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Climate Change Policy After Kyoto: A Blueprint for a Realistic Approach

Warwick J. McKibbin

Australian National University

& The Brookings Institution

Lecture 3: Korea University November 2003

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Presentation based on:

McKibbin W.J and P.J. Wilcoxen (2002) Climate Change Policy after Kyoto: A Blueprint for a Realistic Approach, Brookings Institution, November

McKibbin W.J. and P.J Wilcoxen (2003) “Estimates of the Costs of Kyoto-Marrakesh Versus The McKibbin-Wilcoxen Blueprint” forthcoming Energy Policy

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Overview

• What is the climate change policy issue?– Managing Uncertainty in a sustainable way

• Features of a Sustainable System• The UN Framework Convention on Climate

Change• The Kyoto Protocol• Some Simple Economic Solutions• Problems with the Kyoto Protocol?• An Alternative Approach: The McKibbin

Wilcoxen Blueprint?• Where to go from here?

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A Comment on the climate debate:

• Some argue that climate change doesn’t exist, that the science is wrong, that nothing should be done

• Some argue that climate change is so important that there is no cost too high to tackle the problem

• Both approaches are likely to be wrong

• Good public policy must recognize the risks as well as the costs to society of the responses.

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What is Climate policy about ?

– We know that carbon concentrations in the atmosphere have risen 30% since the industrial revolution.

– We know the science of the greenhouse effect.

Everything else is uncertain:Everything else is uncertain:

– UncertaintyUncertainty about link between carbon dioxide emissions and the timing and magnitude of climate change

– UncertaintyUncertainty about costs and benefits of climate change

– UncertaintyUncertainty about costs and benefits of abatement

– UncertaintyUncertainty about the policy responses

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Figure 2.1: Global Carbon Dioxide Emissions, 1751-1998

0

1000

2000

3000

4000

5000

6000

7000

1750 1770 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990

Year

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Some Illustrations of the uncertainties

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Figure 2.6: Emissions of Carbon Under IPCC Scenario A1B

7.1

15.9

26.6

22.9

17.9

7.1

12.1

18.718.0

13.4

7.1

9.6

13.013.5

16.4

0.0

5.0

10.0

15.0

20.0

25.0

30.0

1980 2000 2020 2040 2060 2080 2100 2120

Year

Gig

ato

ns

of

Car

bo

n (

Gt)

AIM

ASF

IMAGE

MARIA

MESSAGE

MiniCAM

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Figure 2.7: Global Temperature Record, Vostok Ice Core Data

-12

-10

-8

-6

-4

-2

0

2

4

050,000100,000150,000200,000250,000300,000350,000400,000450,000

Years Before Present

Dif

fere

nce

in M

ean

Tem

per

atu

re, C

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Figure 2.11: Median Carbon Tax Needed in 2010 to Achieve Kyoto Target, by Region(Error bars show the range between the 20th and 80th percentiles)

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200

300

400

500

600

USA Europe Japan CANZ

Country or Region

1990

US

Do

llars

per

To

n

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Figure 2.12: Median GDP Loss in 2010 Under Kyoto Targets, by Region(Error bars show the range between the 20th and 80th percentiles)

0

0.5

1

1.5

2

2.5

USA Europe Japan CANZ

Country or Region

Per

cen

t o

f 20

10 G

DP

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Features of a Sustainable System

– Extensive - all major carbon emitters need to participate

– Implementable in key countries– Equitable - across a range of dimensions– Efficient - minimum economic cost– Flexible - need to adjust as new information is

revealed– Low cost of implementation/administration– Must establish clear property rights over a long period

of time to provide the right incentives for all involved• households, industry, governments

– Should be in all participants interest to commit current and future participants within each country involved

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The UN Framework Convention on Climate Change

• Negotiated at the Earth Summit in 1992 in Rio• Set Goals (not targets)

– “preventing dangerous anthropogenic interference with the Earth’s climate system”

– Annex I countries (industrial countries) were to adopt policies to “aim” to reduce their emissions

– Entered into force in March 1994

• Set in process a series of meetings of the “Conference of the Parties” (COP)

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COPS

• 1995: COP1, Berlin– Adopted the “Berlin Mandate,” a declaration that the

UNFCCC would have little effect on greenhouse gas emissions unless Annex I countries were held to “quantified limitation and reduction objectives within specified time-frames,” an approach now described as setting “targets and timetables” for emissions reduction. Established a two-year “analytical and assessment phase” to negotiate a comprehensive set of “policies and measures” that should be taken by Annex I countries. No new commitments or obligations were imposed on countries outside Annex I.

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COPS

• 1996: COP2, Geneva– Called for the establishment of legally binding

emissions targets as proposed at COP1. Rejected the COP1 proposal that uniform policies be imposed in favor of allowing Annex I countries the flexibility to develop their own policies.

• 1997: COP3, Kyoto– Adopted the “Kyoto Protocol,” in which most Annex I

countries were assigned legally binding emissions targets to be achieved by 2008-2012 The average target was about 95 percent of the country’s emissions in 1990. Many details of implementation were left for future negotiations.

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COPS

• 1998: COP4, Buenos Aires– Adopted a two-year plan of action to design

mechanisms for implementing the Kyoto Protocol. Issues discussed included financial transfers and clean development mechanism (CDM) for developing country participation. Also discussed issues for incorporating “carbon sinks”.

• 1999: COP5, Bonn– Primarily devoted to monitoring progress on the work

program adopted at COP4.

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COPS

• 2000: COP6, The Hague– Intended to finalize details on implementation of the Kyoto

Protocol. Negotiations ended without agreement. Many issues were unresolved: how the mechanisms in the Protocol would operate; what measures would be used to enforce compliance; how large allowances would be for “sinks” that remove carbon dioxide from the atmosphere; and whether there would be restrictions on the use of the Protocol’s flexibility mechanisms.

• 2001: COP6bis, Bonn (July)– Continuation of COP6 following the stalemate at The Hague.

However, President Bush declared in March 2001 that the United States would not participate in Kyoto Protocol. Other Annex I countries agreed to proceed without the United States. Large sink allowances were granted to Japan and Canada. Produced a set of recommendations on implementing the Protocol that were to be discussed at COP7.

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COPS

• 2001: COP7, Marrakesh (October)– Formally adopted most of the recommendations of

COP6. Finalized rules for use of flexibility mechanisms, especially the Clean Development Mechanism. Also, established a “Compliance Committee” to “facilitate, promote and enforce” compliance with the Protocol. In the event of noncompliance, the “Enforcement Branch” of the Compliance Committee may deduce 1.3 times the amount of the violation from the violator’s emissions allowance for the next commitment period. The violator may also be barred from using the flexibility mechanisms. Also finalized the accounting procedures to be used for sinks.

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The Kyoto Protocol

• Protocol to the 1992 UN framework Convention on Climate Change, negotiated in 1997

• Annex 1 countries agreed to reduce emissions of 6 greenhouse gases to 5.2% below 1990 levels on average between 2008 and 2012

• No commitments for Developing Countries (countries such as China ratify but have no targets!)

• flexibility allowed through– permit trading– clean development mechanism (CDM)– joint implementation

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The Kyoto Protocol

• legally binding if 55 countries accounting for 55% of developed country emissions ratify

• USA and Australia have rejected• Russia is the key country that will determine if

the Protocol enters into force

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What would a simple economic approach be?

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Two well known approaches:

• Carbon tax• Permit trading

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A carbon tax:

• A fixed price for carbon with revenue going to the government

• Emission outcome is unknown but the cost of carbon is known with certainty

• Problems– Tax payments are enormous– If optimal reduction is 20% of emissions, firms must

pay tax on 80% of original output.

– Very unpopular with industry!

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Domestic permit trading:

• Quantity of emissions is certain and fixed at the quantity of permits

• Price of carbon is uncertain and depends on marginal abatement costs given the target

• Problems:– Price of permits (i.e. cost to the economy) might be

very large– Costs might substantially exceed the benefits

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Kyoto-style Permit Trading

• Emission permits are issued equal to the target

• Each country receives an allocation of permits• Countries/firms

– buy permits if they wish to increase emissions – sell permits if they wish to reduce emissions

• Trading allows original country targets to be tightened or relaxed depending on the costs– Abatement differs across countries depending on

costs of abatement relative to the price of permits– The permit price will be determined by demand and

supply and will equal the cost of preventing the emission of an additional unit of carbon

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Advantages

• Global target is met but differential country response allowed through the market

• Cost of removing an additional unit of carbon is equal everywhere (efficient)

• Compensation (across countries and within countries) can be built into the initial permit allocation

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The Problem with Targets & Timetables?

• A fundamental problem with targets and timetables

• What is the correct target for each country and the world?

• What is the optimal period?– targets impose unknown cost for given outcome for

emissions• permit trading gives greater flexibility across

countries but no flexibility in total

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Some Problems

• If costs are low we miss the opportunity to cut emissions quickly (in total) because we have a fixed target

• If costs are high we might create severe problems that would destroy the commitment to Kyoto

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Some Problems

• Permit trading more widely implemented could cause economic and political problems with large wealth transfers between economies and large fluctuations in trade balances and real exchange rate

• Some historical examples– Dutch Disease – e.g. North Sea Oil Discovery in

1970s– Keynes classic “transfer problem” related to German

Reparations after WWI

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Some Problems

• If one large country reneges the permit system would likely collapse since the price depends on all countries supply and demand

• This requires a very strong monitoring and enforcement mechanism in all participating countries.

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Many Key Remaining Questions • How do you get developing countries into the

system if it proceeds? Without developing countries UNFCCC goals will not be achieved (and US will not ratify).

• What enforcement mechanism will be required to keep a global Kyoto style system from collapsing under a range of alternative future scenarios?

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What should be done given uncertainty?

• Some proposals:– Do nothing

Problem may be small, avoiding it may be expensive– Do something drastic

Problem may be enormous, avoiding it may be cheap

• A prudent policy would avoid extremes– Reduce emissions where possible at low cost

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How can Climate Policy be made Sustainable?

• Difficult without a fundamental shift of focus because Kyoto fails to acknowledge and address the single most important aspect of climate change: uncertainty

• Targets and timetables imply uncertain costs which some industrial countries reject and developing countries will be unlikely to accept.– No developing country commitments and no United

States participation

• Current time frame for commitments is too short• Complex – requires new international institutional

structures that are infeasible in the near term

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How can Climate Policy be made Sustainable?

• Global markets in emissions trading means – the withdrawal of a large country risks can destroy

the system – The threat of withdrawal can create political

compromise on the targets– Monitoring and enforcement a major source of

tension between countries

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Are there any alternatives?

• Need a policy with best features of permits and taxes

• Like a tax:– Should guarantee that costs won’t be excessive

• Like permits:– Should avoid huge transfers to the government

• Importantly it should make property rights clear over a long period and provide incentives for industry,households and governments to reduce emissions at low cost

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Solution: The Blueprint (a hybrid policy)

• Each participating country would:

– Require that producers of energy within their borders have an annual emission permit for each ton of carbon embodied in their energy produced and sold domestically or imported

– Issue perpetual emissions permits equal to a specified fraction of a base period emissions.

– Be allowed to sell additional annual permits to firms within its borders at a stipulated price ($P per ton of carbon), we say $P could be $US10 per ton of Carbon ($US2.72 per ton of CO2).

– Create domestic markets in the perpetual and annual permits

• The permits can only be used in the country of issue: no international trading.

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PerpetualPermit

(Endowment)

Looking at the policy in more detail:

Allows one unit per year forever (or for a long period)

Distributed once at enactment Can be leased or sold within country Quantity can set by treaty: QT

Price will be set by the market

AnnualPermit

Allows one unit for one year Sold by government as demanded Price set by treaty: PT

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Supply of each type of permit (for use in a given year)

$

SS

QP

Annual permits for sale

PT

Perpetual permits for lease

SL $

QP QT

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Overall supply of permits (for use in a given year)

S

$

QP

PT

QT

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If abatement is easy:

MAC rise slowly Low D for permits P below threshold No annual permits Hit target QT

S

$

Q Permits

D P

PT

QT

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If abatement is difficult:

MAC rises rapidly High D for permits P at threshold PT

Annual permits used Emissions exceed QT

S

$

Q Permits

D

P, PT

QT

QA

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Key Points

• Each system is run within a country using that country’s own imperfect monitoring and enforcement mechanisms and its own legal and accounting systems

• No international trade in the assets – only domestic markets– Short run efficiency guaranteed by a common price– Long run efficiency driven by structural change

• Incentives for all actors are internalized within countries

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Developing Countries ...

• Negotiate a perpetual permit allocation that is larger than current emissions

• Price of annual emission permits zero in the short run because more permits than needed

• Price of perpetual emission permits will be non zero giving important signals for investment projects

• Over time the permit price in countries will equalize as developing countries “ability to pay rises”

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Developing Countries ...

• Will developing countries ever agree?– Depends on who is expected to get the

valuable assets called permits– Will they ever agree to Kyoto style

interventions?

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Advantages of the Blueprint policy

• Guarantees that compliance costs would not be too high– Passes the test that Kyoto fails

• Can be justified on cost-benefit grounds– Current knowledge about climate risks justifies slowing emissions

at low cost• Avoids huge transfers to the government

– Each government can decide how to hand out perpetual permits but once these property rights are distributed they are not revisited (like land contracts)

– Permits act as transition relief for industries (and affected workers) and will reduce opposition

– Also, easy for industry to understand -- like grandfathering

• Reduces emissions wherever cost-effective– Prudent: eliminates emissions where possible below a fixed price

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More advantages ...

• Maintains national sovereignty– Important for US and developing country participation

• Incorporates an explicit mechanism for developing country commitments with no short term costs but clear incentives for future investment in less carbon intensive activities

• Provides a futures market (perpetual permit market)– Allows individual risk management

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More advantages ...

• No direct international transfers of wealth– Trading is national, rather than international– Less disruptive to exchange rates and foreign aid budgets

• Gives incentives for early action– Perpetual permits could be distributed now, even without a treaty!– The private sector is already doing this but property rights unclear

• Built-in incentives to monitor and enforce– Annual permits generate government revenue– Owners of perpetual permits do not want permit prices to erode

• Credible– Less draconian so more likely to be enforced into the future

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Still more advantages ...

• Relatively easy to modify as information arrives– Can raise or lower the world price as risks become better known

• Easy to add countries over time– Does not require re-negotiation of treaty– New countries don’t hurt existing permit owners

• Creates a future market in carbon (the perpetual permit market)– Gives a long term price signal but with a fixed short term cost

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An Illustration of how Uncertainty impacts on the costs of Kyoto versus Blueprint

• Suppose Russia grows at 1% per year faster from 2000 to 2012 than our baseline forecast (4.4% rather than 3.3%)

• What is the cost of Kyoto versus the Blueprint under the baseline scenario versus the alternative scenario of higher Russian growth?

• Both Kyoto and the Blueprint assume non participation by developing countries even though the Blueprint has a clear mechanism for getting developing country participation!

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The Model Used

• The G-Cubed Multi-Country model

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The G-Cubed Multi-Country Model

• Used by governments of US, Australia, Canada, New Zealand and IPCC for evaluation of alternative policies

• Used by many academics with open source documentation on the internet

www.gcubed.com

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The G-Cubed Model

– Countries (in this version)• United States• Japan• Australia• Europe• Rest of OECD• China• Eastern Europe and Former Soviet Union• Oil Exporting Developing Countries• Other non Oil Exporting Developing Countries

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The G-Cubed Model

– Sectors– Electric Utilities– Gas Utilities– Petroleum Refining– Coal Mining– Crude Oil and Gas Extraction– Other Mining– Agriculture, Fishing and Hunting– Forestry and Wood Products– Durable Manufacturing– Non Durable Manufacturing– Transportation– Services

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The G-Cubed Models

• Dynamic intertemporal general equilibrium model of the world economy– Intertemporal optimization plus stickiness in the

short run

• Integrates the macro-econometric, Computable general equilibrium and real business cycle approaches to modeling.

• Sectoral dis-aggregation• Consistent macroeconomic structure• Integration of financial assets and real

economy

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Based on Simple Neoclassical model in the long run

• Plus stickiness in the short run– Adjustment costs in capital accumulation– Some agents re-optimize while others use long run

optimal rules of thumb – Money required for transactions– Nominal wages adjust gradually

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Advantage

• Structural model with estimated structural parameters but with an explicit treatment of expectation so less susceptible to the Lucas Critique than reduced form econometric models

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Emission Outcomes

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Figure 1: Cumulative World Carbon Emissions1999-2015

100000

110000

120000

130000

Unconstrained Kyoto Blueprint

mmt of carbon

BAU Russian growth High Russian growth

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GNP costs under Kyoto and the Blueprint in High and mid Russian

growth

GNP (high growth in Russia) minusGNP (moderate growth in Russia)

under both regimes

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Europe

-1.6

-1.2

-0.8

-0.4

0.0

1999 2004 2009 2014 2019 2024

OPEC

-2.8

-2.4

-2.0

-1.6

-1.2

-0.8

-0.4

0.0

1999 2004 2009 2014 2019 2024

Strong Russian Growth - BlueprintMod Russian Growth - Blueprint

Strong Russian Growth - KyotoMod Russian Growth - Kyoto x

Change in GNP relative to BAU:

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Difference between Costs under Kyoto

GNP (high growth in Russia) minusGNP (moderate growth in Russia)

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Change in GNP under KyotoAlternative Russian Growth Assumptions

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025

US Japan

Europe Australia

Russia China

LDC OPEC

% pts

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GNP under MWAlternative Russian Growth Assumptions

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025

US Japan

Europe Australia

Russia China

LDC OPEC

% pts

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Where to go from here?

• The current approach as embodied in the Kyoto protocol does not deal with uncertainty and is not sustainable

• The Blueprint dominates in terms of– the extent of emissions reductions; – risk management; – sustainability.

• The Blueprint can be implemented within countries and is consistent with moving towards Kyoto if a country ever wanted to.– Just have the government pull out of the annual permit

market and allow these asset to be traded internationally

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Background Papers

www.sensiblepolicy.com

www.notwrong.com