Climate Science and Policy » economics

Challenges for a Post-Kyoto Agreement

Raymond J. Kopp — Mon, 25 Oct 2010 17:52:24 +0000

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“The first issue is that anything that results in foreign policy from any particular government whether it’s a developed country or a developing country is really based on the domestic policies of those countries. You can’t have foreign policy without a foundation of domestic policy. Basically what is this going to cost to deal with it? I think that’s true in the US, it’s true in the EU, and it’s certainly true in the Brics countries”.

To achieve a new climate agreement we need both domestic and global policy, Ray Kopp (Resources for the Future – RFF) says in this video interview to Climate Science&Policy

Challenges for a Post-Kyoto Agreement

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I think there’s probably 3 or 4 things that are important to keep in mind. The first issue is that anything that results in foreign policy from any particular government whether it’s a developed country or a developing country is really based on the domestic policies of those countries. You can’t have foreign policy without a foundation of domestic policy. Domestic policy then respect to climate bears on the perceptions that the population of individual countries have respect to the challenges posed by climate change, the costs, and the benefits. Basically what is this going to cost to deal with it? I think that’s true in the US, it’s true in the EU, and it’s certainly true in the Brics countries, which is Brazil, India, China. And so the second thing I think to is to realise that the major emitters that we are dealing with are competitors on the global scheme. So, China, the EU, the US, Russia, India, compete with one another politically and they compete with one another economically. Therefore whatever we do in terms of climate change, it’s got to be in some sense what you might call completion neutral. In that sense there cannot be massive amounts of wealth moving among these competitors that would disadvantage one competitor versus another competitor and so I think you need to take that into mind. The third point is I’d say a lot of things we’re talking about in terms of organising international regimes we’ve based around large-scale carbon markets or flows of money from Annex 1 developing countries to developed countries to developing countries to entice them to undertake particular kinds of domestic actions. Given the current world status right now, fiscal status of the developed countries, massive amounts of flows of currency working in those particular directions I think is not very viable even if it’s into a carbon market. So again I think there is a difficult problem we face in bringing these large-scale economic and political competitors to the table to discuss climate change when there’s larger political and economic issues that are on the horizon.

USA and Developing Countries. Domestic and International Initiatives in Climate Policy

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The first issue that faces the present administration is that the US needs to undertake domestic action. This is the big problem right now. What would the US do? How aggressively would it go after the greenhouse gas emissions and reducing those emissions? There’s a bill that has just been introduced in the US Senate which I think would position the US well with respect to it’s leadership in the world but it’s very unclear whether that’s going to pass the US Senate or not. If that does not pass it does not mean that the US is not going to take domestic action. The Clean Air Act, which is one of our major environmental statutes, is in place and we will regulate greenhouse gas emissions under the Clean Air Act. So I think the US will become a player on the world stage with some credibility but it may take a few more years for that to become apparent. Then of course the administration is heavily engaged in discussions; bilateral discussions, certainly with China and India to provide incentives for those countries to join a larger scale action across the major emitters or the major economies to reduce emissions and so I think the US administration is certainly very much committed to bringing those countries into the fold in some sense, to reduce emissions. But that’s all predicated on the assumption that the US will get its own house in order and reduce its emissions at home. There are bilateral incentives with respect to China having to do with trade and property rights and technologies and what have you. Again I don’t think there’s going to be an awful lot of enthusiasm with respect to the US Congress for massive amounts of money to flow from the US to China. The investments the Chinese are going to have to undertake themselves but I do think there’s going to be coordination with respect to trade, international technology flows, intellectual property and what have you.

Resource for the Future and the Think Tank’s Role in Climate Change Policy

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The role we play as a research institution as opposed to an advocacy organisation is to help inform policy makers about the options available and the strengths and weaknesses of each option. At least in the US there’s usually a window within these political discussions, perhaps early on in those discussions when the policy makers are truly interested in understanding the pros and cons of a different source of approaches. At some point that window narrows and the politics takes over. When the politics takes over recourses for the future necessarily has to leave the stage. But right now with respect to US politics that window is still open. There are still policy makers which tend to be members of Congress that are very interested in the different options available to the US to control emissions and the role we play in helping informing them from a science basis, a research basis about the pros and cons.

The Oil Spill and Its Impact in the American Debate

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It’s surely already having an effect on the politics of Washington. It’s not clear what sort of “environmental disaster” this will be. As you should probably know the oil has not hit the beaches or the shoreline in the US. It’s a large amount of oil but what injuries it’s going to end up causing if any, are unknown at the present time. That said given the magnitude of the oil that’s coming from the well is having an effect I think on Washington and on perceptions about expanding offshore drilling and exploration in the Gulf Waters and elsewhere in the United States. How that’s going to play out, we’ll know within the next few months or so but it certainly is having an impact right now.

Levelling the Playing Field in a Fragmented Carbon Market: Do Carbon-Based Border Tax Adjustments Work?

Christa Clapp — Wed, 08 Sep 2010 11:04:01 +0000

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* 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:

that some of their domestic industrial production will lose competitiveness, and
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).

Environment and Finance: Lessons to be Learnt

Domenico Siniscalco — Tue, 19 Jan 2010 14:49:56 +0000

This article is based on the lecture that Domenico Siniscalco made at the 2009 International Energy Worksop in Venice (June 18th, 2009). The full audio version of the speech is available here.

The world has been changing. Only a few years ago finance was meant to be the panacea for all problems and, at least until 2006, big banks and financial institutions were believed to be the so-called masters of the universe. Since then, things have changed, and now finance and big banks are considered to be the villains. They are blamed for being the culprits of the recent crisis.

Two Dimensions of the Same Problem

When I started preparing this lecture, I saw the title, and I thought that it sounded completely out of fashion. It seemed like the speech for the last world while the speech for the next world should be something completely different.

I think that there are many lessons to be learnt by comparing finance and environment. I’ll attempt to argue that there are very useful interactions between these two areas, both in theory and in practice. It is a convergence worth exploring.

First of all, finance is still crucial in the development of key technological process in investment, in energy production and energy storage, and in transmission and use. Second, finance is crucial, because it moves resources from sector to sector and from period to period.

My point is that whatever happened in environment and finance is two dimensions of the same problem. Lessons can be learnt in both areas by analysing this distortion. These lessons could be very useful for policy, for human behaviour and for the progress of economics.

The Greenspan Put and the Financial Crisis

I’d like to say a few words about the crisis, which are drawn from my experience. As Minister of Finance I had been sitting in the G7 for five years from 2001 to 2006. During that period, everything that occurred in the real economy in terms of shocks was tackled by injecting huge liquidity into the system. This was called “The Greenspan Put”: any sort of problem or risk in the financial world or in the real economy, was basically cured by over expansionary monetary policy. Real interest rates were almost zero, and inflation seemed to be completely under control. Finally, there was a huge deregulation which was not related to risk and banks were allowed to sell any sort of product, from derivatives to the so-called CDO and CLO, with very thin capitalization.

This deregulation of the financial sector is very important because it transformed the business of banking into the business of product selling, and eventually free riding. For instance, if I have a client, and if I give him a mortgage, I will keep that mortgage into my balance sheet for 10 years. I know the client, I’ll take care of him, and I’ll know if he is going to return the money. But if I give a mortgage to a client and then I put that mortgage into a bond and I sell it immediately, I will loose all accountability and responsibility for that bond. As you can easily imagine, this is a huge incentive for free riding.

This situation I just described, connected with big trends of the globalisation and the so-called “global imbalances”, can be summarized in this way: on the one hand the US financial system was consuming more then 100% of the disposable global income by extracting equity from the housing sector. On the other hand, China was consuming too little, saving too much, and was producing for the western consumer as a whole. China was even financing western consumption by lending money. These are the big global imbalances: excess of consumption on the one hand, excess of saving on the other hand, and a financial market connecting the two.

“Don’t Fix it if it’s Not Broken”

At that time many people pointed out the unsustainability of this model by either discussing in terms of twin deficits or discussing the global imbalances per se. If you search on Google for “global imbalances” you’ll find thousands of papers, but nobody took interest in them. I perfectly remember that when we were sitting around the G7’s table, when you talked about global imbalances, they treated you like an academic doing wrinkles on odd topics, and as you finished your speech, they looked at you and said : “Ok, now kids, give way and let the big boys work around the serious matters.” It was impossible to discuss these matters. The general attitude was well known and it sounded something like this: don’t fix it if it’s not broken.

Thanks to these global imbalances, financial deregulations and monetary policies, a strong interdependence developed not only among regions, but also among generations because we were postponing problems to the future. And that future is now.

We also have a cultural problem because finance basically swallowed everything. It swallowed the best students that were attracted to Wall Street by reputation and by huge compensations. Finance swallowed the ethical principles, the real economy (compare the compensation of a CEO in the banking sector to the compensation of an equal CEO in the industry sector; you can’t avoid seeing a big disproportion) and the society, too.

Amartya Sen told us that the world rests on three pillars: markets, state and civil society. For 20 years the market (the financial market in particular) overwhelmed states and whatever was happening in the real economy. Observing this process in depth, you can find several kinds of externalities involving groups and agents, regions (because there are plenty of bonds issued by US banks in the balance sheet of local banks), generations, and middle classes emerging in the developing countries by the consequence of globalization.

Paralleling Finance, Environment and Economics

In 2007, the financial system had the first big shock and again in 2008, with the Lehmann collapse, the bubble burst. The management by the central banks and the government of the crisis were successful in stopping the panic, but at the same time they planted the seeds for future problems. In fact, they socialized the private debt by transforming it into a public one. They nationalized banks, which meant putting the responsibility of the banks on the taxpayers. In doing so, they bailed out whatever needed to be bailed out. In my opinion this was a necessary thing to do, even though now we are left with a delicate question: what is the exit strategy?

The only answer is to reduce public debt, to withdraw all the liquidity we injected in the market and to rewrite the rules: all solutions should require international policy coordination.

There are enormous parallels between the financial crisis and environmental economics. The famous journalist Thomas L. Friedman wrote a book that is considered to be a hymn to globalization, The World is Flat. In his following book, Hot, Flat and Crowded, Friedman wrote about the excess of US consumers, and of the western world in general, including finance and energy sources, a sort of bulimia, which brings consequences to the global level.

Other writers and economists such as George Akerlof and Robert Schiller are developing theories of these excesses by analysing human nature, which include greed and the desire to overwhelm people.