Cooperation to reduce developing country emissions Suzi Kerr (Motu) and Adam Millard-Ball (McGill) Motu climate change economics workshop, March, 2012

The challenge We need DCs to mitigate to meet targets We want DCs to mitigate to lower costs But DCs have insufficient concern and capability / capacity Need to transfer resources Existing instruments – e.g. offsets - have serious flaws How can we do better?

Outline Cooperation within a repeated game Mitigation instruments Challenges Straw man Future Research Directions

Gains from cooperation M IC M DC H MB DC MB IC MB IC+DC MC IC MC DC MC IC+DC Most gains to industrialised country Most cost to developing country

Can we achieve this? Nash equilibrium (e.g. Barrett) very negative More optimistic in a repeated game –Experimental evidence that people are altruistic and conditional cooperators – states? –Good monitoring, low discount rates make cooperation possible –Some countries will lead to generate trust but –Bargaining will generate delay – difficult to identify bargaining space and agree on an equilibrium Need flexibility in cost sharing to find mutually beneficial deals.

A Continuum of Mechanisms 6 Tradable credits E.g. CDM Grants and loans E.g. GEF GHG reductions only Integrated with cap-and-trade Results based Ex-post monitoring and payment Broader development goals No link to cap-and-trade Effort based Ex-ante assessment and payment Non-financial approaches: technology transfer, capacity building

Common Challenges Leakage Adverse selection Risk and moral hazard Incomplete contracts/underinvestment Negotiation Integration with cap and trade Most challenges apply to all instruments on the continuum, not just offsets

Adverse Selection Information asymmetries between ‘regulator’ and offset provider combined with voluntary participation

Adverse Selection

Considerable evidence that adverse selection is a major problem in CDM Admissions by project developers Manipulation of Internal Rate of Return Non-credible claims about barriers Implausibility of aggregate claims Simulation / econometric models Technology diffusion models

Adverse Selection Possible solutions: Reduce private information Conservativeness and discounting Adjust the cap or fund size – or give up and reward all Scale up e.g. Domestic cap and trade in DC with binding cap

Risk and moral hazard baseline response emissions

baseline response emissions Baseline risk 1.Improve baseline 2.Allow baseline to change If fn(DC action) leads to moral hazard Moral hazard: when contract is insufficiently precise (possibly because of unobservable effort) so that what the parties explicitly agree to do in the contract is not exactly the intention of both parties.

baseline response emissions Response risk 3.Improve responses 4.Reward actions rather than emissions Offset cost of actions No incentive for ‘invisible’ actions

Other risk management options 5.Industrialised country direct investment IC takes some response risk If brings extra resources makes response larger and reduces relative baseline risk 6.‘No loss’ baselines Removes risk of absolute liability only Makes effective price θp – where θ = prob of reward Response is lower and relative risk higher.

Hold-up and underinvestment Effective mitigation requires: long-term investment, innovation, policy change and structural change Once investments are made, the DC has little bargaining power during renegotiation they will be unwilling to invest.

Solutions to hold-up 1.IC makes direct equity investments in mitigation Directly addresses under-investment Bargaining becomes more balanced Commitment is visible so less under- investment Has benefits for risk sharing also 2.Build IC credibility for cooperation

Straw man 1.Monitor (and model to assess effort) 2. Differentiate policies depending on the DC For ‘strong’ countries – based on governance not income Agree (bi- or multilaterally) combination of target/pledge and investment package Pay (in cash or tradable credits with commitment to purchase) relative to target

For ‘weak’ countries If possible create regional or sectoral targets with results-based agreements Invest in policy, technology, capital and infrastructure Try to get maximum benefit for funds Be clear about aid objectives Do not link to cap and trade markets Make graduation to national emissions contracts attractive Internalise carbon costs from IC end – through capital and consumer markets

Future Research Directions Potential Model realistic mitigation instruments rather than ideal Leakage Estimates of intertemporal leakage/persistence

Future Research Directions Risk and additionality Better estimates of real uncertainty in emissions projections for DCs and the drivers of that uncertainty More out-of-sample tests of predictions Integration with cap and trade Evaluate costs and benefits of linking markets under uncertainty

Future Research Directions Develop new mitigation instruments More rigorous evaluation of actual mitigation investments and policies in developing countries Theory-based design and simulation of complete policies under uncertainty ‘Experiments’ in small countries/regions