Image by {link:http://commons.wikimedia.org/wiki/File:Tehran_Pollution.jpg} Matthias Blume on WikiMedia Commons {/link}

* The views of the authors do not necessarily represent the views of the OECD or of its member countries.

After Copenhagen, concerns over an uneven playing field for producers, caused by regional differences in climate mitigation policies, appear to be heightened. Consequently, the debate over protective measures continues, focusing largely on carbon-based border tax adjustments (BTAs).

In Europe, citing concerns over fair play for industries and jobs, French President Sarkozy has repeated calls for a carbon tax on imports into Europe, to be applied to countries that fail to implement a climate change mitigation policy. Yet the European Commissioner for Trade, Karel De Gucht, opposes this approach, citing apprehension about inciting trade wars (Chaffin et al, 2010). While the European Council concluded in October 2009 that the first-best solution to address carbon leakage is with a broad and deep climate deal, it left the option available to use appropriate measures to address the risk of leakage, and continues to evaluate additional approaches to address competitiveness (EC, 2009 and EC, 2010).

In the United States, similar fears have resulted in provisions for BTAs in the Waxman-Markey bill passed by the House of Representatives in 2009, and the Kerry-Lieberman bill introduced (and subsequently abandoned) in the Senate in 2010. The draft cap and trade policy in both bills included additional allowances for affected industries based on output (Waxman-Markey, 2009; Kerry-Lieberman, 2010). The extent of competitiveness concerns in the Congress was underscored in a letter to President Obama from nine Democrat Senators in December 2009, noting that “any new US climate change laws should establish a national system of border adjustments, in concert with emission allowances or rebates to trade- and energy-intensive sectors of the economy” (Broder, 2009).

In response, key trading partners are voicing their concerns. India along with the G-77 and China have been calling for language in the draft text of the UN climate negotiations that would caution against developed countries resorting to BTAs and other countervailing border measures (Khor, 2009).

Political debates about BTAs confuse several of the underlying issues. To clarify, there are two related issues of concern for countries taking on climate action:

1. that some of their domestic industrial production will lose competitiveness, and
2. that part of their efforts will be undermined by an increase in greenhouse gas (GHG) emissions elsewhere, or “carbon leakage”.

In economic terms, loss of competitiveness stems from relative price differentials in traded goods: companies confronted with a relatively stringent climate policy will have higher production costs than competitors without such constraints. Insofar as this leads to a shift in economic activity towards regions with a less stringent or no climate policy, this will increase emissions in these new locations (leakage). There is, however, a second indirect channel driving leakage: policy dampens world energy demand, which puts downward pressure on global energy prices that in turn increases demand for GHG-emitting fuels in locations where emissions are not constrained.

Figure 1 – Carbon leakage with and without BTAs in 2030 Source: OECD ENV-Linkages model (Burniaux et al, 2010) Note: Results shown for scenarios with US, Japan, EU and Annex I respectively acting alone to reach a target of a 50% emission reduction by 2050. Leakage rates are calculated as the ratio of emission changes in non-acting countries over the emission reduction in acting countries or regions. Click to enlarge

The degree of carbon leakage depends on which countries are taking climate action and on differences in the level of stringency of policies. In an illustrative simulation using the OECD ENV-Linkages model, the leakage rate is estimated at almost 12% when the European Union cuts emissions unilaterally by 50% in 2050 from 2005 levels (OECD, 2009). Recent research (Burniaux et al, 2010) shows that similar results would occur if the US or Japan would act alone.  Figure 1 shows these leakage rates for 2030. However, if the effort to achieve a similar level of emission reduction is spread across all Annex I countries simultaneously, carbon leakage becomes negligible, falling to less than 2%. This reflects both the broader country coverage (fewer countries where leakage occurs) and reduced mitigation costs (as efforts are shared). Moreover, not only the magnitude but also the nature of carbon leakage changes with the size and composition of the mitigating coalition: larger coalitions have smaller losses in competitive position but a stronger effect on global fossil fuel prices.

While leakage and competitiveness concerns are inter-related, they can stem from different causes and may require separate policy treatment. Although BTAs could be effective to address leakage stemming from the competitiveness channel for a small group of acting countries, they do not address leakage that occurs through the world fossil fuel markets, nor do they directly address the loss of domestic production. And BTAs come with other costs: they can be damaging to the economy, costly to implement, and could instigate trade wars. The perhaps greater concern of loss of competitiveness for domestic industry should therefore be addressed with more targeted and effective policy levers. This article investigates each of these issues in more detail.

BTAs may reduce carbon leakage from the competitiveness channel

BTAs help to reduce the leakage rate when the coalition of acting countries is small by limiting the competitiveness channel. As the number of acting countries increases, the role and the effectiveness of BTAs decline rapidly, because leakage rates are much lower and tariffs address a smaller share of remaining leakage.

The effectiveness of BTAs in reducing leakage also depends on which channel of leakage is dominant. OECD (2009) analysis shows that if the EU were to act alone, and were to supplement its domestic action with a carbon-based border tax adjustment (calculated on the imported direct and indirect carbon content), then leakage disappears. Burniaux et al (2010) find that BTAs are also effective at limiting leakage when Japan acts alone. But if the USA implements a BTA, or all Annex1 countries together, then a BTA is less effective at reducing leakage; in the case of the USA acting alone, the BTA would reduce the amount of leakage by an estimated 2.5 percentage-points (Ross et al, 2009; Burniaux et al, 2010). This is because in these cases the major channel of leakage is not the loss of competitive position, but rather the second channel through international fossil fuel prices.

Figure 2: Impact of BTAs on production volumes of energy-intensive industries in 2030 Source: OECD ENV-Linkages model (Burniaux et al, 2010) Note: Results shown for scenarios with EU and US respectively acting alone to reach a target of a 50% emission reduction by 2050. Click to enlarge

BTAs fail to protect domestic industry

Although addressing competitiveness concerns is often voiced as a rationale for BTAs, analysis shows that BTAs may not curb the output losses incurred by domestic energy‑intensive industries. While carbon leakage may become very small with a large acting coalition, the impact of carbon pricing on the output of energy‑intensive industries in domestic and international markets may still be large in some countries, reflecting a shift in economic structure away from carbon‑intensive production. As Figure 2 shows, in certain cases (e.g. when the EU acts alone), BTAs can actually worsen the impact on the domestic energy-intensive industry. This is due to several factors, including the impact of BTAs on exchange rates and terms of trade, and the (usually large) share of imports of energy-intensive goods demanded by a number of domestic energy-intensive industries (for instance, car companies import huge amounts of steel products). The impact of BTAs on trading partners depends, in part, on the degree of international linkage and the relative energy-efficiency of trading partner industries.  For example, if the EU implements a BTA, Canada and the USA may actually benefit in comparison to less energy-efficient competitors, such as China, who will be impacted negatively.

Figure 3: Real GDP and welfare impacts in 2030 Source: OECD ENV-Linkages model (Burniaux et al, 2010) Note: Results shown for acting countries, the rest of the world (‘Non-Acting’) and global average for simulation scenarios with US, Japan, EU and Annex I respectively acting alone to reach a target of 50% emission reduction by 2050. Welfare is measured by equivalent variation in household income; it does not incorporate impacts of climate change. GDP and welfare are expressed in percentage change from the baseline. Click to enlarge

BTAs come at a cost

Clearly, BTAs can entail substantial economic losses when looking globally and particularly for non‑participating trading partners. For instance, in a scenario where Annex I countries cut their emissions unilaterally by 50% by 2050, BTAs help reduce world emissions, but the cost to non-acting countries’ GDP in 2030 would increase substantially as shown in Figure 3. The costs to world GDP would also increase as the BTA policy reduces global international trade.

BTAs improve welfare for the implementing country, but negatively impact global welfare. Figure 3 illustrates results from the OECD ENV-Linkages model (Burniaux et al, 2010), showing this negative effect on global consumer welfare, as reduced losses in acting countries cannot compensate fully for the additional losses in other countries. These effects are in line with existing estimates of other recent modelling studies (Mattoo et al, 2009; Dong and Whalley, 2009).

An interesting result for acting countries is that even if welfare is improved by imposing BTAs, they still have a negative impact on GDP (Figure 3). In the ENV-Linkages model the welfare improvement is the consequence of a positive effect on terms of trade; even though the policy increases import prices, export prices increase relatively more.

BTAs have additional complications

Apart from the disadvantages of BTAs in terms of aggregate mitigation costs and failure to protect domestic industry, they are also likely to be difficult and costly to implement. There are inherent challenges in measuring the emissions embodied in the full production cycle of goods abroad, including foreign emissions from production, combustion and indirect electricity use.

In addition, there are potential political implications of BTAs. Protectionist policies could incite retaliation from trading partners. BTAs could also face legal challenges by members of the World Trade Organisation. On the other hand, the “threat” of using BTAs may incite broader and deeper participation in a carbon market by trading partners. While this may hold to some extent for certain countries, it is uncertain that it will be credible for strong trading partners such as China.

More effective policy levers

Clearly the first-best option to address carbon leakage and loss of competitiveness would be to have global coverage of a climate policy. But given these uncertain times for the carbon market, the threat of BTAs is likely to remain. Yet considering the wide range of countries that have associated with the Copenhagen Accord and/or pledged mitigation targets and actions for 2020, even as a fragmented carbon market develops, leakage is likely to be very limited. BTAs are only effective in addressing leakage through one of the channels, do not directly address the loss of domestic production, and are costly. Thus the real focus should be on exploring more effective policy options to level the playing field than BTAs.

References:

• Broder, John M. (2009), “In Letter to Obama, Senators State Conditions for Supporting Climate Bill”, The New York Times, 3 December, (web).
• Burniaux J.M., J. Chateau, and R. Duval (2010), “Is there a case for carbon-based border tax adjustment? An applied general equilibrium analysis”, OECD Economic Department Working Paper No. 794, July 2010, (web)
• Chaffin, J., N. Tait and T. Barber (2010), “Trade War Fears Raised on Carbon Border Tax”, Financial Times, 12 January.
• Dong, Y. and J. Whalley (2009), “How Large Are the Impacts of Carbon Motivated Border Tax Adjustments”, Working Paper 15613, National Bureau of Economic Research, Cambridge, Massachusetts, (web)
• EC (2009), “Presidency Conclusions of the Brussels European Council (29/30 October 2009)”, 15265/1/09 REV 1, (web).
• EC (2010), “Analysis of options to move beyond 20% greenhouse gas emission reductions and assessing the risk of carbon leakage”, COM(2010) 265 final, Brussels 26.5.2010.
• Khor, M. and H. Jhamtani (2009), “India, G77 Propose Text Against Trade Protection in Copenhagen Draft”, South Bulletin (Issue 40), South Centre, 10 September 2009,  (web).
• Kerry-Lieberman (2010), “American Power Act”, http://kerry.senate.gov/work/issues/issue/?id=7f6b4d4a-da4a-409e-a5e7-15567cc9e95c.
• Mattoo, A., A. Subramanian, D. van der Mensbrugghe, and J. He. (2009), “Reconciling Climate Change and trade Policy”, World Bank, CGD Working Paper No 189, November 2009.
• OECD (2009), Economics of Climate Change Mitigation: Policies and Options for Global Action beyond 2010, (web).
• Ross, M., A. Fawcett, A. and C. Clapp (2009), “U.S. Climate Mitigation Pathways Post-2012: Transition Scenarios in ADAGE.” Energy Economics, (web).
• Waxman-Markey (2009), “The American Clean Energy and Security Act (H.R. 2454)”, (web).

© PhotoXpress.com

The Copenhagen conference is a bitter disappointment for European countries. While environment is one of the domains in which European integration is deepest, European countries failed to build and support a common position that would have weighed on the outcome of the conference, the Copenhagen Accord. Significantly, this outcome has been negotiated and signed at the national level and European countries had different position on its content. Moreover, this Accord appears at odd with the expectations of most European countries. In particular, this agreement gives up the “global governance” approach of the Kyoto Protocol, which set a collective goal in terms of reduction in greenhouse gas emissions and translated this collective goal into individual targets for each member country. In the Copenhagen accord, instead, each country announces unilaterally an individual target for its 2020 emissions, and the accord introduces a simple verification of individual commitments.

Compared to the Kyoto approach, four essential elements are lost. Firstly, the agreement is not legally binding and there is no provision in case of non compliance. Secondly, in a system where each country unilaterally announces its commitment to reduce emissions, there is no guarantee that individual efforts are of comparable magnitude, and we can only note that the Russian and American proposals are more modest than European ones. Thirdly, although the Copenhagen agreement recalled the objective of maintaining global warming below 2°C, there is no guarantee that the sum of individual commitments is sufficient to achieve this collective goal. And we know that in the current situation, the efforts announced drive us toward a 3°C-or-more warming. Finally, the Copenhagen agreement was negotiated by 28 countries only, and has not been validated by the 192 member countries that are parties to the Climate Convention of the United Nations. It is therefore a partial agreement to a problem that concerns all countries, and the way this agreement has been reached threatens the Climate Convention, a unique 17-year international negotiation process.

Forget Kyoto: Four European Answers

For all these reasons, the outcome of the Copenhagen conference is disappointing. But today, it appears that it was simply impossible to maintain the Kyoto approach. Instead of distributing blames and accusations to explain this failure, it seems more reasonable for Europe to forget the Kyoto Protocol and its philosophy and to recognize that it is an important progress to have included the United States and China in a unique agreement. From there, Europe could try to (re)construct a common position on how to build on the Copenhagen Accord to make it more ambitious and credible. Such a common European position could be based on answers to the four limitations mentioned above.

First, progress is needed on the fact that the accord is not legally-binding and lacks credibility. In the current situation, building a legally-binding framework seems impossible. But if all countries wish to fulfil their obligations, and their reluctance to accept stronger commitments suggests they do, then they can accept a control that is stronger than what is currently agreed on. To do so, an international organization could be created to control emissions of each country and verify that commitments are respected. This proposal was already supported by France and others at Copenhagen, but it met strong opposition. It could now be supported by the European Union, its chance of success increasing if a cap-and-trade law passes the US Congress in 2010. Of course, such an international organization would not make the agreement legally-binding, but it would give weight to the political agreement signed in Copenhagen.

Then, it seems clear that no country can agree to make efforts that are much greater than what other countries are doing, at the risk of disadvantaging its industry and losing jobs and market shares. From an ethical point of view, moreover, it seems unfair that the most ambitious countries suffer from their desire to protect a global public good. In absence of an international mechanism to share emission reduction efforts in a fair manner and in the framework of unilateral commitments, it appears unavoidable to recognize the right to establish fiscal compensation mechanisms. Countries with most ambitious climate policies, whose production costs would increase, would be allowed to introduce a border tax to maintain their competitiveness on their domestic market. The most publicized risk associated with such a tax, namely its use for pure and simple protectionism, could be mitigated if the commitment-control international organization were required to authorize the tax before its introduction. At a later stage, such fiscal mechanisms could even be used to ensure compliance: in practice, a border tax could be applied to exports of countries that do not meet their commitments, after proper analysis and control by the international control organization.

Third, a solution needs to be found to ensure that the sum of individual national efforts is sufficient to achieve the collective objective of maintaining global warming below 2°C. The lack of consistency between the collective goal and individual commitments is undoubtedly the most glaring weakness of the Copenhagen Accord. As the philosophy of this agreement makes it inadequate to impose additional emission reductions, an incentive-based system should be favoured. To do so, the Climate Convention or the IPCC could make a systematic evaluation of the sum of national commitments – in developed and developing countries – and provide an estimate of future emissions trajectories and of the corresponding climate projections. A comparison of these climate projections against the 2°C collective objective would allow to announce a “commitment shortfall,” i.e. the need for additional action to achieve the collective objective. Such an analysis has been done by Carlo Carraro and Emanuele Massetti, and published in Climate Science&Policy (“Two good news from Copenhagen?” January 7th, 2010). They show that the abatement plans proposed by major emitters in Copenhagen are inconsistent with the 2°C target, even if all the climate international finance proposed in the Accord is dedicated to mitigation in developing countries, and they discuss the need for additional effort, i.e. the commitment shortfall. From this type of information, a further mission of the annual Climate Convention conferences could be to announce this commitment shortfall, and to invite all countries to do more to reduce this deficit. The shortcomings of such a process are obvious, but it now seems difficult to do better, and hopefully public opinion pressure will encourage countries to make the necessary commitments.

Finally, it is essential to bring the Copenhagen Accord under the UN Climate Convention and ensure that all countries join its new approach. It could be possible to give up this global approach and work only among big emitters, like in the Major Economies Forum on Energy and Climate. But this approach is inadequate because the climate change issue will not be settled if the most vulnerable countries are not at the negotiation table. And even if mitigation commitments could be discussed in such a group, it is inappropriate to discuss mitigation and adaptation in different arenas, since these two topics are interlinked through financial flows, technology exchanges, and infrastructure design. The Copenhagen approach, based on the selection of a few “representative” countries is also flawed: on which basis should the Maldives be considered as representative of all small islands? In absence of any better solution, therefore, it is urgent to reinstall the Copenhagen agreement within the Climate Convention. And today, acknowledging the impossibility to save the Kyoto Protocol, it may be possible to convince all countries to join a new approach, provided that the three preceding issues are treated properly and that the Copenhagen Accord reaches an acceptable level of credibility.

The Financial Fluxes Issue

In addition to these four questions, it will be necessary to specify as rapidly as possible the modalities of the financial transfers planned by the Copenhagen agreement, i.e. $30 billion for the 2010-2012 period, and annual flows increasing to $100 billion per year in 2020. To make the agreement acceptable to all developing countries, these transfers will have to support emission reduction and adaptation to climate change effects. Supporting emission reductions in developing countries can be done through the financing of the additional costs due to climate policies. These fluxes will be mainly directed toward big emerging economies. Adaptation support, on the other hand, should target in priority the poorest countries through the financing of their infrastructure deficit, i.e. the required infrastructures to manage water, waste, energy, and natural hazards. Adaptation funding should help pay the cost of these basic infrastructures, and not only the additional cost due to climate change, since a poor country that cannot finance any dike system would have little use of a funding source that pay only the cost of upgrading it.

Furthermore, the Copenhagen Agreement puts on an equal foot the adaptation of Bangladesh to rising sea level and the adaptation of Saudi Arabia to climate-policy-driven reductions in oil consumption. Without reconsidering this agreement, financing arrangements have to be developed in such a way that oil-exporting countries do not capture too much funding, to ensure that aid is effective and directed towards the most vulnerable populations.

These five points provide for the year 2010 a European roadmap that is simple, realistic and potentially acceptable by all countries: the creation of an international institution to control country-level commitments, the recognition of the right for countries with particularly ambitious climate policies to introduce fiscal border-adjustment mechanisms, the annual publication of the commitment shortfall, the reinstatement of the strengthened Copenhagen Accord within the Climate Convention, and the development of efficient and fair financial transfer modalities. Rebuilding a European position could help make significant progress on these points over the year, and turn the Copenhagen failure into a Mexican success.

Kyoto Protocol {link:http://commons.wikimedia.org/wiki/File:Kyoto_Protocol_participation_map_2005.png}participation map 2005{/link}

A few days away from COP15 it becomes clear that a potential global agreement on climate change will be limited to a political agreement, instead of being the long expected treaty that would extend the Kyoto Protocol beyond 2012 and further enhance the Climate convention. The main obstacle is that the US politically needs to have first a domestic legislation in place before committing to any international agreement. Delays in the Senate make it unlikely that a climate bill could be approved before April 2010. In the meantime, couldn’t President Obama offer a tangible political gesture to the world community and thereby restore leadership and credibility for the US in the climate negotiations?

Our suggestion is that the Obama administration negotiates a deal in Copenhagen by which the US would buy a quantity of emission units corresponding to all emissions exceeding its Kyoto target over the commitment period 2008-2012, some of the money being allocated to adaptation funding in developing countries. There are three major advantages to this:

• The environmental ambition of the Kyoto Protocol would be restored to its original level (5,2% of GHG emission reductions of Annex I countries from 1990 levels).
• The US would credibly and immediately show its willingness to take its part — a major and a leading one — in the world effort on climate change.
• The Copenhagen meeting would deliver a concrete result with benefits for the environment and financial support for adaptation to developing countries.

How much would our proposal cost to the US? Everyone seems to accept that the US cannot meet its Kyoto target. Let us see whether this is true. The Kyoto target for the US is to reduce its net GHG emissions by 7% from their 1990 level over the period 2008-2012. According to US inventories of GHG emissions (submission 2009) the net emissions in 1990 amounted to 5257.3 Mt CO2eq. Therefore over the 5 years Kyoto period, the maximum US emissions allowed by the Protocol amount to 24446.5 MtCO2eq (i.e. 0.93 x 5257.3 x 5).

Now, according to the most recent inventory, the figure reported for the 2007 actual emissions is 6087.5 Mt-CO2eq. Therefore, and if we assume that US emissions remain at this 2007 level over the commitment period 2008-2012, we can project that the US will have emitted 30437.5 MtCO2eq (= 5 x 6087,5) over that period.To meet its Kyoto objective, the US would thus have to purchase emissions units for an equivalent of 30437,5 – 24446,5 = 5 991 MtCO2eq . Assuming that 1 ton of CO-2equivalent can be purchased for 10 US$ the total cost to bail out the US from its Kyoto commitment would be 59 910 million $((A more accurate estimate should be based on US GHG emissions projections for the years 2008-2012. However, official projections in the public domain over that period
do not account for the impact of the current economic crisis on US emissions which is known to be significant. We therefore chose to rely on reported data which provided
a relevant order of magnitude for the cost. Similarly, the price of 10$/tCO2eq is a guesstimate based on currently observed prices.)).

Most importantly, the modalities for such a bail out agreement should be defined with the suppliers of credits (mostly Russia and Ukraine) and with developing countries potential suppliers of emission units from the Kyoto Protocol Clean Development Mechanism.A fixed price should be negotiated for this purchase so as to avoid speculative price movements at the announcement of a bail out deal. Finally in order to provide funding to developing countries for adaptation – a request of long standing by developing countries – a fraction of the proceeds of the sale could be allocated to adaptation projects in the most vulnerable least developed countries.

To put the above cost figure in perspective, it represents, over the same time span less than 10% of the observed cost of the war in Irak, or, per year, 0.01% of the US GDP.

With those figures in mind is this project unthinkable?
Economically, it is affordable for the US economy.
Politically it would be a bold move with many advantages, the no least important of which would be to restore confidence in the willingness of the US to act effectively on climate change, and do it globally in a cooperative way. Buying out now the full Kyoto target would prove that. It requires no new treaty, and would open a credible way for trustful negotiations on the future commitments to be concluded soon.

© PhotoXpress.com

Mitigation costs to reach ambitious stabilization targets are estimated below 5% of GDP (IPCC, 2007). Most models used represent a first based world (optimizing agents with perfect foresight, market clearing equilibrium in all markets, and full utilization of production factors). With such assumptions, the optimal policy is a carbon tax, or a cap and trade system to equalize marginal costs. Any deviation from this is supposed to lead to additional costs and to veer from the optimum. By nature, synergies between development and climate policies and no-regret potential are excluded. The world is on the contrary, full of imperfections that could lead to higher mitigation costs however, they can also provide opportunities for implementing synergies between climate and development. In this article, we analyze the potential for implementing these synergies in a case study focusing on the power sector sub-optimalities in India. To do this, we rely on the modeling framework, Imaclim-R, which is well suited to represent a second best world and to embark sub-optimalities, disequilibrium, and inertia in technical systems.

Institutional and Market Failures of the Indian Power Sector

The Indian power sector is characterised by many institutional and market failures. The most critical symptom of these failures is a restrained access to energy services for both households and productive sectors: while electrification covers only 60% of Indian households (the remaining 40% that are not connected to the grid rely mainly on traditional biomass or on diesel generators), capacity shortage in 2007 reached 9.6% of total demand from the grid reinforcing the use of diesel generators by households and industries.

These power cuts and capacity shortage are caused by structural underinvestment in the power sector. The opening of the sector to the private sector in 1991, failed in absorbing the shortage and in compensating for the constraints on public funding. Less than half of the additional power capacity that had been programmed in the 10th Plan has been built. This underinvestment is largely due to the critically low profitability of investments in this sector induced by a very expensive cross subsidy system.

In 2006, the average level of administrated price covered only 77% of the average production cost: tariffs for households and farmers covered respectively 56% and 12% of the generation costs while industries and the commercial sector were partly compensated because they paid respectively 108% and 122% of production costs. Between 1993 and 2000, subsidies to households and to agriculture more than tripled and reached respectively 0.4 and 1.1% of GDP. In 2000, agriculture uses represented 1/3 of electricity sales in volume but less than 5% of total revenues.

These subsidies are justified by positive externalities on development (access to cheap energy for irrigation to promote food production). Nevertheless, they have significant side effects:

• the combination of critically low prices and of frequent but unpredictable power cuts create a strong incentive to a continuous use of electric pumps for irrigation and induces over consumption (estimated at 30% at least of consumption in agriculture), which increases the magnitude of capacity shortage;
• low revenues from electricity sales induce maintenance under financing and increasing inefficiencies in transmission and distribution, which represented at least 30% of the production in 2005.

Moreover, power sector inefficiencies constrain economic growth: electricity shortages hamper productivity and competitiveness. This reduces government tax revenues, and therefore capital availability to invest in additional power capacity.

Source: Annual report 2008-2009. Ministry of Power, India Click to enlarge

These sub-optimalities namely, power generation shortage, under-investment, tariffs not reflecting costs and T&D losses¹ are implemented within the Imaclim-R² hybrid recursive modelling framework. Imaclim-R has been developed to account for sub-optimalities and inertia in technical systems. Underinvestment in the power sector is represented by a gap between the estimated need of investments and realised investments in the power sector. The induced power generation shortage is represented by over utilisation of generation capacities, as Imaclim-R allows for endogenous disequilibrium due to inflexible characteristics of equipment vintages available at each period (putty-clay technologies). In case of underinvestment, in the short term, the main available flexibility lies in the rate of utilization of capacities, which may induce shortage of production factors, entail extra generation costs³, and raise the electricity usage cost.
Whether these sub-optimalities will persist or not is a determining factor for defining climate mitigation strategies.

Deadlock of a Carbon Price

Even if the demand decrease in the power sector for a 450ppm CO2 stabilization objective is large enough to absorb the power shortage and to remove over costs of generation due to over-utilization of capacities, persisting energy inefficiency in power production, transmission, and distribution coupled with over-consumption habits for farmers will introduce a substantial delay in the potential pace of decarbonization in the power sector⁴. A carbon pricing policy will then impact for a longer time the usage cost of electricity for households and industry.

As a result, a carbon price only scenario will induce prohibitive macroeconomic costs for India (-20% of the baseline GDP in 2030) even if GDP losses decrease after 2030 because of a faster technical change induced by the carbon price and of less vulnerability of the Indian economy to oil prices rising. The increased usage cost of electricity has a very important eviction effect for households on other goods consumptions. It induces a decreased competitiveness of Indian production due to the higher energy share in industrial production costs compared to other regions.

Financial transfers from a cap and trade system could reduce these losses. Indeed, with a contraction and convergence rule, financial transfers amount to 1.5% of GDP in 2020, and more than 2% of GDP between 2030 and 2040. On the long term, GDP is 15% higher than in the baseline due to the income effect of financial transfers and to the induced technical change. But on the short term, transition costs persist and India still loses 6% of its GDP in 2015 compared to the baseline. Organizing higher financial transfers to alleviate transition costs have little chance to be accepted by industrialized countries.

Looking for Synergies Between Climate Policies and Development

An alternative approach is investigated to enlarge the spectrum of climate policies to domestic policies targeting sub-optimalities in the power sector:

• the progressive reduction of subsidies to electricity consumption for the agricultural sector, accompanied by demand side management (improvement of irrigation pumps, evolution of consumption habits⁵);
• the implementation of a program to reduce electricity T&D losses to 15% over a 20-year period;
• the revenues following the partial removal of electricity consumption subsidies in the agricultural sector are used to finance all of these components. Remaining additional revenues are rebated to households through lump-sum transfers.

These measures are implemented within the same contraction and convergence allocation and result in GDP losses limited to 2% of the reference scenario during the first three years after the implementation of policies. The main reason for this is the decrease in the electricity usage cost induced by the reduction of T&D (transmission & distribution) losses and by demand side management. These measures lead to a reduction of energy budget share for households and less crowding-out of other goods consumption; in industry these measures lead to a substitution from fossil fuels to electricity and a reduced share of the energy budget.

Therefore Indian products lose relatively less competitiveness than in other simulations, and salaries are less squeezed to restore commercial balance: wage levels are 9% higher in 2020 and 2030. A positive income effect stems from higher wage levels. More wages increase due to more overall activity, and transfers to households coming from the remaining revenues generated by subsidies decrease. They are not used to finance the policies. Climate policies focusing on the alleviation of sub-optimalities constitute a win-win solution for climate and development.

Conclusion

From a methodological point of view, modeling frameworks are able to represent second best world characteristics in order to embark specificities of each national economy and to exhibit no regret potential. Possible synergies between climate policies and development policies should be used for mitigation cost assessment.

From a political point of view, the future international climate agreement should support the implementation of specific policies such as no-regret potential and energy efficiency measures to account for the heterogeneity of the real world instead of only dictating the implementation of a cap and trade system.

1. By default, tariffs not reflecting costs and T&D losses are expected to persist until 2050
2. For a detailed description of Imaclim-R and of the implementation of sub-optimalities within Imaclim -R, please refer to Sassi et al. (2007) and to Mathy and Guivarch – under review
3. Mean generation costs increase when capacity is overused due to the existence of static decreasing returns due to higher labour costs and because less efficient units are switched on at the last aggregate level. By default, in our model, the increasing factor is attached to wages.
4. In India, 69% of electricity is produced with coal.
5. If the service is improved, the number of unpredictable power cuts will be lower, and farmers will not have to leave their pumps switched on all day long.