Too Good to be True?

Global climate change is a serious environmental threat, and sound public policies are needed to address it effectively and sensibly.

There is now significant interest and activity within both the U.S. Administration and the U.S. Congress to develop a meaningful national climate policy in this country.  (If you’re interested, please see some of my previous posts:  “Opportunity for a Defining Moment” (February 6, 2009); “The Wonderful Politics of Cap-and-Trade:  A Closer Look at Waxman-Markey” (May 27, 2009); “Worried About International Competitiveness?  Another Look at the Waxman-Markey Cap-and-Trade Proposal” (June 18, 2009); “National Climate Change Policy:  A Quick Look Back at Waxman-Markey and the Road Ahead” (June 29, 2009).  For a more detailed account, see my Hamilton Project paper, A U.S. Cap-and-Trade System to Address Global Climate Change.)

And as we move toward the international negotiations to take place in December of this year in Copenhagen, it is important to keep in mind the global commons nature of the problem, and hence the necessity of designing and implementing an international policy architecture that is scientifically sound, economically rational, and politically pragmatic.

Back in the U.S., with domestic action delayed in the Senate, several states and regions in the United States have moved ahead with their own policies and plans.  Key among these is California’s Global Warming Solutions Act of 2006, intended to return the state’s greenhouse gas (GHG) emissions in 2020 to their 1990 level.  In 2006, three studies were released indicating that California can meet its 2020 target at no net economic cost.  That is not a typographical error.  The studies found not simply that the costs will be low, but that the costs will be zero, or even negative!  That is, the studies found that California’s ambitious target can be achieved through measures whose direct costs would be outweighed by offsetting savings they create, making them economically beneficial even without considering the emission reductions they may achieve.  Not just a free lunch, but a lunch we are paid to eat!

Given the substantial emission reductions that will be required to meet California’s 2020 target, these findings are ­- to put it mildly – surprising, and they differ dramatically from the vast majority of economic analyses of the cost of reducing GHG emissions.  As a result, I was asked by the Electric Power Research Institute – along with my colleagues, Judson Jaffe and Todd Schatzki of Analysis Group – to evaluate the three California studies.

In a report titled, “Too Good To Be True?  An Examination of Three Economic Assessments of California Climate Change Policy,” we found that although some limited opportunities may exist for no-cost emission reductions, the studies substantially underestimated the cost of meeting California’s 2020 target — by omitting important components of the costs of emission reduction efforts, and by overestimating offsetting savings some of those efforts yield through improved energy efficiency.  In some cases, the studies focused on the costs of particular actions to reduce emissions, but failed to consider the effectiveness and costs of policies that would be necessary to bring about those actions.  Just a few of the flaws we identified lead to underestimation of annual costs on the order of billions of dollars.  Sadly, the studies therefore did not and do not offer reliable estimates of the cost of meeting California’s 2020 target.

This episode is a reminder of a period when similar studies were performed by the U.S. Department of Energy at the time of the Kyoto Protocol negotiations.  Like the California studies, the DOE (Interlaboratory Work Group) studies in the late 1990s suggested that substantial emission reductions could be achieved at no cost.  Those studies were terribly flawed, which was what led to their faulty conclusions.  I had thought that such arguments about massive “free lunches” in the energy efficiency and climate domain had long since been laid to rest.  The debates in California (and some of the rhetoric in Washington) prove otherwise.

While the Global Warming Solutions Act of 2006 sets an emissions target, critical policy design decisions remain to be made that will fundamentally affect the cost of the policy.  For example, policymakers must determine the emission sources that will be regulated to meet those targets, and the policy instruments that will be employed.  The California studies do not directly address the cost implications of these and other policy design decisions, and their overly optimistic findings may leave policymakers with an inadequate appreciation of the stakes associated with the decisions that lie ahead.

On the positive side, a careful evaluation of the California studies highlights some important policy design lessons that apply regardless of the extent to which no-cost emission reduction opportunities really exist.  Policies should be designed to account for uncertainty regarding emission reduction costs, much of which will not be resolved before policies must be enacted.  Also, consideration of the market failures that lead to excessive GHG emissions makes clear that to reduce emissions cost-effectively, policymakers should employ a market-based policy (such as cap-and-trade) as the core policy instrument.

The fact that the three California studies so egregiously underestimated the costs of achieving the goals of the Global Warming Solutions Act should not be taken as indicating that the Act itself is necessarily without merit.  As I have discussed in previous posts, that judgment must rest – from an economic perspective – on an honest and rigorous comparison of the Act’s real benefits and real costs.