July-August 1996 vol. 21, number 4
A newsletter published by the American Council for Capital Formation

Articles:

Capital Formation Forum: Senate Majority Leader Outlines Legislative Goals
Capital Formation Forum: Deputy Treasury Secretary Summers Stresses Need to Address Saving Deficit
Issue Brief: The Appropriate Timing of Greenhouse Gas Emission Reductions
New ACCF Web Site Generates Growing Interest

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Capital Formation Forum:
Senate Majority Leader Outlines Legislative Goals

"We have very little time and a lot of work to do," Senate Majority Leader Trent Lott (R-MS) told ACCF supporters at a June 24 Capital Formation Forum as he outlined the Senate's legislative schedule for the remainder of the session. He noted that there could be different combinations of issues as the upper house addresses the legislation before it, as well as slippage in the timetable. "The Senate has a full plate to deal with before the October 4 adjournment target," Senator Lott said.

Characterizing his legislative agenda as "minimalist," the new Senate Majority Leader observed that a key issue before adjournment is budget reconciliation. "I hold out the possibility that we may get a budget agreement we can live with, that will be good for the country, and that will help Senator Dole's presidential campaign." He added that he hoped to avoid a repeat of the 1995 budget stalemate that twice caused a partial shutdown of the federal government.

"We also need to continue our efforts to make the tax code more fair," he noted. "Two issues I hope to address in the budget this year are the child credit and capital gains tax cuts."

"Right now, I have a clean slate and I want to write positive things on it," Senator Lott said of his new role. "We have some real challenges ahead and many demands on us, but we are going to make serious and aggressive efforts to find consensus and achieve our goals."

Elected to the Senate in 1988, Trent Lott rose rapidly in the leadership ranks. He was elected Secretary of the Senate Republican Conference in 1992, Majority Whip in 1995, and Majority Leader on June 12, 1996. He served in the U.S. House of Representatives from 1972-88, where he was as Republican Whip from 1980-88. Return to Beginning

Capital Formation Forum:
Deputy Treasury Secretary Summers Stresses Need to Address Saving Deficit
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"Three factors are critical to the health and well-being of the private economy," the Honorable Lawrence H. Summers, deputy secretary of the Treasury, told ACCF supporters at the July 23 Capital Formation Forum.

First, Dr. Summers noted, growth in the government sector needs to be kept under control. Second, there needs to be a willingness to export to and deal with other countries. Finally, there needs to be a willingness to save and invest for the future.

"We have made enormous progress in the first two areas," the deputy secretary stressed. We are on the verge of success with the budget deficit, which has decreased every year for the past four years and is the lowest of the G-7 countries. But, while this is an important achievement, the next president faces the challenge of continuing to cut the deficit if we are to attain the goal of a balanced federal budget."

In the area of trade, Dr. Summers noted, the Unites States has put in place important changes to facilitate exports, including removing many export controls and negotiating a number of treaties. "There is more to do but we have made substantial progress," he observed.

Although private investment has shown considerable strength, private saving remains a problem that must be addressed. "Now that the baby boomers are beginning to turn 50, the public policy emphasis is shifting to retirement saving. The Clinton Administration has offered three productive approaches to the problem, including liberalized IRAs, changes in the pension regulation, and an indexed government bond." But, he cautioned, as we address these issues, it is important that we do not lose sight of the need to share the prosperity.

"I think we are on the verge of a remarkable period in the United States. If we can continue to take care of the fundamentals, then the twenty-first century will be even more of an 'American Century' than the twentieth century has been," Deputy Secretary Summers concluded. Return to Beginning

Issue Brief:
The Appropriate Timing of Greenhouse Gas Emission Reductions
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Introduction

Concerned about the potential effects of global climate change, some policymakers have called for specific timetables and targets to reduce emissions of carbon dioxide (CO2) and other greenhouse gases.

The United Nations Conference of the Parties to the Framework Convention on Climate Change is considering various proposals to reduce emissions of CO2 in the near term. One such proposal calls for a 20 percent reduction below 1990 levels in CO2 emissions for the developed countries by the year 2005. Other proposals are less stringent, but nonetheless focus on near-term actions to reduce emissions as the best way to deal with the potential problem of global climate change. In July of 1996, the Administration's negotiators at the Conference of the Parties meeting in Geneva made a commitment to legally binding midterm (2010?) targets to cap U.S. greenhouse gas emissions.

However, recent studies suggest that focusing on mandatory near-term reductions may not be cost-effective in light of the specific characteristics of global climate change. A new report by Drs. David Harrison, Jr. and Albert L. Nichols (1) (H&N) of National Economic Research Associates summarizes the results of recent studies on climate change policy and provides a non-technical explanation of the factors that underlie the importance of flexible timing in addressing emissions of CO2 and other greenhouse gases. The studies reviewed are striking in the unanimity of their conclusions on this key issue. Whether the authors are EPA economists, industry-sponsored researchers, or academic scholars, all agree that near-term efforts to freeze emissions or to reach other arbitrary short-term emissions targets are not cost-effective, H&N state.

Timing of Emission Reductions

Understanding the key scientific and economic factors that help determine the most cost-effective paths for reducing greenhouse gas emissions is critical for evaluating various climate change policy options. Return to Beginning

Scientific Factors

Sensible policy on greenhouse gas emissions is predicated on two key scientific characteristics of global climate change. First, CO2 and other greenhouse gases have the same effect on global climate regardless of where they are emitted in the world. Second, climate effects depend on global atmospheric concentrations of greenhouse gases, which are the cumulative result of emissions over time periods measured in decades and even centuries.

The first proposition is widely acknowledged. The term "global climate change" implies that one must take a global perspective and consider emissions and emission-mitigation opportunities from all regions of the globe. This fact poses serious problems of international coordination, because it will always be in the self-interest of individual countries to reap whatever benefits arise from global reductions in emissions without having to incur the costs of making reductions themselves. However, all of the studies discussed by H&N assume, at least implicitly, that the problems of international coordination have been solved, so that all nations work together to find the most efficient, least-cost approach to reducing greenhouse gas emissions.

The second proposition is key to understanding the results of recent studies on the cost-effective time path for controlling emissions, H&N observe. The greenhouse effect of CO2 and the other gases that trap the earth's radiated heat depends upon their concentrations in the atmosphere. Future concentrations depend upon current concentrations, future emissions, and the removal rate from the atmosphere due to natural processes. The natural removal rate varies among the greenhouse gases; CO2 has a long life, implying that the concentration of CO2 in a future target year (e.g., 2100) is proportional to cumulative emissions over the preceding years. However, emission reductions closer to the target year are more important than early reductions, because the natural carbon cycle results in a substantial portion of the CO2 emitted now being absorbed by the oceans by 2100. Return to Beginning

Economic Factors

For any long-term target concentration of greenhouse gases, the world can be thought of as having a long-term emissions budget that can be used over time, H&N observes. If more is "spent" now, less will be available later. If the concentration target is taken as fixed, cost-effectiveness analysis can help determine the least-cost way of staying within that long-term global budget (assuming that problems of international coordination have been solved, so that in any time period emissions are reduced at the least cost).

Four important factors influence the shape of the cost-effective path, the authors observe:
  • Rising Marginal Costs

    At any point in time, as deeper cuts in emissions from the business-as-usual (BAU) path are made, the incremental cost per ton of CO2 reduced rises. Intuitively, the first tons reduced are the easiest, obtained at virtually no cost. For example, they may involve increases in energy efficiency for which the savings in fuel costs are almost as great as the cost of more efficient equipment, or changes in fuel where the fuel prices are nearly equivalent. More drastic cuts, however, require making increasingly expensive changes in technology or fuel.

  • Time Value of Money

    Reductions in emissions of greenhouse gases can be thought of as investments-spending money today to yield benefits in the future in the form of reductions in potential damages from global climate change. In evaluating any potential investment, it is essential to recognize that it matters not only how large the investment is, but also when it is made. Funds tied up in one investment are not available for other purposes, where they could earn a return. Thus, investing money today to reduce CO2 emissions must be compared to alternative investments. It is economically rational to make that investment in CO2 reductions only if it yields a higher rate of return (in the form of savings in future control costs) than other investments available in the economy.

  • Premature Replacement of Capital Stock

    Many of the actions needed to reduce CO2 emissions involve changes in long-lived capital equipment, such as electric generating plants, manufacturing equipment, and motor vehicles. Typically it is much more costly-if not simply impossible-to make these changes in existing equipment, rather than incorporating them in new equipment. By introducing flexibility in the timing of CO2 reductions, it is possible to take advantage of normal replacement cycles for equipment and plants. Return to Beginning

  • Technological Progress

    During this century, energy efficiency has improved dramatically in the United States and other developed countries, with ever smaller amounts of energy needed per unit of output. For example, from 1974 to 1994, energy consumption in the United States fell from 22,330 Btu per dollar of GDP to 16,556-a decline of almost 26 percent. There is every reason to believe that this trend will continue. In addition, technological progress is likely to lower the relative cost of low-carbon or carbon-free substitute forms of energy, which will further cut the cost of reducing CO2 emissions in the future.

When Should CO2 Emission Reductions Occur?

Harrison and Nichols reviewed various studies on the cost of alternative emission reduction strategies by authors including Richard Richels and Jae Edmonds, Richard Kosobud, Neil Leary, and Joel Scheraga. These authors' studies, which are based on cost-effectiveness analysis, conclude that near-term freezes or reductions in emissions are unnecessarily costly, and that more flexible temporal strategies can reduce costs substantially.

For example, Richels and Edmonds (1995) evaluate the costs of alternative emissions time paths that achieve a CO2 concentration of 500 parts per million volume (ppmv) in the year 2100; although that specific target is arbitrary, it lies within the range of hypothetical targets offered by the Intergovernmental Panel on Climate Change (IPCC) and others (see Figure 1). The top line shows emissions under the business-as-usual scenario. The horizontal line represents the oft-proposed policy of stabilizing emissions at their 1990 level, which requires increasingly stringent reductions from the BAU path, starting immediately. The line labeled 500a is a scenario in which emissions follow the BAU path until roughly 2010, are reduced gradually below the BAU path between 2010 and 2050, and are reduced sharply thereafter so as to keep concentrations below 500 ppmv in 2100. The line labeled 500b represents an emissions path between the 500a path and the emissions stabilization path. Richels and Edmonds point out that the cumulative emissions under the three scenarios (as represented by the areas under the curves) are approximately the same, reflecting the fact that all three are designed to lead to the same concentration in 2100. Return to Beginning


Figure 1Alternative Emission Time Paths Evaluated by Richels and Edmonds (Source: Richels and Edmonds 1995)



Richels and Edmonds also estimate the costs of these alternative paths using two different models of long-term energy-economy interactions: Global 2100 and the Edmonds-Reilly-Barns Model (ERB). Figure 2 shows the alternative estimates of the costs of the three emission trajectories. Although the absolute estimates differ, the fundamental finding is the same. Stabilizing emissions at 1990 levels is by far the most costly strategy. Shifting emission reductions to the later years reduces the present value of overall costs substantially, although they are still large in absolute terms. Relative to immediate stabilization, the path labeled 500a reduces estimated costs by about 50 percent according to the Global 2100 model and about 30 percent according to the ERB model.


Figure 2 Richels and Edmonds' Estimates of the Costs of Alternative Time Paths to a 500 ppmv Concentration (Source: Richels and Edmonds 1995)



Benefit-Cost Analyses of Alternative Time Paths

The cost-effectiveness analyses discussed in the previous section take a target concentration of CO2 (or temperature) as given for some future year and then compare the costs of alternative paths to reach that goal. That approach avoids the difficult task of estimating the damages (or benefits, in at least some regions) that may be caused by global climate change. However, the cost-effectiveness approach suffers from two important limitations:
  1. It is based on arbitrary targets, which may be far from optimal in the balance they strike between the costs of emission reductions and the potential damages caused by climate change.

  2. It does not account for differences in damages caused by different time paths of concentrations using alternative emission trajectories to the same long-term target.

Several studies by scholars such as William Nordhaus, Alan Manne, Richard Richels, S. Peck, and T. Teisberg have attempted to avoid these limitations by adopting a broader benefit-cost framework that accounts for benefits as well as costs over time. Despite the differences in approach, these studies come to the same fundamental conclusion: optimal policies do not impose near-term freezes or reductions in emissions, but rather take a more flexible approach.

For example, a recent book by Nordhaus (1994) estimated the costs and benefits of different emission paths for slowing or arresting the rate of global climate change. The cost components of the model are based upon a detailed set of economic relationships. The benefit estimates are based upon geophysical relationships that link emissions of CO2 and other greenhouse gases, atmospheric concentrations of these gases, average temperature change, and damages from global climate change. Nordhaus uses his model to evaluate alternative approaches to climate change policy and to find the policy that maximizes the present value of estimated global net benefits. Return to Beginning

Nordhaus' book is notable for its explicit treatment of the large uncertainties that surround estimates of the costs and benefits of slowing climate change. It is useful to begin by looking at his "best case," one in which Nordhaus determines the time path that maximizes predicted net benefits using his best estimates of the uncertain parameter values. Figure 3 plots three emission paths: the one that Nordhaus estimates to be optimal given his "best" estimates, his projection of BAU, and the ubiquitous alternative of freezing emissions at their 1990 level. Nordhaus' optimal path lies well above that followed under the policy of freezing emissions at 1990 levels. Relative to the BAU line, the reductions under the optimal path are small, rising gradually from just under 9 percent from 1990&shyp;2010 to a little over 13 percent in the 2070s. The reductions in the first decade include the phaseout of CFCs and the introduction of forestry programs that provide carbon sinks, as well as reductions in CO2 emissions per se. In contrast, although the freeze policy starts off with a 9 percent reduction in CO2 emissions in the 1990s, it rises quickly to 24 percent in 2000-2010 and to 62 percent in the 2070s.


Figure 3Comparison of Business-as-Usual (BAU) and Optimal Time Paths Using Nordhaus' Best Estimates of Parameter Values (Source: Nordhaus 1994)




Policymaking Under Uncertainty

A major problem in designing climate mitigation strategies is that all the estimates of the costs and environmental effects are very uncertain, H&N note. Several studies, including one by Manne and Richels, have analyzed these uncertainties explicitly to see how they affect the optimal policy, and how the possibility of resolving those uncertainties over time should be incorporated into strategies.

According to Manne and Richels, it is unrealistic to think of policy towards greenhouse gas emissions as a one-time decision that can be settled "once and for all." Instead, such policies should be viewed from a long-term perspective, one in which policies can be adjusted over time in response to changing conditions and new information. Choices made today should incorporate the possibility of such future adjustments. Their analysis shows how a rational hedging strategy can help determine policy when the outcome is very uncertain.

Figure 4 shows a situation in which there are two possible future outcomes-the base case and the high damage scenario-and we know which one applies. The dashed lines show the emissions path with such perfect foresight. The upper dashed line shows the optimal emissions path corresponding to the base case, while the lower dashed line shows the optimal path if we knew today that temperature sensitivity and nonmarket damages were both high.


Figure 4 Carbon Emissions Under Perfect Foresight and Hedging (Source: Manne and Richels 1995)




In reality, of course, we do not know which outcome will occur, although over time we will gain additional information that will allow us to refine our estimates. For illustrative purposes, Manne and Richels assume that by 2020, we will know whether the high-damage case is correct. In the meantime, what policy is optimal given our uncertainty? With imperfect information about which outcome will occur, the optimal strategy is likely to involve "hedging," picking a path somewhere between the two extremes. Where the optimal path lies within that band depends on various factors, the most important of which is how likely we think it is that the high-damage case will prove to be correct. Because of its extreme nature, Manne and Richels assign it only a 5 percent probability. In that case, the optimal near-term strategy is shown by the solid line in Figure 4. This hedging strategy consists of reducing emissions slightly more than would be optimal under Manne and Richels' base-case assumptions. If we then learn in 2020 which set of assumptions is correct, we can change the policy based on which outcome occurs. If the base-case assumptions are borne out, control efforts can be relaxed a bit, as shown by the rising solid line after 2020. On the other hand, if the high-damage case proves correct, contrary to expectations, then control efforts will have to be tightened significantly, as shown by the falling solid line after 2020.

Conclusion: What Should Be Done Now?

These recent studies reviewed by H&N provide powerful arguments against locking the nations of the world into rigid schedules for freezing or reducing CO2 emissions in the near term. The arguments for avoiding the adoption of rigid emission targets in the near term are even stronger if one takes into account the difficulty of achieving international coordination. The studies summarized in this paper all implicitly assume that the countries of the world act in a unified manner to minimize global costs and maximize global benefits, without regard to the interests of individual countries. Moreover, reductions within each country are assumed to be achieved at the lowest possible cost. In reality, of course, the policies adopted are unlikely to be least-cost, and the world is far from unified on this issue. Few countries are likely to adopt policies that impose large costs on their own citizens to generate potential benefits spread over the world as a whole, H&N conclude.

The problems outlined above with regard to premature commitment to a freeze or other rigid emission schedule do not mean that nothing should be done to address concerns about the possible adverse affects of long-run change in global climate. The studies reviewed here suggest that to the extent that reductions can be achieved through "low-regrets" action, they may be worth making in the near term. The studies that explicitly analyze uncertainty also point to the importance of continued research, not just on potential changes in temperature, but also on other aspects of climate change and technology development.

Finally, countries can develop the institutional capacity to make coordinated decisions on global change. The costs and benefits of policies to affect global climate change are very different for different regions of the world, as well as for different sectors of the world economy. The world community needs to develop mechanisms that take such differences into account while at the same time achieving the gains from coordinated and cost-effective policy choices.

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1. David Harrison, Jr. and Albert L. Nicholas, "Recent Evidence on the Appropriate Timing of Reductions in Greenhouse Gas Emissions," National Economic Research Associates, Cambridge, Mass., July 1996.

References

Manne, A. and R. Richels. 1995. "The Greenhouse Debate: Economic Efficiency, Burden Sharing and Hedging Strategies." Energy Journal 16(4):1-37.
Nordhaus, W.D. 1994. Managing the Global Commons: The Economics of Climate Change. Cambridge, Mass.: The MIT Press.
Richels, R. and J.A. Edmonds. 1995. "The Economics of Stabilizing Atmospheric CO2 Concentrations." Energy Policy 23(4/5):373-378.
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New ACCF Web Site Generates Growing Interest
Site Address: http://www.accf.org

Now in its second month of operation, the ACCF's new Web site has seen a great deal of growth in activity, with more than 3,000 hits since going online. For a site that emphasizes solid academic research, this level of activity is considered excellent.

User activity should continue to increase now that the Web's major search engines have indexed the site, including Yahoo, Alta Vista, and WebCrawler, and related sites have begun adding cross links.

An intriguing number of international visitors have sought access to ACCF's publications and announcements, including users from Aruba, Australia, Belgium, Canada, China, Costa Rica, Croatia, Denmark, Finland, France, Israel, Japan, Mexico, New Zealand, Philippines, the Russian Federation, Singapore, South Korea, Sweden, Thailand, and the United Kingdom.

Reports also indicate numerous hits from users linked to the Internet through Senate, House, and other government servers. Return to Beginning