CBO Report: The Real Story

Nat KeohaneThis post is by Nat Keohane, Ph.D., Director of Economic Policy and Analysis at Environmental Defense.

The Congressional Budget Office (CBO) released a report this month on Policy Options for Reducing CO2 Emissions [PDF]. It concludes that a carbon tax reduces emissions more efficiently than cap-and-trade.

But a careful reading reveals the report to be a theoretical exercise with no real-world relevance. It highlights the drawbacks of a version of cap-and-trade that no one advocates, and bases its efficiency analysis on a faulty premise.

The CBO report compares four scenarios:

  • carbon tax
  • cap-and-trade with banking and a "safety valve"
  • cap-and-trade with banking and a "circuit breaker"
  • cap and trade with no flexibility

These scenarios are unrealistic. No one is suggesting inflexibly capping emissions in every individual year – this is a straw man. Plus they make the mistake of coupling a sound strategy like permit banking with cap-breaking safety valves and circuit breakers.

Banking, Safety Valves, and Circuit Breakers

Banking permits for use in different years is widely accepted as good strategy. With permit banking, a total "emissions budget" is set over a long period. For example, current legislation before Congress would determine total emissions between 2012 and mid-century. Banking and borrowing permits lets the market determine when emissions cuts can be made at least cost.

Permit banking was a key reason for the wild success of the cap-and-trade system that reduced acid rain. Banking also is a feature of the legislation currently before Congress, and indeed of every serious legislative proposal that’s been made.

A safety valve, in contrast, seriously undermines the main advantages of a cap. With a safety valve, when prices reach a predetermined dollar value, businesses no longer have to rely on the established supply of allowances available in the market. Instead, the federal government makes new allowances available for sale at a specified price – potentially in an unlimited quantity. This creates two serious problems:

  1. It destroys the cap, and the hard limit on emissions is critical. A safety valve gives the illusion that we are controlling emissions while allowing more greenhouse gas pollution into the atmosphere.
  2. It limits the economic opportunity of those who develop cleaner technology. Higher permit prices signal the market to invest more in innovative low-carbon technologies – happy news if you’re in the business of inventing and selling ways to cut pollution. A safety valve would sharply curtail incentive for innovation, driving costs up in the long run.

A circuit breaker has all the same problems as a safety valve. With a circuit breaker, the cap is loosened if the price of permits rises above a certain level.

The Key Premise is Wrong

Let’s forget for a moment that the report’s scenarios make no sense. The CBO report says that even when compared to the most flexible cap-and-trade system, a carbon tax is a more efficient way to reduce emissions. They reach this conclusion from a faulty premise.

At the heart of the CBO analysis is the notion that the cost of greenhouse gas emissions (i.e. the damage from climate change) is relatively flat and predictable, so the cost of each additional ton of emissions (the "marginal cost") is roughly constant. If this were true, they’d be right – the most economically efficient approach would be a tax equal to the marginal damage.

But this premise is false! Far from being constant and predictable, the damage from climate change is nonlinear and uncertain.

Scientists tell us that climate change is subject to "tipping points" – that after a certain threshold is reached, climate can change in qualitative and discontinuous ways. For example, at 32°F ice changes to water. The best known climate tipping point affects the Greenland Ice Sheet, which could begin a slow, irreversible meltdown if global temperature passes a certain threshold. (For more on tipping points, see our post on "9 Dangerous Tipping Elements".)

A carbon cap sets a quantity target – the amount of emissions is certain, the price is uncertain. A carbon tax sets a price target – the price is certain, and the amount of emissions is uncertain. If the amount of emissions has a predictable cost, then it makes sense to base policy on price. But this is not the case in a climate system subject to tipping points. If we exceed our "carbon budget", the costs could become astronomical. Scientists may differ on exactly what our carbon budget should be, but there’s no question that a quantity target is what’s required.

When the central problem is setting the right quantity – how much we can safely emit in total – then the arguments that support a carbon tax flip in favor of cap-and-trade. The CBO report actually acknowledges this. Almost as an aside, the report points out that the existence of a threshold or "tipping point" for the consequences of climate change "could make a cap more efficient than a tax." The CBO report treats this as a merely hypothetical concern, but scientists tell us that it is, in fact, the case.

So don’t be too impressed by the conclusions in the CBO report. It might be useful reading for undergraduate economics classes, but it has little relevance for real-world policy debates.

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  1. Posted February 23, 2008 at 8:52 pm | Permalink

    A lifelong interest in meteorology, climatology, geology, astronomy, and related sciences, and being familiar with the scientific method (as a mathematician), I am amazed that certain assumptions are taken as proven, one of them being that the greenhouse effect is a significant driver of climate change, another being that concentrations of atmospheric CO2 are a significant driver of climate change (aka, global warming). Recent warming in the several decades from late 1970s through the late 1990s has stabilized and there is growing evidence of a significant cooling trend over the next several decades (at least). When errors in the data were corrected, the 1930s resumed the title of warmest decade since the Little Ice Age, and 1934 is once again the hottest year in recorded history (not a very long time in terms of climate). Clearly, little understood solar interactions with the Earth climate system appear to be a far better match for climate change than any measure of CO2 concentrations in the atmosphere, and with good reason (there is no credible science to support the theory that CO2 emissions — from whatever source — are responsible for significant climate change). Tracking various solar measures (magnetic flux, solar wind, sunspot cycle, frequency, etc.) shows a much stronger correlation than that produced by atmospheric CO2 concentrations (which have grown steadily and consistently since at least the beginning of the Industrial Revolution). It is far more plausible to suggest that the rise in CO2 is attributable to the gradual long term warming as the Little Ice Age ended and the Modern Warm Period began. Ironically, the arguing over “global warming” is likely (according to recent studies and observations) likely to spill over into the most intense period of cooling since the Little Ice Age. One wonders why there is so little concern over the much more dangerous potential for global cooling? The adverse consequences to all life forms of protracted global cooling are far more serious than that which would attend global warming.

  2. fred1
    Posted February 25, 2008 at 9:39 pm | Permalink


    i could not agree more. to add to what you are saying, in the last several thousand years, civilization has tended to flourish in warmer periods and have difficulties in colder periods (little ice age). i am also surprised by the alarmism over the fact that warming will result in greater incidence of diseases. What? When is cold and flue season? not in the summer that is for sure. the largest malarial outbreak occured in Russia in the 1920’s. no tropical paradise there.

    Nat, looking forward to a response to these posts. i will tell you, i am a closet environmentalist. I recycle, i try to save energy (and money at the same time) by turning the thermostat down in the winter, i sweep my fertilizer off my driveway so hopefully it doesn’t flow into the local sewer. i just am not sure i understand the alarmism over global warming. it has become political. China and India are having their coldest and snowiest winters in 50 years. we don’t hear any radical press stories about that. (By the way probably need to include the American West as having one of its coldest and snowiest winters in decades as well.). no huge alarmist headlines about that. ironically if it was the hottest summer in the last 50 years that would make huge headlines. please admit that this is has become far too politically charged of a debate. the fact of the matter is CO2 as the driving factor for global warming is not even close to being proven. historical records do not correlate that at all.

  3. Posted February 26, 2008 at 11:53 am | Permalink

    bwebster, what you state about the temperature record is simply incorrect. I refer you to two previous posts. This one talks about the 1930s:


    This one talks about how temperature data is collected (and why there is a margin of error):


    I won’t bother going through the rest of your message point by point. I would just ask that you please not make unsubstantiated claims. If you state a claim, back it up with a link to the data (as we always do) or don’t make the claim. Anyone can spout misinformation. It just muddies the discussion and serves no one.

    I would ask the same of you, fred1. You’ve posted many unsubstantiated claims on this blog.

    Thank you.

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