Two Practical Problems with Emissions Caps

Besides monetizing the free-rider problem of emissions, the use of national caps has two other drawbacks that cause it to be rejected, especially by poor countries.

1. Why caps appear unfair to poor countries

• As Stiglitz (2006-09) points out, developing countries naturally ask, “By what right are the developed countries entitled to pollute more than we are, simply because they polluted more in the past?”
• As Dion and Laurent (2012) say,
  • “Developing countries, which now account for 60% of emissions worldwide, cannot accept what they perceive as an obstacle to their economic development, when developed countries have been able to get rich on unlimited use of fossil fuel energy.”
  • “Developing countries perceive emission reductions as a “carbon constraint” that unfairly hinders their economic development; in times of economic crisis, quantitative targets can become hard for developed countries to accept as well.”
• For example, if India had accepted any cap near its expected business-as-usual level of emissions (or even on the high side), it would have been accepting a cap lower than the 1870 per-capital emissions of the United States.
• The result of Copenhagen was, according to the UN climate chief Christiana Figueres, “a widening split between rich and poor nations over how to slow climate change, with almost no chance of a treaty in 2010.”

2. Why Caps Are More Risky than Prices

If caps work as planned they provide emissions certainty. This has been a big selling point with environmentalists. But the cost of emissions certainty is price and cost uncertainty, and that is risky. While this has been recognized, the connection between this risk and international payments has not been sufficiently appreciated. Here is an sketch of how that works.

• If a country emits more than expected, say, because it begins smelting aluminum
  • With either a cap or a price commitment,
    • the carbon price will induce the same emission abatement from the new smelting operation. This imposes an abatement cost.
  • Under a cap,
    • it must pay “foreign” countries for emission permits
  • Under an equivalent price commitment
    • It need not have any additional costs because a price commitment requires no foreign payments.
• The main difference between the two is the risk of foreign payments under a cap.

Here is an example of how foreign payments arise under global cap and trade. In this example we compare what happens if China is surprised by extra emissions under a cap and under a tax. The two policies are set so that they would be equivalent without the surprise. 

The result is that the unexpected emissions cause a $50 billion purchase of foreign permits under global cap and trade, but of course have no such affect under a domestic carbon tax. In both cases the domestic impact is an extra $5 billion in abatement costs. Hence emission quantity uncertainty cause far more cost uncertainty under international cap and trade than under a domestic carbon tax.

1. Suppose China:
   1. expects to emit 7 billion tons ten years from now
   2. expects the global price to be $50/ton.
   3. actual emission are 8 gigatons after 10 years.
   4. and the extra gigaton has been abated by 0.2 gigatons (from 8.2) due to the carbon price.
2. How much will this surprise cost it
   1. under a 7 gigaton cap?
   2. under a $50/ton price commitment?
3. Either way it ends up emitting the same amount
   1. so its abatement costs are the same either way.
   2. domestic tax and permit payments have no net cost.
4. With a 7 gigaton cap,
   1. it must purchase 1 billion permits at $50/ton,
   2. for a cost of $50 B,
   3. paid to say the US, Japan, India or the EU.
5. With a price commitment,
   1. it will tax itself, and
   2. keep the tax revenues.
   3. There is no net cost.
6. The only uncertainty under a price commitment, is the uncertainty in the cost of abatement, and that is there under either taxes or caps.
   1. Extra average abatement cost = (0.2 Gt × $50/t)/2 = $5 billion.
7. A quantity commitment adds the uncertainty of international payments at the full marginal cost of abatement on all un-abated emissions.
   1. In this case, $50 billion.
8. Highly visible payments to “foreign” countries will be far more problematic politically than the rather obscure internal abatement costs.
   1. This will put severe pressure on governments to select a weak target.
   2. This pressure to avoid foreign payments by weakening commitments is entirely absent under a price commitment.