Cap and Trade’s Economic Impact

Six experts weigh in on the consequences for the U.S. economy if Congress creates a greenhouse gas cap-and-trade system.

March 10, 2009

Expert Roundup
CFR fellows and outside experts weigh in to provide a variety of perspectives on a foreign policy topic in the news.

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Climate Change

President Obama has pledged to combat climate change and has asked Congress to pass legislation to lower U.S. greenhouse gas emissions. Concerns over economic costs have stymied attempts at federal policy in the past, and during the economic crisis it may prove even harder. The debate over U.S. climate policy comes amid lingering doubts by a majority of the U.S. public (TIME) about whether climate change should be a priority. And new studies questioning the effects of climate change -- such as a recent study that estimates the West Antarctic ice sheet will melt in thousands and not hundred of years (Nature) -- help reinforce those doubts. Despite possible hurdles, the president’s first budget assumes that a cap-and-trade system for greenhouse gases will be up and running by 2012 and will begin generating revenues for the U.S. Treasury. asked six experts what impact a cap-and-trade system would have on the U.S. economy if it were imposed right now.

Michael A. Levi

Capping and hence pricing carbon immediately, while we’re still in a recession, would be unwise, but no one is talking seriously about doing that. Passing legislation now that would cap emissions starting in a few years would probably have a small but positive net impact on the U.S. economy. A delayed cap wouldn’t impose any immediate costs on U.S. consumers. It would, however, do two good things:

First, it would reduce current uncertainty about the shape of future greenhouse gas regulations. Uncertainty is a deterrent to investment. Passing cap-and-trade legislation soon would thus (at least marginally) help unlock spending.

Second, it would remove pressure to implement far clumsier regulations under the Clean Air Act, which was not designed for tackling the sort of broadly distributed and extraordinarily varied emissions sources that drive climate change. Using the Clean Air Act to regulate emissions would likely be far more expensive than using a cap-and-trade system; anything that makes the first path less likely, then, would be an economic plus.

That said, there are places where we should be cautious. There’s substantial interest in Congress in including "carbon tariffs" in a climate bill. Such tariffs could have dangerous reverberations at a time when global support for trade--a critical engine of economic growth--is strained. And don’t count on a cap-and-trade system to deliver a big long-term economic boost. Jobs created in new energy industries will probably be roughly offset by job losses elsewhere (both in traditional energy and in the balance of the economy). Ultimately the best economic boost will come from economic policy based on sound fundamentals. The core goal in designing climate policy should be to do the most good for the climate at the lowest price.

William Yeatman, Energy Policy Analyst, Competitive Enterprise Institute

A cap-and-trade system necessarily harms the economy because it is designed to raise the cost of energy. Given the current economic crisis, an expensive energy policy is a bad idea.

Almost all acts of economic production are powered by combusting fossil fuels (coal, oil, and natural gas), a process that emits greenhouse gases thought to cause global warming. A cap-and-trade system is simply a mechanism to put a price on emissions in order to compel businesses and consumers to emit less. That is, it’s essentially an emissions tax. But greenhouse gas emissions are virtually synonymous with energy use, so it’s actually a roundabout energy tax. In fact, economists agree that the simplest, most efficient way to reduce emissions is a direct tax. Politicians, however, are terrified of the "t-word," which is why they have embraced a cap-and-trade system.

Crisis Guide: Climate ChangeThe numbers are staggering. President Barack Obama’s recently unveiled cap-and-trade plan would raise $645 billion in revenue from the government-run emissions auctions over eight years. Everyone would feel the pinch. Businesses would compensate for higher production costs and diminished markets by slashing jobs. Consumers would have to pay more for energy and energy intensive goods.

Expensive energy is bad enough, but the real danger of a cap-and-trade policy is a global trade war. A cap-and-trade system would give a competitive advantage to industries in countries that aren’t subject to a de facto energy tax. Jobs would flow overseas, but so would emissions, a dynamic known as "carbon leakage." To prevent this, a broad coalition of industry, labor, and environmental groups have expressed interest in a tariff that would tax the emissions content of imports from countries without stringent climate policies. Naturally, these countries would retaliate if such a tariff were enacted. Protectionism deepened the Great Depression, just as climate protectionism would worsen the current recession.

Mark Tercek, President and CEO, The Nature Conservancy

Contrary to what may be a developing strain of conventional wisdom, strong policies to reduce climate emissions, such as a market-based cap on U.S. greenhouse emissions (also known as "cap and trade"), can provide a form of stimulus to the U.S. economy. As during the Great Depression and other recessions, the U.S. economy is suffering from a shortfall in aggregate demand -- the collective willingness of American consumers and businesses to buy goods and services. Just one example: New car sales have fallen from roughly 17 million vehicles per year just a few years ago to just over half that number today. This phenomenon ripples throughout the economy and builds on itself. What is needed is a strong shock to the system--just the sort of shock that the president’s recovery package was intended to administer.

That shock may be short-lived, however, unless there is a strong sustained basis for continued investment. As the 1930s came to a close, it was World War II that finally provided that function, with the war effort driving up demand for goods and services. Today, by driving private investment in zero- and low-carbon technologies and boots-on-the-ground conservation efforts to reduce net carbon emissions, a national market-based cap on carbon that tightens over time can act as a long-term driver for demand.

A cap-and-trade system will not only lower emissions and fight climate change, but also will stimulate the economy. In the short run, it will spur investment and create jobs; in the long run, it will accelerate the deployment of a new productive generation of capital stock.

One element that should not be neglected is our nation’s natural capital. The administration has prudently suggested that a portion of money generated from the sale of carbon allowances under a cap-and-trade system should go toward critical conservation projects that will ensure our natural resources survive the impacts of climate change. Such investments will not only protect our natural resources, but contribute to generating jobs and income through fisheries, forestry, agriculture, recreation, and other industries that rely on healthy productive lands and waters.

Sergey V. Mityakov, Assistant Professor, Department of Economics, Clemson University

Restricting carbon emissions by cap and trade is probably not a good idea even in a booming economy. Many studies assessing the costs of mitigation of climate change (either through some cap-and-trade system or by means of a carbon tax) indicate that the losses in consumer welfare are likely to be enormous. At the same time the costs of climate change itself are not very well estimated to justify swift mitigation efforts; different studies produce different recommendations. Thus, there is no clear consensus among the scholars whether and when such a scheme should be implemented in the first place.

In the case of a recession, additional negative shock to the economy in a form of cap-and-trade system seems like even a worse idea. If cap and trade were created now, it would lead to higher energy prices for American consumers and businesses, as energy producers would be forced to switch from cheaper and "dirty" fuels such as coal to "cleaner" and more expensive sources of energy.

Thus, it is likely to hit American households through the following channels. On the one hand, consumers are going to suffer directly from the increased prices of the energy and energy-intensive goods they buy. On the other hand, higher energy prices will increase the production costs of American producers, making American-produced goods less competitive in the world market. This would tend to make the current recession even more severe, as businesses, which cannot compete against foreign producers, would close. Facing increased energy costs and competition from abroad, some American companies would have an incentive to shift their production overseas where no cap-and-trade system is operating. These adverse effects on producers are likely to lead to additional job losses in the United States, further increasing the costs of the recession for the American households.

I think we should carefully analyze the costs of climate change to see whether they are indeed worth such sacrifices. Probably it is a better idea to postpone this decision until the current economic downturn is over.

Rick Duke

At first glance, passing carbon cap legislation in the midst of the still worsening "great recession" may appear ill-advised. In fact, moving to control global warming emissions now can help us put the world back to work while containing the growing threat of climate change.

Passing climate legislation in 2009 would not impose a price on pollution until the cap goes into effect, in 2012 at the earliest (once the administrative details have been sorted out). Upon passage, the law would reduce investor risk by clarifying long-term carbon reduction goals. This is a prerequisite for anyone contemplating capital-intensive clean energy investments, ranging from combined heat and power efficiency upgrades to scaling up the nascent wind, solar, and carbon-capture industries.

A well-designed 2009 law could also enable fiscally responsible stimulus spending during 2010 and 2011 by providing a carbon allowance revenue stream to pay back the Treasury once the cap goes into effect. For example, the legislation could extend stimulus spending for efficiency and renewables past 2010 and authorize immediate launch of a new facility to provide credit enhancement for energy efficiency and renewable energy investments.

Countering the global recession requires decisive stimulus spending paired with a long-term plan to restore fiscal balance. Otherwise we risk a Japan-style lost decade and the dual trap of zero short-term interest rates compounded by chronic deficits, leaving the government increasingly powerless to restart growth.

It is tempting to hunker down and simplify in response to the worsening economic crisis--but in this case bolder policy reduces risk. Carbon caps put essential guardrails in place to enable aggressive stimulus spending and unleash private investment that will leave a legacy of a cleaner and more secure energy economy.

Trevor Houser, Visiting Fellow at the Peterson Institute for International Economics and Director of the Energy & Climate Practice at the Rhodium Group

President Obama has indicated that addressing climate change is not only possible during the current economic crisis, but required to lay the foundation for future economic growth. To evaluate this claim, it’s important to understand the instruments used to reduce greenhouse gas emissions, and the timetable in which they will be implemented. The national cap-and-trade legislation that President Obama has called for and that the U.S. Congress is currently drafting wouldn’t impose any costs on the economy until 2012 at the earliest, by which time we should be on more stable footing.

While the politics of passing such legislation in the midst of an economic crisis are challenging, the economic arguments in favor of doing so are compelling. Uncertainty about the health of the financial system has slowed the rate of new investment dramatically. In the energy sector, this is compounded by uncertainty about the Washington’s approach to climate policy. Signaling clearly to markets the targets and timelines for U.S. emissions reductions will help provide investors with the ability to start preparing today for the transition to a low-carbon economic future.

The cost of making that transition will depend largely on the ability of firms to access low-carbon technology in time to meet the emission-reduction schedule called for in legislation. The good news is that overall U.S. emissions, as well as the cost of cleaner fuels and renewable energy equipment, has declined as a result of the current crisis, making it cheaper to meet emission-reduction goals. The bad news is that fossil fuel prices have dropped as well, eroding the incentive for further clean-tech innovation in the absence of a price for carbon. To ensure that adequate alternatives are available once that price is imposed, policymakers need to prime the pump with targeted investments in low-carbon technology and enabling infrastructure. The American Recovery and Reinvestment Act made a good start on this, with roughly $100 billion in climate-friendly investment. The challenge now is ensuring this money is well spent and that emission-reduction timelines match technological reality.