Nordhaus, William D. (2013-10-22). The Climate Casino. Yale University Press. (Available from Amazon.)
STRUCTURE OF INTERNATIONAL AGREEMENTS
An efficient policy to slow global warming requires that national policies be harmonized among countries. Strictly speaking, policy harmonization means that the marginal costs of emissions reductions in each country are the same. The idea here is exactly parallel to my discussion of the rationale of national emissions trading. Suppose an optimal emissions target is 30 billion tons of CO2 per year. To minimize the costs of meeting this objective, the cost of the last unit reduced (which is the marginal cost in economists’ language) would need to be equal in every sector of every country. Go back and read the text around Figure 34 . Just replace “firm” with “country,” and the reasoning is exactly the same.
The easiest way to achieve harmonization of marginal costs is by ensuring that the prices of CO2 emissions are equalized in every country. This means that every firm will set its marginal costs of abatement equal to the CO2 price, and that will mean that every firm in every country will have the same marginal cost. This will imply that the cost of meeting the global emissions objectives is minimized. While this objective will strike many as utopian to the nth degree, it is important to keep that ideal in mind when considering different approaches to national and global policies.
As with approaches inside countries, there are two approaches that can harmonize policies across countries. One way to do this is through an international cap-and-trade policy, such as the one run by the EU or that envisioned in the Kyoto Protocol. Under such plans, country emissions would be limited (cap), and the emissions allowances could be bought and sold among countries (trade). The market mechanism would ensure that the prices were equalized across different countries, and this would lead to equalizing marginal costs of abatement across countries and to a global minimum cost.
A second approach would be a regime in which countries agree upon a harmonized minimum carbon price; countries then undertake to penalize carbon emissions at this minimum price. I describe the system in the next section and then compare the two approaches.
A CARBON PRICE REGIME
While the structure of a cap-and -trade system is relatively familiar to those who have followed climate -change negotiations, the structure of a carbon price regime is a novel idea and requires some explanation. The basic idea is that countries would agree on a carbon price rather than an emissions limitation. The actual implementation would be under the control of individual countries subject to agreed-upon norms of monitoring, verification, and enforcement.
The first step is to agree upon a target carbon price. There is a substantial literature on carbon prices that countries could draw upon. For this discussion, I have chosen a price path that would be consistent with a temperature limit of 2 ½ ° C. While other targets might be chosen , this range is suggested by the cost-benefit analysis in Chapter 18 as well as more complete integrated assessment models. Look back to Figure 33 to see the path of carbon prices that were generated from several economic models under the idealized situation of universal participation and efficient implementation. For this discussion , I use as an example the midpoint of the estimates in Figure 33 , which is $ 25 per ton of CO 2 in 2015 and rises sharply after that. Note however that there is a wide range of estimates of the carbon prices necessary to attain that target, that changing the target would also change the carbon price, and finally that the target path would change with changing economic and scientific information.
The next question is the obligation that countries would undertake in a carbon price treaty. At a minimum , all countries should agree to penalize carbon and other GHG emissions by the agreed-upon minimum price. Countries could set their price at a higher level if they desired. Verifying the actual carbon prices would require transparent reporting by countries.
The process of setting the international norm price would require a framework treaty . Decisions might take the form of weighted voting, but they would clearly be a major and contentious set of international negotiations. A key point to recognize is that negotiating the minimum price would be much simpler compared to negotiating a complete set of individual national emissions caps. The simplicity of a single carbon price compared to country-specific emissions caps is an important but elusive point. It can be illustrated with the example of negotiations over dues to a club. Suppose that several people want to set up a club— for golf, cricket, or duck hunting. People differ in their enthusiasm, proximity, family size, and income. One approach is to negotiate dues on a member-by-member basis, where each member would have a certain share of the total. This procedure would require a long and painful negotiation over shares. There may be clubs that negotiate dues on a member-by-member basis, but I have never seen one in operation. This is the approach of the Kyoto model, and you can see why it is has proven so difficult and eventually fruitless.
Negotiating a single minimum price would be much easier than negotiating emissions quotas. Germans might argue for a high price , while Canadians argue for a low price, and Saudi Arabia for a penny price. But once the price is set, there is no need for any further negotiations about the differentiated prices for each country. You can see from the example of club dues why negotiating an international carbon price is simpler and more likely to produce a constructive outcome than negotiating emissions reductions country by country.
The administration of the harmonized price would be different from the cap-and-trade system. Countries could determine the price using whatever mechanism they choose. Even though countries would agree to meet the minimum international price, the agreement would not dictate the mechanism by which countries meet their obligations. Some countries might simply use carbon taxes. Others might implement their commitment using a cap-and -trade mechanism such as was envisioned by the Kyoto Protocol and embedded in U.S. legislation. Yet another approach would be a hybrid cap and trade with a minimum price floor (perhaps by using an auction with a reservation price).
From an economic and environmental point of view, the comparison between an international cap-and-trade system and a harmonized carbon tax system parallels the discussion above about domestic variants. Many of the advantages and disadvantages are the same. However, the real issues are not technical ones of design but fundamental political ones. Any treaty will need to tread softly on country sovereignty and domestic prerogatives . Countries will need to believe that they have wide latitude to shape their climate policies under an international agreement. The minimum-price regime is a friendly approach, more like agreements on tariffs or tax treaties that countries already engage in. It is less likely to trigger nationalistic jealousies and taboos than the highly intrusive cap-and-trade approach of the Kyoto Protocol.
OBLIGATIONS FOR RICH AND POOR
International agreements often differentiate the responsibilities of poor and rich nations. Under the Kyoto Protocol, for example, rich countries had binding emissions limitations, while middle-income and poor countries had no binding emissions limits and were required only to report their emissions . In a future and more comprehensive arrangement, rich countries would take immediate steps to curb emissions; middle-income countries would need to join the agreement and reduce emissions in the near term; and, as is discussed shortly, poorer countries could postpone participation or would receive assistance for their emissions reductions.
What is the distribution of emissions among countries by different income groups? Table 11 shows CO2 emissions by country groups. I have taken 167 countries for which the World Bank provides data and divided them into five groups ranked by per capita income. 6 Today’s high-income countries (per capita income of $ 20,000 or more) are responsible for slightly less than half of all CO2 emissions. The top three groups , representing 90 percent of current emissions, include not only rich countries but also China, South Africa, Ukraine, Thailand, Kazakhstan, Egypt, Algeria, Colombia, Turkmenistan, Peru, and Azerbaijan. Table 11. Distribution of emissions by country income level. High-income countries had commitments under the Kyoto Protocol (although not all of them met these commitments, and the United States and Canada withdrew). They will serve as the critical mass for an effective agreement.
However, as I have emphasized repeatedly, this problem cannot be solved if rich countries act alone. Meeting an ambitious temperature target will require that countries representing virtually all emissions participate. As Table 11 shows, an effective agreement will require including most middle-income and low-middle-income countries, particularly China and India. For these countries, joining in the carbon price regime would seem a reasonable goal for an international climate-change treaty. On the other hand, the prospects of India or China joining a Kyoto-like agreement in the near future seem remote. The range of institutional structures and integration in the global economy and in international institutions differs greatly among these countries, but they need to be persuaded to join a global agreement if it is to be effective, and the agreement needs to be designed in a way that is not overly burdensome for middle -income countries. A minimum carbon price regime does that.
What about the poorest countries? On the one hand, we have seen the importance of universal participation. On the other hand, it is unfair and unrealistic to expect countries struggling to provide clean drinking water and primary schooling to make sacrifices for people in richer countries many decades in the future. Fortunately , this is not a major loss. Aside from Nigeria, the current emissions of the lowest-income countries are negligible. As we see in Table 11 , the bottom 72 countries produce only 10 percent of global emissions. If the top 100 countries plus India and China are included, this would account for 90 percent of global emissions.
The best mechanisms for encouraging the participation of low-income countries would be a combination of financial and technological assistance in adopting low-carbon technologies as well as a campaign to persuade these countries to substitute carbon taxes for other taxes. The advantage of carbon taxes relative to binding emissions reductions is particularly applicable to countries with weak governance structures. It seems unlikely that these countries could run a cap-and-trade system without pervasive problems of corruption and evasion. 7 By contrast, a carbon tax could meet the revenue needs of governments while reducing other burdensome taxes and would pose no especially difficult governance problems.
COMBATING FREE RIDING WITH ENFORCEMENT MECHANISMS
Whatever the international regime to slow climate change— whether it be a revived Kyoto approach or a carbon price regime— it must confront the tendency of countries to free ride on the efforts of others. A critical component of a new regime will be to design a mechanism to overcome the free-rider problem. Countries have strong incentives to proclaim lofty and ambitious goals— and then to ignore these goals and go about business as usual. When national economic interests collide with international agreements, there will be a temptation to shirk, dissemble, and withdraw.
Canada is an interesting case. Canada was an early enthusiast for the Kyoto Protocol. It signed up for a 6 percent reduction in emissions and ratified the treaty. However, the Canadian energy market changed dramatically in the following years , with rapid growth in production from the Alberta oil sands. By 2009, Canadian emissions were 17 percent above 1990 levels, far above its target . Finally, in December 2011, Canada withdrew from the protocol. There were no adverse consequences except for some scolding from environmentalists. The Canadian experience shows that the Kyoto Protocol had yet a further disadvantage of being a toothless treaty, without sanctions or any mechanism for enforcement. In a deep sense, participation was voluntary. 8
How might international climate-change treaties introduce enforcement mechanisms? The only serious candidate would be to link participation and compliance with international trade. For example, countries that do not participate or live up to their obligations would be subject to trade sanctions. The standard way to employ sanctions under current international law is to put tariffs on the imports from countries that are not complying with a treaty’s provisions. This approach is commonly used when countries violate their trade agreements, and is also included in several international environmental agreements. 9
Two specific approaches might be considered. The simplest one is to impose a straight percentage tariff (perhaps 5 percent) on all imports from the noncomplying country. This has the advantage of simplicity and transparency, although it does not relate the tariff specifically to the carbon content of the import.
A second proposal— more commonly promoted by scholars who have advocated this enforcement mechanism— would put tariffs on goods in relation to their carbon content . This mechanism is known as “border tax adjustment.” Under this plan, imports into a country would be taxed at the border by an amount that would be equal to the agreed-upon international carbon price times the carbon content of the import.
Let’s work through an example of the border tax adjustment approach. Suppose that the internationally negotiated minimum carbon price was $ 25 per ton of CO2. Assume that noncomplying Canada exports a ton of steel to Europe. If calculations show that the ton of steel has used 1.2 tons of CO2 in its production, then Europe would levy a border tax of $ 30 per ton of steel on this import. 10 On the other hand , if Korea complied with the treaty and had a domestic CO2 price of at least $ 25 per ton of CO2, its trade would be treated as normal international commerce with no border tax adjustments.
This all sounds simple, but in reality, the border tax adjustment regime would become terribly complicated for noncomplying countries. How exactly would we calculate the carbon content for imports? Should we apply the tax to all products? Imports of oil or natural gas would be easy to tax at the border, but different kinds of coal have differing carbon contents, and countries would need to deal with that. Conventional goods would be even more difficult. If we included cars, would we count the CO2 that comes from the coal that goes into the steel that goes into the cars ? Trade specialists warn that relying on trade sanctions would open the door to protectionism, which is always lurking in the shadows looking for excuses to keep out foreign goods and services.
In analyzing the impact of the border tax adjustment enforcement mechanism, we need to consider that trade sanctions affect only goods in international trade, while much of a country’s CO2 emissions come only from domestic production . For example, virtually none of the energy used by U.S. residences, in transportation, or in electricity generation enters directly into international trade. Yet it forms 95 percent of U.S. CO2 emissions. To look at this from another angle, consider the question of reducing U.S. CO2 emissions from coal-fired electricity generation. Studies indicate that this would be the single most efficient way to reduce emissions. But the United States exports less than 1 percent of its electricity generation, so the effect of tariffs here would be tiny.
Given the complexity of the border tax adjustment approach, the alternative of a uniform percentage tariff on imports might be preferable. The rationale is that nonparticipants are damaging other countries because of their total emissions of GHGs, not only from those embodied in traded goods. While the trade is the instrument, it is not the target of the sanctions. The size of the tariff should relate to the damages in a fashion that gives countries incentives to be part of the solution, not just the problem.
This discussion suggests that the major motivation for countries to join the carbon treaty would come from the stigma and messiness of being outside the carbon-compliant region. But would it work? The main cost of noncompliance would be an array of proceedings that would be visible, costly, contentious, and undesirable for noncomplying countries. In effect, there would be a free-trade zone of complying countries and a tangle of regulations and penalties for noncomplying countries.
While harnessing the world trading system to a climate agreement is the most promising route to overcoming the tendency of countries to ride free on the efforts of others, it must be used with great caution. The current free and open trading system is the result of hard-fought efforts to combat protectionism. It has produced large gains to living standards around the world. It should be tied to a climate-change agreement only if the benefits to the climate regime are clear and the dangers to the trading system are worth the benefits.
Let’s summarize the lessons on devising incentives to participate. To begin with, past approaches such as the Kyoto Protocol contained completely inadequate enforcement mechanisms, with the result that countries could stay out without any adverse consequences. Trade measures that impose duties on imports from nonparticipating countries are likely to be the most useful instrument for overcoming free riding and inducing participation. However, trade measures are only indirectly related to emissions, and the need to calibrate and apply them effectively is uncharted territory in environmental and trade policy.
Establishing effective policies to slow global warming will require four important steps. First, it will require focusing on raising the price of CO2 and other GHG emissions in the marketplace. Second, because free markets will not do the job, it will require nations to use either a cap-and-trade or carbon tax system to raise CO 2 prices. Third, it will require most nations to agree to the first two steps and to coordinate their policies at a global level. And finally, an international climate-change agreement must contain an effective mechanism to combat free riding.
The hurdles facing global coordination are extremely high. Countries guard their sovereignty like the family jewels. They are loath to cede power to any international organization or group of other countries. Given the urgency of reaching an agreement and the realities of national reluctance, the most fruitful approach is a harmonized carbon price with trade sanctions as a way to prevent countries from free riding on the investments of others.
Nordhaus, William D. (2013-10-22). The Climate Casino. Yale University Press. Kindle Edition.