Tradable Emissions Rights and Joint Implementation:
What Are the Issues?
by Richard Schmalensee*
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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
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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
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
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
- 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
- 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
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
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
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.
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.