AEI-Brookings Joint Center Policy Matters 99-01

With the nation distracted by Chinese spies and Serbian anti-aircraft missiles, climate change is far from the minds of the chattering classes. But some day, some way, Washington will have to face up to the issue.

President Clinton signed, but the Senate has yet to ratify, the 1997 Kyoto Protocol calling for the rich industrial nations to reduce greenhouse gas emissions to 5% below 1990 levels before 2012. Meeting that objective is likely to be economically and politically painful, with an estimated cost of about $1 trillion.

The worry over climate change--what drove the advocates of the Kyoto Treaty--is that unchecked global warming will produce dramatic changes such as the disappearance of coastlines and an upsurge in tropical diseases. We will probably not live to see that day, but our children and grandchildren easily could. Thus the task facing us now is how best to address the unquantified possibility of disaster decades hence.

Analysts disagree about the science of climate change and appropriate policy targets. But they do agree that emission control costs need to be reduced substantially before anything like the Kyoto targets can be met. Technological innovation is the key to reducing those costs.

Alas, the timing of such innovation does not respect treaty deadlines or Congressional mandates. But the timing of putting new technology into use can be very much affected, for example, by how and when "credits" for reducing pollution are handed out. Thus the first priority is to remove obstacles and add incentives for early adoption of cleaner and cheaper technology. Everybody wins, whether or not the Senate ever ratifies the Kyoto treaty.

The United States has two options for promoting clean-up technology. The obvious one is to subsidize sensible research and development. Less obvious--and arguably more important--government could introduce market-like mechanisms that give industry incentives to look for cheap emission fixes now.

While Washington may be unable to remove all the political pork from R&D policy, it could minimize the waste by focusing on what it does best: funding basic research. President Clinton advanced a $6 billion R&D climate initiative last year that fell largely on deaf ears in Congress. And for good reason: Over half of the money would have gone to tax incentives of dubious value. Unfortunately, Congress has done no better, as illustrated by its pork-laden clean coal program, which subsidizes the coal industry. If Congress and the White House cannot resist the temptation to promote pet projects under the guise of stimulating environmental innovation, they should at least be required to show some economic justification for their proposals.

A second way to stimulate innovation is to give private industry market-based incentives to develop technologies. In the case of acid rain, for example, the government introduced tradable allowances for emissions of sulfur dioxide. Firms that invented inexpensive ways to reduce sulfur emissions found a ready market among electric utilities that wanted to lower their pollution control costs. The resulting savings: about $1 billion annually.

Policymakers have proposed similar markets to help meet the objectives specified in the Kyoto Protocol, but those markets would not become operational until 2008. The question is what to do now.

"Early reduction" credits could be offered to businesses that took action now, in advance of hard and fast regulation of greenhouse gas emissions. That sounds great, but the resulting cuts might not lead to overall reductions. Consider, for example, a laundromat that chose to reduce energy use by 50 percent. Should it receive credits for reducing greenhouse emissions, even if it were planning to cut its fuel use anyway?

One bill introduced in the Senate would do exactly that. It offers credits that could be applied after the year 2008 regardless of the motive for cutting emissions now. Fewer credits would be available for other firms later on. Such early-reduction schemes would create a business constituency for using market-based incentives to meet the Kyoto target, but do little to stimulate new technologies or to reduce total emissions.

Another problem with the early-credit approach is that policymakers have no obvious baseline from which to determine credits. That would require a real market in greenhouse gas emissions now, which in turn would require setting emission limits now.

Economists have suggested such markets, or a combination of markets and taxes, to achieve explicit (if modest) emissions targets. But their notions do not pass political muster. If the Senate is not ready to ratify the Kyoto Protocol for the year 2008, it is hardly ready to set emission limits in 1999, no matter how modest.

I propose an alternative that would yield substantial environmental benefits without generating the same degree of opposition. Congress could resolve that if it does limit emissions sometime down the road, it will determine each firm's initial emissions allowance on the basis of the firm's activity before 1999.

This would reduce the incentives to game the system. If businesses developed innovative technology, they would not hold back in hopes of getting a better deal if allowances were set according to past rates of emissions. If new, more efficient and less costly means of reducing greenhouse gases come along, all firms will have an incentive to install them. Congress could take an even bolder step by extending this approach to all environmental policy, not just greenhouse gas emissions.

Such a declaration of intent is not equivalent to a firm policy on emissions. Congress can always change its mind and rescind the resolution, and firms know that. Second, businesses could still lobby to get favorable regulatory treatment--a political fact of life.

But the United States is going to have to face the music on climate change sooner or later. And a key to success will lie in reducing the costs of compliance to politically acceptable levels. Surely a constructive first step would be to lower the barriers to emissions-reducing innovation.

Robert Hahn is Director of the AEI-Brookings Joint Center for Regulatory Studies in Washington.