Discounting and Climate Change Economics: Estimating the Cost of Cap and Trade

by David Kreutzer, Ph.D.
WebMemo #2705
November 19, 2009

The Environmental Protection Agency (EPA) recently released its preliminary analysis of the Boxer-Kerry cap-and-trade bill. It largely reheats their analysis of the Waxman-Markey bill from last summer.

Proponents of both bills often claim the EPA analyses pegs the cost per household at a postage stamp per day. However, the reality is that the costs of both bills are far from trivial.

The Real Cost of a Car

The EPA lists the cost of the Waxman-Markey energy tax for the year 2050 at just $174 per household. Summed over all households, this figure still adds up to tens of billions of dollars per year, but it is relatively small in a world of trillion-dollar proposals. The problem is that that amount is not what the actual cost would be.

If inflation over the next 40 years equals that of the past 40, the EPA analysis would project that Waxman-Markey would cut consumption by $7,465 per household per year in 2050. The impact for Boxer-Kerry would be similar.

How, then, does the EPA transform $7,465 into $174? It adjusts for inflation and then takes the discounted present value. It is this second step that can be misleading.

To help sort this out, imagine that a time machine takes analysts back to 1969 — a time when the average price of a new car was about $3,500. Once back in 1969, the exercise is to explain to Congress how much a new car will cost 40 years later in 2009.

Having already lived to see 2009, we know the average price for a new car is about $23,000. But telling the Congress of 1969 that in 40 years cars will cost $23,000 would give an exaggerated notion of the cost increase, because inflation alone will have increased prices by a factor of 5.8. If inflation is taken into account, the price of a new car in 2009 is about $4,000 in 1969 dollars.

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