From the Kyoto convention to the European Emission Trading (ET) scheme (1997-2005)

1. From the Kyoto convention to the European Emission Trading (ET) scheme (1997-2005) Economic, policy and institutional issues

2. The Kyoto frameworkfrom 1997 to 2005 • The climate change issue: harsh debate • In favour: UE, UK • Against: US, some social scientists (Lomborg) • While its is accepted that industrial growth is responsible of greenhouse gas emissions growth, it is not a shared vision that gases are correlated with climate change  big issues: how do we measure temperatures; very long run historical patterns of temperatures, possible not anthropic but natural effect.. • Criticism on IPCC functioning • Greenhouse gases • CO2 (industry, transport, deforestation) (66%) • Methan, CFC, N2O • 85% energy related uses; 15% deforestation: forests are valuable as carbon sinks • Costs from higher temperatures • Health effects, biodiveristy loss, Sea level rise, water scarcity • Benefits • Higher agricultural productivity in some areas

3. Economic reasoning • Marginal cost of abating gases vs marginal benefits of reducing such gases  usual CBA approach • Issues: CO2 reduction is a pure public good as far as countries are concerned • It does not matter where CO2 is abated • Then, countries face different (lower/higher) abatement costs depending on energetic structure of the economy and past history of energy policies. The development stage also matters (abatement costs are plausibly increasing with abatement efforts) • A typical cooperation game is then played by countries..individual incentives to free ride on other agents…

4. Global benefits • Thus, it does not matter where we reduce/abate CO2 • This is a positive factor counterbalancing the free riding issue • In fact, from an economic efficiency standpoint, we should abate where marginal abatement costs are lower (recall theory of economic instruments)

5. Global public benefits… • ..but country-specific heterogenous costs… • Typical problem of cooperating for the production of a pure (global) public good  free riding • Importance of ancillary “private” benefits or spillovers: reduction of pollutants deriving from CO2 reduction (given links in production and technology) • Ancillary benefits are a motivation for the win-win hypothesis….they enlarge the set of benefits accruing to countries from global policies • Paper by Markandya and Rubbelke (2003, FEEM) on ancillary benefits of CO2 reductions: CO, NOx, SO2, N2O, CH4, PM.. • They may help mitigating the disincentive in investing towards a pure public good.. But we may also see the other way round..local environmental policies could target local regional air pollution, creating a link to international issues without a full explicit cooperation..we cannot be sure that such private/national efforts are sufficient to cope with the CO2 global issue..

6. Kyoto 1997 • The Kyoto convention outcomes • Countries joining • Annex I (OECD + eastern) • Annex II (industrializing) • Ratification (55% of countries representing at least 55% of emissions..US and Russia pivotal roles) • Agreed objectives • % reduction by 2008-2012 with respect to 1990 CO2 levels • Note: 1990 levels, but Kyoto in 1997…what has happened during those years? Gases increased as long as economies..in reality objectives were stricter than the Kyoto ones..

7. Examples of targets • US -7% • EU -8% (but allocated within the EU) • Russia 0% • Japan -6% • Australia +8% • Canada -6%

8. The EU bubble • Main issue: is this an economic oriented or politically oriented allocation? • Which countries are reducing more? • The bubble is associated with the economic idea of sharing a common good costs..but the implementation is based on non economic rationales.. • It opens the way to the EU ET experience..

9. Economic instruments • MAC are lower in industrializing countries, which have more polluting and obsolete technologies • The higher the efficiency level is, the higher the MAC (plausible hp) • Thus, the abatement burden shoud be placed on developing countries • BUT this was an hot unresolved issue at Kyoto

10. What role for economic instruments? • First phase: EU supporting the Carbon tax idea (1992 Delors Commission, linked to the double dividend hypothesis), US strongly against • US in favour of a global system of emission permits…but how allocating quotas? • Both systems turned out to be too difficult to implement… • ..then US did not ratify…

11. Flexible instruments • The scenario is now based on a set of feasible and pragmatic tools: • Single countries may manage environmental taxes and other fiscal tools • Regional areas may develop emission trading schemes • Paradox: the EU has developed a ET scheme, starting in 2005, surprising the US • Global instruments are flexible tools like: • Joint implementation (UE/US  eastern Europe) • Clean development mechanisms (Annex I  non Kyoto) • Carbon sinks (managed within 1 and 2)

12. Current situation • Thus, Kyoto targets will be achieved (?) by means of a differentiated set of tools • The use of flexible tools is maybe the only global feasible opportunity since: • They depend on bilateral and multilateral agreements between states and/or private agents (bottom down rather than top down approach) • They are project based • The investor (Kyoto participants) invest money in abatement activities located in other countries (i.e. China). The two parties share the investment benefits, and the investor get the abatement certification • Issue: it gets the reduction wrt the BAU situation… • We may ecpect those are not “new projects”: either environmental values were included in projects selected even before, and now are possibly obtained and marketed (The environment is not a shifting factor), or the new environmental value included shifts at the margin teh value of projects with environmental elements (The environment is a shifting factor)

13. Abatement costs • Thus, we may achieve the same reduction at lower costs (though we must include monitoring and transaction costs to get net cost figures) • Some examples: • A ton of CO2 abated may cost around a range of 15-50€ in Europe (investment costs), depending on sectors and areas • Italy, for example, is the most efficient country, depending on high energy prices (low market competition, not environ policies and climate) • A ton of CO2 in developing countries may cost 2-5€ • Big issue which lead to US non ratification: how much do we have to abate in our country and abroad? • US position was/is even 100% (economically meaningful in static terms) • EU 50%-50% • US firms producing environmental technology were strongly against BUSH adm..without ratification, they are out of themarket for CO2 quotas and investments…

14. Carbon sink • Another hot issue is the use of carbon sinks • US wanted to be free to account carbon sinks and investment in carbon sinks (link US-Russia) • Main problems: monitoring, investments are not irreversible as for technology • The value of CO2 stock in forests is highly heterogenous (tropical possess much higher value in CO2 and also Biodiversity. Brazil, Costarica, Indonesia, Central Africa) • Interesting point, in any case: the existence of a market for CO2 under Kyoto turn the stock of CO2 in forest from a non market to a marketable asset…another opportunity cost of cutting a forest emerges, in addition to tourism, species conservation, biodiversity value, etc..

15. Hot air • One issue during the first Kyoto phase is the so called hot air: CO2 reduction for eastern European countries which are not deriving from higher efficiency but instead from the economy collapses of ex communist countries (GDP reductions even about 70%..slow recovery..) • The issue is that those gas reductions cannot be certified. Monitoring needed.

16. Summing up • Flexible tools are the most feasible way of dealing with Kyoto targets at global level..politically acceptable..economically sound.. • Main criticisms: • Exporting technologies not on the frontier.. • High monitoring and transaction costs..institutions are needed in any case to regulate the market • Too little effort within national boundaries…possible negative effects on innovation dynamics deriving from less stringent regulations and lower prices of carbon in the market.. • EU Countries face 3 options for abatement: • Abatement abroad (outside EU15  CDM, JI) • Abatement by ET • Abatement outside ET but inside EU (country) • The 3 sum up to 100% of total abatement • Critical issue in the near future: Kyoto and ET strategies of new european countries (eastern ones)

17. The EU ET scheme • Green book 2000 + EU communications lead to the 2003 Directive on Emission trading in EU • Pilot phase 2005-2007 • Initially limited to energy, ferrous metal, refinery, some manufacturing sectors..(46% CO2 in the EU) • Model: cap and trade with decreasing cap • Banking in the first phase, no borrowing allowed • Fines: 40-100€/tCO2 for each ton produced by firms without showing allowance permit

18. The EU ET scheme • Allocation system: grandfathering by national plans + a share of quotas allocated by auctions each year in order to cope with the new entrants issue • It is worth noting that allowances are not firm assets..the owner of property rights is the state, that can withdraw quotas at any time, in order to reduce supply and affect the market equilibrium.. • Future extensions • More gases • More sectors (transport) • More auctioned quotas

19. The Linking issue • A Linking directive was necessary to regulate the link between ET and JI/CDM markets • Main point: a complete mixing of the two markets for credits may lead to an over supply of credits in the ET EU market  • Lower prices (estimates around 20-30€ with a closed EU market, 2-3€ with complete inter-exchange at global level) • A full EU25 market is estimated to produce prices around 11-20€..the more we include low abatement areas/markets, the lower the carbon price is.. • Lower prices reduce costs but may undermine innovation dynamics in the EU..balancing static and dynamic considerations…. • The solution is now a monitoring of inflows, with a threshold of 6% that, if reached, leads the Commission to eventually apply a 8% max ceiling, for assuring “supplementarity” of JI/CDM policies (opposite to US position on it)

20. Other policies • The EU ET is only one tool (46% of CO2) • Carbon tax for SME? Proposal of 23€/ton • Voluntary agreements • Energy policies • Renewable energy..what is its potential and realistic role in energy production? • Nuclear emerging issue

21. ET costs • It is worth noting that the implementation of ET schemes depends on the theoretical result that such a market is cost saving with respect to other policy instruments (not wrt environmental taxes..) • In reality, the cost should be the same, but different emphasis: • The tax emphasis is on the price paid by firms • The ET emphasis is on the allowance given to firms, which nevertheless are associated to a price, paid in the market or in the auction • The saving is with respect CAC systems • Estimates: -34% with all sectors, -24% with energy alone (but transaction market costs should be then accounted for)

22. ET costs…in the political debate • The market price in this initial phase is about 20€ per ton of CO2 • The Energy sector claimed recently (Italy) that Kyoto (ET scheme) will cost 100 millions € of “extra costs” (??)  where’s the flaw in the statement? • When you measure policy costs you must refer them to the benchmark: • Alternative policy action (the less costly policy is more efficient, if both achieve targets) • No action..but in this case we go back to the analysis of total social costs and benefits, including environmental costs higher with no action • But maybe they are lobbying against the reduction in total italian allowances that EU requested in order to accept the Ntional allocation plan…less ET quotas..higher costs..

23. WhenThe issue is very uncertain… recently the italian treasury claimed that Kyoto will cost to Italy “only” 3 billions of € (0,2% GDP, compared to international estimates of 1-2%))..with an average abatement cost of 5,5€, compared to the 10-15€ of the ET… • bit strange..efforts with costs lower than ET…like car efficiency..new gas technologies in electric energy, more renewables..(it would be interesting to see cost estimates and methods)??? • Italian trend without policy 613 millions tons (Kyoto objective is 475)..with policy above 576..more 101 to be abated..what ways?

24. Papers on EU ET • Very nice general paper by Kruger and Pizer (2004), RFF 04, www.rff.org • Klepper and Peterson (2004, 2005), FEEM paper, www.feem.it • 2004 paper on model simulations for allowances prices under different scenarios • 2005 dealing with EU climate policy, CDM, JI and ET…very good general overview.. • EU Directive 2003: 87/CE 13.10.2003 • Good reading to see how a Directive is presented..it sets rules