Contents Summary Policy Options for Reducing Emissions Results of CBO’s Analysis Comparison of Policies’ Efficiency Comparison of Policies’ Implementation Comparison of Policies’ International Consistency Chapter 1: Efficiency Implications of Different Policy Designs A Carbon Dioxide Tax Versus an Inflexible Carbon Dioxide Cap An Illustrative Example of How a Tax Would Be More Efficient Than a Cap Empirical Estimates of the Efficiency Advantage of a Tax The Impact of Price Volatility Conditions Under Which a Cap Could Be More Efficient Than a Tax Other Efficiency Implications of a Tax or a Cap Flexible Cap Designs A Ceiling or Floor on Allowance Prices Banking and Borrowing Allowances Circuit Breaker Chapter 2: Implementation Considerations for Different Policy Designs A Carbon Dioxide Tax Versus an Inflexible Carbon Dioxide Cap Flexible Cap Designs A Carbon Dioxide Tax Versus an Inflexible Carbon Dioxide Cap Harmonizing a U.S. Tax on CO2 With Policies in Other Countries Linking a U.S. Cap-and-Trade Program With Outside Cap-and-Trade Programs Flexible Cap Designs Appendix A: Current and Proposed Cap-and-Trade Programs in the United States and Europe U.S. Programs for Sulfur Dioxide and Nitrous Oxide U.S. and European Programs for Greenhouse Gases Figures 1-1. Illustrative Comparison of Various Policies to Reduce CO2 Emissions Under Different Cost Conditions 1-2. Relative Economic Efficiency of Various Policies to Reduce CO2 Emissions, When Cost Uncertainty Is Taken Into Account 1-3. Volatility of SO2 Allowance Prices and Selected Other Prices, 1995 to 2006 1-4. Illustrative Range of Net Benefits for a Cap With a Safety Valve Compared With a Tax or an Inflexible Cap on CO2 Emissions Table 1. Comparison of Selected Policies for Cutting CO2 EmissionsFEBRUARY 2008PolicyOptions forReducingCO2 EmissionsCONGRESS OF THE UNITED STATESCONGRESSIONAL BUDGET OFFICEAS T U D YCBO© JupiterImages Corp.Pub. No. 2930The Congress of the United States O Congressional Budget OfficeASTUDYCBOPolicy Options for Reducing CO2 EmissionsFebruary 2008PrefaceThere is a growing scientific consensus that rising concentrations of carbon dioxide (CO2) and other greenhouse gases, which result from the burning of fossil fuels, are gradually warming the Earth’s climate. The amount of damage associated with that warming remains uncertain, but there is some risk that it could be large and perhaps even catastrophic. Reducing that risk would require restraining the growth of CO2 emissions—and ultimately limiting those emissions to a level that would stabilize atmospheric concentrations—which would involve costs that are also uncertain but could be substantial. The most efficient approaches to reducing emissions of CO2 involve giving businesses and households an economic incentive for such reductions. Such an incentive could be provided in various ways, including a tax on emissions, a cap on the total annual level of emissions combined with a system of tradable emission allowances, or a modified cap-and-trade program that includes features to constrain the cost of emission reductions that would be undertaken in an effort to meet the cap. This Congressional Budget Office (CBO) study—prepared at the request of the Chairman of the Senate Committee on Energy and Natural Resources—compares those policy options on the basis of three key criteria: their potential to reduce emissions efficiently, to be implemented with relatively low administrative costs, and to create incentives for emission reductions that are consistent with incentives in other countries. In keeping with CBO’s mandate to provide objective, impartial analysis, the report contains no recommendations.The study was written by Terry Dinan of CBO’s Microeconomic Studies Division under the guidance of Joseph Kile and David Moore. Robert Dennis, Douglas Hamilton, Robert Shackleton, and Thomas Woodward provided comments. Outside CBO, William Pizer of Resources for the Future, Reid Harvey of the Environmental Protection Agency, and Martin Weitzman of Harvard University provided comments. (The assistance of external reviewers implies no responsibility for the final product, which rests solely with CBO.)Christine Bogusz and Christian Howlett edited the study, Sherry Snyder proofread it, and Angela McCollough prepared the final draft of the manuscript. Maureen Costantino prepared the study for publication, designed the cover, and took the photograph of the traffic on the cover. Lenny Skutnik printed copies of the study, Linda Schimmel handled the distribution, and Simone Thomas prepared the electronic version for CBO’s Web site (www.cbo.gov).Peter R. OrszagDirectorFebruary 2008ContentsSummary vii1Efficiency Implications of Different Policy Designs 1A Carbon Dioxide Tax Versus an Inflexible Carbon Dioxide Cap 2Flexible Cap Designs 82Implementation Considerations for Different Policy Designs 15A Carbon Dioxide Tax Versus an Inflexible Carbon Dioxide Cap 15Flexible Cap Designs 173International Consistency Considerations for Different Policy Designs 19A Carbon Dioxide Tax Versus an Inflexible Carbon Dioxide Cap 19Flexible Cap Designs 21ACurrent and Proposed Cap-and-Trade Programs in the United States and Europe 23VI POLICY OPTIONS FOR REDUCING CO2 EMISSIONSTableS-1. Comparison of Selected Policies for Cutting CO2 Emissions xFigures1-1. Illustrative Comparison of Various Policies to Reduce CO2 Emissions Under Different Cost Conditions 31-2. Relative Economic Efficiency of Various Policies to Reduce CO2 Emissions, When Cost Uncertainty Is Taken Into Account 61-3. Volatility of SO2 Allowance Prices and Selected Other Prices, 1995 to 2006 71-4. Illustrative Range of Net Benefits for a Cap with a Safety Valve Compared With a Tax or an Inflexible Cap on CO2 Emissions 9SummaryGlobal climate change is one of the nation’s most significant long-term policy challenges. Human activities are producing increasingly large quantities of greenhouse gases, particularly carbon dioxide (CO2), which accumu-late in the atmosphere and create costly changes in regional climates throughout the world. The magnitude of such damage remains highly uncertain, but there is growing recognition that some degree of risk exists for the damage to be large and perhaps even catastrophic. Reduc-ing greenhouse-gas emissions would be beneficial in lim-iting the degree of damage associated with climate change. However, decreasing those emissions would also impose