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A Changing Policy Climate

What a difference a year can make. In twelve months the center of gravity has strikingly shifted in the debate over U.S.

climate change policy. Eleven states have developed mandatory greenhouse gas limits. More corporations are calling for federal policy. And numerous studies and media stories, including the report this month from the United Nations Intergovernmental Panel on Climate Change and Al Gore's movie, are tipping the scale of public opinion. But the biggest difference is in Congress. Since January, Capitol Hill has been inundated with a wave of climate bills.

At this point, a federal climate policy seems inevitable. That's certainly what many electric power company senior executives think. More than 80 percent of those polled in CERA's most recent executive power survey expect a mandatory carbon policy by 2015.

But designing a U.S. climate change policy is a big undertaking.

It may be difficult to reach a consensus in this Congress; however, a real debate is underway. At the very least, that debate will be an important prelude to the 2008 presidential election and a signal that climate policy is moving to the front and center of U.S.

politics. The Bush Administration's existing climate change policies emphasize research, technology development and public-private partnerships such as the Asia-Pacific Partnership on Clean Development and Climate. The new policy proposals would move to a mandatory approach of regulating carbon dioxide (CO2) emissions. These bills seek to accelerate investments in lower emitting fuels and technologies by setting specific emissions targets. The obvious questions for setting these emissions targets are, "What level of reductions will be required?" and "On what timetable?" We will hear much discussion about these in the coming months. But there are other, less obvious questions that will really chart the course for U.

S. climate policy. To start, policymakers will need to decide any program's scope and framework- what sectors will be affected and how. The electric power and transportation sectors account for more than 70 percent of U.S.

CO2 emissions. So it's no surprise that they are at the top of the list of sectors to control. But how should these emissions be effectively limited? Cap-and-trade is the framework getting most of the attention right now, at least for the power sector. First used to control sulfur dioxide (SO2) emissions from U.

S. power plants, cap-and-trade has become the favorite of academics, corporations and regulators. In January 2005, Europe adopted this approach to controlling its CO2 emissions. Now over 11,000 power plants and industrial facilities across Europe are covered under the European policy.

And CO2 cap-and-trade programs are now sprouting up in the United States. The Regional Greenhouse Gas Initiative, a cap-andtrade program for power plants in 10 northeastern states, is scheduled to start in 2009. California is also drafting a similar policy for in-state power companies set for 2012. How does cap-and-trade work? It starts with a government setting an emissions cap or ceiling for a group of sources.

For example,power plants-and then issuing a set of "allowances," the currency of the program, equal to the overall size of the cap. The requirements are really very simple: companies comply by limiting their emissions to the number of allowances they hold. The innovation with cap-and-trade is that by trading allowances,companies get to choose where to reduce their emissions.

And in circumstances where it's not economic, they can buy additional allowances in the open market. Regardless of who buys and sells allowances, the overall cap ensures that industry-wide emissions stay below a certain level. Based on past successes with similar policies in controlling SO2 and nitrogen oxide emissions and early promising results from the European program, there is substantial support to create a national CO2 cap-and-trade program in the United States. Almost all of the federal climate bills propose this approach for power plants.

Some proposals, including one by Senators John McCain and Joe Lieberman and one by Senator Jeff Bingaman, would expand cap-and-trade beyond power plants and include the transportation sector. Regardless of the sectors regulated, the question of how allowances are distributed under a cap-and-trade program looms large. Current programs have mostly followed the precedent of the U.S. SO2 program by allocating the majority of allowances directly to the regulated companies at no cost. But this could change because the stakes are higher with CO2.

The government allocation of CO2 allowances would be a major wealth transfer with the annual value ranging anywhere from $5 to over $200 billion. This has not been lost on interest groups and many are already staking out positions. Certainly regulated companies want to hedge future costs through allowance allocations. Consumer groups would like some of the allowances as a compensation for the higher prices they expect to be paying. And some advocates want to use allowances to subsidize investments in new, lower emission technologies. Some proposals would avoid free allocations altogether and instead use auctions and in the process create a major revenue source for the federal government.

That is how New York plans to distribute the state's CO2 allowances under the regional program being set up in the Northeast. It is likely that a federal allocation scheme will move away from any single approach to a blend of these mechanisms and incentives. Beyond designing how a domestic climate change policy will function, policymakers will also have to define how a U.S. program connects with the policies of other nations. Linking a U.

S. CO2 emissions market with other trading systems seems an obvious step. Regulators in the Northeast and California are already thinking about how their programs could link with international markets. But the real question comes down to how the United States should deal with major emitting countries that are not capping emissions.

The United States accounts for over 20 percent of global CO2 emissions today, but the global balance is changing. Due to rapid economic development, emissions in China and India have grown more than five times faster than those of the United States since 1990. And CERA projects this trend to continue, with China and India contributing about half of the growth in global emissions over the next quarter century.

The global emissions trends are daunting, and the effectiveness of any policy to curb them will depend on the collective actions of the international community. Nonetheless, it is very possible that the United States will push forward with a domestic policy before any new international system is established. Given this reality, a number of proposals include measures to ensure that a U.

S. program does not impose sudden cost increases that place its economy at a disadvantage to those of its major trade partners. Such economically-oriented approaches will likely be balanced by other voices asserting that the U.S.

needs to take the first step to encourage countries like China and India to adopt their own emissions policies. But whatever system emerges internationally, climate change will be a central issue in U.S. politics going into the 2008 presidential election and beyond.

Daniel Yergin, chairman of Cambridge Energy Research Associates (http://www.ceraweek.com, http://cera.ecnext.com) and executive vice president of IHS, received the Pulitzer Prize for "The Prize: The Epic Quest for Oil, Money & Power" and the US Energy Award.

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