The cost of cap and trade?

As Waxman-Markey starts to bed into the consciousness of the US, there has been a rush to calculate the “cost” of climate legislation – some with the view of destroying the bill and others to reassure us that it won’t impact us at all.

So it seems that this might be a useful subject to do some basic thinking about. But beware, I am not an economist, so I will be probably get roundly dumped on by those that are – but I am an engineer and engineers are quite good with envelopes and the back of them – or in my case this evening a pad of Post-It notes.

There is no doubt that reducing emissions in the USA will cost some money. But there will be benefits as well. For starters, have a look at the McKinsey abatement curve for the USA.

An batement curve for the USA

An abatement curve for the USA

There are two parts to this curve, the left hand side where no carbon price is actually necessary to deliver the reductions, and the right hand side where a carbon price is needed.

On the left hand side there are actions such as improved lighting, better domestic appliances and building insulation. All these actions improve energy efficiency and lower our costs – so we should just do them. But we don’t as a matter of practice (bad housekeeping really), so improved standards and building codes should be employed to force these changes into the marketplace and as a result the economy benefits.

On the right hand side we are using technologies such as Carbon Capture and Storage which will cost money. If CO2 didn’t have the impact that it does in the atmosphere we would never do this. Equally, we wouldn’t force offshore wind, certain solar technologies and perhaps new nuclear into the market quite as quickly. Earlier take-up of these technologies could cost us money overall.

Simply eyeballing the abatement curve, shows that the two blue areas are about equal, which means through to 2030 this is a zero sum game. What we gain on efficiency in the economy we spend on early technologies and CCS. But that doesn’t mean that cap-and-trade doesn’t cost anything, because it does. Cap-and-trade is only needed on the right hand side of the abatement curve, so let’s just focus on that bit alone.

First of all it shows that the CO2 price needed for these technologies ranges from a few dollars to about $50 per tonne, so lets say the average is $40 per tonne in the big industry and power sectors which is where the CO2 price is really needed. We run with this from 2012-2030 during which time emissions in the power and industrial sectors of the US economy are reduced by about 35% or 1.2 billion tonnes per annum.  So the total emission reduction is 1.2*18/2 = 11 billion tonnes (rounded up). At $40 per tonne, the total cost of abatement is $440 billion. There are about 90 million families in the USA (340 million people by 2030), so this means a cost to each family for much of the right hand side of the abatement curve of under a dollar a day (actually 75 cents).

This isn’t nothing, but it is hardly going to break the economy either (between 1945 and 1996 the USA spent at about double this rate just manufacturing and deploying nuclear weapons). In addition, Waxman-Markey skews the distribution of allowance value to low income families, so compensation is there for those who rightly need it.

There are other reductions on the right hand side of the curve as well, but much is in the agricultural and forestry sector and seems to come in at around $15 per tonne. So overall, I will go with the $1 per day per family from 2012 to 2030 for the real “cap-and-trade” bit. Don’t forget though that these same families also get the benefit of the left hand side of the abatement curve as well, because of improved appliances, home insulation programmes, new lighting standards and so on.

But what is the benefit of doing all this? That’s easy – Nick Stern did the calculations for us and put the social cost of CO2 at about $80 per tonne – i.e. the cost we leave to future generations if we just keep on emitting.