In the wake of the Gulf oil spill, Senate Democrats are gearing up to bring an energy bill to the floor next week in the hopes of improving the safety of offshore oil production and beginning to wean the country off fossil fuels. The biggest outstanding question surrounding the draft legislation is whether it will include a cap on greenhouse gas emissions, in addition to the oil drilling provisions and clean energy incentives that will certainly make it into the bill. "Cap-and-trade," the term for a market-based mechanism for reducing pollution used successfully for sulfur dioxide control in the United States, has become a dirty word in Washington. The Republican leadership labels the mechanism (developed during the George H. W. Bush administration, ironically) a "job-killing national energy tax" or "cap-and-tax."
Under cap-and-trade, polluters would pay a fee for each ton of carbon dioxide ( CO2) they emit, with pollution permits traded between firms to minimize the cost of meeting emission reduction goals. Opponents of this system argue that, while raising the cost of fossil fuels for households, setting a price for carbon emissions will do little to reduce US dependence on imported oil, a policy goal Democrats and Republican share. Senator James Inhofe, ranking member of the Senate Environment and Public Works Committee, has argued that independent analysis from the Environmental Protection Agency and Department of Energy's Energy Information Administration (EIA) doesn't support backers' claims that cap-and-trade legislation, such as the "American Power Act" introduced by Senators Kerry and Lieberman in May, would curb US oil imports. Indeed, a number of energy economists have recently suggested that while effective in addressing climate change, pricing carbon is the wrong tool for improving US energy security. This makes life tough for Senate Majority Leader Reid, who has indicated the bill he introduces will include a "price on carbon," but only for utilities.
So what's the real story?
First, it's important to note that energy security is much broader than simply how much oil a country imports. The US Chamber of Commerce has created an "Energy Security Risk Index" with 37 different indicators. In an article last month, Michael Levi of the Council on Foreign Relations and I assessed the American Power Act using the Chamber's index and found it scored well overall. But what is the effect on oil imports specifically? And how does cap and trade stack up against measures targeting oil consumption directly, such as vehicle efficiency mandates (known as CAFE [Corporate Average Fuel Economy] standards)?
Pricing carbon creates an economic incentive for firms to reduce CO2 emissions, either by improving energy efficiency, switching from fossil fuels to cleaner alternatives, or capturing CO2 emissions from fossil fuel combustion and storing them underground (known as carbon capture and sequestration or CCS). Market-based systems, like cap-and-trade or a carbon tax, are designed to ensure that firms take advantage of the lowest-cost emission reduction opportunities first, which minimizes the impact on the US economy. Conventional wisdom is that for the first couple decades of a cap-and-trade or carbon tax regime, most reductions will come from the power sector through moving from coal to nuclear, natural gas, and renewable energy for power generation. Oil is primarily consumed in the transport sector, which is assumed to be one of the last parts of the economy to decarbonize.
This line of argument can best be illustrated with a graph. Figure 1 below is what's called a "marginal abatement cost curve." It maps out the cost of reducing each additional ton of CO2 over time. On the left-hand side of the chart are the cheapest emission reduction opportunities. These are generally improvements in energy efficiency that are profitable, even in the absence of a price on carbon. Economically optimal policy would capture these emission reductions first. On the right-hand side of the curve are the most expensive emission reduction options, generally coming from advanced technologies that aren't yet widely available in the market.
Source: International Energy Administration. 2008. Energy Technology Perspectives. Paris: Organization for Economic Cooperation and Development/International Energy Administration.
Abatement opportunities in the transport sector generally fall either on the far left or the far right of the cost curve. On the far left are changes in vehicle choice that would clearly save the consumer money—for example, choosing a Ford Focus over a Hummer. Yet at the carbon prices forecast under most cap-and-trade proposals, cap and trade itself will have a pretty modest impact on gasoline prices, hardly enough to prod potential Hummer shoppers (for whom fuel cost is clearly not a concern anyway) toward more efficient alternatives. For example, EIA estimated that the "American Clean Energy and Security Act" passed by the House of Representatives last June, would result in an average carbon price of $37 per ton during the first two decades. Thirty-seven dollars per ton of CO2 translates into 33 cents per gallon of gasoline, which is overwhelmed by the swings in crude oil prices we've seen in recent years. And some of the new, advanced vehicle technologies that would reduce the amount of oil a Hummer consumes fall on the right-hand side of the cost curve and are unlikely to be widely deployed under a carbon pricing regime until the cheaper abatement alternatives are exhausted.
But changing the consumer's vehicle preference or deploying advanced vehicle technologies are not the only ways to reduce US oil imports. And a new report from EIA shows that pricing carbon will change the US energy system in other ways that significantly reduce US dependence on foreign oil. On July 16, EIA published its analysis of the Kerry-Lieberman American Power Act. As in my analysis of the draft legislation published in May, EIA found that putting a price on carbon would, in fact, significantly reduce US oil imports over the next two decades. EIA predicts that by 2035, US net oil imports (imports minus exports) would be 2.1 million to 2.8 million barrels per day below business as usual. For reference, the United States is projected to import 1.7 million barrels of oil per day from the Middle East in 2035. US spending on imported oil would drop by $100 billion per year by 2035 and global oil prices would fall from $122 to $114, reducing the amount of money oil-producing states make on all their sales, not just those to the United States.
How are these oil import savings to be achieved? Figure 3 breaks down the EIA results for their central scenario (a 2.42 million barrel per day reduction by 2035) by source.
As discussed above, the modest carbon price forecast under the legislation means there is little improvement in vehicle efficiency, though industry (more cost-oriented than the Hummer shopper) reduces its oil use. Rather it's a change in energy supply that's behind EIA's headline number. Consistent with conventional wisdom, most of the emission reductions in their analysis come from the power sector. But a good-sized chunk of those power sector reductions are from capturing CO2 emissions from coal and natural gas–fired power plants. This CO2 is used for Enhanced Oil Recovery (EOR), which would increase domestic oil production by 920,000 barrels per day, 900,000 of which would be onshore. Because domestic crude is different in quality than the imported oil it displaces, these 920,000 barrels per day of domestic production would displace 820,000 barrels per day of oil imports.
The second major source of oil import savings is an increase in biofuels consumption. The increase would be a big one. EIA predicts that under the American Power Act, US biofuels consumption will increase by 1.48 million barrels per day by 2035 relative to business as usual. There is not enough detail in EIA's published report to see the balance between traditional and advanced biofuels in meeting this increase in demand, and I have questions about EIA's assumptions about the cost, availability, and life-cycle greenhouse gas emissions of biofuels feedstock. Likewise, there are questions about whether CCS can be deployed on the timeline and at the scale EIA forecasts to deliver such an impressive increase in domestic oil production. But the bottom line is that while cap-and-trade won't do much to change the kinds of vehicles that are available on the market or that consumers choose to buy, it will change what they put in their tank.
How do the oil import savings projected by EIA under the American Power Act stack up against those resulting from policies targeting vehicle efficiency directly? To find out, my colleague Shashank Mohan and I assessed the impact of extending the Obama administration's planned 2011–2016 CAFE improvements to 2035 using the same model EIA used for their report (the AEO2010 version of the National Energy Modeling System). Under this scenario, the efficiency of new vehicles increased by 4 percent per year, resulting in an average fuel economy for passenger vehicles of 82 miles per gallon in 2035. Yet these aggressive vehicle efficiency improvements still fall short of the oil import savings an economywide emission cap would deliver (figure 3), by over 600,000 barrels per day in 2035. CAFE standards and carbon pricing are not mutually exclusive policies, however, and a combination of the two would yield substantial reductions in US dependence on foreign oil.
What happens if the carbon cap is scaled back to cover utilities only, as the legislation introduced by Senate Majority Leader Reid next week is likely to do? My colleagues and I will conduct a complete analysis of such an approach once the bill is released, but a couple things are clear from EIA's report. First, the 140,000 barrels per day in import savings from residential, industrial, commercial, and transport sector efficiency will be lost if these sectors aren't under the cap. This is only 6 percent of the projected savings from an economywide approach—so it's not so bad. Second, and more importantly, excluding transport from the cap, while lowering prices at the pump, will reduce the incentive for consumers to switch from gasoline to biofuels in filling up their tank. Finally, a utility-only approach might create less incentive for CCS through lower carbon prices and less allowance revenue for CCS demonstrations, which would cut back the increase in domestic oil production EIA projects. So while a utility-only cap will reduce US oil imports more than no cap at all, policymakers looking to deliver meaningful oil import savings with a utility-only approach will need to combine it with additional measures aimed specifically at promoting vehicle efficiency and alternative fuel sources, or clear a pathway for transport to be included in the cap over time.