Motivation

2. Motivation A successful international climate policy needs to bring the major emitting countries together into a “climate coalition” that delivers ambitious emission reductions International carbon market can lower costs but is likely to entail significant financial transfers What are the implications of a departure from the full carbon trade hypothesis along a “when”, “where”, “how much” dimension on: policy macroeconomic costs financial transfers and distributional equity Analysis using the Integrated Assessment WITCH model www.feem.it/witch 1

3. Sharing the burden: commitments • 1. Shared vision on burden sharing => more commitments on developed countries but also developing countries have some target • Beyond 2050, all regions cooperate for reaching the long-term target, and each region is allocated permits proportionally to their emissions in 2050 • Long-term target 3.5 W/m^2 (a more stringent target 3.2 is also experimented) • 2. Trading schemes: proposals on the table (USA, EU) do include limits to the use of international offsets 2

4. The use of international offsets International Carbon Trading Trade of carbon permits starts in 2020 Perfect market Full “when, where, how much” flexibility from 2020 to 2100: no constraints on the use of international offsets Departure from the full trade hypothesis “When”: postpone any trade between 2030 and 2045 “How much”: only a share of each region abatement can be met with international offsets before 2045. The limits are set at 20%; 15% and 10%. 3. “Where”: exclude some regions until 2045 (they join in 2045) 3

5. Full trade hypothesis - macroeconomic costs • Global losses of 1% of global consumption (gross of damage) • OECD face higher costs, but EEX and DA also incur losses despite the trading position (fast growing) • ROW gains because of the generous allocation and of the contained economic growth 4

6. Full trade hypothesis – carbon market • Significant carbon market already in 2020-2025, about 3 GtCO2-eq (Waxman-Markey allows for 1 GtCO2-eq of international offset a year for the USA) • Carbon price initially low but it increases rapidly, driving up market value • Value of carbon market in 2025 is comparable to current ODA flows (76 USD billion) and it reaches values above oil market (2.2 USD trillion) • Net transfers from OECD grow up to 1.7 USD trillion in 2050 => ROW 5% of their GDP 5

7. Giving up “When” flexibility – macroeconomic costs • When trade is restricted policy is more expensive by as much as 60% globally and for OECD countries • However, the tighter mitigation goal for OECD leads to better technological change. Non-OECD regions benefits from positive technology spillovers and lower oil price this compensates the foregone profits of selling carbon credits 6

8. Technology Externality More investments in carbon free technologies are required in OECD countries to meet the more stringent reduction target in the presence of limits to the use of international offsets Renewables and energy R&D are characterized by positive spillovers => single regions can benefits from investments in virtuous regions (OECD) 7

9. International experience spillovers Global Experience spillovers for Wind&Solar: The higher investments in OECD more than compensate the lower ones in nonOECD and global investment costs are lower when carbon trade is constrained. 8

10. International oil price Lower consumption of fossil fuels is another alternative to the use of trade. This leads to a lower international oil price, with benefits for fossil fuels-intensive regions. 9

11. Giving up “How much” flexibility – macroeconomic costs • Mild restrictions on the use of trade from 2020 (v20% and v15%) are less costly than postponing trade to 2030 (1.12%) • Tighter restrictions (v10%) are comparable to postponing trade to 2035-2040 (respectively 1.15% and 1.34%) • Dynamics of regional costs depend on interactions of different forces and on the trading position of each region 10

12. Giving up “How much” flexibility – financial transfers Current OECD Oil Imports @ 70$/bbl Current OECD Oil Imports @ 50$/bbl Current OECD Gas Imports A limit to the use of emission trading to 10% of total abatement would keep the amount of transferred resources around 100 USD Billion 11

13. Giving up “Where” flexibility – macroeconomic costs • The exclusion of DA, which includes the major seller of permits (China), leads to the largest loss • Net buyers (OECD) lose more when China, the major seller, is excluded • Net sellers (EEX, DA and ROW) gain when other sellers are excluded • The externality effect also contributes to the gain in developing countries 12

14. Giving up “where” flexibility – financial transfers 13

15. Restrictions along different dimensions 2035 V10% v10% reduces market size by about 35%, with an increase in costs of 25% => financial flows in 2040 from 600 down to 100 USD billion 14

16. Conclusions Most assessments of mitigation policies have overlooked the role of international offset mechanisms, which is instead highly debated in the policy arena If unrestricted, the international carbon market would entail financial transfers that are initially small but that would grow very rapidly, equaling today’s OECD gas imports in 2025 and today’s OECD oil imports in 2040. Reducing the use of international offsets makes abatement more costly globally and for the OECD but induces more innovation and thus lower oil prices. Non OECD losses from lost revenues are compensated by higher technological spillovers. Limiting offsets to 10-15% of abatement would raise the policy bill modestly and avoid a several hundred billions USD of transfers 15

17. Thank you!

18. Giving up“How much” flexibility – carbon market The effect on the carbon market are more visible in the short run (2025). 17

19. Carbon market – short run 18

20. “When” flexibility – explaining regional costs Externality effect: The lack of trade is compensated by additional investments in other abatement options. Some of these investments generate positive externalities of knowledge and experience: innovation energy efficiency and technologies and LBD in W&S About 90% of knowledge/experience investments are concentrated in OECD regions, which pay for the costs of LBR and LBD externalities Externalities compensate the foregone profits from carbon sales in net sellers regions (non-OECD) When full trade is an option, the need for innovation is lower, and so is the scope for positive externalities effects. In the full trade scenario, it is “better” to join trade and reap the profits from the sale of permits Oil price effect Lower prices benefit in particular fossil fuels -intensive economies (EEX, ROW) Carbon market effect: Carbon price increases, boosting financial resources transferred to net sellers. This effect is partly offset by a lower volume of traded emissions 19

21. CO2 emissions OECD regions: More effort is undertaken at home NON-OECD regions cannot sell their permits and therefore they can emit more. Emissions fall as soon as trade is open up (anticipation effect) Emission patterns already suggest what happens to investments 20

22. Giving up“When” flexibility – carbon market and financial flows When carbon market is halved, macroeconomic costs double A trade restriction that may appear neutral can have redistributive effects. When trade is postponed, DA reduces its net supply which is instead provided by ROW and EEX 21

23. Giving up“How much” flexibility – global costs/2 • The v15% case is more costly in the short run • Less trade, more expensive investments in breakthrough technologies and energy efficiency • These investments payoff in the LR and the more restrictive case (v15%) becomes less costly thanks to the competitiveness and deployment of carbon-free options 22

24. “How much” flexibility – explaining regional costs Welfare effects of quantity restrictions depend on whether the quantity restriction is binding or not and whether a region is net buyer or seller A quantity limit increases carbon price, with different regional effects depending on the trading position of each region. BUYERS - If the limit is binding, the region will lose because more expensive options have to substitute for trade (OECD) - If the limit is not binding, the region will gain because carbon permits are cheaper SELLERS lose because of the lower carbon price (DA in v20%). China is the major seller (it supplies 40% of the market). ROW and EEX include BUYERS (Sub-Saharan Africa and Middle East and North Africa) in which the 20% limit is not binding (gain) More stringent limits (v10%) increase the magnitude of the “externality effect”

25. Giving up“Where” flexibility – carbon market Short term effects: The exclusion of DA reduces mkt size, but it increases carbon price (supply effect) The exclusion of EEX and ROW reduces both mkt size and price (demand effect) 24

26. Market size and marcoeconomic costs “How much” “When” 25