Implicit Carbon Price

My posting last Friday on greenhouse gas cap & trade prompted some interesting reader comments and questions, one of which got me thinking about the price of carbon implied by the revenues included in the budget submitted to Congress. Estimating this required an examination of our recent greenhouse gas track record, along with some assumptions about how rapidly emissions would be reduced. The result appears to suggest that surprisingly modest CO2 permit prices in the initial period would be sufficient to generate the revenues shown in the budget.

President Obama campaigned on a pair of high-level greenhouse gas targets, to reduce emissions to 1990 levels by 2020, and to 80% below 1990 by 2050. That would entail a somewhat easier transition than the previous cap & trade legislation submitted to Congress, last year's Boxer-Lieberman-Warner bill, but a stricter long-term cap. Expressed in terms of tons of CO2-equivalent emissions per year, as of the most recent US greenhouse gas estimates from the Department of Energy, the President's goals would require a net reduction of slightly more than one billion tons per year (tpy) from 2007 levels by 2020, and a further 5 billion tpy in the subsequent 30 years. If emissions were flat between now and 2012, when the budget suggests reductions would begin, and the cuts proceeded in a linear fashion, cumulative emissions from 2012-2019 would be 54.1 billion tons, down from a baseline of 58.3 billion tons. Based on the $645.7 B in expected revenue from auctioning cap & trade permits over that period, the implied price per ton emitted works out to a surprisingly low $12/ton. Since this is well below the $20/ton that many experts expect to see initially, I took a look at my math and then my assumptions.

The biggest assumptions concern how much emissions might grow between 2007 and the start of cap & trade in 2012, and how rapidly they would be reduced subsequently. I initially assumed no growth to 2012, considering that emissions have increased at an average rate of 0.4% per year since 2000, spanning both the previous recession and the asset booms of the last few years. More realistically, I would expect 2008 emissions to reflect a drop from 2007, based on high energy prices in the first half and the effects of the recession in the second half, with 2009 emissions likely even lower. If we factored in a 5% cumulative drop through 2012, that would reduce the severity of cuts required to achieve 1990 levels by 2020, while also reducing the cumulative emissions over the 2012-2019 period, slightly increasing the effective cost per ton CO2e required to deliver the same revenue. Phasing in reductions more slowly would increase cumulative emissions and drive down the effective dollars per ton, perhaps to $11/ton. In other words, within reasonable bands of uncertainty about how emissions might change from 2007 levels before cap & trade started, and how rapidly the annual caps tightened toward achieving 1990 levels by 2020, the implied cost per ton of CO2 equivalent looks pretty modest in this period--the equivalent of roughly 1 cent per kWh for coal-generated electricity or 11 cents per gallon of gasoline.

Cap & trade still faces many hurdles, including the chance of a significantly different concept emerging from Congressional debate or a postponement due to the weak economy. However, at least in terms of the assumptions built into the budget, my back-of-the-envelope estimate indicates that it might not cause dramatic increases in energy prices in the first few years of the program, although the sums collected across the entire economy would still be material.