International Trade and Investment Leakage Associated with Climate Change Mitigation Jean-Marc Burniaux (GTAP and OECD)

What carbon leakage means ? Why is it important ? How to measure it ? Economic costs of participating countries. Environmental effectiveness. Size of coalition.

there is a large disagreement among models about the size of carbon leakages generated in implementing the Kyoto Protocol. - high side estimates : % (MERGE, Light et al., Worldscan). - low side estimates : below 10 % (GREEN, G-Cubed). Little empirical evidence to validate these results. Uncertainty is large about the values of the key parameters. So sensitivity analysis is needed! Carbon leakages in Kyoto : an analytical overview

Channels for leakages. loss of competitiveness of energy- intensive industries in Annex 1 countries. trade substitution elasticities (Armington) 1) the trade channel.Key parameters 2) the energy channel. fall of the carbon price in non- Annex 1 countries supply elasticities of carbon. Trade substitution elasticities of carbon. 3) The investment channel reallocation of foreign direct investment across countries degree of international capital mobility. investment behaviour and expectations.

The approach : based on several models; static and dynamic. Typically a GE issue. Experience with the OECD GREEN model. A static prototype for extensive sensitivity analysis. A new dynamic GTAP model with a full specification of investment behavior. GDYN-E

The static approach (1) a framework aimed at extensive sensitivity analysis which would otherwise be very difficult by using a large CGE model. a simplified CGE model solved analytically. Þ we are looking for an expression of the leakage rates as continuous functions of some parameters values, such as : leakage = F (par.1, par.2, ….,par.n) Two regions, three energy sources (coal/oil/low-carbon source), two differentiated final goods, capital more or less internationally mobile, region-specific labour. Solved with Mathematica. (1) See Burniaux et Oliveira Martins, 2000.

Result 1 (1) The degree of substitution on non-energy markets (Armington elasticities) and does not matter a lot for the rate of leakages. (except for very low values of the trade sustitution elasticities) (1)Burniaux et Oliveira Martins, Economic Department Working Paper, No242, OECD, 2000

Result 2 The value of the supply elasticity of coal is, by far, the key factor.

Result 4 The elasticity of coal supply is more influential than the degree of substitution on the coal market

Result 5 The degree of technological flexibility matters ! (negative leakages).

Result 6 In a static framework, capital mobility has little impact, whatever the degree of technological adjustment ….. … but this is no longer true in a dynamic framework !!!!

But how does this outcome transpose in a dynamic setting ? Dynamic GDYN-E : – Dynamic GTAP (Ianchovichina and McDougall, 2001) – International capital mobility with full account of assets ownership and location; – Explicit investment behavior … – … based on adaptive expectations. + the production structure of GTAP-E (Truong, 1999). … and extended to deal with CO 2 policies (Burniaux, 2001)

Does capital mobility in a dynamic framework change the outcome about leakages ?

Leakage decomposition over time in GDYN-E ….. over the longer run, investment reallocation becomes a major factor.

Leakage dynamics : the investment reaction. Ror Kstock Expected investment schedule Exp. K Actual investment schedule Act. Targ. (1) (2) (3)

Leakage dynamics : the case of a non-Annex 1 country. Targ Ror Kstock Act=Exp =Targ Actual = Expected schedules Actual Investment increases because the rate of return is attractive compared with A1 countries and investors revise their expectation about the normal rate of growth upward.

Leakage dynamics : the case of an Annex 1 country. Act=Exp =Targ Ror Kstock Actual = Expected schedules Actual Act = Targ Investment decreases because investors revise their expectation about the normal rate of growth downward.

Leakage dynamics : the importance of the expected investment behavior. Little impact !

Leakage dynamics : the role of trade elasticities. Same outcome as in static …. But higher trade substitution implies higher investment outflows from A1

Leakage dynamics : the role of the coal supply elasticity. Need a fairly low value of coal supply elasticity (<1) to get high leakage rates !

Leakage dynamics : the role of technology substitution. Investment reallocation may generate high leakages in case of low substitution possibilities.

Assessment For “reasonable” parameter values : the leakage rate is likely to be small … … and investment reallocation does not matter. But alternative values of some key parameters may generate quite substantial amount of leakage … … and under certain circumstances, investment reallocation induces high leakages. Over the longer term, investment reallocation becomes a critical component of leakages.

The policy design influences the amount of leakages : the size of the acting coalition : the larger the coalition, the smaller the leakages. “hot air” reduces leakages. the use of the flexibility mechanisms reduces leakages. 2.7% with A1 trading < 5% without A1 trading 8% without US > 5% with US

Implications for further researchs Further empirical evidence about the value of key parameters is badly needed : Value of coal supply elasticity. Behavior of oil producers. Transitional rigidities in technological adjustment (putty-clay) may increase the leakages over the medium term.