Waxman-Markey Cost-Benefit Analysis

There has been widespread agitation in the influential blogosphere for a cost-benefit analysis of the Waxman-Markey cap-and-trade proposal. This sure seems like a reasonable request to me, and you have to wonder why the sponsors and advocates of this bill – who are, after all, proposing an enormous commitment of resources – haven’t provided one. So I tried to do a quick version of it. I have a longer and more complete version of this coming in the next National Review, but wanted to get the bones of the analysis out for discussion as rapidly as possible.

Background Analysis

According to the authoritative U.N. Intergovernmental Panel on Climate Change (IPCC), under a reasonable set of assumptions for global economic and population growth, the world should expect (Table SPM.3) to warm by about 2.8°C over the next century. Also according to the IPCC (page 17), a global increase in temperature of 4°C should cause the world to lose about 3 percent of its economic output. So if we do not take measures to ameliorate global warming, the world should expect to be about 3 percent poorer sometime in the 22nd century than it otherwise would be. This is very far from the rhetoric of global destruction. Because of its geographical position and mix of economic activities, the United States is expected (Table 3) to experience no net material economic costs from such warming through the end of this century, and to begin experiencing net costs only thereafter.

A government program to force emissions reductions to avoid some of these potential future losses would impose a cost of its own: the loss in consumption we would experience if we used less energy, substituted higher-cost sources of energy for fossil fuels, and paid for projects—which are termed “offsets”—to ameliorate the effect of emissions (an example would be planting lots of trees). It’s complicated to estimate the cost of an emissions-reduction program, but the leading economists in this area generally agree that it would be large, and that we should simply let most emissions happen, because it would be more expensive to avoid them than to accept the damage they would cause. This makes sense, if you consider that most such plans (for example, Waxman-Markey) call for eliminating something like 80 percent of carbon dioxide emissions within the next 40 years or so. Even if the economy becomes more efficient over this period, such a quick transition away from our primary fossil-fuel sources will be expensive.

If a) the total potential benefit of emissions abatement is about 3 percent of economic output more than 100 years from now, b) we can avoid only some of this damage, and c) it’s expensive to prevent those emissions that we can prevent, the net benefit of emissions reduction will likely be a very small fraction of total economic output. William Nordhaus, who heads the widely respected environmental-economics-modeling group at Yale, estimates (page 84) the total expected net benefit of an optimally designed, implemented, and enforced global program to be equal to the present value of about 0.2 percent of future global economic consumption. In the real world of domestic politics and geostrategic competition, it is not realistic to expect that we would ever have an optimally designed, implemented, and enforced global system, and the side deals made to put in place even an imperfect system would likely have costs that would dwarf 0.2 percent of global economic consumption. The expected benefits of emissions mitigation do not cover its expected costs. This is the root reason that proposals to mitigate emissions have such a hard time justifying themselves economically. (If interested, you can read much more about this here).

Costs vs. Benefits of Waxman-Markey

Let’s start with the costs. The Environmental Protection Agency (EPA) has done the first cost estimate for Waxman-Markey. It finds (page 17) that by 2020 Waxman-Markey would cause a typical U.S. household to consume about $160 less per year than it otherwise would, and about $1,100 less per year by 2050 (before any potential benefits from avoiding warming). That doesn’t sound like the end of the world, but this cost estimate is based on a number of assumptions that seem pretty unrealistic, to put it mildly.

First, it assumes that every dollar collected by selling the right to emit carbon dioxide will be returned to taxpayers through rebates or lowered taxes. Waxman-Markey establishes this intention but doesn’t (as of the time I’m writing this) describe how it would be achieved, which reflects the political difficulty of achieving it. Second, it assumes no costs for enforcement and other compliance measures, which would be awfully nice. Third, it assumes that large numbers of foreign offsets will be available for purchase; without these, costs would be far higher. Fourth, it assumes that the rest of the world will begin similar carbon-reduction programs. Lack of such foreign action would either increase U.S. costs or risk a trade war if we tried to compensate for lack of international cooperation with targeted tariffs. Fifth, it assumes that there will be no exemptions or other side deals—that is, no economic drag created by the kind of complexity that has attached to every large, long-term revenue-collection program in history. And so on.

The EPA forecast is something like an estimate of the pure loss in economic productivity from replacing some fossil fuels with less economically efficient fuels or conservation in a laboratory setting; in the real world, expected costs are far above 0.8 percent of economic consumption by 2050. The EPA does not forecast costs beyond 2050.

Remember that the U.S. should not expect any net economic damage from global warming before 2100. That is, the bill’s benefits would accrue to U.S. consumers—who are also bearing its costs—sometime in the next century. The EPA underestimate has costs rising from zero to 0.8 percent of consumption between now and 2050, and offers no projection beyond that year; but to what level would costs rise over the more than 50 years between 2050 and the point in 22nd century when we might actually expect some net economic losses from global warming? The answer is likely to be much higher.

Now consider the benefits. Climatologist Chip Knappenberger has applied standard climate models to project that, under the scenario for global economic and population growth referenced above (A1B), Waxman-Markey’s emissions reductions would have the net effect of lowering global temperatures by about 0.1°C by 2100. Remember that the estimated cost of a 4°C increase in temperature (40 times this amount) is about 3 percent of global economic output. Assume for the moment that global warming has the same impact on the U.S. as a percentage of GDP as it does on the world as a whole (an assumption that almost certainly exaggerates the impact on the U.S.). A crude estimate of the U.S. economic costs that Waxman-Markey would avoid sometime later than 2100 would then be about one-fortieth of 3 percent, or about 0.08 percent of economic output. This number is one-tenth of 0.8 percent, the EPA’s estimate of consumption loss from Waxman-Markey by 2050. To repeat: The costs would be more than ten times the benefits, even under extremely unrealistic assumptions of low costs and high benefits. More realistic assumptions would make for a comparison far less favorable to the bill.

I’ve had to rely on informal studies and back-of-envelope calculations to do this cost/benefit analysis. Why haven’t advocates and sponsors of the proposal done their own? Why are they urging Congress to make an incredible commitment of resources without even cursory analysis of the net economic consequences? The answer should be obvious: This is a terrible deal for American taxpayers.

Two Potential Objections

One potential objection to my analysis is that the bill is part of a global drive for all countries to reduce emissions, and that the U.S. needs to “show leadership.” By this logic, we should ascribe much larger benefits to the Waxman-Markey bill—specifically, the benefits to American consumers of the whole world’s engaging in similar programs. There are two obvious problems with this argument, however. First, ascribing all of the benefits of a global deal to reduce emissions to a specific bill that does not create such a commitment on the part of any other countries is loading the dice. The benefit we should ascribe to the bill is rather that of an increase in the odds of such a global deal. But would Waxman-Markey actually increase them, or would it decrease them instead? Whenever one nation sacrifices economic growth in order to reduce emissions, the whole world can expect to benefit, because future temperature should decrease for the entire globe. Every nation’s incentive, therefore, is to free ride on everybody else. Our most obvious leverage with other emitting nations would be to offer to reduce our emissions if they reduced theirs. Giving up this leverage and hoping that our unilateral reductions would put moral pressure on China, Russia, Brazil, and similar countries to reduce their emissions reveals a touchingly sunny view of human nature, but it strikes me as a poor negotiating strategy. Second and more fundamentally, even if the whole world were to enact similar restraints on emissions, the cost / benefit economics would still not be compelling, for the reasons outlined at the beginning of this post.

A second and more serious potential objection to my analysis is that while Waxman-Markey may not create benefits if the projections I offered above turn out to be accurate, climate science is highly inexact, and the bill is an insurance policy against higher-than-expected costs. Now, climate and economics modelers aren’t idiots, so it’s not as though this hadn’t occurred to them. Competent modelers don’t assume only the most likely case, but build probability distributions for levels of warming and associated economic impacts (e.g., there is a 5 percent chance of 4.5°C warming, a 10 percent chance of 4.0°C warming, and so on). The economic calculations that compose, for example, the analysis by William Nordhaus that I cited earlier are executed in just this manner. So the possibility of “worse than expected” impacts means, more precisely, the possibility of “impacts worse than those derived from our current probability distribution.” That is, we are concerned here with the inherently unquantifiable possibility that our entire probability distribution is wrong.

This concept has been called, somewhat grandiosely, the “Precautionary Principle.” Once you get past all the table-pounding, this is the crux of the argument for emissions abatement. It is an emotionally appealing political position, as it easy to argue that we should reduce some consumption now to head off even a low-odds possibility of disaster. The most compelling version of this argument, by far, has been presented by Martin Weitzman. You can read my detailed response here (note that this was to a slightly earlier edition of the paper). The essence of my response is that in order to drive a decision, Weitzman must take his argument from the conceptual idea of a “fat-tailed distribution” of danger to a numerical estimate of risk. He recognizes that the logic of his argument entails this. In his article, he ends up having to do the kind of armchair climate science that has been the bane of the “global warming is all a hoax” set. He uses a couple of ice bore studies to develop his own probability distribution for potential warming that calls for a 1% chance of 22.6C or more of warming by 2100. To put this in perspective, a 22.6C increase in the earth’s temperature would mean that the average global year-round temperature would be the same as summertime Death Valley is today. If you could convince me that there was a reliably-quantified 1% chance of this happening, you wouldn’t need all of the mathematical formalism of Weitzman’s paper – I’d be the biggest emissions mitigation proponent on earth. The problem is that the IPCC has already built a distribution of potential temperature changes (see Figure 10.28, page 808) that looks nothing like this. If you don’t want to believe me, read Cass Sunstein’s book about why the Precautionary Principle, even in sophisticated form, is a very bad decision rule.

In the end, clarity about costs and benefits is the enemy of Waxman Markey. It is hard to get around the conclusion that it can not be justified rationally based on the avoidance of climate change damages.