Tradable Emissions Rights and Joint Implementation:
What Are the Issues?


by Richard Schmalensee*

October 1997

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*Summary of a paper prepared by Richard Schmalensee, Gordon Y Billard Professor of Economics and Management, Massachusetts Institute of Technology, and member of the Board of Scholars of the ACCF Center for Policy Research. This paper was prepared for a September 24, 1997 policy conference sponsored by the ACCF Center for Policy Research, and will be published in the ACCF's forthcoming book, Climate Change Policy, Economic Growth, and Environmental Quality. The ACCF Center for Policy Research is the education and research affiliate of the American Council for Capital Formation. Its mandate is to enhance the public's understanding of the need to promote economic growth through sound tax, regulatory, and environmental policies. For further information, contact the ACCF Center for Policy Research, 1750 K Street, N.W., Suite 400, Washington, D.C. 20006-2302; telephone: 202/293-5811; fax: 202/785-8165; e-mail: info@accf.org; Web site: http://www.accf.org.


Special Report Summary:

This study concludes that the Administration's approach to climate change policy is strategically unsound. Applying the concept of tradable permits to carbon dioxide emissions at the national and global level would be very difficult. Numerous questions must be answered, including (1) How are carbon allowances to be distributed? and (2) How can emission levels be monitored? Such a system with fixed annual total emissions would be inflexible and would tend to destabilize the price level. In addition, while the Administration's proposal calls for developing nations to participate in controlling global emissions, it will be very difficult to get meaningful participation from these countries. We have time to design and adopt realistic strategies to respond to the threat of climate change; we should not be distracted by political pressures to take short-term symbolic actions at international climate negotiations in Kyoto that may well be counter-productive in the long run.


Background

The so-called "Berlin Mandate," adopted at the first Conference of the Parties in March 1995, decreed that the current round of climate negotiations was to be about limiting the emissions only of the so-called Annex I nations: the OECD circa 1990 (Western Europe, the United States, Canada, Australia, New Zealand, and Japan) and the "economies in transition" (Eastern Europe and most of the former Soviet Union).

The Administration has proposed a target of reducing greenhouse gas emissions to 1990 levels for the 2008-2012 period, with undefined reductions below that level in the post-2012 period. More severe constraints on greenhouse gas emissions are also on the table. The European Union has proposed reducing Annex I emissions to 15 percent below 1990 levels by 2010. Whatever approach to emissions limitation is chosen, costs will clearly vary directly with stringency, and they will be particularly burdensome in any case if the European Union's proposal is implemented.


Administration's Approach to Reducing Emissions

The Administration's proposal, announced in October 1997, includes a system of domestically tradable emission allowances to ensure that the constraint on U.S. emissions is met. That is, the U.S. quota would be divided (somehow) among (most likely) a set of domestic firms, and these firms would be free to trade emission rights (allowances) among themselves. In theory, such a system could ensure that whatever abatement the United States achieves is accomplished at minimum cost. Moreover, such a system could in principle allow private parties, rather than or in addition to governments, to trade emission rights internationally.


Will the Administration Approach Work?

Perhaps the most important features of the climate change issue are the long time scales and high uncertainty involved. We know that emissions of carbon dioxide remain in the atmosphere for something like a hundred years and that both emissions and atmospheric concentrations of greenhouse gases have increased substantially over the last century. Even if emissions were stabilized at today's levels, atmospheric concentrations would rise substantially for decades.

Most long-run forecasts show substantial global emissions growth in the absence of stringent controls, with the bulk of the growth (and thus a rising fraction of global emissions) occurring in the developing world. It will very likely be impossible to attain stabilization at widely discussed concentration levels without significant abatement by developing nations. In fact, most long-term scenarios show that driving emissions to zero in developed countries (Europe, United States, Japan, etc.) is by itself insufficient to stabilize carbon emissions or concentrations.


Tradable Permits: What Are the Issues?

Several sticky problems would need to be resolved in order for a system of tradable permits to function:

  • First, if, as seems highly likely, carbon allowances are to be given away under the Administration proposal, who is to get them? If carbon allowances are not given away, would they be auctioned? And if so, what would be their price?

  • Second, as we learn more about climate policy, unexpected changes will occur in appropriate global emissions and in national quotas. Implementing such changes would create capital gains or losses for those who held allowances. The prospect of capital gains or losses may well act to make it even harder to change national carbon dioxide emission quotas.

  • Third, the standard data on carbon dioxide emissions from fossil fuels are computed by combining unverified national reports of imports, exports, production, and inventory change of various fuel types with assumptions regarding the carbon content of each. This will surely not be adequate when the financial stakes are large and incentives to misrepresent become impossible to ignore.

  • Fourth, how will the implementation of international emissions trading, which is critical to holding down world-wide and domestic costs, be put in place? In order to make allowances issued to private U.S. parties effectively tradable internationally, foreign governments would need either to implement compatible tradable allowance programs or to stand ready to buy and sell allowances to and from private U.S. parties on a businesslike basis. The first of these raises issues of sovereignty, while the second raises issues of plausibility.

Taxes vs. Tradable Permits for Emission Reductions

A good deal of recent economic research has compared the net static welfare effects of various sorts of environmental policies in economies in which tax systems distort the allocation of resources, as all real tax systems do. The basic conclusion of this research is that systems that involve auctioning allowances or taxing emissions are better for the economy as a whole than regimes in which allowances are given away for free (as the Administration appears to favor), all else (including total emissions) being equal. The difference seems to arise mainly because auctioning allowances or taxing emissions generates revenue that can be used to reduce tax-induced distortions elsewhere in the economy, while this cannot occur if allowances are simply given away.

At the very least, this issue deserves serious study before a comprehensive abatement scheme is put in place.

A second set of issues relates to unexpected changes in national output (GDP) and other factors affecting energy consumption. With tradable domestic allowances, total emissions are fixed, while the emissions corresponding to any given carbon tax are uncertain. In particular, unexpected increases (decreases) in GDP will raise (lower) fossil fuel use and thus increase (decrease) carbon emissions with a fixed tax, but with a fixed limit on total emissions, unexpected GDP growth would be constrained by the limits on carbon emissions and therefore energy use.

Indeed, because energy is important in at least some major cyclically sensitive industries, there could be significant impacts on the business cycle. If total emissions were absolutely fixed in the short run, national real output would tend to be stabilized. Unexpected increases in aggregate demand would raise energy prices (via raising allowance prices) more rapidly than at present, making purchase of U.S.-produced energy-intensive products less attractive relative to imports and to saving. This would tend to choke off booms, and the same mechanism operating in reverse would tend to mitigate recessions.

On the other hand, the price level would be destabilized. Increases in aggregate demand would cause rapid (and non-transitory) increases in energy prices, while energy prices would fall more rapidly than at present in recessions. I do not believe these effects have been seriously studied or that anyone can say with confidence whether they would be important or whether on balance they would be good for the economy. It would seem prudent to perform a serious study of this issue before going forward with a tradable allowance regime with fixed numbers of allowances.


Joint Implementation: What Are the Issues?

The Administration's latest proposal promotes joint implementation efforts until such time as the developing countries agree to their own target and timetable requirements. The basic concept of joint implementation is to promote joint projects in developing countries and Eastern Europe to reduce emissions for relatively low costs compared with achieving the same emissions reductions within OECD countries. In many respects, little likely will be gained by joint implementation.
  • First, developing nations are generally hostile toward joint implementation, fearing (among other things) that it will threaten their sovereignty, reduce flows of foreign aid, and saddle them with de facto emissions control obligations.

  • Second, transactions costs for joint implementation projects may be prohibitively high. The problem here is not measuring actual emissions (though this must be done) but estimating what emissions would have been in the unobservable "but for" world without the project in question. Such estimates are inevitably project-specific, and the process of constructing them is inevitably controversial and detail-intensive.

In fact, emission limitation efforts in Annex I countries may make non-Annex I countries even less willing to participate in emissions reduction efforts like joint implementation. Annex I-country efforts to limit emissions, by implicitly or explicitly raising the prices of fossil fuels, will promote "leakage," that is, investment in energy-intensive industries outside Annex I countries. A country that just invested heavily in energy-intensive industry will clearly be less eager than otherwise to reduce the value of that investment by raising domestic energy prices to limit carbon emissions. The inevitable process of "leakage" will make it harder to persuade additional nations to assume abatement obligations.


Conclusions

The Administration has partially designed a vehicle that, despite a range of unanswered questions, could reduce domestic emissions. But as I have tried to argue, there are two basic problems that suggest we should not buy that vehicle now.

The first problem is that this vehicle may not move us down the right road. By concentrating on near-term reductions in rich-country emissions, it fails to attach adequate importance to investments in technologies for mitigating and adapting to climate change.

The second problem is that the Administration's vehicle promises us a bumpy ride or, in ordinary language, non-negligible implementation problems and potentially excessive abatement costs. We have time to design and adopt realistic strategies to respond to the threat of climate change; we should not be distracted by political pressures to take short-term symbolic actions at international climate negotiations in Kyoto that may well be counter-productive in the long run.