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Three Pillars of a New Climate Pact

THE climate change summit at the United Nations on Tuesday, September 22nd, is aimed to build momentum for the 15th Conference of the Parties to the UN Framework Convention on Climate Change in Copenhagen in December, where nations will continue negotiations on a successor to the 1997 Kyoto Protocol, which expires in 2012. Later this week, the G20 finance ministers will meet in Pittsburgh, Pennsylvania, where international climate policy will be high on the agenda.

In the midst of this, Professor Sheila Olmstead of Yale University and I wrote an opinion piece which appeared as an op-ed in The Boston Globe on Sunday, September 20th. (See the original here, with the artwork; and/or for a detailed description of our proposal, see our discussion paper for the Harvard Project on International Climate Agreements.)

In the op-ed, we argued that to be successful, any feasible successor agreement must contain three essential elements: meaningful involvement by a broad set of key industrialized and developing nations; an emphasis on an extended time path of emissions targets; and inclusion of policy approaches that work through the market, rather than against it.

Consider the need for broad participation. Industrialized countries have emitted most of the stock of man-made carbon dioxide in our atmosphere, so shouldn’t they reduce emissions before developing countries are asked to contribute? While this seems to make sense, here are four reasons why the new climate agreement must engage all major emitting countries – both industrialized and developing.

First, emissions from developing countries are significant and growing rapidly. China surpassed the United States as the world’s largest CO2 emitter in 2006, and developing countries may account for more than half of global emissions within the next decade. Second, developing countries provide the best opportunities for low-cost emissions reduction; their participation could dramatically reduce total costs. Third, the United States and several other industrialized countries may not commit to significant emissions reductions without developing country participation. Fourth, if developing countries are excluded, up to one-third of carbon emissions reductions by participating countries may migrate to non-participating economies through international trade, reducing environmental gains and pushing developing nations onto more carbon-intensive growth paths (so-called “carbon leakage’’).

How can developing countries participate in an international effort to reduce emissions without incurring costs that derail their economic development? Their emissions targets could start at business-as-usual levels, becoming more stringent over time as countries become wealthier. If such “growth targets’’ were combined with an international emission trading program, developing countries could fully participate without incurring prohibitive costs (or even any costs in the short term). (For a very insightful analysis of such growth targets, please see Harvard Professor Jeffrey Frankel‘s discussion paper for the Harvard Project on International Climate Agreements.)

The second pillar of a successful post-2012 climate policy is an emphasis on the long run. Greenhouse gases remain in the atmosphere for decades to centuries, and major technological change is needed to bring down the costs of reducing CO2 emissions. The economically efficient solution will involve firm but moderate short-term targets to avoid rendering large parts of the capital stock prematurely obsolete, and flexible but more stringent long-term targets.

Third, a post-2012 global climate policy must work through the market rather than against it. To keep costs down in the short term and bring them down even lower in the long term through technological change, market-based policy instruments must be embraced as the chief means of reducing emissions. One market-based approach, known as cap-and-trade, is emerging as the preferred approach for reducing carbon emissions among industrialized countries.

Under cap-and-trade, sources with low control costs may take on added reductions, allowing them to sell excess permits to sources with high control costs. The European Union’s Emission Trading Scheme, established under the Kyoto Protocol, is the world’s largest cap-and-trade system. In June, the US federal government took a significant step toward establishing a national cap-and-trade policy to reduce CO2 emissions, with the passage in the House of Representatives of the American Clean Energy and Security Act (about which I have written in many previous posts at this blog). Other industrialized countries are instituting or planning national CO2 cap-and-trade systems, including Australia, Canada, Japan, and New Zealand.

Linking such cap-and-trade systems under a new international climate treaty would bring cost savings from increasing the market’s scope, greater liquidity, reduced price volatility, lessened market power, and reduced carbon leakage. Cap-and-trade systems can be linked directly, which requires harmonization, or indirectly by linking with a common emissions-reduction credit system; indeed, this is what appears to be emerging even before a new agreement is forged. Kyoto’s Clean Development Mechanism allows parties in wealthy countries to purchase emissions-reduction credits in developing countries by investing in emissions-reduction projects. These credits can be used to meet emissions commitments within the EU-ETS, and other systems are likely to accept them as well.

Countries meeting in New York and Pittsburgh this week, and in Copenhagen in December, should consider these three essential elements as they negotiate a new climate agreement. A new international climate agreement missing any of these three pillars may be too costly, and provide too little benefit, to represent a meaningful attempt to address the threat of global climate change.

Too Good to be True?

Global climate change is a serious environmental threat, and sound public policies are needed to address it effectively and sensibly.

There is now significant interest and activity within both the U.S. Administration and the U.S. Congress to develop a meaningful national climate policy in this country. (If you’re interested, please see some of my previous posts: “Opportunity for a Defining Moment” (February 6, 2009); “The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey” (May 27, 2009); “Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal” (June 18, 2009); “National Climate Change Policy: A Quick Look Back at Waxman-Markey and the Road Ahead” (June 29, 2009). For a more detailed account, see my Hamilton Project paper, A U.S. Cap-and-Trade System to Address Global Climate Change.)

And as we move toward the international negotiations to take place in December of this year in Copenhagen, it is important to keep in mind the global commons nature of the problem, and hence the necessity of designing and implementing an international policy architecture that is scientifically sound, economically rational, and politically pragmatic.

Back in the U.S., with domestic action delayed in the Senate, several states and regions in the United States have moved ahead with their own policies and plans. Key among these is California’s Global Warming Solutions Act of 2006, intended to return the state’s greenhouse gas (GHG) emissions in 2020 to their 1990 level. In 2006, three studies were released indicating that California can meet its 2020 target at no net economic cost. That is not a typographical error. The studies found not simply that the costs will be low, but that the costs will be zero, or even negative! That is, the studies found that California’s ambitious target can be achieved through measures whose direct costs would be outweighed by offsetting savings they create, making them economically beneficial even without considering the emission reductions they may achieve. Not just a free lunch, but a lunch we are paid to eat!

Given the substantial emission reductions that will be required to meet California’s 2020 target, these findings are - to put it mildly – surprising, and they differ dramatically from the vast majority of economic analyses of the cost of reducing GHG emissions. As a result, I was asked by the Electric Power Research Institute – along with my colleagues, Judson Jaffe and Todd Schatzki of Analysis Group – to evaluate the three California studies.

In a report titled, “Too Good To Be True? An Examination of Three Economic Assessments of California Climate Change Policy,” we found that although some limited opportunities may exist for no-cost emission reductions, the studies substantially underestimated the cost of meeting California’s 2020 target — by omitting important components of the costs of emission reduction efforts, and by overestimating offsetting savings some of those efforts yield through improved energy efficiency. In some cases, the studies focused on the costs of particular actions to reduce emissions, but failed to consider the effectiveness and costs of policies that would be necessary to bring about those actions. Just a few of the flaws we identified lead to underestimation of annual costs on the order of billions of dollars. Sadly, the studies therefore did not and do not offer reliable estimates of the cost of meeting California’s 2020 target.

This episode is a reminder of a period when similar studies were performed by the U.S. Department of Energy at the time of the Kyoto Protocol negotiations. Like the California studies, the DOE (Interlaboratory Work Group) studies in the late 1990s suggested that substantial emission reductions could be achieved at no cost. Those studies were terribly flawed, which was what led to their faulty conclusions. I had thought that such arguments about massive “free lunches” in the energy efficiency and climate domain had long since been laid to rest. The debates in California (and some of the rhetoric in Washington) prove otherwise.

While the Global Warming Solutions Act of 2006 sets an emissions target, critical policy design decisions remain to be made that will fundamentally affect the cost of the policy. For example, policymakers must determine the emission sources that will be regulated to meet those targets, and the policy instruments that will be employed. The California studies do not directly address the cost implications of these and other policy design decisions, and their overly optimistic findings may leave policymakers with an inadequate appreciation of the stakes associated with the decisions that lie ahead.

On the positive side, a careful evaluation of the California studies highlights some important policy design lessons that apply regardless of the extent to which no-cost emission reduction opportunities really exist. Policies should be designed to account for uncertainty regarding emission reduction costs, much of which will not be resolved before policies must be enacted. Also, consideration of the market failures that lead to excessive GHG emissions makes clear that to reduce emissions cost-effectively, policymakers should employ a market-based policy (such as cap-and-trade) as the core policy instrument.

The fact that the three California studies so egregiously underestimated the costs of achieving the goals of the Global Warming Solutions Act should not be taken as indicating that the Act itself is necessarily without merit. As I have discussed in previous posts, that judgment must rest – from an economic perspective – on an honest and rigorous comparison of the Act’s real benefits and real costs.

Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal

The potential impacts of proposed U.S. climate policies on the competitiveness of U.S. industries is a major political issue, and it was one of the key issues in the Energy and Commerce Committee of the House of Representatives in the design of Henry Waxman and Edward Markey’s H.R. 2454 (the American Clean Energy and Security Act of 2009). In the floor debate that will soon take place as the full House considers the bill, it will be an important issue. It promises to be an equally important topic when the Senate takes up its own climate legislation, although the debate in that body on this issue will likely be quite different.

The ultimate answer to the question of how best to address concerns about international competitiveness is to bring all countries – both the industrialized nations and the developing world’s large, rapidly-growing economies (China, India, Brazil, Korea, Mexico, South Africa, and Indonesia) – into a meaningful (post-Kyoto) international climate change agreement (a topic on which I’ve spent much time over the past several years). But – for the most part — that long-term objective is outside of the reach of the domestic policy of any single nation, even the United States.

Can Domestic Climate Policy Address Competitiveness Concerns?

A range of approaches has been considered for implementing sound, domestic climate policy while seeking to “level the economic playing field” with other countries. While no approach is without its flaws (as I describe below), the approach taken in the Waxman-Markey legislation is sensible and pragmatic: in the short term, output-based updating allocations of allowances are employed for a few energy-intensive, trade-sensitive sectors; and in the long term, the President is given the option to put in place (under specific, stringent conditions) import-allowance-requirements in selected cases.

In order to explain my reasoning for coming to this conclusion, let’s back up for a moment and reflect on the reasons for the high level of political attention and receptiveness in the United States toward employing a cap-and-trade system nationally to address emissions of greenhouse gases.

It is because of the significant economic and political advantages of cap-and-trade systems to address carbon dioxide and other greenhouse gas emissions that most (but not all) attention by policy makers has been focused on this policy approach. First, it provides a cost-effective means of achieving meaningful reductions in emissions over relevant time horizons. Second, it offers an easy means of compensating for the inevitably unequal burdens imposed by virtually any climate policy. Third, it is less likely than alternative approaches (such as a carbon tax) to be degraded – in terms of environmental performance and cost-effectiveness – by political forces. Fourth, it has a history of successful adoption and implementation over two decades. And fifth, it provides a straightforward means to link and harmonize with other countries’ climate policies.

The Waxman-Markey bill, H.R. 2454, would establish such a U.S. cap-and-trade system to reduce emissions that contribute to global climate change. The bill would put a declining cap on emissions and create a corresponding number of emission permits. Regulated firms could trade these permits at a price determined by the market – creating powerful incentives to reduce emissions cost-effectively.

But imposing a price (cost) on carbon in the United States at a time when some other countries (in the developing world) are not taking comparable actions raises concerns about negative impacts on the competitiveness of U.S. industry, particularly in energy-intensive, trade-sensitive sectors. This heightens worries about possible job losses, a particularly troubling concern when the United States find itself in the worst global recession in a generation.

The environmental side of the same coin is “carbon leakage.” Again, imposing a cost on the production of carbon-intensive goods and services shifts comparative advantage in the production of those same goods and services in the direction of countries not taking on such costs. Also, reduced demand in the United States for carbon-intensive fuels such as coal can be expected to reduce worldwide demand enough that the world price of coal would fall, thereby making it more attractive for use in countries that are not participating in a meaningful international climate agreement (or otherwise taking significant domestic climate actions).

Both routes can result in a shift of carbon-intensive production to countries without climate controls, and therefore an increase in their CO2 emissions. This is carbon leakage, which reduces the environmental benefits of mitigating emissions and reduces cost-effectiveness of any actions (properly measured in terms of net changes in CO2 atmospheric concentrations). Given that the United States, the European Union, and Japan are net importers of embodied CO2, while China and India are net exporters, the environmental – as well as the economic – impacts of carbon leakage are a natural concern of lawmakers.

Despite the high levels of attention that international competitiveness therefore receives in debates about domestic climate policies, economic research has consistently found that the actual competitiveness impacts of proposed domestic climate policies would not — in quantitative terms — constitute a major economy-wide economic issue for the United States, partly because differences in other costs of production (including labor and energy costs, without accounting for carbon constraints) across countries swamp differences in costs due to environmental policies, including prospective climate policies.

On the other hand, this is a real issue for some specific sectors, in particular, energy-intensive industries subject to international competition, such as aluminum, cement, fossil fuels, glass, iron and steel, and paper. More importantly, it is in any event a major (economy-wide) political issue. So, it needs to be addressed in any domestic climate policy which is to be both meaningful and politically pragmatic.

How About Free Allowance Allocations?

The approach frequently proposed by policy makers and the approach utilized in the European Union for its Emission Trading Scheme, and discussed in a number of other countries for their planned cap-and-trade programs is generous and free allocation of allowances to specific sectors and companies. This makes the receiving companies happy, but has no effect on their international competitiveness. This is because such a free grant of allowances is no different than cash, that is, a fixed subsidy. The allowances can be sold by the receiving companies, are as good as cash, and represent a lump-sum transfer from the government, not tied to carbon abatement efforts or production (and hence, in the language of economics, are infra-marginal subsidies rather than marginal incentives).

Since the subsidy has no effect on the company’s marginal cost of production (its supply function), it has no effect on international competitiveness. The company will continue to find it as challenging as it did without the subsidy to produce cement, steel, or whatever at a price that can compete with companies located in countries without climate policies (apart from liquidity effects, which are minor in most cases). And the domestic company will have the same incentives as previously to locate its next production facility in a country without a climate policy.

A Potentially Effective Approach: Output-Based Updating Allocations

With proper design, allowance allocations can be used effectively to address leakage and competitiveness. If the free allocation of allowances is tied to the company’s production level, then it does affect marginal production costs, and therefore does affect competitiveness. Such a “home rebate” can thereby reduce leakage. This is, in fact, the approach taken in the Waxman-Markey legislation, and it is a potentially effective means to address concerns about international competitiveness for a select set of energy-intensive trade-sensitive sectors.

There are, however, some legitimate concerns about this approach of linking annual allowance allocations with production levels, as I wrote in my previous post, “The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey.” Such output-based updating allocations can provide perverse incentives and thereby drive up the costs of achieving a cap. This is because an output-based updating allocation is essentially a production subsidy. This distorts firms’ pricing and production decisions in ways that can increase the cost of meeting an emissions target.

Think of it this way. On the one hand, the cap-and-trade system is (sensibly) increasing the cost of using carbon-intensive fuels and emitting CO2 into the atmosphere. An aluminum producer, for example, is therefore paying more for the (fossil-fuel generated) electricity it uses, driving up its cost of production. At the same time, the government hands a subsidy to the company for each unit of aluminum it produces, working at cross-purposes with the energy-pricing incentive, and thereby driving up the aggregate social costs of achieving the cap. In addition, these home rebates do not distinguish between competition from countries with and without domestic climate policies.

The Key Question

So, there are problems with output-based updating allocations, but the key question in the real world of legislative design is whether better approaches are available? The answer – in my view – is that there are several other available approaches, but they are not any better; and indeed, they appear to be significantly worse.

An Alternative Approach: Import Allowance Requirements

One alternative approach is an import allowance requirement, whereby imports of highly carbon-intensive goods (in terms of their manufacture) must hold allowances for the U.S. cap-and-trade system, mirroring requirements on U.S. sources, if those imports come from countries which have not taken comparable climate policy actions. Note that this approach – which is referred to as a border adjustment, and is an implicit border tax – differentiates according to the country of origin. In principle, this approach can maintain a level playing-field between imports and domestic production, reduce leakage, and possibly help induce key developing countries to take domestic action to avoid the implicit border tax on their products.

The import allowance requirement approach has its own problems, however. First, it focuses exclusively on imports into the United States, and has no effect on the competitiveness of U.S. exports. Second, it may not be compliant with World Trade Organization (WTO) rules, because it would discriminate among trading nations (I’ll leave that issue for trade economists and trade lawyers to analyze and debate).

Third, it is questionable whether it would be effective as an inducement for developing countries to join an international agreement to reduce emissions. Why is that? Think about China, for example. China is the largest producer of cement in the world, accounting for almost 50% of world output. It is also the world’s largest exporter of cement. This may sound as though the threat of import allowance requirements in the U.S. and European cap-and-trade systems would be a powerful incentive for China to undertake emission reductions at home in order to avoid the border tax on its cement exports. But China consumes 97% of its cement domestically, exporting only 3%, and much of that to developing countries. So, would a country such as China be willing to increase the costs of producing 97% of its output in order to protect a market for 1% or 2% of its production?(To be fair, for small developing countries for which their exports of a given product are a large share of their total output, the message could potentially be quite different.)

Despite these three problems with the import-allowance-requirement approach, note that it was a key part of the Lieberman-Warner Climate Security Act in the U.S. Senate in 2008, and may re-appear when serious debate commences in the Senate on climate legislation later this year. Also, it should be noted that this approach of import-allowance-requirements is included as a long-term backstop in Waxman-Markey if the President determines by 2022 that the output-based allocation mechanism is insufficient for some of the energy-intensive trade-sensitive sectors (and if a number of stringent conditions are met; see the “International Reserve Allowance Program” in the bill).

Other Possible Approaches

Another potential approach is a border rebate for exports to level the playing field abroad, whereby the government rebates the value of emissions embodied in exports. Imports, however, would retain their competitive advantage at home, and there are problems with WTO compliance. Finally, there is full boarder adjustment, meaning a border (import) tax plus a border (export) subsidy. Here there are questions not only about consistency with international trade law, but also concerns about feasibility. In some cases, there are tremendous challenges of calculating the embodied emissions of foreign products, and more generally, there are difficulties of defining and enforcing reliable rules of origin.

The Good, the Bad, and the Ugly

Thus, none of these approaches are ideal, not home rebates as in Waxman-Markey, nor implicit border taxes on exports as in Lieberman-Warner, nor border rebates, nor full border adjustments. As I said at the outset, the only real solution to the international competitiveness issue in the long term is to bring non-participating countries within an international climate regime in meaningful ways. (On this, please see the work of the Harvard Project on International Climate Agreements.) But that solution is fundamentally outside of the scope of the domestic policy action of any individual nation, including the United States.

So, among the feasible set of options to address international competitiveness concerns – if only imperfectly and at some cost – which is best? The two live political options appear to be the output-based updating allocation mechanism in the Waxman-Markey legislation and the import allowance requirement, typically associated with the former Lieberman-Warner bill. At this time, meaning in the short term, I would be more worried about the potential damage to the international trade regime that import allowance requirements could foster than about the incremental social costs that an output-based updating allocation mechanism will create.

This is a political problem without a perfect solution (other than bringing all key countries into a meaningful international climate agreement). For now, the domestic political process has done a credible job of patching together a set of interim solutions. Among the range of possible approaches of trying to level the international economic playing field, none is without its flaws, but the approach taken in the Waxman-Markey legislation appears best. Subject to possible improvements on the House floor or in the Senate, the Waxman-Markey approach of combining output-based updating allocations in the short term for select sectors with the option in the long term of a Presidential determination (under stringent conditions) for import allowance requirements for specific countries and sectors seems both sensible and pragmatic.

A Broader Question: Should the U.S. Enact a Domestic Climate Policy without a New, Sound International Climate Agreement in Place?

Stepping back from the specific policy design question, the broader argument has been made (indeed until a few years ago I was among those making it) that there should be no serious movement on a U.S. domestic climate policy until a meaningful and sensible (post-Kyoto) international agreement has been negotiated and ratified. It is natural for questions to be raised about the very notion of the U.S. adopting a policy to help address a global problem. The environmental benefits of any single nation’s reductions in greenhouse gas emissions are spread worldwide, unlike the costs. This creates the possibility that some countries will want to “free ride” on the efforts of others. It’s for this very reason that international cooperation is required.

That is the why the U.S. is now vigorously engaged in international negotiations, and the credibility of the U.S. as a participant, let alone as a leader, in shaping the international regime is dependent upon our demonstrated willingness to take actions at home. Europe has already put its climate policy in place, and Australia, New Zealand, and Japan are moving to have their policies in place within a year. If the United States is to play a leadership role in international negotiations for a sensible post-Kyoto international climate regime, the country must begin to move towards an effective domestic policy – with legislation that is timed and structured to coordinate with the emerging post-Kyoto climate regime.

Without evidence of serious action by the U.S., there will be no meaningful international agreement, and certainly not one that includes the key, rapidly-growing developing countries. U.S. policy developments can and should move in parallel with international negotiations.

The Bottom Line

So, like any legislation, the Waxman-Markey bill has its share of flaws. But it represents a solid foundation for a domestic climate policy that can help place the United States where it ought to be – in a position of international leadership to develop a global climate agreement that is scientifically sound, economically rational, and politically acceptable to the key nations of the world.