KYOTO IN QUESTION:

A NORTH-SOUTH-OPEC MODEL OF FOSSIL-FUEL USE AND GREENHOUSE-GAS EMISSIONS

JAMES GAISFORD* AND JULIA SAGIDOVA**

Draft: Do not cite or quote without permission. Comments and suggestions are welcome.

ABSTRACT: This paper assesses the environmental efficacy of the Kyoto Protocol on climate change. On the theory side, we present an elegant four-sector North-South-OPEC model of the world economy where fossil fuel use leads to greenhouse gas emissions. Kyoto-style commitments, which reduce the North’s emission cap but do not constrain the South, tend to cause increases in global emissions as dirty good production is displaced from the relatively clean North to the dirtier South. When Southern firms can sell emission credits to Northern firms as allowed under the Clean Development Mechanism, further increases in world emissions will occur if the South initially uses a sufficiently small proportion of world fossil fuel. Our empirical analysis adds sector control variables to environmental Kuznets curve regressions for CO2 emissions. The empirical results strongly support our theoretical premise that high-income countries adopt less emission intensive production techniques in each sector and, thus, are cleaner than low-income countries. We also find evidence of surprising emissions intensity reversals whereby manufacturing, which is initially more emission intensive than agriculture or services, becomes less emissions intensive at per-capita incomes in the range of 15,000 USD. In empirical simulations these emission intensity reversals lead to a provocative positive assessment of the outcome of Kyoto. As developed countries adopt a greater proportion of manufacturing activity than would otherwise be the case so as to meet their emission reduction targets, developing counties would be induced to put greater emphasis on agriculture and/or services, which for most of them are cleaner activities. JEL Codes: F10, F12, F18 * Corresponding Author: James Gaisford, Department of Economics, University of Calgary, 2500 University

Drive N.W., Calgary, Alberta, Canada T2N 1N4. E-mail: gaisford@ucalgary.ca. Telephone: 1-403-220-3157. Fax: 1-403-282-5262,

** Julia Sagidova, Department of Economics, University of Calgary, 2500 University Drive N.W., Calgary, Alberta, Canada T2N 1N4.

— 1 —

KYOTO IN QUESTION: A NORTH-SOUTH-OPEC MODEL OF FOSSIL-FUEL USE AND GREENHOUSE-GAS EMISSIONS

ABSTRACT: This paper assesses the environmental efficacy of the Kyoto Protocol on climate change. On the theory side, we present an elegant four-sector North-South-OPEC model of the world economy where fossil fuel use leads to greenhouse gas emissions. Kyoto-style commitments, which reduce the North’s emission cap but do not constrain the South, tend to cause increases in global emissions as dirty good production is displaced from the relatively clean North to the dirtier South. When Southern firms can sell emission credits to Northern firms as allowed under the Clean Development Mechanism, further increases in world emissions will occur if the South initially uses a sufficiently small proportion of world fossil fuel. Our empirical analysis adds sector control variables to environmental Kuznets curve regressions for CO2 emissions. The empirical results strongly support our theoretical premise that high-income countries adopt less emission intensive production techniques in each sector and, thus, are cleaner than low-income countries. We also find evidence of surprising emissions intensity reversals whereby manufacturing, which is initially more emission intensive than agriculture or services, becomes less emissions intensive at per-capita incomes in the range of 15,000 USD. In empirical simulations these emission intensity reversals lead to a provocative positive assessment of the outcome of Kyoto. As developed countries adopt a greater proportion of manufacturing activity than would otherwise be the case so as to meet their emission reduction targets, developing counties would be induced to put greater emphasis on agriculture and/or services, which for most of them are cleaner activities. JEL CODES: F10, F12, F18

— 2 —

1. INTRODUCTION

This paper presents both a theoretical and empirical assessment of the environmental efficacy of

the Kyoto Protocol on climate change. There is now overwhelming scientific evidence of

climate change, strong evidence that human economic activity may be a significant contributing

factor and mounting evidence that the changes in climate will cause economic effects that are

generally negative and often substantive.1 Against this backdrop, policy action addressing

climate change appears to be reasonable, if only on precautionary grounds. Although

greenhouse gas (GHG) emissions are a negative public good warranting coordinated global

policy action, the theoretical model developed in this paper suggests that the Kyoto agreement is

seriously flawed. Not only are there problems with the basic structure of the accord, which lacks

constraints on developing countries, but also with the so-called “Clean Development

Mechanism” or CDM, which allows firms in unconstrained developing countries to sell emission

credits. Kyoto-style commitments, which reduce the North’s emission cap but do not constrain

the South or OPEC, strongly tend to lead to increases in global emissions because the reduction

in fossil fuel use in the “cleaner” North is more than offset in the “dirtier” South. Paradoxically,

the theoretical model suggest that if Northern countries such as the US do not make

commitments or countries such as Canada fail to fulfill their commitments, the increase in world

emissions becomes smaller. When firms in the South can sell emission credits to Northern firms

as allowed under the CDM, there will be further increases in world emissions if the South-OPEC

region initially uses a sufficiently small proportion of world fossil fuel. Emission credits

indirectly subsidize fossil fuel use in South, which may lead to an increase in world emissions.2

While our theoretical model indicates that the Kyoto Protocol may fail the most

fundamental litmus test of reducing global GHG emissions, our empirical analysis paradoxically

suggests that fortuitous emissions intensity reversals could come to the rescue. There appears to

be very strong empirical support for our premise that rich capital abundant countries adopt

cleaner production techniques, mainly by engaging in fossil fuel-saving investment. The

— 3 —

empirical evidence also suggests that, while the manufacturing sector is dirtier than agriculture or

services at the per-capita income levels of most developing countries, surprisingly the reverse

appears to be true at the per capita income levels of most developed countries. Because of these

emission intensity reversals, the empirical outcome of Kyoto could be mutually favourable. As

developed countries adopt or, more aptly, retain a greater proportion of manufacturing activity

than would otherwise be the case so as to meet their emission reduction targets, developing

counties would be induced to put greater emphasis on agriculture and/or services. Consequently,

each group of countries expands its relatively clean sector.

This paper introduces an elegant four-sector North-South-OPEC model of the world

economy where fossil fuel use leads to GHG gas emissions. While the model follows in the

general-equilibrium tradition of assessments of international trade and the environment,3 the

structure of this model is of particular interest. The world economy is comprised of two principal

regions, North and South, with the latter further divided into OPEC and non-OPEC sub-regions.

While OPEC shares most key features with the rest of the South, its abundant natural resource

endowment allows it to set the world price of fossil fuel above the competitive level. There are

two intermediate goods, fossil fuel and electricity, and two final goods, one dirty and the other

clean. Fossil fuel and both final goods are freely traded, but electricity is non-tradable. All four

sectors use labour and capital, and there is a natural resource that is specific to the fuel sector.

Fossil fuel and electricity are used by households and by all sectors except the clean sector.

While all fossil fuel using activity causes GHG emissions, fuel-saving investment is possible.

Figure 1 outlines the sectoral structure of production in the world economy.

[Insert Figure 1 about here]

While we assume that there is an underlying technology that is common to all regions,

our model takes a long-run perspective where capital is supplied (perfectly) elastically. North is

assumed to have a lower user-cost of capital than the South, say due to a lower risk premium.

North’s lower user cost is equivalent to a general technological advantage, which is more

pronounced in capital-intensive activities, including fuel saving. Lower capital costs in the

— 4 —

North, thus, lead to greater fuel saving than the South. Since the two regions will then have

different emissions intensity, shifting the production of dirty goods from North to South in

response to Kyoto agreement tends to cause greater world emissions.

In the initial pre-Kyoto situation we assume that North has at least an indirect cap on

overall GHG emissions. If there were also an exogenous emissions cap in South, then the

success of Kyoto-style reductions in North’s emissions cap would be automatic. World

emissions would fall on a one-for-one basis with reductions in the North’s cap. If the South’s

cap were endogenous and determined through a policy game, then the possibility of carbon

leakage through increased free riding looms as a possible issue (Hoel, 1991). As in Copeland

and Taylor (2005), favourable income effects, at least in theory, may also lead to a tighter cap

and endogenous reductions in South’s emissions. The possibility of free riding appears to

understate the potential for carbon leakage under the Kyoto Protocol. Suppose that at initial

income and consumption levels, South’s marginal benefit from the abatement of GHG emissions

is less than the marginal cost of abatement with given Northern emissions and its own emissions

completely unrestrained. Then, rather than an internal solution to the policy game, which is

assumed in much of the literature, there would be a boundary solution with zero fuel-saving

investment in South. On theoretical as well as empirical grounds, therefore, the notion that the

counties of the South have effective endogenous or exogenous cap appears highly problematic.

Consequently, our theoretical model assumes that there are no effective direct or indirect

environmental controls on GHG emissions in the South such that its pre-Kyoto emissions price is

equal to zero. Since the North’s emissions price will typically be positive, there is a further

incentive for more fuel-saving investment in the North than the South.

While there have been many detractors,4 some of the theoretical literature has been

relatively sanguine about the Kyoto Protocol. In an important paper, Copeland and Taylor

demonstrate that “unilateral emission reductions by the rich North can create self-interested

emission reductions by the unconstrained poor South” (2005, 205) if the positive income effects

in the South are sufficiently strong. Nevertheless, this endorsement of Kyoto is highly

— 5 —

conditional. Implementation of policies such as international permit trade, which in other

contexts might be broadly beneficial, may be mutually immiserizing and lead to increased

emissions. In Copeland and Taylor’s (2005) Kyoto model factor price equalization arises

because the technology is uniform worldwide and all regions including the South have

endogenous emissions caps, which can be likened to factor endowments. Consequently, even in

the absence of international permit trade, there is a fully efficient world equilibrium with equal

emissions prices. Consequently, all countries adopt the same production techniques and sector

emission intensities are uniform across countries. This is important for Copeland and Taylor

(2005) and contrasts sharply with the theoretical model we develop. If there are only dirty and

clean goods, and not dirty and clean countries, then shifting the production of dirty goods from

North to South in response to Kyoto would not tend to lead to greater world emissions.

To investigate the degree of support for our model versus that of Copeland and Taylor

(2005), we introduce sector variables controlling the value-added mix of the economy to

otherwise conventional environmental Kuznets curve regressions. The empirical evidence

strongly suggests that there are clean and dirty countries as well as clean and dirty goods. With

the exception of agriculture, marginal sector CO2 emissions intensities eventually decline as per

capita income increases. Overall, strong environmental Kuznets relations persist despite the

introduction of sector control variables. Nevertheless, the introduction of sector controls does

help to resolve why support for inverted “U” Kuznets relations for CO2 emissions has been much

weaker for predominantly agricultural developing countries than for developed countries (for

example, see Schmalensee et al., 1997; Holtz-Eakin and Selden, 1995; and Dinda, 2004). Given

that countries with low capital costs accumulate more capital and become high-income countries,

our empirical finding that emissions intensities decline as per capita income increases dovetails

nicely with our theoretical model. The empirical finding that agriculture and services become

more emission intensive than manufacturing at per-capita incomes in the order of 15,000 USD

per annum, however, opens up the possibility of unanticipated favourable outcomes from Kyoto.

— 6 —

2. A THEORETICAL MODEL OF TRADE, FOSSIL FUEL USE AND EMISSIONS

2.1 Foundations

We construct four-sector model of the world economy where the use of fossil fuel leads to GHG

emissions. Reductions in emissions are possible through investment in a fuel-saving technology,

but costly. We assume that there are two regions indexed by g consisting of North, N, and South,

S. South is further divided into, OPEC and non-OPEC sub-regions denoted by S1 and S2

respectively. There are four outputs indexed by j: a clean good, C; a dirty good, D; electricity, E;

and fossil fuel, F. Since electricity will be assumed to be non-tradable, electricity prices will

differ across countries such that

!

pEN" pE

S . For clean goods, dirty goods and fossil fuel, which we

assume are freely traded, the domestic price in each country will be equal to a common world

price where

!

p j

N= p j

S= p j

W . Further,

!

pCW

=1 given that the clean good is chosen as the numeraire.

Inputs, which are indexed by i, consist of intermediate goods and the services of standard

factors of production. In addition to being consumed by households, fossil fuel and electricity

are used as intermediate inputs in the production of dirty goods, electricity and fossil fuel. The

standard factors are: labour, L; capital, K; and a natural resource, R. While capital and labour are

used in the production of all goods, the natural resource is a specific factor used only in the

production of fossil fuel. As is standard in much of the literature, emissions, M, can be likened

to an additional factor of production (Copeland and Taylor, 1995, 2005). GHG emissions arise

wherever fossil fuel is used. The use of fossil fuel by households, and in the production of

electricity and final goods is intended to capture major sources of GHG emissions from

transportation, electrical generation and industry respectively. In addition, the use of fossil fuel

in producing fossil fuel helps to account for increasingly emission-intensive activities such as oil

sands production in the energy sector itself. While for clarity and tractability we follow the norm

in much of the literature by assuming that the clean good leaves no environmental footprint, our

empirical analysis will later show that this assumption is more restrictive than is often thought.

In the current setting, the clean good does not produce emissions either directly through using

— 7 —

fossil fuel or indirectly through using electricity. Figure 1, summarizes the input-output structure

of the world economy.

Each sub-region is endowed with a natural resource,

!

Y Rg , which is a specific factor used

in the production of fossil fuel. For simplicity, we abstract from natural resource depletion

issues by assuming fixed reserves of the resource. The North and the non-OPEC South behave

competitively on the world fossil fuel market and, thus, fully utilize their natural resource

endowments. In contrast, OPEC sets a binding minimum price for fossil fuel,

!

pF

W= p F

S1, which is

above the competitive equilibrium level, by limiting the use of its natural resource endowment.

While setting the world price of fossil fuel is OPEC’s signature role in the model, it is assumed

to be similar to the non-OPEC South in all other respects.

While labour and the natural resource are assumed to be conventional factors of

production with fixed endowments, we take a long-run approach where the supply of capital is

perfectly elastic.5 We assume that the user cost of capital in South lower in than North, say due

to a lower risk premium:

!

pKS

> pKN . (1)

While the technologies per se are the same across countries, the lower user cost of capital in

North is equivalent to a technological advantage that becomes more pronounced in capital-

intensive activities. At equal emissions prices, therefore, North has an advantage in the dirty

good, which we assume to be more capital intensive than the clean good.

Emissions prices, however, are not likely to be equal. In contrast to Copeland and Taylor

(2005), we assume an initial corner solution in emissions policies where there are no overall caps

on GHG emissions in South, but the North has at least an indirect cap on its GHG emissions,

which is denoted by

!

Y M

N .6 While in general

!

pMN" 0 , the imputed price of emissions is likely to

be positive in North as a result its cap. Since firms in South do not have to pay to emit, the pre-

Kyoto emissions price in South is equal to zero. Although the Clean Development Mechanism

(CDM) of the Kyoto agreement introduces the possibility of credit market integration, there are

— 8 —

likely to be political as well as economic constraints on credit market transactions. The

European Union and many environmental groups argued against the CDM and remain suspicious

of it. Consequently, much of our focus will be on small increases in the degree of credit market

integration in the vicinity of an initial pre-Kyoto situation.

2.2 Emissions and Fuel-Saving Investment

On the one hand, each unit of fossil fuel used, whether in production or in household

consumption, is assumed to always generate one unit of emissions regardless of the particular

use or scale of that use. This appears to be a reasonable simplification of reality because the

direct abatement of GHG emissions appears to have been of limited importance to date, as our

empirical analysis will confirm later. On the other hand, we will allow emissions to be reduced

indirectly through investment in an auxiliary fuel-saving technology, which is assumed to be

uniform across regions and common to all fuel uses including household consumption. In

particular, if

!

1"µg actual units of fossil fuel are combined with

!

" µg( ) units of capital in region

!

g , then one efficiency unit of fossil fuel will be obtained, where:

!

" 0( ) = 0 ,

!

" 1( )#$,

!

"# $( ) > 0 ,

!

"## $( ) > 0. (2)

Consequently,

!

µg represents the fuel saving associated with obtaining one efficiency unit of

fossil fuel. Further, in the absence of any capital invested in the fuel-saving technology, one

actual unit of fossil fuel can be used to obtain one efficiency unit. So-called standard production

and consumption processes will subsequently be defined with respect to the number of efficiency

units of fossil fuel that they use. While our formulation of the fuel-saving technology as

exclusively reliant on capital is somewhat extreme, fuel saving is typically a very capital-

intensive activity.

The opportunity cost of using an efficiency unit of fossil fuel in the North,

!

"N , includes

spending on

!

1"µN actual units of fossil fuel and the associated emissions permits plus

expenditures on the fuel-saving technology:

— 9 —

!

"FN = 1#µN( ) pFS1 + pM

N( ) +$ µN( )pKN . (3)

The opportunity cost of an efficiency unit of fossil fuel in the South,

!

"S , is different because

firms in South do not pay to emit but they may receive credit revenue from reducing their GHG

emissions and, thus, their fossil fuel usage below a business as usual baseline. If we let

!

µ S

represent the business-as-usual fuel saving in South, then the fuel saved beyond this level,

!

µS"µ S , is potentially available to be sold as credits to Northern firms at a price of

!

pMN . The

level of fuel savings that is eligible to be sold as credits, however, is constrained to be less than

or equal to

!

" . Given that we must also impose a non-negativity restriction, the credit revenue

associated with a standardized unit of fossil fuel can be written as

!

max min µS"µ S ,#{ },0{ }pMN .

Consequently, the resultant opportunity cost of an efficiency unit of fossil fuel in South is:

!

"FS = 1#µS( )pFS1 +$ µS( )pKS #max min µS#µ S ,%{ },0{ }pMN . (4)

From the standpoint of individual firms, the business as usual fuel saving,

!

µ S , is parametric.

Firms minimize the opportunity cost of fossil fuel by choosing the level of fuel saving to

equate the marginal cost and marginal benefit. The first-order condition, which always applies in

North and also applies in South when credits are unconstrained, is:

!

p FS1 + pM

N = pK

g"# µg( ),

!

g = N,S . (5)

A region’s fully optimal fuel-saving level is an increasing function of

!

p FO + pM

g( ) pK

g , the price

fossil fuel plus emissions relative to capital:

!

µg = µ" p FS1+ pM

N( ) pK

g( ) ,

!

g = N,S ; where:

!

µ" 0( ) = 0,

!

µ"# $( ) =1 # # % $( ) > 0 . (6)

For the most part, we heroically assume that the business-as-usual baseline level of fuel-savings

by South and OPEC has a solid economic foundation and, thus, is equal to the constrained

optimum fuel-saving level for the case where there is no integration of emissions markets. With

!

" = 0, the first-order condition for minimizing the opportunity cost of fossil fuel in South would

be

!

p FS1 = pK

S"# µS( ) yielding the business as usual baseline:

!

µ S = µ" p FS1

pK

S( ) . (7)

— 10 —

For discussion purposes, we will assume that

!

p FS1 > pK

S"# 0( ) so that

!

µ S is strictly positive and

firms in South, as well as North, employ the fuel-saving technology to some extent.

When the emissions credit constraint is binding, the level of fuel saving selected by firms

in the South is equal to the business as usual level plus allowable credits:

!

µS = µ S + " = µ# p FS1

pK

S( ) + " , whenever:

!

0 " # " µ$S%µ S . (8)

In an initial pre-Kyoto situation where

!

" = 0 and emission credits are completely absent, the

business-as-usual level of fuel savings prevails. If the emissions credit constraint is gradually

eased allowing greater degree of integration of emissions markets, fuel savings in South rises

gradually. Eventually

!

" if is increased beyond

!

µ"S #µ S , the constraint becomes non-binding

and actual fuel savings remain at

!

µS = µ"S .

Figure 2 consolidates some intuitive but important results, which follow immediately

from the fact that capital and thus fuel-saving is less expensive in North.

Proposition 1. The fuel-saving level in North exceeds the fully optimal level in South, which in

turn is greater than or equal to the actual level in South, which finally is greater than the

business-as-usual level in South.

Since the user cost of capital is higher in South than North, it has a higher marginal cost of fuel

saving and a lower fully optimal level of fuel saving,

!

µ"S < µ"N , as shown in Figure 2. The

lower marginal benefit in the business-as-usual versus fully optimal case in South implies that

!

µ S < µ"S or that its business as usual fuel savings are less than its fully optimal emissions.

[Insert Figure 2 about here]

Substituting equation (5) into (3) and yields the optimum opportunity cost function for an

efficiency unit of fossil fuel for North:

!

"F

N = "F

#Np F

S1, pK

N, pM

N( ) , (9)

where:

!

"#F$N " pF

S1= "#F$N " pM

N =1%µN ,

Drawing on equations (4) and (8), we write the South’s constrained opportunity cost function as:

!

"F

S = 1#µ$ p FS1

pK

S( ) # %( )p FS1 +& µ$ p F

S1pK

S( ) + %( ) + %pM

N ' " FS

p FS1, pK

S, pM

N,%( ) . (10)

— 11 —

where:

!

"#F

S "p FS1=1$µS + % & µS( ) $ p F

S1pK

S( )( ) % % & µS( )$1

,

!

"#FS " pM

N= $ ,

!

"#F

S "$ = pK

S%& µS( ) ' p FS1 ' pM

N < 0 .

In the vicinity of an initial pre-Kyoto situation where there are no emission credits, an increase in

the North’s emission price, increases the opportunity cost of fuel saving in North but leaves that

of South unchanged. An increase in OPEC’s fossil fuel price results in a larger increase in the

opportunity cost of fossil fuel use in South than North because South engages in less fuel saving.

Finally, South’s opportunity cost falls by

!

pMN when the constraint on emissions credits is eased

and credit revenue begins to be forthcoming.

2.3 Diversified Production

In a long-run competitive equilibrium, price must be equal to unit cost in each sector.

Consequently, the zero-profit conditions for the three traded goods are:

!

pCW =1= "C pK

g, pL

g( ) ,

!

g = N,S ; (11)

!

pDW = "D pK

g, pL

g( ) + pEgaED + #F

gaFD ,

!

g = N,S ; (12)

!

p FS1 = "F pK

g, pL

g, pR

g( ) + pE

gaFE + #F

gaFF

,

!

g = N,S . (13)

And, for non-traded electricity, we can write:

!

pEg = "E pK

g, pL

g( ) + #FgaFE( )$EE ,

!

g = N,S ; where:

!

"EE# 1$ a

EE( )$1

%1. (14)

Notice that the underlying production technologies use intermediate inputs in fixed proportions

denoted by

!

aij for

!

i = E,F , but they allow substitution between primary factors. Since

!

aFj

denotes the required input of efficiency units of fossil fuel, we emphasize that the auxiliary fuel-

saving technology is implicitly incorporated into overall unit costs through the opportunity cost

functions for fossil fuel use. Given that the clean good is the numeraire, we can solve the zero-

profit condition for the clean sector in each region to determine its equilibrium wage,

!

˜ p Lg . The

Southern wage must be lower than the Northern wage such that

!

˜ p LSO

< ˜ p LN so as to offset the

higher user cost of capital in South and OPEC. Substituting equations (9), (10) and (14) into

(12) yields the following diversified production conditions:

— 12 —

!

pD

W = "F

#NpF

S1, pK

N, pM

N( )AFD + $D pK

N, ˜ p L

N( ) , (15)

!

pD

W = " FS

pF

S1, pK

S, pM

N,#( )AFD + $D pK

S, ˜ p L

S( ) . (16)

where:

!

" j #( ) $ % j #( ) + %E #( )&EEaEj ,

!

Aij " aij + aiE#EEaEj .

Here,

!

Aij denotes the overall use of input

!

i in the production of one unit of good

!

j inclusive of

any use of the input in the underlying electricity required for one unit of traded good

!

j .

The NN and SS curves in Figure 3 are graphical representations of the diversified-

production conditions given by equations (15) and (16) for the North on the one hand and South

and OPEC on the other. The NN curve is upward sloping because a higher Northern emissions

price raises costs and necessitates a higher world price for dirty goods if firms in North are to

continue to break even. In the initial pre-Kyoto equilibrium where firms in South and OPEC do

not participate in North’s credit market because

!

" = 0, the world price of dirty goods that is

required for firms in South and OPEC to break even is independent of the emissions price in

North making the SS′ curve horizontal. A necessary condition for an internal equilibrium is that

the intercept of the SS curves exceeds that of the NN curve or that the unit cost of dirty-good

production in South or OPEC evaluated at the equilibrium wage and a zero price of emissions in

North is larger than corresponding minimum average cost in North.

Lemma 1. Diversified production of clean and dirty goods both in North and in the South is

possible if and only if the production of the dirty good inclusive its underlying electricity is more

capital intensive than the clean good when North’s price of emissions is equal to zero.

A proof is provided in the Appendix. In an equilibrium where both the North and the South are

diversified, North’s more favourable access to capital gives it a latent comparative advantage in

the dirty versus clean good, which is then counterbalanced by the costs of emission permits.

[Insert Figure 3 about here]

The diversification conditions given in equations (15) and (16) can be solved

simultaneously for the world price of dirty goods and the North’s price of emissions.

Consequently, there is an initial equilibrium with diversified production both in North and in

— 13 —

South and OPEC when the world price of the dirty good is

!

pDW " and the Northern price of

emissions is

!

pMN".7 Afterward, it is possible to recover: the fuel-saving levels of North and South

using equations (7) and (9), the price of electricity in each region using equation (15), and natural

resource rents in each region using equation (14).

Proposition 2: Suppose that the North and both the OPEC and non-OPEC sub-regions of South

are diversified and that the South initially engages in some fuel-saving activity. Both the world

price of the dirty goods and the North’s price of emissions are: (2a) increasing in OPEC’s price

of fossil fuel (2b) independent of the North’s emission cap, and (2c) decreasing the degree of

integration of emissions credits.

Table 1 summarizes the comparative static properties that hinge on proposition 2. While formal

elements of the proof of Proposition 2 are provided in the Appendix, the intuition underlying it

can be readily established using Figure 3. A higher price of fossil fuel shifts the NN curve

upward to a lesser extent than the SS curve because the South uses more fuel per unit output of

the dirty good than North. To allow South to break even, there must be an increase in the

North’s emissions price as well as the world price of dirty goods. Natural resource rents rise

because of the higher price of fossil fuel and electricity prices rise because of the higher

opportunity costs associated with fossil fuel use.

Turning to Kyoto-style environmental policy, both diversification curves in Figure 3 are

independent of the North’s emissions cap,

!

Y M

N , which has not yet entered the analysis.

Consequently, the world price of the dirty good and the Northern price of emissions, along with

electricity and resource prices, opportunity costs of fossil fuel and investments in fuel saving,

remain unchanged in response to a reduction in the North’s emissions cap.

— 14 —

TABLE 1: Features of a Diversified Equilibrium Increase in OPEC’s

fossil fuel price,

!

p FS1

Decrease in North’s emission cap,

!

Y M

N Increase in allowable emission credits,

!

" North’s emissions price,

!

pM

Np F

S1,"( )

(+) zero (–)

World dirty-goods price,

!

pD

Wp F

S1,"( )

(+) zero (–)

Fuel-saving in North,

!

µNp F

S1,"( )

(+) zero (–)

Fuel-saving in South,

!

µSpFS1,"( )

(+) zero (+)

Opp. costs of fossil fuel,

!

"F

gp F

S1,#( ) ,

!

g = N,S (+) zero (–)

Electricity prices,

!

pE

gp F

S1,"( ) ,

!

g = N,S (+) zero (–)

Natural resource rents,

!

pR

gp F

S1,"( ) ,

!

g = N,S (+) zero (+)

An increase in the emissions market integration parameter,

!

" , leaves the NN curve

unaltered in Figure 3. The SS curve, however, pivots downward from

!

S " S to

!

S " " S . This implies

that the world price of dirty goods falls to

!

pDW "" and the North’s price of emissions falls to

!

pMN"".

Relaxing the emissions credit constraint leads directly to an increase in fuel saving in South such

that

!

dµSd" =1, but there is an induced decrease in North such that

!

dµNd"

!

= " 1"µN( )pKN # # $ µN( )( )"1

pMN % "&'

N < 0 because of the decline in North’s emissions price. The

opportunity cost of an efficiency unit of fossil fuel declines in South due to increased credit

revenue and in North due to the lower emissions price. Lower opportunity costs of fossil fuel

lead in turn to lower electricity prices in each region, higher natural resource rents.

2.4 National and International Markets

With world and domestic prices determined by diversification requirements, we can now turn to

an examination of quantity determination through market equilibria. Since electricity is a non-

tradable good, supply is equal to demand on each region’s market:

— 15 —

!

YEg = aEDYD

g + aEFYFg + XEH

g( )"EE ,

!

g = N,S . (16)

Here,

!

XEH

g represents the demand for electricity by the household sector in country

!

g . On regional

and sub-regional natural resource markets, utilization of use of the resource in the fossil-fuel sector

must be less than or equal to the endowment:

!

aRF pR

gpK

g, pR

gpL

g( )YF

h"Y R

h ,

!

g = N,S1,S2 , where:

!

aRF "( ) = #$F "( ) #pRg . (17)

Shephard’s lemma is used to obtain the demand for natural resource per unit of fossil fuel. In

order to set the world price for fossil fuel above the competitive level, OPEC must underutilize

its natural resource such that

!

aRF"( )YF

S1 < Y R

S1. Since condition (21) will hold with equality for

North and the non-OPEC South, which behave competitively, we obtain the following fossil-fuel

supply functions:

!

YF

gp F

S1,"( ) = Y R

haRF pR

gp F

S1,"( ) pK

g, pR

gp F

S1,"( ) pL

g( )#1

,

!

g = N,S2 . (18)

These supply functions are increasing in the both the fossil fuel price and allowable credits because

an increase in either of these variables raises natural resource rents and thereby reduces the intensity

of natural resource usage, which in turn allows greater output of fossil fuel.

OPEC must produce sufficient fossil fuels such that the South’s total fuel production

balances with world demand minus Northern supply at the going price:

!

YF

S= X

F

N+ X

F

S"Y

F

N , where:

!

YF

S"Y

F

S1+Y

F

S2. (19)

Here

!

XF

g denotes the aggregate fuel demand in region

!

g , which includes demand from final

consumption and all fossil-fuel using lines of production:

!

XF

g = 1"µg( ) aFDYDg + aFEYEg + aFFYF

g + XFH

g( ),

!

g = N,S . (20)

Since we assume that consumers as well as firms make full use of the fuel-saving technology, it

is convenient to define

!

XFH

g to be the demand for efficiency units of fossil fuel by the household

sector in region

!

g . After making use of equation (16), we can rearrange equation (20) to obtain:

!

AFDYDg = 1"µg( )

"1

XF

g" AFFYF

g" aFE#EEXEH

g" XFH

g ,

!

g = N,S . (21)

where:

!

" Sp F

S1,#( ) $ 1%µ S &( ) % #( )

%1

> 0 ;

!

" Np F

S1,#( ) $ 1%µ&N

'( )( )%1

> 0 ;

— 16 —

Here,

!

" N and

!

" S are efficiency coefficients which convert the number of actual units of fossil

fuel used into the larger number of efficiency units that would have been used if there had been

no investment in the fuel-saving technology.

Equilibrium in the world market for the dirty good requires balance between supply and

demand:

!

YD

N+Y

D

S= X

DH

N+ X

DH

S . (22)

The regional fuel requirements consistent with goods market equilibrium can be obtained using

equations (18), (19) and (21) in conjunction with (22):

!

" N# NXF

N+ " S# S

XF

S= Z

FH

W or

!

XF

N = ZFH

" N# N( )( ) $ " S# SXF

S( ) " N# N( )( ). (23)

where:

!

ZFH

W" Z

FH

N+ Z

FH

S ;

!

ZFH

g" AFDXDH

g# aFE$EEXEH

g# XFH

g .

Here,

!

" g#1$ 1$µg( )AFF , which is greater than zero but less than one, is the net quantity of

fossil fuel available for use outside the sector for each unit of fossil fuel produced. It should be

observed that

!

" g is greater than zero but less than one and that

!

" g# g= " g

$ AFF .

In the goods market equation (23),

!

ZFH

g represents the imputed demand for efficiency

units of fossil fuel by final consumers in country

!

g and

!

ZFH

W represents the corresponding

imputed consumer demand for efficiency units of fossil fuel for the world as a whole. These

variables include the indirect consumer demand for fossil fuel associated with the consumption

of electricity and dirty goods as well as the direct consumer demand for fossil fuel per se. For

aggregation purposes, all fossil fuel quantities are measured in efficiency units. Due to trade in

fossil fuel and the dirty good, there is no direct connection between a region’s aggregate demand

for fossil fuel given by

!

XF

g and the imputed demand of its own final consumers given by

!

ZFH

g .

The underlying demand for good

!

j by final consumers in country

!

g can be written as

!

X jH

g = X jH

gpDW, pE

g,"F

g,I

g+# g( ) . Since consumers make use of the fuel-saving technology, the

domestic opportunity cost of fossil fuel,

!

"Fg , appears in these consumer demand functions rather

than OPEC’s price of fossil fuel,

!

p FS1. A region’s income is equal to the sum of its GDP,

!

Ig , and

its transfer income from emission credits,

!

" g .8 Domestic product is endogenous and typically

— 17 —

depends on product prices and factor endowments. For brevity, we can write South’s GDP

function as

!

IS = I

SpD

W, pE

S, p F

S1( ), but for North we must write

!

IN = I

NpD

W, pE

N, p F

S1,Y M

N( ) .9 North’s

emissions its emissions cap, which is analogous to a factor endowment, is included because of

the centrality of emission permit revenue to our analysis. The envelope theorem implies that the

elasticity of North’s income with respect to the emissions cap is equal to the income share of

permit revenue,

!

"M

N # pM

NY M

NI

N , which seems likely to be of negligible magnitude.

Using the consumer demand functions and GDP functions, the world’s imputed consumer

demand for efficiency units of fossil fuel is

!

ZFH

W = ˜ Z FH

WpD

W, pE

N, pE

S,"F

N,"F

S,# N

,# S,Y M

N( ) , which can

be summarized as:

!

ZFH

W = ZFH

Wp F

S1,Y M

N,"( ); (24)

where:

!

Y M

NZ

FH

W( ) "ZFH

W "Y M

N( ) =#M

N$NZ

FH

NZ

FH

W ,

!

"N # $ j

N" j

N

j=D,E ,F% ;

and it is assumed that:

!

" ZFH

W "# > 0 ;

!

" ZFH

W "p FS1

< 0.

Here,

!

" is the overall income elasticity of imputed consumer demand for efficiency units of

fossil fuel in country

!

g ,

!

" j

g is the income elasticity of consumer demand for good

!

j and

!

" j

g is the

share of good

!

j in the imputed consumer demand for efficiency units of fossil fuel in country

!

g .

Assuming that the dirty good, electricity, and fossil fuel are all normal goods in North, the

world’s overall imputed consumer demand for efficiency units of fossil will decline if North

tightens its emissions cap, but the proportionate decline will be of negligible magnitude if the

share of credit revenue in North’s income,

!

"M

N , is negligible. In accordance with proposition 2,

either an increase in allowable emission credits or a decrease in OPEC’s fossil fuel price must

reduce the electricity prices and opportunity costs of fossil fuel in both regions as well as the

world price of the dirty good. Consequently, it is reasonable to assume that the standardized

overall consumer demand for fossil fuel is increasing in

!

" and decreasing in

!

p FS1 even though

some innocuous restrictions are implicitly placed on the substitutability of goods in both

consumption and production.

— 18 —

The linear, negatively sloped FF locus in Figure 4 and subsequent figures shows the

regional fuel requirements that are consistent with goods market equilibrium given by equation

(23). Since the North engages in greater fuel saving and uses less fuel per unit output than the

South, it follows that

!

" N# A

FF> " S

# AFF

. Thus, the magnitude of the slope of the FF curve,

!

" S# S( ) " N# N( ), is less strictly than one. By adjusting clean good production within each

country, dirty good production can be switched across countries on a one-for-one basis in

accordance with equation (22) within the limits set by the non-negativity requirements for all

outputs. Consequently, more dirty good production and, thus, fossil fuel demand in South is

associated with less dirty-good production and fossil fuel demand in North, which gives the FF

curve its negative slope. Since the South engages in less fuel saving than the North, a one-unit

decrease in fuel demand in North is always associated with a greater than one unit increase in

fuel demand in South. Given that OPEC holds the price of fossil fuel constant, it must

accommodate the increase in world usage by increasing its own production.10

[Insert Figure 4 about here]

We can now close the model by turning to the emissions market. In equilibrium North’s

emissions must be equated with the North’s cap plus the emissions credits, which its firms buy

from firms in South:

!

XM

N= Y

M

N+ "# S

XM

S ; (25)

Since

!

" represents the allowable transfers per efficiency unit of fossil fuel and the efficiency

coefficient

!

" S gives the number of standardized of fossil fuel units per unit actually used in

South,

!

"# S represents the available emission credits per unit of fossil fuel used. Recalling that

one unit of fossil fuel always generates one-unit of GHG emissions such that

!

XF

g= XM

g for

!

g = N,S , the emissions market equilibrium condition given by equation (25) can be graphed as

the linear MM curve shown in Figure 4 and subsequent Figures. In an initial pre-Kyoto

equilibrium where

!

" = 0 and credits are absent, the MM curve is horizontal because Northern

emissions are fixed and independent of emissions by the South.

— 19 —

By solving the linear good-markets and emissions-market equilibrium conditions

specified by equations (23) and (25), we can determine the equilibrium fossil fuel demands for

each region, and thus for the world as a whole:

!

XF

Np F

S1,Y M

N,"( ) =

# S$ SY M

N + "# SZFH

W

# S$ S + "# S# N$ N; (26)

!

XF

Sp F

S1,Y M

N,"( ) =

ZFH

W#$ N% N

Y MN

$ S% S + "$ N$ N% N. (27)

!

XF

Wp F

S1,Y M

N,"( ) =

1+ "# S( )ZFH

W$ # N

$# S( )Y MN

# S% S + "# S# N% N. (28)

In Figure 4, there is an initial pre-Kyoto equilibrium at the intersection of the

!

F " F and MM

curves where the levels of emissions and fossil fuel demand are

!

XF

N" = XM

N" and

!

XF

S" = XM

S" in

North and South respectively.11

Before assessing the impact of provisions of the Kyoto agreement on this equilibrium, it

is helpful to establish a key result concerning fossil fuel prices.

Proposition 3: Consider an initial pre-Kyoto equilibrium where emissions credits are not traded

and where the North and both the OPEC and non-OPEC sub-regions of South are diversified. If

OPEC raises the price of fossil fuel, the levels of aggregate fossil fuel demand and GHG

emissions drop in the South and the world as a whole, but remain unchanged in North.

Thus, in an initial pre-Kyoto equilibrium where credits are absent (i.e.,

!

" = 0), North’s fossil fuel

demand is fully constrained by its cap such that

!

XFH

N= Y

M

N , but the aggregate fossil fuel demand

curves of the South and the world as a whole are negatively sloped. While mathematical details

of the proof are provided in the Appendix, Figure 4 illustrates the salient features. An increase in

the price of fossil fuel shifts the goods market curve inward from

!

F " F to

!

F " " F due to greater

fossil fuel saving in both regions and declines in the world’s standardized overall consumer

demand for fossil fuel which arises in response to increases in all fossil-fuel related prices. Since

the MM curve is horizontal and does not shift, North’s fossil fuel demand and emissions remain

unaltered at

!

XF

N" = XM

N" but South’s fossil fuel demand and emissions fall to

!

XF

S"" = XM

S"".12

— 20 —

2.5 Kyoto-Style Reductions in the North’s Cap and World GHG Emissions

In the spirit of the Kyoto protocol, consider the impact of a reduction in North’s emission cap

with South’s GHG emissions remaining uncapped.

Proposition 4: Consider an initial zero-credit equilibrium where the North and both the OPEC

and non-OPEC sub-regions of South are diversified. If the North tightens its emissions cap and

OPEC holds the price of fossil fuel constant, then: (a) North’s fossil fuel demand and emissions

must decline, (b) South’s fossil fuel demand and emissions will rise if and only if emission permit

revenue comprises a sufficiently small share of North’s income such that

!

"M

N#N< $ N% N

XF

NZFH

N , and (c) world fossil fuel demand and emissions will rise if and only if

emission permit revenue comprises a sufficiently small share of North’s income such that

!

"M

N#N < $ N %$ S( )XF

NZFH

N .

While formal details of the proof are provided in the Appendix, the results are readily explained

using Figure 5, which shows a case where emissions permit revenue constitutes a negligible

share of North’s income.13 In such a case, tightening the emissions cap shifts the emissions

market equilibrium locus downward from

!

M " M to

!

M " " M , but leaves the FF curve representing

goods market equilibrium unaltered. Consequently, there is a new equilibrium at

!

XF

N"" = XM

N"" and

!

XF

S"" = XM

S"". Since the magnitude of the slope of the FF curve is less than one, this immediately

implies that the magnitude of the increase in fossil fuel use and emissions in South exceeds that

of the reduction in North. This makes intuitive sense since consumer demand for fossil fuel

itself and each fossil-fuel-using good remains constant. There is, however, a one-for-one

displacement in footloose dirty-good production from the North to the South. Since the North

engages in more fuel-saving activity than the South, this causes an increase in world emissions.

There is not only so-called carbon leakage through the South, but this also outstrips the

improvement in North leading to overall leakage at the world level.

[Insert Figure 5 about here]

If emissions permit revenue constitutes a non-negligible share of North’s income and the

North’s imputed consumer demand for efficiency units of fossil fuel is normal, then declining

— 21 —

income in North will reduce world as well as Northern consumer demand and shift the FF curve

inward displacing the final equilibrium inward from

!

XF

N"" = XM

N"" and

!

XF

S"" = XM

S"" along the

!

M " " M .

World emissions will continue to rise if and only if the final equilibrium lies to the left of the

pre-Kyoto world fossil fuel isoquant,

!

XF

W " , which depicts combinations of use in North and

South that hold world usage constant. The environmental impact of reducing the North’s cap

could only be neutral if the induced decline in national income in North was sufficiently large.

Further, if the Kyoto Agreement were to be successful on the environmental front, it would be

the result of even more pronounced adverse effects on national income.

Proposition 4 assumes that OPEC will fully accommodate the increase (or decrease) in

world demand for fossil fuel by changing its output. Suppose instead that OPEC allows its price

to change and take the extreme case where it does not change its output at all.

Corollary 4.1: If OPEC holds its fossil fuel output constant and allows its price to vary when

North tightens its emissions cap, then the magnitude of the change in world fossil fuel use and

emissions, whether positive or negative, will be attenuated but not reversed.

Proof: If the world fossil fuel demand would rise (fall) when OPEC holds the price of fossil fuel

constant, then the price will rise (fall) when output is held constant instead. This not only

moderates the increase (decrease) in fossil fuel demand, but also causes increased (reduced)

production in North and the non-OPEC South. The increase (decrease) in world fossil fuel

output implies that worldwide fossil fuel use and emissions must rise (fall). QED

In terms of Figure 5, the increase in OPEC’s fossil fuel price would cause an additional inward

shift of the FF curve, which is not shown. Consequently, the world equilibrium would be

displaced inward along the

!

M " " M curve from

!

XF

N"" = XM

N"" and

!

XF

S"" = XM

S"" but not as far as the pre-

Kyoto world fossil fuel isoquant,

!

XF

W " .14

Now suppose that the North is comprised of two or more technologically equivalent

countries and one or more of these countries opts out of an emissions reduction program.

— 22 —

Corollary 4.2: If the magnitude of the reduction in North’s emissions declines cap from

!

dY M

N to

!

"dY M

N where

!

0 <"<1, then the magnitude of the change in world fossil fuel use and emissions,

whether positive or negative, will be attenuated but not reversed.

Clearly this corollary follows immediately from Proposition 4 and it can also be applied in

conjunction with Corollary 4.1. Suppose that emission permit revenue constitutes a negligible

fraction of North’s income and that world emissions would rise due to a tighter cap in North as in

Figure 5. If a sub-region in North refrains from cutting its emissions, then the magnitude of the

downward shift in the MM curve will be reduced and there will be less displacement of fossil

fuel use and emissions to the South. Consequently, the model suggests that if a developed

country such as the US refuses to ratify the Kyoto accord, or a country such as Canada ratifies

the accord but fails to meet its reduction commitments, there could be net environmental benefits

for the world!

The results of Proposition 4 and its associated corollaries would be weakened if either the

North or South were not diversified. The prices of dirty goods and electricity and the

opportunity costs of fossil fuel use would no longer be determined independently of the North’s

emissions cap. Consequently, tightening the cap would raise at least one of these prices and the

likely reduction in the world’s overall standardized consumer demand for fossil fuel would shift

the FF curve inward. Once again, there would be a less than one-for-one increase in fossil fuel

utilization in South, lessening or even reversing the increase in world emissions. While it

appears that price-increase effects have frequently been assumed, they are highly dependent on

the dimensionality of general equilibrium trade models (Dixit and Norman, 1980; Feenstra,

2005). In a long-run setting such as the present model where there are more traded goods than

non-tradable primary factors, key product prices may be independent of factor endowments and,

thus, may not change when the “endowment” of emission permits declines.15

— 23 —

2.6 Kyoto-Style Emission Credits and World GHG Emissions

We now turn to another key facet of the Kyoto protocol by exploring the impact of the

introduction of introducing partial North-South trade in emissions credits under the auspices of

the Clean Development Mechanism (CDM).

Proposition 5: Consider an initial zero-credit equilibrium where the North and both the OPEC

and non-OPEC sub-regions of South are diversified. If the constraint on allowable emissions

credits is relaxed, then: (a) North’s fossil fuel use and emissions must increase, (b) South’s

fossil fuel use and emissions increase if and only if South uses a sufficiently small share of world

fossil fuel such that

!

XF

SXF

W < "N# N 2 + # S2 + # S# N$ N[ ]%1

" N# N 2 + 1 XF

W( ) &ZFH

W &'( )[ ] , and (c)

world fossil fuel use and emissions will rise if and only if South uses a sufficiently small share of

world fossil fuel such that

!

XF

SXF

W < "N# N 2 + # S2 + # S # N $# S( )[ ]$1

" N# N 2 + 1 XF

W( ) %ZFH

W %&( )[ ] .

While the Appendix provides a proof, Figure 6 clarifies underlying intuition. If

!

" is increased

and credits are introduced, then the credits that can be made available will be in proportion to

South’s fossil use as is clear from equation (27). Consequently, the MM curve pivots upward

and becomes positively sloped because firms in North are able to purchasing emissions credits,

use more fossil fuel and emit more GHGs at each level of fossil-fuel use and emissions by South.

Since the MM curve is initially horizontal, this upward pivot alone seals the increase in North’s

fossil fuel use and emissions. The North emits more because of the availability of the newly

introduced emission credits.

[Insert Figure 6 about here]

The FF curve depicting equilibrium fossil-fuel use twists in response to increasing the

extent of allowable emission credits. On the one hand, the increase in fuel saving in South and

the reduction in fuel saving in the North stemming from an increase in

!

" would cause the slope

of the FF curve to become steeper, the vertical intercept to become larger and the horizontal

intercept to become smaller. On the other hand, the reduction in the price of the dirty good and

electricity associated with greater efficiency on goods markets would increase consumption of

— 24 —

these goods by the household sector and cause a parallel outward shift in the FF curve. The

overall effect of an increase in

!

" on the FF curve, therefore, is that the vertical intercept must

become larger and the slope must become steeper, but the horizontal intercept could increase or

decrease. Figure 6 shows a situation where the FF curve shifts upward in the vicinity of the

initial equilibrium and where the magnitude of the vertical shift is exactly equal to that of the

MM curve. In this situation, the level of fossil fuel use and emissions in South remains unaltered

while the level of world fossil fuel use and emissions rises due to the increase in North.

Whenever the vertical shift in the FF curve exceeds that of the MM curve, the level of fossil fuel

use in South, as well as North, will increase. Such a situation must arise if the South initially

accounts for a sufficiently small proportion of fossil fuel and the initial equilibrium is sufficiently

close to the vertical intercept of the FF curve and the pivot point of the MM curve. By contrast,

suppose that there is a region of the diagram where the FF curve shifts downward and that the

proportion of fossil fuel used in South is sufficiently large that the initial equilibrium lies in this

vicinity. In such a situation, both Southern and world emissions would decline. Finally, if the

FF curve shifts upward but with a vertical shift that is of smaller magnitude than that of the MM

curve in the vicinity initial equilibrium, then Southern emissions will decline, but the impact on

world emissions is ambiguous. Given that emissions increase in North, the condition for an

increase in world emissions is weaker than the condition for an increase in Southern increase as

indicated in the proposition.

The analysis in Proposition 5, like that in Proposition 4, assumes that OPEC will hold its

price constant and accommodate an increase (or decrease) in world fossil fuel use by varying its

output. Once again, it is useful to consider the alternative scenario where OPEC holds its output

rather than price constant.

Corollary 5.1: Suppose that the constraint on allowable emission credits is relaxed starting

from an initial zero-credit equilibrium. On the one hand, if world fossil fuel use and emissions

would have increased with a constant price, then with a constant output the increase could be

attenuated or magnified but not reversed. On the other hand, if world fossil fuel use and

— 25 —

emissions would have decreased with a constant price, then with a constant output the decrease

could be attenuated or reversed but not magnified.

Proof: While world demand may increase or decrease at the initial fossil fuel price in accordance

with proposition 5, greater emission’s market integration raises natural resource rents and,

thereby, unambiguously increases the non-OPEC supply of fossil fuel by the North and the non-

OPEC South as specified equation (18). This leads to three possibilities. First, if world demand

increases to a lesser extent than the non-OPEC supply at the initial price, then the fossil fuel

price will decrease if OPEC holds output rather than price constant. This would cause a

reinforcing price-induced increase in the quantity of fossil fuel demanded and world emissions.

Second, if world demand increases to a greater extent than the non-OPEC supply at the initial

price, then the price will increase when OPEC holds output rather than price constant. This

would cause a price-induced decrease in the quantity of fossil fuel demanded by the world that

lessens but does not reverse the initial increase. Third, if there were a decrease in world demand

at the initial price, then the price will decline when OPEC holds its output constant, causing an

offsetting price-induced increase in the quantity of fossil fuel demanded. The initial decrease

will be reduced or reversed depending on whether the price induced increase in the quantity

demanded is of smaller or larger magnitude than the initial decrease.16 QED.

In Figure 6 we have seen that the initial shifts of the FF and MM curve are associated with an

world increase in the world demand for fossil fuel at the initial OPEC price. If OPEC holds its

output rather than price constant, there will be an additional inward or outward shift in the FF

depending on whether the price rises or falls. While the final world equilibrium will be

displaced either inward or outward along the

!

M " " M curve from

!

XF

N"" = XM

N"" and

!

XF

S"" = XM

S"", it

must lie to the right of the pre-Kyoto world fossil fuel isoquant,

!

XF

W " .

Propositions 5 and Corollary 5.1 provide grounds for pessimism concerning the likely

impact of the CDM on global GHG emissions. While this may seem to suggest that there are

grounds for Europe’s suspicion of the CDM, the problem is not so much the direct nullification

— 26 —

of the commitments of developed countries, but rather the indirect subsidy afforded to fossil-fuel

intensive activities in developing countries.

2.7 GHG Emissions and Orthodox Environmental Policy

It is instructive to contrast the results associated with Kyoto-style environmental policy

with those of more orthodox policy. Since GHG emissions represent a global pollutant,

determining policy on a strictly national policy is open to free riding (Copeland and Taylor,

2005; Hoel, 1991). In this context, international coordination is a necessary but not sufficient

condition to achieve an efficient allocation. An agreement between North and South to allow

international permit trade under an overall cap would reduce world emissions by construction.

In addition, if there were an auction or untied allocation of permits, there would be partial

specialization as the North focussed more on capital-intensive activities including fuel saving

and South moved away from such activities. Either the North would cease producing the clean

good, or the South would cease producing the dirty good, or possibly both. The intuition for this

partial specialization result is that for any price of the dirty good, a firm in North is always able

to outbid a firm in South for emission permits on the basis of cheaper capital. As is frequently

the case, a Pigouvian tax would achieve a result similar to the global cap and trade policy.17

The direction of the change in specialization with orthodox environmental policy is more

important than the magnitude. Whereas orthodox environmental policy shifts fuel-using activity

toward the clean country and leads toward greater efficiency, a Kyoto-style policy perversely

does the opposite. The results of orthodox environmental policy are instructive on another level.

The structure of the Kyoto agreement appears to be largely an artefact of the legitimate equity

concerns of developing countries. It appears, however, that these equity concerns could also

have been addressed through the distribution of the Pigouvian tax revenue or the initial allocation

of emission permits.

— 27 —

3. EMPIRICAL ANALYSIS: TRADE, FOSSIL FUEL USE AND EMISSIONS

3.1 Issues

The theoretical model presented in this paper suggests deeply rooted structural deficiencies in the

Kyoto-approach to addressing GHG emissions that have the potential produce a contrary

environmental impact. Two important empirical issues arise from this analysis. The first key

empirical issue concerns the degree of support for the current model versus alternatives that

generate more sanguine results, most notably Copeland and Taylor (2005). The second key issue

for our empirical investigation concerns the direction and magnitude of the environmental impact

of the Kyoto-induced relocation of emission intensive activities away from developed countries

with relatively low emission intensities toward developing countries with higher emission

intensities.

A central premise of the current theoretical model is that there are dirty and clean

countries in the production of each good, as well as dirty and clean goods. Low user-cost,

capital-rich developed counties will adopt less emission intensive techniques than high user-cost,

capital-scarce developing counties at any point in time. In contrast, in the Copeland and Taylor

(C&T) (2005) model there are only dirty and clean goods. Due to factor price equalization, all

countries in the C&T model adopt the same production techniques and emission intensities for

every good. The difference between the two models in this respect drives the differences in their

conclusions. In the current model, shifting the production of one unit of dirty-good production

from the clean North to the dirty South increases global GHG emissions, whereas there is no net

impact in the C&T model. Consequently, it is important to devise an empirical test to investigate

whether rich and poor countries adopt similar production techniques as the C&T model presumes

or whether rich counties systematically adopt cleaner production techniques as the current model

suggests. Assuming that the data support our central premise that sectoral GHG emission

intensities vary across high-versus-low countries, it is also relevant to explore in whether there is

— 28 —

support for our secondary premise that these variations arise principally as a result of differences

in fuel-saving activity rather than direct abatement activity.

To explore the extent of empirical support for the central and secondary premises of the

current theoretical model, we pursue a modified environmental Kuznets-curve analysis that

introduces sector controls on the output composition of economies.18 In the absence of such

sector controls, both the current model and the C&T (2005) model expect carbon dioxide

emissions to rise at a diminishing rate, and perhaps eventually decline, as per-capita GDP rises.

In the Copeland and Taylor (C&T) model, this “greening” would be entirely the result of richer

countries adopting a greener mix of activities in response to more stringent environmental

policies. Consequently, C&T model predicts that if we control for the output composition of the

economy, per-capita emissions will no longer rise at a diminishing rate as per capita GDP

increases. In contrast, our model predicts that per-capita emissions will continue to rise at a

diminishing rate as per capita GDP increases because richer countries adopt greener techniques

in each sector as well as selecting greener output mixes. In addition to providing evidence

concerning model validity, introducing sectoral controls to the estimation of environmental

Kuznets-curve provides a foundation for simulating the quantitative impact of the Kyoto protocol

on global GHG emissions. In particular, the regression coefficients for the sector control

variables can be used to examine the likely magnitudes of Kyoto-induced national sector shifts

and the associated changes in national and global emissions.

3.2 Data

Annual information on a broad spectrum of countries was assembled for 24 years from 1980 to

2003. In the raw data set, there are 173 countries including most developed, developing and

transition countries. For the most part, however, we focus on a four-sector decomposition of

GDP into agriculture, manufacturing, other industry and services rather than a three-sector

decomposition. This narrows the dataset to 1704 observations on 71 countries in a balanced

panel or 2925 observations on 159 countries in an unbalanced panel. While developing as well

— 29 —

as developed countries are well represented in the balanced as well as unbalanced panels, all

transition countries from the former Soviet Union are excluded from the balanced panel due to

lack of data. For some of our robustness checks reported in the Appendix, we further decompose

the manufacturing sector at the cost of additional restrictions on the dataset.

We focus on carbon dioxide (CO2) emissions due to significant limitations on the

availability of data on other greenhouse gasses. Yearly data on carbon dioxide emissions and

coal, natural gas, petroleum and overall fossil-fuel use were obtained from the United States

Energy Information Administration (EIA) website. The World Development Indicators (WDI)

dataset available from the World Bank furnished data on other variables including: land,

population, real GDP19, and sector shares of GDP.

3.3 Empirical Results: Are There Dirty Countries?

Table 3 presents results for a variety of specifications of environmental Kuznets regressions for

per-capita CO2 emissions using Generalized Least Squares estimation with random effects.

Generally Hausman tests indicated a preference for random effects rather than fixed effects in the

regressions using the balanced panel, but broadly similar results were obtained for the

comparable fixed effects regressions. In all cases, we employ year dummies to capture year-to-

year differences in prices, technologies and evolving environmental policies.

— 30 —

Table 2: Environmental Kuznets Curves for Carbon Dioxide

ln (CO2 per Capita) CO2 per Capita 1A (1) 1B 2A 2B GDP per Capita (pc) 1.81E-04 *** 3.01E-04 *** 7.94E+02 *** 7.73E+02 *** [0.000] [0.000] [0.000] [0.001] (GDP pc)2 -3.50E-09 *** -1.16E-08 *** -1.74E-02 *** -4.90E-02 *** [0.000] [0.000] [0.000] [0.004] (% Agri)*(GDP pc) -2.13E-04 ** -1.29E+03 *** [0.011] [0.000] (% Agri)*(GDP pc)2 1.78E-08 *** 8.03E-02 [0.008] [0.188] (% Serv)*(GDP pc) -1.07E-04 ** -2.45E+02 [0.011] [0.346] (% Serv)*(GDP pc)2 8.09E-09 *** 4.99E-02 ** [0.000] [0.019] (% OthInd)*(GDP pc) -1.57E-04 *** 7.53E+02 * [0.000] [0.050] (% OthInd)*(GDP pc)2 9.84E-09 *** 1.21E-02 *** [0.000] [0.434] Gas/Fossil Fuel 1.08E-01 1.66E-01 3.68E+06 *** 4.16E+06 *** [0.325] [0.120] [0.000] [0.000] Coal/Fossil Fuel 1.56E+00 *** 1.41E+00 *** 3.14E+05 9.96E+05 ** [0.000] [0.000] [0.447] [0.011] Land/Population 1.22E+00 *** 1.43E+00 *** 6.56E+06 *** 1.89E+06 [0.004] [0.001] [0.000] [0.332] Observations 1704 1704 1704 1704 Countries 71 71 71 71 Panel Type Balanced Balanced Balanced Balanced Random vs Fixed Random Random Random Random R-squared within 0.491 0.514 0.293 0.344 R-squared between 0.67 0.711 0.506 0.615 R-squared overall 0.658 0.697 0.496 0.601

Robust p values in brackets; * significant at 10%, ** significant at 5%, *** significant at 1%. (1) Asymptotic properties for Hausman test of random vs. fixed effects not satisfied.

In regressions 1A and 1B in Table 2, the natural logarithm of CO2 per capita is used is

the dependent variable, while in regressions 2A and 2D the level of CO2 per capita is used. The

— 31 —

log specifications appear to generate a better fit with the data, but strong results are obtained for

both specifications. For reference purposes, regressions 1A and 2A provide a standard test for

environmental Kuznets curve results without controls on the sector composition. In both

regressions the level of per-capita GDP has a statistically significant positive effect on emissions

per-capita. While it is intuitive that economies that produce more tend to emit more due to a

scale effect, the important question is whether that effect is dissipated or even reversed as per-

capita incomes rise. Consequently, the statistically significant negative coefficient on the

squared per capita GDP term in both regressions is decisively important. In regression 2A, per

capita CO2 emissions increase at a decreasing rate from the outset as per capita income rises and

routine calculations show that the Kuznets curve reaches a peak at an per capita GDP of 26,191

USD. The log specification in regression 2A allows per capita emissions to initially increase at

an increasing rate. There is an inflection point when the per-capita GDP reaches 13,929 USD

and beyond point this per-capita CO2 emissions increase at a decreasing rate. Finally the

Kuznets curve reaches a peak at a per capita GDP of 25,881 USD.

The conventional Kuznet’s curves arising from regression 1A and 2A are consistent with

a wide variety of theoretical models including both the one presented in this paper and that of

C&T (2005). To differentiate between these theoretical models, we introduce a range of sector

variables in regressions 1B and 2B. The share of agriculture in GDP (% Agri), the share of

services in GDP (% Serv) and the share of other non-manufacturing industry (% OthInd) are

each interacted with both per capita GDP and per capita GDP squared. With per-capita GDP and

per-capita GDP squared also included in these regressions, manufacturing is the omitted sector.

As a strong counterpoint to the expectation of the C&T model, we still obtain a highly

significant negative coefficient on the square of per-capita GDP in regression 1B and 2B. This

implies that if other things are held constant, as per capita value added in manufacturing rises,

per-capita emissions eventually rise at a diminishing rate. Similar results hold for services and

other industry in regression 1B, but as agriculture expands, per-capita emissions continue to

increase at an increasing rate. The peak of the Kuznets curve for per capita CO2 emissions is

— 32 —

now dependent on the sector composition of an economy. For example in regression 1B, the

peak income would be 22,061 USD for an economy that consist of 30% manufacturing, 10%

agriculture, 40% services and 20% other industry. The peak for a pure manufacturing economy

would be 12,927 USD, while that for a pure service economy would be 27,350 USD. For a pure

agricultural economy, CO2 emissions continue to increase at an increasing rate as per capita

income increases. The results for agriculture suggest one possible explanation for the absence of

inverted U-shaped environmental Kuznets curve results for CO2 emissions for developing

countries elsewhere in empirical literature (Schmalensee et al., 1997; Perman and Stern 2003).

Overall, there is strong empirical evidence that lower per-capita CO2 emissions in rich countries

are not solely the result of different sector mixes as the C&T model implies. Rather as the

current theoretical model suggests, rich countries are generally cleaner even when sector the

sector mix is held constant. In the Appendix, we obtain similar conclusion when we use either a

larger unbalanced panel, which includes many additional transition and developing countries or a

smaller (unbalanced) panel, which further decomposes the manufacturing sector.

The coefficients on each of the sector variables per se in both regressions 1B and 2B are

significantly negative but the sector interaction terms are all significantly positive.

Consequently, agriculture, services and other industry all start out cleaner than manufacturing,

but as per capita income rises, the contributions of each of these sectors to CO2 emissions

converges with manufacturing. What is interesting and surprising is that the econometric results

suggest the presence of emission intensity reversals. At per-capita incomes well within the range

of the dataset, agriculture and services become dirtier than manufacturing. Table 4 reports the

critical values for per capita income at which agriculture and services switch from being less

emissions intensive than manufacturing to being more emissions intensive. As we show below

in our simulation results, the presence of these emissions intensity reversals has the potential to

have a profound and positive impact on our empirical assessment of Kyoto.

— 33 —

Table 3: Levels of per-capita GDP where Emission Intensity Reversals Occur Regression 1B Regression 2B Manufacturing becomes less CO2 intensive than Services

13,195 USD 4,908 USD

Manufacturing becomes less CO2 intensive than Agriculture

12,002 USD 16,014 USD

In all four model-specifications in Table 2, the per-capita land endowment (i.e., the

inverse of population densities) appears as control variables. Larger land endowments always

have a statistically significant positive impact on CO2 emissions, perhaps because of greater

internal transportation needs. The share of natural gas in overall fossil-fuel use and share of coal

in overall fossil fuel use also appear as control variables in all regressions, with the share of

petroleum in overall fossil fuel use as the omitted category. Since coal tends to be dirtier than

oil, the statistically significant positive coefficients on the share of coal use are expected. Since

natural gas is typically cleaner than oil, one might expect the share of natural gas to have a

negative sign. Although only statistically significant in regressions 2A and 2B and always

smaller in magnitude than the coefficients on the share of coal use, the coefficients on natural gas

use are always positive. One possible explanation is that over the time interval covered by the

dataset most counties controlled CO2 emissions indirectly, at best, via measures primarily aimed

at other air pollutants. Countries using a high proportion of natural gas may then have faced

fewer constraints on overall fossil fuel use, with higher CO2 emissions arising as a consequence.

3.4 Empirical Results: Fuel Saving versus Abatement?

The overall evidence seems to strongly support our primary premise that sector emission

intensities differ across countries according to their level of development in a way that is not

expected by the C&T Kyoto model. It is also relevant to investigate our secondary premise that

the lower sector emission intensities in high-income countries arise principally from fuel saving

activity rather than direct abatement activity. In Table 4, we present evidence supporting our

secondary premise. To facilitate quantitative comparisons, the regression coefficients have been

— 34 —

converted to elasticity form at the sample means for each variable. Regressions 3A and 3B

examine the data for environmental Kuznets curves pertaining to per-capita fossil fuel use.

There is a striking qualitative and even quantitative correspondence with regressions 1A and 1B

suggesting a strong relationship between fuel-saving and emission reduction as per-capita

incomes rise.20

The aggregate intensity of CO2 emissions relative to fossil-fuel use is also examined in

regressions 4A and 4B so as to investigate whether more direct abatement also plays a role in the

decline in emissions as per capita income rises. The income variables are highly statistically

significant in regression 4A and imply that, as per capita income increases, the aggregate

emissions-to-use intensity declines at a decreasing rate. In regression 4B, however, several of the

per-capita GDP and sector coefficients are statistically insignificant. Interestingly, in regression

4B increasing the value added in services at the expense of manufacturing results in an increase

in the aggregate emissions intensity if (and only if) per capita income is in excess of 11,783

USD. A similar result holds for increases in value added in agriculture at the expense of

manufacturing for per-capita incomes above 3,063 USD, while increases in the value added of

other industry raises the emissions intensity at all levels of per-capita income.

While the overall empirical evidence seems to suggest that fuel saving has a strong role

to play in the reductions in CO2 emissions that occur as incomes rise, it appears that to date

direct abatement has played a weaker role in terms of the magnitude of elasticities, statistical

significance and goodness of fit. Of course, this may evolve over time and direct abatement

efforts may be come more important as a result of the Kyoto Protocol and other policy initiatives

related to climate change.

— 35 —

Table 4: Partial Elasticities for Fuel-Saving versus Abatement

ln (Fossil Fuel Use per Capita) ln (CO2/Fossil Fuel Use) 3A 3B 4A 4B GDP per Capita (pc) 1.96E-04 *** 3.02E-04 *** -1.22E-05 *** -7.52E-06 [0.000] [0.000] [0.002] [0.499] (GDP pc)2 -3.90E-09 *** -1.02E-08 *** 3.90E-10 *** -1.23E-09 * [0.000] [0.000] [0.000] [0.079] (% Agri)*(GDP pc) -2.17E-04 *** -2.13E-05 [0.005] [0.655] (% Agri)*(GDP pc)2 1.55E-08 ** 6.94E-09 [0.014] [0.070] (% Serv)*(GDP pc) -7.39E-05 * -2.58E-05 * [0.064] [0.085] (% Serv)*(GDP pc)2 5.66E-09 *** 2.20E-09 ** [0.010] [0.012] (% OthInd)*(GDP pc) -1.89E-04 *** 4.58E-05 *** [0.000] [0.005] (% OthInd)*(GDP pc)2 8.78E-09 *** 7.20E-10 [0.000] [0.312] Gas/Fossil Fuel 7.34E-01 *** 7.32E-01 *** -5.04E-01 *** -4.82E-01 *** [0.000] [0.000] [0.000] [0.000] Coal/Fossil Fuel 1.26E+00 *** 1.09E+00 *** 2.09E-01 *** 2.42E-01 *** [0.000] [0.000] [0.000] [0.000] Land/Population 1.80E+00 *** 2.07E+00 *** -5.04E-02 -2.46E-01 [0.000] [0.000] [0.838] [0.306] Observations 1704 1704 1704 1704 Countries 71 71 71 71 Panel Type Balanced Balanced Balanced Balanced Random vs Fixed Random Random Random Random R-squared within 0.533 0.555 0.096 0.115 R-squared between 0.756 0.772 0.088 0.125 R-squared overall 0.743 0.759 0.077 0.112

Robust p values in brackets; * significant at 10%, ** significant at 5%, *** significant at 1%.

3.5 Kyoto Simulations: Do Emission Intensity Reversals Matter?

The estimated regression coefficients for the sector variables can be used to simulate the impact

of achieving Kyoto targets by reducing CO2 emission intensive activities in the Annex-I

— 36 —

countries of the North, which have made reduction commitments, and scaling up those activities

in the non-Annex countries of the South to compensate. This is a particularly relevant exercise

because the presence of emission intensity reversals in the data opens the door to a possible

favourable impact of the Kyoto Agreement rather than the adverse impact suggested by our

theoretical model. In our theoretical model, which assumes that the dirty good is always more

emissions intensive than the clean good, production of the dirty good is displaced from the

cleaner countries of the North to the dirtier countries of the South leading to an unambiguous

overall increase in world GHG emissions. More generally, if the sector that is dirtier for most

Annex-I countries happens to be cleaner for at least some non-Annex countries, those non-Annex

countries will have reduced rather than increased emissions and world emissions could fall.

In our simulations, we assume that emission permit revenue constitutes a negligible share

of GDP for each Annex-I country and consequently we do not make any downward adjustment

in its GDPs to help it attain its Kyoto targets unless it is not feasible for it to attain its target

through sector adjustment. The actual reduction commitment of each Annex-I country is used to

generate its target level of emissions. While the official base year for calculating emission

reductions in the Kyoto agreement is 1990, we use 1993 as the base year due to the lack of

separate data for many of the transition countries for 1990. We consider exercises where the

Annex-I countries reach their targets starting from their 1993 emissions levels and from their

2001 emissions levels, which are frequently but not always higher. We also consider cases

where the US participates in emission reductions and where it does not.

Using the estimated sector and sector interaction terms for services and agriculture

relative to manufacturing regression coefficients from regressions 1B, 2B from Table 2 above

and 5B from Table A1 in the Appendix, we adjust the sector mix of each individual Annex-I

country so as to achieve its target. We consider cases where: (i) the sector adjustment occurs

entirely between manufacturing and services, (ii) the adjustment occurs entirely between

manufacturing and agriculture, and (iii) where there is a combination of both types of adjustment

with half of the adjustment made through each channel.21 We then calculate the change in the

— 37 —

sector’s value added for each Annex-I country and then aggregate across all countries in the

group. Each non-Annex country then makes a contrary adjustment that is in proportion to its

share of the total GDP of the non-Annex group. Next, we calculate the change in CO2 emissions

that these sector adjustments imply for each non-Annex country. Finally, we aggregate the CO2

emission changes of all Annex-I and non-Annex countries to determine a prediction of impact of

the Kyoto agreement.

Table 5 reports provisional simulation results. Because of the increases in world and

Annex I CO2 emissions between 1993 and 2001, the impact of the Kyoto agreement is larger if it

is judged against 2001 emissions levels than if it is assessed against 1993 levels. For reference

purposes we include a naïve prediction based on the actual commitments of the Annex-I

countries and the naïve assumption that the non-Annex countries will maintain the status quo on

their CO2 emissions either at the 1993 or 2001 level depending on the case. For the 1993

starting point, the naïve prediction is a 3.58% reduction in world emissions with US participation

and a 1.58% reduction without. Starting from 2001 starting point, the naïve predictions rise to

5.4% with US participation and 3.85% without.

The emission intensity results prove to be decisive in our simulation results. In each

provisional simulation, the Kyoto agreement achieves reductions in world CO2 emissions. Since

there are induced reductions in the emissions in non-Annex countries in response to reductions

by the Annex-I countries, the reduction in world emissions from the Kyoto Agreement would

always be larger if the US were to participate rather than opt out. The model-based simulations

frequently generate emission reductions that exceed the naïve prediction indicating that on

average the non-Annex countries reduce emissions by a greater proportion than the Annex-I

counties. The only exception arises when there are manufacturing-versus-services adjustments

using the Regression-2B coefficients. In this case, Table 3 reports that the per-capita income at

which manufacturing becomes the relatively cleaner sector is only 4,908 USD. Consequently,

the manufacturing sector is cleaner for the higher income non-Annex countries in these cases.

— 38 —

Since these higher income non-Annex countries increase rather than reduce their emissions, there

is a smaller reduction in world emissions.

Table 5: Simulations of the Impact of the Kyoto Protocol Naïve Model Prediction Prediction Regression 1B Regression 2B Adjustment between Manufacturing and Services (1993 Levels) US Included -3.58% -3.76% -3.57% US Excluded -1.85% -1.96% -1.84% Adjustment between Manufacturing and Agriculture (1993 Levels) US Included -3.58% -3.82% -7.34% US Excluded -1.85% -2.04% -4.16% Adjustment between Man. and Both Ag. and Serv. (1993 Levels) US Included -3.58% -3.79% -5.45% US Excluded -1.85% -2.00% -3.00% Adjustment between Manufacturing and Services (2001 Levels) US Included -5.40% -6.35% -4.23% US Excluded -3.85% -4.76% -2.74% Adjustment between Manufacturing and Agriculture (2001 Levels) US Included -5.40% -6.06% -8.89% US Excluded -3.85% -4.49% -6.48% Adjustment between Man. and Both Ag. and Serv. (2003 Levels) US Included -5.40% -6.20% -6.56% US Excluded -3.85% -4.63% -4.61%

While the simulation results are provocative and surprising, they should be treated with

caution for at least four reasons. First, the purported emission intensity reversals merit further

investigation in their own right even though they arise across a very wide range of econometric

model specifications when applied to the current dataset. Second, governments may use trade

policy to at least partly thwart the predicted inter-sector adjustments. For example, the US, EU

and Japan are all famous for imposing trade measures, which support their agricultural interests

— 39 —

and impede exit from the sector. Third, even if the further research verifies the existence of

emission intensity reversals at the broad sector level, much of the adjustment to Kyoto may take

place at the intra-sector level, particularly within the manufacturing sector, where such reversals

are less likely to be relevant. Consequently, computational general equilibrium analysis based

on the current theoretical model appears to offer the possibility of a finer decomposition of

sectors and, thus, further insight into the both the direction and magnitude of the impact of

Kyoto. Finally, the simulations omit consideration of the impact of the Clean Development

Mechanism, which could have an adverse environmental impact as suggested by the theoretical

model. Once again, computational analysis would appear helpful in unraveling this issue.

4. CONCLUSION

The theoretical model presented in this paper suggests that there are serious flaws in the Kyoto-

approach to reducing greenhouse gas emissions. When the North reduces emissions but the

South is unconstrained, dirty fossil-fuel using activity is displaced from the cleaner North to the

dirtier South. Consequently, the US decision not to ratify the agreement and Canada’s apparent

inability to implement it, may paradoxically reduce the environmental damage caused by Kyoto.

In addition, the theoretical model suggests that the Clean Development Mechanism may

indirectly subsidize dirty fossil-fuel utilizing activity in the South causing a further increase in

global emissions.

Reality, however, may be more complex than the theoretical model. Our empirical

results suggest strongly support our theoretical model in the sense that we find that marginal

sector CO2 emissions intensities vary with per capita income and, with the exception of

agriculture, these intensities eventually decline. Consequently, there are clean and dirty

countries as well as clean and dirty goods. Nevertheless, the possible presence of fortuitous

emission intensity reversals may brighten the outlook for the Kyoto accord. With agriculture and

services apparently more CO2 emission intensive than manufacturing for the Annex-I countries,

our empirical results suggest that they may meet there Kyoto targets by slowing their long-term

— 40 —

movement into services, slowing their long-term movement away from manufacturing and

accelerating their movement away from agriculture. The non-Annex countries would then be

induced to accelerate their long-term movement into services, slow their movement into

manufacturing and slow their movement out of agriculture. Since our empirical results suggest

that these activities may be more emissions intensive than manufacturing at the per-capita

income levels of many non-Annex countries, our simulations suggests that there is a possibility

of overall reductions in world CO2 emissions and that these may be significant in magnitude.

In spite of the possibility of a fortuitous beneficial outcome from the current Kyoto

agreement, it would appear unwise to gamble global climate-change policy on the existence of

emission intensity reversals. Consequently moving to a second-round agreement on climate

change should be a priority. While developed counties might reasonably be subject to more

onerous commitments and emission permits should be internationally as well as nationally

tradable, all countries should have emission caps.

— 41 —

APPENDIX:

Proof of Lemma 1

The input-output coefficients for the C sector are

!

aiC "( ) # $%C "( ) pig for

!

i = K,L . In the D and E

sectors, the labour requirements given by

!

aLj "( ) # $% j "( ) pLg are analogous, but the capital

requirements given by

!

aKj "( ) # $% j "( ) pkg + $&F

g "( ) pKg include capital invested in fuel saving as

well as production per se. Setting the

!

pMN

= 0 in equations (15) and (16), diversification in both

regions requires that

!

"F

#NpF

S1, pK

N,0( )AFD + $D pK

N, ˜ p L

N( ) ≤

!

" FS

pF

S1, pK

S,0,#( )AFD + $D pK

S, ˜ p L

S( ) or that

the intercept of the NN curve is less than that of the SS curve in Figure 2. Recall that

!

pKN

< pKSO

and that

!

pLN

> pLSO since

!

"C pKN, pL

N( ) = "C pKSO, pL

SO( ) . Consequently, in the absence of factor

intensity reversals and with

!

pMN

= 0 , the cost of the dirty good can be higher in South than North

only if the overall production of the dirty good inclusive its underlying non-tradable electricity is

more capital intensive than the clean good. This implies that

!

AKD

"( ) ALD"( ) > a

KC"( ) a

KL"( ) in

both countries where

!

AiD" a

iD+ a

iE#EEaED

represents the overall requirement for input

!

i = K,L

in the production of one unit of the dirty good inclusive of the quantity of the input required to

produce the underlying electricity. QED

Proof of Proposition 2

Differentiating of equations (9) and (10) with respect to

!

pMN reveals that the slopes of the NN and

SS curves are

!

"pDW "pM

N

NN= 1#µN( )AFD > 0 and

!

"pDW "pM

N

SS= #$AFD % 0 respectively. Totally

differentiating equations (9) and (10) in the vicinity of an initial zero-credit equilibrium yields:

!

1 " 1"µN( )AFD

1 0

#

$ %

&

' (

dpD

W

dpM

N

#

$ %

&

' ( =

1"µN( )AFD 0

1"µ S( )AFD "pM

NAFD

#

$ % %

&

' ( (

dp FS1

d)

#

$ %

&

' ( .

The determinant for the matrix on the left side is

!

1"µN( )AFD> 0. For row one in Table 1 we

obtain

!

dpM

Ndp F

S1

!

= 1"µN( )"1

µN"µ S( ) > 0 and

!

dpMNd" = # 1#µN( )

#1

pMN < 0 . For row 2,

!

dpD

Wdp F

S1

!

= 1"µ S( )AFD> 0 and

!

dpDWd" = # pM

NAFD $ 0. For row 3, equation (6) is used to get

!

dµNdp F

S1

!

= "µN "p FS1 + "µN "pM

N( ) "pM

N "p FS1( )

!

= 1"µN( )pKN # # $ µN( )( )"1

1"µ S( ) % &FN > 0 and

!

dµNd"

!

= "µN "pMN( ) "pMN "#( )

!

= " 1"µN( )pKN # # $ µN( )( )"1

pMN % "&'

N < 0 . For row 4, equation (8)

implies

!

dµSdp F

S1

!

= "µ S "p FS1

!

= pKS " " # µ S( )( )

$1

% &FS > 0 and

!

dµSd" =1. For row 5, equation (9)

— 42 —

implies that for North

!

d"F

Ndp F

S1

!

= "#F

N "p FS1( ) + "#F

N "pM

N( ) "pM

N "p FS1( )

!

=1"µ S > 0 and

!

d"F

Nd#

!

= "#FN "pM

N( ) "pMN "$( )

!

= " pMN

< 0. Using equation (10) for South,

!

d"F

Sdp F

S1

!

= "#F

S "p FS1( )

!

+ "#F

S "pM

N( ) "pM

N "p FS1( )

!

=1"µ S > 0 and

!

d"F

Sd#

!

= "#FS "$( ) + "#F

S "pMN( ) "pMN "$( )

!

= " pMN

< 0.

For row 6, differentiation of equation (14) reveals that

!

dpE

gdp F

S1

!

= aFE"EE d#F

gdp F

S1

!

= 1"µ S( )aFE#EE> 0 and

!

dpEgd"

!

= aFE"EEd#Fgd$

!

= "aFE#EE pMN

< 0 for

!

g = N,S . For row 7,

substituting equation (14) into (13) gives

!

p FS1 = "F pK

g, pL

g, pR

g( )

!

+aFE"EE#E pKg, pL

g( ) + $FgAFF

.

Differentiating and rearranging implies that

!

dpR

gdp F

S1

!

= 1" d#F

gdp F

S1( )AFF[ ] aRF

!

= 1" 1"µ S( )AFF( ) aRF

> 0 and

!

dpRgd"

!

= " AFF aRF( ) d#Fg d$( )

!

= pMNAFF aRF > 0 for

!

g = N,S ,

where

!

aRF "( ) # $%F "( ) $pRg . QED

Proof of Proposition 3

To begin, recall that

!

" g# 1$µg( )

$1

and note that

!

"# g "p FS1 = # g2

dµgdp F

S1 > 0 where, from the

proof of Proposition 2,

!

dµNdp F

S1

!

= 1"µN( )pKN # # $ µN( )( )"1

1"µ S( ) % &FN > 0 and

!

dµSdp F

S1

!

= pKS " " # µ S( )( )

$1

% &FN > 0. Consequently, differentiating equation (26), (27) and (28) with respect

to the price of fossil fuel in the vicinity of a pre-Kyoto equilibrium where

!

" = 0 yields

!

"XF

N "p FS1

!

= " S # S( ) Y M

N$ X

F

N[ ] = 0 , and

!

"XF

S "p FS1

!

= "XF

W "p FS1

!

= " S# S( )$1

%ZFH

W %p FS1( ) $ XF

N&F

N" N 2 $ XF

S&F

S" S2[ ] < 0. QED

Proof of Proposition 4

Differentiating equations (26), (27) and (28) with respect to a reduction in North’s emissions cap

in the vicinity of an initial equilibrium where

!

" = 0 yields

!

"#XF

N #Y M

N= "1,

!

"#XF

S #Y M

N

!

= " S# S( )$1

" N# N( ) $ ZFH

NXF

N( )%M

N&N[ ] , and

!

"#XF

W #Y M

N

!

= " S# S( )$1

" N $" S( ) $ ZFH

NXF

N( )%M

N&N[ ]. QED

Proof of Proposition 5

To begin, note that

!

"# g "$ = # g2dµg

d$ where, from the proof of Proposition 2,

!

dµSd" =1

and

!

dµNd"

!

= " 1"µN( )pKN # # $ µN( )( )"1

pMN % "&'

N < 0 . Differentiating equations (26), (27) and (28)

with respect to allowable emission credits in the vicinity of an initial equilibrium where

!

" = 0

yields

!

"XF

N "# = $ SXF

S> 0 ,

!

"XF

S "#

— 43 —

!

= XF

W " S# S( )( ) $%N" N 2 + 1 X

F

W( ) &ZFH

W &%( )[ ] ' $%N" N 2 + " S2 + " S " N# N( )[ ] XF

SXF

W( )[ ] , and

!

"XF

W "#

!

= XF

W " S# S( )( ) $%N" N 2 + 1 X

F

W( ) &ZFH

W &%( )[ ] ' $%N" N 2 + " S2 + " S " N '" S( )[ ] XF

SXF

W( )[ ].

QED

Robustness Checks for the Empirical Results

Table A1 compares the results reported in the text for the balanced with those obtained for

unbalanced panels, which include countries of the former Soviet Union and additional

developing and developed countries. The dependant variable in all five regressions is the natural

logarithm of per capita carbon dioxide emissions. Broadly similar results arise in regressions 1A

and 5A and in regressions 1B and 5B although 5A and 5B pertain to larger unbalanced panels.

In regression 5C, the manufacturing sector is decomposed into chemicals (Chem), food and

beverages (Food), machinery and equipment (Mach), and textiles and clothing (Text) with other

manufacturing as the omitted category. For this decomposition of manufacturing, it is necessary

to focus exclusively on an unbalanced because data limitations preclude a 24-year balanced

panel. The results suggest that the impact of the various sub-sectors of manufacturing on per-

capita CO2 emissions do not differ in a statistically significant manner from other

manufacturing. This lends credence to the analysis in the text where the manufacturing sector is

not disaggregated.

— 44 —

Table A1: Balanced versus Unbalanced Panels 1A (1) 1B 5A (2) 5B (2) 5C (2)

GDP per Capita (pc) 1.81E-04 *** 3.01E-04 *** 1.52E-04 *** 2.17E-04 *** 2.34E-04 *** [0.000] [0.000] [0.000] [0.000] [0.000] (GDP pc)2 -3.50E-09 *** -1.16E-08 *** -3.00E-09 *** -6.00E-09 *** -6.86E-09 *** [0.000] [0.000] [0.000] [0.000] [0.006] (% Agri)*(GDP pc) -2.13E-04 ** -7.75E-05 -0.000084 [0.011] [0.277] [0.356] (% Agri)*(GDP pc)2 1.78E-08 *** 1.52E-08 *** 1.37E-08 *** [0.008] [0.000] [0.005] (% Serv)*(GDP pc) -1.07E-04 ** -9.79E-05 *** -0.000142 ** [0.011] [0.002] [0.022] (% Serv)*(GDP pc)2 8.09E-09 *** 3.70E-09 ** 5.01E-09 * [0.000] [0.016] [0.055] (% OthInd)*(GDP pc) -1.57E-04 *** -7.60E-05 ** -0.000171 *** [0.000] [0.019] [0.004] (% OthInd)*(GDP pc)2 9.84E-09 *** 3.80E-09 *** 6.65E-09 *** [0.000] [0.005] [0.009] (% Chem)*(GDP pc) -2.35E-06 [0.162] (% Chem)*(GDP pc)2 8.07E-11 [0.196] (% Food)*(GDP pc) 1.81E-06 * [0.062] (% Food)*(GDP pc)2 -2.41E-11 [0.570] (% Mach)*(GDP pc) 7.70E-07 [0.477] (% Mach)*(GDP pc)2 1.31E-11 [0.777] (% Text)*(GDP pc) 2.13E-06 * [0.079] (% Text)*(GDP pc)2 3.77E-12 [0.942] Gas/Fossil Fuel 1.08E-01 1.66E-01 2.16E-01 * 1.99E-01 * 6.47E-01 *** [0.325] [0.120] [0.075] [0.083] [0.000] Coal/Fossil Fuel 1.56E+00 *** 1.41E+00 *** 1.49E+00 *** 1.27E+00 *** 1.64E-00 *** [0.000] [0.000] [0.000] [0.000] [0.000] Land/Population 1.22E+00 *** 1.43E+00 *** 2.03E-01 5.86E-01 4.06E-00 *** [0.004] [0.001] [0.622] [0.221] [0.000] Observations 1704 1704 3389 2925 1315 Countries 71 71 160 159 99 Panel Type Balanced Balanced Unbalanced Unbalanced Unbalanced Random vs Fixed Random Random Fixed Fixed Fixed R-squared within 0.491 0.514 0.335 0.364 0.571 R-squared between 0.67 0.711 0.335 0.364 0.593 R-squared overall 0.658 0.697 0.683 0.676 0.627

Robust p values in brackets; * significant at 10%, ** significant at 5%, *** significant at 1%. (1) Asymptotic properties for Hausman test not satisfied.. (2) Hausman test indicates fixed effects.

— 45 —

Figure 1: Production Linkages

— 46 —

Figure 2: Fuel Saving

pMN!p N

M

Wp

D

p!!

DW

SS !!

SS !

NN

p!

DW

N!!pM

— 47 —

Figure 3: Diversification

pMN!p N

M

Wp

D

p!!

DW

SS !!

SS !

NN

p!

DW

N!!pM

— 48 —

Figure 4: An Increase in the Price of Fossil Fuel

X = XSF M

S

X = XFN

MN

!!XFS !X

FS

FF !

MM

FF !!

N!XF

!!X NF

=

— 49 —

Figure 5: A Tighter Northern Cap X = XN

F MN

X = XN !F M

N !

!!X = XN

F MN!!

X = XSF M

S

MM!

MM!!

!!X = XSF M

S !!

FFWYF

_!

X = XS !F M

S !

— 50 —

Figure 5b: Tighter Northern Cap with OPEC’s Output Constant

Y FS1!

X FW

pFS1!

_

p W !!!F

pFW

D-WLD!!D-WLD!

S-NON S-NON+

p W!F

X W !!!F

X W !!F

X W !F

NONX F

! NONX F

!!!

Y FS1!

— 51 —

Figure 6: Increasing Allowable Emission Credits

X = XFN

MN

X = XFN !!

MN!!

X = XFN !

MN!

X = XFS

MS

MM!

MM!!

X = XFS !

MS!

YFW

_!

FF !

FF !!

— 52 —

Figure 6b: Increasing Allowable Emission Credits with OPEC’s Output Constant

Y FS1!

Y FS1!

X F

!!NON!!!X = XNONF

! FNON X W !!

F

D-WLD!

S-NON!

X FW

pFS1!

_

p W !!!F

pFW

D-WLD!!

p W!F

WF

X = XWF! !!!

+S-NON!!S-NON!!

— 53 —

REFERENCES

Antweiler, Werner, Brian R. Copeland, M. Scott Taylor (2001), “Is Free Trade Good for the

Environment”, American Economic Review, 91 (4), 877-908.

Copeland, Brian R. (1994), “International Trade and the Environment: Policy Reform in a

Polluted Small Open Economy”, Journal of Environmental Economics and Management,

26, 44-65.

Copeland, Brian R. and M. Scott Taylor (1994), “North-South Trade and the Environment”,

Quarterly Journal of Economics, 109, 755-87.

Copeland, B.R. and M.S. Taylor (1995), “Trade and Transboundary Pollution”, American

Economic Review, 85 (4): 716-737.

Copeland, Brian R. and M. Scott Taylor (2003), International Trade and the Environment,

Princeton University Press.

Copeland, B.R. and M.S. Taylor (2005) “Free Trade and Global Warming: a Trade Theory View

of the Kyoto Protocol”, Journal of Environmental Economics and Management, 49, (2)

205-234.

Dinda, Soumyanda (2004), “Environmental Kuznets Curve Hypothesis: A Survey”, Ecological

Economics, 49, 431-455.

Dixit, A.K. and V. Norman (1980), Theory of International Trade. Cambridge University Press;

Cambridge, UK.

Feenstra, Robert C. (2004), Advanced International Trade: Theory and Evidence. Princeton

University Press, Princeton.

Gaisford, J.D., and R.D. Pancoast (2005) ‘Will the Kyoto Protocol be Good for the

Environment? Implications for Agriculture,’ Current Agriculture, Food and Resource

Issues, 6 (August), 95-104. Available at: www.cafri.org.

Grossman, G. and A.B. Krueger (1991) “Environmental Impacts of a North American Free

Trade Agreement,” Garber, NBER Working paper 3914.

— 54 —

Grossman, G. and A.B. Krueger (1995), “Economic Growth and the Environment”, Quaterly

Journal of Economics, 110, 353-377.

Hoel M. (1991), “Global Environmental Problems: the Effects of Unilateral Actions Taken by

One Country”, Journal of Environmental Economics and Management, 20 (1): 55-70.

Holtz-Eakin, D., and T.M., Selden (1995), “Stoking the fires?: CO2 Emission and Economic

Growth”, Journal of Public Economics, 5, 85-101.

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national Panel on Climate Change – Climate Change 2001, Cambridge University Press.

Kavunku, Y. Okan, Shawn D. Knabb (2005), “Stabilizing greenhouse gas emissions: Assessing

the intergenerational costs and benefits of the Kyoto Protocol”, Energy Economics, 27

(2005), 369-386.

Nordhaus. Williams D. (2005) “Life After Kyoto: Alternative Approaches to Global Warming

Policies”, NBER Discussion Paper 11889. Available at:

http://www.econ.yale.edu/~nordhaus/kyoto_long_2005.pdf

Pancoast, R. (2003), “Is the Kyoto Agreement Good for the Environment: A General

Equilibrium Consideration of Global Carbon Leakage”. Calgary: M.A. thesis, University

of Calgary.

Schmalensee, R., T. Stoker, and R. Judson (1997), “World Carbon Dioxide Emissions: 1959-

2050”, Review of Economics and Statistics, 80, 15-27.

United States, Energy Information Administration (EIA). Website:

http://www.eia.doe.gov/environment.html.

Weber, M. and G. Hauer (2003), “A Regional Analysis of Climate Change Impacts on Canadian

Agriculture.” Canadian Public Policy, 29 (2), 163-179.

World Bank, World Development Indicators (WDI). Website:

http://devdata.worldbank.org.ezproxy.lib.ucalgary.ca/dataonline/.

— 55 —

ENDNOTES

1 See, for example, the Inter-governmental Panel on Climate Change (2001). Some analysts

such as Weber and Hauer (2003) expect positive rather than negative net benefits at least at

the regional or sector level within particular countries.

2 Related work by Gaisford and Pancoast (2005) and Pancoast (2003) comes to essentially the

same conclusions in the context of a more conventional clean-good, dirty-good model.

3 For examples of the use of this methodology, see Antweiler et al. (2001) and Copeland and

Taylor (1994, 1995, 2005). An overview is provided by Copeland and Taylor (2003).

4 For example, Kavunku and Knabb (2005) contend that the first generation that will benefit

from Kyoto will be in the twenty fourth century.

5 For example, capital could originate as output of the clean good, be internationally mobile

and accumulate passively in the background.

6 To ensure the efficiency of the cap and trade policy in North, we assume the initial

assignment of permits does not affect the current marginal or total profits of dirty firms and,

thus, is fully detached from current production and participation decisions.

7 These results imply that the South’s supply functions for both dirty goods and emission

credits are perfectly elastic.

8 The total value of emission credits transferred form North to South is given by

!

" S = #" N = $ pMNXM

S where, as discussed below,

!

" # 1$µSp F

S1,%( )( )

$1

% represents the

available emission credits per unit of fossil fuel used in South. In an initial pre-Kyoto

equilibrium, transfer income is absent because

!

" = # = 0. Starting from such an equilibrium,

transfers are unaffected by any changes in South’s emissions,

!

XM

S .

9 Because capital is elastically supplied in the current model, the price rather than quantity of

capital would enter into a complete statement of the GDP functions. Strictly speaking, the

value added in producing a good rather than its price would enter the GDP function, but the

value added in each product depends, in turn, its own price and intermediate input prices.

— 56 —

10 The implications of OPEC increasing the price of fossil fuel will be discussed below.

11 At this point the world equilibrium is fully determined. Given the equilibrium levels of fuel

use, we can recover South’s output of fuel from equation (23), the electricity outputs of each

country from equation (20) and the dirty-good outputs from equation (24). Each country’s

output of the clean good can then be determined using the labour market equilibrium

condition, which stipulates that exogenous endowment of labour is equal to the utilization of

labour by the four sectors such that

!

Y Lg

= aLCYC

g+ aLDYD

g+ aLEYE

g+ aLFYF

g . By Shephard’s

lemma, we obtain

!

aLj = "# j $( ) "pLg . Next, the endogenous quantity of capital, which

accumulated in each region, can be determined from the region’s aggregate capital

requirements. This implies that

!

YKg

= aKCYCg

+ aKDYDg

+ aKEYEg

+ aKFYFg , where

!

aKj = "# j $( ) "pKg + aFj"%F

&g $( ) "pKg . Finally, note that the world equilibrium condition for the

clean good,

!

YC

N+Y

C

S= X

CH

N+ X

CH

S , is redundant by Walras’ law.

12 If credits are present, the MM curve pivots upward in response to an increase in OPEC’s

fossil fuel because fuel use per unit of output declines as the business as usual baseline

increases. While fossil fuel use and emissions continue to decline in the South and in the

world as a whole, the direction of change for the North becomes ambiguous.

13 The situation in Figure 5 would also arise if North’s overall standardized consumer demand

for fossil fuel were income-neutral.

14 Figure 5b provides further clarification. The world demand curve for fossil fuel shifts

outward from

!

DF

WLD" to

!

DF

WLD"" in response to the tighter cap in North given that the share of

permit revenue is sufficiently small. The

!

SF

NON curve represents the non-OPEC supply of

fossil fuel (i.e., the supply by the North and the non-OPEC sub-region of South), while the

!

SF

NON + adds the initial OPEC output,

!

YF

S1", to the non-OPEC supply. Consequently, world

fossil fuel use rises from

!

XF

W " to

!

XF

W """ if OPEC holds its output constant whereas it would

rise further to

!

XF

W "" if OPEC were to hold its price constant.

— 57 —

15 We have three freely trade outputs — clean goods, dirty goods and fossil fuel — and two

internationally immobile inputs — labour and natural resources. In North, the emissions cap

acts as a third factor endowment rendering its production pattern determinate, but leaving

indeterminacy in the production pattern of the South-OPEC region.

16 Figure 6b shows a case where the world demand curve shifts inward but the price decrease

associated with OPEC holding its output constant increases the quantity demanded so as to

exactly offset the initial decrease in demand. The price decrease just suffices to reduce the

non-OPEC output to its original level despite the outward shift in the non-OPEC supply

curve from

!

SNON" to

!

SNON" .

17 In a model with uncertainty, Nordhaus (2005) argues in favour of international emissions tax

coordination rather than quantitative controls and international permit trade. World

efficiency would require that the global emission cap or global Pigouvian tax was set such

that the inverse world demand for emissions by all fossil fuel using activities was equated to

the sum of the marginal damages to North, South and OPEC in accordance with a standard

Samuelsonian analysis of public goods.

18 Grossman and Krueger (1991, 1995) did pioneering work on environmental Kuznets curves.

Schmalensee et al. (1997) suggest that for developing countries there is rapid growth of per

capita CO2 emissions as per capita GDP increases. For highly developed countries such as

the US and Japan, however, the growth in CO2 emissions becomes less pronounced and may

be reversed at high enough income levels. In contrast, Holtz-Eakin and Selden (1995)

suggest that global pollutants like CO2 may increase monotonically and that evidence for

turning points is weak. For a survey of the literature on environmental Kuznets curves, see

Dinda (2004).

19 Real GDP is measured in US constant dollars with a base year of 2000 and purchasing

power-parity currency conversions.

— 58 —

20 While this correspondence appears to be largely an artifact of the methodology by which

CO2 emissions data is constructed, the methodology itself presupposes limits on directly

reducing emissions from combustion processes.

21 We do not consider changes in the “other industry” category much of the activity in this

sector may be locked in by sector-specific natural resources.