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The Warsaw Climate Negotiations, and Reason for Cautious Optimism

The Nineteenth Conference of the Parties (COP-19) of the United Nations Framework Convention on Climate Change (UNFCCC) came to a close in Warsaw, Poland, on Saturday, November 23^rd, after what has become the norm – several all-night sessions culminating in last-minute negotiations that featured diplomatic haggling over subtle changes to the text on which countries were finally willing to agree. The key task of this COP was essentially to pave the way for the negotiations next year at COP-20 in Lima, Peru, as a lead-up to the real target, reaching a new international climate agreement at the 2015 negotiations in Paris to be implemented in 2020, when the second commitment period of the Kyoto Protocol comes to an end. If that was the key objective, then the Warsaw meetings must be judged to be at least a modest success – the baton was not dropped, rather it was passed successfully in this long relay race of negotiations.

Before going further, I would like to acknowledge something else about COP-19 in Warsaw, namely the excellent logistics. Anyone who suffered through the disastrous logistical arrangements for COP-15 in Copenhagen will not take this for granted. Perhaps ironically, in the years I’ve been participating in these annual events, the two best organized conferences (in terms of logistical arrangements) were the two Polish COPs – COP-14 in Poznan in 2008 and COP-19 in Warsaw this year.

As I have written in many previous essays at this blog, the challenges standing in the way of an effective international climate change agreement are numerous and severe. A brief historical account is necessary to explain the significance of what transpired in Warsaw. However, if you’re familiar with international climate policy, particularly the history of these international negotiations, I suggest you skip the next section and move directly to “Issue #1: Making Progress toward a Post-Kyoto Agreement.”

Some Historical Background to Place the Warsaw Talks in Context: the UNFCCC, the Berlin Mandate, the Kyoto Protocol, and the Durban Platform

The U.N. Framework Convention on Climate Change, adopted at the U.N. Conference on Environment and Development (the first “Earth Summit”) in Rio de Janeiro, Brazil, in 1992, contains what was to become a crucial passage: “The Parties should protect the climate system for the benefit of present and future generations of humankind, on the basis of equity and in accordance with their common but differentiated responsibilities and respective capabilities. Accordingly, the developed country Parties should take the lead in combating climate change and the adverse effects thereof.” [emphasis added] The countries considered to be “developed country Parties” were listed in an appendix to the 1992 Convention – Annex I.

The phrase – common but differentiated responsibilities – was given a specific interpretation three years after the Earth Summit by the first decision adopted by the first Conference of the Parties (COP-1) of the U.N. Framework Convention, in Berlin, Germany, April 7, 1995 – the all important Berlin Mandate, which interpreted the principle as: (1) launching a process to commit (by 1997) the Annex I countries to quantified greenhouse gas emissions reductions within specified time periods (targets and timetables); and (2) stating unambiguously that the process should “not introduce any new commitments for Parties not included in Annex I.”

Thus, the Berlin Mandate established the dichotomous distinction whereby the Annex I countries were to take on emissions-reductions responsibilities, and the non-Annex I countries were to have no such responsibilities whatsoever. This had wide-ranging and profound consequences, because it became the anchor that prevented real progress in international climate negotiations. With 50 non-Annex I countries coming to have greater per capita income than the poorest of the Annex I countries, the distinction was out of whack within a few years.

But, more important than that, this dichotomous distinction meant that: (a) half of global emissions would be from nations without constraints; (b) the world’s largest emitter – China – would be unconstrained; (c) aggregate compliance costs would be driven up to be four times their cost-effective level, because many opportunities for low-cost emissions abatement in emerging economies were taken off the table; and (d) an institutional structure was perpetuated that made change and progress virtually impossible.

The dichotomous Annex I/non-Annex I distinction remained a central – indeed, the central – feature of international climate negotiations from COP-1 in Berlin in 1995 continuously until COP-15 in 2009, when hints of possible change first appeared. The Copenhagen Accord (2009) and the Cancun Agreements (2010) began a process of blurring the Annex I/non-Annex I distinction. But this blurring was only in the context of the interim pledge-and-review system established at COP-15 in Copenhagen and certified at COP-16 in Cancun, not in the context of an eventual successor to the Kyoto Protocol. Thus, the Berlin Mandate retained its centrality.

Then, in December, 2011, at COP-17 in Durban, South Africa, the Durban Platform for Enhanced Action was adopted. Under some interpretations, it essentially eliminates the Annex I/non-Annex I (or industrialized/developing country) distinction. In the Durban Platform, the delegates decided to reach an agreement by 2015 that will be applicable to all countries by 2020.

Rather than adopting the Annex I/non-Annex I (or industrialized/developing country) distinction, the Durban Platform focuses instead on the pledge to create a system of greenhouse gas reductions including all Parties (what matters, really, is all key countries) by 2015 that will come into force by 2020. Nowhere in the text of the decision were phrases such as “Annex I,” “common but differentiated responsibilities,” “distributional equity,” “historical responsibility,” all of which had long since become code words for targets for the richest countries and blank checks for all others.

By replacing the Berlin Mandate, the Durban Platform opened an important window. National delegations from around the world took on the challenging task to identify a new international climate policy architecture that is consistent with the process, pathway, and principles laid out in the Durban Platform, namely to find a way to include all (key) countries (such as the 20 largest national and regional economies that together account for upwards of 80% of global carbon dioxide emissions) in a structure that brings about meaningful emissions reductions within an appropriate timetable at acceptable cost, while remaining within the overall framework provided by the UNFCCC, including the celebrated principle of common but differentiated responsibilities.

Issue #1: Making Progress toward a Post-Kyoto Agreement

In Warsaw, the negotiators were tasked under the Durban Platform track (the so-called “ADP” track) to develop a work plan of substantive topics and a related calendar that will lead to the development of the text of an agreement of a new comprehensive policy architecture that can be discussed at COP-20 in Lima one year from now and then subject to final consideration and adoption a year after that at COP-21 in Paris. This they did, and in the process they identified six components for the new architecture: mitigation, adaptation, finance, technology development and transfer, capacity-building, and transparency of action and support. Some of these are more necessary than others, but it was this package that generated agreement in Warsaw.

The actual agreement in Warsaw could only be achieved through carefully negotiated text. The delegates’ obligation is to eventually adopt “a protocol, another legal instrument or an agreed outcome with legal force under the Convention applicable to all Parties…” In truth, the phrase “under the Convention” is not necessary, because any decision by the UNFCCC is under the Convention, and therefore it is the case that any agreement produced under the Durban Platform is still subject to the UNFCCC principle of “common but differentiated responsibilities.” But the large emerging economies tend to view the phrase “under the Convention” as supporting the dichotomous distinction of, on the one hand, commitments for Annex I (industrialized) countries to reduce emissions, and, on the other hand, no obligations for non-Annex I (developing) countries, who would take actions only voluntarily and only with financial assistance from the Annex I countries. The same set of large emerging economies insisted that if they were to be included in the agreement, then the word “commitments” must be replaced by “contributions.”

It is looking increasingly likely that the 2015 agreement will take the form of a hybrid architecture, combining: (1) a bottom-up system of national commitments (sorry, national contributions) that arise from – or are at least consistent with – national policies and goals; plus (2) top-down, centralized management of oversight, guidance, and coordination, with an eye to increasing ambition over time. At the Harvard Project on Climate Agreements, we outlined such a hybrid international climate policy architecture four years ago (“A Portfolio of Domestic Commitments: Implementing Common but Differentiated Responsibilities”), and we explored it further just last month in a new report (“Identifying Options for a New International Climate Regime Arising from the Durban Platform for Enhanced Action”). In Warsaw, we co-hosted and participated in two sessions that explored these ideas in considerable detail (you can learn more about that here; we will soon place all of the slide decks from those sessions at the Harvard Project web site).

Issue #2: Loss and Damage

As I predicted at the conclusion of last year’s climate negotiations (COP-18) in Doha, Qatar, the issue that held the greatest potential for blowing up this year’s talks in Warsaw was the topic of “loss and damage,” which the delegates agreed to put on the agenda for discussion this year at COP-19. The phrase “loss and damage” is typically understood to refer to the range of damages and loss associated with climate change impacts in developing countries that are particularly vulnerable to the adverse effects of climate change. Discussions about potential international policy in this realm frequently bring up thoughts about who should pay for such loss and damages, presumably those most responsible for climate change.

Since climate change is a function not of current emissions, but of concentrations, responsibility for damages is presumably correlated with cumulative emissions. Hence, the industrialized countries, in particular, the United States, worry that negotiations on “loss and damage” would soon raise the specter of unlimited legal liability.

The link is less direct than one might think, however. First, there is the global commons nature of the problem, meaning that climate change cannot be linked to emissions from a specific country. Second, there is the highly stochastic link from climate change to changes in weather patterns, so that no specific weather incident – whether Superstorm Sandy in New York, Hurricane Katrina in New Orleans, or Typhoon Haiyan in the Philippines – can be deterministically linked with global climate change. These two scientific realities mean that moving from “loss and damage” to legal liability would be a long and perilous road.

But this is a very important issue in the climate negotiations for many developing countries, in particular, for the small island states that are most at risk. Hence, it should not be surprising that this area of discussion – in some ways only a sideshow of the primary talks on reducing emissions and the risk of climate change – almost caused the talks to collapse.

In the end, the delegates agreed to finesse the topic by creating the Warsaw International Mechanism for Loss and Damage, which does not mention liability or promise compensation, but rather states that this is a topic to be discussed further at future meetings, and under the general topic of adaptation to climate change.

Issue #3: Finance

Those are two – the Durban Platform, and Loss and Damage – of three major issues that were considered in Warsaw. The third was “finance,” that is, the question of when and how the industrialized countries will meet the commitment they made at COP-15 in Copenhagen in 2009 to begin delivering $100 billion per year of financial assistance to developing countries in 2020 to help with mitigation and adaptation. Not surprisingly, there was little or no progress on that front. More about this in a future essay. For now ….

The Path Ahead – Any Reason for Optimism?

Given my description above of the debates and “resolution” regarding the major issues, is there any cause for optimism regarding the path ahead. Regular readers of this blog will know that I tend to see the half-full glass (or one-tenth full glass) of water, and in this case I think there really is cause for cautious optimism regarding the path ahead.

This is based upon a singular reality – the growing convergence of interests between the two most important countries in the world when it comes to climate change and international policy to address it, namely, China and the United States.

First of all, the annual carbon dioxide (CO₂) and greenhouse gas (GHG) emissions of these two countries have already converged. Whereas U.S. CO₂ emissions in 1990 were almost twice the level of Chinese emissions, by 2006 China had overtaken the United States. We are the world’s two largest emitters.

Second, as I explained above, cumulative emissions are particularly important, because they are what cause climate change. Any discussion of distributional equity in the climate realm inevitably turns to considerations of historic responsibility. Looking at the period 1850-2010, the United States led the pack, accounting for nearly 19% of cumulative global emissions of GHGs, with the European Union in second place with 17%, and China third, accounting for about 12% of global cumulative emissions. But that is changing rapidly, because of the fact that emissions are flat to declining throughout the industrialized world, but increasingly rapidly in the large emerging economies, in particular, China. Depending upon the relative rates of economic growth of China and the United States, as well as many other factors, China may top all countries in cumulative emissions within 10 to 20 years from now.

Third, China and the United States both have historically high reliance on coal for generating electricity. At a time at which U.S. dependence on coal is decreasing (due to increased supplies of unconventional natural gas and hence lower gas prices ), China continues to rely on coal, but is very concerned about this, partly because of localized health impacts of particulates and other pollutants. Importantly, both countries have very large shale gas reserves. U.S. output (and use for electricity generation) has been increasing rapidly, bringing down CO₂ emissions, whereas Chinese exploitation and output has been constrained by available infrastructure (i.e., lack of pipelines, but that will change).

Fourth, in both countries, sub-national climate policies – cap-and-trade systems – are moving forward. In the case of the China, seven pilot CO₂ cap-and-trade regimes at the local level are under development, while in the United States, California’s ambitious AB-32 cap-and-trade system continues to make progress.

Fifth and finally, there is the reality of global geopolitics. If the twentieth century was the American Century, then many observers, including leaders in China, anticipate (or hope) that the twenty-first century will be the Chinese Century. And, as I was quoted by David Jolly in the New York Times as saying, “If it’s your century, you don’t obstruct, you lead.”

Conclusion

There was no fundamental setback in Warsaw to the stream of work that needs to be accomplished in Lima in 2014 in preparation for an agreement to be reached in Paris in 2015 under the Durban Platform for Enhanced Action. This, combined with the reality of increasing convergence of Chinese and U.S. perspectives and interests, leaves me cautiously optimistic (or perhaps, just hopeful) about the path ahead.

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You can view and listen to an assessment of the Warsaw negotiations in a discussion in which I participated on the PBS NewsHour on November 27^th, moderated by Judy Woodruff.

For other summaries and analyses of Warsaw’s COP-19 climate conference, I recommend:

Carraro, Carlo. “COP19: Between Weak Commitments and Tiny Successes.” International Center for Climate Governance. November 27, 2013.

Center for Climate and Energy Solutions. “Outcomes of the U.N. Climate Change Conference in Warsaw.” November, 2013.

Stowe, Robert. “COP-19: Different Strokes?”The Energy Collective, November 27, 2013.

Remembering Ronald Coase’s Contributions

On September 2^nd, Ronald Coase, professor emeritus of economics at the University of Chicago Law School, Nobel laureate, and principal creator of the academic field of law and economics, passed away at the age of 102. Numerous, lengthy obituaries have appeared in the national and international press. And in an effective essay posted at the Energy Economics Exchange web site, Severin Borenstein, professor of economics at the University of California, Berkeley, wrote about the effect that Coase’s thinking had decades ago on his own intellectual development (while lamenting that the Wall Street Journal in its own tribute to Coase had twisted the implications of his work to fit the Journal’s view of the world).

The passing of Professor Coase brings to mind an essay I wrote for this blog in July of 2012, in which I recalled that a group of economists and legal scholars had gathered in December, 2010, at the University of Chicago to celebrate two notable events. One was the fiftieth anniversary of the publication of Ronald Coase’s “The Problem of Social Cost” (Coase 1960). The other was Professor Coase’s 100^th birthday. The conference resulted in a special issue of The Journal of Law and Economics.

Robert Hahn (of the University of Oxford) and I were privileged to participate in the conference (a video of our presentation is available here). We recognized that the fiftieth anniversary of the publication of Coase’s landmark study provided an opportunity for us to examine one of that study’s key implications, which is of great importance not only for economics but for public policy as well, in particular, for environmental policy.

The Coase Theorem and the Independence Property

In our article, “The Effect of Allowance Allocations on Cap-and-Trade System Performance,” Hahn and I took as our starting point a well-known result from Coase’s work, namely, that bilateral negotiation between the generator and the recipient of an externality will lead to the same efficient outcome regardless of the initial assignment of property rights, in the absence of transaction costs, income effects, and third party impacts. This result, or a variation of it, has come to be known as the Coase Theorem.

We focused on an idea that is closely related to the Coase theorem, namely, that the market equilibrium in a cap-and-trade system will be cost-effective and independent of the initial allocation of tradable rights (typically referred to as permits or allowances). That is, the overall cost of achieving a given emission reduction will be minimized, and the final allocation of permits will be independent of the initial allocation, under certain conditions (conditional upon the permits being allocated freely, i.e., not auctioned). We called this the independence property. It is closely related to a core principle of general equilibrium theory (Arrow and Debreu 1954), namely, that when markets are complete, outcomes remain efficient even after lump-sum transfers among agents.

The Practical Political Importance of the Independence Property

We were interested in the independence property because of its great political importance. The reason why this property is of such great relevance to the practical development of public policy is that it allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (a pollution reduction goal) and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs. Indeed, this property is a key reason why cap-and-trade systems have been employed and have evolved as the preferred instrument in a variety of environmental policy settings.

In Theory, Does the Property Always Hold?

Because of the importance of this property, we examined the conditions under which it is more or less likely to hold — both in theory and in practice. In short, we found that in theory, a number of factors can lead to the independence property being violated. These are particular types of transaction costs in cap-and-trade markets; significant market power in the allowance market; uncertainty regarding the future price of allowances; conditional allowance allocations, such as output-based updating-allocation mechanisms; non-cost-minimizing behavior by firms; and specific kinds of regulatory treatment of participants in a cap-and-trade market.

In Reality, Has the Property Held?

Of course, the fact that these factors can lead to the violation of the independence property does not mean that in practice they do so in quantitatively significant ways. Therefore, Hahn and I also carried out an empirical assessment of the independence property in past and current cap-and-trade systems: lead trading; chlorofluorocarbons (CFCs) under the Montreal Protocol; the sulfur dioxide (SO₂) allowance trading program; the Regional Clean Air Incentives Market (RECLAIM) in Southern California; eastern nitrogen oxides (NO_X) markets; the European Union Emission Trading Scheme (EU ETS); and Article 17 of the Kyoto Protocol.

I hope some of may find time to read our article, but a quick summary of our assessment is that we found modest support for the independence property in the seven cases we examined (but also recognized that it would surely be useful to have more empirical research in this realm).

Political Judgments

That the independence property appears to be broadly validated provides support for the efficacy of past political judgments regarding constituency building through legislatures’ allowance allocations in cap-and-trade systems. Governments have repeatedly set the overall emissions cap and then left it up to the political process to allocate the available number of allowances among sources to build support for an initiative without reducing the system’s environmental performance or driving up its cost.

This success with environmental cap-and-trade systems should be contrasted with many other public policy proposals for which the normal course of events is that the political bargaining that is necessary to develop support reduces the effectiveness of the policy or drives up its overall cost. So, the independence property of well-designed and implemented cap-and-trade systems is hardly something to be taken for granted. It is of real political importance and remarkable social value. It is just one of many lasting contributions of Ronald Coase.

Economics and Politics in California: Cap-and-Trade Allowance Allocation and Trade Exposure

In my previous essay at this blog – The Importance of Getting it Right in California – I wrote about the precedents and lessons that California’s Global Warming Solutions Act (AB 32) and its greenhouse gas (GHG) cap-and-trade system will have for other jurisdictions around the world, including other states, provinces, countries, and regions. This is particularly important, given the failure of the U.S. Senate in 2009 to pass companion legislation to the Waxman-Markey bill, passed by the U.S. House of Representatives, highlighting the absence of a national, economy-wide carbon pricing policy.

In my previous essay, I focused on three pending design issues in the emerging rules for the AB-32 cap-and-trade system: (1) the GHG allowance reserve; (2) the role of offsets; and (3) proposals for allowance holding limits. I drew upon a presentation I made on “Offsets, Holding Limits, and Market Liquidity (and Other Factors Affecting Market Performance)” at the 2013 Summer Issues Seminar of the California Council for Environmental and Economic Balance.

At the same conference, I made another presentation, which was on “Allowance Value Distribution and Trade Exposure,” a topic that is of great importance both economically and politically, not only in the context of the design of California’s AB-32 cap-and-trade system, but for the design of any cap-and-trade instrument in any jurisdiction. It is to that topic that I turn today. (For a much more detailed discussion, please see a white paper I wrote with Dr. Todd Schatzki of Analysis Group, “Using the Value of Allowances from California’s GHG Cap-and-Trade System,” August, 2012).

Why Does Anyone Care About the Allowance Value Distribution?

A cap-and-trade policy creates a valuable new commodity – emissions allowances. In a well-functioning emissions trading market, the financial value of these allowances (per ton of emissions, for example) is approximately equivalent to their opportunity cost, which is the marginal cost of emissions reductions. This is because of the existence of the overall cap, which – if binding – fosters scarcity of available allowances, and hence generates their economic value.

It should not be surprising, then, that the initial allocation of these allowances can have important consequences both for environmental and for economic outcomes.

Environmental Consequences of the Initial Allowance Allocation

No matter how many times I meet with policy makers around the world to talk about alternative policy instruments (for climate change and other environmental problems), I never cease to be struck by the confusion that abounds regarding the environmental (and the economic) consequences of the initial allocation of allowances in a cap-and-trade system. As I have written many times in the past at this blog, the initial allocation does not directly affect environmental outcomes. Regardless of the allocation method used, aggregate emissions are limited by the emissions cap. This is true whether the allowances are sold (auctioned) or distributed without charge. Furthermore, which firms or sources receive the initial allocation of allowances has no effect on either aggregate emissions or the ultimate distribution of emissions reductions among sources.

This independence of a cap-and-trade system’s performance from the initial allowance allocation was established as far back as 1972 by David Montgomery in a path-breaking article in the Journal of Economic Theory (based upon his 1971 Harvard economics Ph.D. dissertation). It has been validated with empirical evidence repeatedly over the years. (More below about the initial allocation’s potential effects on economic performance.)

However, it is also true that the initial allocation method can indirectly affect emissions. In particular, emissions leakage can arise if economic activity shifts to unregulated sources – this risk is greatest with auctions or free fixed allocations. In contrast, an updating, output-based allocation (used in AB 32 for “industry assistance”) can reduce leakage risk by making the free allocation of allowances marginal, rather than infra-marginal (as is the case with a simple free allocation).

Economic Consequences of the Initial Allowance Allocation

A favorite topic of academic economists is that the allowance allocation method in a cap-and-trade system can affect the overall social cost of the policy if the allowances are auctioned (sold by government to compliance entities), and if the revenues are then used to reduce distortionary taxes (such as taxes on labor and investment), thereby eliminating some deadweight loss and cutting overall social cost. I discuss this a bit more below, but for now let’s recognize that the combination of two California propositions and subsequent court rulings means that the State is not permitted to use the auction proceeds to cut taxes (rather, any auction proceeds must be used to achieve the purposes of AB 32, that is, reducing GHG emissions).

So, within the set of feasible options, the initial allowance allocation will not directly affect the cost-effectiveness of actions taken by emission sources to reduce emissions. In other words, aggregate abatement costs will not be directly affected by the nature of the initial allocation.

I was careful to use the word, “directly,” because the initial allowance allocation can indirectly affect economic outcomes. In particular, the use of updating, output-based allocations can: (1) lower the costs seen by consumers, which can reduce incentives to conserve; (2) avoid reductions in economic activity within California, with associated distributional impacts; and (3) avoid potential shifts of production to less efficient, more distant producers.

Auction Revenue Use

Decisions about how auction revenues are used can have profound consequences for the potential benefits of auctioning. There are three basic options.

First, as I emphasized above, in theory, reducing distortionary taxes provides the greatest net economic benefit (by reducing the social cost of the policy). But California’s unique legal context takes this option off the table.

Second, funding programs to address other market failures that are not addressed by the price signals provided by the cap-and-trade system can be meritorious. For example, information spillovers can be addressed through financing of research and development activities, and the principal-agent problems that infect energy-efficiency adoption decisions in rental properties can be addressed — to some degree — through zoning and other local policies.

The third and final option, however, is highly problematic, if not completely without merit, and yet, ironically, there are strong incentives in place for policy makers to go this third route. This third option is to use auction revenues to fund programs to subsidize emission reductions. There is a strong incentive to do this, because of California’s legal constraint to employ any auction revenues in pursuit of the objectives of the statute, that is, reducing GHG emissions.

What’s the problem? The AB-32 cap-and-trade system will cover approximately 85% of the economy. In other words, the vast majority of sources are under the cap. As I have explained in detail in several previous essays at this blog, under the umbrella of a cap-and-trade mechanism, (successful) efforts to further reduce emissions of capped sources will have three consequences: (1) allowance prices will be supressed (take a look at the hand-wringing in Europe over allowance prices in its CO₂ Emissions Trading System); (2) aggregate compliance costs will be increased (cost-effectiveness is reduced because marginal abatement costs are no longer equated among all sources); and (3) nothing is accomplished for the environment, in the sense that there are no additional CO₂ emissions reductions (rather, the CO₂ emissions reductions are simply relocated among sources under the cap).

Economics, Policy, and Politics

As I concluded in my previous essay, the California Air Resources Board has done an impressive job in its initial design of the rules for its GHG cap-and-trade system. Of course, there are flaws, and therefore there are areas for improvement. A major issue continues to be the mechanisms used for the initial allocation of allowances. Because of the economics and politics of this issue, it will not go away. But, going forward, it would be helpful if those debating this issue could demonstrate better understanding of the allowance allocation’s real – as opposed to fictitious – environmental and economic consequences.