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SCOPE AND POINT OF REGUlATION FOR PRICING POlICIES TO REDUCE FOSSIl- FUEl CO
ISSUE BRIEF 4
SCOPE AND POINT OF
REGUlATION FOR PRICING
POlICIES TO REDUCE FOSSIl-
FUEl CO
2
EmISSIONS
wIllIAm A. PIzER
4 S C O P E A N D P O I N T O F R E G U L AT I O N
F O R P R I C I N G P O L I C I E S
T O R E D U C E F O S S I L - F U E L C O
2
E M I S S I O N S
70
William A. Pizer
SCOPE AND POINT OF REGULATION FoR
pRicinG policies to Reduce Fossil-Fuel
co
2
eMissions
SUMMARy
This issue brief examines the choice of what
emissions to includeand where to regulate
themunder a tax or tradable allowance
policy to reduce fossil-fuel carbon dioxide
(CO
2
) emissions. A companion brief (Issue
Brief # 14) examines options for regulating
non-CO
2
greenhouse gases (GHGs) and non-
fossil CO
2
emissions. Several points emerge
from this discussion:
A regulatory program that establishes a price
on CO
2
emissionseither through a tax or
tradable permit systemwill achieve the most
reductions at the least cost when it covers as
many emissions as possible under a single
program with one price. Broader coverage
also mitigates the tendency for emissions to
shift to uncovered sources over time, raising
the profile of any excluded emissions sources
(that is, leakage).
The argument for a broad-based,

single-price program is grounded in cost
considerations. Other policies, however,
are often proposed instead of, or in
addition to, a pricing policy. These
proposals are often motivated by a desire
to pursue more popular technologies,
to guarantee certain technology outcomes
or emissions-reducing actions within a
sector, and to shield some fossil-energy
users from higher energy prices.
A program to price CO

2
emissions that
focused on large emission sources (for
example, sources that emit over 10,000
metric tons of CO
2
annually) could cover
just over half of U.S. GHG emissions by
regulating roughly 13,000 facilities. A
program focused solely on the electricity
sector would cover roughly one-third of
U.S. emissions and involve 2,0003,000
facilities.
An upstream tax or emissions-trading

program could effectively cover almost all
fossil-energy CO
2
emissions by regulating
approximately 3,000 entities, including
refineries, natural gas pipelines or
processors, coal mines, and importers.
While regulatory programs for other forms

of pollution have traditionally focused
on emitters, the unique nature of CO
2

emissions makes it possible to regulate
effectively at any point in the fossil-fuel
supply chain. The vast majority of CO
2

emissions result from the combustion of
fossil fuels. Because these emissions do
not depend on the combustion technology
used or on other operating parameters,
and because there is limited opportunity
to reduce emissions other than by burning
less fuel, downstream emissions can be
calculated with relative ease and accuracy
based on the quantity of fuel produced
or processed and its carbon content.
Thus, fuels can be regulated as a proxy for
emissions at any point in the chain from
production to processing to distribution
and final consumption. Important
adjustments must be made for imported
and exported fossil resources and fuels,
sequestered emissions (including carbon
capture and storage), or uses of fossil fuels
that do not result in emissions. 71
A S S E S S I N G U . S . C L I M AT E P O L I C y
O P T I O N S
A concern frequently raised about upstream regulation of

CO
2
emissions is that fossil-fuel users will respond more
strongly to direct incentives for reducing emissions than
they will to higher fossil-fuel prices. There is a psychological
appeal to this logic, but basic economic theory and
business pressure to minimize cost argue against it.
While existing tradable permit programs have traditionally

allocated free permits to regulated sources, there is no
reason why CO
2
permits cannot be allocated to other
actors throughout the fossil-fuel supply chain that are
directly or indirectly affected by regulation. Decisions about
how to allocate permits or allowances need not be tied to
decisions about which entities will be required to submit
permits or allowances under a trading program.
For a

given set of design choices concerning permit
allocation and program coverage, the decision about
where to regulate does not generally change the
economic burden imposed on different actors in the
fossil fuel supply chain. Important caveats may apply in
situations where products are not competitively priced
(as, for example, in regulated utility markets). In addition,
point of regulation does affect which entities bear the
administrative burden of demonstrating compliance under
a tradable permits program (in a well-designed program,
however, administrative costs should be relatively small).
Key Choices
A high-level question that arises early in designing a market-
based climate-change mitigation policy for the United States
is how to define the scope of economic activities regulated
under the policy, particularly with respect to fossil energy CO
2

emissions. Entities involved in generating emissions that are
covered by a market-based policy (including entities upstream
and downstream of the entity that is actually regulated) face
a common incentive to reduce emissions; entities involved
with the production of emissions that are not covered do not.
This issue brief outlines the basic motivations for including
and excluding various emissions sources, along with different
regulatory options for including sources in a market-based
emissions-reduction program.
Motivation
A principal motivation for market-based policiestaxes or
tradable permitsis that they encourage the most reductions
at the lowest cost compared to other policy architectures.
1

Among market-based policies, those that include more
emissions sources can deliver larger reductions at even
lower costs. Broader coverage implies more opportunities
including possibly very cost-effective opportunitiesto
reduce emissions. Broad coverage also avoids the tendency
for emissions to shift over time to sources that are not covered
under the trading program. This is referred to as emissions
leakage. Finally, broad coverage may satisfy a desire for
fairnessthat is, ensuring everyone is part of the policy
though it is worth noting that this desire could also
be satisfied by a less-efficient, sector-by-sector approach
(and is, in any case, a much more subjective goal).
Reducing GHG emissions enough to limit future climate
impacts could eventually cost the world economy as
much as 13 percent of gross product according to recent
assessments by the Intergovernmental Panel on Climate
Change (IPCC) and other studies.
2
All of these studies assume
cost-effective global efforts to reduce emissions in which all
emission sources face the same market price for CO
2
. If future
mitigation efforts focus on a smaller number of sources or use
less-efficient policies, costs could rise significantlyperhaps
by a factor of ten.
3
A sector-by-sector approach that tackles
various emissions sources with distinct policies risks precisely
this outcome.
4
Even though such an approach may cover all
emissions, it does not do so in a way that encourages least-
cost reductions across all sectors.
5

Distinct from the issue of cost is the concern that, over time,
excluding some fuels and sources from regulation could
gradually encourage leakage as CO
2
prices rise. A program
that only covered electricity-related emissions, for example,
could encourage households and businesses to shift to direct
use of fossil fuels.
6
While policies with partial coverage may not
create significant leakage problems in the short run because
the price incentive is not sufficiently high, this may change
over time as policies evolve to achieve deeper reductions
and incentives for regulated sources to avoid emissions rise
1 alternate, technology-based regulations are discussed in a companion issue brief on technology deploy-
ment options.
2 see companion issue brief on costs and intergovernmental panel on climate change, 2007. Report of
Working Group III, Summary for Policymakers.
3 see pizer, w. et al, 2006. Modeling economywide versus sectoral climate policies using combined
aggregate-sectoral Models, Energy Journal 27(3): 135-168. the authors find that mitigation costs double
when only electricity and transportation are included, and increase by a factor of ten when standards for
fuel economy and renewable portfolios are used in those sectors.
4 consider, for example, the suite of actions being considered in california under aB32, http://www.arb.
ca.gov/cc/ccea/ccea.htm.
5 sector-by-sector regulations lead to higher costs for three reasons. First, absent emissions pricing of some
sort in all sectors, there will not be an efficient balance of conservation and mitigation. second, it is unlikely
marginal costs will be balanced, leading to expensive reductions in one sector while cheaper abatement
opportunities go unrealized in another. third, absent emissions pricing, there will be a weaker incentive to
innovate. see issue Briefs #10 and #5 on technology deployment policies