03 July, 2011

Should international trading in emission permits be encouraged?

Introduction

Many evidences show that climate change is real. The National Academy of Sciences reports 'with a high level of confidence that global mean surface temperature was higher during the last few decades of the 20th century than during any comparable period during the preceding four centuries' (2006, p. 3). Although the economic impacts of climate change are hard to predict, there are serious prediction in non-market impacts such as the additional 165,000 to 250,000 children could die (Stern 2007, p. 63).

The serious mitigation actions must be taken at global level as soon as possible. The delay inaction will just cost the world economy i.e. US$5.7 trillion per year (Bosetti et al. 2009, p. 304). Since the GHG concentration is caused directly by human activities (Australian Academy of Science 2010, p. 4), the key thing in mitigation is to change people's behaviour. In domestic level, there are three public policy options which currently practiced and/or considered; they are: carbon tax, cap and trade, and the combination of both (the hybrid). The former sets the carbon price; the second fixed the emission quantity; while the latter start by settling the emission quantity but also allowing additional permits to control the carbon price. Although there are huge debates on comparing the three (see, for example, McKibbin & Wilcoxen 2007, pp. 187-190; Hansen 2009, p. 2; Stiglitz 2007; Garnaut 2008a, p. 311; Pizer 2002), the basic principle of the three approaches is the same; that is to put a price into carbon. Carbon price is important because price has rationing and allocating function of the scarce resources (Frank et al. 2009, p. 233). Theoretically, the price must be set at the level so that the cost of the emission equal to the present value of the social damage it causes (IMF 2008, p. 9). The three carbon pricing approaches are central to carbon market.

The current international emission permit trading practices are operated under carbon market mechanisms. There are three carbon market mechanisms under the 1997 Kyoto protocol; they are: carbon trading, clean development mechanism (CDM), and joint implementation (JI) (Gerrard et al. 2007, p. 1). Both carbon trading and JI involve international permit trading, the difference is that the latter is project based, whereas the former is purely a permit trading. Meanwhile, CDM is only about offset either it is project or program based. Permit trading can be conducted only between actors in countries with cap, whereas countries without caps can provide offsets to countries with caps.

This paper will focus on international trading in emissions permits (IPT). It will first elaborate the pros and cons of IPT and will argue that IPT should be conducted gradually after the improvement of the capacity of the developing countries and the global market regulatory body.

Pros

IPT could reduce the global mitigation costs which reflected by the lower permit price or lower carbon price. That could happen because of the marginal abatement costs differ across countries (McKibbin et al. 2004, p. 25; Nordhaus 2008, p. 13), which developing countries have lower marginal abatement costs (Weyant & Hill 1999, p. xxxv; Howes 2009, p.10). When there is global trading, the abatement cost will be equalized into a global price which will be between the developed countries' marginal abatement cost and the developing countries' marginal abatement cost. That will result in a lower global abatement costs to achieve the same emission reductions. And the reduction will be more when there are more big players cap their emissions and participate in the permit trading (Aldy & Stavins 2007, p. 12).

IPT could increase the possibility to achieve the higher target of stabilization level through more participation. Another effect of the different marginal abatement costs in IPT is the attraction to more countries to join the global efforts on climate change mitigation. IPT could attract net-sellers countries through profit-making motives, whereas net-purchaser countries could be tempted to join because of their domestic political interests (Keohane & Raustiala 2008, p. 6). As more countries participate and more ambitious target they can make due to the lower abatement costs (Garnaut 2008b, p. 6), the more global abatements can be expected. In contrast, incomplete participation could reduce the effectiveness, and increase the cost of mitigation (Howes 2009, p. 13). If we just rely only to Annex B of the Kyoto protocol, the GHG concentration in atmosphere will exceed 550 ppm—or leads to more than 30C warming—by the end of this century (Wigley 1998, p. 2288).

IPT is an instrument that can help the creation of global economic convergence as an impact of the emissions convergence in per capita basis. Although developed countries are unlikely to support, developing countries—especially India—have been in the position to argue that equity requires setting quantitative targets at equal amounts per capita (Frankel 2007, p. 40). Indeed, distributing permits based on equal right to emit is the only principle that has some ethical basis (Stiglitz 2007). The best way to achieve equal emission per capita is through 'convergence and construction' approach (Garnaut 2008a, p. xxiv). There are two main steps as reflected in the name of the approach: set-up the stabilization level as the global target, for example 450 ppmv (contraction); share the emission limit among all countries so that per-capita emissions converge by specific date (convergence). There are two key elements to be negotiated and agreed upon: the target atmospheric concentration of GHG and the date (HÖhne et al. 2006, p. 47). This approach will lead to the transfer of resources to the least developed countries through IPT. Without IPT the costs of mitigation in developed countries will be higher and there will be no resources transfer to the developing countries. The resources transfer, which can be in the form of finance or technology or others, could help developing countries to catch up the developed countries which could result in the economic convergence. Interestingly, the sources of financing for developments support in developing countries can be mainly from private sectors in developed countries rather than from public sectors as that in the development aid.

IPT will self-enforce the low-emission development. Once the IPT is there and the caps are set, every participant countries will have strong incentives to work hard to lowering their emission intensity (of GDP) because it is the only way to optimize benefit from the trading. The more they can maintain or increase their outputs but lowering emission at the same time, the more they can sell their permits to other countries or just hold the excess permits for the future developments. It is even possible for them who highly efficient in GHG emissions to use their excess permits as an asset in international political bargaining since permits will be highly valuable. Carbon price can attract investments in low-carbon developments such as investment in green energy. Since IPT increases carbon price in developing countries, it would attract more investments in developing countries in low-carbon development economic activities. The promotion of low-emission development can be more explicit in the case of 'joint implementation' where permit trading is conducted through carbon offset projects. The EU ETS claims the promotion of low-carbon development as one of its successes (Carbon Finance 2010, p. 7).

Domestic trading scheme in developing countries is hardly to be established without IPT. That is because variation of the marginal abatement costs among actors is less in domestic market compared to the global market. This is particularly difficult in developing countries where we can expect to find more sellers than buyers. For example, 180,000 tonnes of voluntary credits in the first auction in Latin America (Brazil) was end up without a single bid (Reuters 2010).

Cons

IPT might reduce future development possibilities of developing countries and might lead to the emission per capita divergence. If one country sells emission permits to another country, the seller country basically transfer its future development possibilities. When every country adopts a cap and the cap is fixed, the cap reflects the future development possibilities. If the cap is equal to current level of emission of one country, the country would be allowed to produce more economic output only if the emission intensity of output of that country is reduced. Reducing emission intensity, however, is not easy. It does not only require investments in new technology, but also need better public governance. For example, reducing emission intensity in forests activities require better forest management, whereas better forest management needs better public governance (Mayers et al. 2006, p. 101). It also depends on the quality of the global trading governance. If the global trading governance is weak, one poor country might sell its permit just because they need revenue (or because the corrupt leaders need quick cash for their political interests), not because the country has reduced its emission intensity. It is just similar to the case where a poor farmer sold his farm land to a mining company just because he wanted to have a motorcycle. At the end, the emission per capita will diverge, not converge. In this case, although the emission reduction might be well-proven, it does not meet ethical standard.

Without a credible government of countries involved in the trade, the IPT might increase the level of GHG and weaken the credibility of the high integrity domestic market scheme. IPT cannot avoid the involvement of government even though the trade might be between private firms. That is because the legal basis of IPT is international agreement which supposed to be made by governments. National government capabilities are needed at least for two important functions: the monitoring, reporting, and verification (MRV) system and the market regulation. IPT requires reliable MRV which not easy to build internationally. The lesson from the successful acid rain program (ARP) in the U.S. points out that the MRV is central to develop the accuracy and maintaining emission data which lead to the development of public confidence in the program, and has resulted in a high compliance rate (Schakenbach et al. 2006, p. 1576). A weak MRV system could end up raising the level of global emissions if the monitoring in the seller's country is ineffective because the emission of the buyer would rise while the seller's emission would remain unchanged (Nordhaus 2008, p. 160). The market regulator function is important to maintain the trust, not only the trust of the sellers and buyers, but also the tax payers in the participating countries. This is particularly relevant in developed countries where their political concern values the integrity of the mitigation measures (Grubb 2003, p. 166). An international trading system implies that governments in all participating countries would perform the functions with similar competence (Victor 2007, p. 143). However, the quality of governments around the world is vary which many of them, particularly in developing countries, are still associated with high corruption. One trading scheme with high integrity might be poisoned by other trading scheme in different countries with low integrity.

IPT might make developing countries (sellers) worse-off. The IPT might lead to the increase of production cost of output which could result in the increased cost consumptions and create reduced real wages. The effects would continue to the reduced labour supplies and would end up with reduced tax revenues. These effects chain called 'tax interaction effect' (Goulder et al. 1998, cited in Babiker et al. 2002, p. 4). Theoretically, the effects can be overcome by cutting other distorting taxes, such as social security taxes and corporate income taxes (Parry 1997, p.1). That could happen if the incomes gained from emission trading exceed the efficiency costs from the tax interaction effect (Babiker et al. 2002, p. 5). That means the benefits of IPT for developing countries depend a lot on the level of the carbon price in the global market.

IPT might harm marginal communities. For example, the high value of carbon could adversely affect indigenous people and local communities when government move them to other place in order to reduce emission from deforestation and forest degradation (Macintosh 2010, p. 2).

IPT might bring 'resource curse' through corruption practices and low productivity. IPT must involve cap which imply the permit limitation and the high value of the permits. That creates scarcity of permits and would invite corruption practices (Cooper 2007: 106). Cap and trade is a rent-creating program which, in the case of weak governments, could easily lead to corrupt practices and low productivity (Nordhaus 2008, p. 159).

Price volatility cannot be avoided totally because of the nature of the permit trading and also because of its link with the stability of global economy and politics. Price volatile caused by the complete inelasticity of the supply of permits along with the highly inelastic demand for permits in the short run (Nordhaus 2008, p. 153). The stability of politic and economic influences the stability of supply and demand which affect the carbon price (Carbon Finance 2010, p. 7). In addition, since EU ETS began in 2005, it is observed that the stability of carbon price correlates with the stability of energy price since there is high correlation between the two (Harvey 2009).

The price volatile phenomenon reflects the inability of any national government, particularly government from small countries, to control global carbon price. This is very important because, as discussed earlier, price is matter. Without sufficient price, developing countries can be worse-off and therefore reduce their incentive to participate.

The success of IPT depends on the quality of the caps, whereas set-up the right caps is difficult. Since IPT requires binding caps, the plan of make a trading might increase the value of the permit during the negotiation time which will make the permit distribution among countries become difficult and sensitive. Giving more permits than required to one country (i.e. hot air) will attract participation of the country but at the same time will harm the participation of all other countries (Barret & Stavins 2003, p. 360). This can lead to a failed negotiation. The errors in allocating caps—e.g. because of the mistake of baseline making such as the 'hot air' phenomenon—could discourage the abatement and even increase the cost of the abatement (CCAP 2007, p. 5; Gilbertson & Reyes 2009, p. 9). The errors in allocating caps could also discourage wide participation especially when it leads to the reduction of commitment of big player countries which might caused by the perception of unfairly treated. The exit of one country could magnify the pressures for others to exit (Victor 2007, p. 142).

My proposal

Considering the pros and the cons, I propose to implement the IPT gradually. That is because the success of IPT requires credible nation state institutions and credible international climate institution. The former is crucial for developing countries, whereas the latter is the main challenge in global level. Institutional development in national and global level is a must to reduce the potential of negative impacts, as well as to optimize the potential benefit, from the IPT.

Although the IPT should not be set-up until we have credible institutions, the emission caps must be agreed soon. We can use the pledges that have been agreed in Copenhagen. As being agreed in previous negotiations, arrangement of the IPT must be based on the 'common but differentiated responsibilities and respected capabilities' principle. It implies that, unlike for developed countries, the caps of developing countries are not immediately binding.

I would copy the way the successful Montreal Protocol did on dealing with emission limit. That is that all countries must have emission limits which immediately binding the developed countries but allowing grace period to developing countries (Barrett & Stavins 2003, p. 361). We can just adopt the pledges made in Copenhagen which—after compared across different metrics—imply significant efforts and considered to be more equal among developed and developing countries; for example the emission per capita differences are smaller (Jotzo 2010, p. 21). In addition, the Copenhagen pledges (if we can get it) brings a solid foundation to bring the emission down to the 450 trajectories which make the 20C target possible to achieve. It is important to note that Copenhagen pledges made in bottom-up nature which allow us to expect a stronger commitment because the promises were made without pressure and were according to individual country's interest. The equal per capita emission must be part of the targets by using the 'convergence and contraction' approach. The converged date must be set by considering the sufficient adjustment time and accepted by developed and developing countries, say, 2050, as suggested by Garnaut (2008a, p. 207).

The gradual implementation of IPT involves three stages: (a) capacity development; (b) IPT implementation that combined with the project based, caps bind developed countries only, but monitored, reported, and verified in developing countries as well (almost similar to the Kyoto), and (c) full IPT implementation which all caps are binding.

The capacity development activities must focus on two targets: (a) developing countries, (b) global regulatory body. The objective of capacity development of developing countries should cover the following issues: low-carbon development; good governance, MRV system, domestic market regulation; market policy making capability e.g. to avoid the tax interaction effect. The global regulatory body capacity development must address the following issues: prioritizing domestic abatement as opposed to trading and offset; market regulation e.g. to avoid human right violation; monitoring and leadership communication to ensure the achievement mitigation target and per-capita basis target; monitor to minimize the price volatility. The costs of capacity building must be paid by developed countries as part, or addition to, development aid. In order to be successful, some lessons from development aid effectiveness can be considered; for example, the three aid effectiveness determinants: the quality of the government of recipient country, the quality of the aid donor, and the way in which aid business is organized (Howes 2011).

The low-carbon development must in line with the nationally appropriate mitigation actions (NAMA). NAMA will likely balance the mitigation and development objective of developing countries. The priority of developing countries is more to bring prosperity to the most of their people, not so much about environmental concern. Therefore government of developing countries are unlikely to cap the economy soon. However, prosperity can be developed under sustainable development approach which includes some elements that support climate mitigation. For example, the policy of government of India called 'perform achieved and trade (PAT)' with the main intention is energy saving, but is contributing to climate change mitigation by reducing or avoiding GHG emissions (Uphadyaya 2010, p. 564). The focus of developing countries in their NAMAs should be on low carbon development strategy which means that they alleviate poverty through low carbon intensity activities.

In the second and third stage, buying permit from other countries is allowed only if the domestic price is too high and could harm domestic economy seriously. In the second stage in particular, selling permit from developing countries must be meet some criteria; for example, the permits to be sold are only that as result from the increased emission efficiency.

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