INTERNATIONAL DIMENSION OF CLIMATE POLICY

2. INTERNATIONAL DIMENSION OF CLIMATE POLICY Many environmental problems are not confined within the boundaries of countries They are TRANSBOUNDARY => at the cross of different countries: acid rain, ozone depletion, global warming pollution of rivers International trade add an additional channel of interactions => environmental policies in one countries can affect other countries Race to the bottom Pollution haven hypothesis 1

3. INTERNATIONAL DIMENSION OF CLIMATE POLICY Methodology to deal with transboundary problems Determine the market, non cooperative equilibrium in which countries do not take into account the external effect of their action Determine the cooperative equilibrium (Pareto efficient outcome) Propose a course of action to achieve the Pareto efficient outcome Use the same approach used to deal with local problems There is an important, INSTITUTIONAL difference 2

4. INTERNATIONAL DIMENSION OF CLIMATE POLICY Local problems can be addressed by GOVERNMENTS International problems are based on voluntary provisions A treaty must be signed on a voluntary basis Self-enforcing agreements = agreements that are voluntarily because they create incentives on all parties to adhere The institutional framework is no longer that of REGULATORS but that of NEGOTIATION between countries INTERNATIONAL AGREEMENTS CAN Propose the implementation of a specific policy instrument by all countries Propose some internationally agreed quota system 3

5. THE NEED FOR POLICY COORDINATION Global environment = public good: all countries are going to benefit from the emission reductions undertaken by a subgroup of one or more countries => incentive to free-ride High degree of interdependence among countries: the welfare of each country depends on its own action as well as on the action of any other country Unilateral policies can be jeopardized and possibly made useless by the other countries’ reaction. Hence, the need for policy co-ordination 4

6. COALITION FORMATION THEORY Game theory => coalition formation in the presence of free-riding incentives when countries must decide to cooperate or not on public goods=> Prisoner Dilemma’s result or tragedy of commons In the real world there are agreements on the commons => need for a theory that can explain the formation of these agreements => non-cooperative theory (Carraro and Siniscalco, 1992,1994; Barret, 1997) 5

7. NON-COOPERATIVE THEORY In the first step – the coalition game – countries decide whether or not to cooperate. In the second step – the policy game – countries choose the optimal level of carbon emissions. Carraro and Siniscalco (1993): partial cooperation is fully rational and can emerge as the outcome of the non-cooperative game. Different degrees of cooperation: If all countries form a coalition to control global emissions it is said that “full cooperation” is achieved; only a subset of countries join the coalition is defined as “partial cooperation”. The non-cooperative case is still a possible equilibrium of the game A coalition exists as an equilibrium if it is self-enforcing 6

8. INTERNATIONAL ENVIRONMENTAL AGREEMENTS What are the necessary conditions for the existence of a coalition? What are the conditions for agreements on global environmental problems to be signed by all or almost all world countries? Do some countries play a strategic role? What are the measures that can help to expand the number of countries which commit to control their emissions? Non-cooperative theory applies the theory of cartel formation (D’Aspremont, 1983) => formation of effective international agreements share problems similar to constructing effective cartels Successful cartels must be self-enforcing => understand what make cartels working and apply this to environmental agreements 7

9. NOTES 8

10. NECESSARY EXISTENCE CONDITIONS Profitability: A coalition is profitable if the overall welfare of the coalition is larger than the sum of its members’ welfare in the fully non-cooperative (Nash) scenario. Profitability is a necessary condition for stability. Stability: A coalition is stable if it is internally and externally stable: a coalition is internally stable if signatory countries do not have the incentive to defect and to behave non-cooperatively when other coalition members cooperate; a coalition is externally stable if there is no incentive to enlarge the coalition by including non-signatory countries 9

11. MAIN RESULTS 1. The presence of asymmetries across countries and the incentive to free-ride make the existence of global self-enforcing agreements quite unlikely (Carraro and Siniscalco, 1993) 2. When self-enforcing international environmental agreements exist, they are signed by a limited number of countries (Hoel, 1991, 1994; Carraro-Siniscalco, 1992; Barrett, 1994). 3. When the number of signatories is large, the difference between the cooperative behaviour adopted by the coalition and the non co-operative one is very small (Barrett, 1997) 4. The grand coalition, in which all countries sign the same environmental agreement, is unlikely to be an equilibrium => coalition of different size may emerge at the equilibrium 10

12. What matters in the analysis of coalition formation is the concept of stability which identifies which countries have an incentive to join the coalition Two key questions in the presence of partial agreements: Are these partial coalitions effective? What is the reaction of non-signatories? => Reaction function and carbon leakage Can they be enlarged by inducing other countries to join? => Issue linkages and transfers 11

13. REACTION FUNCTIONS The optimal reaction of non-signatory countries might imply higher emissions compared to the case in which no coalition is formed, carbon leakage firms relocate polluting activities from signatory to non-signatory countries; the sharp contraction of fossil fuels demand that would follow a strong stabilization policy adopted by the climate coalition would translate into lower international prices for those resources and in higher consumption – and higher emissions – in non participating countries The optimal reaction of non-signatory countries might imply lower emissions compared to the case in which no coalition is formed: with international knowledge or technological spillovers, the virtuous behavior of coalition members might lower investment costs in abatement technologies worldwide, and thus lower emissions also in countries that do not participate to the coalition. 12

14. TRANSFERS Heterogeneous players => each region has a different incentive structure to participate which depends on the damage and on abatement costs Countries with high damage/low abatement costs => find it optimal to abate more. This implies that within a coalition some gains and some lose Transfers: a redistributive mechanism that guarantee profitability (the coalition as a whole gains) or that increases stability (that offsets the incentive to free ride) Ex ante: the coalition chooses the optimal strategies knowing that it can use transfers to redistribute cooperation gains Equal weights Give more payoffs to those with higher MD Ex-post: transfers are used after the coalition has formed 13

15. Potentially stable coalition PIS coalitions are those whose aggregate welfare gain is large enough to guarantee each of its members at least their free-rider pay-off PIS coalitions can always ensure internal stability, since it can always design a transfer scheme that gives each member its free-riding pay-off and shares the surplus according to any unspecified rule 14

16. TRANSFERS If the developed countries (US, EU and Japan above all) on the one hand increases their financial and technological support to developing countries, and makes this support conditional on the achievement of given environmental targets, then a number of countries are likely to be induced to join the environmental coalition, i.e. to sign a treaty in which they commit themselves to adequate emission reductions. 15

17. ISSUE-LINKAGES Countries bargain not only on emission reduction but also on other issues: Barret (1997) => link to negotiations on trade liberalization Carraro and Siniscalco (1995,1997) => link to negotiations on R&D Some countries gain on a given issue, whereas other countries gain on a second one. By "linking" the two issues it may be possible that the agreement in which the countries decide to cooperate on both issues is profitable to all of them. If countries which do not sign the environmental agreement do not enjoy the benefits arising from signing simultaneously other multilateral agreements, e.g. the ones on technological co-operation, then there is a strong incentive for all countries to sign the linked agreement. This approach is likely to function when the negotiation on an issue with excludable benefits (a club good, in economic words) is linked to the environmental negotiation (which, if successful, typically provides a public good, i.e. a non-excludable benefit). 16

18. GLOBAL AGREEMENT: SOME ISSUES Heterogeneity of countries => some countries may not find it profitable => use transfers Free ride incentive => defection on a large coalition is an optimal strategy if there are no sanctions => credible sanctions are difficult to design Equity=> if the burden is equitably shared, the agreement is more likely to be signed by a large number of countries But not equitable agreements (e.g. with transfers) may be more efficient => trade-off Sequential agreements that start off with a partial, leader coalition 17

19. “THE INCENTIVES TO PARTICIPATE IN AND THE STABILITY OF INTERNATIONAL CLIMATE COALITIONS: A GAME-THEORETIC APPROACH USING THE WITCH MODEL” OECD ECONOMICS DEPARTMENT WORKING PAPERS No.702, 2009

20. Motivation • A successful international climate policy framework needs to bring the main greenhouse gas (GHG) emitting countries together into a “climate coalition” that delivers ambitious emission reductions at least cost. • Broad-based country participation is required for any coalition to be environmentally effective. • Wide coalitions may be harder to achieve, reflecting the difficulty to provide sufficient participation incentives to widely heterogeneous countries. • Against this background, this paper provides a game-theoretic analysis of three main issues: • The identification of potentially effective coalitions (PECs) • The incentives for main emitting countries to participate in climate coalitions. • The internal stability of such PECs

21. The WITCH model: General Set-up Game Payoffs=Welfare of consumption from economic activity in Ramsey Players’ strategies: investments Two solution concepts

22. The Two Solution Concepts/1 The game theoretic setup of the WITCH model makes it possible to capture the strategic nature of international relationships. Non-cooperative solution: countries optimize their own welfare and react optimally to other countries’ behavior (sources of interactions are: the climate externality, fuel markets, technological spillovers) Cooperative solution (coalitions): Countries cooperate on the climate externality (a social planner maximizes the aggregated welfare taking into account all regions’ damages) and fully take technological spillovers into account. The reactions to climate damage are different in the two setting.

23. The WITCH model: Game Theoretic Setup / 1 Non-cooperativecoalition formation theory: partial cooperation is possible at the equilibrium (Carraro and Siniscalco, 1993, Barrett, 1994) One-shot game with a first stage in which coalitions are formed and a second stage in which countries choose the optimal level of emissions. The game is solved backward. In the second stage: Coalition members maximize aggregate joint welfare Free-riders behave as singletons and maximize individual welfare Equilibrium is found employing the γ-characteristic function approach (Chander and Tulkens, 1997): With WITCH we compute the unique Nash equilibrium in which coalition members jointly play their best response to non-coalition members, who adopt individually their best reply strategy

24. The WITCH model: Game Theoretic Setup / 2 Countries interactthrough the climate externality, through technology spillovers (LbD and LbR) and through fuel markets. Countries joining the coalition cooperate on the climate externality The game exhibits positive spillovers: when a new member joins the coalition all countries outside the coalition are better off because they benefit from: A better environment Enhanced technology spillovers (knowledge is not a club good) Lower fossil fuel prices In the first stage, countries decide whether or not to join the coalition (binary strategy set) by anticipating the outcome of the game in the second stage .

25. Participation incentives Broad-based country participation is required for any coalition to be environmentally effective. At the same time, wide coalitions may be harder to achieve, reflecting stronger incentive to free ride. Drivers of individual incentives to participate in international climate coalitions include inter alia: The expected impacts of climate change; Abatement costs; The influence of distant impacts on current policy decisions (i.e. the discount rate);

26. Climate change impacts in the WITCH model • The impacts of climate change are expected to vary widely across regions. • Developing countries would be more affected than their developed counterparts (Jamet et al. 2009) • Uncertainties are large, however, as reflected by the wide variance in damage estimates across studies

27. Climate change impacts: upper and lower bounds A higher damage function reflecting upward revisions of recent estimates (UNFCCC, 2007; Stern et al. 2006) has been considered, so as to define an upper and lower bound around estimates available in the literature Time horizon: 100 years

28. Discount rate • In order to take into account the existing debate on the choice of the social discount rate, the analysis is performed here under two different assumptions regarding the pure rate of time preference, namely 3% and Stern’s 0.1% assumption. • In order to account for uncertainty regarding both damages and inter-temporal preferences, the analysis of climate coalition will consider four cases: • Low damage - high discount rate (3%) LDAM_HDR • Low damage - low discount rate (0.1%) LDAM_HDR • High damage - high discount rate (3%) HDAM_HDR • High damage - low discount rate (0.1%) HDAM_HDR

29. Abatement costs • The costs of mitigation policies are also expected to vary widely across regions. • Ceteris paribus, the higher the overall carbon intensity of output • the flatter the aggregate marginal abatement cost curve • the larger the economy’s abatement efforts • the larger the costs under a global carbon tax • the smaller its incentives to participate in a climate coalition • Developing regions (China, South-East Asia, Africa and, to a somewhat lesser extent, South Asia (including India) and Latin America) incur larger costs than their developed counterparts in the absence of explicit or implicit financial transfers • Economies that are both carbon-intensive and produce fossil fuels (non-EU Eastern Europe (including Russia), Middle East and North Africa) face the largest costs from broad-based mitigation action.

30. Abatement costs under a range of world carbon tax scenarios

31. Fully cooperative versus non-cooperative outcomes A natural first step towards analysing coalition formation and stability is to determine the optimal abatement policy that would be implemented by a “grand coalition” of world regions that fully internalises the environmental externality due to GHG emissions A second step, is to assess the sensitivity to damages and discounting In both the non-cooperative and cooperative cases, the optimal emission path depends on the damage and discount rate assumptions.

32. Non cooperative outcomes The non-cooperative solution is also defined as the “baseline” because it best represents the nature of present international relations, far from being fully cooperative. Little variations are observed in a non-cooperative setting, reflecting the inability of individual regions to internalise the environmental externality

33. Cooperative outcomes Sensitivity to these assumptions is far greater in the cooperative case. Damage and especially discount rate drive emissions down.

34. Summary In a non-cooperative world, externalities dominate and equilibrium emissions are not very sensitive to different assumptions on damages and discount rates. In a cooperative world, the internalization of the externality through the climate damage component provides enough incentive to moderate pollution. In particular, the HDAM-LD case leads to stabilization of emissions and concentrations in line with a 550 ppm CO2 eq target.

35. Potentially effective coalitions: definition Among the 4095 coalitions that are possible with 12 regions, only a subset is politically meaningful AND has the potential to stabilize GHG concentrations at a chosen target, in the present context, 550 ppm CO2eq A coalition is defined as a PEC if it could technically achieve a given world concentration target by bringing down its own emissions to zero and non-participating regions remain at their BAU levels. Being a PEC is a necessary (but not sufficient) condition for the 550 ppm CO2eq target to be attainable (there are free riding incentives for singletons and technical unfeasibility of zero emissions for coalition members).

36. Definition of the target: three different metrics The two targets together define environmentally effectiveness: they ensure with high probability the stabilization of radiative forcing at 3.7 W/m2 .

37. Main Insights from PECs analysis If big emitters do not join the coalition, then the 2050 and 2100 targets cannot be achieved even under the extreme assumption of zero or negative emissions for coalition’s members. All (politically relevant) PECs include all industrialised countries and both China and India by 2050, unless all other developing regions (except Africa) reduce their emissions below BAU levels. A coalition consisting of industrialised countriesonly cannot, even potentially, meet the target at the 2050 horizon. The participation of both China AND India is needed to attain the 2100 target. When the goal is GHG stabilization in 2100, PECs are subsets of the 12 regions in which at most three regions are not included. Generally, only SSA or SSA plus another region (LAM, TE, MENA, SEASIA) can be singletons.

38. From PECs to Cost-Benefit Analysis (CBA) • The identification of PECs is very robust: they hold under each of the four possible damage and discount rate scenarios • Being a PEC is a necessary but not sufficient condition for the 550 ppm CO2eq target to be attainable • => unfeasibility of zero emissions • => free-riding incentives and carbon leakage, raising emissions in non-participating regions above their BAU levels. • CBA analysis will illustrate how PECs underestimates the actual emission levels of both cooperating regions and singletons • Policy implication: international coalitions will have to be larger than PECs in practice.

39. Cost-benefit analysis (CBA) of PECs Evaluate PECs in a cost-benefit framework to check whether they actually attain the required environmental goal. What does each coalition actually achieve in terms of emission reduction? How far from the stabilization goal is the equilibrium solution equalizing marginal costs and benefits? We start the analysis from the high damage and low discount rate (HDAM_LDR) case, again because if a coalition is not effective in this case, it cannot be effective in the other ones.

40. CBA: Environmental effectiveness Ambitious mitigation action is economically rational at the world level in the high-damage/low-discounting case, in line with Stern (2007).

41. CBA: What Drives Coalition’s Emissions? The major incentive from reducing emissions comes from the size of climate damage for coalition’s members The composition of damages within the coalition determines the benefit from emission reductions and thus the degree of emission reductions For example, when we consider the coalition composed by all countries but SSA (GC_SSA) and consider the difference in emissions w.r.t. the grand coalition, two forces are at play Countries in the coalition emit more because they do not internalize the high negative impact of climate change on SSA (damage effect). As expected SSA emits more (free riding effect), BUT less than in the non cooperative baseline (technological spillovers).

42. CBA: Free riding – the case of SSA

43. CBA: Free riding – abatement costs

44. CBA: Effective and Profitable Coalitions (EPCs) Having identified the effective coalitions in a CB setting, we now turn to the analysis of their Profitability (any unilateral loss can be compensated) Internal Stability (no incentive to deviate) Potential Internal Stability (incentives to deviate can be bribed by means of coalition surplus) (Although only the Grand Coalition - and close to be the GC_SSA - has been shown to be effective, we evaluate profitability and stability also for other coalitions e.g. PECs and PICs)

45. Some definitions Profitability: A coalition is profitable if a signatory’s welfare is larger than its welfare in the fully non-cooperative case. Profitability is a necessary condition for stability. Stability: A coalition is stable if it is internally and externally stable: a coalition is internally stable if signatory countries do not have the incentive to defect and to behave non-cooperatively when other coalition members cooperate; a coalition is externally stable if there is no incentive to enlarge the coalition by including non-signatory countries Potential Internal Stability: a coalition is potentially internally stable if the aggregate welfare level of cooperating countries is at least as high as the sum of the welfare that its members would enjoy behaving as singletons when the others cooperate.

46. CBA: Profitability and Stability for the PECs • PROFITABILITY: environmental cooperation internalizes externalities, an thereby increases collective welfare. • STABILITY: the overall welfare gain from the coalition relative to the non • cooperative outcome is not large enough to find a set of transfers that would give • each country/region its free-riding pay off. Having compensated all losers in the • coalition to achieve profitability, the remaining surplus is too small to offset free • riding incentives. • To stabilize the grand coalition, OECD countries would have to give up 3% of their GDP

47. CBA: Gainers and Losers CHINA and TE are the major losers from climate cooperation, essentially because these regions, TE in particular, benefit from climate change for a large part of the century and their economies are or will be very fossil fuel intensive (China in particular).

48. Conclusions Ambitious mitigation action is economically rational at the world level in the high-damage/low-discounting case, in line with Stern (2007). “Buying-in” all emitting regions will be challenging. While profitable to its member countries as a whole, the grand coalition is not found to be stable: coalition surplus is not sufficiently large to provide all free riders the incentive to join the coalition This is in line with previous literature, which finds international climate coalitions to be unstable or, when stable, to deliver only limited emission cuts These findings are subject to a number of limitations, however. One important caveat is that the co-benefits from mitigation action, e.g. in terms of human health, energy security or biodiversity, are not taken into account.

49. Some positive thinking…. Copenhagen Accord was not as bad: Financial commitment: 100Billions to 2020 Pledges REDD+ However, the Accord was only NOTED, not signed (Venezuela, Peru, Tuvalu, ) UNFCCC unmanageable (192 countries) Larger role for bilateral agreements or smaller multilateral (MEF, G20, G30) UNFCCC might stay given its inclusiveness, status, legal capability, but it won’t be determinant for mitigation. Emission mitigation will not be sufficient to limit to 2 degrees, so prepare for adaptation.

50. MEAs: milestones 1972 UN Conference on the Human Environment and UNEP. The Stockholm conference is rooted in the pollution and acid rain problems of northern Europe. It leads to the establishment of many national environmental protection agencies and the United Nations Environment Programme (UNEP). 1992 The Rio Conference (Earth Summit) where the concept of sustainable development gained broad support. Agreement was reached on the adoption of United Nations Framework Convention on Climate Change (UNFCCC), Convention on Biological Diversity (CBD), the decision to negotiate the Convention to Combat Desertification, the Agenda 21 plan, Rio Declaration including a set of principles such polluter pay principle, differentiated but common responsibility, precaution 49