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Flaws in the Economic Analysis of California’s AB 32 Scoping Plan

On Friday, October 3, the California Air Resources Board is scheduled to formally release its Scoping Plan pursuant to AB 32, the “California Global Warming Solutions Act of 2006.” AB 32 calls for the state of California to reduce its greenhouse gas emissions to 1990 levels by 2020. One of the primary means to achieve this ambitious goal is a statewide “cap and trade” program, in which the state legislature will issue or sell permits entitling the owner to emit a certain amount of greenhouse gases. By lowering the total number of permits issued, the California legislature will control total emissions and reduce them over time. But because the permits can be bought and sold, individual businesses can adjust their own emissions at different rates, depending on the relative cost.

The immediate drawback of a cap and trade program—as well as other government policies that discourage the use of the most economical and reliable energies—is that it acts as a stealth tax. Because the emission permits will have a market price, the cap and trade program will raise the costs of doing business for firms in California. In fact, among those economists who are concerned about the threat of manmade global warming, many prefer an explicit tax on carbon, rather than a cap and trade program. This is because they believe that the negative impact on jobs and economic growth from a transparent tax would actually be preferable to the economic damage inflicted by a subtler cap and trade program.[1]

Despite warnings from top economists that climate-change policies will result in very high here-and-now costs, the California Air Resources Board wants to have their cake and eat it too. The Economic Supplement to the Draft Scoping Plan argues that not only will AB 32 reduce harmful global warming, but (they claim) it will actually boost the economy! Below are some of the more dubious arguments put forth in the Economic Supplement.

Politicians Telling Business How to Cut Costs?

Standard economic theory, as well as common sense, says that if the government forces businesses to operate differently, costs will rise and output will be lower than it otherwise would have been. After all, companies are legally allowed to reduce their emissions right now as much they want. Left to their own decision-making, California businesses would not meet the AB 32 emissions goals, and this indicates that higher emissions lead to higher economic output and income in the state. Businesses are in business to make profits, and they will choose the fuel sources and production techniques to minimize costs, maximize their revenues, and attract the best workers. If the state government then decides to force businesses to switch to different techniques which the businesses themselves originally did not want to adopt, then their profits will necessarily be lower, output will be reduced, and per capita income will fall. To repeat, this is standard economic analysis. Even prominent economists who endorse government action against global warming admit that in the short-run, policies that penalize carbon use will harm the economy; it’s just that these economists think the long-run benefits of mitigated climate change are worth the upfront pain.
So how then does the Air Resources Board reach the opposite conclusion? How do they believe ambitious measures to revamp California business practices can end up boosting economic growth? Here is their explanation:

Continued economic growth is perhaps the clearest indicator of the fundamental health of California’s economy. Under a business-as-usual case (i.e., without putting into effect any significant measures to reduce global warming emissions) economic growth is expected to total 43 percent between now and 2020, culminating in a Gross State Product of almost $2.6 trillion. The analysis we have conducted indicates that if California implements the comprehensive greenhouse gas reduction strategy, as recommended in the draft Scoping Plan, not only will the economy grow by a similar amount as we move toward 2020,but it will grow at a slightly higher rate. Increased economic growth is anticipated primarily because the investments motivated by several measures, such as the expansion and strengthening of existing energy efficiency programs and implementation of new and existing policies to reduce emissions from the transportation sector, result in substantial energy savings that more than pay back the cost of the investments at expected future energy prices.

Thus the fundamental assumption driving the result is that the government’s experts have identified several changes that California businesses could adopt that would both (a) reduce their greenhouse gas emissions and (b) make them more profitable. If this is true, then no cap and trade program is necessary. The government could simply produce thousands of copies of the Economic Supplement analysis, and mail them to every business in the state. After all, if these plans will help businesses make money, why does the government need to force firms to implement them?

In contrast to the very unrealistic assumption that government experts are savvier businesspeople than those actually in the private sector, we turn to the analysis of Yale University’s William Nordhaus. Nordhaus is a world expert in and pioneer of the economics of climate change, having written his first book on the topic since 1979. In his 2008 book, Nordhaus reports the latest runs of his “DICE” model of the world economy and climate. Even with a theoretically optimal tax on carbon—i.e. the best possible action against climate change, perfectly implemented by all governments around the world in unison—Nordhaus calculates that the economic costs of compliance would have a present value higher than $2 trillion.[2] To repeat, Nordhaus is an advocate of such a tax, because he believes it would prevent some $5 trillion in assumed environmental damages, at least in his DICE model.[3] But as a serious economist, Nordhaus recognizes that achieving these possible environmental benefits carry a very high cost in terms of forfeited economic output. The California Air Resources Board has assumed away the existence of tradeoffs, and thinks businesses are foolishly ignoring billions of dollars in profit opportunities year after year.

Unrealistic Targets

Simply put, the emissions targets in AB 32 are unrealistic with given technologies. As Margo Thorning, Chief Economist for the American Council for Capital Formation, explained in a 2007 analysis:

To illustrate the difficulty of reducing California’s emissions to 1990 levels by 2020, consider that over the entire 1990-2000 period, per capita emissions in California fell by only 2.9 percent… California’s projections show that, under its baseline forecast, emissions per capita will decline by 2.3 percent from 2000 to 2010 but will increase by 0.9 percent from 2010 to 2020…

In order to meet the emission reduction target in AB 32, per capita emissions would have to fall by 13.1 percent over the 2000-2010 period and an additional 19.4 percent from 2010 to 2020… In other words, the required reductions in per capita emissions are 4.5 to 6.5 times greater than what occurred from 1990 to 2000. The technologies simply do not exist to reduce total (and per capita emissions) over the next 14 years by the amounts mandated in AB 32—to say nothing of the time and expense required to replace existing energy using equipment—without severely reducing growth in California’s Gross State Product (GSP) and employment.[4]

Counting Benefits, Ignoring Costs

The Economic Supplement lists the specific (alleged) benefits of AB 32:

[O]ur modeling shows that implementation of the Preliminary Recommendation in the draft Scoping Plan will benefit California’s economy above and beyond the business-as-usual projections, in 2020, by:

  • Increasing production activity by $27 billion
  • Increasing overall Gross State Product by $4 billion
  • Increasing overall personal income by $14 billion
  • Increasing per capita income by $200
  • Increasing jobs by more than 100,000

The mistake here is to look only at the industries and jobs helped by AB 32, while ignoring those harmed or destroyed by the ambitious measures. For example, it is true that firms which install solar panels on commercial buildings will undoubtedly have increased sales, and will have to hire more workers because of AB 32. But this doesn’t mean that the California economy will incur net benefits, because there are other firms who will be harmed by AB 32, and will have to lay off workers accordingly. Indeed, a recent study commissioned by IER estimated that the proposed denial at the Federal level of the Section 199 manufacturing tax deduction to oil and gas companies could destroy over 600,000 jobs in those industries during a ten-year period.[5]

There is no getting around basic economics: If the government forces businesses to comply with additional constraints (such as an emissions reduction target), then it takes away options and necessarily reduces output. Workers in the state will be poorer. They already have the option of working for solar panel companies and other “green” firms, but they choose to work at other jobs that are currently paying higher salaries or other attractive features. If the government forces workers to switch from their current occupations into “green” ones, this can only make them worse off, because it forces the workers into positions that they did not voluntarily choose.[6]

The language of AB 32 is vague regarding who will actually pay for the upfront costs needed to achieve its ambitious emissions goals. For example, the impact on targeted businesses could be reduced by providing tax credits for costly, emission-reducing technology. Yet even in this case, unless the tax break is accompanied by equal cuts in the government’s spending, the result will be to increase the deficit, meaning that California’s taxpayers will ultimately foot the bill. The politicians in Sacramento may be able to shift the burden of AB 32 from one group to another, but there will be no avoiding the fact that Californians as a whole will suffer very large compliance costs.

“Go-It-Alone” Approach Will Yield No Environmental Benefits

There are reputable economists, such as William Nordhaus, who believe there is grave danger in allowing unfettered greenhouse gas emissions. Such economists recommend a carbon tax or a cap and trade program (since the latter is more politically feasible), knowing full well the large harms they would impose on economic growth and per capita incomes, because they believe these huge upfront costs will be more than compensated down the road by reduced damages from climate change.

Whatever the danger from unchecked global emissions may be, any serious analyst would agree that the policy decisions of one state (or even a coalition of a few Western states) will have virtually zero impact on the path of global temperatures. For one thing, California’s total emissions constitute about 1.5% of worldwide emissions.[7] Therefore, even if the state banned all emissions tomorrow, this action by itself would not register a perceptible change in the path of global temperatures over the next fifty or one hundred years, when the conjectured damages from climate change are supposed to really kick in.

However, it gets even worse. If California passes draconian measures to reduce emissions within its borders, this will not translate into a ton-for-ton reduction in global emissions (small though they may be). This is because many of the affected businesses in California will simply relocate to other states.

In the academic climate change literature, this phenomenon is known as “leakage.” We again turn to Nordhaus’ latest DICE model to get an idea of the problem. Interpreting the results of his “optimal carbon tax,” Nordhaus explains:

Moreover, the results here incorporate an estimate of the importance of participation for economic efficiency. Complete participation is important because the cost function for abatement appears to be highly convex. We preliminarily estimate that a participation rate of 50 percent instead of 100 percent will impose a cost penalty on abatement of 250 percent.[8]

What Nordhaus is saying is that if his textbook ideal tax were imposed on only half of the world’s emitters, rather than being uniformly applied in every single jurisdiction on the planet, then the economic costs of achieving a given environmental objective rise 250 percent. To repeat, this cost increase of 250 percent occurs when the participation in the program drops from 100% of the entire world down to only 50% of the entire world. Nordhaus does not even bother giving figures for the benefit/cost tradeoffs if only a single U.S. state were to implement climate change legislation, because such measures would obviously be pointless.

Conclusion

IER believes that the current range of government imposed “solutions” on climate change will inevitably fail to achieve their stated goals.[9] However, we recognize that many serious economists and other policy makers, including Nordhaus, disagree with us on the need for a worldwide carbon tax or other such instrument, to restrain global emissions of greenhouse gases.

Yet all serious economists on both sides of the issue understand that government policies to reduce emissions carry large, upfront costs, in terms of forfeited growth and lower incomes. Moreover, unilateral policies implemented at local levels will have virtually no impact on global emissions, and hence on climate change. California’s AB 32 will impose serious harms on its economy, with virtually no offsetting environmental benefits. Its Economic Supplement reaches the opposite conclusions by assuming that government experts have spotted billions of dollars in cost-saving measures that the actual businesspeople stubbornly refuse to implement.


[1] For example, see chapter eight, “The Many Advantages of a Carbon Tax,” in Yale University’s William Nordhaus’ (2008) book, A Question of Balance: Weighing the Options on Global Warming, available at: http://nordhaus.econ.yale.edu/Balance_2nd_proofs.pdf.

[2] See Table 5-1 on page 82 of the prepublication version of Nordhaus’ (2008) book, A Question of Balance: Weighing the Options on Global Warming Policies, available at: http://nordhaus.econ.yale.edu/Balance_2nd_proofs.pdf.

[3] IER questions the high costs of global warming assumed by Nordhaus. See IER economist Robert Murphy’s critique of Nordhaus available at: http://instituteforenergyresearch.org/2008/06/05/ier-economist-murphy-takes-on-nordhaus-case-for-a-carbon-tax/. However, the point above is that Nordhaus agrees that climate change mitigation policies carry a large upfront cost; Nordhaus happens to think the cost is worth paying.

[4] See page 5 of Margo Thorning, “A Reality Check on Initiatives to Reduce Greenhouse Gas Emissions in California, Oregon, the Northeast, and in Europe,” available at: http://www.accf.org/media/dynamic/1/media_19.pdf.

[5] IER’s report on the job losses from removal of the Section 199 tax deduction is available at: http://instituteforenergyresearch.org/2008/09/12/gang-of-ten-economic-analysis/.

[6] For a critique of the “Green Jobs Now” campaign, see IER’s article at: http://instituteforenergyresearch.org/2008/09/26/destroy-jobs-now-green-jobs-latermaybe/.

[7] California emits 6.71 percent of U.S. CO2 emissions (2004 data). http://www.eia.doe.gov/oiaf/1605/ggrpt/excel/tbl_statesector.xls. The U.S. emits about 22 percent of the world total www.eia.doe.gov/oiaf/1605/ggrpt/ p. 6. These numbers overestimate current California and US contributions because emissions from China are increasing at a dramatic rate.

[8] See page 198 of Nordhaus, at: http://nordhaus.econ.yale.edu/Balance_2nd_proofs.pdf.

[9] In fact, IER economist Robert Murphy has written an extensive critique of Nordhaus’ case for a carbon tax, available at: http://instituteforenergyresearch.org/2008/06/05/ier-economist-murphy-takes-on-nordhaus-case-for-a-carbon-tax/.


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