Climate Change Policy After Kyoto: A Blueprint for a Realistic Approach

1. Climate Change Policy After Kyoto: A Blueprint for a Realistic Approach Warwick J. McKibbin Australian National University & The Brookings Institution Lecture 3: Korea University November 2003

2. Presentation based on: McKibbin W.J and P.J. Wilcoxen (2002) Climate Change Policy after Kyoto: A Blueprint for a Realistic Approach, Brookings Institution, November McKibbin W.J. and P.J Wilcoxen (2003) “Estimates of the Costs of Kyoto-Marrakesh Versus The McKibbin-Wilcoxen Blueprint” forthcoming Energy Policy

3. Overview • What is the climate change policy issue? • Managing Uncertainty in a sustainable way • Features of a Sustainable System • The UN Framework Convention on Climate Change • The Kyoto Protocol • Some Simple Economic Solutions • Problems with the Kyoto Protocol? • An Alternative Approach: The McKibbin Wilcoxen Blueprint? • Where to go from here?

4. A Comment on the climate debate: • Some argue that climate change doesn’t exist, that the science is wrong, that nothing should be done • Some argue that climate change is so important that there is no cost too high to tackle the problem • Both approaches are likely to be wrong • Good public policy must recognize the risks as well as the costs to society of the responses.

5. What is Climate policy about ? • We know that carbon concentrations in the atmosphere have risen 30% since the industrial revolution. • We know the science of the greenhouse effect. Everything else is uncertain: • Uncertainty about link between carbon dioxide emissions and the timing and magnitude of climate change • Uncertainty about costs and benefits of climate change • Uncertainty about costs and benefits of abatement • Uncertainty about the policy responses

7. Some Illustrations of the uncertainties

12. Features of a Sustainable System • Extensive - all major carbon emitters need to participate • Implementable in key countries • Equitable - across a range of dimensions • Efficient - minimum economic cost • Flexible - need to adjust as new information is revealed • Low cost of implementation/administration • Must establish clear property rights over a long period of time to provide the right incentives for all involved • households, industry, governments • Should be in all participants interest to commit current and future participants within each country involved

13. The UN Framework Convention on Climate Change Negotiated at the Earth Summit in 1992 in Rio Set Goals (not targets) “preventing dangerous anthropogenic interference with the Earth’s climate system” Annex I countries (industrial countries) were to adopt policies to “aim” to reduce their emissions Entered into force in March 1994 Set in process a series of meetings of the “Conference of the Parties” (COP)

14. COPS • 1995: COP1, Berlin • Adopted the “Berlin Mandate,” a declaration that the UNFCCC would have little effect on greenhouse gas emissions unless Annex I countries were held to “quantified limitation and reduction objectives within specified time-frames,” an approach now described as setting “targets and timetables” for emissions reduction. Established a two-year “analytical and assessment phase” to negotiate a comprehensive set of “policies and measures” that should be taken by Annex I countries. No new commitments or obligations were imposed on countries outside Annex I.

15. COPS • 1996: COP2, Geneva • Called for the establishment of legally binding emissions targets as proposed at COP1. Rejected the COP1 proposal that uniform policies be imposed in favor of allowing Annex I countries the flexibility to develop their own policies. • 1997: COP3, Kyoto • Adopted the “Kyoto Protocol,” in which most Annex I countries were assigned legally binding emissions targets to be achieved by 2008-2012 The average target was about 95 percent of the country’s emissions in 1990. Many details of implementation were left for future negotiations.

16. COPS • 1998: COP4, Buenos Aires • Adopted a two-year plan of action to design mechanisms for implementing the Kyoto Protocol. Issues discussed included financial transfers and clean development mechanism (CDM) for developing country participation. Also discussed issues for incorporating “carbon sinks”. • 1999: COP5, Bonn • Primarily devoted to monitoring progress on the work program adopted at COP4.

17. COPS • 2000: COP6, The Hague • Intended to finalize details on implementation of the Kyoto Protocol. Negotiations ended without agreement. Many issues were unresolved: how the mechanisms in the Protocol would operate; what measures would be used to enforce compliance; how large allowances would be for “sinks” that remove carbon dioxide from the atmosphere; and whether there would be restrictions on the use of the Protocol’s flexibility mechanisms. • 2001: COP6bis, Bonn (July) • Continuation of COP6 following the stalemate at The Hague. However, President Bush declared in March 2001 that the United States would not participate in Kyoto Protocol. Other Annex I countries agreed to proceed without the United States. Large sink allowances were granted to Japan and Canada. Produced a set of recommendations on implementing the Protocol that were to be discussed at COP7.

18. COPS • 2001: COP7, Marrakesh (October) • Formally adopted most of the recommendations of COP6. Finalized rules for use of flexibility mechanisms, especially the Clean Development Mechanism. Also, established a “Compliance Committee” to “facilitate, promote and enforce” compliance with the Protocol. In the event of noncompliance, the “Enforcement Branch” of the Compliance Committee may deduce 1.3 times the amount of the violation from the violator’s emissions allowance for the next commitment period. The violator may also be barred from using the flexibility mechanisms. Also finalized the accounting procedures to be used for sinks.

19. The Kyoto Protocol • Protocol to the 1992 UN framework Convention on Climate Change, negotiated in 1997 • Annex 1 countries agreed to reduce emissions of 6 greenhouse gases to 5.2% below 1990 levels on average between 2008 and 2012 • No commitments for Developing Countries (countries such as China ratify but have no targets!) • flexibility allowed through • permit trading • clean development mechanism (CDM) • joint implementation

20. The Kyoto Protocol • legally binding if 55 countries accounting for 55% of developed country emissions ratify • USA and Australia have rejected • Russia is the key country that will determine if the Protocol enters into force

21. What would a simple economic approach be?

22. Two well known approaches: • Carbon tax • Permit trading

23. A carbon tax: • A fixed price for carbon with revenue going to the government • Emission outcome is unknown but the cost of carbon is known with certainty • Problems • Tax payments are enormous • If optimal reduction is 20% of emissions, firms must pay tax on 80% of original output. • Very unpopular with industry!

24. Domestic permit trading: • Quantity of emissions is certain and fixed at the quantity of permits • Price of carbon is uncertain and depends on marginal abatement costs given the target • Problems: • Price of permits (i.e. cost to the economy) might be very large • Costs might substantially exceed the benefits

25. Kyoto-style Permit Trading • Emission permits are issued equal to the target • Each country receives an allocation of permits • Countries/firms • buy permits if they wish to increase emissions • sell permits if they wish to reduce emissions • Trading allows original country targets to be tightened or relaxed depending on the costs • Abatement differs across countries depending on costs of abatement relative to the price of permits • The permit price will be determined by demand and supply and will equal the cost of preventing the emission of an additional unit of carbon

26. Advantages • Global target is met but differential country response allowed through the market • Cost of removing an additional unit of carbon is equal everywhere (efficient) • Compensation (across countries and within countries) can be built into the initial permit allocation

27. The Problem with Targets & Timetables? • A fundamental problem with targets and timetables • What is the correct target for each country and the world? • What is the optimal period? • targets impose unknown cost for given outcome for emissions • permit trading gives greater flexibility across countries but no flexibility in total

28. Some Problems • If costs are low we miss the opportunity to cut emissions quickly (in total) because we have a fixed target • If costs are high we might create severe problems that would destroy the commitment to Kyoto

29. Some Problems • Permit trading more widely implemented could cause economic and political problems with large wealth transfers between economies and large fluctuations in trade balances and real exchange rate • Some historical examples • Dutch Disease – e.g. North Sea Oil Discovery in 1970s • Keynes classic “transfer problem” related to German Reparations after WWI

30. Some Problems • If one large country reneges the permit system would likely collapse since the price depends on all countries supply and demand • This requires a very strong monitoring and enforcement mechanism in all participating countries.

31. Many Key Remaining Questions • How do you get developing countries into the system if it proceeds? Without developing countries UNFCCC goals will not be achieved (and US will not ratify). • What enforcement mechanism will be required to keep a global Kyoto style system from collapsing under a range of alternative future scenarios?

32. What should be done given uncertainty? • Some proposals: • Do nothingProblem may be small, avoiding it may be expensive • Do something drasticProblem may be enormous, avoiding it may be cheap • A prudent policy would avoid extremes • Reduce emissions where possible at low cost

33. How can Climate Policy be made Sustainable? • Difficult without a fundamental shift of focus because Kyoto fails to acknowledge and address the single most important aspect of climate change: uncertainty • Targets and timetables imply uncertain costs which some industrial countries reject and developing countries will be unlikely to accept. • No developing country commitments and no United States participation • Current time frame for commitments is too short • Complex – requires new international institutional structures that are infeasible in the near term

34. How can Climate Policy be made Sustainable? • Global markets in emissions trading means • the withdrawal of a large country risks can destroy the system • The threat of withdrawal can create political compromise on the targets • Monitoring and enforcement a major source of tension between countries

35. Are there any alternatives? • Need a policy with best features of permits and taxes • Like a tax: • Should guarantee that costs won’t be excessive • Like permits: • Should avoid huge transfers to the government • Importantly it should make property rights clear over a long period and provide incentives for industry,households and governments to reduce emissions at low cost

36. Solution: The Blueprint (a hybrid policy) • Each participating country would: • Require that producers of energy within their borders have an annual emission permit for each ton of carbon embodied in their energy produced and sold domestically or imported • Issue perpetual emissions permits equal to a specified fraction of a base period emissions. • Be allowed to sell additional annual permits to firms within its borders at a stipulated price ($P per ton of carbon), we say $P could be $US10 per ton of Carbon ($US2.72 per ton of CO2). • Create domestic markets in the perpetual and annual permits • The permits can only be used in the country of issue: no international trading.

37. Looking at the policy in more detail: • Allows one unit per year forever (or for a long period) • Distributed once at enactment • Can be leased or sold within country • Quantity can set by treaty: QT • Price will be set by the market Perpetual Permit (Endowment) Annual Permit Allows one unit for one year Sold by government as demanded Price set by treaty: PT

38. Perpetual permits for lease Annual permits for sale SL $ SS QP QT QP Supply of each type of permit (for use in a given year) $ PT

39. Overall supply of permits (for use in a given year) $ S PT QT QP

40. If abatement is easy: MAC rise slowly Low D for permits P below threshold No annual permits Hit target QT $ PT S P D QT Q Permits

41. If abatement is difficult: MAC rises rapidly High D for permits P at threshold PT Annual permits used Emissions exceed QT $ P, PT S D QA Q Permits QT

42. Key Points • Each system is run within a country using that country’s own imperfect monitoring and enforcement mechanisms and its own legal and accounting systems • No international trade in the assets • only domestic markets • Short run efficiency guaranteed by a common price • Long run efficiency driven by structural change • Incentives for all actors are internalized within countries

43. Developing Countries ... • Negotiate a perpetual permit allocation that is larger than current emissions • Price of annual emission permits zero in the short run because more permits than needed • Price of perpetual emission permits will be non zero giving important signals for investment projects • Over time the permit price in countries will equalize as developing countries “ability to pay rises”

44. Developing Countries ... • Will developing countries ever agree? • Depends on who is expected to get the valuable assets called permits • Will they ever agree to Kyoto style interventions?

45. Advantages of the Blueprint policy • Guarantees that compliance costs would not be too high • Passes the test that Kyoto fails • Can be justified on cost-benefit grounds • Current knowledge about climate risks justifies slowing emissions at low cost • Avoids huge transfers to the government • Each government can decide how to hand out perpetual permits but once these property rights are distributed they are not revisited (like land contracts) • Permits act as transition relief for industries (and affected workers) and will reduce opposition • Also, easy for industry to understand -- like grandfathering • Reduces emissions wherever cost-effective • Prudent: eliminates emissions where possible below a fixed price

46. More advantages ... • Maintains national sovereignty • Important for US and developing country participation • Incorporates an explicit mechanism for developing country commitments with no short term costs but clear incentives for future investment in less carbon intensive activities • Provides a futures market (perpetual permit market) • Allows individual risk management

47. More advantages ... • No direct international transfers of wealth • Trading is national, rather than international • Less disruptive to exchange rates and foreign aid budgets • Gives incentives for early action • Perpetual permits could be distributed now, even without a treaty! • The private sector is already doing this but property rights unclear • Built-in incentives to monitor and enforce • Annual permits generate government revenue • Owners of perpetual permits do not want permit prices to erode • Credible • Less draconian so more likely to be enforced into the future

48. Still more advantages ... • Relatively easy to modify as information arrives • Can raise or lower the world price as risks become better known • Easy to add countries over time • Does not require re-negotiation of treaty • New countries don’t hurt existing permit owners • Creates a future market in carbon (the perpetual permit market) • Gives a long term price signal but with a fixed short term cost

49. An Illustration of how Uncertainty impacts on the costs of Kyoto versus Blueprint • Suppose Russia grows at 1% per year faster from 2000 to 2012 than our baseline forecast (4.4% rather than 3.3%) • What is the cost of Kyoto versus the Blueprint under the baseline scenario versus the alternative scenario of higher Russian growth? • Both Kyoto and the Blueprint assume non participation by developing countries even though the Blueprint has a clear mechanism for getting developing country participation!

50. The Model Used • The G-Cubed Multi-Country model