Kyoto Kritik

The EU Pressuring the US on Kyoto, Again.

13. december 2005
Af Dr. Constantin Gurdgiev , Honorary Fellow, Copenhagen Institute & Director, Open Republic Institute.

In 1976, a Nobel Prize winning economist Robert Lucas, Jr. made a revealing observation, known as the Lucas Critique. Any economic model with broad behavioural aggregates is unlikely to generate a useful and reliable assessment of the effects of economic policies on aggregate economic activity. The reason for the failure of such models lies in the assumed static nature of people's expectations. Lucas famously remarked that as people anticipate changes in policies, they change their behaviour, which in turn changes the outcome of the policy itself. The more dramatic is the proposed policy or the longer the time horizon used in forecasting, the lower is the ability of the models to track its effects.

Today, the Lucas Critique is a fundamental piece of macroeconomics - so much so that even undergraduates encounter its postulation and applications. Yet, as recent reports from the UN's Sustainable Development Commission annual meeting and the European Conference on Environment in Brussels indicate, some of the EU's top brass never heard of the Lucas Critique. Led by the EU Commissioner for Environment, Stavros Dimas, the European delegation that included Lord Whitty of the UK and Lucien Lux of Luxembourg tried to tackle (again) the US on its failure to join the Kyoto Protocol. This time, the European representatives were armed with a recent report on the costs of climatic change, issued by the US Energy Information Administration (EIA), part of the US Energy Department.

The EIA report provides macroeconomic analysis of the small subset of the National Commission on Energy Policy (NCEP) recommendations, issued in December 2004. These included: cap-and-trade program for Green House Gas (GHG) emissions, comprehensive corporate strategy on fuel economy, tax incentives for manufacturers and consumers, price guarantees for natural gas production in Alaska, new standards in the building sector and new R&D spending. In addition, the report considered a host of new subsidies that include incentives for improving efficiency of energy generators, carbon capture and sequestration, and nuclear power.

According to the original NCEP recommendations, beginning with 2010 the US should cap emissions for businesses and set a tax of $7 per ton of GHG. This, according to the NCEP will reduce emissions by 2.4% per annum. The EIA estimates that the combined effect of NCEP measures will reduce GHGs emissions of 7% by 2025. This, according to the EIA, will cost the US around 0.54% of GDP per annum, or around $470 per household. From the EU's perspective it is a cheap price to pay - after all, Brussels is ready to sacrifice between 0.8 and 1.7% of GDP for Kyoto.

So what's the catch? Why is the US refusing to join the calls by Mr. Dimas? In the case of the EU argument that the NCEP plan paves the way for the US to accept the Kyoto Protocol, the problem is that this free lunch is neither free nor, indeed, much of a lunch.

Consider the main claim made by the NCEP: GHG reductions of 7% under the proposal refer to the benchmark case of Government projections for 2025. Kyoto requires that the reductions should be made relative to 1990 levels. Roughly translated, the EIA model will push the cost for the US compliance with Kyoto targets to 1.5-1.7% of GDP, or to nearly $1500 per annum per US household.

The EIA analysis of the NCEP proposals does not include the costs consideration the dead-weight losses arising from government-imposed regulations and trading schemes. The EU thinks these are chop-change. They are not - the idea that taxing emissions and transferring money back through subsidies is costless ignores the fact that administration will swallow as much as 30-40% of each transaction. The EIA appears to impute a global estimate of these costs, concluding that by 2022 the costs will be recouped through the GHG charges. Yet, the assumptions behind this estimate are suspect. First, the EIA includes only the set up costs but not transactions charges. Second, the agency uses a low interest rate estimate of 4% per annum in discounting the real value of the start up costs, which ignores the opportunity cost of using the funds elsewhere in the economy. Adjusting for these two shortcomings alone pushes the break-even date on the cost of setting up the government-run system of caps on emissions beyond 2050 and adds at least 0.2% of GDP to the losses (0.65% under Kyoto-compliant targets).

Several other problematic assumptions warrant caution. EIA-built in prices for natural gas, oil and electricity assume that the current level of high prices will continue into 2025. On the supply side, reflecting a pro-development climate and expected high prices, Russian gas production and exports will continue to grow, providing significant pressures on gas prices. New technologies for liquefaction and shipping will enable cheaper gas deliveries to the US. Higher energy prices will continue to stimulate alternative generators and more efficient energy utilisation. Finally, a growing number of the US states are developing their own legislation aimed at reducing emissions and incentivising lternative energy use. On the demand growth side, the EIA benchmark case assumes strong growth in China and India through the year 2025. However, it is unlikely that China and India will continue operating in the current energy-extensive mode for much longer than a decade. For reasons of caution and tractability, the EIA does not fully price these possibilities in its assessment of the NCEP proposals. Yet, taken together they imply significantly lower rate of return from the proposed energy and cost savings under the plan.

Unlike the EU environmental pundits, the EIA is cautious about its own projections, noting in the report that the results of macroeconomic simulations serve as "a simplified representation of reality". Commenting on report's methodology, the agency states that its figures are "based on engineering cost estimates" that "do not capture real-world factors… [and] behaviour of decisionmakers". Mirroring this caution, the US delegation was right to dismiss the EU calls for Washington to recognise the Kyoto targets. Instead the US Federal Government should stick to the current plan that introduces moderate initiatives aimed at developing cleaner coal and hydrogen fuels, improving nuclear energy generation and electricity transmission, investing in the International Thermonuclear Reactor research, incentivising green vehicles and long-term research. The riskier and less certain means of controlling emissions, such as some of the programmes advocated by the NCEP and costed in the EIA report are best left to the individual states and private markets, which already address some of them.

Instead of lecturing the US on the ways of achieving a greener future, the EU should adopt the two major principles of the US policy - caution in the face of uncertainty and experimentation with policy at the competitive local level. One-policy-fits-all approach adopted by the EU and advocated by the green lobby never is the best way to proceed with costly polices. As any student of economics will note, this is especially true when the policy proposals involve forecasting markets' expectations based on the aggregate macroeconomic models' conclusions.

Previously Published Business and Finance Magazine, May 19, 2005.

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