Cooperation to reduce developing country emissions

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

2. 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?

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

4. MCDC MCIC MCIC+DC MBIC+DC H MBIC MBDC MDC MIC Gains from cooperation Most gains to industrialised country Most cost to developing country

5. 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.

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

7. 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

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

9. Adverse Selection

10. 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

11. 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

12. Risk and moral hazard baseline response emissions

13. Baseline risk • Improve baseline • Allow baseline to change • If fn(DC action) leads to moral hazard baseline response emissions 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.

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

15. Other risk management options • Industrialised country direct investment • IC takes some response risk • If brings extra resources makes response larger and reduces relative baseline risk • ‘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.

16. 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.

17. Solutions to hold-up • 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 • Build IC credibility for cooperation

18. Straw man • 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

19. 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

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

21. 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

22. 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