Key climate question: What's the cost of carbon?

Current offset prices vary from 50 cents to $30 a ton. But the US Congress will have to find the optimum rate.

Iowa farmer Jeff Labertew knows the price of carbon dioxide as well as he does the price of corn. A company pays him $1 per acre – about 50 cents per ton of CO2 emissions – not to till his soil. (Plowing releases CO2 trapped under the soil's crust.)

But that's a voluntary program. The company pays him to offset its own emissions. Now a raft of bills emerging in the US Congress wants to mandate something similar – a system where the market determines the price. One bill envisions an upper limit of $7 per ton; others would let it swing far higher. In Europe, which has wrestled far longer with impending mandatory cuts in emissions, the price has fluctuated from $30 a ton to $1.

Of all the issues now facing policymakers worried about climate change, the price of carbon emissions may be the most fiendishly difficult to solve. Set it too low and companies have little incentive to curb their emissions. Set it too high and the economy grinds to a halt.

At least a half dozen bills in Congress aim to solve the problem by letting the market decide through "cap-and-trade" systems. But those systems, where companies decide the most economical way to meet an overall cap, include widely varying details whose impact is largely unknown. How lawmakers implement the system could propel the program forward – or sink it entirely. That's why finding the right price of carbon is key.

"You have a lot of people right now talking in broad terms about cap-and-trade or carbon tax approaches to dealing with the problem, but a lot of them haven't gotten into details," says Andrew Bowman, director of the Doris Duke Charitable Foundation climate-change program. This week, the foundation announced it would spend $100 million on climate change – at least a third of it on developing more robust economic theory to undergird emerging greenhouse-gas pricing policies.

The region with the most experience in setting carbon prices is, arguably, Europe. Under the mandates of the Kyoto Protocol, the European Union modeled its cap-and-trade approach on a US program for reducing sulfur dioxide. But CO2 prices have gyrated between $30 a ton and $1 a ton. Those wild shifts have undermined emissions goals there and must not be replicated in the US, economists say.

To avoid that, key economic problems must be resolved, including:

• Proper allocation of pollution allowances. In Europe nearly all of the valuable emission allowances – permits that each allow one ton of CO2 emissions – were given away to power companies. Those free permits became a windfall for the companies. And because an excess of permits were issued, market trading has seen carbon prices remain depressed or unsteady, driving only tiny gains in pollution reduction.

"If the amount of the allowances allocated for free exceeds the cost of reducing emissions, then you've given away a windfall gain and undermined the emissions program," says Richard Newell, professor of energy and environmental economics at Duke University in Durham, N.C.

• Do companies need a "safety valve"? Many corporations say they need protection against dramatic spikes in carbon-emission prices. A climate bill sponsored by Sen. Jeff Bingaman includes such a safety valve. When the cost of emissions reached $7 a ton, his bill would issue more emission allowances, effectively capping their price at $7. But environmentalists argue that the provision sets the price too low and would undermine emissions goals. As an alternative, they suggest that power companies and other carbon emitters should be able to borrow from their own future years' emissions allowances. That would allow businesses to plan long term without worrying about spikes due to weather or other factors.

Borrowing is a new feature of a climate bill by Sens. John McCain (R) of Arizona and Joseph Lieberman (I) of Connecticut, which is strongly endorsed by some environmental groups. "We're adding borrowing to help smooth out spikes in the price of carbon emissions," says David Doniger, policy director of the Natural Resource Defense Council in New York. "We think this makes far more sense than a safety valve approach."

But the economic impact of this borrowing feature is not well understood, others say.

"Economists haven't really thought in any detail about what including a borrowing mechanism really does," says William Pizer, an economist and senior fellow at Resources for the Future, a Washington think tank. "You could end up with a bunch of emissions debtors" who never can reduce emissions enough to make up for the allowances they've borrowed.

• Foreign competition. Under most cap-and-trade approaches, the cap on emissions would drop over time, increasing the cost of emissions and leading to higher-priced goods and services. But what happens if other countries do not take comparable action on global warming?

For example: If Chinese-made autos arrive on US shores made with unacceptably high levels of greenhouse gases, one possible solution is a tariff. But a new idea bouncing around among economists is that companies importing such products would be required to purchase emissions allowances for them.

• Who's the emitter? Producers of oil, gas, and coal are considered upstream sources of carbon emissions. Downstream sources include buildings, automobiles, electric utilities, and refineries to name a few. Choosing whom to regulate is a critical question that could mean billions of dollars in costs to the industries affected. Power companies are the focal point of some legislation, while most economists argue the focus should be on the entire economy to spread the cost around.

• Who gets the emissions revenue? So vast are US carbon emissions that if the value of US greenhouse-gas allowances rose to $15 per ton, revenues from their sale could bring in $100 billion annually, by some estimates. If more stringent targets were set on total emissions, allowance values could soar to hundreds of billions of dollars annually.

So how should that money get spent? Revenues could go to develop new emissions technology – or to lower income taxes, cut the federal deficit, or some other priority.

"Right now you have different legislative approaches, most of them pretty sketchy. Or [they] leave it up to agencies to figure out how allowances are handled," Dr. Newell says. "But I think in the end Congress will have a big hand in determining how these billions are handed out.

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