A

Source: The underlying model is described in William Nordhaus and Joseph Boyer, Warming the World: Economic Models of Global Warming (MIT Press, 2000), chap. 8. Input data are revised to reflect changes in trends since 1999.

a. The date 2002 includes coverage of the Kyoto Protocol; 2010 includes application of the Emissions Trading Scheme.

to include the major developing countries along with lack of an agreed-upon mechanism for including new countries and extending the agreement to new periods. The major blow came when the United States withdrew from the treaty in 2001. By 2002, the protocol covered only 30 percent of global emissions, while the hard enforcement mechanism in the ETS accounts for about 8 percent of global emissions (see figure 6-1).

Even if the current protocol is extended, models indicate that it will have little impact on global temperature change. Modeling estimates indicate that global emissions under the revised Kyoto Protocol will be very close to "business as usual." Global emissions in 2010 under the current protocol are estimated to be 1.5 percent lower than a no-controls scenario, if the new forestry offsets are ignored (see figure 6-2). Unless there is a dramatic breakthrough or a new design, the protocol threatens to be seen as a monument to institutional overreach.

Figure 6-2. Estimated Emissions Reductions under Different Scenariosa Difference from base (percent)

Figure 6-2. Estimated Emissions Reductions under Different Scenariosa Difference from base (percent)

Source: The underlying model is described in Nordhaus and Boyer, Warming the World, chap. 8. Input data are revised to reflect changes in trends since 1999.

a. Numbers are for total global industrial CO2 emissions and measure the percent reduction relative to a business-as-usual path of no emissions reductions (or zero carbon prices). "Original Kyoto Protocol" shows the impact of the protocol with U.S. participation. "Kyoto Protocol without U.S." shows the impact of the protocol without the United States. "Limit to 2XCO2" shows the emissions reductions that would minimize the costs of limiting CO2 concentrations to double preindustrial concentrations (that is, to 550 parts per million). The estimates are for the decades centered on the listed year. Estimates do not include reductions in targets due to new provisions regarding sinks and other technicalities contained in the most recent version of the Kyoto Protocol.

Nations are beginning to consider the structure of climate change policies for the period after 2008—12. Some countries, states, cities, companies, and even universities are adopting their own climate change policies. Are there in fact alternatives to the scheme of tradable emissions permits embodied in the protocol? The fact is that alterative approaches have not received a serious hearing among natural scientists or among policymakers. What are some of the alternatives?1

For global public goods, there are three potential approaches: command-and-control regulation, quantity-oriented market approaches, and tax- or price-based regimes.2 Of these, only the tradable-quantity and price-based regimes have any hope of being reasonably efficient.

Under a tradable-quantity approach, an agreement proceeds by setting limits on emissions by different countries. The limits are partially or wholly transferable among countries. This is the approach taken under the Kyoto Protocol. This approach has very limited international experience under existing protocols such as the chlorofluorocarbon mechanisms and somewhat broader experience under national trading regimes, such as the U.S. SO2 (sulfur dioxide) regime.

A radically different approach is to use harmonized prices, fees, or taxes as a method of coordinating policies among countries. This approach has no international experience in the environmental area, although it has modest experience nationally in such areas as the U.S. tax on ozone-depleting chemicals. In contrast, the use of harmonized price-type measures has extensive international experience in fiscal and trade policies, such as harmonized taxes in the EU and harmonized tariffs in international trade.

Price-Type Approaches to Climate Change

Price-type approaches (or hybrids that combine price and quantity controls) have been discussed in a handful of papers in the economics literature, but much careful analysis remains to be done.3 I highlight a few of the details here.

For concreteness, I discuss harmonized carbon taxes. Under harmonized carbon taxes, there are no international emissions limits; rather, countries agree to penalize carbon emissions domestically at an agreed-upon and harmonized "carbon tax." This is essentially a dynamic Pigovian pollution tax for a global public good (Pigovian taxes are designed to align the social costs and social benefits of pollution). The carbon tax is negotiated, but conceptually it is determined by weighing environmental and economic objectives. This might involve aiming to limit changes in greenhouse gas concentrations or global mean temperature below some level, or it might use some kind of cost-benefit approach. Unlike the quantitative approach under the Kyoto Protocol, there are no country emissions quotas, no emissions trading, and no base-period emissions levels. The efficient tax would be equalized across space and grow over time at approximately the "real carbon interest rate."

It would be critical to distribute the cost of emissions reductions fairly among nations. It would be reasonable to allow participation to depend on the level of economic development. For example, countries might be expected to participate fully when their incomes reach a given threshold (perhaps $10,000 per capita), and poor countries would receive transfers to encourage early participation. The issues of sanctions, the location of taxation, international trade treatment, and transfers to developing countries under harmonized carbon taxes are important details that are subject to discussion and refinement. If carbon prices are equalized across participating countries, there will be no need for tariffs or border tax adjustments among participants. While much work on the details would be required, this is familiar terrain because countries have been dealing with tariffs, subsidies, and differential tax treatment for many years. The issues are elementary compared to those of a quantity-based regime.

The literature on regulatory mechanisms entertains a much richer set of approaches than the polar quantity and price types that are examined here. Important combinations or hybrids include quantity controls with price caps and floors or harmonized taxes with quantity caps. This discussion focuses on the price-type mechanism because it is superior in so many respects.

Comparison of Price and Quantity Approaches

Policymakers, environmentalists, and economists are so accustomed to quantity constraints in environmental policy that the fundamental advantages of price-type approaches have been largely overlooked. The price-type approach is particularly advantageous for "stock global public goods" such as global warming. Some points are familiar to environmental economists, but others have particular force in an international regime.

The fundamental defect of the Kyoto Protocol lies in its objective of reducing emissions relative to a baseline of 1990 emissions for high-income countries. This policy lacks any connection to ultimate economic or environmental policy objectives. The approach of freezing emissions at a given historical level for a group of countries is not related to any identifiable goal for concentrations, temperature, costs, damages, or "dangerous interferences."4 It is not inevitable that quantity-type arrangements are inefficient. The target might be set to ensure that the rise in global temperature does not exceed 2 or 3°C (centigrade) or to achieve some other well-defined and well-designed economic and environmental objectives. That would be a welcome alternative to the current structure.

A related issue concerns the baseline policy against which countries set their policies. Quantity limits are particularly troublesome in a world of growing economies, differential economic growth, and uncertain technological change. These problems have become evident under the Kyoto Protocol, which set its targets thirteen years before the control period and used baseline emissions from twenty years before the control period. Base-year emissions have become increasingly obsolete as the economic and political fortunes of different countries have changed. The 1990 base year penalizes efficient countries (such as Sweden) or rapidly growing countries (such as Korea and the United States). It also gives a premium to countries with slow growth or with historically high carbon-energy use (such as Britain, Russia, and Ukraine).

The baselines for future budget periods and for new participants are deep problems for the Kyoto Protocol. The natural baseline, were it feasible to calculate, is the zero-restraint level of emissions. That level is impossible to calculate or predict with accuracy. Problems would arise in the future as to how to adjust baselines for changing conditions and how to take into account the extent of past emissions reductions.

Under a price approach, the natural baseline is a zero-carbon-tax level of emissions, which is a straightforward calculation for old and new countries. Countries' efforts are then judged relative to that baseline. It is not necessary to construct a historical base year of emissions. Countries are not advantaged or disadvantaged by their past policies or the choice of arbitrary dates for the baseline. Moreover, there is no asymmetry between early joiners and late joiners.

One key difference between price and quantity instruments concerns the structure of the uncertainties, and uncertainty is clearly a central feature of climate change policy. As is well known, if the curvature of the benefit function is small relative to the curvature of the cost function, then price-type regulation is more efficient; the converse holds as well.

While this issue has received little attention in the design of climate change policies, the structure of the costs and damages in climate change gives a strong presumption to price-type approaches. The reason is that the benefits are related to the stock of greenhouse gases, while the costs are related to the flow of emissions. This implies that the marginal costs of emissions reductions are highly sensitive to the level of reductions, while the marginal benefits of emissions reductions are essentially invariant to the current level of emissions reductions. More generally, where the damages are caused by stock externalities (as is the case for climate change because damages are a complicated function of the stock of greenhouse gases), then the damage function is likely to be close to linear with respect to current emissions. Abatement costs, by contrast, are likely to be highly nonlinear as a function of emissions. This combination of relative non-linearities means that emissions fees or taxes are likely to be much more efficient than quantitative standards or auctionable quotas when there is considerable uncertainty, as is clearly the case for climate change.

Closely related to the point about uncertainty is that quantity-type regulations are likely to show extremely volatile trading prices for carbon emissions. Carbon prices are likely to be extremely volatile because of the complete inelasticity of supply of permits in the quantity case along with the presumption of quite inelastic demand for permits in the short run.

Preliminary indications are that European trading prices for CO2 are highly volatile, fluctuating in a band of ± 50 percent over the last year. More extensive evidence comes from the history of the U.S. sulfur-emissions trading program. SO2 trading prices have varied from a low of $70 per ton in 1996 to $1,500 per ton in late 2005. SO2 allowances had a monthly volatility of 10 percent and an

Figure 6-3. Prices of Sulfur Emissions Permits, 1994—2005 12.0-

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Figure 6-3. Prices of Sulfur Emissions Permits, 1994—2005 12.0-

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