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Carbon Leakages, Climate Change ‘Free Riders’ and Copenhagen

The issue of devising an efficient and equitable global climate change mitigation agreement is examined. While there are strong damage cost reasons for self-interested, large countries to unilaterally move towards climate change mitigation there are practical reasons for them not to commit.  A key issue for developed countries is that of possible carbon leakages while, for developing countries, the need to pursue growth objectives restricts their proclivity to mitigate.  Carbon leakage issues can be addressed using such things as border tax adjustments which, however, raise computational complexity, GATT-rules consistency and, importantly for developing countries, equity issues.  If the efficiency gains from utilising BTAs are to be realised, compensation schemes must also address the equity issues that bind practical policy-making in developing countries. The specific analysis is related to devising climate change agreements that include China and the United States.

I wrote this paper while being Visiting Scholar at Peking University. 

 1. Background. There is often claimed to be a need to ensure that developed countries who do take action to address climate change are not disadvantaged simply because developing countries do not mitigate.  The US for example declined to ratify the Kyoto Protocol because developing countries and particularly China, a key supplier of exports to the US, was not required to control its greenhouse gas emissions (GGEs) under it.  This was seen as resulting in a loss of US competitiveness and the possible migration of US firms to ‘havens’ where GGEs were not being mitigated – in short, carbon leakage effects.  Such carbon leakages can be addressed by border tax adjustments (BTAs) which internalise the GGEs externalities generated by exports of countries which do not mitigate their emissions. These operate as trade penalties on countries which do not mitigate. Indeed the threat of introducing them may induce developing countries to mitigate to preserve favourable market access for their exports.  

By insuring that no disadvantage arises to the country mitigating it is claimed that ‘free-rider’ problems with respect to mitigation effort have been reduced. Countries then have reduced incentives to leave it to other countries to mitigate climate change.  Free-riding is certainly a moral problem particularly if, as has been the case until recently, with respect to the United States, it is this wealthy country with high per capita GGEs that is doing the free-riding. But the practical consequences of free-riding are of greatest relevance to policy debates not moral arguments. A poor developing country with the legitimate moral right to not price GGEs on the basis of equity and development concerns can still itself be severely impacted on by climate change. The practical difficulty is that, with free riding, it may be difficult or impossible to devise a global climate change treaty post-Kyoto.  An initial attempt to derive such a treaty will be sought by the United Nations from November 30-December 11, 2009 in Copenhagen.

As a matter of pure logic it is therefore questionable whether the focus on free-riding should be a concern on the basis of national self-interest.  Even if other countries do ‘free ride’ on climate change there remain good reasons for pursuing unilateral mitigation. 

1.  Because there are real prospects of a climate change catastrophe if global carbon emissions are not mitigated satisfactorily by any large emitter. If cost benefit analysis is implemented by any nation by attaching probabilities to the various possible states of the world and one state involves a catastrophically bad outcome with a non-negligible probability then it is that state which should dominate the focus of a sensible policy designer – discount rates and indeed strategic interdependence issues become irrelevant. Weitzman (2009), for example, argues that if we only gradually ramp up global mitigation efforts as climate change worsens over the next 200 years that, with ballpark probability 0.05, mean global surface temperatures will rise by 10oC and that, with probability 0.01, they would rise by 20oC. Such temperatures have not existed on the earth for hundreds of millions of years and would be plausibly catastrophic for continued human existence on this planet.  In this event standard cost-benefit studies for each country will be dominated by the prospects of such catastrophic events at low though not negligible probabilities provided that the country is or will be a large enough emitter so that it is in a position to take action to reduce the risk.

It is only if individual countries know that life on earth is to certainly cease as a consequence of catastrophic climate change and that nothing can be done unilaterally to avoid this disaster that active unilateral policies to avoid catastrophic outcomes should be avoided. Then countries should perhaps ‘have a final relaxed drink’ as the Titanic goes down.  But this is an extreme scenario – the more plausible assumption is that, with enough mitigation effort, large countries and groups of countries (e.g. China, Europe, India, United States) can reduce the probability of catastrophe. In this case, as argued in Clarke and Reed (2006), individual countries should be prepared to commit to unilateral actions simply to avoid the huge losses associated with a climate catastrophe.

Forcing recognition of such dire possible consequences of climate change is a key to securing multi-lateral co-operation on climate change.

2. Indeed even from a less apocalyptic viewpoint, even if national climate change policies are not based on offsetting the prospects of a catastrophic collapse but take the plausible range of global mean average forecast temperature increases to be in the range 1.4oC-6.4oC between 1990 and 2100 (IPPC, 2007), the situation is dire. Plausibly warming of between 1.8oC and 2oC is predetermined to occur on the basis of existing CO2E concentrations. This range is dangerously close to the 2-3oC warming that mainstream science sees as a dangerous threshold. For example the Stern Review estimate that business-as-usual emissions would produce damages equal to 20 per cent of GDP by 2050 (Stern, 2006). There are thus huge costs for all countries in not pursuing unilateral mitigation options even given the ‘non-catastrophic’ temperature range forecasts of the IPCC. Countries which are large enough to derive direct benefits the global effects of their mitigation efforts derive these benefits even if they incur carbon leakage losses from unilaterally mitigating.

This means that with respect to many countries the best way to endorse support for climate change mitigation is to use realist geopolitical persuasion based on self-interest rather than moral obligation.  For example, in China the prospects of for different groups of severe drought in the north, flooding and sea level change issues in the south, the benefits of energy independence and the prospects of severe urbanisation pressures may be a way of engaging the country in climate change. Chinese politicians, for example, might be reminded of the fact that climate change has sparked wars and dynastic change in Chinese history (Wiener, 2008).

Despite these strong arguments, as a matter of practical politics, it is important to address ‘free-rider’ issues. It is not only logic that matters in political debates. With respect to climate change there are constant assertions by those opposed to climate mitigation policies that unilateral action makes no sense. The claim has been repeated enough for it to become ingrained. Conservative groups around the globe use the claim that, because others are not mitigating their GGEs that this is a sufficient reason for governments not to  mitigate.  For example, public announcements in the lead-up to the Copenhagen meetings, the G8 Meeting in July 2009 in Italy, confirmed that Canada, Japan and Russia refused to endorse attempts to limit global climate change to 2oC. This is the level that the IPPC and other groups see as critical for avoiding severe effects of climate change.

As a practical matter the strong logical case for unilateralism has not been accepted widely-enough for it to translate into a compelling case for a coordinated global response.

The remainder of this paper analyses policies that encourage governments not to ‘free-ride’.  The main policy examined is the use of BTAs to inhibit possible carbon leakages which are the key reason developed countries refuse to endorse unilateral action. Section 2 provides background information on carbon leakages. Section 3 surveys the consequences of leakages in a game-theoretic setting and demonstrates precisely the claim that unilateralism is not necessarily dead. Section 4 provides a policy proposal for limiting the prospects of such leakages by simultaneously providing compensations which insure distributional fairness globally. Section 5 summarises conclusions.

2. Carbon leakages and the carbon tax base. Carbon leakage occurs when (i) the mitigation response of one country (for example, the US) raises local costs thereby giving countries that do not mitigate (for example, China) a trade advantage with US consumers substituting Chinese goods not subject to GGE restrictions for US products that are subject to restrictions and, perhaps, with parts of the US production base moving offshore to a pollution ‘haven’ in China, or (ii) when GGE restrictions in the US add a premium to the cost of its exports which reduces the demand for them in China[1]. The choice of the US and China as the respective countries here summarises the current policy debate given the recent US passing of the Waxman-Markey Bill[2] and given China’s continued reluctance to price its carbon emissions.

These leakages can arise if there is no uniform global emissions tax or, equivalently, if there is no free international trade in emissions permits via an international cap-and-trade scheme that would equalise mitigation costs across nations. If carbon leakages are important, and are accounted for when countries choose their climate change policies, then the global strategic analysis of such policies becomes complex. 

The empirical extent of likely carbon leakages is a matter of debate. Impressionist characterisations in the daily press suggest dramatic possible effects.  According to Kahn and Landler (2007) ‘Germany is China’s mirror image. Polluting factories have migrated abroad…. Since 1990, Germany has reduced its annual carbon emissions by 19 percent.’ [But] the same hulking blast furnace [was] dismantled and shipped piece by piece from Germany’s old industrial heartland to Hebei Province, China’s new Ruhr Valley. The transfer, one of dozens since the late 1990s, contributed to a burst in China’s steel production, which now exceeds that of Germany, Japan and the United States combined…’China’s less efficient steel mills, and its greater reliance on coal, meant that it emitted three times as much carbon dioxide per ton of steel as German steel producers.’ (emphasis added). According to this report the net effect of such firm migrations is to worsen GGEs globally.

 

More academic studies do not confirm these views. Houser et al. (2008) argue that the damages to developed countries from leakages would be small. The claim is that for many manufacturers (and certainly service industries) do not use much energy, the main source of emissions, and so would not suffer big costs. Energy makes up less than one per cent of the cost of making cars, furniture or computers. Even some energy-intensive industries, such as power generation, should not be much affected. Since they have no foreign competition, they could pass on extra costs to their customers.  The Stern Review (Stern, 2007) also argued such effects were likely to be small and evidence from the European Union’s experiences with its internal emissions trading scheme tends to confirm this (Convery et al., 2008).  Recent influential studies by the WTO-UNEP study (Taniotti et al., 2009) and by the Pew Institute (Aldy & Pizer, 2009) reach the same conclusion.  The Pew study concludes that competitiveness effects are relatively small and restricted to a narrow range of industries:

‘We find that higher energy prices, of the sort associated with pricing CO2 at $15 per ton, would lead to an average production decline of 1.3 percent across U.S. manufacturing, but also a 0.6 percent decline in consumption (defined as production plus net imports). This suggests only a 0.7 percent shift in production overseas. There is no statistically discernible effect on employment for the manufacturing sector as a whole.

 ‘…. We estimate that industries with energy costs exceeding 10 percent of shipment value, (e.g., metal foundries, cement, and lime) would expect output declines of about 4 percent and consumption declines of 3 percent, associated with a $15 per ton CO2 price, suggesting a 1 percent shift overseas. The decline in consumption presumably reflects efforts to economize on the use of energy-intensive manufactured commodities in end-use products and substitution to less-energy-intensive input. This 1 percent shift—out of a 3–4 percent decline in production—illustrates that most of the domestic climate policy impacts on industry do not reflect adverse competitiveness effects….. Rather, they reflect shifts in consumption patterns.

….We can apply our results to key energy-intensive manufacturing industries…. We calculate production declines of 2.7 percent in iron and steel, 2 percent in aluminum, 1.6 percent in cement, 3.4 percent in bulk glass, and 3.3 percent in paper, associated with a $15 per ton CO2 price. The comparable estimates of production shifts overseas range between 0.7 percent and 0.9 percent in these industries, roughly on par with the overall manufacturing sector (more narrowly defined energy-intensive industries would expect competitiveness effects ranging from 0.3 percent to 1.8 percent)…’

Despite these findings the carbon leakage issue and measures to address it are very much on the current policy agenda.  For example the Waxman-Markey Bill which aims to trim GGE emissions by 17 percent from 2005 levels by 2020 using a ‘cap-and-trade’ scheme and an 80 per cent reduction by 2050, contains an amendment to levy BTAs on the imports of countries after 2025 if they do not comply with US GGE controls. Taniotti et al. (2009) go to considerable length to ascertain the extent to which such BTAs are consistent with the rules of the GATT.

Carbon leakage of industries from countries which mitigate to countries which do not mitigate can, in principle, be dealt with by taxing the carbon emissions associated with consumption rather than production and by taxing imports of goods originating from non-mitigating countries so that these goods do effectively bear a carbon tax prior to local consumption.  This is destination accounting of GGEs as discussed in Taniotti et al. (2009) as being the basis on which corrective BTEs might conceivably be conceivably be consistent with GATT rules.  Such accounting, however, has strong implications.

To illustrate the destination principle suppose that a US firm produces a manufactured item that emits CO2 during its production or consumption. Further suppose the good is consumed in the US and also exported to China. The carbon emissions in the US should then be taxed to reflect global damages imposed with a rebate provided on output exported to China.  If this rebate is not lump-sum but, rather, levied ad valorem as is the case under the Waxman-Markey proposals which awards rebates on the basis of output exported then the firm would have incentives to raise prices domestically and to divert output to China. This would reduce US consumption of that good. If exemptions from carbon charges were made on the basis of a fixed free carbon emission allocation this amounts to a lump-sum rebate of the type being offered now in Australia. This avoids distortionary impacts on local consumption but it is unclear how this rebate would be adjusted through time if the pattern of trade changed without eventually creating a distortion.

If China produced the same good and exported it to the US, but did not impose a sufficiently large carbon charge – thus it either applied no carbon charges or if it also followed the destination principle and exempted its exports from charging – then the US would then impose a BTA on imports equal to the carbon charge that would need to have been applied to provide comparability with US GGE standards. 

Using the destination principle means there is never a no loss of competitiveness for US production irrespective of the GGE policy of China. This means that designing border taxes on a destination basis carries no implication of being a penalty for not mitigating. Hence such a tax base will not encourage countries to mitigate.

Nor is there any incentive for a US firm to relocate to China even if China did not price carbon emissions as the US did. There is no advantage in supplying the Chinese market from relocating since US exports are, in any event, exempt from carbon charges and no advantage in supplying the US market since the carbon charges would, in any event, be levied on US imports via a BTA.

Note that destination accounting consistently applied means that all imports will be subject to BTAs even if countries apply the same GGE charges. In addition charge revenue will always accrue to the country of destination. The obvious point is then countries would have incentives to levy carbon charges on their exports as well as their local production so  charge revenues would accrue locally not to destination countries  – this amounts to a production or origin-based accounting for the charging.  It is unclear how a switch to an origin-based accounting affects the Taniotti et al. (2009) argument for introducing a charging regime based on consumption taxes as a way of meeting the GATT articles governing trade.

Interestingly China has, in the past, supported the destination principle presumably on the grounds that 35 per cent of its carbon emissions are related to exports. In arguing this China ignores the fact that China is a significant importer of carbon intensive products such as building materials, steel and concrete  under destination accounting (Whalley & Walsh, 2008, p. 25)[3].  It is also surprising that China also seems implacably opposed to BTAs since these are a logical implication of applying the destination principle – then charges do target a country’s consumption of carbon emissions.

Adopting an origin-based accounting system makes more sense if BTAs are – as seems to be the case – primarily viewed as means for addressing the failure to charge for GGEs by non-mitigating countries. The difficulty then is that if exports are then charged that such exports lose competitiveness in export markets if other countries do not charge. Exempting such exports from charging returns arrangements to a destination basis.

In a practical sense there are really major difficulties in assessing the carbon content of manufactures with multiple intermediate inputs that are produced using various production technologies with differing carbon intensities. BTAs would need to be product, technology and country specific.  For example it would be erroneous of a country to levy the same BTA on aluminium imports produced used hydroelectric power rather than coal-fired electricity.

At best this objection might be met by estimating carbon content for key carbon-intensive outputs and by ignoring all those goods and inputs with relatively low implied carbon contents.   A practical difficulty remains that such duties always seem inconsistent with the World Trade Organisation’s Article I (General Most Favoured Nation Treatment) which requires nations to levy tariffs on imports to do so uniformly and without discrimination on the basis of their country of origin.  There are ways of circumventing such GATT rules. Articles XX (b) and (g) of the GATT allow measures to protect the environment necessary to protect human or animal life and health and to conserve exhaustible resources.  A thorny issue is whether such measures can be based on production methods used. The Shrimp-Turtle dispute outcome suggests there may be the possibility for such measures (World Bank, 2008, 37-39).

The issue also becomes complex if the carbon charges emerge endogenously as the result of a global cap-and-trade system rather than because of set taxes by different countries.  Then BTAs will vary as the global price of carbon varies.  One way to include differential tax rates by nation would be to adapt the Alexeeva-Talebi et al (2008) proposal for an integrated emission trading (IET) regime where producers in non-mitigating nations must purchase emission entitlements in destination countries.  While BTAs best protect local competitiveness, IET help to reduce foreign emissions to a greater extent.

 The approach to BTAs in the Waxman-Markey Bill draws on elements of the Alexeeva-Talebi et al. (2008) approach. It is not quite a pure destination based tax and certainly not an origin-based accounting model. The specifics are intrinsically important and important because they provide a coherent model that other developed countries may emulate[4].

Under Waxman-Markey US exporters get free carbon allowances as rebated charges for from 2012-2025. These rebates phase out from 2025-2035.  As noted above this means that US firms will then gain an increased price if they divert their outputs internationally. Indeed the rebates are effectively an export subsidy and hence would, if industries are competitive, raise US prices by the full extent of the implied carbon charge.

US importers will be subject to an international reserve allowance (IRAs) from 2020. The Environmental Protection Agency (EPA) would create a pool of such IRAs separate from the allowances domestic entities must use to comply with their cap-and-trade obligations. The EPA would sell IRAs at the same price at which the domestic allowances are offered for sale. Imports that require such IRAs must be 85 per cent sourced from countries with (i) emissions reduction commitment than are less stringent than the US or (ii) when the country and the US fail to be parties to a sectoral international agreement or (ii) when the energy or carbon intensity of the sector is less than in the US.

There is an exemption from this provision if a country is listed by the UN as a ‘least developed’ developing country or if the country is responsible for less than 0.5 per cent of global emissions and less than 5 per cent of imports of covered goods with respect to the eligible sector.

 This provision does not target the specific carbon regulation that a product is subject to but rather the general level of emissions control in the economy. The implication is that, since the US will exempt its own exporters by giving them free carbon allowances, so other countries have incentives to do the same so that competitiveness concerns in the US are likely to persist.

 3. Carbon leakages and GGE strategy. What are the specific strategic implications of carbon leakages? Is the strategic situation faced by countries simply a Prisoner’s Dilemma (PD) where carbon leakages intensify incentives to free-ride? These issues need to be set out in a strategic setting. The following extends Clarke (2009).

Consider two countries China (C) and the US (U) each with only two options with respect to their GGEs, either to mitigate them (M) or not to (DM).  The mitigation option can be taken to imply the adoption of carbon mitigation policies that are consistent with a cutback in emissions guaranteeing no more than 2oC global mean average temperature increase. With some additional formalism the choice of mitigation level can be formalised by permitting a continuum of mitigation choices. If China mitigates then the gross local benefits it receives are Bc while spill-over benefits to the US are Bcu. The costs of mitigation are Cc.  If the US mitigates it gets local gross benefits Bu and provides benefits to China of Buc with mitigation costs being Cu.  Suppose that if both countries mitigate in a coordinated way – via for example a global cap-and-trade scheme that net local benefits are increased by λu > 1 for the US and λc > 1 for China – this reflects respective efficiency gains from integrating carbon markets. Define respective net national benefits from mitigation as πu = Bu-Cu and πc= Bc-Uc. These are the environmental benefits and costs experienced by the countries.

On the basis of behavioural economic reasoning it might also be supposed that there are also benefits and costs related to a country’s perceived international image in terms of mitigation stance. Countries are sensitive to international perceptions of their national ‘citizenship’ status but such costs and benefits depend on the policy stance of a country relative to others. A country will presumably experience the most intense national embarrassment costs if it is an isolated or sole non-mitigator and national prestige benefits if it is a unilateral mitigator.  Suppose therefore that, if the US mitigates but China does not, that China experiences national embarrassment costs Ec while the US gets a good-citizen dividend Eu’ while if China mitigates but the US does not that the US experiences additional embarrassment costs Ec while China receives a good citizen dividend Ec’.

With carbon leakage effects the local benefits and costs one country gains from a mitigation response depend on the mitigation responses of other countries.  Suppose if the US mitigates but that China does not, that the US experiences extra costs Luu and China receives benefits Luc from this unilateral action compared to the situation where both mitigate. Similarly define Lcc and Lcu as the extra costs and benefits to China and the US respectively when only China mitigates. 

Figure 1 outlines the relevant payoffs. Interest focuses on conditions for the dominant strategies for each country to be mitigation since these are unilateral strategies that will be pursued. For each country to have a dominant strategy to mitigate on the basis of a local cost benefit analysis local gains from mitigation must exceed the extra costs imposed by mitigating unilaterally and the extra benefits received by being the last country to mitigate. Then for China to have a dominant strategy to mitigate its emissions λcπc +Buc > Buc +Luc-Ec and πc -Lcc+Ec’ > 0 so that πc > max{ (Luc-Ec)/ λc, Lcc– Ec’}. Thus net local benefits to China from migrating must exceed the carbon leakage benefits if would gain by not mitigating less any consequent embarrassment costs – all deflated by the efficiency parameter describing the cost reductions consequent on joint mitigation – and the losses it would incur by unilaterally mitigating less any gains in national prestige from doing so.

 

China-US Game with Carbon Leakages

US

M

DM

 

China

M

λcπc +Buc,  λuπu +Bcu

πc -Lcc+Ec’, Bcu+Lcu-Eu

DM

Buc +Luc-Ec, πu -Luu+Eu

0,0

 Figure 1: Payoffs for General Two-Country Game with Carbon Leakage

Further note here that embarrassment costs and prestige benefits precisely reverse the effects of carbon leakages. Without losing any generality explicit attention to embarrassment costs is unnecessary. When they are relevant, interpret embarrassment costs and benefits as the negative of the respective carbon leakage effect.  

Higher levels of carbon leakages make the conditions for a country to have a dominant strategy to mitigate more stringent – their existence makes a Prisoner’s Dilemma (PD) game structure more likely. Embarrassment costs and benefits have precisely the reverse effect of making this constraint easier to satisfy thus making a PD less likely.  With increased cost savings from joint mitigation the prospects for cooperation improve.

With increased likelihood of a PD structure the prospects for unilateralism diminish so that the prospects for a multilateral agreement diminish.

The second almost obvious point is that, even if net leakage effects are positive, large enough local environmental benefits from addressing climate change are sufficient to provide a case for addressing climate issues unilaterally.

Further observations are reasonably direct consequences of the arguments in Clarke (2009):

  • With large enough embarrassment costs – or if cost savings achievable by joint mitigation are large enough through economies gained via a global cap-and-trade scheme – there is an increased likelihood that the policy game becomes an Assurance Game (AG) where unilateral action to mitigate by either country will assure a mitigation response by the other.
  • The effects of trade restrictions such as BTAs can be examined formally using a version of the policy game where there are possible rewards in terms of general trade benefits (e.g. inclusion in a ‘carbon free’ trade area) that are made contingent on both countries mitigating – suppose these are TBc and TBu respectively.  If neither mitigates suppose that both are subject to BTA costs dictated by the rest of the world (TCc, TCu) that reflect exclusion from free trade agreements while if China mitigates but the US does not China receives reduced benefits TBc’ < TBc while the US experiences increased costs TCu’ > TCu.  Similarly if the US mitigates but the US does not respective additional benefits and costs are TBu’ < TBu, TCc’ < TCc. The resulting payoffs are set out in Figure 2.  Conditions for China to have a dominant strategy of mitigation are that πc > max(Luc-Ec-TCc’- TBc)/λc, Lcc-Ec’-TBc’-TCc) which are strictly weaker than those provided before when either trade penalties are applied to non-mitigators (‘stick’ policies) or when trade rewards are provided to those who do mitigate (‘carrot policies’).  Note that these conditions depend negatively and linearly on possible trade benefits and trade penalties.
  • As Clarke (2009) shows, an AG – or indeed a situation where each country has dominant strategies to mitigate – also arises if a penalty mechanism, such as a tariff of the BTA-type, is introduced since, as is clear from the formal analysis, this increases the costs of not mitigating.  This is the sense in which BTAs provide the enforcement or penalty mechanism that was not delivered by the Kyoto Protocol. Moreover, it is often argued that this type of penalty mechanism will be particularly effective in motivating China to mitigate its emissions given the weight that China places on 30 per cent growth in exports as a basis for its continued development.  China fears a closing of export markets to it – particularly given that China’s exports are becoming increasingly technologically sophisticated and hence likely to lead to increased protectionism (Whalley and Walsh, 2008).
  • Clearly this last idea can be phrased in terms of ‘carrots’ (rewards such as TBc, TBu) rather than ‘sticks’.  As a practical matter China may be willing to make firmer agreements on climate change in return for greater security of access for its goods in world markets. This might be obvious but it is worth pointing out that rewards only have intrinsic advantages over penalties if their size is much larger than that of the penalties. This follows from the linearity of the conditions for dominant strategies in rewards and penalties.
  • Even if a PD structure does obtain in the policy game there can be no presumption that both parties should mitigate for a globally efficient outcome.  It may be the case that, with asymmetric costs and benefits, that at most one country should mitigate – perhaps with a side-payment from the other. This can be rationalised in terms of the ‘public goods’ model as discussed in below in Section 4. A case for unilateral action can also be justified in non-PD settings if one ‘dominant’ country loses a lot from its unilateral failure to mitigate – a Leadership Game.
  • With strong enough carbon leakage effects the policy game can be a Game of Chicken. Here exactly one country does not mitigate in equilibrium but both countries prefer the consequences of each mitigating to that where neither does.
  • In multi-country (>2) settings ‘emulation’ effects and the possibility of intense embarrassment costs become critical.  The issue is how one country unilaterally committing to mitigate affect the incentives to mitigate of other countries? With carbon leakages such effects are, in general, ambiguous. Having an extra country mitigate reduces the carbon leakage losses that a country faces if it too chooses to mitigate but increases the carbon leakage gains it can enjoy by holding out to be a residual non-mitigator – more migrant industries will head towards it from countries which choose to mitigate. Of course if one country accompanies its unilateral decision to mitigate with the imposition of BTAs then the prospects of emulation improve.
  • If one country commits to ‘no regrets’ options that increases the prospects for others to unilaterally mitigate since then carbon leakage costs for those countries are at least somewhat reduced.  For example if China pursues energy efficiency policies by increasing energy prices then that reduces the incentives of US FDI to seek a safe pollution ‘haven’ in China and partially restore the competitiveness of US home produced goods versus tradeables. The difficulty with relying on energy efficiency gains alone is that such improvements increase the marginal product of energy use and may therefore increase total emissions even if they reduce emissions per unit of output.
  • If one country pursues adaptation policies that improve its ability to ‘live with’ climate change this reduces the incentives of that country to seek to mitigate its emissions. The productivity of local mitigation investments is reduced with successful adaptation investments.  This is not to say that adaptation moves are counterproductive since there will be a certain degree of climate change even with stringent mitigation moves and these effects need to be ameliorated.

The simple point is that the assumption that equilibrium climate mitigation policies in a strategic setting will not involve unilateralism is an oversimplification. The strategic situation need not be characterised as a PD – there are circumstances where unilateralism makes sense particularly if it is accompanied by side policies such as BTAs. 

 

China-US Game with

Trade Policies

US

M

DM

 

China

M

λcπc +Buc + TBc,  λuπu +Bcu +TBu

πc -Lcc+Ec’+TBc’, Bcu+Lcu-Eu-TCu

DM

Buc +Luc-Ec-TCc’, πu -Luu+Eu’+TBu

-TCc, -TCu

 Figure 2: Payoffs for Two-Country Game with Carrot and Stick Trade Policies

At first sight a criticism of the present analysis might be that it is static and not nuanced. The US has signalled that it will unconditionally introduce a national cap-and-trade scheme and that it will introduce BTAs after 2020 (this can be taken as the base DM policy).  There are criticisms that this scheme does not go far enough in reducing emissions – to what might be a more forceful policy with more stringent interim targets (the M policy) but what is crucial at this stage is China’s response to the eventual US choice.  The US will not go further in making cuts unless China reveals a positive medium term mitigation stance. China has options of continuing to pursue ‘no regrets’ and adaptation policies for many years or increasing them up to the date at which the US would impose BTAs or perhaps mitigating more decisively before that date in which case the US and other countries might consider intensifying their mitigation efforts. These issues are a target for future work.

4. Developing countries, border taxes & distributive justice.  Economic, energy consumption and emission characteristics of the four major carbon emitting nations are set out in Table 1. China is the world’s biggest emitter from fossil fuel burning of CO2 but the US has 6 times its per capita energy consumption.  The disparity in incomes is greater.  The contrasts in per capita energy consumption and incomes between the US and India are even greater still.  In terms of per capita income Russia lies somewhere in the middle of this group but has relatively high per capita carbon emissions.

Country Aggregate GGE emissions (billion tons) Per capita GGE emissions (tons) Per Capita energy consumption (2005, kgoe) Per capita income (2008)
China

6

4.6

1316

5693

India

1.3

1.1

491

2762

Russia

1.7

17

4519

15922

US

5.9

19.7

7886

46,859

 Table 1: Income and energy consumption characteristics of major GGE emitters.        Emissions data from EIA (http://www.eia.doe.gov/), energy data from WRI            (http://earthtrends.wri.org/), per capita income data (for 2008) from IMF       (http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)_per_capita).

 Given these strikingly divergent emission, energy consumption and income experiences it is unsurprising that China, India, Brazil and Russia are hostile towards use of BTAs to enforce common carbon taxes across countries.  Indeed the use of BTAs as a component of the Waxman-Markey Bill is described by the Chinese Ministry of Commerce as violating WTO rules, against the spirit of the Kyoto Protocol, unfair and a form of trade protectionism (Ding Quinfen, 2009).

It is such gaps between the policy positions of OECD countries such as the US and lower wage, large population, rapidly-growing countries that are major obstacles to progress in Copenhagen[5].

The claims of protectionism by China, and other countries, are justifiable if BTAs set do not reflect unpriced GGEs. They are intended to be charges that seek to internalise an externality and hence to remove a distortion.  That these charges might eventually amount to protectionism is not out of the question given complexities in determining them and consequent potential to conceal protectionist motives in this complexity. The claim that BTAs are illegal under the Kyoto Protocol is unusual since these changes are envisaged to take effect well after that Protocol expires – indeed BTAs would not be imposed until 2020.

Ignoring issues of BTA computational complexity the most valid criticism of these taxes is that while setting charges to internalise global externalities promotes global economic efficiency it will have adverse distributional effects on emerging and developing countries unless compensation is provided.  Furthermore, standard economic theory suggests compensation can be effected in these situations by means of an appropriate set of transfers from revenues generated by charging-based efficiency reforms.  

If low income, low per capita energy consumption developing countries are to be goaded into imposing carbon charges  – and, more generally, regulation-based carbon mitigation efforts – that are comparable to those planned in countries such as the US they reasonably might be compensated for this. Indeed, indirectly at least, such compensation is a key component of the bargaining that is occurring in the lead-up to the Copenhagen meetings.  Such compensation is one interpretation of the ‘common yet differentiated responsibilities’ provisions of the Kyoto Protocol (Whalley & Walsh, 2008, p. 23).

One path to providing such compensation and hence to getting countries to agree to BTAs can be achieved by providing large shares of what must eventually be gradually diminishing aggregate global greenhouse gas emission quotas to poor and emerging countries and then making this quota tradeable internationally to achieve a common carbon price.  This is simply a global cap-and-trade scheme with international trade in quotas. Countries that do not levy the appropriate internationally-determined carbon charge are then subject to BTAs reflecting the going international carbon price but emerging countries which do charge are compensated for doing so. Access to an international carbon market is not an essential prerequisite for such a scheme to work but, it if used, it is estimated to reduce global costs of halving 2050 GGEs by 20 per cent and in particular would permit greater compensations to be paid to developing countries (Climate Group, 2009).

The quota assigned to China for example might be consistent with China growing its energy use, for a period, at half the going GDP growth rate. This is close to current Chinese policy. China has agreed to cut its energy use per unit of GDP by 20 per cent between 2005 and 2010 while the economy might be expected to grow by 46 per cent over this period (assuming 8 per cent growth) (NCCCC, 2008, p.8).  Given greater planned Chinese use of renewables the carbon-based energy growth target should be met.

Poorer countries like India might be given quotas that were, initially at least, more generous than this.

As per capita incomes and energy intensities converge closer toward those of developed countries shares the aggregate quota might be split so as to equate per capita emissions.

Clearly compensation will not only be in terms of direct purchases of GGE quota entitlements. Transfer mechanisms in these countries might not be adequate to compensate, for example, the poor who face higher fuel and electricity prices.

Moreover, some technologies – carbon capture and storage – for ameliorating carbon emissions are only now in the process of development yet countries such as China rely on coal for most of their energy sector expansion.

Therefore assistance should take the form of (i) investments in relevant R&D to foster the development of non-carbon based energy technologies, to encourage more fuel efficient buildings and motor vehicles; (ii) the direct provision of clean energy technologies and carbon sequestration technologies should be fostered and the transfer of appropriate technologies facilitated and (iii) direct income transfers through sale of quotas.

Estimated annual costs of meeting 30 per cent of abatement targets in emerging countries are $100-$160b annually from 2010-2020. The average global investment required between now and 2050 is $1t or about 40 per cent of global infrastructure investment (Climate Group, 2009). This forecast is conditional on the international carbon price that emerges and also, particularly, on oil prices.  Much of the investment displaces business-as-usual spending that, particularly in developed countries, is designed to address higher oil prices.  Incremental costs may be lower than suggested if oil prices become much higher than at present which would call for replacement technologies on direct cost-efficiency grounds.

The purchase of carbon quotas from emerging countries might take the form of ‘offset’ purchases under the Kyoto Clean Development Mechanism or through multilateral financing through the recently developed World Bank Climate Investment Funds.  Indeed such moves might increase the effectiveness of the Waxman-Markey bill.  This bill targets a 14 per cent reduction of US GGEs over 2005 levels by 2020 whereas many emerging countries – for example China – were seeking cuts in US emissions of 25-40 per cent below 2005 levels. This level of cutback however may be effectively achieved if one factors into the Bill’s effects the aid it offers for forest conservation measures in the developing world. These measures preserve valuable natural resources and offer carbon abatement at the bargain price of about $10/ton CO2 (Stevenson, 2009). These reductions are cheap partly because they occur in developing countries. They are inexpensive conservation and carbon-reduction options and would increase US CO2 reductions to be up to 23 per cent by 2020 which is close to the level of cutbacks sought by China.

This US international assistance is part of $5b in total that the US will provide to developing countries by 2020 – $740m for technology, $3.7b – for tropical forest conservation and $740m for adaptation. Including mobilisation of private efforts to reduce emissions in developing countries – the extent of this will depend on international compared to US costs – the amount committed for international assistance would rise to from $8.5-$20b in 2020. 

These amounts are clearly less than required but give the US some credibility in Copenhagen.  Indeed it is clear that the US sees the negotiations in Copenhagen as being as much about financing carbon reduction in developing countries as devising targets.

World quotas on GGE levels need to be reduced over time so that sought-after GGE targets are eventually hit. A modest target of the Garnaut-Stern type would be 550 ppm by 2050 but an environmentally preferred target would be 450 ppm.  This latter target will only be remotely achievable if all countries, including China, drastically curb their emissions well before 2050.

Again China is currently pursuing policies that are broadly consistent with these emission targets – China will cut the energy intensity of production so that CO2 emissions peak at around 2035 at 8.8 billion tons, compared with around 5.5 billion tons in 2010.  From 2035 to 2050, emissions would remain stable or decline marginally (Shasha, 2009). But current Chinese emissions growth remains unsustainable even with the energy intensity reduction objective (Auffhammer & Carson, 2008; Garnaut et al., 2008).  In the medium term China needs to set quotas and make absolute cuts in emissions. For 2008-2100 a specific and plausible timetable, which gradually shifts targets for developing countries from business-as-usual toward income and energy intensity targets and then to per capita targets is due to Frankel (2007).

India’s proposal to pursue its development and poverty alleviation policies but to ensure that India’s per capita emissions never exceed those of Western countries is an interesting twist since it provides a challenge to Western countries to do the best they can and then be matched in this by developing countries.

5. Conclusions and final comments. The case for unilateral actions to mitigate climate change is logically a strong one. The climate change issue is a serious and potentially catastrophic problem that will impinge on all societies. Moral right will not exclude countries from being subject to the effects of climate change.

BTAs can promote the case for unilateralism in climate change policy and hence improve the prospects for a global cooperative agreement. They can thus encourage countries to internalise the externalities associated with climate change. The design of such BTAs is problematic – neither destination nor origin-based accounting procedures for levying carbon taxes are entirely appropriate.

The carbon leakages rationale for BTAs needs to be empirically assessed as it is by no means clear that the effects are as substantial as some claim.

Implementing BTAs will impose such severe equity concerns on poor and developing countries that they may not lead to desired climate change policies in such countries. 

Compensation for the extreme equity costs faced by such countries can be met by encouraging them to join an international cap-and-trade scheme and providing enough tradeable carbon quotas to meet their energy growth imperatives. Developed countries concerned with cutting emissions in developing countries should buy back these quotas on terms acceptable to the developing countries and contribute to a global R&D effort to reduce the use of carbon based fuels and a funding of green energy alternatives to coal in developing supplies. The intent should be to deliver both efficiency and a fairness that gives developing countries the scope to address urgent development priorities as well as climate change.

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[1] The effects of mitigation policies in reducing international carbon-based fuel prices such as oil prices and hence in increasing the consumption of such fuels and consequent carbon emissions in non-mitigating countries is also a form of carbon leakage although not one that is addressed here.

 

[2]  More accurately, the ‘American Clean Energy and Security Act of 2009’ was passed by the US House of Representatives on June 26, 2009.

[3] Pan et al (2008) reject this claim.  They claim that adopting the destination principle for China’s emissions reduces Chin’s emissions liability by 30 per cent.

[4] The European Commission has recently opposed the adoption of a direct border tax but it has floated the idea of requiring importers to buy carbon credits in the future. Carbon equalisation measures have been repeatedly demanded by France. In the past European parliamentarians have called for a ‘Kyoto carbon tax’ to be imposed on imports from the US after it failed to join the international emissions protocol.

 

[5]  On the other hand the controversy over BTAs does make more specific the negotiation mandate.

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