1 How Can the Next Steps in International Climate Policy Be Made More Cost-Effective? Peter Bohm Stockholm University

2 How Can the Next Steps in International Climate Policy Be Made More Cost-Effective? Would the cost-effectiveness of the Kyoto Protocol be improved by having the tradeable quota approach replaced by a ’hybrid policy’? more complete intertemporal flexibility – borrowing in addition to banking? facilitating for DCs to come onboard already now? phasing out the CDM at an early stage? Cost-effective to have countries giving away emission permits for free?

3 Implications of a Hybrid Policy If used solely and effectively for the US, inside a revised KP: –US em’s > its AA  total em’s > sum of AAs –The net-cost distribution changes in favor of the US –MACs differ among Parties (KP = Kyoto Protocol; AA = Assigned Amounts; MAC = marginal abatement cost)

4 A common cap on AAU prices Illustration with two Parties, different MACs and the same AA AAU priceAA X I AAU price w/o a price cap L G ” ” with ” ” ” Lo MAC Hi MAC Country emissions potentially cost-effective further increase in global em’s general change in the net-cost distribution

5 A common cap on AAU prices (cont’d) - indirect effects and alternatives Indirect effects Increased negotiation costs? ’Manipulation’ risks, violating environmental integrity and equalized MACs? Alternatives: Renegotiating the US AA? Allowing borrowing in the KP?

6 TOPICS FOR RESEARCH The pros and cons of hybrid policy (the ’safety valve’ approach) Other alternatives to make KP policy targets more flexible

7 Borrowing in a revised Kyoto Protocol Increases cost-effectiveness, other things equal, just like banking Suggested by the US, rejected for risk of abatement delays ’Constraints’ on Borrowing: Limiting Borrowing to one commitment period would increase intertemporal flexibility from 5 to 10 years Cap on Borrowing as a percentage of AA and/or Charging an interest in terms of AAUs. Lower MACs, replacing part of the benefits of a hybrid system

8 ’Borrowing’ in the present Kyoto Protocol Kyoto allows unlimited de facto borrowing for Parties in non- compliance - at 30% 5-year restoration rate  10-year intertemporal flexibility period Plus two other sanctions with a priori unknown contents: - a mandatory action plan - temporary ban on sales Plus reputation and stigmatization effects

9 Borrowing in a revised Kyoto Protocol (cont’d) Regular Borrowing inserted before NC sets in The net emissions effect of the added flexibility of a Borrowing option: Reduces Annex B Parties’ reservation AAs and Could make risk-averse DCs more interested in joining IET  Counteracts the aforementioned effect that borrowing delays emissions abatement ( NC = non-compliance; IET = international emissions trading)

10 TOPICS FOR RESEARCH The nature of the opposition to borrowing Alternative designs of a borrowing option

11 Near-future participation of DCs in IET The US required DC participation now. Imposes costs on the DCs? AA, large enough to be acceptable to a DC (no hot air, if possible) –Adds low-cost abatement options, not feasible for CDM –Reduces carbon leakage –Reduces reliance on the imperfect CDM Each period w/o DC participation is a loss of cost-effectiveness Alternatives to a large AA may be more cost-effective: E.g. replace part of the AA by financial transfers, - more cost-effective, if DCs more risk-averse than ICs - reduces the risk for hot air allocations and its consequences

12 Phasing out CDM speeds up DC participation in IET IET and JI are more powerful flexibility instruments No baseline problems for IET Reduced risk for overstated baselines for JI as compared to CDM CDM host and investor countries have incentives in common to exaggerate baselines IET is based on monitoring of nation-wide emissions, while CDM is certain to observe only project-wide emission reductions, often larger than the projects’ nation-wide reductions

13 TOPICS FOR RESEARCH The DCs’ political opposition to accepting AAs and joining IET Alternative designs for DCs joining Annex B What is the likely contribution of the CDM? How can the CDM be phased out, if it turns out to be counterproductive?

14 Will national emissions trading be cost-effective if carbon permits are given away for free?

15 Who Gets Free Permits? (FF = fossil fuel) FF ProducersFF Importers Refineries Wholesale dealers Retailers FF using firms Households

16 Distribution aspects - Parties that receive FA may be overcompensated, although typically undercompensated - Affected parties not given any permits tend to be at least as worse off as under A - Total distribution effects of A and FA cannot be compared until the use of auction revenue has been determined - FA may be given to parties other than those who are permit- liable (FA = free allocation, e.g. Grandfathering; A = auctioning)

17 Who Are Permit Liable? And Who Gets Free Permits? FF ProducersFF Importers Refineries Wholesale dealers Retailers FF using firms Households

18 Efficiency Aspects - Auction revenue is used most efficiently when used to reduce distortionary taxes - FA to existing firms discriminates against new firms and hence reduces productivity - FA tends to make real investment allocation less efficient - FA allows inefficient firms to remain in business

19 What is the (marginal) emissions cost difference of between FA and A? Marginal costs (MCs) under FA at least as high as under A, since to increase emissions, you either have to buy permits or avoid selling permits and, if efficiency were the same, permit prices and MCs would be the same The essential difference between FA and A is with respect to the transfer of permit wealth

20 To protect a country’s international competitiveness, is it necessary to copy other countries’ FA? - Auctioning does not raise MCs of its export and import-competing industries more than FA does. In fact, MCs in these industries tend to be lower, since efficiency is higher with A - Auctioning would hardly make firms move to other countries where similar firms get FA

21 Summing up A does not make marginal emissions more costly than FA does A has equal or smaller effects on international competitiveness A transfers money to government which allows a reduction of distortionary taxes – which also has some compensation effects Also in other respects, A is at least as efficient for the overall economy The business community is lobbying against A - even though only part of this community is favoured by FA and - a deal can be made to use part of A revenue for compensation (at least initially)

22 TOPICS FOR RESEARCH Implications for a participant using A instead of FA? Regulating the use of A revenue in a ’social contract’ Regulating the phaseout of FA in a ’social contract’ Giving permit-liability to FF producers/importers and the permits to households

23 TOPICS FOR RESEARCH (cont’d) Norway as a potential participant in the EU trading scheme Implications of replacing the KP by something the US prefers (e.g. carbon intensity targets)