International Consistency Considerations for Different Policy Designs

Chapter
3

International Consistency Considerations for
Different Policy Designs

Carbon dioxide is a global pollutant: A ton of emissions from any point on the globe (at a given time) would have the same effect on the atmospheric concentration of CO₂ and, therefore, would result in the same amount of damage. As a consequence, the most cost-effective method of achieving a given atmospheric concentration of CO₂ would be to undertake the lowest-cost emission reductions, regardless of where those opportunities were located. Achieving that goal would require that major emitting countries coordinate their policies to create a consistent economic incentive to reduce emissions. Choices that U.S. policymakers might make could affect the feasibility of creating such an incentive.

As in the previous chapter, this discussion is not meant to provide a comprehensive examination of the challenges in coordinating policies with other countries but rather to highlight how the ability to achieve that goal might vary across the policy designs. For example, effective government institutions and legal systems in each country would be necessary to successfully implement any type of multinational tax or cap-and-trade program and, therefore, would not give one policy a comparative advantage over another. Further, this discussion focuses primarily on the efficiency implications of creating a consistent economic incentive to reduce emissions in major emitting countries and touches only briefly on the potential equity issues associated with achieving that goal.

A Carbon Dioxide Tax Versus an Inflexible Carbon Dioxide Cap

Major emitting countries could achieve a uniform price on CO₂ by agreeing to implement the same tax on emissions (that is, to harmonize their countries’ policies). Alternatively, each country could establish a national cap-and-trade program and agree to link their programs by permitting allowance trading across borders. In that case, competitive forces would lead to a single allowance price.

Harmonizing a U.S. Tax on CO₂ With Policies in Other Countries

A direct method of achieving a uniform price on CO₂across multiple countries would be for each country to adopt the same tax. For example, each country might agree upon a specific tax rate, such as $15 per metric ton of CO₂. (That tax rate was used as an illustrative example in Chapter 1.) A uniform tax rate would ensure an equal level of incentive to reduce emissions in participating countries only if the following conditions were met:

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Participating countries had equally effective monitoring and enforcement provisions. Less effective monitoring, lower penalties, or less rigorous enforcement in any given country would reduce the economic incentive provided by its tax and would be equivalent to reducing the country’s tax rate.¹

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Participating countries agreed on similar tax exemptions or other special provisions. For example, if one country provided an exemption for the steel industry, that industry would have a reduced incentive to cut its emissions and would have a competitive advantage over steel industries in other countries with the same tax but no exemption.

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Participating countries implemented the tax at the same point in the carbon supply chain or made special provisions for differences in the point of implementation. For example, a country with an upstream tax on fossil fuel suppliers would need to exempt fossil fuels that were sold to a country with a downstream tax on fossil fuel users in order to avoid double-taxing emissions.

Alternatively, the United States could choose to implement a CO₂ tax set at a rate to be consistent with the price of CO₂ in an outside cap-and-trade system, such as the European Union’s Emission Trading Scheme (see the appendix). Such a tax could only roughly approximate the allowance price because allowance prices are difficult to predict and can fluctuate widely over time.² Further, attempts to harmonize the CO₂ tax rate in the United States with the allowance price in an outside trading program would have to take into account differences in the point of implementation. For example, if the United States adopted an upstream tax, it would need to exempt any fossil fuels that were sold to countries participating in the EU’s ETS, because that system regulates emissions at the point of combustion.

Linking a U.S. Cap-and-Trade Program With Outside Cap-and-Trade Programs

Linking the cap-and-trade programs of multiple countries to achieve a uniform price of CO₂ would involve the same complications associated with harmonizing tax rates. As with a tax, participating countries would need similar monitoring of emissions, tracking of allowance transactions, penalties for noncompliance, and enforcement provisions. In contrast with a harmonized tax, lax monitoring or enforcement in one country would undermine the effectiveness of the policy not only in that country but in other participating countries as well. The country with lax enforcement could become a supplier of fraudulent allowances (ones that did not correspond to actual reductions), diminishing the environmental integrity of the entire trading system.³ Further, the systems that track and transfer allowances in different countries (referred to as "registries" in the EU) would need to be able to communicate with each other.⁴ Finally, as with a harmonized tax, each country’s cap-and-trade program would need to cover similar sources of emissions, and provisions would need to be made to avoid double-charging (or not charging for) emissions if countries applied their caps at different points in the carbon supply chain.

Linking cap-and-trade programs would also entail additional challenges beyond those associated with harmonizing a tax on CO₂. Linking would change the price of allowances in each participating country, which would alter gains and losses and could create incentives for strategic behavior. A country with a relatively high allowance price (because of a more stringent cap, for example, or a greater dependence on high-carbon fuels) would experience a price decrease as a result of linking. In contrast, a country with a relatively low price before linking would see an increase. Those price changes would have several effects that countries would need to consider:

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The change in the price of allowances would alter the gains and losses experienced by companies that, before linking, had been net buyers or net sellers of allowances. For example, if the United States experienced an increase in the price of allowances as a result of linking, U.S. firms that had been net sellers could benefit, whereas net buyers could be worse off.

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In addition to altering the gains and losses experienced by individual firms, linking would create net flows of allowances—and flows of resulting revenues—into, or out of, countries. Countries could have an incentive to choose their caps strategically so as to take advantage of those potential flows. For example, a country might try to choose a less stringent cap so that it could become a net supplier of allowances.⁵

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A change in the price of allowances as a result of linking could alter the incentive of domestic producers to invest in new technologies—such as energy efficiency improvements or alternative fuels—that would reduce CO₂ emissions.

Linking would remove a country’s ability to determine the terms of regulation for its own businesses. For example, if a country that did not allow its firms to borrow future allowances for current use was to link with a country that did, firms in both countries would have access to borrowed allowances. In a similar manner, the use of other flexible design features—such as banking, offsets, and a safety valve (discussed in the next section)—would be available to all firms in a linked system should any one country allow its firms to comply in those ways.

Flexible Cap Designs

Design features that could make a U.S. cap-and-trade program more efficient than an inflexible cap could make other countries more or less willing to link their cap-and-trade program with a U.S. program. The following discussion examines linkage considerations associated with efficiency-improving design features discussed in the previous chapter: a safety valve, a price floor, banking and borrowing provisions, and a circuit breaker. It does not address other design features that could influence whether a country decides to link its trading system with a U.S. system. Those features might include U.S. decisions about how to allocate allowances to domestic sources or decisions about whether to allow sources to comply by using offsets such as biological sequestration (capturing carbon for long-term storage in trees or soil), geological sequestration (capturing carbon and storing it in the ocean or in the earth), and projects designed to reduce emissions in developing countries.⁶

Including a safety valve in a U.S. cap-and-trade program could limit the likelihood that countries participating in a system with an inflexible cap, such as the EU’s ETS, would be willing to link with a U.S. program. That reluctance could stem from two concerns. First, if the EU agreed to link with a U.S. program, it would no longer be able to maintain a rigid cap because EU sources would have access to allowances at the safety-valve price.⁷ In addition, the U.S. government could receive significant revenue by selling allowances to EU firms.

Linking a U.S. cap-and-trade program with trading programs in other countries could limit the ability of the U.S. government to set a floor on the price of allowances, even if it chose to sell a significant fraction of domestic allowances in an auction. Linking could greatly expand the size of the allowance market, which, in turn, would lessen the government’s ability to affect their price by withholding allowances from the domestic auction.

As with a safety valve, if one country in a multinational cap-and-trade program chose to allow its emitters to bank or borrow allowances, then those options could become available to all emitters within the system, regardless of their location. For example, if firms in one country were allowed to bank allowances (for example, in 2010), those additional allowances would be available through the allowance trading market to firms in all countries in the linked trading system in a future year (for example, in 2015). Banking could be problematic if some countries had binding targets that had to be met within a given period, however. That concern has caused EU countries to prevent emitters from banking allowances from the first phase (2005 to 2007) of its ETS for use in the second phase, which has binding targets for the 2008–2012 period.⁸

One of the challenges in designing an efficient global approach to reducing CO₂ emissions is how to include developing countries. Those countries have contributed a small fraction of global emissions in the past, but they are expected to become major contributors in the future. Some researchers suggest that linking a system of fixed cap-and-trade programs could offer an opportunity to equalize the marginal cost of emission reductions among participating countries while allowing for a differentiated level of effort among countries (that is, some countries could be required to make larger emission reductions than others) based on fairness or other criteria.⁹ Other researchers suggest that the revenue generated by taxing CO₂ emissions—or by selling allowances—in developed countries could be used to fund emission reductions in developing countries.¹⁰

1

In addition, countries would need to be prevented from changing their tax codes in order to neutralize the effect of the carbon tax. See Joseph E. Aldy, Scott Barrett, and Robert N. Stavins, 13+1: A Comparison of Global Climate Change Policy Architectures, Discussion Paper 03-26 (Washington, D.C.: Resources for the Future, August 2003),p. 13. For a discussion of some potential methods of inducing international compliance—such as using economic sanctions, social sanctions, "carrots," or other indirect incentives—see Joseph E. Aldy, Peter R. Orszag, and Joseph E. Stiglitz, "Climate Change: An Agenda for Global Collective Action" (paper prepared for the Pew Center on Global Climate Change’s workshop "The Timing of Climate Change Policies," Washington, D.C., October 11–12, 2001).

2

Prices depend on numerous factors, including the stringency of the cap, available technologies, supply and demand conditions in energy markets, and monitoring and enforcement provisions.

3

See Richard Baron and Stephen Bygrave, Towards International Emissions Trading: Design Implications for Linkages (Paris: Organisation for Economic Co-Operation and Development and International Energy Agency, October 2002), p. 21.

4

See Joseph A. Kruger and William A. Pizer, "Greenhouse Gas Trading in Europe: The New Grand Policy Experiment," Environment, vol. 46, no. 8 (October 2004), p. 15.

5

See Jane Ellis and Dennis Tirpak, Linking GHG Emission Trading Schemes and Markets (Paris: Organisation for Economic Co-Operation and Development and International Energy Agency, October 2006), p. 24; and Erik Haites, "Harmonisation Between National and International Tradeable Permit Schemes: CATEP Synthesis Paper," in Greenhouse Gas Emissions Trading and Project-Based Mechanisms (Paris: Organisation for Economic Co-operation and Development’s Global Forum on Sustainable Development, Emissions Trading CATEP Country Forum, March 17–18, 2003), p. 107.

6

For a discussion of the implications of those design features for linking, see Ellis and Tirpak, Linking GHG Emission Trading Schemes and Markets; and Kruger and Pizer, "Greenhouse Gas Trading in Europe."

7

See Ellis and Tirpak, Linking GHG Emission Trading Schemes and Markets, p. 26. Even if EU firms were prohibited from purchasing U.S. allowances through the safety-valve mechanism, U.S. entities could serve as intermediaries: They could purchase safety-valve allowances for their own use, freeing up other allowances to sell to firms in the European Union.

8

Ibid., p. 23.

9

This point was made by Robert N. Stavins in "Linking Tradable Permit Systems: Opportunities, Challenges, and Implications" (paper presented at the 7th International Emissions Trading Association’s Forum on the State of the Greenhouse Gas Market, Washington, D.C., September 27, 2007).

10

See Aldy, Orszag, and Stiglitz, "Climate Change: An Agenda for Global Collective Action"; and Aldy, Barrett, and Stavins, 13+1: A Comparison of Global Climate Change Policy Architectures.