Designing a Realistic Climate Change Policy that Includes Developing Countries

1. Designing a Realistic Climate Change Policy that Includes Developing Countries Warwick J. McKibbin The Brookings Institution & Australian National University and Peter J. Wilcoxen The Brookings Institution & University of Austin, Texas

2. A sustainable system must deal with the key features of the climate change problem • Uncertainty about link between carbon dioxide emissions and climate change • Uncertainty about costs and benefits of climate change • Uncertainty about costs of abatement • Adding further policy uncertainty will undermine efforts to address climate change

3. Features of a Sustainable System • Extensive - all major carbon emitters need to participate • Implementable in key countries • Equitable - across a range of dimensions • Efficient - minimum economic cost • Flexible - need to adjust as new information is revealed • Low cost of implementation/administration • Provides the right incentives for all involved • Current and future • households, industry, governments

4. The Kyoto Protocol • Protocol to the 1992 UN framework Convention on Climate Change, negotiated in 1997 • Annex 1 countries agreed to reduce emissions of 6 greenhouse gases to 5.2% below 1990 levels on average between 2008 and 2012 • flexibility allowed through • permit trading • clean development mechanism (CDM) • joint implementation

5. The Kyoto Protocol • legally binding if 55 countries accounting for 55% of developed country emissions ratify • as of August 14, 2002, • 84 countries signed, 79 have ratified, 36% of global emissions (not yet Russia/Ukraine/Canada/NZ/Aust) • 180 signatories to the UNFCCC

6. What is wrong with the Kyoto Protocol? • A fundamental problem with targets and timetables • What is the correct target for each country and the world? • What is the optimal period? • targets impose unknown cost for given outcome • permit trading gives greater flexibility across countries but no flexibility in total and may be destabilizing to world trade and finance

7. Kyoto-style Permit Trading • Emission permits are issued equal to the target • Each country receives an allocation of permits • Countries/firms • buy permits if they wish to increase emissions • sell permits if they wish to reduce emissions • Trading allows original country targets to be tightened or relaxed depending on the costs • Abatement differs across countries depending on costs of abatement relative to the price of permits • The permit price will be determined by demand and supply and will equal the marginal cost of abatement

8. Advantages • Global target is met but differential country response allowed through the market • Cost of removing an additional unit of carbon is equal everywhere (efficient) • Compensation (across countries and within countries) can be built into the initial permit allocation

9. Some Problems we find in using the G-Cubed model • Permit trading more widely implemented could cause economic and political problems with large wealth transfers between economies and large fluctuations in trade balances and real exchange rate: • Keynes classic “Transfer Problem” • “Dutch Disease” transition issues for permit exporting economies

10. Other Problems • If one large country reneges the permit system would likely collapse since the price depends on all countries supply and demand • This requires a very strong monitoring and enforcement mechanism in all participating countries.

11. Many Key Remaining Questions • How do you get developing countries into the system if it proceeds? Without developing countries UNFCCC goals will not be achieved (and US will not ratify). • What enforcement mechanism will be required to keep a global Kyoto style system from collapsing under a range of alternative future scenarios?

12. Permits • For every dollar of permit purchased internationally by a resident of a country, there must be an increase of a dollar in the present value of exports relative to imports to transfer the resources required to pay for this permit. • The sale of a permit will improve the current account of the selling country and worsen the current account of the buying country.

13. The Economic Effects of the Kyoto Protocol • Generate a baseline out to 2050 • Given Kyoto targets this implies significant reductions in carbon emissions will be required for each region by 2010 • model estimates the economic consequences of these reductions under alternative scenarios

18. McKibbin-Wilcoxen Proposal II • An internationally coordinated system of domestic actions • Rather than target world emissions, countries agree on a fixed world price for emissions in the short run, remove fixed targets (but not goals), and let market trading determine the extent of abatement • Distinguishes between short run costs and long run goals

19. Create two new assets in each Country • Emission Permit • An annual permit that is required for emitting a unit of carbon within an emission year (only valid in the year dated) • The price of permits is the short run cost of carbon abatement • Emission Endowment • a perpetual guarantee to obtain a free emission permit each year forever • The quantity of endowments are the long run goal of policy

20. Analogy • Permits are flows, endowments are stocks • If compared to the value of a firm • A permit is like the dividend of a firm in a period • An endowment is the stock market value of the firm (the expected future dividends of the firm)

21. How MWII Works • Each country is allowed to initially allocate an agreed baseline number of emission endowments. • Perhaps Kyoto starting points for Annex B countries • current emissions plus X% for non-Annex B countries • Energy producers require annual emission permits to account for carbon content of product. • They can get these by either • presenting an emission endowment to obtain a free emission permit from the government • by buying annual emission permits in the domestic permit market.

22. How MWII works • The number of emission endowments is fixed forever • Governments issue additional emission permits at the agreed fixed price in order to satisfy any excess demand for permits in a given year • if excess supply of permits (constrained by the number of endowments) , the price of permits is allowed to fall within the domestic market • the market value of emission endowments will reflect the expected future price of emission permits

23. Annex B • In Annex B countries - • Permit price will be $US10 (in 1990 dollars) per ton of carbon because of the binding constraint that demand will likely outstrip supply • Endowment price will be determined by the long run demand for permits given a fixed supply

24. Developing Countries • price of emission permit will be at most $10 per ton of carbon but likely will be much less (and even zero) because of large supply of permits in the early years • price of emission endowments will be non-zero providing an important market signal to emitters • in the medium run, the permit price will be equal to the Annex B fixed price.

25. Negotiation Process • Every decade countries meet to review the extent of emission abatement and the state of climate science • Decide on the emission price for the next decade • Governments can by back endowments in they wish but can’t issue endowments

26. Key Points • The maximum price of permits (the short run cost) is fixed and known for 10 years at a time • Clear property rights are established immediately • this creates a constituency for binding future governments to remain committed to the goals of the UNFCCC • Significant reduction in uncertainty for investment planning • The market is used to allocate who abates, where the abatement happens and what activities change

27. Advantages • Minimizes costs in the long run by making the cost of removing an additional ton of carbon the same everywhere and by removing future carbon rather than present carbon where it is cheap to do so; • Recognizes the fact that developing countries need to increase emissions over coming decades;

28. Advantages • provides a clear credible price signal to decision makers in developing countries via the value of emission endowments, WITHOUT imposing any actual costs for a long period.

29. Advantages • Provides information on abatement costs when uncertainty is key - can measure actual abatement and respond each decade as information on abatement and climate is revealed • Does not necessarily stabilize emissions unless it is relatively cheap to do so

30. Advantages • Less potentially disruptive to international trade - • Same marginal carbon charge everywhere • All countries involved • No international permit trading • Flexible: • if future action is urgently needed the permit price can be raised by international negotiation • A country can join simply by agreeing to participate rather than having to renegotiate permit allocations

31. Advantages • A different philosophical approach based on decentralized coordinated responses with known costs • Retains national autonomy in policy making This may be important for encouraging countries to participate (e.g. US Congress , developing countries)

32. Disadvantages • Many vested interests who expect to make profits out of providing financial products to minimize transactions costs associated with Kyoto will not make profits because we minimize transaction costs in the simple design of the system. • Negotiators and lobbyists for direct interventions and subsidies in the climate change industry will have to find something else to do.

33. How to make progress • A. Adopt MWII directly • B. Countries agree to adopt MWII as an early action policy while they continue to work on the Kyoto Protocol • Start domestic permit and endowment trading in 2001with a fixed permit price of $US1 per ton of carbon rising each year by $US1 per ton until reaching $US10 per ton.

34. Conclusion • The Kyoto Protocol as it currently exists has a number of serious flaws • Even flexibility mechanisms under Kyoto may raise serious adjustment problems because of the international resource transfers

35. Conclusion • We explicitly include developing countries in a way which imposes no short run costs on these countries while giving economic incentives to reduce carbon emissions for potentially large long term gains.

36. Conclusion • Carbon emissions under our system will be lower than otherwise would be the case

37. Background papers are available from: WWW.NOTWRONG.COM and WWW.WWECONOMICS.COM