Modeling economy-wide vs sectoral climate policies using combined aggregate-sectoral models.

Economic analyses of climate change policies frequently focus on reductions of energy-related carbon dioxide emissions via market-based, economy-wide policies. The current course of environment and energy policy debate in the United States, however, suggests an alternative outcome: sector-based

and/or inefficiently designed policies. This paper uses a collection of specialized, sector-based models in conjunction with a computable general equilibrium model of the economy to examine and compare these policies at an aggregate level. We examine the relative cost of different policies designed to achieve the same quantity of emission reductions. We find that excluding a limited number of sectors from an economy-wide policy does not significantly raise costs. Focusing policy solely on the electricity and transportation sectors doubles costs, however, and using non-market policies can raise cost by a factor of ten. These results are driven in part by, and are sensitive to, our modeling of pre-existing tax distortions.

1. INTRODUCTION

Achieving environmental goals at lowest cost has sparked considerable interest in flexible, market-based policies that typically limit pollution by requiring emission sources to obtain a permit for each unit of pollution released. An overall emission cap is established by distributing a fixed number of these permits and flexibility is introduced by allowing users to freely trade the permits in a market. Market-based policies are also currently being used to address water pollution (Boyd et al. 2003), lead in gasoline (Stavins 2002), and overfishing (Newell et al. 2005).

Opposition to these policies can arise because in the process of creating a permit market, substantial transfers of wealth are possible--transfers that would not occur under non-market-based alternatives. For instance, users who previously paid nothing to emit pollution may now face the prospect of buying permits from a competitor or a regulatory agency. Furthermore, people and firms who are not directly regulated may see a greater increase in the price of pollution-intensive goods compared to command-and-control policies because every unit of emission incurs an opportunity cost. (1) Related to this concern is the fact that market-based policies to address climate change would operate primarily by raising the cost of using fossil fuels; meanwhile broad support remains for low energy prices as a means to promote economic growth (National Energy Policy Development Group 2001).