Phone Calls from the Congressional Budget Office

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

My February 21 post, CBO Report: The Real Story, caught the attention of the folks at the Congressional Budget Office (CBO). Last Wednesday, I received a call from Terry Dinan, the senior analyst at CBO who wrote the report. A little while later I got a second call, this time from Peter Orszag, the Director of CBO.

In particular, they didn’t like the attention-grabbing paragraph at the top that said:

…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.

I stand by what I wrote, as I’ll explain in a moment. But a call from the Director of CBO is fairly attention-getting, as well. Moreover, Dinan and Orszag are smart and well-respected economists, and my conversations with them helped to sharpen my own thinking. So I thought I’d explain a couple of points in more detail.

To be perfectly clear: The folks at CBO did a good job of presenting the economics literature. If you read all the way through the report, you will find a balanced characterization of mainstream economic thinking.

But I had two concerns:

• The report puts too much weight on a straw man – the so-called "inflexible cap-and-trade" system, a policy that has never been proposed in the real world.
• The report’s main conclusions rely on a faulty premise that, while in line with the economics literature, is at odds with the conclusions of climate scientists.

The Straw Man: "Inflexible" Cap-and-Trade

The CBO report opens by comparing a carbon tax with a straw man: an inflexible cap-and-trade system that precludes banking and borrowing of allowances. Nobody is proposing such a policy. As I explained in my previous post, banking and borrowing are crucial ways of giving firms flexibility to manage their emissions reductions over time, and are a key part of every proposal before Congress.

When I spoke to Terry Dinan, she said she didn’t intend readers to dwell on the inflexible cap. Rather, she used a simplified version of cap-and-trade as a way to "build intuition" (highlight basic concepts). This is a common strategy in academic circles, and in fact, all the theoretical analyses on which CBO relies also consider an inflexible cap-and-trade system.

But a CBO report is not merely an academic document; it’s also a political one. And in that context, I worry that such nuances are lost on the average reader.

The Faulty Premise: Flow versus Stock

What about that "faulty premise" I mentioned? In considering the damages from greenhouse gases (GHGs), the mainstream economic literature that CBO cites looks at annual emissions, rather than total concentration in the atmosphere.

In my view, this focus on current emissions rather than total concentration is a fundamental error. Although annual emissions are what we can control, they are not what policy must manage. The total concentration of GHGs in the atmosphere is what drives global warming, so the objective of climate policy should be to stabilize total GHG concentration – cumulative emissions.

Cumulative emissions are distinct from annual emissions because the pollution we emit today will still be there in a hundred or even a thousand years. We’re emitting GHGs into the atmosphere much faster than natural processes can remove them. What matters is not what we emit in a given year, but the total amount that ends up in the atmosphere.

In economic terms, global warming is a problem of managing a "stock" (total GHG concentration) rather than "flow" (annual emissions).

Economists do recognize that global warming depends on the stock of GHG pollution. The problem is, they haven’t incorporated that fact into their thinking about policy solutions.

Marginal Damages Will Be Steep

If the factor you’re considering is emissions, then the marginal damages (the incremental damages from each additional ton) are essentially constant. That is, the damage from one more ton of emissions doesn’t depend on how much has already been emitted in a given year. Framed in this way, the most "economically efficient" policy to control climate change (that is, the policy that achieves the greatest expected net benefits) would appear to be a carbon tax, since a carbon tax controls price. That, in a nutshell, is the CBO’s argument.

But if the factor you’re considering is total GHG concentration, then marginal damages are anything but flat. Scientists tell us that far from being constant, climate change is abrupt and non-linear. From the National Academies report Abrupt Climate Change: Inevitable Surprises:

…greenhouse warming and other human alterations of the earth system may increase the possibility of large, abrupt, and unwelcome regional or global climatic events.

One reason that the effects of global warming are non-linear is "tipping points", critical thresholds at which small changes qualitatively alter the state of a system. An example is the Greenland Ice Sheet, which could start a slow but irreversible meltdown if GHG concentrations cause global temperature to rise above a tipping point (that scientists warn could be just 2°F above today’s temperature). If the Greenland Ice Sheet melts, this would eventually – and inevitably – cause sea levels to rise over 20 feet, flooding heavily populated coastal areas around the world. And this is just one example.

Translated into economic terms, this means that the marginal damages from global warming are likely to increase very rapidly at some point.

When marginal damages are steep, the most efficient way to manage climate change is through a cap-and-trade system, since a cap directly controls cumulative emissions.

The CBO report actually makes this point, acknowledging that the existence of a threshold or “tipping point” for the consequences of climate change "could make a cap more efficient than a tax." CBO treats this as a merely hypothetical concern, but scientists tell us it’s actually the case.