After recent disillusions, international climate change negotiations need to be jumpstarted. This paper first argues that countries’ strategic positioning will increase the cost of delay beyond that associated with the classic free-riding problem. It then investigates the governance of an agreement and the design of negotiation and compensation, emphasizing political economy considerations. The paper concludes with a possible roadmap for future negotiations.
Keywords: Global warming, International negotiations, Institutions, Compensation
aToulouse School of Economics and Institute for Advanced Study in Toulouse, Manufacture des Tabacs, 21 allees de Brienne, F-31000 Toulouse. E-mail: firstname.lastname@example.org. Phone:+33(0)5-61128642.
The author is grateful to Paul Joskow for helpful comments.
Economics of Energy & Environmental Policy, Vol. 1, No. 1. Copyright © 2012 by the IAEE. All rights reserved.
The Copenhagen negotiations on climate change (2009) unfortunately did not bring the waiting game initiated by the Tokyo protocol (1997) to a halt. The lack of firm commitments for 2020 stands in stark contrast with the generous promises for 2050. This paper accordingly investigates a series of related questions: What are the consequences of delaying agreement? How can we get countries on board? What roadmap could we set so as to achieve a better outcome?
In a nutshell, it first argues that countries’ strategic behavior will increase the cost of delay beyond that associated with the classic free-riding problem. That is, not only will countries pollute too much in the meantime, but their technological and societal choices will reflect the desire to extract more concessions in future negotiations. This strategic positioning makes it even more important to reach a binding agreement soon.
Next, the paper investigates negotiations and emphasizes the governance of an agreement and the design of negotiation and compensation. As could have been anticipated, political economy considerations are not only a primary cause of the current laissez-faire; they also loom large in the future choice among alternative institutional arrangements. It is therefore time to substitute Realpolitik for wishful thinking and to take on board the various participation constraints.
Finally the paper concludes with a possible roadmap for future negotiations.
We are well acquainted with the tragedy of the commons. If no agreement is reached between 2011 and 2020, say, then countries will have a suboptimal incentive to preserve the environment during that period. Each country bears the full cost of its carbon emissions reduction and receives only a small fraction of the benefits. This problem is exacerbated by the leakage problem: The country’s economizing 1 ton of CO2 actually results in much less than 1 ton of CO2 reduction for the planet: Goods are imported from cheap-carbon-emissions countries, plants move to such countries, the reduction in the world price of oil brought about by the country’s reduced oil consumption induces more oil consumption elsewhere, etc.
To be certain, free-riding does not mean unbridled pollution. Despite the absence of constraint, some actions will be (and are already) voluntarily taken, that reduce carbon emissions. Both emerging and developed countries have some programs (such as the ETS in Europe and renewable energy subsidies and mandates in Europe and many U.S. states) that deliver some carbon savings. There are three pragmatic reasons for such behavior, beyond the simple wish to “save the planet”. First, countries do internalize and want to economize on collateral damages; for example, an efficient supercritical coal plant emits less SO2, a local pollutant, as well as less CO2, a global one than does a less efficient subcritical plant. Second, if they are big (as is China, say) countries bear a non-negligible, even though still small, fraction of the cost of CO2 for the entire world. Finally and crucially, officials are eager to placate public opinion at home and to avoid international pressure.
All three incentives imply that the free-riding model- which, especially if one accounts for leakage, predicts internalization of a negligible fraction of the social cost of pollution- offers too grim a picture and thereby over-predicts the extent of free-riding.
Still, in view of both theory and actual behavior in the last twenty years, it would seem naïve to take declarations of good intent too seriously and to trust non-binding agreements to solve the global warming problem. How do we know whether such voluntary actions will deliver 20% or 80% of what should be achieved?
There is another good reason to take countries’ promises with a grain of salt: Binding agreements are a screening device. Countries that do intend to abide by their promises would benefit from the existence of a binding agreement: Making the agreement binding would not change their policy, and would make it more likely that others abide by their promises. The reluctance of most to even discuss binding agreements should by itself raise suspicion.
Several recent papers (Harstad 2009, Beccherle-Tirole 2010)1 argue that countries will bias their moves so as to extract concessions in future negotiations. Consider a country’s pre-agreement choices (say, pre 2020) that affect its post-agreement (post 2020) marginal cost of abatement. Such moves include green R&D (that affects tomorrow’s technological feasibility set) and the choice of the installed base of polluting equipments (housing and transportation standards, power plant investments, early phasing out of polluting equipments). Let us call these moves “green investments”; green investments have in common that they all decrease the country’s future marginal cost of abatement for any given level of abatement.
Under delayed negotiations, three effects concur to provide incentives against green investments.2 Suppose first that the country has no or low bargaining power in the negotiation, and so the country’s behavior is driven by what it would receive in the absence of an agreement. As is standard from incomplete contracting models, its investment is expropriated in the negotiation and so incentives for investment are low. Furthermore, a “raising one’s rivals’ cost” effect exists if pollution damages are convex: the threat of high pollution tomorrow acts as a Stackelberg-type commitment to force other countries to reduce their own future pollution in the absence of agreement. Third, if, to the contrary, the country has substantial bargaining power in the negotiation, and so the country’s behavior is chosen with an eye on what other countries would get in the absence of an agreement, then the threat of a high pollution in case of negotiation breakdown forces concessions from others. Either way, the incentive not to sink green investments in order to get a better deal in the future negotiation is there.
Pure theory? Certainly not: experience shows that in environmental negotiations, regions or countries with antiquated or high-pollution equipments receive a rather favorable deal to be brought on board. The establishments of the SO2 market in the U.S. and of the CO2 ETS in Europe are two cases in point.3
Thus, with strategic governments, green investments are insufficient and it is not only today’s (pre-agreement) flow pollution, but also tomorrow’s (post-agreement) flow pollution that is increased by the delay in reaching an agreement. Indeed, the flow pollution, despite the reduction brought about by the agreement, might be even higher than what it would have been in a situation where no negotiation is ever feasible.
A perhaps surprising application of these ideas is to regional cap-and-trade initiatives. When an emission-permit system embodies either forward allowances (as for the U.S. SO2 market) or bankable allowances (as was planned in the U.S. Waxman-Markey bill that passed the House, but was rejected by the Senate), it puts property rights on future polluting ability into private hands. It then becomes expensive for the country to retire part of these emission permits after reaching an agreement in the future. Forward and bankable permits thus represent a credible commitment to future pollution and thereby a bargaining chip in future negotiations.
Despite apparent differences (for example on whether prices or quantities should be used to control pollution), economists’ positions by and large are remarkably similar in comparison with opinions expressed more widely in the civil society. I will therefore only touch on the topic to the extent that I feel that economists’ disagreements, while real, seem of second-order importance “in the broad scheme of things”.
Simplifying substantially, one can envision the following design for a good agreement:
Price coherency: the price of carbon should be the same in all countries and industries and should be intertemporally coherent. This rules out sectoral differentiation, and rather calls for environmental taxes, permits and standards to reflect the same price of carbon.
Long-term visibility: there must be sufficient commitment power in the system. The impact of any private deployment decisions (power sector, buildings, transportation, forestry, etc.) spans 20, 40 or more years. So do R&D commitments in the most promising green technologies.
Incentive-compatible rules: policies must be neutral with respect to entry and phasing-out decisions. For example, grandfathering of emissions beyond the initial stage, new permits for entrants, or the loss of permits in case of plant shutdown are to be avoided.
Single accord: sectoral negotiations make it unlikely to even come close to the price coherency objective as carbon prices will be influenced by specific lobbies differentially across industries. The proponents of sectoral agreements argue that breaking up the problem in multiple pieces may facilitate negotiations. I am not sure, however, it would do so, for two reasons: first, one would need to reach N international agreements instead of one; second, industry lobbies are even more powerful in sectoral negotiations than in a global negotiation, where some free-riding in lobbying is to be expected.
As for the choice of instrument, a wide post-Weitzman (1974) literature has investigated the trade-offs between a carbon tax and cap-and-trade. Political economy considerations matter too, pushing in my opinion slightly in the direction of the cap-and-trade solution4:
Verification is easier under cap-and-trade: under a permits system it suffices to measure a country’s overall emissions, a very reasonable task. With taxes levied on domestic sources, one must verify that taxes are actually collected and not undone (it would obviously be easier to ask the country to pay a tax on its pollution, a solution akin to the purchase of permits; but see the fourth bullet point below).
Sometimes legal reasons make it easier to agree on a cap-and-trade system. This was indeed a very relevant argument in Europe, in which bizarrely a qualified majority is required for setting up a cap-and-trade system while unanimity is required for setting up a uniform tax.
Cap-and-trade can be set for the long term, while taxes are usually revised annually (although this need not be the case).
The allocation of permits is often an easy, and politically less visible way to operate compensation. We will return to this point later on.
As I said, I feel that economists’ disaccord on the choice between taxes and permits, while it will require further attention when the international negotiation is put back on track, is in the current situation of second-order importance. Note, though, that these disagreements among economists have been misused by interest groups that oppose placing any price on GHG emissions.
Let’s envision a cap-and-trade approach for instance (most insights carry over to a carbon tax scheme). Such a design could build on the following principles:
Target setting: A global pollution target path is elaborated. Adjustments to this path to account for future realizations of uncertainty about the speed of technology accrual, scientific knowledge about climate change or societal and economic demand, can be envisioned and an adjustment process specified.5
Accountability: As in a standard ETS, each country is allocated permits and must buy new ones on the world market if it pollutes more than the number of these permits (sells permits if it has an excess number of permits).
Subsidiarity: Each country chooses its own domestic CO2 policy. This point is potentially controversial. The rationale for subsidiarity is two-fold: First, only the total CO2 pollution of a country matters for other countries, and not the distribution of this pollution among sources within the country. Second, an international agreement must get governments on board; giving them some flexibility as to the policy that they will implement may reduce their reluctance to sign a binding agreement.
But an approach respecting the subsidiarity principle has its own caveats. Interest group politics are likely to lead to deviations from the price coherency principle.6 One might respond to this by saying that the absence of cost minimization is the country’s own business; however, costly abatement policies make it less credible that the country will abide by its commitments over time. Second, permits might go into the hands of corrupt governments in some instances. These caveats should be borne in mind, but I still feel that subsidiarity has its merits.
Enforcement: Enforcement is a very difficult topic and a weak point of all proposals, including this one. The Kyoto protocol specified non-credible penalties, to little effect.
It is easy to see why the enforcement problem is a complex one. When a country violates the WTO rules, it faces potentially costly retaliation measures or even the possibility of outright exclusion. Being excluded from free trade is undesirable for most countries. In environmental matters, there is no such natural “collateral”; being excluded from an environmental agreement ceteris paribus only benefits the country, which can then free-ride on the others. A few standard measures may help induce compliance, though:
The distribution of permits should be progressive and conditional on the country’s compliance with the agreement; in case of deviation, permits are to be withheld.
As has been much discussed, WTO sanctions could provide countries with an incentive to comply.
Naming and shaming could be used to create some domestic and international pressure on the country’s government.
Monitoring indebtedness and treating commitments as sovereign debt: Countries may fall behind in the timing of their permits repurchase or sell too many permits in the futures market; they may not honor their hedging commitments. Countries’ commitments should be counted and treated as national debt. This implies that the IMF should have a role in the international governance of climate agreements.
Collaborative innovation: It is now well-acknowledged that climate change mitigation will require substantial progress in green technologies, and that carbon pricing provides an incentive for green innovation. It is also well-understood that, for the standard spillover reason, incentives provided by carbon pricing are insufficient and so another instrument is required. To correct two market failures (pollution externalities and R&D spillovers), one needs two instruments (carbon price and R&D subsidy).7 The issue with subsidies to non-appropriable R&D investment is the same as for pollution: the incentive to free-ride is substantial.8 This in turn raises the issue of how to organize international R&D consortia like ITER.9 Negotiations (on who should contribute and on the location of R&D facilities), and the securing of sustained funding and governance are complex issues. One must draw the line between true R&D subsidies and lavish subsidies to make current generations of green technologies commercially viable. To take but one example, the subsidy for solar in Pennsylvania is presently somewhere between $650 and $1,000/MWh when one takes all state and federal subsidies into account. That’s 15 to 20 times the market price of electricity in PJM and implies a very high price per ton of CO2 displaced. Similarly, solar subsidies in Germany can reach 1,000 Euros per avoided CO2 ton for a market price of a ton of CO2 around 15-20 Euros.
A country will get on board if its welfare (or at least that internalized by their governments) when joining the agreement exceeds that of staying outside the agreement. The former, studied in this section, depends on the nature of the agreement as well as on compensation for joining the agreement. The latter, analyzed in the next section, depends on the signatories’ pollution targets and the policies, such as Border Tax Adjustments (BTA) and the Clean Development Mechanism (CDM), that are applied to non-signatories.
Pareto improvements are unlikely to come about if the winners do not compensate the losers. In the context of climate change negotiations, which until recently have put too little emphasis on the design of compensation, two questions come to mind:
How should transfers be operated?
Who should receive transfers?
Starting with the first question, a broad support has emerged in favor of a green fund that would collect contributions and redistribute to specific countries. Historically, though, most of redistributions associated with environmental reforms have come in the form of an allocation of tradable permits. Examples include the SO2 market set up in the U.S. in 1990, and the CDM and European ETS markets designed in the wake of the Kyoto protocol.
In theory, there should not be much difference between transfers in cash and in kind. After all, permits have a market price, which can be used to compute the underlying transfers. In practice, though, side-transfers through permit allocations seem to raise less controversy in the public opinion than direct transfers. Few inhabitants of Massachusetts became aware of the large transfers of money involved in the grandfathering of emissions in the 1990 design of SO2 markets. Similar observations can be made concerning the ETS system in Europe and the hot air permits awarded to Eastern Europe and Russia by the Kyoto protocol. By contrast direct budgetary transfers to foreign countries, which are perhaps less abstract than transfers of permits, tend to raise an outcry in the population; indeed this is one of the reasons why aid to development is so meager and why international promises to fund good causes are not always kept. It is unclear whether the plans of building up a sizeable green fund will peter out.
Second, who should receive compensation? Detailed computations require models and lie way beyond the scope of this paper. At best can I offer a few guidelines as to how to proceed. There will in general be a trade-off between two objectives: that of bringing countries on board (RealPolitik) and fairness. Unfortunately, these objectives may not be aligned. First, a rich country with a cold climate (Russia, Canada say) will show little eagerness to reach a climate change agreement, when climate change actually benefits it in the short and medium run; by contrast a poor country in Sub-Saharan Africa will be more eager to reach an agreement. Second, bygones are bygones, and arguments concerning previous carbon-intensive consumption or bad behavior since the Kyoto protocol are unlikely to sway countries on which the finger is pointed.
If Africa can probably be set aside for a special deal, it is still the case that the proposal of India (and others) to base the agreement on an equal per capita level of emissions, while ethically appealing, actually goes against the interests of developing countries. The latter indeed will be hurt by the refusal of rich countries to join the agreement. These examples show that pragmatism must be given more weight, and that pie-in-the-sky schemes, while often well-meaning, can prolong the waiting game with disastrous consequences for developing countries.
RealPolitik unfortunately tends to favor countries with high abatement costs (which, returning to the theme of section 2 may reflect a low willingness to install carbon-light equipments and to phase out carbon-intensive ones) and countries that will bear little impact of climate change.
Let us return to the other side of the equation: making free-riding on an international agreement less attractive and inducing countries to negotiate a binding agreement. This section briefly comments on two central and controversial mechanisms: the Clean Development Mechanism and Border Tax Adjustments.
The Kyoto Protocol allows “rich countries” (those in Annex 1 of the Kyoto protocol) to apply credits obtained in participating emerging countries toward fulfilling their carbon-abatement commitments. For example, a European company can participate in a project reducing carbon emissions in China and claim certified emissions reduction credits in the form of permits in the European ETS.
The CDM has two clear benefits:
It provides aid to developing countries.
It is market based: the payoff to abating pollution in emerging countries is indexed on the price of carbon in more developed ones.
On the other hand, it has a number of important drawbacks:
It ignores general-equilibrium (leakage) effects. Suppose a project rewards reduced deforestation in an emerging country. The world price of wood, soy, or whatever was harvested following the deforestation then goes up slightly, raising incentives everywhere else in the same country or in the world to engage in deforestation. All in all, the project has no marginal effect on emissions. Only a global approach can have large effects.
It imposes high-transaction costs. Indeed, a project is approved only if it makes a difference (assuming no leakage …). This “additionality” criterion requires contemplating, and answering negatively a counterfactual: would the abatement have taken place in the absence of CDM incentives? It is in general difficult to answer this question. Neither is it obvious how to apply the criterion to new projects: if we do, a wasteful clean project could become profitable thanks to the CDM subsidy, received on the grounds that the alternative variant is dirty (rather than the alternative project is “no project at all”).
Relatedly, a country may refrain from enacting environmental regulations, because various domestic projects would then lose their additionality feature.
Finally, the CDM impacts the countries’ incentive to join an international agreement (see the Appendix). For example, a small emerging country benefiting from the CDM and feeling that the likelihood of an international agreement does not hinge on its participation will accept entering a binding cap-and-trade agreement only if it receives more free permits than its business-as-usual level of emissions; for, under both the CDM and an encompassing international agreement, the country receives a compensation equal to the market price of permits times the difference between a baseline level of emissions and actual emissions. This baseline level is equal to business-as-usual level under the CDM and is the negotiated allowance under an encompassing agreement. The former is likely to be higher than the latter, and so the CDM mechanism is likely to be relatively advantageous to the country. But it may reduce the developed countries’ incentive to reach an agreement, with catastrophic consequences for poor countries.
Finally, economists are rather divided as to whether CO2-intensive imports should be taxed when the exporter does not apply a proper price to CO2 emissions. Similarly, exports toward low-CO2-price countries could be subsidized. I have little to add to the debate, and will just repeat the obvious. The theoretical rationale for BTAs is impeccable: a) they restore a level playing field and solve the leakage problem (but of course they do nothing with respect to the untaxed goods produced and consumed within the group of low-carbon-price countries). b) Unlike the CDM, they put pressure on countries to join an international agreement.
BTAs’ drawbacks are equally well-known. They relate to their implementation rather than to their economic logic. The right level for such taxes is clearly difficult to assess: goods are produced in multiple countries and can be re-exported; their carbon content is often hard to measure; and the shadow price of carbon in a country may be hard to observe if the country relies on regulations rather than on market-based instruments (permit price or carbon tax); similarly the country may be deficient in terms of abatement, but perform well in terms of green R&D. These ambiguities make it likely that BTAs will be used for protectionist purposes more than for their economic virtues. The possibility of manipulation reinforces the case for market-based instruments, which make international comparisons a bit simpler, and it calls for supervision by the WTO or an independent agency. Overall, BTAs are at best a pis-aller, with significant costs to be expected. But again, the devil is in the detail.
In the current state of climate-change negotiations, one should strive at getting the negotiations back on track. Refocusing seems a priority. There is no sure-proof way of doing so, but an approach might include:
Defining a pollution-control policy. Economics offers much guidance about the design of efficient pollution-control policies. Yet, inefficient “command-and-control” approaches and all kind of inefficient patches and technology specific subsidies and mandates are playing a growing role in policy implementation. Similarly, efficiency and redistributive concerns are constantly tangled up. This is an old issue in policy design, and the only alternative consists in bringing compensation design to the center stage of the negotiation. Emission rights should be used to bring reluctant countries on board.
Accounting for pre-and post-agreement gaming. Contrary to generous statements aimed at placating domestic and international opinion, one should expect substantial gaming during the transition. Neither should we fully trust the credibility of an international agreement. The fields of history, political science and political economy have largely demonstrated the utmost relevance of national interests, and there is no reason why they should not be dominant in the context of climate change. While any agreement must build on a minimum amount of trust, one should not shun constructing binding commitments and designing institutions that will make it more likely that countries abide by their pledges.
Accordingly, countries could agree on some short-term actions as well as a process for future negotiations. Such a process could include:
an agreement on a good governance:
a path for global CO2 emissions
a worldwide CO2 market
a sketch of an international governance, including an enforcement mechanism, carrots and sticks,
the phasing out by 2015, say, of inefficient policies such as the CDM, regardless of whether an agreement is reached by then,
the launch of a satellite emissions tracking system enabling to measure precisely the evolution of emissions at the country level,
a negotiation process for the design of compensation and remaining issues.
This roadmap leaves a number of questions open. We have discussed some of these, but others come to mind. For instance, given that negotiations involving close to 200 countries are rather inefficient, it would seem desirable to first reach an agreement among the big (current and future) emitters, who would then gently coerce the other countries into doing their share. In this two-step process, we could start with an agreement between (say) the U.S., the EU, China, Russia, Brazil, Canada, Japan, Australia, India, etc. (the big emitters) and gradually induce the smaller emitters to join over a period of time (perhaps using border adjustments if push comes to shove)?
But while defining such a process would be no substitute for a real agreement, the more modest refocusing of the discussion on a narrower and efficient set of policies would already be a big success in the current context.
Acemoglu, D., P. Aghion, L. Burstyn, and D. Hemous (2010). “The Environment and Directed Technical Change.” Forthcoming, American Economic Review.
Beccherle, J. and J. Tirole (2010). “Regional Initiatives and the Cost of Delaying Binding Climate Change Agreements.” Forthcoming, Journal of Public Economics.
Ellerman, D. and P. Joskow (2008). “The European Union's Emissions Trading System in Perspective.” Pew Center on Global Climate Change.
Ellerman, D., Buchner, B., and C. Carraro, ed. (2007). Allocation in the European Emissions Trading Scheme: Rights, Rents and Fairness. Cambridge: Cambridge University Press.
Ellerman, A.D., P.L. Joskow, R. Schmalensee, J.P. Montero, and E.M. Bailey (2000). Markets for Clean Air: The U.S. Acid Rain Program. Cambridge: Cambridge University Press. http://dx.doi.org/10.1017/CBO9780511528576.
Harstad, B. (2010). “Incomplete Contracts in Dynamic Games.” Mimeo, Northwestern University.
Consider a global agreement setting up a uniform carbon trading system with resulting market price p. Ideally the price of carbon p is derived from a desired worldwide emission target n. Let ni et Ci (ni) be the corresponding pollution and production costs in country i.
Ci (ni) is necessarily decreasing and convex in the level of pollution ni (permits help reduce abatement costs; convexity as usual comes from the fact that additional permits substitute for cheaper and cheaper forms of abatement). Last, let Di (n) denote country i ’s damage cost associated with world emissions n (for most countries this damage is positive and increasing, but it may be negative and decreasing for a country that benefits from global warming).
Suppose that if country i decides not to join the worldwide agreement, it will adopt an emission level (“BAU” refers to “business as usual”). Evaluating the impact the decision of staying out of the agreement will have on the agreement itself is a crucial issue for country i. Let n′ be the expected global pollution when it does not participate. Two polar cases can be considered:
Country i is “pivotal” in that the agreement fails if it does not join. Then n′= nBAU, worldwide emissions are at their business-as-usual level, equal to the non-cooperative equilibrium level.
Country i is “non-pivotal”, perhaps because it is small on a worldwide scale. Then the worldwide level of ambition remains n′=n despite country i 's non-participation.
Generally, the country can expect some intermediate situation between these two polar cases, except perhaps for small countries which should be non-pivotal (small countries however might be coerced by a larger ally or neighbor countries).
In a first step, we ignore the CDM program. Country i has utility:
where denotes the number of free permits. Country i participation constraint imposes that the level granted to country i satisfy:
Put differently, the market value of country i ’s permit surplus (or deficit) plus its incremental environmental damage due to its refusal to join the agreement must exceed the additional abatement cost from its joining the worldwide agreement.
The sum of emission permit entitlements over all countries is equal to the sum of used permits ni over all countries, i.e. actual pollution n (so, permits in use are equal to granted permits). Because the agreement produces a worldwide surplus, the summation of the participation constraints brings about 2 simple remarks:
Pareto improvement: if all countries (or at least the important ones) feel they are pivotal, there exist allocations of permits such that it is in the interest of every country to join the agreement (benefits from a global agreement exist10);
If all countries (or at least the largest emitters) feel they are not pivotal, no worldwide agreement can be reached.
The second remark (which is a mere reinterpretation of the free rider problem) shows how interesting conditionality can be. Without a sufficient amount of conditionality or “pivotality” (which arises when n′ is close to, or equal to n), there is no possible agreement.
Let us now introduce the CDM mechanism. Suppose that it applies to every economic activity in emerging country i (which currently is not the case, but it may be relevant to consider this polar case after focusing on the other polar case, namely that without CDM). Assume that the emissions target n (and so the permits’ price p in Annex 1 countries) remains unchanged, but that the CDM mechanism induces Annex I countries to buy credits from emerging countries. Emerging country i then receives permits.11
Emerging country i 's welfare is then
from the convexity of the cost function; the country is clearly willing to join the agreement and benefit from the CDM, even if it is not pivotal. The CDM amounts to a) entitling emerging countries with (giving them a number of permits equal to) their business-as-usual pollution levels, and b) disposing of the country’s participation constraint.
The rich countries’ participation condition on the other hand becomes harder to satisfy provided that emerging countries receive fewer permits in the absence of CDM than their business-as-usual pollution , as is likely to be the case.
Returning to the no-CDM case, the smallest number of permits needed for country i to join the international agreement is clearly higher if the country does not consider itself pivotal or, if it feels pivotal, if it does not suffer too much from global warming.
Assume next that its cost function is indexed by some parameter θ : Ci (ni ,θ), where an increase in θ raises the country's marginal cost of abatement, or equivalently its demand for tradable permits:
For instance, an increase in θ might represent a more polluting power sector or a higher GDP (raising the demand for permits). Alternatively, it could stand for fewer past investments in green technologies (see section 2): Early abatement efforts can be viewed as a truncated cost function Ci (ni) at some point Using the envelope theorem, the country must be granted more permits when θ grows:
2 See also the comparative statics in the Appendix.
4 None of these arguments is “overwhelming”; but all together they reinforce the case for cap-and-trade.
5 Creating scope for adjustments raises questions about the commitment to the scheme. See Laffont-Tirole (1996a, b) for an incentive compatible mechanism that trades-off the need for flexibility and the potential incentive to flood the market with new permits.
6 Or to imply a series of inefficient or unfair concessions along the way. A case in point is the Waxman-Markey bill voted by the U.S. Congress in 2009. Its 1426-page long text went way beyond what was needed to create a cap-and-trade system for CO2!
8 Even if R&D is appropriable, there is as much free-riding on green R&D as on emissions as long as a binding agreement is not in place (and when they are in place, the extent of free-riding on R&D depends on how long-lasting agreements are: see Harstad 2009).
9 ITER stands for ”International Thermonuclear Experimental Reactor”.
10 This follows from an implication of a globally optimal choice of pollution:
11 This is an obviously crude description of the CDM. For example, one of the criticisms of the CDM is that the additionality criterion is hard to implement. Some switches to less polluting technologies would occur even under a business-as-usual scenario, and yet be counted as giving rise to a permit allocation. Also, we assume that the CDM is effective, i.e. does not create leakage.