 This afternoon, I'm honored to introduce Paul Josko, Professor of Economics and Management at MIT. He graduated from Cornell University with a BA in Economics in 1968. And in 1972, he earned a PhD in Economics from Yale University. He has served as a distinguished faculty member at MIT since 1972. Since 1999, he has served as director of the MIT Center for Energy and Environmental Policy Research. On January 1, 2008, he will become president of the Alfred P. Sloan Foundation. During his 35-year academic career, Professor Josko has published six books and over 125 scholarly papers on industrial organization, energy and environmental economics, and government regulation. This scholarship examines the major economic issues facing the energy industry during this period. Early in his academic career, Professor Josko studied regulation of electric utility rates. These papers examine regulators' efforts to protect consumers from the monopoly pricing power of utilities while providing a reliable service. With the energy shortage in the last half of the 1970s, he expanded his research to include energy efficiency, the future of nuclear power, and utilities' long-term fuel contracts. Since 1991, he has studied the effects of restructuring the electric utilities, strategies to reduce energy consumption and air pollution, and a re-examination of nuclear energy. His 1998 papers on sulfur dioxide trading demonstrate the efficiency and effectiveness in using market-based approaches to controlling air pollution. His most recent research examined strategies to control global warming. In addition to his activities as a scholar, Paul Josko has also exercised leadership in the business and public sectors. He is a member of the Board of Overseers of the Boston Symphony Orchestra. He has served on the boards of directors of several energy companies. In the policy arena, Paul Josko has served on the EPA's Acid Rain Advisory Committee and the Environmental Economics Committee of the EPA Science Advisory Board. During his 35-year academic career, Professor Josko has been honored with numerous awards. I will name a few of the most recent awards here. In 2004, the International Society for Energy Economics honored him with the Outstanding Contributions to the Profession Award. In 2007, the Industrial Organization Society named him to the Distinguished Fellow Award. In 1982, in 2002, his students recognized him with the Graduate Teaching Award and Undergraduate Teaching Award, respectively. Clearly, Professor Josko uses his academic and leadership skills to promote workable solutions for our environmental and energy challenges. Thank you very much for that nice introduction. And thank you all for being here. And thank you for letting me to participate in what's been a very interesting set of lectures and also very enjoyable entertainment. I changed the title of my talk slightly. I'm the economist here. And I suppose many of you expect me to say that, well, everything's really too expensive. And we've got to wait and see what happens. And this is all pie in the sky. But I'm not. What I want to focus on are public policy options, in particular the importance of placing a price on CO2 emissions in order to stimulate some of the behavior and the new technologies that we've discussed in the past day and a half. I believe that there are many people who are altruistic. There are even corporations which are altruistic. However, I often also believe that in general, both for corporations and for many individuals, it's important to make behavior that we would like them to engage in to be in their own self-interest. And that's going to be the focus of my policy proposals. I thought of giving the talk a slightly different name, and I'll tell you what it is. It's called the rat needs to smell the cheese. And I'm going to talk about how we create the smell and try to get the rat to smell it. I'd like to start, first of all, by making it clear that all economists aren't bad people who don't believe in things, I want to start with reference to the Stern review that was completed last year. The Stern review was commissioned by the British government nearly three years ago. The leader of the review was Sir Nicholas Stern, a very distinguished British economist who I've known for many years. And the focus of the review was on the economic consequences of climate change, although it ended up covering many, many things. And I agree with many of the conclusions in that review, maybe not in every single detail, but certainly in the major thrust. So let me just go through what I see as the major conclusions for us to focus on. First of all, there's overwhelming scientific support to conclude that the Earth's climate is rapidly changing due to human activity resulting in emissions of greenhouse gases. We've heard about that today. We heard about it yesterday. Under business as usual, and I'm going to come back and talk a little bit more about what this mysterious business as usual really means, under business as usual, average global temperatures will rise by two to five degrees by 2030 to 2060 by mid-century. At current levels of emissions, global temperatures will rise by three degrees to 10 degrees by 2100. I'm giving wide ranges here. I'll come back and talk about that as well. And as the Earth warms, abrupt large-scale changes in the climate are possible with serious economic and social consequences. The potential adverse economic and social consequences of climate change are large compared to the cost of mitigation. The cost of mitigation are going to be uncertain. The potential costs and consequences of climate change are uncertain. But I'll argue, looking at this properly, the benefits of beginning to do something now, something significant, are likely to far outweigh the cost. Climate change is thus an urgent and serious issue requiring a global response to a global commons problem, or what economists call an externality problem. The longer we wait, the higher will be the costs of climate change, as well as the costs of mitigating greenhouse gases to stabilize greenhouse gas concentrations in the atmosphere. There are differing views at what we should aim at. Dr. Hansen this morning spoke about aiming at 450 parts per million of CO2 equivalent. I'll discuss the difference. The Stern review says that aiming at 550 parts per million by 2050 is a practical, and when I use the term practical, I mean economically practical, politically practical, and technically feasible. And those are not all the same thing. And perhaps a prudent goal. I think I saw Nick Stern on Friday, and I think he would say that 550 given developments and information about changes in the climate is probably pretty risky. But we'll see it's a challenge even to meet 550 by two of them. But that some of the potential for future mitigation are things that we don't really know about yet, or which we know about with great uncertainty. And providing a framework in which new ideas can be developed and applied is very important. The Stern review also concludes that carbon taxes or cap and trade mechanisms that place a price on greenhouse gas emissions should be the primary policy instrument. And I'll explain why in a little while. It's not the only policy instrument. There are also opportunities for using energy efficiency standards, labeling requirements, and other mechanisms to provide information and obligations on individuals and corporations to deal with other types of market imperfections that go beyond the narrow commons and externality problem, which we associate with climate change. We also need dramatic increases in R&D support. And there's been very little mention of that so far in these sessions. Government R&D throughout the developed countries has declined dramatically since the early 1980s. We do need new technologies, and we need better technologies. We need more options to choose from. And the issue here is how to provide the incentives to get not only governments but private firms to invest in research and development in new technologies. And finally, we have a global problem. This is not just a US problem. It's not just a European problem. It's a global problem. We need to find some way of engaging China, India, and other developing countries in solutions to this problem, recognizing that we have different levels of standard of living and also that we've made different contributions historically to the current concentrations of CO2 in the atmosphere. Very quickly, just to provide some background, as we learned this morning, there are many different greenhouse gases. They have different physical attributes in terms of their forcing capabilities. The US greenhouse gas emissions of carbon dioxide, methane, nitrous oxide, and others have been increasing slowly since 1990 by about a percent a year. I think you may read in the newspaper soon, if you have not already, that the increase in CO2 emissions in 2006 was either zero or perhaps slightly negative. I think one of the reasons for that is the high energy prices we had and the conservation that resulted. But nevertheless, historically, our greenhouse gas emissions have been growing slowly but steadily over the past decades. While there are a number of different gases, carbon dioxide is the most important. It's something like 85% of the greenhouse gases we produce. And if we look at carbon dioxide sources, combustion of fossil fuels is by far the most important source of CO2. And that's why we've mixed together and put together in these discussions energy policy and CO2 policy. They go together because energy combustion of fossil fuels is such an important contributor to US CO2 emissions. If we turn to the energy sector itself, the two most important sources of CO2 emissions are the electric power sector here. And you can see that much of the CO2 emitted by the electric power sector is coal combustion. While coal accounts for only about 50% of the electricity we produce in the US, it accounts for a very large fraction of the CO2 emissions. The second sector is transportation. And the transportation sector has another important feature. We haven't talked much about energy security, in particular the dependence of the US on imports of petroleum from unstable parts of the world. But you can see there's a big difference between the transportation sector and the electric power sector. The electric power sector, we use almost no oil. In the transportation sector, we use about 67% of the oil consumed in the US. And that's forecast to rise over the next 20 years to over 75%. So things we do in the transportation sector to reduce consumption of petroleum are a twofer. We get benefits in terms of climate change. We also can get benefits in terms of energy security. So these two sectors have some different attributes to them from that perspective. As we look forward under business as usual, future emissions in the United States are forecast to continue to grow from about 6 billion tons a year of CO2 today to about 8 billion tons a year of CO2 in 2030. Now let me say something about business as usual. What does that mean? Business as usual doesn't mean that we do nothing. These are forecasts from the Energy Information Administration of the Department of Energy. And they incorporate current policies, including the policies that were adopted in the 2005 Energy Policy Act. They also try to reflect known and likely technological changes on both the supply sides and the demand sides. But nevertheless, as we look going forward at the US, not only are we not stabilizing our CO2 emissions or reducing them, but they're continuing to grow rather significantly despite some major efforts in the Energy Policy Act of 2005 and at the state level to try to affect these historical trends. And it's not that Americans are becoming as individual, more gluttonous users of energy and emitting more CO2. Actually, emissions of CO2 per capita in the US have been declining slightly since 1990 and have been roughly constant since the early 1970s. And emissions per dollar of GDP have been declining. However, the population continues to rise. And as the population rises, we have more people who are consuming energy so that our consumption of energy and our emission of greenhouse gases continues to increase despite the fact that there in fact have been some major increases in energy efficiency. If we look back historically, this chart shows energy consumption per dollar of GDP. These are historical data. These are EIA's forecast data. Here are historical data for energy consumption per capita. Energy consumption per capita has been about constant. Going back to the 1970s, actually for a period of time it declined when prices were very high. And energy use per dollar of GDP has been declining. And it's not all that the structure of the economy has changed. About three quarters of the improvement in energy use per dollar of GDP is associated with energy efficiency. The typical home today is much larger than it was 20 years ago. It has many more appliances. It has personal computers. It has flat screen TVs. But the energy use in the typical home has not increased because of improvements in energy efficiency. So it's not a question of having done nothing on energy efficiency. To reverse the trends in overall consumption of energy, which continue to go up, we're going to have to do much better on this and other fronts. So looking forward, the recent carbon dioxide emissions are forecast to grow. As energy consumption is forecast to grow. So liquids are gasoline, heating oil, both conventional gasoline, but also gasoline produced from imports of heavy oil that are refined into gasoline. You'll notice here that coal production increases, and then actually increases even faster later in the period. We heard this morning coal is bad from a CO2 perspective. Well, under business as usual, what happens in this particular model is we don't run out of natural gas or petroleum. But the prices go up rather dramatically towards the end of this period. And generating electricity from coal becomes relatively more economical and more profitable as time goes on. And then down here, you can see the non-carbon generating sources of energy like nuclear power, which I'll talk a little bit about, non-hydro renewable energy resources and hydroelectric power are forecast to grow, but to grow very, very slowly during this period of time. So over the next 25 years, under business as usual, the economy from an energy perspective is primarily a fossil fuel economy. If we now go to the world, and I won't spend much time on this, the US, as we've heard, is a major producer of CO2. Our CO2 production is growing at about 1% per year under business as usual. But other countries are also major producers in the European Union. And most recently, although not historically, China has become a major producer of CO2. And India, while not quite as large as China, is likely to become a major producer of CO2. It doesn't matter where the CO2 is produced, whether it's in the United States or Canada or France or Russia or China, it goes up into the atmosphere and eventually gets mixed together and contributes to global warming. You can see that this is primarily a post-industrial revolution problem where human beings have emitted large amounts of CO2 into the atmosphere. And from a policy perspective, as I'll discuss in more detail, getting so many countries together to solve a challenging problem that involves both costs and benefits is a major international diplomatic and domestic political challenge. And if we go to the world, there are business as usual forecasts for the whole world as well. And these are business as usual forecasts that also incorporate the Kyoto Protocol, at least up until 2012 when it, as it's now structured, runs out, actions in the European Union and others. And again, the story is not very bright. Continuing emissions of carbon dioxide, coal continuing to grow in use no matter how bad it is from a CO2 perspective, from an economic perspective, it's relatively cheap. And continued but slow increases in use of liquids from both conventional sources and non-conventional sources like the tar sands in Alberta. And let me note, I visited the tar sands last year. I took a tour. They're producing a lot of stuff up there. It's booming. At $80 a barrel of oil, a lot of that production is economical without a charge on CO2 emissions because it produces a lot of CO2 along with the production of petroleum. The developing countries will eventually overtake the developed countries in terms of their CO2 production potential, whether it will be 2015 or 2010 or 2025. 2025 depends on uncertain assumptions about rates of economic growth. But it's fairly clear that the trends are in this direction. And as I'll show you in a moment, this is a problem that developed countries can't deal with on their own. Let me say something about climate change models. I'll be beating up on economic models in a moment. I don't want to beat up on them. This is from the Stern Review. And it's a summary of some of the results of climate change models that were available to them at the time this was published. It was just before the IPCC's latest reports came out. But that's not really all that relevant for my purposes. You see along this axis different equilibrium concentrations of CO2 in the atmosphere. This is the 450 that Professor Hansen talked about. I'm going to probably focus on 550 in my talk. And you can look across, and this gives you the range of estimates of what the effects on global temperatures will be in equilibrium at different levels of carbon dioxide concentrations in the atmosphere. And the one thing that should strike you as you look across the page is that there's a lot of uncertainty about what the effects will be. And I think this uncertainty is a necessary consequence of the imperfections in these models. As we get better information, the uncertainty bands are narrowing. Some people look at this and say, well, why don't you come back and talk to me after you get the uncertainty band down? I don't think that's the right way to think about these data. The right way to think about this is we are always going to be uncertain until we know what the consequences are. And by the time we know what the consequences are, it's going to be too late to do anything about them. What we should be focusing on is the upper tail, the bad consequences. Because the bad consequences have really bad results, bad economic consequences for economic well-being and social well-being on Earth. I think the way I think about developing policies in this area is as an insurance policy, as a way of trying to ensure that if it turns out from a climate change perspective that the worst happens, we will have taken actions to ensure that will not occur. And if it turns out that the Earth only increases in temperature by, I put only in quotations, by one or two degrees, the amount of money we will have spent will not be greater than the associated benefits. We've talked about the kinds of effects that can happen. And the thing I want to emphasize is the potential impacts, economic impacts and social impacts are non-linear. If you get large increases in global temperatures, if you go from three to four, the effects are much, much worse than going from zero to one or going from one to two. And exactly how much they cost and exactly what they are, even the best economists can't tell you, what they can tell you is there is a possibility for catastrophic events that could be extremely costly to the world economies. So having looked at all of this, the Stern review develops it as always. This is business as usual if we do nothing and global emissions just continue to rise forever. And here are two alternative mitigation paths, a path that stabilizes at 550, which is the path that Dr. Hansen discussed this morning, and a path for emissions that stabilizes at 550. And at this point, there are two or three things I'd ask you to note about these stabilization paths, which we might take as goals. One is by the middle of the century, on either path, our emissions are dramatically below what they would be under business as usual. But more importantly, by 2050 under both paths, our emissions are below what they are today. And merely stabilizing emissions at current levels on a global basis is not going to get on either of these paths. In addition, the 450 path, I would say, is extremely challenging. It requires global CO2 emissions to peak at 2010 and then to decline. I just don't think that's going to happen from a political and economic perspective, at least from my perspective at this point. I'm focusing on seeing if we can develop policies that will at least get us to concentration levels of 550 parts per million if it's possible to do better, so much the better. But as of now, we're not doing nearly that well. So how do we do it? Well, there aren't that many things that we know of you can get to individuals and corporations that produce CO2 to do. We can reduce the rate of demand for energy by promoting energy efficiency without significantly reducing economic growth. We can do it in end use, in vehicles, in appliances, and in housing stock attributes. We can do it in the production of various commodities, in the production of electricity using more efficient power plants. We can substitute low carbon for high carbon fuels and electricity generation and in other industrial sectors that could be nuclear power for coal, wind for fossil fuels generation, and biofuels for gasoline. We've heard about some of those already. And finally, we can continue to burn fossil fuels. But if we do that, we have to capture and then store the CO2 pretty much for good somewhere underground and in the process of, for example, creating synthetic gas and sequestering the carbon that is stripped out of it, using hydrogen-rich synthetic gas that produces very little CO2 emissions. How does the Stern review meet a 550 parts per million mitigation scenario? I'm going to use this to try to demonstrate what a challenge this actually is. I'm not going to focus on land use. Let me just focus on energy because that's what this conference is about. He anticipates needing an energy saving of about 70% from business as usual levels. That's a big reduction. A significant fraction of that comes from energy efficiency, but also a big fraction comes from supply technology. I'm not sure when he issued the report he ever looked carefully at this pie chart, but it comes from the Stern review. And it shows a portfolio of strategies consistent with meeting a 550 parts per million target by 2050. Here's energy efficiency. This increases in use of combined heat and power, what we call cogeneration in the United States. We can add them together and call them both together. Improvements in energy efficiency, that's less than a quarter of the, excuse me, that's where it's combined heat and power. That's over here. Energy efficiency, solar, wind, biofuels, they're all in there. There are two we haven't talked too much about that I just want to emphasize to indicate why this is a real challenge. Their model has a lot of carbon capture and sequestration. So it continues to use coal, but it takes out the CO2 in some way and it stores it. It also has quite a bit of nuclear power. And just to give you a sense for the magnitudes involved here, for those two, this is the scale. That little pie is 1,200 new 1,000 megawatt nuclear power plants. And that's compared to the equivalent of 300 1,000 megawatt nuclear power plants operating in the world today. Do you think that's going to happen between now and 2050? It could. It's conceivable, but it would require countries adopting policies that were favorable towards developing new nuclear power plants. As someone indicated, no new nuclear power plant has been planned in the US since the late 1970s and the last one completed was in 1996. There's one nuclear power plant under construction in Europe in France. Carbon capture and sequestration, from my perspective, is even more interesting. At least I know how to build and make a nuclear power plant that works. Carbon capture and sequestration of that magnitude on a global basis is the equivalent of building 3,400 500 megawatt coal plants that have carbon capture and sequestration technology associated with them. And that should be compared to 500 500 megawatt coal plants that are actually operating in the US today. And coal is a major source. So that would be an increase in the number of plants on a global basis, or the factor of about seven, with a technology which we know relatively little about at large scale. This experience with enhanced oil recovery is interesting. It's suggestive, but it doesn't reflect the magnitude of the challenge that we have in front of us here. How much CO2 is involved? It's 8 billion tons per year compared to almost zero today. And if you don't think in terms of tons of CO2 getting sequestered, if you compress the liquid CO2 volume, it would be the equivalent of 140 million barrels of crude oil per day. The entire world now produces 85 million barrels of crude oil per day. So at the very least, you have to admit we have a major infrastructure problem that has to be addressed here if we're going to be able to rely 50 or 60 years from now on significant carbon capture and sequestration. And this is an area where substantial R&D and demonstration is desperately needed now to see if this is really going to be an available option. I mentioned this morning in the Q&A, the studies we've done at MIT when we asked people little questions about carbon capture and sequestration, like how would you like to have it stored near your house? The answer you get is exactly the same as if you ask them, how would you like a nuclear waste dump near your house? So a lot of education is going to be required here if that's going to be a viable option. If nuclear and carbon capture and sequestration are not viable options, the challenge of meeting $5.50 and the cost of doing so are going to be much higher than would otherwise be the case. The Stern review also publishes costs. I won't go into these. I want to refer you maybe to the vertical axis. This is the cost per ton of CO2 removed. They have the prices starting high and going low to reflect learning effects. But the price to keep in your mind is over the period of the next 50 years, roughly an average price of $50 per ton of CO2 or more. And we come back and we'll talk about some of the federal energy legislation. We'll see how that compares. There's also substantial uncertainty, as you can see, especially going out on what the costs will actually be. But Nick would argue that these costs are relatively small. On the order of 1%, I would say probably closer to one and a half or 2%, compared to the catastrophic consequences of business as usual and the dramatic costs that would affect the economy that could be as high as 15% of GDP per year. Another challenge is that the effects of climate change are not going to be realized for some period of time. So here's just a scatter diagram that has a range of estimates of what the consequences of business unusual might be going out 100 and 200 years. Well, 200 years from now you're talking about potentially very, very major economic effects on most countries in the world if the worst outcomes happen, and fairly significant economic effects if even the best outcomes happen. The challenge from a public policy perspective and even from an economic analysis perspective, so you've got to spend the money now in this century, in the first half of this century, but the benefits are largely going to be realized in the next century and the century after. Very few of us will be alive in 2100 or 2200. These raise intergenerational issues of one generation paying for benefits that will be accrued by another generation. It raises ethical issues of intergenerational equity. It raises economic issues. For those of you who are economic majors, you've learned about discounting and there's a lively dispute about how you should discount costs and benefits and when you discount them, is it really worth doing anything? I'm not gonna go into that, but this is a major challenge in terms of developing policy because you're asking voters today to do things for their grandchildren, their great grandchildren, and their great, great grandchildren. There are also differences in effects across the globe. This is just one chart from the Stern review that looks at changes in serial production from a three degree rise in warming in different countries, from different models. On a global basis, it's a minus, but for a group of developed countries, it's a plus. For a group of developing countries, it's a big minus. How do you get them together to agree on a policy when the problem is a benefit to some and a cost to others? Well, let me now turn to the economics. How do economists think about this problem? Well, it's what's known as an externality problem more commonly among scientists, a commons problem, and an externality occurs when an action by either a producer or a consumer affects other producers or consumers but is not reflected in market prices. That is, there could be a negative externality, you could do something that harms others and creates damages, but you don't have to recognize the consequences because you don't pay for them. There can also be positive externalities. You keep your lawn nice and tidy, you paint your house every three years, you don't put your old car in the backyard, things like that. That's a positive externality. It makes your neighbors feel better. Greenhouse gas emissions at destabilized climate are global negative externalities. And they create a number of inefficiencies. If these costs are not recognized in some way, too much energy will be produced. It will be produced in the wrong ways. The prices of output will be too low because it won't reflect the social costs of producing and using energy. And there'll be underinvestment in technologies to mitigate CO2. If there's no payoff, there's no benefit for doing it, why would you bother spending the money except because you're altruistic? It's also important to have at least a slight understanding of why the externality problems arise because they do arise all the time. And they arise basically because there are missing markets. There are no markets for clean air, in most cases for clean water. There certainly isn't a market for ozone in the atmosphere or for CO2 concentrations. So you can't rely on the market to fix the problem. There's no market because there are no property rights that are clearly defined and enforceable. And even if there were, the transactions costs of trying to pin the tail on the coal plant donkey, you did a bad thing, you're gonna pay for it, would be amazingly expensive. This is not to say there are some examples on the Connecticut River in Massachusetts, which was developed with hydroelectric resources 100 years ago. Somehow the owners of the dams worked out a release schedule among them and have contracts to do it rather than the government. But by and large, it's very hard to define property rights and enforce them in these cases. We don't get the right prices then and externalities are a market failure and they lead to a need for government action. So there is no free market solution. There is no voluntary solution. It requires government action. So how do we do it? How do we internalize these externalities? There are a number of different ways. They all should be evaluated from the perspective of trying to achieve these stabilization targets at the lowest possible cost. As I've already indicated, they're quite challenging to even to get to 550. And we wanna do it in a way that minimizes costs, taking uncertainties into account on both the climate side and the mitigation side, recognizing that there's a portfolio of options we're gonna be relying on, some of which have attributes that are uncertain. And we wanna stimulate innovation and decentralized decisions to make effective use of information that is available out there in the world. So there are a number of different approaches. The economist's favorite approach, going back to an economist named Pagu, is to place a price on the source of the externality, in this case, greenhouse gas emissions. We can have emissions charges, so-called green taxes. Or almost equivalently, we can have a property rights-based system called the cap-and-trade system, which also puts a price on CO2 emissions. I'll explain how each of these work in a moment. There's a debate among economists about should it be prices or quantities. And I would say that's almost in-house baseball. The most important thing is both of these mechanisms put a price on CO2 emissions. There are other mechanisms that can be used. Regulations, we can have emissions regulations. We can have subsidies for low-carbon resources. We can have energy efficiency standards. And obviously, we can subsidize R&D as the federal government has done. I agree with Nick Stern's conclusion that the primary mechanism should be a price system and that these other mechanisms should be viewed as supplements to deal with other clearly defined market imperfections. Well, how does it work? Well, by placing a price on CO2 emissions, we make low-carbon supply technologies more profitable and high-carbon technologies less profitable. We attract the rats who are going to smell the cheese. It's going to increase energy prices. And anyone who tells you it's not is lying. We want it to increase energy prices. And that's going to make energy efficiency more profitable by reflecting the social costs of energy production and use. It will increase the financial attractiveness of R&D, focused on low-carbon technologies and energy efficiency. And it also efficiently uses diverse consumer and producer circumstances by stimulating decentralized self-interested decisions. They become self-interested because we placed a price on CO2 emissions. The way an emissions tax system works is very straightforward. You have to measure the emissions. This would probably be done upstream at the power plant level and the refinery level and at the gas pipeline level. A fee is placed on the carbon content of the fuel and producers have to pay for their emissions. So I think these are my only equations. If we go down here, A is abatement, E is emissions. If there's no abatement, the firm would have to pay PE the price of emissions times E. There's some cost of abatement. And now that we've placed a price on emissions, there'll be some abatement. There'll be abatement up to the point where the cost of additional abatement is equal to the price that's been placed on emissions. And this kind of decentralized scheme is very attractive because it allows different firms to adapt to their own circumstances. So here are different firms that have one has a low marginal cost of abatement curve, one has a low marginal cost of abatement curve, the one with the lower cost abates more, the one with the higher cost abates less. And this is quite different from the traditional mechanisms that have been used by the EPA in the old days, which was to apply uniform standards on all sources regardless of their abatement costs. And this is a much lower cost way of achieving any particular level of reduction. Cap and trade systems work a little differently, but the result is the same. We set a cap at what we think is the optimal level of pollution. This can be a trajectory. We issue tradable pollution permits to emitters. We could auction them off and earn revenue for the government as we would with the tax. Or we can allocate them in some other way. We can give them away for free. We can give them to consumers and have the consumers sell them to the oil companies and the coal companies. We then require all sources to match their emissions with a permit. This creates a demand for permits based on the costs of abating. So if the price of permits is high, firms will abate more. The price is low. They'll buy permits. Permit trading will establish a price just as with the tax. And we'll get the same type of behavior. So here, this is an example. This would be the aggregate amount of permits issued. And this would be the demand for permits based on the marginal abatement cost. And the market would equilibrate at peace door. Which is better, taxes or cap and trade? There are some technical economic issues here. There are also a lot of political issues. One question is, are we more confident about getting the price trajectory or the quantity trajectory right? Based on the science, I like the quantity approach myself. What are the costs of getting the price or the quantity trajectory is wrong? We're in a world with uncertainty. And one of the things that a tax system does is it fixes the price, but lets the quantity vary over time, depending on how abatement costs and demand are realized. Whereas the quantity approach allows the price and the cost to vary because it fixes the quantities while the costs of abatement are uncertain. There are domestic political considerations that have to be taken into account. Another way of saying this is we can't ignore those evil interest groups. They're going to have to be paid off in some way to get them to sign on to this program. And here we have to make sure that the perfect is not the enemy of the good. One of the nice things about a cap and trade system is these permits are like currency. You can give some to the existing coal units. You can give some to the existing oil producers. You can give some to consumers to try to insulate them from some of the wealth effects of this system while continuing to have a trading system so that they understand that the value of these permits is still the market price. Experience is an issue. We have a lot of experience with cap and trade systems now in the US. We have no experience with a comprehensive green tax system. And then finally, international linkage considerations are important. We have this is a global problem. We need to have mechanisms that allow us to link with the European Union, with Canada, with China, with India. And there are good reasons to believe that, at least from my perspective, that a pure tax system is going to be difficult to link. The EU has already adopted a cap and trade system. Many developing countries do not have well-developed, credible tax collection systems and are going to find it very difficult to rely on a tax. And even Canada has developed a system that's not based on charges, but is based on caps. So it may be that international linkage considerations also play in the minds of cap and trade advocates. Now, there are hybrid systems that combine attributes of both. So this would be a cap and trade system would actually have a backstop or a safety valve, which would allow permit prices to go only so high to take it to account some of the uncertainty about costs. And then the government would begin to sell permits at that price, effectively capping the price. In these hybrid systems to work, it's important that the safety valve be high, not be low, not be an excuse for keeping the CO2 price too low. And the safety valve can also be adjusted over time to reflect changing conditions. So let me now talk about a number of programs. I'll talk about the US's emissions trading program for sulfur dioxide emissions. This is a cap and trade program that was created by the Clean Air Act amendments of 1990. It was designed to control SO2 emissions by power plants that contribute to acid rain. The target was to reduce emissions by 50%. It was one of many cap and trade programs that we've now introduced in the US. And let me just show you some results from this program. The SO2 program was a two-phase program that affected the dirtiest coal units first, and then all coal units after 1995. This is business as usual. This is what would have happened without the regulations. Here's the actual cap. It's actually up here and down here. And the actual emissions are down here. And the reason you see this funny shape is this system had banking between the two periods. It allowed companies to reduce emissions a lot now in return for smoothing out their emissions paths in the future. We see the same phenomenon for the whole all power plants. This is business as usual. This is actual emissions over time, way below business as usual. Perhaps the proof of the pudding is in what happened to acidification. This is before. This is after. Brown is bad. Green is good. Much less brown over here. This was a very successful program. It met its target in, it met its reduction targets early with a cost saving that we estimated 50%. Emissions prices also adapted to changing economic circumstances. Up here, this is a period when natural gas prices rose dramatically. And the electric power sector led to a shift towards production of electricity with coal. This created an increased demand for allowances in the short run. In the long run, more power plants put on scrubbers as the price of emissions allowances went very high. Scrubbers take sulfur dioxide out of the flue gas of the power plant and the demand for allowances fell and has now fallen back to what the cost to scrub the remaining coal plants without scrubbers. The European Union has adopted a carbon trading program as part of its commitment to the Kyoto Protocol. I won't spend a lot of time on this, but there's much to learn from it. It doesn't cover all emissions. It covers power plants in some industrial sectors. It also has linkage mechanisms with developing countries. And in phase two with developed countries, each country's been assigned a target emissions reduction. Permits have been allocated and they're fully tradable within the EU. It's a program that was designed and implemented very quickly and has had some problems, but I think overall it's worked fairly well. Let me just note a couple of good things about it. First of all, we have to understand that phase one was really a trial period. The real action's gonna be in phase two, the Kyoto Commitment Period, but even during the trial period, a robust liquid market for emissions permits emerged. Prices varied widely through the period as economic circumstances changed, which is what we wanted. There's some evidence of short-term mitigation responses, although the ambitions of the program were very modest, but the program wasn't perfect. It was a very complex allocation system and it allowed for updating. Updating is a very bad thing to do. It's to allow firms in the next phase to get more permits if they omitted more. They made allowances available to new coal plants. That's a no-no, we shouldn't do that. They took the allowances away if plants closed. Well, you really want all dirty plants to close and you don't want them to stay open to keep their allowances. So under the SO2 program, if you close your plant, you get to keep the allowances and that provides the right economic incentives to do so. The emissions accounting and trading system is not as transparent in the US and it's quite clear that many policymakers in Europe did not understand the most fundamental principle of introductory microeconomics. It's called opportunity cost. If you give someone something for free, it doesn't mean they're not gonna include it in their prices. If somebody gives you a free acre of land and you come to sell it three years ago, you're not gonna give it away for free. You're gonna charge the market price for it. So although 95% of the allowances were given away for free, during the first year and a half of the program, the price of allowances wasn't zero. It was pretty high and it affected in particular the prices for electricity. Here's some data on prices in the EUETS. Here are the prices for the trial period. They're now zero. The trial period's almost at an end. Here are the forward prices for next year, for 2008, for the second period, which are about $30 a ton and have been much more stable. There are some things to learn from the trial period. You see this big drop here. Information was very hard to come by in the European system about how much emissions there actually had been during the first year and a half. On April of 2006, the first report came out and there were many fewer emissions than had been anticipated of CO2, which meant that there were more allowances available going forward to cover future CO2 emissions. The price dropped like a stone. 2006 was a relatively warm year. There wasn't a cold winter. And eventually as we got towards the end of the trading period, it was clear that there were gonna be enough allowances to cover emissions during the rest of the first trading period and prices have now fallen to zero. Let me now talk about going back to the US. What kind of prices would we need to hit a 550 stabilization target? Here's a business as usual, going out to 2100 forecast of energy production and electricity production from an MIT model, from the MIT joint program done by my colleagues. And under business as usual, I think the thing is we still use a lot of coal. We still use quite a bit of oil. We're now using alternatives, oil shale and tar sands, which produce a lot of CO2. We're using still some natural gas. We're using very little renewables. And in the electricity sector, we're using a lot of coal and a lot of natural gas in this forecast. This isn't a forecast, I just wanna show you what happens. What if we wanna change this? Here is the emissions profile associated with that business as usual. Increasing emissions. Here is a profile that seeks to stabilize global emissions at 550 parts per million. And here's the price trajectory on carbon prices that you need to make that happen. And I just wanna say something about the price trajectory. It actually looks just like the price trajectory that Dr. Hansen discussed this morning. The one thing I wanna emphasize is this is a global tax or a global cap and trade system, sort of an ideal system. But by 2050, the price is $200 a ton of carbon or roughly $50 a ton of CO2. There are lots of politicians talking about $7 or $8 or $9. Those prices are too low. We're talking about really significant prices and bills that have much lower prices are not likely to work. And the effects of the higher prices to dramatically change the nature of the emissions that an energy use that we see. The scales here are different. Total energy consumption declines rather dramatically under this scenario from over 1300 to just around 900. But also the mix changes dramatically. We use coal, but we use carbon capture and sequestration in the model. This has both economic and potential political implications. From a political perspective, we think we need to do something for the coal miners or the railroads or the coal miners unions or who knows who else. You can continue to use coal if you use carbon capture and sequestration. We also in this scenario get a lot more biomass, primarily in the transportation sector substituting for oil. So prices are what have an effect in changing the mix of energy resources and in stabilizing emissions. Let me conclude just with some brief remarks on where we stand in the US with regard to federal greenhouse gas initiatives, a word on state actions. The US actually signed the Kyoto Protocol. We just never ratified it. And we can blame President Bush, I suppose, but President Clinton never submitted the treaty to the Senate for ratification either. So nobody's ever had the courage to go to the Senate to have Kyoto ratified. The US is not gonna sign the Kyoto Protocol. It will be in a global system beyond 2012 and the nature will be different. There are several states that have now proposed their own greenhouse gas initiatives. These will probably put more pressure on the federal government. The Supreme Court has now recognized that greenhouse gases emissions are a pollutant covered by the Clean Air Act, which has important legal implications. And I think most importantly, there are now several bills in Congress to develop a comprehensive national greenhouse gas mitigation program. And the attributes of those bills is they're built around cap and trade systems. A small fraction of the allowances are initially auctioned off and the rest given away to buy off those special interest groups. But the auction fraction grows over time so that eventually the government is auctioning all of those allowances and the question then becomes what the government does with all the money. There are safety valve prices in them so prices can't go too high. There's banking and borrowing. This is very important. We don't really care if CO2 is admitted in 2014 or 2018. What we care about is the total emissions. And banking and borrowing allows prices to be smoothed out. It allows corporations to plan for investments and is an important feature of these programs. These bills also have other programs that are bolted onto them. Renewable energy programs is a lot of money for demonstrations of carbon capture and sequestration. Many economists are against these cap and trade bills. They have this dream that we'll have a tax and all the money will come to the federal government and the federal government will then use the money to reduce other taxes, bad taxes. It's nice to dream about that but it's unlikely that that's gonna happen. And I think those who are supporting a tax system and opposing a cap and trade system may be committing the error of trying to support the perfect, but in the end become the enemy of the good. Congressman Dingell from Michigan is supporting a tax system. Why is he supporting a tax system? A man who has a history of protecting the automobile industry. He wants it to fail. And a tax system by all surveys is not nearly as popular among Americans as a cap and trade system combined with the use of the money to promote energy efficiency and renewable energy. I've overtaken my time. Let me skip some other interesting stuff and just go to my conclusions. Greenhouse gas stabilization at 550 parts per million requires significant global reductions in greenhouse gas emissions from businesses usual levels by 2050. This is a big challenge. There aren't silver bullets. We have to keep that in mind. And the cost of mitigation isn't free. One of the worst things you can say is this won't cost anything. It's gonna cost something. But the costs of it's done right can be much lower than the benefits. The costs are in the order of maybe one to 2% of GDP per year going forward. GDP is now about $14 trillion. 1% is about $150 billion a year. 2% is about $300 billion a year. Just to put that in perspective, this year we will send to oil exporting countries $350 billion a year at the current price of oil. So it's not something the economy can't sustain. The attributes of a lease cost mitigation portfolio are uncertain. We have to keep that in mind. Placing a price on greenhouse gas emissions is the way to go. So the rat smells the cheese. And cap and trade is politically more attractive than taxes. And I would add it's easier to link with the programs in other countries that either have been developed or will be developed. Thank you. I could invite our panelists to come up and join us once again for Q&A. Send questions to the aisles. We'll pick them up and we'll begin in just a moment. We'll begin by asking our panelists if they have questions or reactions to Dr. Joscoe's talk. Dr. Chiu, you were wiggling your finger. I was wiggling my finger. I don't know why, but I'm in agreement with about 99.9% of what he said. So. Oh, Jim. Just a comment. Yeah, I'm also in agreement with essentially all of it. But rather than rats and cheese, maybe you'd have sugar and something else because the businessmen are not inherently bad. I mean, the country runs on business and profits, but we need to have the incentives for them. Honey and bees or something? Honey and bees. And also it's not entirely good marketing if you want their corporate image. Actually, I got the term from the CEO of a large energy company who listened to a talk like this. He said, I get it, the rat needs to smell the cheese. So, yeah, right. I thought the point about policies that interface well with the rest of the world was a particularly excellent one. I mean, we went back to the comment I made earlier that in my top three to things to do on climate would be to actually come to an international accord because I think when the world starts acting in consort on this, we'll be in a very different position than we are today. And I think it's an objective statement that our country has been one of the largest impediments to the world acting in consort. So, I thought that was a particularly, I hadn't thought about that. I thought that was a very important point. I had one comment as well on incentivizing R&D in this whole area, which I think is really critical. It's been underfunded for a long time. And I was glad to see at several points you brought that up as a complimentary thing to having say a cap and trade or some other kind of carbon valuation system. Let me just add one slight remark because the session yesterday that mentioned BP reminded me. We talk a lot about government R&D and it's an important part, but to be able to mobilize oil companies and coal companies and electric power companies to start doing R&D at a higher level and to refocus what they're spending it on is important as well. And if you give them these incentives rather than spending money on a new technique for horizontal drilling of oil, they may in fact do the kinds of things that BP has done in the Berkeley area and in London with Imperial College to focus on biofuels because I think that's a company that sees that in a carbon constrained world as a potential business opportunity for them. I don't think they're doing it because they're nice. I think they're doing it because they think it makes sense from their perspective. I should also add, and this goes to your comment in your talk, BP is not only investing of scale, half a billion plus dollars in research, they're actually investing of scale of billion dollars on a shortage time scale in biofuels industry because they see biofuels as a new way ahead and they said, we know bio refineries or we know oil refineries, therefore we can understand bio refineries. So they really mean it in a true business sense. And it doesn't have to be just big companies. You know, a lot of the developments in agriculture in the US occurred earlier in the 20th century at the local level with some help from the Department of Agriculture and local people and farmers working together. And there's no reason ideas only have to come from big companies. They'll come from venture capital companies, they'll come from individuals, but they need to see there's something at the end of the tunnel for it. One more thing, if Jim Hansen or Lind or I asked for more R&D in research, it would sound like pigs feeding at the trough. If you ask for more, it's much better. Starting on January 1st, I'm gonna be giving it out. It's a long foundation. Let's see. Here's a question from the audience. How do these cap and trades affect underserved communities, the poor, lower middle class in the short term? Well, in the short term, if we just, let's just say whether we give them away for free or re-auction, then they're gonna lead to an increased price of energy. And since energy use is, it's positively correlated with income, but it's relatively regressive, not quite as regressive as people think, but it still is regressive. So it would harm somewhat lower income people. And one of the reasons I'm in favor of, and I'm one of the few people in favor of giving some of these allowances to individuals, which they could then sell back to the oil companies or the coal companies is to let them get some of the revenues that they might have gotten through a tax rebate system, but in the context of a cap and trade system. And the, actually the McCain-Lieberman bill has a provision that has some fraction going back to lower income people underserved communities and others which they can then sell for revenues to try to mitigate some of the effects on them of higher energy prices. So the plans sound like they have potential, but how will they be enforced? The EPA already has enforcement issues. Won't this plan require an expansion of government? You know, the experience with both the SO2 trading program, which has now been running for 12 years and the NOX trading program in the Northeast which has been running since 1999 is that these operate at least for large facilities very, very easily. They have continuous emission monitors on their stacks. They have a requirement to submit the data every month. There's a computerized registry where their emissions are registered and they have until 30 days after the end of the year to put basically it's a bank deposit to emissions credits into their account to cover them where they pay a fine. And it's worked very, very smoothly. It's operated by very few people. It really hasn't been a major problem. For smaller facilities, the monitoring and the measurement of emissions would be more challenging. The way you would do it would either be to just measure how much oil and gas is being delivered there and impute a carbon content to it or the trend is to try to move most of this upstream to the larger producers, to the power plants, oil refineries and gas pipelines and have them be responsible for basically delivering energy that's already covered with an emissions credit. And we collect all those data already. The energy information administration collects them and they're pretty good. So I don't think that would be a major challenge either. I says pure economics question. Is regulation generally the best way to deal with the commons problem? Well, the commons problem or the externality problem is we ought to try to internalize the externality. It just becomes a question of what mechanism you use. I, as well as most economists, would like to use a price-based mechanism because the source of the problem is a missing markets problem. And it provides both the incentives to change your behavior, to produce less of the externality and it also leads to an increase in prices for the product or reflected social costs. I think in general, it's gonna be a better system. There may be circumstances where it's just too expensive to run such a system. The transactions costs may be very high and you may wanna rely more on standards. But I think our experience with standards for large facilities, on large electric generating facilities, for example, has been pretty bad in that they get delayed, they're not implemented, they're in court for years. We're still arguing about the new source review standards. It's almost 30 years now since they were passed. The thing about the SO2 program that was so impressive is once I went into operation, it just worked. No delays, it just worked like a charm. So I think it's pretty good. We just said, there may be other sources of market imperfection though that you wanna deal with. So we know that consumers for whatever reason appear to behave quite myopically when it comes to decisions about energy efficiency investments in their homes and how they choose their vehicles. So you may wanna have supplementary regulations, labeling regulations, efficiency standards and so on to deal with other. Other real world decision making issues that arise. Dr. Chu? I'm not an economist, but let me say that there are certain externalities that I don't think would be, it'd be very difficult to couple. For example, if you're a chemical company, one of the externalities of water pollution is higher medical costs of people downstream. It would be hard to put in the price of the plastics you sell that because the chemical company would work very hard to say this is not our fault or you can't put a real price on it. And so you get ended up in this stalemate. You'd be amazed at where these ideas have been used in New Zealand. They use essentially a cap and trade system to allocate rights to fish and the fish move and you think this wouldn't work at all, but it sort of works. Although I would say that a cap and trade system is somewhere between a real incorporate into the externalities, into the internal price naturally and a regulation. Again, I'm not an economist, but I... It's only a government intervention. Yes, it's heavy government intervention and it's somewhere in between there. So you mentioned the prices like $50 per ton of CO2 emission. Could you translate that into the rate that would cost or the rate that would be passed onto the consumer? How much would that raise the price of a kilowatt hour of electricity, for example? I have a chart here somewhere, let me see if I can find it. It's one of those numbers I don't keep on the top of my head. Well, how would effect electricity would depend very much on where you live because electricity is generated with different fuels, but the biggest effect would be on coal. It would raise, if it's $50, would raise the price of utility coal by about 400%. So it would probably raise the price of electricity in a Midwestern area on the order of 40 or 50%. It would raise the price of gasoline by about 50 cents a gallon. So you can compare that, gasoline's about $3 a gallon, so it would be about 20%. So the price effects are significant, but let me just point out, I didn't have time to go through some of the other modeling that my colleagues have done, but the price effects are quite important for meeting the mitigation target because that's what stimulates energy conservation. And these price effects are what get people to buy more efficient vehicles, it's what gets them to put in those compact fluorescence more quickly, it's what gets industry to put in new technologies to monitor there and control their energy use in their buildings. And you don't have to do it with price effects, you could do it with regulations and with building codes and so on, but those have not proven to be all that effective in many cases. So I think the price side of this is important and the message that one has to send to one senator or congressman in Washington is that we think this is important and we're willing to pay. If you say this is important, but we're not willing to pay anything, then the message they're gonna get is keep that safety valve price at $7 and the result of that will be relatively little mitigation activity. Yes, yeah. And I think it's important that the consumer recognize that there will be a gradual change because when there's a sudden change in the price of gasoline, you don't run out and get a new car. But if you know 10 years from now, it's going to be higher and significantly higher than you can make rational decisions. That's why we need to decouple it as much as possible from political ups and downs so that each election, it doesn't change by a big amount. That's why I think we need some sort of apolitical equivalent of the Federal Reserve Chairman to try to do what's best for the country. This is a very important point. In the simulations we've done, we don't even put the price on until 2010 or 2012. We let people know what it's gonna be and then we publish a price trajectory and it starts out low and it rises over time. And most of the action is with new investments. And one of the attributes, I mean the energy system is a little like the climate. It responds slowly because there are a lot of long-lived investments and what you wanna do is make it clear that for new investments, you've got to factor into your analysis the fact that five or 10 or 20 years down the road, you're gonna be paying substantial CO2 charges. That's why it's absolutely insane to have a program that gives new coal plants free allowances because it just gives them incentives to get built. Even if down the road they decide not to produce very much, they can sell the allowances and pay back their capital costs. So I think this is a very important design issue that is both good economics and probably good politics. Well, I think at this point, perhaps we should call our session to a close. Thank you once again for a stimulating talk. Thank you.