Table of Contents
Table of Abbreviation
1. Introduction: „The greatest example of market failure“
2. Carbon Pricing and Emissions Markets in Practice
3. Framework for Understanding International Collective Action for Climate Change
3.1 Understanding International Collective Action
3.2 Existing Intern. Arrangements for Global Cooperation on Climate Change
3.3 Building and Sustaining coordinated Global Action on Climate Change
4. Creating a Global Price for Carbon
4.1 Reducing the Costs of Mitigation through Framework Efficiency
4.2 Sharing the Costs of Mitigation
4.3 The Experience of the Kyoto Protocol
4.4 Building on and Expanding the Kyoto Protocol Framework
4.5 Interaction with the International Trade Regime
5. Conclusion: Equitable Intergenerational Risk Sharing
This paper targets the intergenerational risk sharing dilemma of the current international policy effort to establish conditions of global cooperation for a global carbon price which could, with an adequate carbon-pricing framework, reduce and share cost of mitigation in an efficient, effective and equitable way helping to decouple growth from greenhouse gas emissions.
Carbon Markets, Carbon Pricing, Emission Trading, Externality, Flexible Mechanism, Framework, Free-riding, Game Theory, Intergenerational Risk Sharing, Market Failure, Moral Hazard, Kyoto Protocol, Price Signals, Public good.
Table of Abbreviation
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1. Introduction: „The greatest example of market failure"
“Climate Change presents a unique challenge for economics: it is the greatest example of market failure we have ever seen. “ Stern Review
Human-induced climate change is caused by the emissions of carbon dioxide and other GHGs that have accumulated in the atmosphere mainly over the past 100 years. Those who create these negative externalities by generating electricity, powering their factories, flare off gases, cut down forests, fly in planes, heat their homes or drive their cars do not have to pay for the cost of the climate change because these costs are not reflected in market prices. Free-riding incentives are in the nature of public goods like global climate and illustrate exemplary the weakness of markets to clear at equilibrium prices. Scientific evidences illustrate that impacts of climate change are persistent and develop over the long run. There are uncertainties that prevent precise quantification of the economic impact and there is a serious risk of major irreversible change with non-marginal economic effects on global economical and social welfare. Global welfare at risk can be substantially reduced if GHG concentration in the atmosphere can be stabilized between 450-550 ppm CO2e. Economics of stabilization at this level would require an emission reduction in developed and developing countries, where developed countries take responsibility for cuts to 60% of their 1990 emissions by 2050. Depending on the overall stabilization goal, the remaining emissions from developing countries could not exceed an increase of 25% on 1900 levels by 2050. Three pillars of climatic policy are required for an effective global response. First tackling policy responses for mitigation by (a) pricing carbon and (b) supporting low carbon technology development, deployment and cooperation. Second, raise awareness and remove barriers to behavioral change of the demand side, and third tackling policy responses for adaption. This paper builds on the latest scientific evidence on the economic impact of climate change derived of the Stern Review. In the following chapter 15, 22 and 23 of the Stern Review are synthesized and structured with the goal to leverage the comprehension of this historic development of international mitigation policy responses. This paper focuses on conditions for global cooperation for carbon pricing with a particular emphasis on carbon markets as efficient, effective and equitable market-based solution concept by which agents are driven by price signals.
2. Carbon Pricing and Emissions Markets in Practice
Carbon Pricing means to establish a tangible price for carbon by which carbon emissions can be taken into account. Tax and trading schemes can used to create an explicit price for carbon. In contrast regulation can be used to create an implicit price. The policy debate has centered on cap-and-trade systems versus emission taxes. The two systems are almost equivalent if the caps (the targets) are auctioned. On the one hand, the government is setting a price and letting the quantity adjust in the other the government is setting a quantity and letting the price adjust. If the government had perfect information about the demand curve, then the two approaches would yield a perfectly equivalent explicit price. In practice, either quantity or price will adjust over time in response to achieve stabilization goals. Carbon pricing is only one part of the three pillars of policy response on climate change but it is highly significant because it can tackle the supply side via Emission trading schemes. ETS create unique market incentives, which enable free agents to price information and allocate resources more cost-effective than a unilateral “command and control approach”. However a lack of credible policy can undermine the effectiveness of carbon pricing as well as creating uncertainties for firms to lock in a low carbon trajectory. Investors need as well a predictable carbon policy to have the confidence that the carbon-pricing policy framework will be maintained over sequential periods into the future. ETS markets in practice experienced three drivers of framework confidence: (1) credibility (belief that the policy will endure, and be enforced), (2) flexibility (the ability to change the policy in response to new information and changing circumstances), and (3) predictability (setting out the circumstances and procedures under which the policy will change). All three affect the degree uncertainty that is at the core of investment decision. Modeling work by Blyth and Yang (2006) showed that business would adopt a ”wait and see” attitude to make a more informed choice in the future. Given this uncertainty, a much higher expected payoff level would be required to trigger the real option to invest now in low-carbon technology. As already outlined an ETS has several additional benefits. Besides the linking advantage of existing ETS, Burtaw (1996) showed that ETS under the US acid Rain Program could deliver least-cost emission reduction by allowing reduction to occur wherever they are cheapest. The EU commission presented a “Green Paper” in 2000 that outlined that an ETS would meet better its Kyoto target emission reduction obligations. The EU has launched in 2005 the first international emissions trading scheme (EU ETS) and represents today the world’s largest GHG emissions market. It established a uniform price for carbon for GHG emissions mandatory for specified heavy industry sectors in the 25 EU member states. Member states decide, through their National Allocation Plans (NAPs) on the quota or total allocation of allowances for each phase within their country and on how these are distributed between companies. Early experience of the EU ETS has highlighted a number of important issues that should be improved to design more efficient, liquid and deeper emissions markets. E.g. (1) broadening the effective scope of the ETS, to include more gases, more economies, economic sectors and international credits. (2) Ensuring appropriate scarcity in the system by setting the cap significantly below the expected BAU emissions level and taking into account flexible mechanism such as JI and CDM credits is important to price efficiently negative externalities of industrial emitters. Another efficiency issue is to (3) design appropriate allocation schemes, e.g. auctioning, because free allocations can significantly distort incentives and risks creating substantial windfall profits. (4) Granting transparency, e.g. by clear and regular information on emissions, to lower price volatility and prevent price spikes. (5) As already stated, tackling the three drivers of framework confidence by lengthening the trading periods, to provide longer-run confidence, and banking and borrowing facilities between periods which can help to smooth compliance, investment cycles over time and attract investment capital of the financial sector. The EU ETS will enter in 2012 in the third phase. Decisions made on the third phase of the scheme pose the opportunity for the EU ETS to influence the economic evolution trajectory in developed and developing economies via the flexible mechanism of the Kyoto Protocol. Besides bearing the potential to contribute to clear structural imbalances via technological cooperation the EU ETS appears to be the nucleus of future global carbon markets incorporating carbon pricing across sectors of the economy, e.g. power and heavy industry, road transport, aviation, agriculture and land use, and attracting the attention of the financial sector to invest in and finance low-carbon investments around the globe. However latter objective is constraint by the lack of international collective action for climate change.
3. Framework for Understanding Internat. Collective Action for Climate Change
3.1 Understanding International Collective Action
The voluntary nature of collective action means that each individual country has to be committed to play their part in response to the climate change challenge. Commitment ultimately comes from the understanding that climate change means global welfare at risk, and that through cooperation the risk can be reduced to the benefit of all. Reducing the risk of climate change is the most important example of the provision of a global public good. I.e. emissions of GHGs from any country have the same effect on the atmosphere as those from any other. Climate change shares some key characteristic with other environmental challenges that require international collective action (1) to overcome free riding and adverse selection incentives and (2) to establish better price signals which reduce costs of both mitigation and adaption policy efforts in the long run. However in the short run the paradigm of the “Tragedy of the commons” illustrates the dilemma between individual and collective rationality. This rationality trap is a central issue in game theory proving that many free market allocation processes do not fulfill the fist welfare theorem. E.g. “The tragedy of the commons” is concerned with understanding how to overcome such market failure that lead to the under-provision of public goods where individuals or countries face an incentive to free ride on the actions of others. Economists seek to understand the relevant incentives to situations that require collective action. Findings in repeated games illustrated that the increased frequency of contact and transparency contributes to building cooperation, just as institutional structures and repeated negations do in international agreements. Barett (2005) concluded in his review of 190 arrangements of environmental cooperation that the most successful treaties create a gain for all their parties, and sustain cooperation by changing the rules of the game, thus restructuring the incentives for countries to participate. Latter is known as mechanism design theory, which focuses on how to design mechanism (rules) to achieve a certain outcome, e.g. global cooperation on climate change.
 Using the results from formal economic models, the Stern Review estimates that no action (BAU) costs could at least be equivalent with 5-20% GDP or more each year (Stern, 2007, p. 239)
 Even 550 ppm 2-5oC average warming by 2050 with a 90% confidence interval (Stern, 2007, p. 15)
 This three pillars of climatic policy are illustrated in the Appendix (II)
 See a summary of carbon price determinant in Appendix (III).
 Burtaw (1996) estimated that emissions trading under the US Acid Rain Program saved 50% of the cost compared to command and control. Other empirical evidence: energy prices drive energy efficiency.
These currently include energy generation, metal production, cement, pulp and paper (Stern, 2007, p. 327).
 NAPs are subject to approval by the European Commission. Article 9 to 11 and Annex III of EU outline the criteria for allocation in the NAP. (Stern, 2007, p. 357)
 Joint Implementation (JI) and Clean Development Mechanism (CDM) are Flexible Mechanism constituted in the Kyoto Protocol expanding the options for generating credits for emissions reductions to most parts of the world, maximizing the opportunities for efficiency, transfer of low carbon technology to the developing world and additionally tackling structural imbalances (Stern, 2007, p. 540).
 E.g.international aviation emissions are twice of domestic flights, but do not need allowances (Stern, 2007)
 E.g. carbon credits are traded by compliance and non-compliance agents, e.g. carbon funds, and they can be successfully incorporated as new assets in a well diversified portfolio (Mansanet-Bataller; Pardo, 2009).
 In economics a public good is a good that is non-rivalrous and non-excludable. Non-rivalry means that consumption of the good by one individual does not reduce availability of the good for consumption by others; and non-excludability that no one can be effectively excluded from using the good (Varian, 2006)
 A rationality trap characterizes a drifting apart of what is rational for an individual decision maker (individual rationality), and what is rational for the whole (collective rationality). The rationality trap describes this contradiction of individual and collective rationality. The stronger the contradiction the higher the probability of moral hazards committed by agents (Aklerof, 1986).
 The commons dilemma is a specific class of social dilemma in which people's short-term selfish interests are at odds with long-term group interests and the common good (Garrett Hardin, 1968)