Interaction Effects of Market-Based and Command-and-Control Policies.

AuthorTuladhar, Sugandha D.
PositionReport
  1. INTRODUCTION

    Scientific evidence continues to indicate that anthropogenic emissions of greenhouse gases are a significant contributor to global climate change (IPCC, 2007). Mitigating the impact humans have on the global environment will require significant reductions in GHG emissions. Many scientists believe global GHG would need to decline over the next 40 years by at least 50% from today's levels to prevent global average temperatures increasing by more than 2[degrees]C. Achieving this level of reductions will be quite challenging.

    The landscape for U.S. carbon policy has evolved significantly over the past several years. As recently as 2009, there were multiple legislative proposals moving through Congress aimed at establishing a national cap-and-trade system for reducing carbon emissions throughout the economy. However, in the wake of the financial crisis and shifting political sentiments, these market-based economic instruments have more or less been scrapped and replaced with proposals for command-and-control regulatory mandate frameworks. These federal frameworks have primarily been proposed at the sector level, in the cases of a national renewable energy standard (RES), a clean energy standard (CES), a national renewable fuels standard (RFS) for transportation fuels, or a national fuel economy standard (CAFE), or even at a unit level. At the same time, several states and regions are developing and implementing their own versions of carbon legislation, such as the sectoral cap-and-trade Regional Greenhouse Gas Initiative (RGGI) program and the combination mandate and cap-and-trade system in California as a result of AB 32. Policy design is moving away from singular and comprehensive policies to multiple and narrowly-focused policy regimes. This variety of specific and potentially overlapping regulatory regimes creates a complex policy landscape with many potential unforeseen risks and unintended impacts.

    This paper investigates two important approaches to reduce GHG emissions in the U.S.: policy prescriptions and introduction of new technologies. The choice of policy is crucial to the availability of capital to develop new technologies and achieving GHG reductions in the most cost-effective manner. Technological breakthroughs and advances in energy efficient technologies are required if the world is to curtail emissions by a meaningful amount while maintaining economic growth. This paper addresses these two aspects by constructing a set of scenarios that varies largely over two dimensions: (1) assumptions about emissions reduction policies and (2) assumptions about technology.

    To understand the implications of policy choice, we run scenarios that range from being purely market based such as a cap-and-trade program to policies that are completely command-and-control such as a policy that employs vehicle fuel efficiency standards, emission intensity standards for transportation fuels, and an emissions intensity standard for electric generation. This paper also considers hybrid policies that have both a cap-and-trade program and some command-and-control measures.

    Much of the work in this paper builds on a body of work that began in 2007 with an analysis of California's AB 32 policy. (1) The analysis in this paper uses a similar modeling framework to that of Tuladhar et al. (2009) who showed that a national Low Carbon Fuel Standard (LCFS) when combined with a national cap-and-trade program increases overall costs to the economy. Tuladhar et al. (2012) used the [N.sub.ew]ERA model to analyze economic efficiency tradeoffs and energy price effects associate with a clean energy standard with a carbon tax policy. Karplus et al. (2012), (2) using a computable general equilibrium model, showed that cost of meeting a greenhouse gas emissions constraint increases when a fuel economy standard is combined with a cap-and-trade policy. Rausch et al. (2012) (3) examined the efficiency and distributional impacts of combining clean and renewable energy standards. They show that command-and-control polices entail significant efficiency costs when compared to a carbon tax or a cap-and-trade program. Clean energy standard policy and renewable energy standard could two and four times than a market-based policy. Morris et al. (2010) (4) analyzed the effects of combining a renewable portfolio standard with a cap-and-trade system for the U.S. using a computable general equilibrium model. This study found that the introduction of RPS increased the welfare cost by 25% over the life of the policy relative to a cap-and-trade system only. Our paper contributes to the current literature in three aspects. One, we bring in multi-sector command-and-control policies within a modeling framework that links a "bottom-up" with a "top-down" economic model. Unlike previous analyses, this approach allows us to look at possible efficiency costs associated with cross sectoral distortions. Second, we show the implication of a combined policy on the price of carbon, which is largely omitted from the literate discussion. Third, we further validate the findings of the other analyses that there are efficiency costs associated with combing command-and-control policies with market-based policies.

    To compare the cost-effectiveness of the different policies we map out the economically efficient frontier and plot the cost-effectiveness of the command-and-control policies and hybrid policies relative to this frontier. The farther that a policy is away from this frontier, the more inefficient it is.

    In considering the effect of technology on the feasibility of achieving needed emission reductions, this paper considers three discreet and diverse sets of scenarios that vary by technological assumptions.

    * Nuclear and Carbon Capture and Storage (CCS) will advance as will the efficiency of end-use technology, but large amounts of renewables will be slow to develop;

    * Renewables will be prevalent, but no new nuclear and CCS will be allowed. As in the first set, efficiency of end-use technology is assumed to advance at a pace faster than in recent history; and

    * Nuclear and CCS will be abundant, but the efficiency of end-use will advance slowly.

    To understand the importance of end-use energy efficiency and technology, we compare the cost of cutting emissions by 0% to 80% of 2005 levels by 2050. The model results suggest the maximum emission reductions each technology bundle offers. These runs help inform one about the realistic level of reductions that could be achieved by 2050.

    To achieve significant emission reductions, an economy must, in addition to having significant technological advances in supply side resources, improve its end-use energy efficiency. To understand the importance of energy efficiency, we compare the 50% reduction scenarios under two polar assumptions about the evolution of end-use energy efficiency.

    In addition, resulting permit prices for the series of scenarios that assume different emission targets for 2050 trace out a marginal abatement cost curve. Viewing this curve suggests what level of emission reductions might be politically feasible and at what point there are diminishing points of return or some other technological breakthrough not modeled in this analysis would be needed.

    The remainder of this report is organized as follows. Section 0 describes NERA's modeling system and the scope used for this analysis. Section 0 lays out the scenarios that we analyzed. Then we highlight the key results of the analysis in Section 0. We conclude in Section I.E with insights about policy design and technology assumptions.

  2. [N.sub.EW]ERA MODEL STRUCTURE AND SCOPE

    To conduct this study, we used NERA's [N.sub.ew]ERA integrated model, which consists of a top-down, general equilibrium Macro model of the U.S. economy, and a detailed bottom-up model of the North American electricity sector.

    The [N.sub.ew]ERA model is used to project impacts of command and control regulations and market-based policies on the economy as a whole and at a sectoral level. Different types of policies could impact a sector in a variety of ways. If a policy leads to an increase in the cost of a factor of production then the policy would have a direct effect of raising the cost of production. A policy that mandates a sector to invest in new capital expenditure would lead to an increase in its production cost through higher cost of capital. Cost of production of a sector (e.g., the natural gas sector) would increase if there are constraints in harvesting the resource. These constraints could arise due environmental concerns or technical barriers, which could have impacts on the entire economy. To account for such effects, one needs to use a model that captures the effects as they ripple through all sectors of the economy and the associated feedback effects.

    The [N.sub.ew]ERA modeling framework takes into account interactions between all parts of the economy and policy consequences as transmitted throughout the economy as sectors respond to policies. The model's flexibility allows it to incorporate different natural gas supply curves and evaluate impacts on the economy in a consistent framework.

    1. U.S. General Equilibrium Model (Macro Model)

      The Macro model is a forward-looking dynamic computable general equilibrium model of the U.S. It simulates all economic interactions in the U.S. economy, including those among industries, households, and the government. Industries and households maximize profits and utility assuming perfect foresight. The theoretical construct behind the model is based on the circular flow of goods, services, and payments in the economy (every economic transaction has a buyer and a seller whereby goods/services go from a seller to a buyer and payment goes from the buyer to the seller). The model includes a representative household, which characterizes the behavior of an average consumer, and seven industrial sectors, which represent the...

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