Cross-posted from the Peterson Institute for International Economics.

On May 5, the Congressional Budget Office (CBO) released an issue brief titled “How Policies to Reduce Greenhouse Gas Emissions Could Affect Employment” [PDF]. With unemployment hovering stubbornly around 10 percent, the report could shape the Senate’s appetite for taking up the energy and climate change bill being drafted by Sens. Kerry, Graham, and Lieberman. Unfortunately it’s a pretty weak initial offering by Congress’s independent research shop at a time when the Hill is particularly hungry for good analysis.

I last weighed in on the “green jobs” debate in early 2009 as Congress was debating economic stimulus legislation. In that context, a number of institutions put out analyses suggesting that government spending on clean energy technology and energy efficiency would do more to create jobs than tax cuts or spending on fossil fuel sources of energy supply. The Political Economy Research Institute (PERI) and Center for American Progress (CAP), for example, argued that $100 billion of green spending would create 2 million jobs, four times more than the same amount spent in the oil industry. This analysis looked only at the gross employment effects, ignoring the net effect after raising taxes or cutting government services in future years to offset near-term deficit spending. But as there was broad consensus at the time that a good dose of Keynesian stimulus was required, spending money on windmills rather than ditch digging meant meeting economic and environmental goals simultaneously.

The same analytical approach falls short when assessing the employment impacts of comprehensive energy and climate legislation. The reason is that the investment in clean energy and energy efficiency generated through such policy is paid for with higher energy prices rather than government borrowing. And these higher energy prices work against the job creation benefits of new green investment. Identifying the net employment impact of energy and climate legislation is a daunting task.

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Understanding the CBO’s approach

The May 5 issue brief does not represent independent CBO analysis on the employment impact of policies to reduce emissions, as its title suggests. Instead it reviews three outside studies, two from nonpartisan Washington think tanks-Resources for the Future (RFF) and the Brookings Institution — and one from the private consultancy Charles River Associates (CRA). Only one of these studies, the CRA analysis [PDF], evaluated a specific piece of U.S. legislation — the American Clean Energy and Security Act (ACESA) passed by the House of Representatives last June. The RFF study assesses the impact of a $10 per ton carbon tax on specific U.S. industries. The Brookings study [PDF] evaluates a range of possible greenhouse gas emission reduction scenarios. Although the studies deal with different policies and different carbon prices, the CBO attempts a cross-study comparison of the employment impacts from each study at the carbon prices the CBO projects under ACESA.

What they capture

While the three studies reviewed by the CBO assess different policies, they employ similar methodologies. All three analyze the economic and jobs impact using top-down computable general equilibrium (CGE) models. This approach effectively captures what the bottom-up methodology used by PERI, CAP, and others miss when it comes to comprehensive energy and climate policy — the impact of higher energy prices resulting from the switch to cleaner forms of energy. In CGE models, more expensive energy means lower real wages because U.S. workers have less money left over after paying for electricity, natural gas, and petroleum to buy other goods. And lower real wages prompt some workers to leave the labor market, reducing aggregate employment and further reducing consumer spending. That means lower industrial output from firms selling to U.S. consumers and lower employment in those industries. In addition, energy-intensive industries in the U.S. may be put at a disadvantage vis-à-vis their foreign competitors as a result of higher energy prices if other countries don’t adopt similar policies. This has the potential to reduce employment as well.

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Counteracting these effects are the increases in employment that come from consumers switching from energy-intensive to labor-intensive products, and from firms substituting labor for capital and energy in their production of goods. All three studies forecast a net decline in employment in fossil fuel production, construction, and manufacturing, while two of the three (the Brookings and RFF reports) forecast a net increase in employment in the service sector.

What they miss

As the three studies reviewed by the CBO assess different policy scenarios, they have limited value in gauging the employment impact of a specific piece of legislation. The way revenue is collected and used under either a cap-and-trade system or a carbon tax can significantly alter the employment impact of energy and climate policy. For example, if revenue raised through pricing carbon is used to cut existing taxes that discourage employers from hiring — such as the payroll tax — then the net jobs numbers can change significantly. Carbon tax revenue or emission allowances under a cap-and-trade system can also be used to offset higher energy prices for energy-intensive industries facing international competition.

And while CGE models do a good job of capturing the downside risks of energy and climate policy on U.S. employment, they fall short in capturing the upside potential, particularly in the following five areas:

  1. Investment: While CGE models forecast jobs lost from higher energy prices, they don’t accurately assess jobs created from the increase in investment likely to occur in the United States from pricing carbon. The input-output tables used in CGE modeling indicate the amount of investment, labor, and fossil fuels required by each industry to produce one dollar. These ratios are derived from economy-wide averages in whatever reference year is used in the model. So when policy raises energy prices and households and businesses improve efficiency in response, overall energy consumption falls and energy sector investment falls right along with it. This works okay for fossil fuel production like mining coal and pumping oil, but misses most of the story when it comes to power generation, particularly in the United States.

    Continuing along business as usual for the United States means continuing to operate coal-fired power plants built decades ago for power generation. Pricing carbon would mean replacing these plants with natural gas, renewable energy, or nuclear power or retrofitting them for carbon capture and sequestration. That all requires far more investment than maintaining the existing coal-fired power fleet, even if overall electricity demand falls moderately from efficiency improvements. Most CGE models are too aggregated to capture this turnover in the capital stock. And given the scale of power sector transformation required to meet the policy goals outlined in draft U.S. legislation, the amount of additional investment demand would be significant.

  2. Timing: Now the economically astute reader may point out that it’s all fine and good to argue that pricing carbon will produce an increase in investment in power generation, but that investment needs to come from somewhere — and if the economy is at full employment a surge of investment demand will cause inflation. Both points are correct. But the economy is far from full employment, and the Energy Information Administration doesn’t see us getting back there until 2020. That means that if an energy and climate bill that prices carbon were passed today, for the first decade of the program the United States could see a significant uptick in clean energy investment without robbing other industries of workers or capital.
  3. Market failures: In general, CGE models assume investment automatically flows to its most productive uses, i.e., that there are no imperfections in the market. Yet the energy sector is awash with market failures, primarily in the area of energy efficiency. Last year, the World Business Council on Sustainable Development, United Technologies Corporation, LaFarge Cement, and 12 other corporate leaders published an exhaustive catalogue of energy efficiency investments in the buildings sector that would provide an above-average rate of return but are not exploited because of a range of barriers, from principal-agent problems in commercial real estate to lack of access to capital for residential efficiency improvements. Working with this group I assessed the potential economic benefits of removing these barriers, and they are significant. A U.S. energy and climate bill with a combination of building codes, appliance incentives, higher energy prices, public education, and financing mechanisms would unlock these highly profitable efficiency investments and produce employment gains not captured in the studies reviewed by the CBO.
  4. Export competitiveness: CGE models are good at assessing the impact on incumbent industries from pricing carbon but struggle to forecast the emergence of new industries in response to that carbon price. So while a loss of jobs in energy-intensive manufacturing from higher energy prices is analyzed in the three studies reviewed by the CBO — the potential increase in U.S. competitiveness in clean energy technology abroad from boosting demand at home isn’t captured.
  5. Knowledge-spillover: Finally, long-term economic growth depends largely on how fast a country develops technologically. Pricing carbon will force companies to innovate, whether by developing technologies that deliver energy or changing process and production methods to use energy more efficiently. This innovation will result in spillover effects that lower prices and increase production in other sectors. The question is whether the spillover effects from clean energy technology are greater than under the status quo. This is an important question that CGE models don’t address.

The bottom line

Despite the shortcomings of CGE models in assessing the employment impact of energy and climate policy listed above, there’s not much in the way of alternatives. The problem is not the studies selected by the CBO (the Brookings and RFF reports are nonpartisan, independent, and academically rigorous studies) but the omission of serious discussion of the limitations of CGE modeling in predicting employment outcomes, limitations the authors of the underlying studies themselves would readily acknowledge. There is certainly no shortage of recent reports that, though weak or incomplete, overstate the potential jobs gains from pricing carbon. But the methodological approach of the studies included in the CBO report arguably overstates potential job losses. Hopefully in the months ahead the CBO will conduct its own analysis and provide the Congress with a more balanced picture.

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