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McKinsey Executive Roundtable Series in International Economics: What is the Right Economic Approach to Global Warming? [Rush Transcript; Federal News Service]

Speakers: Ian W.H. Parry, Senior Fellow, Resources for the Future, Richard Sandor, Chairman and CEO, Chicago Climate Exchange, and Robert H. Socolow, Professor, Princeton University
Presider: Christine Todd Whitman, Former EPA Administrator and President, the Whitman Strategy Group LLC
April 15, 2008
Council on Foreign Relations

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CHRISTINE TODD WHITMAN:  Good morning.  If we could have everyone's attention, I hope you've gotten some breakfast and some opportunity to have a conversation.

(Off mike commentary.)

Can't hear?  The mike's on?  I haven't touched it, I promise.  Modern technology is wonderful when it works. 

But anyway, good morning, delighted to have everybody here this morning for a discussion that I know will be very exciting and enlightening.  This is part of the McKinsey Executive Roundtable Series in International Economics.

I would start with the admonition of please turn off cell phones, BlackBerrys, anything that might buzz, jingle, ring, attract attention to itself.  And I will remind everyone this particular panel is on the record, so just know that.

As I said at the onset, this is going to be, I think and can predict, a very lively discussion.  We have up here -- I'm not going to go through their bios simply because you have them.  But you couldn't have a more distinguished panel, frankly, to discuss this issue covering economics and environmental understanding of climate change.  For the purposes of today's panel, what we'll do is make the assumption that the climate is changing and that human activity is having some impact on that.  You can debate that if you want, that's fine. 

But I think we'll start with that premise and ask the panel to take us through their understanding of the issue and its economic implications and some of the things that we are seeing being proposed today as ways of addressing the issue and what their economic consequences are.  Because as we were discussing over breakfast, there are some areas where we have seen unintended consequences to some unanticipated, although I think most of us could have forecast that something would happen, when you move to something like corn-based ethanol and what impact that's having on the food supply around the world, not just in this country.

But leaving that aside for the moment, what I'd like to do is throw open just the broadest question.  What is the best approach to climate change?  There are a lot of things being suggested out there.  There are a lot of areas for discussion.  Right now, the focus seems to be on taking economic measures, whether it's tax on carbon, a cap and trade program, regulatory, doing it strictly through regulation, getting Congress to act. 

I'd like first to have the panel discuss a little bit about how they've approached and looked at this issue of climate change and what they see, off the top of their heads at the beginning, of probably what they feel is the best way to start to try to approach it. 

And maybe I'll just go down the line and, Ian, start with you.

IAN W.H. PARRY:  Okay.  Well, we favor economy-wide approaches to reducing emissions where you place a price on the carbon content of all fossil fuels in the economy.  And as that price is passed forward into fuel prices and electricity prices, that's going to exploit all low-cost opportunities for abatement throughout the economy.

There are two approaches to gauge in the appropriate price -- this broad-based approach is far better than just, you know, trying to pick winners or placing the entire burden of emissions reductions on the transportation sector or the power sector.  Far better, far more cost-effective to have an economy-wide approach where you raise the price of all activities which involve carbon emissions.  And so you exploit all of the low-cost options for abatement throughout the economy.

In economics literature, there are two approaches to gauging the appropriate price that we should put on emissions.  The first is sort of a benefit-cost approach where we attempt to measure the damages from current emissions in terms of the future global warming potential.  So here we're assessing to what extent emissions today will lead to future global climate change and have impacts on agriculture, risks to human health perhaps through the spread of tropical disease.  It's going to raise sea levels so we need to take into account the costs of protecting against rising sea levels and the loss of land that won't be protected.  We also need to take into account the possibility, the risks of more extreme climate scenarios knocking out large portions of world GDP. 

So there is a substantial literature that attempts to do this.  And most of the estimates come up with a price of about 5 (dollars) to $20 per ton of CO2.  Now, most of the studies use conventional or market-discount rates which some have objected to on ethical grounds.  But if you take the view that, you know, we should discount these long-range damages to translate them into current dollars, then you pretty much end up with a range of about 5 (dollars) to $20 per ton of CO2.

And if you (entered into ?) that policy, it would cut near-term emissions by something like about 5 to 15 percent, but then you would progressively ramp-up the policy over time.  Just to give you some idea, a $10 price on CO2 would increase coal prices by about 60 percent, but it would only increase the price of gasoline by about 9 cents per gallon due to differing carbon intensities of those fuels.

Now obviously, some analysts are not comfortable with this benefit-cost approach because it can't really handle the possibility of really an extreme climate scenario like a runaway greenhouse effect causing a warming of, say, 20 degrees Celsius.  So instead, these analysts are focused on an emissions pricing path over time that would be consistent with ultimately stabilizing global warming at acceptable levels.

So if you want to limit warming to about 3 degrees Celsius over longer term, really you should be pricing CO2 on the order of about 5 (dollars) to $20 per ton now.  But if, as many scientists think, we should be trying to limit expected warming to 2 degrees Celsius over longer term, really we should have a much more aggressive policy, and we should be pricing emissions in the order of about 25 (dollars) to $70 per ton of CO2.  Right now, the price of CO2 in the European trading system is about $35, so they're on the fairly aggressive end. 

Then just finally, as regards to the instrument, I think that ideally we should implement this emissions price through a revenue-neutral tax on CO2, on the carbon content of fossil fuels with credits for downstream sequestration activities like a carbon capture at power plants and also credits for forest re-sequestration.  But the advantage of a revenue-neutral CO2 tax is that you use the revenues from carbon taxes, which for a 10 (dollars) or $20 price on CO2 would be around 50 (billion dollars) to $100 billion a year.  So you're talking about a lot of revenues.  But if those revenues were used to cut other taxes in the economy, such as income taxes, payroll taxes, corporate income taxes, those taxes are all distortionary in the sense that they're a deterrent to work incentives or savings and investments.  And studies show that when you use revenues to cut the rates of these other taxes, you get a significant economic benefit, and that helps to keep down the overall costs of the policy.

So I would put the costs to the economy of a revenue-neutral CO2 tax of, say, 10 (dollars) to $20 in the order of about 1 (billion dollars) to $8 billion per year, which, to my mind, isn't that substantial. 

On the other hand, if we used a cap and trade system where you give all the allowances away for free or you go ahead with a carbon tax but you don't specify revenue neutrality up front in the legislation so there's a risk the revenues might ultimately fund wasteful public spending, then the costs of these -- well, depending on your project, you may be able to like fund some socially desirable programs -- but if the revenue's wasted and not used productively, the costs of these policies is substantially higher.

So I would put the costs of a cap and trade system with free -- (inaudible) -- placed a price on CO2 emissions in the order of 10 (dollars) to $20 at about 15 (billion dollars) to $40 billion per year.  So that's a much more substantial cost.

But the other argument for CO2 tax is that is fixes the price of emissions, and this helps to create a stable environment in terms to investing clean technology or energy R&D, unlike under a cap and trade system where the price of the emissions permits could be quite volatile.

So if instead we were to go ahead with a cap and trade system, I think it's very important, first of all, in the legislation we include provisions to limit the volatility of the permit prices.  In particular, I think it's important to allow firms to bank allowances during periods when there's downward pressure on permit prices and borrow allowances when there's upward pressure on permit prices. 

The European trading system is moving in that direction.  They do have full-allowance banking, but they don't allow for borrowed permits.  So that system is still vulnerable if there's, say, for example, a shock to natural gas prices.  The European trading system is still vulnerable that that could really jack up the permit price and cause severe disruptions.  So it's a pity they don't include borrowing provisions in the European trading system.

Then finally, if we were to go ahead with a cap and trade system, in addition I think that we should auction most or all of the allowances and then use the bulk of that revenue to cover the taxes.  And again, the European trading system, it's moved away from essentially 100 percent FIAT allowance allocation.  And the plan is now to transition to 100 percent allowance auctions by 2020, although it's not quite clear how that revenue would be used.

WHITMAN:  Richard, as someone who is actually doing it here in this country with the Chicago Climate Exchange, what's your take on this approach?

RICHARD L. SANDOR:  Christine, maybe just, for the audience sake, to put something in perspective, we generally talk about several approaches.  One is a command and control approach where you just simply say reduce emissions by 20 percent.  Then in the category of other policy tools, you have what are called flexible mechanisms, one being a tax and two being cap and trade.

And what cap and trade does, its says, okay, you have to reduce by economy-wide let's say 20 percent.  But it allows the flexibility for those who can reduce emissions by more than 20 percent to sell them to others who, for some reason, need environmental (siting ?), takes three years to install equipment, et cetera.  So they can hedge themselves by buying other people's reductions.

We're driven, Christie, by the EPA's SO2 program which, according to the EPA, emissions were to be reduced under the Clean Air Act of 1990 by 100 percent or cut in half from 18 million to 9 million tons.  The act was passed in 1990.  We indeed, economywide, have cut them from 8 (million) to 9 million.  The allocation was free.  The price has been very volatile.  The EPA estimates that 1 (billion dollars)) to 3 billion (dollars) is the nationwide cost annually.  In 2010, the savings associated with reduced medical expenses will be 100 billion (dollars) annually.  So there's a model of probably the most successful public program that we've ever had, which includes free allocation, simple cap and trade and no taxes. 

We happen to operate three exchanges worldwide.  I'm the executive chairman of the company called Climate Exchange, and we were very privileged to have Christie as one of our founding directors.  And Climate Exchange, the holding company, operates three exchanges.  One in Europe, the European Climate Exchange, and we have about a 91 percent market share.  We traded about 35 (billion dollars), $40 billion last year, and we're running at about double the rate now.  And it implements both CERs which are a U.N. tool to transfer technologies for the developing world.  And then it operates the European Union allowance system.

In the United States, we either operationalize public policy, as the Kyoto protocol in Europe, or in America we have something called the Chicago Climate Exchange which is a legally binding but voluntary program.  And it was started with a grant.  And I think Paula DiPerna is here.  And the Joyce Foundation funded us in 2000 to see if we could get a voluntary program going.  And everybody said, you'll never get it off the ground.  And the only reason we wanted to get it going was because we anticipated that U.S. policy would go there. 

From the moment we got the grant to when we started, everything that could have gone wrong went wrong.  I don't mean some of the things but everything went wrong.  We got the grant, and then the president pulled out of Kyoto.  And we were told nobody would ever join an exchange without the threat of public policy or public policy.  That was followed by 9/11, the Afghan war, the dot-com bursting, the stock market crashing, Enron imploding, a deep recession and a war in Iraq.  And that was the wonderful background of kick-starting this company.

We now have 11 percent of the Fortune top 102 companies -- Abbott Labs, Ford, Safeway, International Paper, Motorola; 17 percent of the Dow Jones -- IBM, Intel, DuPont, United Technologies, most recently Bank of America, as an emitter, okay, because they own so much building and burn so much fossil fuel; 20 percent of the top power companies -- American Electric Power, Detroit Edison, Alliant, Reliant in Texas, TECO, NRG, Allegheny, et cetera; two states -- New Mexico and Illinois; seven cities -- Chicago all the way to Melbourne; universities from Tufts in the east and, most recently, Scripps and UCSB in the west.  A group of companies that represent 16 percent of the United States stationary source emissions.  And if we were a country, we would be the largest trading country in the world.  Our emission baseline is 550 million tons which is bigger than Germany under the EU scheme.

I mention all of this in the context of the criticisms that are sometimes waged saying, you could never do this.  And the fact is we've done it.  It cost us $5 million.  The European Union, the United Kingdom's pilot program cost $300 million.  Our members were required to reduce emissions by 4 percent, and they've actually done it by 10 percent.  The cumulative reductions are 180 million tons which is actually close to the output of France and Belgium combined on the EU baseline.

So the message is it's being done, it is simple.  We will basically operationalize a national policy when either McCain, Obama or Clinton gets their cap and trade bill.  And the only message I can say to you is a lot simpler than anybody believes, you know.  It is easy to implement.  It's no cost to the public.  It's all borne by private investors.  We trade futures in SO2, about 4 (billion dollars) or 5 billion (dollars) a year.  We trade NOx futures. 

We're implementing, and the message is, to John Phelan and others, capital markets.  Give some incentives to people and there will be a lot of changes in behavior.  Markets work.  Set the price too high above the marginal cost of abatement and people build technology.  The price is below marginal cost of abatement then they buy allowances.  And as long as, as Ian said, you can bank them and you can do a lot of ways to fix the actual architecture of the market, it's pretty easy to implement.

So we're humble operators of exchanges, and we have a joint venture in Montreal.  And we just signed an MOU with Petro China to explore emissions trading in China where we have five members.  And we have five Indian members and exploring an effort there.

And I guess the message I'd like to get across is the markets are already moving.  They are getting globally linked.  And they are beginning to see meaningful reductions and having, I believe, attaining reductions at the least-possible cost. 

WHITMAN:  I would ask then, Dr. Socolow, to say, do we need to do anything?

ROBERT H. SOCOLOW:  For God's sake, yes!  (Laughter.)  No.  One way to start is, I think, for a group like you and the audience here, this is a risk management issue.  The -- (inaudible) -- you see got a Nobel Prize, and I think people didn't truly identify its most important contribution which was that it has spent a lot of time clarifying how large the uncertainties are in this problem.

I mean, when they proposed the consequences of climate change, there was a very wide error bar.  And we could be lucky or unlucky, and that's all inside the picture of the world that is being displayed by the IPCC.  So it is about buying insurance and is about terrible outcomes versus much-less-terrible outcomes.  So we are going to be betting the planet, and we have to react at some appropriate level.

My simple way of thinking about this problem is to follow the carbon atom.  It's coming out of the ground, 30 billion tons of carbon dioxide are going into the atmosphere.  And each year, when the carbon that comes out of the ground is burned, that's our number today globally.  The U.S. is a little under one-quarter -- 7 billion tons of CO2.

The atmosphere is going to tell the truth.  We're going to be able to keep track of that number.  There are an awful lot of ways of kidding ourselves.  And it's a very sticky system.  We've got lots of things we're committed to right now from the interior decorating and the view of what's a well-lit room through to the vehicles we've become very enamored of and are using it in more and more creative ways.

So this is going to be hard.  I do not think the word "simple" is correct.  I think we have institutions that are going to make a big difference.  For example, a very important principle is measure.  We've got to spend a lot of time not giving awards for buildings that look attractive and are supposed to do x but measure them after the fact.  And we don't like to do that.  I've been involved with energy efficiency and buildings as an area for 35 years.  The message has never really been accepted for good reason.  Who wants to know that their pet project didn't work?

Many of you are in the business of measurement.  You know the importance of measurement.  We're going to have to make that very critical when we start talking about what a given utility or company has saved or not saved.  I'm not saying these savings weren't realized, but we don't know if they were realized. 

And another one of these temptations is the offset method.  We have offsets trading at a different price from the high-quality product.  That tells you there's something inferior about them.  And the way I model that in my head is we have bonds rated AAA all the way to junk.  And we will have the same thing going on.  We will have transactions that make people feel good or that carry high risk but that don't get the job done.  And so we've got a very serious challenge.

To have a goal in people's minds that's easy to keep track of, it would be keep the same emissions globally as today some number of years in the future -- 25, 50 -- 30 billion tons of carbon dioxide emitted on the planet in 2030.  That is a much more modest goal than the one that people were talking about in Bali.  They don't want to settle for that.  I say keep that in mind and take that as a target.

The U.S. will have to come down from our current 7 billion tons for the world to stay at 30.  I mean, we are just too prosperous relative to everybody else.  We have the investment capital and so forth.  So we have to do less than our current emissions 25 years from now.

How are we going to do that?  Well, it's not that hard to track the carbon atom.  Forty percent of the carbon atoms come out of our power plants, 60 percent out of everything else globally.  And the U.S. fraction is a little lower than the world average.  It may be 35 because we've got more coming out of vehicles. 

And the third category is stationary emissions where furnaces are.  The power plant and the building go hand in hand.  Seventy percent of the electricity emitted from a power plant is consumed in a building with motors, with lights, with air conditioning equipment and other appliances.  We built power plants because we're building buildings not very well.  China is building power plants because it's building buildings not very well, one-to-one practically.  So we've got to deal with the building sector which tends to get lost when you say transport and power.

So we have to go across the entire economy.  One of the challenges with cap and trade is to catch most of the carbon.  The Europeans are settling for about half of the carbon emissions in their economies right now.  (Inaudible) -- by far the most exciting and adventurous policy initiative which is to put  a serious price on carbon.  They got it wrong the first time around, had too many allowances.  And I thought they'd get discouraged.  But January 1 of this year, they're starting round two.  And there is a political commitment there to keep the price around $35 a ton of CO2.

And so the other thing I want to say is you want to price high enough that things happen.  You can't get the price from cost-benefit analysis.  We don't know how to do the benefits.  These risks are uncertain in probability as well as magnitude.  And so we have to work backwards from saying, what will a given price induce, and what will a given price induce when coupled with specific policies that make those alternatives more appealing? 

You want to put CO2 below ground, we need a policy regime for crediting CO2 below ground, which we know we can do, but it's going to take some serious effort and some practice before we get there.  We need to induce renewables.  We need to induce efficiency in buildings.  We will have to do, I call it, price-plus.  That's my shorthand.  And the plus is a whole set of targeted initiatives which don't take a particular technology but do say we put CO2 underground, we're going to have to learn how to do it, and we're going to have to practice it at large scale and lots of places at once. 

And then we've got to build infrastructure.  Christine and I were talking about that at the breakfast table.  It should roll of the tongue that we've got an investment in infrastructure that is not going to get made through a cap and trade or a tax system.  It's going to be made any more than our highways were built that way.  If you think about that, they were built, in part, by a gasoline tax.  We have to build an infrastructure for power.  We have renewables, and they have to be brought 1,000 or 2,000 miles to unload. 

That's almost surely -- we don't have an electricity transmission system that resembles the highway system.  It isn't a national system.  We probably need to go there if we're going to move electricity a couple of thousand miles.

So we need integrity, we need commitment.  We need a high enough price that we don't end up with my shorthanded mitigation-lite -- L-I-T-E -- avoid mitigation-lite.  That will require these higher prices that Europe has.  And we can kid ourselves and have a lower price and have all the right words and an awful lot of tax (paying ?) and trading but not reduce the carbon emission.

So we're going to have to work backwards from, what does it take to get the carbon emissions of this country down?  And how are we doing at keeping score?  And it's relatively easy to keep score because if carbon comes out of the ground in this country or comes across the border and you know what that is every year.  The energy industry's doing a very good job with carbon bookkeeping.  So we'll be able to keep track of it.  We have to have on -- most of you don't know probably that we put 7 billion tons of carbon dioxide into the atmosphere.  And in this group, one-third of you do, and the public 1 percent does.  So we've got to get that number on the front page of USA Today every day or every month or something so we actually focus on a goal, or the equivalent.  So as I say, follow the carbon atom and realize how easy it's going to be to (carry ?) ourselves. 

And I guess two final things would be, one, every one of the solutions can be done badly.  And we've got to acknowledge that.  There isn't a wonderful alternative.  Conservation can bring unpleasant and self-defeating regimentation.  The nuclear problem really can go well or badly, and it has to be done globally to make a difference.  And with the institutions we have right now, it will probably increase the changes of nuclear war.  So we've got to improve those institutions.

And we can't think of the world as two tiers -- good people and bad people.  We're going to have to assume bad people and have a single system that works.  And the coal has to be cleaned up upstream as well as with carbon dioxide capture and storage.

And finally, in the global scheme, we've got to find way, and I think we can come up with one, where it is acknowledged that there are rich people in poor countries.  At the present time, half of the carbon emissions in the world are coming from the developed world and half from the non-developed world.  If you take OECD to be the developed world, 50-50 -- a little more than 50 now in the developing world -- it crossed a few years back.  And yet, per-capita emissions in the developing world are one-fifth of per-capita emissions in the developed world because there are five times as many people in the developing worlds.  So we've got to keep both facts in mind.

We can't, any longer, give a free pass to the developing world.  A few years ago, the framework we set up in 1992 in the Rio convention did not have any time at which the developing world initiatives kick in, so an indefinite free pass.  In the Montreal protocol, there was a 10-year forgiveness period.  There's an infinite forgiveness period in the way Rio was set up.  The grace period has to be over.  We have to say, with our developing country partners, you have as many emissions as we do.  It comes largely from people living approximately as we do or a small fraction of your population, a much larger fraction of ours.  But we are in this together.  Our lifestyles are parallel.

One of the things that I found extraordinary was this India World Bank -- (inaudible) -- and saying this is going to help the poor people in India.  No!  It's going to air condition office buildings in India.  We've got to deal with the fact that we have to all have the same programs because we're all living the same way.  Those billion of us out of 6 billion people, about 1 billion of us are putting most of those carbon atoms into the atmosphere by living well.

WHITMAN:  Well, before I turn it over to the audience here for questions, I would like to follow up just on what you finished talking about and throw it out to the panel.  Is it practicable to think of an economic model that would allow for the continued economic growth of the developing countries with a carbon-intensity target whereas an absolute carbon-reduction target for the developed nations?  Or is that something that would so skewer the economics in any kind of system regime you'd try to put in place that you can't do that kind of a separation?

SOCOLOW:  A really quick answer is that there's nothing wrong with cap which gets larger with time as long as it's getting larger with time more slowly than the economy would have done without that cap.  So China could have a cap that grows at 1 percent a year or 2 percent a year when its carbon emissions were set to grow 5 percent a year, and you would have carbon trading.  You don't have to mix intensity and cap.

SANDOR:  Yeah, I would agree totally with the comments that were just made.  I think you could reach for a smaller growth rate.  And actually we find that the people that we talked to, and we work with TADA and a few people in India and a few people in China, and they seem to be open to the fact that if they could grow at a lower rate but continue to grow so that they would have political stability, be able to feed the people and have a standard of living.  And I think if you couple that -- and I would go much more aggressive maybe than you might, Bob.  I would hope that cap and trade legislation that's before Congress would cut emissions here in the United States by 50, 60 percent and maybe up to 80 percent over a long period of time.

SOCOLOW:  I didn't give a number, but I wouldn't disagree with you.

SANDOR:  Oh, okay then.  I think you could cut it very aggressively in the United States as long as you allow the glide path of industry to adjust.  You did what SO2 did, you made it very light in the early years, people learn, and then you ratchet it down.  And I think if you had aggressive policies in the European Union, in the United States and a policy like Bob was mentioning in the developing world, you could achieve the goals of 30 billion or even less. 

And again, just to put it in an economist's terms and in somebody who runs a market, the carbon promises to be the largest commodity in the world.  If you take a look at -- and John, you'll appreciate this -- if you take carbon at $35 roughly Euro prices, you take 30 billion, and you do the arithmetic, that's a worldwide crop of carbon of $1 trillion a year, okay.  Just multiply those two.  If you take derivatives markets, they tend to trade 10 to 30 times the underlying crop.  So the corn production, the corn futures will trade 10 times, beans will trade 20 times, Treasury bonds will trade 30 times. 

So we're talking about a market that promises to be anywhere from 10 to 30 trillion a year, ultimately.  And by the way, I think it's reasonable because you tell me what the marginal value of error is, and I will say to you that you can't live in this planet without air.  So why shouldn't these public goods be valued at enormous prices?  They deliver life, and they have to be rationed.

WHITMAN:  Well, Beijing is facing some of that with the upcoming Olympics, no question about it.

Ian, did you have --

PARRY:  Well, just quickly, I mean, I think, ultimately, you know, ideally we should be aiming for a uniform price on CO2 throughout the whole world.  That's the ultimate goal because that's the most cost-effective way to reduce emissions when every country throughout the world is facing the same price on CO2.  But clearly, that's going to place greater burden on countries which have greater emissions intensity relative to GDP than others.

But I'm optimistic that there are ways that independent assessments can be made to gauge, well, what will be a fair system of trans (side ?) payments among countries to address these distribution or equity issues.  That we could come up with formulas for saying, well, if a particular country, based on its per-capita income and based on its emissions intensity, it's got a relatively much higher burden than a bunch of other countries.  I think there are ways that countries could agree on some formulas for side payments to roughly compensate for these concerns.

And that's what they've done within the European trading system.  Every country within the European trading system, whether it's, you know, Britain, Germany or Romania which has a substantially lower per-capita income than the other countries, every country has the same price on emissions.  But the European countries have come up with an agreed-upon formula to redistribute some of the emissions around so there's a way for the relatively wealthy countries to the relatively poor countries to make it worthwhile for the poor countries to still be in the agreement. 

So I guess I'm optimistic that that type of a formula could be more widely developed as other countries come into a broader international agreement.

WHITMAN:  Okay.  It's now time to open it to the audience.  I'd ask that you raise your hand.  There are microphones.  Wait until the microphone gets to you.  If you would stand and state your name and affiliation and limit yourself to one question, that would be wonderful.

Okay, in the back there.  Wait until the mike gets to you.

QUESTIONER:  Thank you.  Steven Kass, Carter Ledyard & Milburn.

My question is for Professor Socolow.  Cap and trade relies on a particular in its clean development mechanism, relies upon some independent verification for the avoided emissions.  Since both parties to a transaction have a similar incentive to inflate that number, these are supposed to be independently verified.  Absent that, you may not be insured.  As you indicated, that we're actually going to get the emissions reductions and cap and trade promises.  How much confidence do you have in the ability of independent verifiers to perform that essential function, particularly in view of the failure, for example, of the accounting industry to perform that in certain other well known areas?  (Laughter.)

SOCOLOW:  I think it's harder than just doing accounting well.  I have very little confidence that that offset process is going to save a lot of carbon because not only is the question what actually happened, but you have the tougher question, what would have happened if you hadn't had this transaction.  This is the issue called additionality.  It's extremely difficult to say that something wouldn't have happened.  And you have perverse consequences such as a country, and this is going on right now, declines to pass a law that would save carbon so that the offset would be demonstrably producing the carbon savings. 

So I think this international offset thing is really flawed, deeply flawed.  And my view is that the developing countries, particularly the ones that are emerging and transitional, growing rapidly should have their own carbon policies, complete at a national level, that set a tax or a cap and trade as we've just been talking about.  And there would be no cherry-picking from outside.  And that offset will be just an investment in that country as any other investment. 

And it's worse than just bad accounting, the consequences.  There is a lot of money being made on any transaction, but these are really perverse in many directions.

WHITMAN:  Richard.

SANDOR:  Yeah, I would agree that there are problems, and they will be addressed.  But I think we have to be guided by the fact that no matter how imperfect it might be and no matter how you might get it right, as Bob said earlier, or wrong, you might over allocate, I think that you've got to take action.  And you cannot let the perfect be the enemy of the good.

There will be measurement problems.  In some instances, they will be monitoring, and verification is very easy.  At the EPA, they put a continuous emission monitors on stacks.  And those are, you know, well known, easy technologies.  You can monitor anaerobic manure digesters and the methane that's taken out in some of those CDM projects.  And there are independent verifiers.  And the U.N. has been careful and loathed.  As a matter of fact, the criticism is that they're going too slow and spending a lot more time on monitor and verification.

But we are getting an infrastructure.  They will not work perfectly like any market will.  And it will have its problems from time to time as, you know, you implied about the current conditions that exist in today's capital markets.  But overall, I think we've got to move, and we've got to take action and recognize we're going to get some things wrong, and we're going to get some things right.  And we'll change those things as they did in Europe.  And they'll change the protocols that they are at the U.N.

But the choice is not for us to make.  This is such a serious problem that we've just to get on with it and do the best we can.  I'm driven by Santayana's quote, the Harvard philosopher in the 19th century, who said nature rules with a loose rein, and a vitality of any sort will muddle through any predicament in which reason would despair.  So I think he meant to take action, recognize if you bang into a wall, assess the damage and go after the wall again. 

And I think humankind -- and you've got people like Vinod Khosla working on cellulosic ethanol because he thinks he can make some money.  You've got Craig (Ventner ?) just raised $200 million based upon a $6 price on carbon to go out for three years and get genetically modified bacteria that eats sulfur and eats carbon.  I mean, there's a lot of creativity.

And you put this price on it, you're going to get a whole green tech industry.  I'd rather do that and have some errors in the system and police them and get rid of them than not have a U.N. process that deals with CERs, recognizing that I think 99 percent will be okay and maybe 1 percent we won't get right.  But the goal is to do something.

(Cross talk.)

WHITMAN:  Okay.  Another question right there.  Two of them coming at you.

QUESTIONER:  Thank you.  I'm Mark Levinson with JPMorgan Chase.

I had a question for Ian Parry.  As an economist, I'd like to believe that prices change behavior.  But I think that the empirical evidence shows that that's really not always true, particularly in the area of transport, all the evidence is that price elasticity of demand is extremely low and in fact is swamped by the income elasticity.  When people get richer, they drive more, they fly more.  And an increase in the price of doing that really doesn't make a whole lot of difference to them.  How do you deal with that in the context of reducing carbon emissions from vehicles?  What kind of mechanism do you think here works other than, frankly, a command-and-control type of mechanism?

PARRY:  Yeah, I think you're right that the behavior responses in the transportation sector are very limited because at the moment you don't have many alternatives to conventional motor fuels.  So for example, the evidence suggests that if you increase the price of gasoline by 10 percent over the long run as people drive their vehicles less and they demand more fuel-efficient vehicles, you'll maybe cut fuel consumption by about 4 percent.  So there's some response but it's pretty modest.

And that's why when studies look at what happens when you impose a uniform price on CO2 throughout the economy, a relatively modest portion of the emissions reductions comes from the transportation sector.  There's a much greater response within the power sector where there's more scope for fuel substitution, substituting away from coal to natural gas and to renewables and possibly down the road incorporating carbon capture and storage.

So yeah, I mean, it's tough in the transportation.  I mean, unless there's some additional market imperfection within the transportation sector, I wouldn't necessarily recommend any supplementary measures.  I think, you know, if you're not happy with -- it is tough, you know.  You have to impose these 5 (dollar) to $20 prices on CO2, and even then you're only going to cut emissions by 5 to 15 percent in the near term.  You know, you do need stiff prices to get substantial reductions.  But you know, if you're not happy with the progress in economywide emissions reductions, then I think you should jack up the economy wide price rather than trying to guess, oh, well, this sector's not pulling its weight; therefore, we should have supplementary additional regulations on that sector.

Unless there's some specific market imperfection that's been identified and is evidenced that there's a clear market failure there -- and you know, these are open issues.  In the literature, there are some people who think that people undervalue fuel economy improvements from vehicles and that's a justification for tightening CAFE standards in addition to raising carbon prices or gasoline prices. 

Other people think that people undervalue the energy savings from more efficient appliances or heating systems or fridges or whatever.  And therefore, they think that in addition to raising the price on carbon emissions throughout the economy, we should have supplementary measures tightening energy efficiency standards. 

But those are issues that are much disputed among analysts.  There's not much evidence on whether there are actually these additional market failings or not.  But if future evidence suggests that there is these additional market failures then, yes, in principle, they justify some supplementary measures.  But if there is an evidence of these supplementary market failures, I would just say raise the economywide price on emissions if you're not happy with the progress on emissions reductions.  And then just let the market decide which are the most cost-effective ways to respond to the higher price.

WHITMAN:  Let me just add a little something on that because just last year, as you probably -- I hope everybody here knows about the Energy Star program of the Environmental Protection Agency and Department of Energy.  Last year, purchases of environmental Energy Star products, to go to the uncertainty that you were putting out there, reduced the carbon equivalent of taking 27 million cars off the road and saved the necessity of building 50 new power plants in this country.  So there's a way to measure, and there are some very measurable results that are real from the voluntary programs.  It doesn't mean that that's enough, but you really can measure them.

We have another question over there.  We have lots of questions.  I'll try to get around to them.

QUESTIONER:  Thank you.  My name is -- (name inaudible).  I'm with Columbia University's Graduate School of Business.  I have two short, international-dimension questions on the international dimensions of the problem.  The first question is addressed to Dr. Parry and Dr. Sandor.  And the second question can be to any of the panelists.  In developing countries like China, India and Brazil make a lot of arguments against joining any international agreement that's binding on them.  Some are plausible arguments.  And one of the plausible arguments I've heard is that industrialized countries during the last (170 ?) years have emitted lots of stuff, you know, without paying for it.  And why should now they be subject to or bound doing the same thing?  Now, the question is, what is the best -- suppose we just, you know, industrialized countries, give them the credit of all the emissions we have but in the form of a dedicated, technical assistance.  What is the best way -- (inaudible) -- in dollar amounts, number one?  And with a feasible amount, that's question number one.

Question number two, also on international dimension, I do research on corruption, tax evasion, accounting fraud and so on.  And one of the questions in this area is, you know, verifiability.  So I mean, I imagine some of the missing activities are easily checked, verified, measured, others are perhaps less.  So this is maybe an engineering question, maybe -- (inaudible) -- question, maybe economic question.  The question is, you know, how difficult is it to properly measure and verify those emission activities once a globally binding activity agreement is in place, particularly monitoring those activities in a developing country?  Thank you.

WHITMAN:  Richard, do you want to star with that one?

SANDOR:  Yeah, you know, the first question on equity, I think, you know, Professor Socolow spoke to it earlier and I believe is the right approach is the equalize that and to make sure there's political stability, you would not demand a cut from them, you would just have an increasing rate but not quite as high as it might be in order to get a political buy-in from them.  And I think that at some particular point, with China's economy, GDP -- it's now the second-biggest economy, it just passed Japan -- there will be a buy-in.  Maybe it will take five or six years of slower rates of growth but I think there will be, and India similarly.  India, with only an 8, 9 percent GDP growth rate, won't be as much.  But I think Professor Socolow's approach is, you know, just reach for the stabilization. 

As far as the corruption, it's unambiguously a problem.  And it's a problem that you have to address very, very carefully.  The monitoring and verification, you can, in cases of China has an SO2 program.  And it has what are called scrubbers which are chemical factories that take the sulfur out of the flue gas.  Well, you know, I've heard of instances where they just turn them off, you know, or jig with them.  And I'm sure it's done in the U.S.  I'm sure it's done around the world with different degrees of dishonesty.  But you know, you have to recognize that this will go on and build your enforcement procedures as tightly as possible.  And I think, just like in the criminal system, you won't catch everybody.  But if you get a good enough job done, you'll catch 98 percent of them.

WHITMAN:  Ian, did you -- (inaudible) -- and then Bob.

PARRY:  Well, just quickly, I mean, to bring in a developing country has got to make it worthwhile.  In a sense, they've got to be made better off from being in the agreement from being outside the agreement, which clearly, to my mind, means that, you know, we're going to have to have transitory (side ?) payments to make them really want to be in the agreement. 

And then once we've got them wanting to be in the agreement because they're getting this compensation, you know, in a tax system, this would just be, you know, some of the tax revenue from the wealthier countries gets redistributed according to some formula to the developing countries.  Or under a cap and trade system, you'd bring them into the trading system but give them relatively lax emissions targets, possibly even have quotas for them, which are about at their current emissions levels, possibly even a little bit greater, to give them some incentive to want to join the coalition. 

And once they have that incentive, then you can say, look, to be in this coalition and to make you better off, we have to develop some accounting practices to measure the fossil fuels.  And you know, we have to have international inspectors coming in.  And you know, if the program is focused on fossil fuels, which is should be, it shouldn't be a downstream program.  It's much harder to track CO2 in a downstream program that's focused on the power sector or the transportation sector.  Far better to have it upstream on the fossil fuels and just keep track of all the fossil fuels produced in the economy and coming into the economy.  Just develop accounting procedures that can be verified by international inspectors to account for the fossil fuels and then, you know, we know the emissions factors for those fossil fuels.

In addition, there's various downstream activities like carbon capture and sequestration.  But there again, you know, we can say, well, if you want to be in this agreement, we have to verify when you have carbon capture.  And therefore, you have to have continuous emissions monitoring systems installed in the smoke stack.  And then we can, you know, then we can meter and make sure that these things are switched on the whole time rather than turned off.

Similarly in the forestry sector, through satellite photography and aerial photography, we can get some measure, we can get an overall picture of land-use changes in Brazil or Indonesia, wherever where there may be changes in forestry.  And through the photography, we can gauge which tree species are there so we can get some rough idea of what's happening to the carbon that's either being released through deforestation or that's being stored through land-use changes.

So I guess, in principle, I think that these are problems that can be overcome if we give developing countries incentives for them to want to be in the agreement because they benefit up front.  This compensation will be phased out over time.  But in the near term, they all want to be in the agreement because they're better off.  They want these transfer payments and (side ?) payments.  And therefore, it's in the interests of both parties to come up with some scheme for measuring fossil fuels and various downstream activities for capturing emissions.

And again, on the historical emissions, I mean, that's obviously a really important point.  But again, we can have independent analyses saying, well, suppose that, you know, we force rich countries to pay a price, say $10 per ton -- for all the emissions they've released into the atmosphere.  Or we can say, well, you got 50 years' worth of emissions into the atmosphere for free.  What would that be equivalent for other countries coming into the agreement.  You could work out roughly how much, effectively un-priced for the rich countries, under different prices for CO2 -- $10, $20, $30. 

And again, I'm optimistic that there would be some hope for bargaining over what would be a fair price to transfer to developing countries to say, well, you didn't get these early emissions for free.  You have to pay for the emissions.  And therefore, you are justified in obtaining some compensation.  But we can work out what that compensation would be under different emissions prices.  And I guess I'm optimistic that we could work out some fair scheme that would be acceptable to both parties if they have incentives to want to be in this agreement.

WHITMAN:  Bob, did you have something you wanted to (add ?) to this?

SOCOLOW:  Yeah, well, first of all, the first question, sometimes called the legacy question, we put CO2 into the atmosphere, we have raised the CO2 concentration by one-third relative to the pre-industrial time.  That's a very particular amount of carbon. 

The legacy numbers, if we really took them into account in some serious way, they would not make a big difference in the way we're thinking about the world.  Fifty years ago, we emitted five times less CO2 than we do today -- 1950 compared to today.  So we have done most of those emissions in the last 50 years.  And we were already pretty developed in the U.S. in 1950 with emissions that altogether haven't amounted to very much.  I'm talking fossil fuels, and it's hard to figure out what our deforestation costs and so on.

There's perhaps two-thirds, one-third, industrialized and developing-country emissions up to now.  And already 50-50 or 55-45 in favor of developing countries.  It's emotionally charged, and we should say legacies need to be taken into account when you're talking any international audience because it diffuses something.  But quantitatively, it's not a very big deal.

And the developing countries' self-interest -- two more things than the ones that were mentioned.  First of all, developing countries have real potential for damage from climate change.  They have their own very serious risk management questions because the worst alternatives are pretty terrible in terms of losing river flow and things of that kind all over the developing world, including the transitional countries and the poorest countries.  And most of what we're talking about in terms of carbon markets is about those richer countries.

And the other is self-determination.  There is something not very pretty about these CERs when you go into another country and you cherry pick.  If they have their own carbon policies, they determine how their country is run, and they drive their own investments toward efficient buildings, toward efficient power plants and so forth, some of which the West participates in, some which it doesn't.  They're in charge of their own minds.

But we have this two-tier world institutionalized in the Rio convention, 1992, 16 years of it.  It was the best people could do.  In this city they negotiated it.  It was the best they could do for various reasons that I hope historians will pick apart.  But it doesn't solve the problem.  And so we have to go past the two-tier world in 2012, and this is the right group to start thinking about or to continue to think about how we actually do it.

I want to say one last thing because there is an extra problem that I've become aware of that I'd like this group to think about.  When we talk about the U.S. and we talk about the next 10 or 15 years, we have a lot of sunk costs in our power system.  And nobody wants to retire any coal plant or any nuclear plant.  But rather, the entire political lament in this is toward life extension in both -- 300,000 megawatts of coal, 100,000 megawatts of nuclear.  If we take efficiency seriously, we may not need much more power in this country if we also refuse to retire any.

And so we have people chomping at the bit in the nuclear community to build the next-generation nuclear plants and the coal community -- not them but people joining them, like me -- attach capture and storage to new coal plants.  And we've got the renewables people with all kinds of ideas on how to add hundreds of gigawatts of renewables.  That's going to happen mostly abroad, I'm afraid.  And therefore, our own technological frontier is going to have to be expressed abroad if we can't retire existing plants.  And that feature is unlike any developing country's feature where they're building new stuff because they haven't got much in the ground.

We love life extension.  We haven't confronted the implications of loving life extension in both nuclear and coal.  That's a lot of power that is going to be kept there.  And you know how these industries are going to behave.  They'll put almost anything on as a bargain to keep going because the entire plant is written off already.  So we have to think about that as a special U.S. issue in carbon management.  I don't know the way around it.  It obviously makes more prominent the idea of capturing CO2 from an existing coal plant, for example.  And that requires technologies that we know are pretty expensive but then issues we didn't build the coal plants where carbon storage was nearby in many instances.  Some instances yes, some no.  People talk about the plant itself not having a lot of room around it.  We'd much rather start fresh, but we've got this enormous sunk costs.

WHITMAN:  Well, I know there are a host of other questions out there, but given the time and the council's desire to keep on time so you all can keep to your schedules, I'm afraid we're going to have to end this.  But you always want to end it with people wanting more so you'll come back again.

I want to thank our panel.  I think you couldn't have had a more excellent group.

(Applause.)

Thank you all very much.

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