Economic Analysis of the Kyoto Protocol

The last chapter reviewed a wide range of alternative approaches for dealing with the threat of climate change. This chapter focuses on the current approach that has been adopted under international agreements, namely the Kyoto Protocol. The discussion begins with a description of the protocol and then analyzes its impact on economic and environmental outcomes.1

Climate-Change Policy and the Kyoto Protocol

Governments have struggled to find policies that can at the same time satisfy the demands of electoral politics and meet the needs for responsible global stewardship. The initial response of nations to the threat of global warming was the Framework Convention on Climate Change (FCCC), which was issued at the Rio Summit of 1992. Under the FCCC, Annex I countries (high-income nations plus the former Soviet Union and Eastern European countries) committed on a voluntary basis to limit their concentrations of GHGs to 1990 levels. The FCCC left open almost all the important questions, such as the environmental, economic, and political components of such a commitment.2

It soon became apparent that the voluntary approach under the FCCC was producing next to nothing in real policy measures. Moreover, some countries, particularly the United States, were experiencing rapid growth in CO2 emissions. This led the advocates of strong policy measures to pursue binding commitments, which led to the Kyoto Protocol of December 1997. The key provision of the Kyoto Protocol is

1. An earlier version of this chapter, using the RICE-98 model, appeared in Nordhaus and Boyer 1999.

2. A full discussion of the FCCC can be found at the website http:// www.unfccc.de/. The text and discussion of the Kyoto Protocol can also be found at that site.

article 3, which states that Annex I countries will on average reduce their emissions of GHGs by 5 percent relative to 1990 levels by the budget period 2008-2012, with each country facing an individual emissions limit (see chapter 7, the second section, the fourth subsection).3

Both economic theory and historical experience have shown that allowing economic agents to trade—in this case, to trade national emissions-reduction permits—can substantially reduce the cost of meeting an aggregate quantitative reduction target. The United States therefore proposed international emissions trading. The trading provision is contained in article 6, which reads: "For the purpose of meeting its commitments under article 3, any party included in Annex I may transfer to, or acquire from, any other such party emission reduction units ... provided that:... the acquisition of emission reduction units shall be supplemental to domestic actions for the purposes of meeting commitments under article 3." This provision gives Annex I nations the right to trade emissions units. It is haunted by the vague and troubling provision, however, that the acquired permits will be supplemental to domestic actions. In other words, nations can buy only part of their emissions reductions, although the allowable amounts are unspecified in the protocol.

An additional provision introduces the possibility of offsets from developing countries. Article 12 defines a clean development mechanism, under which "(a) parties not included in Annex I will benefit from project activities resulting in certified emission reductions; and (b) parties included in Annex I may use the certified emission reductions accruing from such project activities to contribute to compliance with part of their quantified emission limitation and reduction commitments ... Emission reductions resulting from each project activity shall be certified ... on the basis of ... real, measurable, and long-term benefits related to the mitigation of climate change [and] reductions in emissions that are additional to any that would occur in the absence of the certified project activity."4 Some have interpreted this as a green light to include trading with developing countries, but the need to ensure additionality and to certify each transaction probably means it will lead to only a small fraction of potential trades.

3. As discussed below, the protocol opens the door for possible emissions trading and other cooperative schemes, so it might be possible for a country to meet its emissions limit even if its actual emissions exceed that limit.

4. All citations of the protocol have omitted provisions that are not relevant to the present analysis, such as the need for consent and the monitoring by international bodies.

A further complication involves GHG emissions other than those from energy use. The Kyoto Protocol has provisions for five other gases as well as for the potential for enhancing sinks. Specialists are working to understand the potential offsets that might come from these additional actions and to clarify the treatment of carbon sinks in the treaty.

The various versions of the Kyoto Protocol considered below make a variety of assumptions about Annex I regions' abilities to reduce their own abatement costs by buying emissions reductions elsewhere. We assume that other gases and sinks are neutral. More precisely, we assume that reductions in other GHGs and increased sequestration in carbon sinks for each region are such that the percentage reduction in industrial emissions required to meet Kyoto is below 1990 industrial emissions by the same fraction as the overall GHG target is below the 1990 level.

Economic Analysis of the Kyoto Protocol

Earlier chapters discussed the details of the RICE-99 model. We now discuss the modifications of RICE-99 needed to analyze the Kyoto Protocol. We analyze in this chapter a number of different approaches to implementing the Kyoto Protocol and compare the different approaches with the optimal run described in the last chapter. Table 8.1 shows the major runs analyzed in this chapter. Most of them require no discussion, but a few details need elaboration.

Table 8.1

Runs for analysis of Kyoto Protocol

1. Reference: no controls

2. Optimal: sets emissions by region and period to balance the costs and benefits of emissions reductions

3. Kyoto emissions limitations:

a. No trade: no trade among 4 major Annex I blocs b. OECD trade: emissions trading limited to OECD countries c. Annex I trade: emissions trading limited to Annex I countries d. Global trade: emissions trade among all regions

4. Cost effectiveness benchmarks:

a. Limit atmospheric concentrations to those resulting from the Kyoto Protocol case 3c (for the period after 2050)

b. Limit global mean temperature to that resulting from the Kyoto Protocol case 3c (for the period after 2100)

Note: This list shows the runs examined in the analysis of the Kyoto Protocol.

The reference case (policy 1) and the optimal case (policy 2) were described in chapter 7. The cases denoted Kyoto emissions limitations take the emissions permit allocations agreed upon in the 1997 Kyoto Protocol and extend them indefinitely for Annex I regions—this might be called "Kyoto forever."5 Four variants of the Kyoto Protocol are analyzed here. Under the "no-trade" run 3a, no trading of emissions permits is allowed among the four Annex I regions included in RICE-99, and there are no offsets with the non-Annex I regions. Under the "OECD-trade" runs (run 3b), emissions trading is allowed only among the OECD regions.6 The "Annex I-trade" case (run 3c) allows trading among all Annex I regions. This is the same as policy 4 in the previous chapter. The global trading policy (run 3d) extends the umbrella of trading to all regions. In this case, the non-Annex I regions receive emissions permits equal to their baseline emissions from run 1, but regions are then allowed to sell any emissions rights that exceed their actual emissions. Each of these runs has serious implementation issues, but these are ignored in this analysis.

Although the Kyoto emissions limitation cases are referred to as types of trading regimes, each of these could be implemented as a fiscal regime in which carbon taxes are made uniform across a trading bloc and the tax revenues shared across regions in a bloc.

It should be emphasized that global trading in case 3d is a radical extension of the Kyoto Protocol and contains crucial and problematical assumptions about the behavior of non-Annex I countries. In principle, each non-Annex-I country will be better off by agreeing to this limit-and-trade procedure; it can do no worse than simply consuming its permits and can do better by reducing its low marginal-cost sources and selling the permits at the world price. This assumption is questionable in practice, however, for three reasons: (1) the difficulty of estimating and assigning the appropriate baseline emissions, (2) the need to ensure compliance among countries with weak governance structures, and (3) the potential for countries to repudiate their commitments in the future.

In addition to the Kyoto runs, two alternative cases are presented that are useful for assessing the efficiency of different approaches. The

5. See chapter 7, section two, part four for description of Annex I in RICE-99.

6. Strictly speaking, the "OECD" here consists of the US, OHI, and OECD Europe regions, the high-income regions. This includes the actual OECD less Mexico, South Korea, Poland, Hungary, and the Czech Republic plus Singapore, Israel, Hong Kong, and a handful of small island nations.

emissions objectives of the Kyoto Protocol are not based on any ultimate environmental objective; instead, they are the simple and easily understood guidelines of holding emissions constant. The emissions objectives can be translated into more meaningful environmental objectives by examining the consequences of the Kyoto Protocol for CO2 concentrations and for global temperature. Run 4a finds a Pareto optimal carbon tax trajectory subject to the concentrations target implicit in the Kyoto emissions limitations; in this policy, concentrations are constrained to be at the same level implied by the Kyoto Protocol after 2050. Run 4b takes the same approach for global temperature, where temperature is constrained to be at the same level as that implicit in the Kyoto Protocol after 2100. (These dates are selected to take account of the lags between emissions and the two other objectives.) Runs 4a and 4b allow one to ask how cost-effective the different approaches are in attaining the environmental objectives embodied in the Kyoto Protocol. In both runs 4a and 4b, the entire world is treated as one trading bloc, and net permit revenue is held to zero by assigning to each region emissions permits equal to its emissions.

As one moves from the no-trade case to the global-trading case, the where-efficiency of the Kyoto Protocol is improved. Each step from global trading to case 4a and from 4a to 4b improves on when-efficiency. But even case 4b is not why-efficient, as a comparison with the optimal run will demonstrate, since the temperature target chosen has no grounding in optimization (see discussion of types of efficiency in chapter 7, section one).

Major Results

This section presents the results of the analysis of the Kyoto Protocol using RICE-99. Important conclusions are highlighted in this summary: the ranking of policies, the optimal carbon price, and a revised view of the climate-change problem.

Environmental Variables

The first set of results pertains to the major environmental variables: emissions, concentrations, and global temperature increases. Figure 8.1 and table 8.2 show global industrial CO2 emissions for the major cases. The overall level of abatement in the early years under the Kyoto Protocol is close to that of the optimal program; in 2015 global emissions

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