The Economics of Climate Change: a Primer/Chapter 5

ecause the causes of climate change are global, the stabilization of greenhouse gas concentrations in the atmosphere will ultimately require international cooperation. However, the nature of the climate problem will make agreement difficult to reach. Near-term, concentrated costs of regulation combined with diffuse, long-term future benefits make it easy for countries to postpone action. The scientific and economic uncertainty discussed in earlier chapters also makes it difficult to reach a consensus about the appropriate response. Although nations have found it relatively easy to agree to expand, coordinate, and report climate-related scientific and technological research, they have found it very hard to agree about whether and how much to restrict the growth of greenhouse gas emissions.

That lack of agreement may stem in part from uncertainty, but it also reflects nations’ differing circumstances and conflicting interests. Policymakers in countries vulnerable to potential changes in climate favor dramatic action to avert warming, while policymakers whose countries appear to be less vulnerable are correspondingly less concerned. Countries with significant fossil-fuel production or high levels of emissions tend to oppose policies that would restrict the use of fossil fuels. Five countries (the United States, China, Russia, Saudi Arabia, and Canada) produce more than half of the world’s fossil carbon, and five countries (the United States, China, Russia, Japan, and India) account for about half of all fossil carbon consumption. Thus, a small group of nations can strongly influence the structure and effectiveness of any agreement related to climate change.

But the fundamental differences at the global level are between more and less affluent countries. Developed countries have contributed the majority of historical emissions, but countries that are now in the early stages of development will account for the bulk of emissions over the next century. Even so, on a per capita basis, developing countries will continue to have much lower income and levels of emissions than developed countries will have, and they appear to be more vulnerable to damage from climate change. As a consequence, policymakers in many developing countries favor significant action to reduce global emissions—but only by developed nations. Put another way, they maintain that developed countries have already used up a large portion of their rightful allotment of emissions and that developing countries now have a strong claim to the bulk of emissions to be allowed in the future—those that are unlikely to cause serious damage to the climate.

Because of the global nature of the climate problem and competing national interests, countries have little incentive to act unilaterally to reduce emissions, and every nation has an incentive to free ride and let other countries shoulder most of the burden. As a result, the development of effective coordination of international climate policy is likely to be gradual, as was the 50-year process that brought the World Trade Organization to its current form.

International Policy Considerations
In addition to considering the nature of the climate change problem and the distribution of interests, policymakers who seek to foster effective international coordination may draw from a wide range of past experience in the design and implementation of international environmental and other treaties, and of domestic regulatory systems as well. Some of the factors to be considered are purely international in scope. Other factors, which have been discussed in previous chapters, are common to domestic and international regulatory systems alike.

Cooperation among sovereign, independent nations can involve a variety of formal structures. Governments can agree to formal treaties, which are considered binding instruments under international law; or they can agree to less rigorous, nonbinding instruments—referred to as executive agreements in the United States—that serve as guidelines to action rather than as legal requirements.

Cooperation can range from modest commitments to share information and undertake coordinated research, to more extensive agreements to restrict emissions, monitor compliance, and enforce penalties.

Several other institutional considerations can influence the effectiveness of international agreements (Victor and others, 1998). Such agreements tend to be more effective when they:
 * Encourage relatively frequent interaction and extensive sharing of information among national delegates;
 * Help link the solutions of related problems, such as climate change and energy security or climate change and biodiversity;
 * Give countries incentives to continue to participate even if other countries refuse to;
 * Allow new countries to enter with relatively little effect on the system; and
 * Distribute the cost of the response in a way that is acceptable to participating countries.

Regulatory Approaches
To regulate the global growth of emissions, international negotiators can draw on essentially the same set of options as domestic policymakers can: command-and-control regulations, emissions taxes or permits, or a hybrid system. Negotiators would need to consider whether and how to coordinate such policies among countries. Alternatively, they might allow each country to choose an independent system but still coordinate action in the form of agreed-upon national targets.

As Victor and others (1998) have noted, agreements are more likely to succeed if they involve commitments that are relatively straightforward to apply and enforce. Nations may find it easier to commit to undertake research programs than to adopt uniform technologies, complex regulatory policies, or specific targets for emissions. Targets may be particularly difficult to decide on or achieve in the face of uncertainty about implementation costs.

Past international agreements have called for varying levels of effort by different countries, but they have not usually called for formally differentiated commitments. Instead, countries tend to interpret their commitments in ways that reflect their different national circumstances and domestic goals. Given the complexities that policymakers face in securing domestic political agreement about implementation, the more ambitious the commitments, the more varied the implementations are likely to be.

Countries with relatively large absolute or per capita emissions, or with large fossil-fuel industries, are likely to insist on some degree of cost-effectiveness before committing themselves to restrictions on emissions—although political and distributional considerations may lead nations to ignore cost-effectiveness. An international command-and-control approach would be much more costly and difficult to monitor and enforce than would other approaches and is therefore unlikely to secure much backing.

Uniform international incentives are likely to be more cost-effective than country-specific regulations because every country has at least some low-cost opportunities to reduce emissions, whereas the incremental cost of controlling emissions in any given country is likely to rise steeply with increasingly tight restrictions. Developing countries have particularly extensive low-cost opportunities, for several reasons: many of the costs of production there tend to be relatively low; energy use is rarely taxed and often subsidized; and energy efficiency is cheaper to build into new infrastructure in developing industries than to retrofit in industries in developed nations. Restricting emissions in only a few countries—particularly developed ones—would therefore significantly raise the cost of achieving almost any global goal for emissions.

Differences between countries’ emissions control policies can also lead to “leakage” of energy consumption—and therefore emissions—from one country to another. For instance, if only developed countries controlled emissions, they would consume less oil. International oil prices would fall in response, and developing countries would be able to increase their oil consumption. Similarly, corporations in emissions-intensive industries could simply reduce their investments in countries with stricter controls and increase their investments in countries with less strict or no controls, gradually transferring their production to them. That potential leakage effect would raise the cost and reduce the effectiveness of more-restrictive countries’ commitments.

Independent action would allow each country to tailor policies to its national circumstances. But a system of independent approaches would still require international agreement about what constituted an acceptable degree of action and of burden sharing. It would also be unlikely to minimize emissions control costs, could lead to extensive leakage, and might present difficult problems in monitoring and enforcement.

Much of the debate about international climate policy has focused on national quotas, or allowances, for emissions. Under such a system, nations would agree to allocate emissions rights in the form of strict limits, or caps. The limits could apply to one-, five-, or 10-year periods, or indefinitely; nations would be free to meet the caps by using the domestic regulatory system of their choice. Some proposals would allow nations to trade emissions allowances. That feature would tend to equalize permit prices—and thus the incremental costs of mitigation—among participating countries and result in the most cost-effective achievement of the overall emissions cap.

A system of quotas would make the international allocation of rights transparent. If quotas could be enforced, they would ensure that a strict emissions cap was met in participating countries. Given a strict limit, the international trading of emissions allowances could equalize incremental costs, and the system would be relatively straightforward to implement—at least it would be if it was limited to carbon dioxide from fossil fuels—once countries determined how to allocate emissions allowances domestically.

However, an international cap on emissions could entail unnecessarily high costs if the cap was tighter than was warranted for balancing the overall costs and benefits of averting climate change. That pitfall could be avoided by implementing a hybrid permit system with a price cap —but only at the cost of abandoning strict emissions limits and clear emissions rights.

In contrast to quotas, a price mechanism—a system of uniform emissions taxes or fixed-price permits—would guarantee equal incremental costs for emissions controls at a fixed price without requiring any international trading of emissions allowances. Furthermore, as discussed in Chapter 4, price mechanisms are likely to constrain emissions more cost-effectively than strict quotas, given the uncertainty about the net benefits of doing so.

But price mechanisms also present problems. A system of taxes would not, by itself, address issues of international burden sharing. And maintaining strictly uniform taxes on emissions would be difficult in the face of fluctuating exchange rates. Moreover, in negotiating a uniform price mechanism, countries might want to consider the extensive variation in their existing energy taxes: even in the absence of price- or quantity-based controls, the effective price of carbon from fossil fuels differs significantly among countries and across fuels. Gasoline prices in western European countries, for example, are about three times higher, on average, than in the United States, largely because of taxes. In contrast, gasoline prices in many developing countries are lower. Countries that implicitly taxed emissions through their gasoline levies might argue that their existing systems constituted sufficient action and no further efforts were necessary.

Compliance
International agreements are particularly difficult to monitor and enforce because the parties to them are sovereign nations that tend to resist international oversight of domestic policies—and whose participation is ultimately voluntary. Few international environmental agreements have provisions for enforcement, and as a general rule, international organizations lack the jurisdiction or the resources to enforce them (General Accounting Office, 1999). To many observers, binding treaties with penalties seem more likely than nonbinding ones to ensure compliance, and experience shows that nearly all countries do, in fact, fulfill their binding commitments. However, given the uncertainty of politics and markets, governments cannot invariably ensure that they will be able to meet such commitments. They generally do so, not because they would face penalties for noncompliance but because they would not have agreed in the first place to commitments that they were unlikely to fulfill.

Some observers argue that for a problem as complex as climate change, international enforcement would require some form of penalty that involved trade and therefore indirectly the World Trade Organization (WTO). Recent decisions by the WTO have allowed nations to enforce environmental rules by penalizing imports on the basis of the processes used in their production (Victor, 2001, pp. 87-89). But some experts worry that entangling the WTO in complex environmental issues could endanger the international trade system.

Yet experience also shows that countries tend to be more willing to adopt clear, ambitious commitments when those commitments are nonbinding, especially when uncertainty about costs makes nations unwilling to accept binding agreements that they might not be able to fulfill. (Escape clauses in binding commitments can perform the same function.) Moreover, a nonbinding framework allows subsets of countries to undertake deeper cooperation without excluding others from an agreement and promotes learning by doing. The evidence thus suggests that in practice, nonbinding agreements may significantly influence behavior (Victor and others, 1998, p. 685).

Restrictions on greenhouse gases vary in the ease with which emissions can be monitored and the limits on them enforced. Under binding agreements, carbon dioxide emissions from the use of fossil fuels would be relatively easy to monitor, although in countries that had serious problems with law enforcement and tax evasion, compliance with the established limits could be difficult to achieve. For most other types of greenhouse gas emissions, the high costs of monitoring would reduce the likelihood of strict compliance—or even of accurate documentation—in all countries.

International Institutions to Address Climate Change
International cooperation to address the prospect of climate change has been developing since 1988, when the United Nations and the World Meteorological Organization created the Intergovernmental Panel on Climate Change (IPCC) to collect information and report on climate-related issues. Shortly thereafter, negotiations began on the United Nations Framework Convention on Climate Change (FCCC), which was signed in 1992 and subsequently ratified by nearly all the world’s nations. The convention provides for a permanent standing bureaucracy dedicated to coordinating international climate policy and for a Conference of the Parties to meet roughly once a year to review and reconsider countries’ commitments in light of the most recent findings on climate change.

The FCCC commits its signatories to undertake extensive research (to better understand the climate system) and to stabilize atmospheric concentrations of greenhouse gases at levels that would prevent dangerous climate change. The convention calls for managing the global climate in a manner that is both efficient and equitable, stipulating that climate-related policies should be cost-effective, but it also urges greater effort from a set of 35 developed countries that are listed in the FCCC’s Annex I. However, the convention does not specify any targets for greenhouse gas concentrations or a time frame for achieving stabilization. Nor does it commit any country to specific limits on emissions or to specific actions to reduce emissions.

The Kyoto Protocol
After five years of international negotiations following the FCCC’s adoption, the third Conference of the Parties adopted the 1997 Kyoto Protocol to the convention. The protocol calls for strict quantitative limits (or allowances) on emissions from 38 developed countries—largely the same ones listed in Annex I of the convention. Those complicated limits, which are specified in Annex B of the protocol, are generally somewhat below the countries’ 1990 emissions levels and are scheduled to take effect during the so-called First Budget Period, from 2008 to 2012. Non-Annex B countries remain exempt from overall emissions constraints.

Under the protocol, countries are allowed a significant degree of flexibility in meeting their commitments. Each country may:
 * Use any policies or technologies it prefers to meet its targets;
 * Achieve its overall target by reducing emissions over a “basket” of six different greenhouse gases rather than just reducing carbon dioxide emissions;
 * Average its emissions across the entire five-year period rather than meet a specific target every year;
 * Earn a limited quantity of credits (that is, additional allowances) for forestry and agricultural projects that sequester carbon;
 * Receive credits by financing emissions-reducing projects in other Annex B countries through a process called Joint Implementation;
 * Receive credits by financing projects in non-Annex B countries through another process known as the Clean Development Mechanism;
 * Buy, sell, or trade emissions allowances to an undetermined extent; and
 * Join with other countries to reduce emissions as a group.

The protocol explicitly mentions that countries should pursue research and development programs but does not require a specific level of expenditures.

To enter into force, the Kyoto Protocol must be accepted, approved, acceded to, or ratified by at least 55 signatories to the convention, including countries that together in 1990 accounted for at least 55 percent of total carbon dioxide emissions from Annex I countries. In effect, the provision means that the protocol must be ratified or approved by either the United States or Russia, which together accounted for over 50 percent of emissions from Annex I countries in that year. It also means that a handful of countries with high levels of emissions could, if they acted together, effectively veto the protocol.

Subsequent Negotiations
The negotiations that followed those in Kyoto brought a substantial shift in direction. Talks collapsed in 2000 over a dispute between U.S. and European delegates about the use of international emissions trading and forestry programs to meet their commitments, with the United States arguing in favor of much greater flexibility than European countries would accept. In early 2001, the Bush Administration indicated that it would not continue to negotiate the terms of the protocol or submit the protocol to the Senate for ratification. Following the effective withdrawal of the United States from the process, the other parties decided to move ahead. In November 2001, they reached agreement on nearly all outstanding implementation issues, largely along the more liberal lines of interpretation that the United States had originally advocated. (Without U.S. participation to potentially drive up the demand for emissions credits, the liberal interpretation allowed the remaining parties to dramatically lower their likely implementation costs; Babiker and others, 2002, provide a detailed discussion.) The European Union ratified the protocol in May 2002, and Japan followed suit in June. As of March 2003, 106 countries had ratified or acceded to the protocol, and the ratifying countries accounted for 44 percent of the carbon dioxide emissions from Annex I countries in 1990 (United Nations, 2003). Ratification by Russia would bring the treaty into force.

Assuming ratification under the current terms of the protocol, participating Annex B countries would probably be able to meet their commitments at very little cost. They would have two sources of low-cost emissions credits: they could earn substantial credit for forestry projects, and they could supplement reductions of domestic emissions with purchases of emissions allowances and credits from other countries. A few nations are expected to have substantial amounts of surplus emissions allowances during the 2008-2012 period—particularly Russia and the Ukraine: their emissions fell dramatically during the economic collapse of the 1990s, and they have experienced substantial forest growth. (The expected surplus is often referred to as “hot air.”) Without U.S. participation to boost demand, the remaining Annex B countries will be able to buy the surplus allowances and forestry credits at a low cost and meet their commitments without undertaking extensive domestic emissions reductions.

The upshot of these developments—assuming ratification and implementation by the remaining parties and full use of the treaty’s many flexibility provisions—is that the protocol will result in relatively few commitments to undertake research, a complex set of emissions caps for a limited set of developed countries for the 2008-2012 period, financial transfers among the parties amounting to several billion dollars per year for the purchase of emissions allowances, unlimited emissions rights for most countries, and a very limited reduction in the growth of global greenhouse gas emissions.

Implementation Costs
The international negotiations surrounding the protocol inspired a large number of analyses of the cost to the United States of meeting its proposed commitments. Such analyses are complicated by uncertainty about how the details of implementation might have been negotiated in an agreement that included the United States. In a recent review of a number of studies, Lasky (forthcoming) has estimated U.S. mitigation costs under three different sets of implementation rules. emissions by non-Annex B countries—Lasky estimates that the United States could have met its Kyoto commitment in 2010 for an incremental cost ranging from $44 to $245 per metric ton of carbon equivalent (in 2002 dollars) and an overall economic cost of between 0.4 percent and 1.5 percent of gross domestic product. for forestry projects, the United States could have faced incremental costs for emissions reductions ranging from $171 to $297 per mtce. Annual tax revenues (or the annual value of auctioned emissions permits) could have totaled between $261 billion and $452 billion, and the policy might have reduced GDP by nearly 2 percent.
 * Under moderately restrictive implementation rules—that is, with some trading of emissions allowances among Annex B countries and modest reductions in
 * Under a loose set of rules that permitted Annex B countries to pay for large emissions reductions in non-Annex B countries and allowed extensive credit for the net absorption of carbon dioxide by forests, the United States would have been able to meet its targets at almost no cost and with little effect on its economy.
 * Under a very restrictive set of implementation rules that prohibited international trading of emissions allowances or credits and permitted only limited credit

Actions by the United States
Over the past 15 years, the federal government has made substantial investments in research to understand the global climate system and the potential effects of climate change, and to subsidize the development of carbon-removal and alternative energy technologies. The United States has also continued a variety of longstanding programs that tend to discourage emissions or encourage the removal of greenhouse gases from the atmosphere—but that were originally intended to achieve other goals, such as pollution reduction, energy independence, and the limitation of soil erosion. The programs include corporate average fuel economy (CAFE) standards, taxes on gasoline, air quality improvement programs, and the Conservation Reserve Program. However, the United States has not adopted taxes or quotas that explicitly address the restraint of greenhouse gas emissions.

After negotiating and signing the Kyoto Protocol in 1997, the Clinton Administration did not offer it to the Senate for ratification. It presented a plan for meeting the United States’ commitment, but many analysts raised concerns about whether the plan could accomplish its goal. The Bush Administration, having withdrawn the United States from subsequent protocol negotiations, has largely continued the previous administration’s level of climate-related expenditures: the President’s budget for fiscal year 2003, for instance, proposed $4.5 billion of climate-related spending, with $1.7 billion dedicated to climate science (including potential impacts of climate change) and $1.3 billion to the development of energy and sequestration technologies. The Bush Administration currently defines its goals in terms of a modest acceleration in the rate of decline of emissions per dollar of GDP rather than the achievement of an emissions target at some point in the future. In the meantime, and largely independently of federal action, some states and firms are adopting policies that are intended to reduce their emissions.

Alternative Approaches
The problems associated with the Kyoto Protocol have inspired researchers to propose a variety of alternative policies for coordinating international efforts related to climate change. Each approach represents a distinct interpretation of the available evidence about the likely benefits and costs of climate change, the uncertainty surrounding it, and practical concerns about how climate policy would affect domestic economies and the world economic system. Many of the approaches offer novel ways to address the simultaneous problems of limiting emissions and distributing the burden of regulation.

Some researchers (for example, Michaels, 2001) conclude that the rate of climate change is likely to be at the low end of the current range of estimates and the effects largely benign, and they argue for a laissez-faire approach.

Such a policy would take no affirmative steps to avert potential damages from climate change or to develop institutions to help coordinate international action.

Other analysts have proposed systems of emissions taxes or tradable emissions permits with fixed prices to limit the costs of mitigation. One such proposal envisages a system of auctioned emissions permits for the United States that would require producers to purchase permits for the right to sell fossil fuels. The permits would be required at the point of import or first sale, and the revenues would be returned to households and states. The charge would start at $25 per metric ton of carbon in 2002 and rise by 7 percent per year (after inflation) through 2007. That approach would be relatively cost-effective, although it would not be as cost-effective as using the revenues to reduce distortionary preexisting taxes. The option would also address distributional concerns but only at the domestic level. A similar system could be envisaged for other countries, and several proposals for an international system call for both setting national targets for emissions and establishing a maximum price (or “safety valve”) at which governments provide additional permits for domestic emissions (see Aldy, Orszag, and Stiglitz, 2001, pp. 25-28; McKibbin and Wilcoxen, 2002, pp. 199-221; and Victor, 2001, pp. 101-108).

Another researcher (Nordhaus, 1998) has proposed a system in which countries with per capita income of more than $10,000 (in 1990 dollars) impose emissions taxes on domestic sales of fossil fuels. Under that approach, countries would use a complex voting scheme to decide on a price path for emissions over time, and developing countries would join the system once their per capita annual income rose above the trigger level. Participating nations would enforce the system through duties on imports from nonparticipating countries, which would be levied on each such country in proportion to the carbon content of its total exports. The approach has several advantages: it provides a method for deciding on a uniform emissions price in the face of conflicting views about the appropriate price and allows for gradual implementation and enforcement through international trade institutions. For simplicity’s sake, the proposal ignores emissions from non-fossil-energy sources and exempts countries with low per capita income for distributional reasons. The system would yield an estimated two-thirds of the net benefits that could be realized by an ideal system covering only emissions from fossil energy use. Furthermore, nearly all regions would share in the system’s beneficial effects on the climate.

An alternative approach (Bradford, 2002) differs from the preceding one by advocating explicit emissions rights, the equivalent of a uniform international emissions tax, and, at the same time, a system of international burden sharing that would be institutionally separate from the allocation of property rights. The approach calls for countries to negotiate and agree on country-specific, long-term, projected “business-as-usual” trends in emissions. For each country, its agreed-upon trend would serve as its emissions quota, which it could allocate domestically as it saw fit. Countries would also contribute financial resources to an international bank that would purchase and retire emissions allowances from their owners at a fixed, negotiated price, which could be renegotiated from time to time in the light of new information. The approach thus involves three elements: allocating emissions, determining a price trajectory, and distributing burdens.

Yet another proposal (McKibbin and Wilcoxen, 2000, 2002) would create and distribute among nations two related types of explicit property rights for emissions. A long-term emissions endowment, which would be valid in only one country, would give its owner a permanent right to receive annual emissions permits. A limited number of endowments would be allocated to each country on the basis of the Kyoto targets for domestic distribution. Each government could also sell an unlimited number of permits every year at a price that would be fixed each decade by international agreement. There would be no international trading of emissions allowances or credits.

The system would yield two distinct markets in every country: a market for permits, with the permits’ price fixed by international accord and their number determined by market demand; and a market for endowments, with the number of endowments set internationally and their price determined by the market’s expectations about future permit prices. If the demand for permits in a country rose above the number of endowments in a given year, the government would sell enough permits to meet demand at the fixed price. If demand did not exceed the number of endowments, the permits’ price would be lower.

To address developing countries’ distributional concerns, Annex I countries would receive endowment levels that were below their total current emissions; non-Annex I countries would receive endowments above their current levels. That distribution would lead to different prices for permits and endowments in the two groups of countries. But even if developing countries’ permit prices were zero in a given year, their endowments would reflect the permits’ expected future value—which would send a long-term signal to investors in those countries about the cost of emissions in the future. That signal could help encourage investment in energy-efficient technologies and processes in the long term and discourage emissions “leakage” from Annex I countries.

If the risks of climate change proved to be significant, countries could negotiate an increasingly higher world price for emissions that would gradually reduce each country’s to the level of its endowments. After that, the country’s government would have to buy back endowments to further constrain emissions and be consistent with the negotiated permit price.

By allowing different permit prices in different regions, possibly for an extended period, the proposed system would trade away some cost-effectiveness to accommodate distributional concerns. Governments could also address domestic distributional concerns through their allocations of emissions endowments. At the same time, the system would build a constituency of endowment owners in both developed and developing countries who would hold property rights for emissions—and who would therefore benefit from a rise in permit prices.

The system would be decentralized but coordinated through the initial international allocation of endowments and the establishment of permit prices. As a result, problems in one country would generally not affect markets for permits and endowments in others. The system would be flexible enough to adapt both to changing political and economic circumstances and to shifts in the rate of climate change. Permit prices could be rapidly adjusted in response to new information, and endowment prices would adjust accordingly. Countries could enter the system simply by agreeing to an internationally negotiated emissions endowment and permit price, allocating their endowments domestically, and enforcing the fixed-price permit system.