The effect of sanctions on prices of quotas fossil fuels and emissionintensive goods

A country that is sanctioned for non-compliance with Article 3.1 commitments under the Kyoto Protocol could respond in different ways. It could opt to withdraw from the agreement (avoiding sanctions and its commitments under the Protocol), partly comply with the sanctions imposed and the Kyoto commitment in the second commitment period,10 or bring itself back into full compliance with its commitments and imposed sanctions in the second commitment period. Which strategy a state will adopt will be influenced by the expected costs and benefits of compliance. A party would presumably consider withdrawal from the agreement if the expected costs of compliance are higher than (or at most equal to) the benefits it expects to receive from fulfilling its obligations.11 The expected costs of continuing to participate in the agreement will be larger when the party is sanctioned for non-compliance. Hence, a party found to be in non-compliance could find it more advantageous than before to withdraw from the agreement because of the increased costs of participating that result from the sanctions.

The imposition of sanctions on a country found to be in non-compliance could affect the prices of quotas, fossil fuels and emission-intensive goods12 regardless of which strategy the non-compliant party adopts - that is, whether it chooses to withdraw or comply - but the price effects would differ. We would expect that the degree to which sanctioning affects prices would depend on the non-compliant country's expected volume of quota sales and its balance of export and import of fossil fuel products and emission-intensive goods.

First, with respect to volume of quota sales, if the non-compliant country expects to be a large seller of quotas and its eligibility to trade is suspended, the international quota price will increase with either the country's withdrawal from the agreement or the party's cooperation with sanctions. Upon withdrawal from the Protocol, the non-compliant country loses eligibility to participate in emissions trading. This will result in an increased quota price as a result of the reduced supply of quotas. On the other hand, if the same country chooses to comply with its commitments and sanctions, the quota price will increase due to the suspension of its eligibility to sell quotas.

If the non-complying country is a large buyer of quotas and withdraws, the quota price will decrease as a result of lower demand for quotas. If the non-complying net buyer instead chooses to comply with sanctions in the second commitment period, it will face a lower assigned amount as the result of a deduction of tonnes, which will require a greater emission-reduction commitment and hence lead to an increased quota demand. This, in turn, will increase the international quota price.

The volume of quota trade will be determined by domestic abatement costs and parties' negotiated emission-reduction commitments. An Annex B party's negotiated emission reduction commitments for the first commitment period will be the difference between its business-as-usual emissions (BAU emissions)13 and the initial number of quotas allocated to it through assigned amounts under the Kyoto Protocol. The lower the BAU emissions of a party, the greater the initial amount of quotas allocated to it, and the lower abatement costs, the higher the amount of quotas that country offers on the international quota trading market. Hence, the greater the impact on quota prices should that country be found to be in non-compliance and choose to either withdraw or comply through the acceptance of sanctions.

Several studies have analysed Annex B trading under the Kyoto Protocol. The general picture is as we would expect: under the Kyoto Protocol's trading regime, Russia and other former Soviet Union and Eastern European countries would become major sellers of quotas, and the Organization for Economic Cooperation and Development (OECD) countries would be net purchasers of quotas. See, for instance, Nordhaus and Boyer, 1999; Bollen, Gielen and Timmer, 1999 and Cooper et al, 1999.14 However, some OECD countries would become sellers of quotas. A study by Holtsmark and Msstad (2002) shows that Greece, Ireland, Portugal, Spain and Australia would be quota sellers under the Kyoto Protocol, whereas Italy, the UK, Sweden, the Netherlands and Germany will be buyers.

Second, the pattern of export or import of various fossil fuel products could be of importance for the price effects of the sanctions on these products. If the non-complying country chooses to withdraw from the agreement, its consumption of fossil fuels may increase, or decrease more slowly, if it considers itself no longer bound by its Kyoto emission-reduction commitment. If the country has a more than an insignificant share of total world consumption of specific fossil fuels, increasing consumption may increase the price of these fossil fuels. If, instead, the non-complying country chooses to remain within the Kyoto framework, this will have three effects:

1 If the country had expected to be a large seller of quotas due to relatively low abatement costs, the suspension of its eligibility to sell quotas would remove this incentive for domestic abatement efforts. This might imply fewer emission-reduction measures than would otherwise have occurred. On the other hand, this would imply that other complying countries will have to do more at home.15 The price pattern between the different fossil fuel products could be changed as a result of the non-complying party's suspension from eligibility to sell quotas. The non-compliant country would be likely to increase its consumption of fossil fuels, whereas the compliant countries would decrease theirs. If countries' consumption patterns of the various fossil fuels, for instance their relative reliance on natural gas, differ between the non-compliant country and the compliant countries, this would change the price differential between the various fossil fuels.

2 The first sanction mechanism (where the assigned amount for the second commitment period is reduced by an amount equal to the excess emissions in the first period multiplied by 1.3) could also affect the price of fossil fuels if a country with significant excess emissions is sanctioned, as the total agreed emission reductions for the first commitment period are effectively increased due to the use of a multiplier.

3 Third, the price of various emission-intensive goods could also be influenced by sanctioning a non-compliant country. If the non-compliant country chooses to withdraw from the Protocol, its production of emission-intensive goods could increase. If the non-compliant country is responsible for a substantial share of the total world production of these goods, prices for these goods may decrease. If, instead, the non-complying country chooses to comply with the sanctions, the suspension of its eligibility to sell quotas will not significantly change the total amount of carbon emitted under the Protocol. However, the export and import pattern of different emission-intensive goods might be altered, with consequent impacts on product pricing, if a large quota seller is suspended from quota trade. The resulting change in price differentials between various emission-intensive products will depend on the export and import product mixes of the non-complying country and the other parties. Also, as for fossil fuels, the price of emission-intensive goods could be altered as a consequence of imposing the 1.3 penalty on each unit of excess emissions.

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