International concern about climate change has led to a series of negotiations aimed
at producing a binding treaty to control worldwide emissions of carbon
dioxide. The next major round of talks, intended to produce a final agreement,
will be held in December in Kyoto. Negotiations have focused on measures
to roll back emissions to 1990 levels and hold them there. A preliminary
proposal advanced by the United States would achieve this by creating a
system of internationally tradable emissions permits. The total number
of permits would be limited to the amount of emissions in 1990, and they
would be distributed among countries by treaty, possibly according to each
country’s population or its actual 1990 emissions. It would be up to individual
governments to decide how to distribute their country’s allocation. Once
distributed, the permits could be bought and sold without restriction on
an international market. The system would initially apply to developed
countries and would later be extended to developing countries.
The U.S. proposal has generally received favorable reviews from economists
and was featured in a widely circulated petition regarding climate change
written by five leading economists and signed by thousands of others. (The
authors were Kenneth Arrow, Dale Jorgenson, Robert Solow, Paul Krugman,
and William Nordhaus.) However, much of the enthusiasm for international
permit trading has been based on purely theoretical arguments. Few economists
or policymakers seem to be aware that it would create such serious practical
problems that a treaty based on international trading would never be ratified
and implemented.
If the remaining rounds of negotiations are to produce a useful agreement,
it is essential that the focus be shifted to a more pragmatic policy. We
propose a system of national permits and emissions fees that would be a
significant step toward controlling climate change and would be practical
and politically viable.
WHY DO PERMITS LOOK GOOD IN THEORY?
The basic idea behind a tradable permit system is simple: any firm emitting
carbon dioxide would be required to own permits equal to the amount of
carbon it produces. For example, a firm emitting one hundred tons of carbon
would have to own one hundred permits. The permits would be allocated among
countries by treaty, and it would be up to each government to decide how
to distribute its permits domestically (we will return to this point below).
Once distributed, the permits could be bought and sold without restriction
on a world market. It would be illegal to burn fossil fuels without having
purchased a permit, and it would be up to each government to enforce the
treaty within its own borders.
Permit systems have three key features as a method of pollution control.
First, they provide a firm upper bound on emissions. In this case, the
limit would be the amount of emissions in 1990. This feature of permits
makes them attractive to those who believe that decisive action needs to
be taken on climate change.
Second, because the permits can be traded, pollution abatement will
be done at the minimum possible cost to the economy. Firms that can clean
up cheaply will end up doing the abatement: they will be able to make a
profit by cutting their emissions and selling their extra permits. Firms
that find it very expensive to reduce emissions will buy permits instead.
To make this concrete, consider the following example. Imagine two companies,
L and H, are each emitting fifty tons of carbon annually for a total of
one hundred tons. Suppose the government wants to reduce total emissions
to eighty tons. One approach would be to require each firm to reduce its
emissions by ten tons. That would achieve the eighty-ton target, and at
first glance it seems like a reasonable policy: both firms contribute equally
to the problem so both contribute equally to the solution.
At a closer look, however, it is clear that the policy could end up
wasting a lot of money. It fails to take into account that it might be
much more difficult for one firm to reduce emissions than for the other.
Suppose firm L has low abatement costs and can reduce its emissions at
a cost of $100 a ton while firm H has higher costs of $200 a ton. If each
firm eliminates ten tons of carbon, the total cost will be $3,000. However,
it is possible to get the same amount of abatement at far less cost: if
firm L cleans up all twenty tons, the cost would only be $2,000. The equal
reduction policy, in other words, costs 50 percent more than necessary
and would waste $1,000.
To avoid this problem, one might imagine a different policy in which
firm H was not required to do anything and firm L was required to reduce
its emissions by twenty tons. This would get the cleanup at minimum cost,
but it would clearly not be regarded as fair by firm L. Firm L would have
to pay $2,000—the total cost of the cleanup—while firm H paid nothing even
though both firms are responsible for the problem.
An ideal policy would have firm L do all the abatement but have firm
H pay some of the cost. The third key feature of tradable permit systems
is that they allow the costs of cleanup to be shared among firms even when
the firms do very different amounts of abatement. The reason is that the
government can exercise a great deal of control over the equity of the
policy by the way it distributes the permits. In fact, a permit system
allows the government to spread the cost of the policy across firms any
way it wants. To see how this works, suppose the government decides to
solve the example problem by setting up a tradable permit system with a
total of eighty permits. One way it could distribute the permits would
be to give forty to each firm. If no trading occurred, each firm would
have to eliminate ten tons of pollution and the costs would be the same
as under direct regulation: $2,000 for firm H and $1,000 for firm L. However,
both firms would have an incentive to trade in the permit market. Firm
H would be willing to buy up to ten permits at any price up to $200 (the
abatement cost avoided for each permit), while firm L would be willing
to sell permits for any price above $100 (the extra abatement cost incurred
in order to be able to sell a permit). If the market price turned out to
be $150, the total cost would drop to $1,500 for firm H (ten permits at
$150 each) and $500 for firm L ($2,000 of abatement costs less $1,500 from
selling permits to firm H).
This solution minimizes abatement costs but would probably not be regarded
as fair by firm H. However, the government could easily even out the burden
by giving H a larger share of the permits. Suppose it gave forty-three
permits to H and thirty-seven to L (rather than forty each). Firm H would
end up buying seven permits from firm L. At a price of $150, the total
cost to H would be $1,050 (7 x $150) and the total cost to L would be $950
($2,000 - $1,050). The abatement would end up being done entirely by firm
L, and at minimum cost, but the overall burden would be shared between
the firms. In general, permit systems give the government great flexibility
in distributing the burden of abatement. The flexibility could be used
to grandfather existing firms or to shift the burden of the policy in other
ways that might make it more politically viable.
WHAT WOULD GO WRONG IN PRACTICE?
Permit systems have worked well when used to control domestic problems.
The best-known example is the sulfur emissions trading scheme introduced
by the 1990 amendments to the Clean Air Act. It has been a tremendous success:
electric utilities, the principal industry affected by the program, have
been able to reduce the cost of controlling sulfur emissions to one-tenth
of the minimum cost projected when the act was adopted. For controlling
carbon dioxide emissions in an international context, however, several
practical problems arise that ensure that a treaty based on the U.S. proposal
would never be ratified and implemented.
The first problem is that the U.S. proposal would force emissions back
to 1990 levels and hold them there without regard to the costs and benefits
of doing so. However, studies to date suggest that the costs exceed the
benefits, perhaps substantially. Estimates of the cost of holding emissions
constant range from -0.5 percent (an increase in GDP) to 2 percent of GDP
annually; most fall in the range of 1 to 2 percent. Considerably less is
known about the benefit of stabilizing emissions. In principle, the benefit
of stabilization is simply the sum of the avoided costs of damages that
higher temperatures would cause. In practice, these damages are fiendishly
difficult to estimate. The link between carbon dioxide emissions and global
temperature is slow and indirect and is not very well understood by climatologists.
At the same time, little is known about the damages higher temperatures
would cause.
Together these problems have proven so daunting that only a handful
of studies have been attempted and most have focused on a single scenario:
estimating the damages caused by an increase of 2.5 to 3 degrees Celsius
in global temperatures. The results vary, but at the upper end of the range
the cost of the damages could be as much as 1.3 percent of annual GDP for
the United States by the middle of the next century. The benefit of stabilizing
global temperatures would be that these damages would be avoided. The benefit
of stabilizing global emissions is considerably less. Even at 1990 emissions
rates, global concentrations of carbon dioxide, and hence global temperatures,
will continue to rise for many years (although at a slower rate than if
there were no restrictions on emissions). In fact, stabilizing temperatures
would require cutting emissions to about half of 1990 levels. This means
that the estimate of 1.3 percent of GDP is not the benefit of stabilizing
emissions, but rather (implicitly) the benefit of cutting them to 50 percent
below the 1990 level. Holding emissions at 1990 levels would only reduce
the rate of warming rather than prevent it entirely, and the damages avoided
would be less than 1.3 percent of GDP.
In a nutshell, current evidence does not give clear support to a policy
of holding emissions constant. The costs and benefits of stabilizing emissions
are not known with much precision, but most studies of costs arrive at
estimates that are higher than the highest estimates of benefits. Moreover,
these costs would have to begin to be paid now in order to avert damages
far in the future. Given these considerations, it is difficult to imagine
that the U.S. Congress would ratify a treaty based on stabilizing emissions.
There is, however, enough evidence to make a clear case for taking steps
to slow the growth of emissions. A better policy would focus on this more
modest, but also more politically viable, goal.
A second problem with the U.S. proposal is that it would generate large
transfers of wealth between countries. Supporters of a permit system regard
this as an advantage because it would allow developed countries to compensate
developing countries for reducing their emissions. However, the size of
the transfers makes it unlikely the treaty would be ratified. Consider
the following rough calculation. In 1990 the United States emitted about
1,340 million tons of carbon in the form of carbon dioxide. Carbon emissions
are expected to grow over time, so suppose that by 2010 the United States
ended up needing to import permits equal to about 20 percent of 1990 emissions,
or about 268 million tons. There is enormous uncertainty about what the
price of an international carbon permit might be, but $100 a ton is well
within the range of estimates and some studies have projected prices of
$200 or more. In this scenario, the permit system would add $27 billion
to $54 billion to the U.S. trade deficit every year.
To put this in context, the entire U.S. trade deficit in 1996 was $114
billion, so adding permits could increase it by 25 to 50 percent. Where
will the money go? If advocates of the policy are correct that emissions
reductions will be cheapest in developing countries, developing countries
could be large sellers of permits on the international market. The value
of permits would dwarf the often-controversial U.S. foreign aid budget,
which is now about $17 billion. Transfers of wealth of this magnitude guarantee
the treaty would never be implemented regardless of its economic merits.
A third problem with the plan is that it would put enormous stress on
the world trade system. The balance of trade for a developed country importing
permits would deteriorate substantially. This would lead to substantial
volatility in exchange rates and distortions in the world trade system.
Equally serious problems would be created for developing countries. Massive
exports of permits would lead to exchange rate appreciation and a decline
or collapse in exports other than permits. Also, the permit revenue comes
with strings attached: much of it would have to be invested in improved
energy technology in order to reduce emissions and free up the permits
in the first place. This is unlikely to be an ideal strategy for long-term
economic development and would make the policy unattractive to developing
countries.
In fact, developing countries have been so unenthusiastic about the
policy that the U.S. proposal actually stops short of setting up a worldwide
system of permits. Instead it would set up a system of trading among developed
countries and the former Soviet Union (“Annex I Countries” in the language
of the negotiations). However, this is a compromise that essentially eliminates
the main reason for having internationally tradable permits in the first
place: the potential gain from trade in emissions rights between industrialized
and developing countries. Permit trading would do little to lower abatement
costs when the participating countries have fairly similar technology.
Moreover, the U.S. proposal would probably not even achieve the goal
of stabilizing emissions. Britain, Germany, and especially Russia are all
already below their 1990 emission levels and would be able to sell their
unused permits abroad. In that case the permit system would really amount
to nothing more than an elaborate accounting mechanism for counting increases
in emissions in countries like the United States against the 1990 allocation
for Russia. There would be little or no overall reduction. If Russian economic
growth begins to recover, the demand for permits within Russia would increase,
sharply driving up the world price of permits. This could add an ironic
twist to an international permit policy: if Russia were to grow quickly,
the United States could soon become the developed world’s low-cost emissions
abater. In that case the United States would be a net seller of permits,
and the rest of the industrial world would end up paying it to reduce its
emissions.
Finally, one further problem with the U.S. proposal, acknowledged even
by its supporters, is that no individual government would have any incentive
to police the agreement. It is easy to see why this is so: monitoring polluters
is expensive, and punishing violators imposes costs on domestic residents
in exchange for benefits that will accrue largely to foreigners. There
would be a strong temptation for governments to look the other way when
firms were exceeding their emissions permits. For the treaty to be viable,
however, each participating country would need to be confident that all
of the other participants were enforcing it. This would require an elaborate
and expensive international mechanism for monitoring and enforcement.
All in all, an international permit system aimed at stabilizing emissions
would not be politically viable in developed countries, would distort or
compromise the world trade system, would be unattractive to developing
countries, and would be difficult to monitor and enforce.
A BETTER APPROACH: NATIONAL PERMITS
AND EMISSIONS FEES
The international permit system is an impractical policy focused on
achieving the unrealistic goal of stabilizing emissions. A better approach
would be an international agreement setting up a system that combines emissions
permits and fees at the national level. As in the U.S. proposal, each country
would be allowed to distribute emissions permits equal to its 1990 emissions.
The permits could be given away, auctioned, or distributed in any other
way the government of each country saw fit. Unlike in the U.S. proposal,
each government would also agree to sell additional permits for a specified
fee, say U.S. $10. Firms within a country would be required to have emissions
permits equal to the amount of emissions they produce. They could buy the
permits from other firms or from the government for the stated fee.
Under this system firms would have an incentive to reduce emissions
whenever they could do so for less than $10 a ton. Because the total supply
of permits would not be fixed, the policy would not guarantee precisely
how much abatement will be done. However, it would ensure that any abatement
would be done at minimum cost. Moreover, firms would always have an incentive
to reduce further, either to avoid having to pay the fee or to be able
to sell excess permits. Because the government could give the base block
of 1990 permits away for free, the permit and fee policy is politically
quite different from a simple tax on carbon emissions, an alternative policy
that has often been proposed. The exemption for 1990 emissions would lower
the cost of the policy to industry by well over $10 billion a year relative
to a carbon tax of the same size. To see this, recall that in 1990 U.S.
carbon emissions were about 1,340 million tons. Under a flat $10 carbon
tax, firms would have to pay $13.4 billion in taxes each year on their
1990 emissions, plus an additional $10 for each ton of emissions above
1990 levels. Under the permit and fee scheme, the fee would apply only
above 1990 levels. Firms would save $13.4 billion a year yet have an equally
strong incentive to reduce emissions at the margin. This would make the
policy much more palatable to industry.
A national permit and fee policy would be a modest but concrete step
forward in protecting the environment from excessive climate change. It
would not necessarily stabilize world carbon emissions, but it would certainly
reduce them below the level that would exist without any policy or with
a stronger but unimplemented policy. It would also provide valuable information
about how much abatement can be done at low cost and how expensive it would
really be to stabilize emissions. There is much debate about how easily
emissions might be reduced: many economists believe that it will be quite
costly, but others argue that emissions can be reduced substantially at
low cost. A modest emissions fee would do a lot to show which group is
right.
The permit and fee policy would also give governments a built-in incentive
to monitor and enforce the treaty. The revenue raised through fees would
be available for a variety of purposes: to reduce budget deficits, lower
personal income taxes, or shore up social insurance programs. This would
give governments enough incentive to enforce the policy that little or
no international monitoring would be needed.
Finally, the permit and fee system would be flexible. The fee could
be adjusted as needed when better information became available on the seriousness
of climate change and the cost of reducing emissions. Equally important,
it would be easy to add countries to the system over time: those interested
in joining would only have to adopt the policy domestically and no international
negotiations would be required. This flexibility is crucial because negotiations
to date suggest that only a small subset of countries would agree to be
initial participants in a climate change treaty. Among the countries not
expected to participate are China and India, both of which are growing
rapidly and will soon account for large shares of world carbon dioxide
emissions. A treaty that cannot easily be extended to allow these countries
to participate will do little to control long-term emissions.
In fact, many of the permit and fee system’s practical advantages arise
because it is really an internationally coordinated system of domestic
policies rather than an international policy in the usual sense. The U.S.
proposal is much less flexible because any change in the number of permits
or the countries participating in the agreement would require international
negotiation.
CONCLUSION
The U.S. proposal to stabilize carbon dioxide emissions using an international
system of tradable permits is attractive in theory but fatally flawed in
practice. It has several major problems, each of which would make the treaty
difficult to ratify. First, it focuses exclusively on stabilizing emissions
even though a better case can be made for reducing the rate of emissions
growth. Second, it would involve large international transfers of wealth.
Third, it would lead to major changes in exchange rates and the pattern
of international trade. Fourth, it would be difficult to monitor and enforce.
Together these problems mean that a treaty based on the U.S. proposal will
have little effect on carbon emissions because it will never be implemented.
A system of national permits and emissions fees would be a better policy.
It would slow the growth of emissions and would do so without creating
large international capital flows or disrupting the world trade system.
It would also be easier to monitor and enforce. These advantages arise
from the fact that the permit and fee policy is really an internationally
coordinated system of domestic policies rather than an international policy
in the usual sense. Because of this, it demands less surrender of national
sovereignty and is a more practical way to achieve international goals.
Some may object to the permit and fee system because it would not guarantee
a sharp reduction in emissions. However, the real choice is not between
a sharp reduction and a more modest policy; it is between a modest policy
and no policy at all. The U.S. proposal, even though its goal is to stabilize
emissions, will do nothing to control global warming because it has no
real chance of ratification. The permit and fee system is a practical policy
that would be a significant step toward addressing the problem of climate
change.
Warwick J. McKibbin chairs the Department of Economics at the
Research School of Pacific & Asian Studies, the Australian National
University. Peter J. Wilcoxen teaches in the Department of Economics
at the University of Texas at Austin. Both coauthors are non-resident senior
fellows in the Economic Studies program at Brookings. They also collaborated
in writing "The Economic Implications of Greenhouse Gas Policy,"
H.English and D. Runnals (eds.) Environment and Development in the Pacific:
Problems and Policy Options (1996), Addison Wesley, Longman, pp 8-34.
The views expressed in this Policy Brief are those of the authors and are not necessarily those of the trustees, officers, or other staff members of the Brookings Institution.
Copyright © 1997 The Brookings Institution
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