-carbon dioxide
greenhouse gases used by the Administration. Since efficient
trading across gases would lower costs and permit prices, the EMF
version of SGM yields slightly higher permit prices than the
Administration version.


Return to Vinnie's Home Page

Return to Global Environment Page