The Brookings Policy Briefing, by Warwick J. McKibbin and Peter J. Wilcoxen, discusses the currently favored U.S. proposal, to be presented at the Kyoto Conference later this year, for the reduction of CO2 emissions. The proposal suggests an international system of tradable emissions permits with the total amount of emissions kept at the 1990 level. International negotiators would decide how the permits are initially distributed among the participating countries. Each country could then decide for itself how to allocate the permits internally. These permits could than be freely traded on an international basis. The system would in the beginning only involve developed countries with the intention that the developing countries would join at a later date.
The proposal was endorsed by some well-known economists – Kenneth Arrow, Dale Jorgenson, Robert Solow, Paul Krugman, and William Nordhaus. McKibbin and Wilcoxen suspect that some of the enthusiasm about international trading permits is more related to the theoretical concept than to the practical application, and note that not enough attention has been given to the practical problems of such a system. The authors then consider why an international system of tradable permits looks so favorable in theory.
The principal idea is that any company which produces CO2 emissions has to obtain enough permits to balance the amount of CO2 emissions it produces. The decision of how the permits are distributed among the participating countries, for example according to population, or actual CO2 emissions, would be subject to international negotiation and agreement. How they are allocated domestically is free for every country to decide. After that companies could trade their permits world-wide without any restrictions.
The advantages seen in this theoretical concept are:
The emissions could be kept to a pre-determined level.
This level of emissions would be achieved with a minimum of costs.
This would be possible because firms with the lowest abatement costs would undertake the abatement and then sell permits to companies which face higher costs and therefore would rather buy permits.
The government can control how the burden of the abatement costs are distributed among companies.
The government can influence the distribution of the costs through the way it allocates the permits in the beginning, for example through free distribution or auctions.
The authors then examined the problems that would arise in the practical application of the concept, which seems so intriguing in theory. McKibbin and Wilcoxen consider the sulfur emissions trading scheme in the U.S. as an example that the system can work for domestic problems, but they foresee many problems for a CO2 emission permits trading system on a world-wide basis.
One of the problems they see is that the emissions would be cut back to 1990 levels and kept there without any concern about the costs such a reduction would imply. Estimates of the economic impact of such a policy range from -0.5 percent increase in GDP per year for the U.S. to up to 2 percent of decline in GDP per year. Most of the studies lay between 1-2 percent decrease of GDP per year.
In contrast, the benefit would be the avoidance of potential costs from climate change. However very little is known about these possible costs and the impact of reduced CO2 emissions on the climate. Some studies have tried to estimate the potential costs of climate change in a scenario with an increase in temperatures of 2.5 – 3 C. The studies say the costs could be as much as 1.3 percent of GDP every year for the U.S. around the year 2050. The benefits would be much smaller for a mere restriction of emissions to the 1990 levels.
McKibbin and Wilcoxen contend that the evidence suggests that there is no real need to keep the emissions at the 1990 levels, because most of the studies estimate that the costs would be far greater than the potential benefits. In addition, the costs would arise now, whereas the benefits would occur far in the future.
The second problem mentioned in the Policy Briefing would be the enormous transfer of wealth from the U.S. to other countries, particularly to developing countries, as a result of the system. Some regard this as a positive part of the agreement, but the sheer amount of the transfer sum makes it unlikely that there would be enough political support given the usual problems of much smaller foreign aid budgets in obtaining approval. The enormous transfer sums would lead to large distortions in the international trade system; the result could be more volatility in exchange rates and the widening of the U.S. trade deficit. Developing countries would receive a huge amount of transfer money, however, most of the money would have to be invested in “environmental technology” to reduce emissions, even though most of these countries are in urgent need of money to improve infrastructure, education and health care systems. Developing countries are not expected to participate from the start, but without these countries’ participation, probably the most important factor of the concept would be lost (the difference in abatement costs), and the cost savings thus would be much smaller.
An additional problem would be that none of the participating governments would have any incentive to monitor the agreement. The costs would fall on domestic firms while the benefits would mostly go to other countries. As a result, there might be a tendency by national governments to “overlook” violations by domestic companies. A complex and expensive international monitoring system would be needed to enforce the treaty.
The authors then explore a possible alternative: a scheme of national permits and emissions fees. Each country would receive permits according to its 1990 level of emissions, and these could be distributed among companies however the country wished to do so. Besides these permits, every company would be able to buy additional permits from its national governments for a specific fee, for example, $10. Therefore, companies could buy permits from two sources – other companies and the government.
This system would not insure a specific emission level, but companies would always have an incentive for abatement if it could be done for less than the fixed fee. The result would not be a cap on emissions, but the abatement would be done with a minimum of costs.
The authors compare the scheme favorably to a carbon tax, because it could save companies a lot of money if the government decides to give away the permits up to the 1990 level for free. A tax would start with the first ton of emission, while the fee would only apply to companies that exceed their 1990 emissions level. McKibbin and Wilcoxen think such a scheme would provide a clearer picture of what the real costs of abatement are and providing this information might be important for future policy decisions if there is less uncertainties about cost and benefits in financial terms of climate change policy. It would also provide greater incentives for monitoring on a national level, because revenues through the fees could be added to governments’ budgets.
McKibbin and Wicoxen also suggest that the system would be flexible enough to adopt a possible change in policy in case scientific evidence would emerge that climate change is a bigger or smaller problem than expected; and if more information become available about the real costs of emission reduction. It would also allow non-participating countries to join by simply adopting the policy at home without the need for further international negotiations.
McKibbin and Wilcoxen conclude that their proposal would be much easier to implement and politically acceptable to more countries. It would probably slow the growth of CO2 emissions without a big distortion to the international system of trade.
They see, therefore, the choice as being not between an international trading system and their proposal, because they think the international trading system has no chance of agreement – but between their proposal and no policy at all.