Janet Yellen
Chair, White House Council of Economic Advisers

(Excerpts of remarks made March 4, 1998, before the U.S. House of Rerpresentatives Commerce Committee.)

In order to evaluate the likely net economic impact of the Kyoto Protocol, excluding the benefits of mitigating climate change itself, we have drawn upon a variety of tools to assess the various possible costs and non-climate benefits of the administration's emissions reduction policy.

To give away the punch line, our conclusion is as follows: the net costs of our policies to reduce emissions are likely to be small, assuming those reductions are undertaken in an efficient manner and we are successful in securing meaningful developing-country participation as well as effective international trading, and the Clean Development Mechanism (CDM) in future negotiations.

To our knowledge, no model has yet been set up to analyze the implications of the Kyoto Protocol, since this agreement is only a few months old and remains unfinished. In particular, no model is currently designed to assess Kyoto's treatment of sinks (such as forests that absorb carbon from the atmosphere), or all six greenhouse gases.

Our thinking has been informed, however, by simulations conducted with the Second Generation Model (SGM) of Battelle Laboratories, one of the leading models in the field. The SGM is one of the models best positioned to analyze the role of international trade in emissions permits, which we consider to be a critical element of the Kyoto Treaty.

However, the SGM does not cover all six gases included in the Kyoto Protocol or include a role for sinks. We have used the SGM model as one input into our overall assessment of the Kyoto treaty, but have attempted to supplement its results with additional analysis to account for such special features of the agreement as the inclusion of six gases, a possible trading arrangement that could include a subset of the Annex I (developed) countries, and the Clean Development Mechanism.

ASSESSING THE POTENTIAL COSTS OF EMISSIONS REDUCTIONS

The costs of cutting emissions can be much reduced if flexible, market-based mechanisms are used. Our economic analysis highlighted the importance of such flexible, market-based mechanisms -- which are therefore reflected, at the president's insistence, in the Kyoto Protocol and our ongoing diplomatic strategy.

Within the Kyoto Protocol, this means an insistence on international trading, joint implementation, the Clean Development Mechanism, and, ultimately, on meaningful developing-country participation. Domestically, this means that we implement any emissions reductions through a market-based system of tradeable emissions permits, which ensures that we achieve reductions wherever they are least expensive. But this also means taking serious and responsible steps in the short run to prepare us to meet our obligations in the longer term.

The first such step is the inclusion in this year's budget of an aggressive, $6,300 million program of tax cuts and R&D investments. The goal is both to stimulate the development of new energy-saving and carbon-saving technologies and to encourage the dissemination of those that exist already.

A second responsible step entails industry-by-industry consultations to prepare emission reduction plans in key industrial sectors. The administration will work in partnership with industry to identify ways in which the federal government might remove regulatory hurdles that discourage energy efficiency. In addition, the Department of Energy will spearhead a comprehensive effort to improve the energy efficiency of the federal government's own operations and purchases.

The third step is the promotion of an environmentally responsible electricity restructuring bill, which the president identified as part of his domestic climate change package. An electricity sector freed from government regulation would be a more efficient energy sector. Costs to consumers would fall.

In addition, stronger incentives for improved generation efficiency in conjunction with appropriate market-based provisions could achieve modest reductions in emissions. A reasonable overall estimate of the contribution of federal electricity restructuring to the rest of the president's program to address climate change is that it would make further progress to the same emissions reduction goals at a cost saving of roughly $20,000 million per year. These steps should be taken regardless of Kyoto, because they make sense in terms of energy efficiency.

ESTIMATED REDUCTION IN COSTS FROM ANNEX I TRADING

In the language of the treaty, "Annex I" is the set of countries that have agreed to take on binding limitations in emissions of greenhouse gases. Even without meaningful developing-country participation -- which the president has emphasized is essential before the treaty would be submitted for ratification -- costs could be reduced substantially by emissions trading among the Annex I countries.

To provide some indication of the possible efficiency improvements, Russia and Ukraine consume six times as much energy per dollar of output as does the United States. Such large international differences in energy efficiency suggest that adoption of existing U.S. technology would yield very large emissions reductions in these countries.

Estimates derived from the SGM model confirm that emissions trading among Annex I countries can reduce the U.S. cost of achieving its targets for 2008-2012 emissions by about half relative to a situation in which such trading was not available. This concept of costs is meant to capture aggregate resource costs to the U.S. economy, including the cost to domestic firms of purchasing emissions permits from other countries where emissions reductions may be cheaper than in the United States.

Although these estimates reflect idealized international trading in efficient markets, the overall conclusion is clear. The dramatic reduction in costs potentially available from Annex I trading within the SGM model -- cutting the costs involved by half -- highlights why the president insisted that international trading be part of the Kyoto Protocol; and why its achievement by our negotiators in Kyoto was such an important accomplishment.

ESTIMATED REDUCTION IN COSTS FROM UMBRELLA TRADING

One possibility that emerged in Kyoto, which none of us foresaw, was the idea developed by the U.S. delegation that the United States might undertake trading with a subset of Annex I countries, dubbed the "umbrella."

Countries that have expressed interest in the umbrella include the United States, Australia, Canada, New Zealand, and Russia, with strong indications of interest from some others. This subset of Annex I countries shares a common interest in promoting market-based mechanisms, specifically, fully flexible rules for international trading of emissions permits.

It is too early to state the precise form the umbrella will take. But we can envision a number of potential benefits. The umbrella could, for example greatly reduce costs to the United States. Results that we have derived from various SGM simulations of efficient international trading suggest that, relative to the situation in which there is no trading at all, the umbrella can reduce costs by an estimated 60 to 73 percent, depending on whether the former Warsaw Pact countries fall within the umbrella.

ESTIMATED REDUCTION IN COSTS FROM
DEVELOPING-COUNTRY PARTICIPATION

The substantial potential gains from meaningful developing-country participation are highlighted by the significant benefits that will likely accrue from the limited role that the developing countries have already agreed to through the Clean Development Mechanism, which is modeled after the U.S. joint implementation concept.

The CDM cannot realistically be expected to yield all the gains of binding targets for developing countries, but it might shave costs by roughly another 20 to 23 percent from the reduced costs that result from trading among Annex I countries.

Another possibility is that we persuade some of the key developing countries that are the largest emitters to commit to targets, and allow us to buy emissions reductions from them. Simulations with the SGM model suggest that full participation by non-Annex I countries could cut roughly 55 percent off the reduced costs that result from Annex I trading.

The actual cost reduction would depend on the extent of developing-country participation that is ultimately obtained, as well as on the effectiveness of international trading arrangements. The more developing countries that take on modest binding targets and trade in international permit markets, the lower will be the costs.

ACCOUNTING FOR CARBON SINKS

The preceding discussion has emphasized the importance of trading arrangements and the CDM. In reaching an overall economic assessment, it is also important to factor in the potential role of carbon sinks. Again, the U.S. delegation obtained a novel concept -- that carbon-absorbing activities called sinks could be used to offset emissions.

The arrangements concerning carbon sinks in the Kyoto Protocol have received less attention than they merit. The protocol specifies that removals of carbon dioxide (CO2) by sinks count toward meeting the target. The protocol counts the net emissions effects of three sink activities -- afforestation, reforestation, and deforestation.

Very preliminary estimates of the implications for the United States of the Kyoto provision on sinks indicate that they could comprise a significant portion of the total required emissions reductions. Moreover, decreasing the required emissions reduction by, for example, 10 percent would likely result in cost-savings greater than 10 percent.

SYNTHESIS

Assuming that effective mechanisms for international trading, joint implementation, and the Clean Development Mechanism are established, and assuming also that the United States achieves meaningful developing-country participation, our overall assessment is that the economic cost to the United States of attaining the targets and timetables specified in the Kyoto Protocol will be modest.

It is worth emphasizing that other model results reflecting the details of the Kyoto Protocol are consistent with our conclusion. Under the assumptions of either trading under the umbrella or within Annex I, and the CDM and permit trading with developing countries, estimates derived using the SCM model suggest that the net energy resource costs of attaining the Kyoto targets for emissions reductions might amount to $7,000 million to $12,000 million per year in 2008 to 2012.

This implies that overall costs, excluding not only climate and non-climate benefits, but also such cost-mitigating factors as sinks and payoffs from the president's electricity restructuring and climate change initiatives, would reach roughly one-tenth of 1 percent of projected GDP (Gross Domestic Product) in 2010.

A more tangible measure of costs is the estimated effects on energy prices. Excluding the impact of electricity restructuring and the ancillary benefits of mitigation and better forest management, the SGM-based estimate, corresponding to the gross energy cost estimate cited above, is an emissions price in the range of $14 to $23 per ton of carbon equivalent. This translates into an increase in energy prices between 2008 and 2012 at the household level of between 3 and 5 percent; an increase in fuel oil prices of about 5 to 9 percent; natural gas prices of 3 to 5 percent; gasoline prices of 3 to 4 percent (or around 4 to 6 cents per gallon); and electricity prices of 3 to 4 percent.

This increase in energy prices at the household level would raise the average household's energy bill in 10 years by between $70 and $110 per year, although such predictions may not be observable because they would be small relative to typical energy price changes, and nearly fully offset by electricity price declines from federal electricity restructuring.

In particular, this increase in energy prices is small relative to the average of year-to-year real energy price changes experienced by U.S. consumers since 1960. Such annual changes have averaged 3-8 percent. In addition, by 2008-2012, the anticipated 10 percent decline in electricity prices from the restructuring that is part of our climate change agenda is projected to lead to expenditure reductions of about $90 per year for the average household,

EFFECTS ON U.S. INDUSTRY

Some have expressed fears that the Kyoto Protocol might adversely affect the competitive position of American industry. Evaluating how the Kyoto Protocol could affect the competitiveness of a few specific manufacturing industries -- especially those that are energy-intensive, such as aluminum and chemicals -- is complex.

But to provide some perspective on this issue, consider the following facts. First, on average, energy constitutes only 2.2 percent of total costs to U.S. industry.

Second, energy prices already vary significantly across countries. According to the 1997 Statistical Abstract, for example, 1996 premium gasoline costs $1.28 per gallon in the United States, but only 8 cents per gallon in Venezuela. Electricity prices also vary significantly -- in the United States they were 5 cents per kilowatt hour in 1995, a fraction of Switzerland's price of 13 cents per kilowatt hour. Yet U.S. industry is not moving en masse to Venezuela, nor is Swiss industry moving to the United States.

Third, roughly two-thirds of all emissions are not in manufacturing at all, but in the transportation and buildings sectors, which by their very nature are severely limited in their ability to relocate to other countries. We therefore believe we need developing country participation because the climate change problem is global and cost-effective solutions are essential to avoid adverse effects on competitiveness.

CONCLUSION

In conclusion, the Kyoto Protocol and the president's general approach to climate change reflect the insight of economic analysis. The Kyoto Protocol includes key provisions on international trading and clean development projects.

The president's approach relies on market incentives -- first, with a system of tax cuts and R&D investments, and then later with a market-based system of tradeable permits to ensure that our objectives are achieved as efficiently as possible.

Global Issues
USIA Electronic Journal, Vol. 3, No. 1, April 1998