Does Money Grow on Trees After All?

Consumers. Households. Citizens. Loyal subjects. The American people. The emergence of cap and dividend as a key piece of the Senate climate debate—either as a stand-alone bill or more likely a core principle of the Kerry-Graham-Lieberman process—can be directly traced to increasing awareness of how climate policy impacts the U.S. economy and the average “Joe Coal.”

However, direct rebate checks are not the only way to make climate policy more economically-friendly. Sens. Cantwell and Collins have acknowledged this by devoting 25 percent of the auction revenues in their bill to clean technology development and other purposes. It does not take a Ph.D. in economics to understand that lowering the cost of key emissions reduction technologies makes it less costly for companies to comply with climate regulations, savings which are then passed on to the broader economy and households in the form of lower allowance prices. Any U.S. government analysis of climate policy that assumes higher costs or delayed implementation of clean technologies shows higher allowance prices and more substantial economic impacts.

Climate policy, costs and international offsets

In bills like the House-passed Waxman-Markey, this is equally if not more true for the supply of international emissions offsets, a majority of which are expected to come from reducing tropical deforestation in developing nations. Indeed, EPA analysis of the House bill shows that average annual allowance prices would be 89 percent higher and average annual net present value costs of climate policy to households would be 75 percent higher without international offsets. In part to help ensure these offsets would be available, policy makers set aside 5 percent of allowance auction revenues to reduce emissions from deforestation and help developing nations prepare for U.S. offset programs.

Since it is such a key driver of costs, why shouldn’t policy makers think of international offsets as just another “technology” that is essential to bring on line in order to manage the costs of climate policy?

While early rumors indicate that the Kerry-Lieberman-Graham bill will allow companies to purchase international offsets for compliance purposes—at least in the electric utility and manufacturing sector cap-and-trade program—the push for returning revenues to households directly is squeezing down the space for a 5 percent set-aside of auction revenues for tropical forests. Removing this set-aside is likely to reduce the supply of international offsets because, without funding to develop measurement, monitoring and verification systems and reform institutions, fewer nations will be prepared to meet U.S. compliance standards.

This raises a number of interesting economic (and political) questions. First, because of a more limited supply of offsets, what would be the impact on allowance prices of removing this set-aside? Second, would the higher allowance prices caused by removing this set-aside make the U.S. economy and households worse off than the benefit they would receive from a direct rebate of auction revenues?

Saving households money by investing in tropical forests

We set out to answer both questions using Resources for the Future and Climate Advisers’ Forest Carbon Index (FCI) model and EPA modeling scenarios of the House climate bill (which can be used as a rough proxy for the electricity and manufacturing sector emissions trading program in the Kerry-Lieberman-Graham “hybrid” bill).

The first step was determining how international offset supply would respond to a reduction in new public funding. Making a qualitative assessment based on the FCI and other studies, we analyzed three possibilities: that reducing public funding would lead to small initial drop in supply and delay in reaching full capacity (“Optimistic” case), that reducing public funding would lead to a large initial drop and longer delay in reducing public funding (“Medium” case), and that reducing public funding would lead to about a ten-year delay in any forest sector offset availability and a slow ramp-up thereafter to full capacity (“Pessimistic” case). These scenarios were intended to be illustrative of a range of possible responses and were based on political and economic judgments about key countries including Brazil and Indonesia.

Across these scenarios, in our analysis eliminating the set-aside could lead to a cumulative reduction in international offset supply of between 6 and 32 percent, which the proportional relationship between international offset supply and allowance prices in EPA scenarios indicates could increase average annual allowance prices by 4 to 27 percent.

Using the proportional relationship between allowance prices and GDP impacts shown by EPA’s modeling scenarios this would lead to a 3 to 24 percent increase in the annual average net present value costs of climate policy (2012-2050). In more concrete terms, even when accounting for the cost of the set-aside, net savings from setting aside new public revenues for tropical forests (in terms of GDP impacts) could range from $317 million to $18 billion per year. This means that under all scenarios each $1 in set-aside spent could yield greater than $1 in savings.

The picture with households is more mixed, and overall the impacts are less significant. Net changes in the average annual net present value cost of climate policy per household range from a $9 per-year increase in costs from eliminating the set-aside under a “Pessimistic” offset supply response case to a $5 per-year reduction in costs under an “Optimistic” scenario. Under a “Medium” scenario households would face roughly the same costs whether the set-aside for forests or a rebate is provided.

Overall, these findings highlight the potential risk to the U.S. economy of not providing a new public funding set-aside for tropical forests. If offset supply is sharply reduced by not providing the set-aside, the economic impacts of climate policy could be much more severe. If offset supply is only reduced a small amount, the annual GDP savings could still exceed the cost of the set-aside. Under either scenario, in economic terms households would be largely indifferent whether they receive these cost savings in the form of a rebate check or in the form of lower allowance prices.

Returning revenues to households or supporting technology development is not the only way to make the American people better off in a cap-and-trade program. Even beyond the vast environmental and foreign policy benefits of investing public revenues in reducing tropical deforestation, it appears to be a winning economic strategy as well.

Read the technical report The Economic Benefits of Public Investments in Tropical Forest Conservation (PDF) here. Andrew Stevenson is a research assistant at Resources for the Future and regular contributor to Common Tragedies.