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Climate Change Policy: The Road to Buenos Aires

Jason Shogren, Robert N. Stavins, Kevin Hassett and Eileen Claussen

Conference Series
October 1998

The American Enterprise Institute for Public Policy Research

When the United Nations Framework Convention on Climate Change met in Kyoto last December, the participating countries, including the United States, established a protocol for reducing emissions of greenhouse gases by developed countries. The U.S. Senate has not yet decided whether to ratify the agreement.

Next month in Buenos Aires, the UN convention will meet again, this time to discuss unresolved matters related to implementing the protocol. AEI held a conference on September 14 to consider some of the key issues on the agenda of that meeting. Below are summaries of the presentations of the four main speakers at the AEI conference.

 

Benefits and Costs of Kyoto
Jason Shogren, University of Wyoming

Few experts see the Kyoto protocol as the solution to the world’s climate change concerns, but some view it more favorably than others. The difference, I would assert, turns on what one chooses to believe about the nature of climate protection.

The Kyoto protocol sets targets and timetables for reducing greenhouse gases in aggregate by 5.2 percent from a 1990 baseline for the period 2008–2012. Nations can act jointly to obtain an overall target by forming multicountry “bubbles.” The protocol covers six greenhouse gases: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride, and it allows for flexible mechanisms for trading rights to emit each of those six gases. The agreement allows for land and forestry measures that counteract emissions and for each nation to determine its best strategy for meeting its commitment. It does not include commitments from developing countries, rules for international emissions trading, or details of compliance and enforcement.

The potential benefits from Kyoto include avoiding damages that could result from climate change–damages such as more severe weather patterns, an increase in infectious diseases, a loss of potable water, and a loss of land from a sea–level rise. The main problem when estimating benefits is that no reasonable estimates of the odds of those events exist. The odds matter, however, and analysts must quantify them to inform policy judgments.

As expected, the range of cost estimates of the Kyoto protocol is wide. Some studies suggest that the United States could meet its target at negligible or modest cost; others call Kyoto an “economic disarmament” driven by rank political opportunism. Still others estimate that Kyoto could cost between 1 and 2 percent of annual gross domestic product.

What one believes about flexibility provisions and about how many nations will be included in an exchange system significantly affects one’s estimate of the costs. An inflexible carbon policy will induce greater economic burden than a flexible policy. The protocol allows for emissions trading, which could reduce costs, but it does not suggest what a trading system would look like.

For those who believe disaster is imminent, emission reductions cannot come soon enough. For those who do not, it is hard to justify the costs of Kyoto without global trading. Numerous unanswered questions persist about the structure of atmospheric systems and their potential thresholds. But is the world on the cusp of catastrophe? Not necessarily. Numerous studies of risk perception have revealed that people commonly overestimate their chances of experiencing low–probability, high–severity events. Of course, inaction is not useful either. Climate protection can be viewed as hedging against uncertainty.

I favor adopting a moderate approach with gradual emissions reduction because, in my opinion, the Kyoto protocol, if put into effect, would provide no additional benefits for the extra cost it would impose. But the uncertainties at present leave enough latitude so that whether one chooses to believe that the benefits justify the costs of Kyoto rests on a choice of vision.

 

Thoughts on Designing an International Greenhouse Gas Trading System
Robert N. Stavins, Harvard University

The global climate policy challenge is threefold: to select goals wisely, to ensure widespread participation, and to provide mechanisms for dynamically cost–effective achievement of goals. Robert Hahn of AEI and I took the Kyoto framework as given and asked the question, Is it possible to create a system of international tradable permits that would provide a cost–effective means of achieving goals and, perhaps, a means of ensuring widespread participation?

The framework and provisions of the Kyoto protocol are the following. The focus is on short–term targets and timetables. Most developed countries must reduce emissions of six greenhouse gases by about 5 percent by 2008–2012, and most developing nations would not be subject to binding targets. The protocol recognizes the potential of market mechanisms and endorses voluntary programs. The agreement allows for trading among the countries (listed in annex B of the protocol) that would be bound to restrict their emissions but does not define the system. The agreement allows for banking of emissions (getting credits for early reductions) and for counting carbon sinks. It does not, however, address compliance tools or enforcement.

We considered three possible types of tradable permit systems: international tradable quotas, quotas allocated to nations that can be traded among governments; international tradable per mits, source–to–source trading (inter– and intrafirm) across countries; and domestic tradable permits (inter– and intrafirm).

The Kyoto protocol allows nations to set up domestic permits and allows undefined international quotas and permits among annex B countries. The problem is designing a system of international tradable quotas and permits within the Kyoto framework. A central design issue is how the three levels of trading will interact.

Under the protocol, international tradable quotas can be defined for the six greenhouse gases in terms of global warming potential. Those quotas can count as both sources and sinks if the tradable unit is net emissions. Nations that are responsible for meeting the obligations can bank but not borrow those quotas and can decide how to use them.

So internationally tradable quotas can be a useful way of reducing costs relative to fixed quantity limits, but the question remains whether governments will execute cost–minimizing trades. Possibly not, but is that a big problem? Not necessarily, because internationally tradable permits can undo those mistakes.

International tradable quotas, like other quantity instruments, are compatible with international tradable permits. The central question is whether widespread use of international tradable permits can overcome the limitations imposed by nations failing to conduct cost–minimizing trades with tradable quotas. If one thinks of the sodium dioxide allowance system with states as the regulated unit and if states are allowed to trade, they correspond to nations in a system of international tradable quotas. Inter– and intrafirm trading across state lines can equate marginal abatement costs, despite the lack of cost–effective trades by states. Therefore, the good news is that our preliminary answer to the question is yes. The bad news is that international tradable quotas under Kyoto involve potentially massive wealth transfers from developed to developing countries. So establishing such a quota would be difficult politically. But it will also be difficult to establish other systems.

International tradable quotas can create enforcement problems if the system is inadequately safeguarded. The system can be severely compromised if countries buy from a nation that fails to comply with its own quotas, but the lowering of costs achievable with such quotas can reduce enforcement problems because it becomes cheaper for nations to comply. Furthermore, if a nation’s liability is specified and an early warning system tracks its compliance, the problems can be reduced. Still, the generic enforcement difficulties will remain.

International tradable quotas do not add much complexity compared with other methods for achieving quantity targets for emissions. But to achieve the objectives of international tradable quotas, international tradable permits, and domestic tradable permits it is vital to have well–defined property rights that allow trading across space and time. It is important to allow banking of emissions reductions and to consider mechanisms for borrowing, such as the use of collateral in the event of default. It is also important that non–annex B countries opt into emission–reduction commitments.

No simple solutions exist for reducing emissions; all methods contain difficulties. Nevertheless, a politically and technically feasible system of international tradable permits that would produce dynamic cost–effectiveness is achievable. Designing and imp lementing such a system need be no more difficult than working through other approaches to achieving quantity targets. But doing so will be very difficult, indeed.

 

Can Energy Conservation Measures Provide Inexpensive Reductions in Carbon Emissions?
Kevin Hassett, American Enterprise Institute

Homeowners have available to them a variety of energy–saving home improvements, many of which can, according to engineering estimates, pay for themselves in a short time period. One of the puzzles facing policymakers has been the persistent observation that homeowners appear to apply high discount rates to those investment opportunities. The energy paradox–the apparent use of high discount rates for home–improvement investments–can perhaps be explained by examining the literature on irreversible investment. If energy conservation investments have low salvage value and their return is risky, then optimal investment hurdle rates can exceed the underlying discount rate by a substantial margin.

With my colleague Gilbert Metcalf of Tufts University, I investigated whether past studies overestimated discount rates because returns to energy–saving investments were overestimated. Previous researchers had used estimated engineering rates of return in calculating consumer discount rates. If an optimizing person with available funds refuses to invest in a project with a 20 percent rate of return, for example, then we can infer that her hurdle rate for that investment is bounded below by 20 percent. One possible explanation for the high estimated discount rates is that consumers do not expect to receive anything like the engineering return if they adopt the home improvement. That might be the case if, for example, engineering estimates of potential energy savings are inapplicable to actual realized savings.

We analyzed whether realized returns are comparable to technical return estimates by using the Residential Energy Consumption Survey conducted by the Department of Energy. That survey carefully records household investment in many different energy–conserving devices for a cross–section of households. We focused on the returns to attic insulation because some engineering studies report that the returns can be about 50 percent per year. We found that realized returns are far smaller.

Our study differs from past work in its methodology and focus. We analyzed the returns for individual consumer projects. That focus was important because, in the first place, participants in a utility program presumably are educated about energy use by the auditors, and it is possible that the energy savings could be received without making any energy investments. Our sample includes all improvements allowing us to approximate the actual savings received by typical individuals who pursue home improvement without careful coaching. Second, we can construct measures of the actual returns achieved in a typical home. That is an important step, since engineering estimates may inaccurately reflect the true returns households could expect to receive.

We combined monthly energy billing data with the survey to assess the energy savings from home–improvement investments and controlled for individual and structure specific heterogeneity. We found that the data provide little evidence of an energy paradox. The median rate of return for attic insulation was 9.9 percent, which is substantially below engineering estimates.

Can energy conservation help lessen the likelihood of climate change? Unfortunately, large returns to investment from energy–conserving home improvements do not exist. Those results do not necessarily imply that subsidies for home improvements are bad policy and that the government has no role to play, particularly if the home improvements help global warming. Even if consumers rationally account for all f actors that directly affect their purchase of home improvements, they might not account for the possible social costs, like global warming, of higher pollution associated with their energy–consumption choices. Conservation could help soften the blow of the need to reduce energy consumption and increase energy prices. But energy conservation is no free lunch and should not be represented that way.

 

Beyond Kyoto: An Agenda for the Next Decade
Eileen Claussen, Pew Center on Global Climate Change

I would like to make two arguments about climate change. First, we in the United States should begin taking steps to reduce our emissions of greenhouse gases. Second, climate change is a long–term, global issue that demands a global response. So we should begin building the national and international systems to deal with climate change.

Sufficient scientific knowledge exists to support taking steps to address the emission of greenhouse gases. But because our domestic debate on climate change is highly politicized, there is little focus on constructive steps to address the problem of our increasing emissions. Internationally, we have agreed to establish binding targets for developed countries. But developing countries are currently unwilling to participate, despite a consensus that all major emitting countries must participate to achieve long–term success. So what is the most effective agenda to deal with the climate change issue? Perhaps a modest beginning is best.

The United States must first depoliticize the issue and focus on economically sound and serious actions to reduce greenhouse gas emissions.

Second, we must design a system that will credit corporations for taking early action to reduce emissions. Failure to adopt a credit program will compel industry to defer action for the next decade to avoid uncertainty over how they will be treated. We can anticipate that both domestic consumers and international trading partners will pay more attention to climate–friendly technologies, and so we must encourage domestic industry.

Our domestic agenda should also include exploring what type of longer–term system to establish. That system should be market–based and should allow the economy to grow as it protects the environment. Development of that system will require participation by all levels of government and is a problem of enormous scope. So we must cooperate to obtain success.

We must also ensure that the system is efficient and fair. Different sectors of the economy should not be treated equally, since opportunities for reducing emissions are not equally available across all sectors. A serious effort to reduce emissions will affect some sectors and regions particularly hard. Resolution of those equity and transition issues must be a key component of a national system.

Some will say that those objectives are impossible; I say that we should take heart from history. During the oil embargo of the 1970s, we became more energy efficient, and economic growth was decoupled from energy consumption. Thus, with national will and appropriate policy support, we can achieve goals that seemed impossible.

Climate change must also be addressed internationally. Nations should consult with one anoth er so that expectations for international programs are realistic–a consultation that will be facilitated by the United States taking effective steps at home. Whatever your view of Kyoto, it does provide for transboundary, market–based programs to encourage climate–friendly development. We must carefully understand the potential for those mechanisms and develop programs to maximize their effectiveness. Nevertheless, working out effective, efficient, and equitable international systems and then developing the institutions to deal with them is not simple. It will take time.

Finally, we need to change the course of all nations. Some developing countries are willing to participate, but the majority have no interest in establishing commitments to reduce emissions. First, they are waiting to see whether developed countries make progress in combating climate change. Second, a framework for equitable obligations has not been established. The debate on that issue that is necessary before an agreement on requirements and equity can be reached has not yet begun.

That is a hefty agenda. But we can succeed if we are thoughtful and if we work domestically and internationally to achieve consensus rather than division.