1 Life After Kyoto: Alternative Approaches to Global Warming Policies



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1Life After Kyoto: Alternative Approaches to Global Warming Policies
William D. Nordhaus

Yale University and NBER

December 7, 2005

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Abstract



This study reviews different approaches to the political and economic control of global public goods like global warming. It compares quantity-oriented control mechanisms like the Kyoto Protocol with price-type control mechanisms such as internationally harmonized carbon taxes. The pros and cons of the two approaches are compared, focusing on such issues as performance under conditions of uncertainty, volatility of the induced carbon prices, the excess burden of taxation and regulation, potential for corruption and accounting finagling, and ease of implementation. It concludes that, although virtually all discussions about economic global public goods have analyzed quantitative approaches, price-type approaches are likely to be more effective and more efficient.

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I. Introduction1
After more than a decade of negotiations and planning under the Framework Convention on Climate Change (FCCC), the first binding international agreement to control the emissions of greenhouse gases has come into effect in the Kyoto Protocol. The first budget period of 2008-2012 is at hand. Moreover, the scientific evidence on greenhouse warming strengthens steadily as observational evidence of warming accumulates. The institutional framework of the Protocol has taken hold solidly in the EU’s Emissions Trading Scheme (ETS), which covers almost half of Europe’s CO2 emissions.2
Notwithstanding this apparent success, the Kyoto Protocol is widely seen as somewhere between troubled and terminal. Early troubles came with the failure to include the major developing countries along with lack of an agreed-upon mechanism to include new countries and extend the agreement to new periods. The major blow came when the US withdrew from the Treaty in 2001. By 2002, the Protocol covered only 30 percent of global emissions, while the hard enforcement mechanism in the ETS accounts for about 8 percent of global emissions (see Figure 1). Even if the current Protocol is extended, models indicate that it will have little impact on global temperature change. Unless there is a dramatic breakthrough or a new design, the Protocol threatens to be seen as a monument to institutional overreach.
Nations are now beginning to consider the structure of climate-change policies for the period after 2008-2012. Some countries, states, cities, companies, and even universities are adopting their own climate-change policies. Is the current design a viable long-term approach to this long-term problem? Are there in fact alternatives to the scheme of tradable emissions permit embodied in the Protocol? The fact is that alterative approaches have not had a serious hearing among natural scientists or among policymakers. The only live alternatives considered for the control of greenhouse gases were standard command-and-control regulation or a variant in which permits are exchangeable. What are some alternatives?
II. Alternative Approaches to the Control of Global Public Goods
Climate change is a member of a special kind of economic activity known as global public goods. Global public goods are public goods whose influences are felt around the world rather than in one nation, town, or family. What makes global public goods different from other economic issues is that there are at best weak economic and political mechanisms for resolving these issues efficiently and effectively.
It is customary to think of climate change as unique. In fact, dealing with global public goods has been an increasingly important feature of global affairs for centuries. Other important examples are national defense, public health, intellectual property rights, international trade, macroeconomic stability, fisheries, international environmental issues, endangered species, and transnational terrorism. We have only to think about nuclear proliferation, the AIDS epidemic, the decline of many ocean fisheries, international financial crises, and the history of warfare to realize how prevalent are global public goods. A little further reflection will indicate that nations have had only modest success in combining to deal with global public goods. On the other hand, we can look to regimes to manage international trade disputes (today primarily through the World Trade Organization) or the chlorofluorocarbon protocols to indicate that all is not hopeless.
A review of mechanisms for dealing with global public goods reveals a wide variety of instruments or techniques. A partial list is:
• Non-cooperative or laissez-faire approaches (as is currently taken for antibiotic resistance)
• Aspirational agreements (e.g., the FCCC) or non-binding voluntary agreements (e.g., the institutional regime created in the 1980s to clean up pollution in the North Sea)
• Specific and binding treaties – contracts between sovereign nations – which are the standard way to deal with international issues (currently in effect for the chlorofluorocarbons (CFCs) and many other global environmental agreements)
• Agreements embedded in broader arrangement (exemplified when Western nations forced developing countries to accept strong patent protection under the last multilateral trade negotiations)
• Limited delegations of regulatory or fiscal authority to supranational bodies (seen in some European activities such as the European Central Bank, in some powers of the WTO, and the international financial institutions such as the IMF).
This array of international institutions reminds us that, although climate change is a new problem, the problems of international political economy raised by climate change are quite ancient.
There are two major problems involved in dealing with public goods. First, we must find the level of “appropriate federalism.” That is, it is necessary to locate the decision making at the political level that can internalize the spillovers. This is a particularly thorny problem for global public goods because global inefficiencies intrinsically need global decision making, or at least global coordination. The second issue is the Westphalian dilemma. Under international law as it developed out of the 1648 Treaty of Westphalia and evolved in the West, obligations may be imposed on a sovereign state only with its consent. In other words, there is no legal mechanism by which disinterested majorities of countries can coerce free-riding countries into mechanisms that provide for global public goods.
These points are useful reminders that we must take entirely different approaches to global public goods from those taken to national public goods.
III. Mechanisms for Economic Public Goods
Looking at the varieties of global public goods, I want to focus on those that I will call economic public goods. These activities are ones which involve huge numbers of economic agents in a large number of countries and where the costs and benefits of action do not indicate any obvious focal policy or technological fix. The opposite of economic public goods is focal public goods, where good policies appear obvious or consensual to most people, such as no AIDS, no smallpox, no financial collapses, no nuclear meltdowns or nuclear explosions, and no trade barriers.
With economic public goods, it is usually difficult to determine and reach agreement on efficient policies because they involve estimating and balancing costs and benefits, where neither is easy to measure and both involve major distributional concerns. Economic public goods include such examples as fisheries (where most everyone agrees that some fishing is tolerable, but the point of overfishing is difficult to calculate); pollution (where most everyone agrees that zero pollution is prohibitively expensive); a multitude of societal risks (where it is difficult to decide where to set the safety margin between zero risk and “low” risk); and climate change (where almost everyone agrees that the optimal abatement is neither zero nor 100 percent of emissions). There is a temptation to redefine economic public goods as focal public goods because that tremendously simplifies analysis and policy. For example, policies have pretended to adopt a complete phase out of CFCs in principle, although that is impossible in practice. Policies to prevent the extinctions of species generally avoid the vexing question of how to draw the line between species and subspecies as well as the intractable question of how far to lower the probability of extinction given that it clearly can never be zero.
For economic public goods, there are three potential approaches: command-and-control regulation, quantity oriented market approaches, and tax or price-based regimes. Of these, only the tradable-quantity and the tax regimes have any hope of being reasonably efficient, and I will therefore limit my discussion to those cases.3
Quantitative limits. Under a tradable quantity approach, an agreement proceeds by setting limits on emissions by different countries. The limits are partially or wholly transferable among countries. This is the approach taken under the Kyoto Protocol. This approach has very limited international experience under existing protocols such as the CFC mechanisms and somewhat broader experience under national trading regimes, such as the U.S. SO2 regime.
Price or tax mechanisms. A radically different approach is to use harmonized prices, fees, or taxes as a method of coordinating policies among countries. This approach has no international experience in the environmental area, although it has modest experience nationally in such areas as the U.S. tax on ozone-depleting chemicals. On the other hand, the use of harmonized price-type measures has extensive international experience in fiscal and trade policies, such as with the harmonization of taxes in the EU and harmonized tariffs in international trade.
IV. Major Issues in Any International Climate-Change Regime
Any climate-change regime must face three fundamental questions – the level of emissions reductions, the distributions of emissions reductions across countries, and the need for transfers to induce low-income countries to participate. Each of these issues is very contentious for climate change.
The overall level of emissions reduction
Because climate change is a global public good, the key environmental question is global emissions, and the key economic issue is how much global emissions should be reduced. The future trajectory of climate does not depend upon the exact location of greenhouse-gas emissions, only on the total. Moreover, the impacts to a first approximation do not depend upon the annual flow of emissions but on concentrations, which are a complex function of cumulative emissions.
Under a quantitative approach, the level of emissions (in covered countries) is in principle directly chosen. Under a price approach, the level of emissions is indirectly determined by the level of the tax or penalty on carbon emissions. However, for a quantitative approach with trading, a market economy is likely to develop markets for emissions, and a market price will therefore emerge. An economist will naturally examine the price in either case, and the first question then will quickly be transformed into a slightly rephrased question: What is the level of the carbon price that is consistent with the regime?
In a world of certainty, either a quantitative or a price regime could target a given carbon price, but in practice the price is likely to be unknowable in advance in a pure quantitative system. The key economic question in either regime is whether the price is likely to be relatively high, say in the $100 per ton of carbon range, or relatively low, say in the $10 per ton carbon range.4
This issue has been at the heart of the debate about the efficiency of the Kyoto Protocol. Several economic studies have found that the Kyoto Protocol will not only lead to high carbon prices but also to a highly differentiated and therefore inefficient allocation of abatement across countries.5 To the extent that an economic rationale lies behind the U.S. rejection of the Kyoto Protocol, it comes from estimates that the U.S. will bear a disproportionate share of the burden of adjustment and that the costs to the U.S. of the Kyoto Protocol far outweigh the benefits. Figure 2 presents an estimate of the economic impact (costs, benefits, and net benefits) of the full trading version of the original Kyoto Protocol using the RICE-2001 model.6 These estimates indicate not only that the U.S. bears a large fraction of the costs of implementing the protocol but also that the net economic impact upon the U.S. is negative even including the environmental benefits. Figure 3 shows, by comparison, how the costs are radically altered by the U.S. withdrawal.
The question of the “right” or the “optimal” level of emissions reductions is undoubtedly the most difficult and controversial question in the economics of climate change. In a series of studies, my coauthors and I have estimated cost and damage functions and estimated “optimal” or cost-beneficial approach to climate change. Our latest estimates in the revised RICE-2001 model suggest that a 2010 carbon price of $16 per ton carbon (in 2005 prices) – rising rapidly over time – would appropriately balance the costs and benefits of emissions reductions using the classical cost-benefit approach. However, this estimate might not appropriately capture many non-market aspects of climate change and does not adequately capture many of the potential “dangerous interferences” with many global processes. 7 Alternative estimates of carbon taxes would be one that stabilize the concentrations of CO2 at twice the pre-industrial level (that is, at 550 parts per million), which is estimated to be $8 per ton carbon; while an efficient trajectory for limiting temperature change to 2½ degrees C would be $26 per ton carbon. The major point is that efficient policies that impose strong but not severe constraints on greenhouse gas emissions would have price signals on emissions in the range of $10 to $20 per ton of carbon in the 2010 time frame.
Modeling estimates indicate that global emissions under the revised Kyoto Protocol will be very close to “business as usual.” Global emissions in 2010 are estimated to be 1½ percent lower than a no-controls scenario if the new forestry offsets are ignored (see Figure 4) and around ¾ percent lower with forestry offsets (not shown).
The modest emissions reductions will be reflected in lower carbon prices. Carbon prices in the implementing regions are projected to be sharply lower under the no-U.S. version compared to the original version. Model results indicate that the carbon price in 2010 would be $41 per ton C with the United States and $18 without the U.S. Actual market prices for the ETS have ranged from $23 to $104 per ton C. With the U.S. out of the picture, the price of permits in Europe falls dramatically as required emissions reductions decline. Figure 5 shows the estimated carbon prices in Europe for variants of the Kyoto Protocol as well as the actual price in the European Trading Scheme.
The distribution of emissions or emissions reductions among countries
Additionally, a global climate-change regime has important distributional dimensions: What should be the relative distribution of reductions among high- and low-income countries, among high-emitting and low-emitting countries, and among countries that are vulnerable to the consequences of climate change and those who are relatively less vulnerable?
The economic approach to these questions leads to a simple and unambiguous answer: emissions reductions should be done in the most efficient way; and the burden of reducing emissions should be shared in a fair way. The first half of this statement refers to the distribution of actual emissions reductions (which was just discussed) while the second half refers to burden sharing (which is discussed below).
Under the economic approach, emissions reductions will be efficient if the marginal costs of emissions reductions are equalized with appropriate discounting across space and time. The spatial component of efficiency is that the marginal cost of reductions should be equal across all countries and industries. The temporal component is more complicated.
A more complex requirement is “when efficiency” or intertemporal efficiency. To a first approximation, intertemporal efficiency requires that the price or marginal cost of emissions reductions grows over time at a rate equal to the “real carbon interest rate,” which is approximately equal to the real interest rate less the disappearance rate of CO2 from the atmosphere. Most analyses focus only on the spatial component, which is always necessary for efficiency, and ignore the temporal component because it requires a complicated intertemporal optimization.
The Kyoto Protocol is defective on both efficiency criteria because it omits a substantial fraction of emissions (thus failing the spatial criterion) and has no plans beyond the first period (thus not attending to the temporal dimension). Indeed, the two largest emitters (the U.S. and China) are not even included in the current protocol, and a third (Russia) has agreed to join only because it is the recipient of large transfers. Figure 6 shows the most recent estimates of the abatement costs under different trading regimes for the original Kyoto Protocol using the RICE-2001 model.8 Because it limits trading to a small part of the world and ignores the intertemporal dimension, the Kyoto Protocol is an extremely costly treaty and makes only modest progress in slowing global warming.
Income transfers from high-income to low-income countries
All studies show that it is efficient for low-income counties to participate in emissions reductions, and indeed some of the most economical emissions reductions will probably come in low-income countries. In both quantity-type and price-type mechanisms, it will be both necessary and fair for high-income countries to provide assistance to low-income countries if the latter are to be expected to take measure to reduce emissions. The transfer mechanism under a quantity approach takes place through the allocation of baseline emissions. Under a fiscal mechanism, transfers would be direct monetary transfers or transfers tied to projects and would therefore be much more visible. Whatever the mechanism, some form of transfer will be necessary.
This set of concerns has been another obstacle to ratification of the Kyoto Protocol in the United States. Both the FCCC and the Kyoto Protocol exempt the developing countries, even relatively affluent ones, from obligations for emissions reductions. It is obviously crucial to have a mechanism whereby countries “graduate” into a set of obligations that are commensurate with their abilities to pay – in a way that is similar to the ability to pay principles of an income tax system.
The Kyoto Protocol has an arbitrary allocation of transfers because it generally used 1990 emissions as a base year when setting targets in 1997. Consequently, those countries with high emissions in 1990 (such as the former Soviet Union) will be advantaged while those who have grown rapidly (such as the United States) will be disadvantaged. Moreover, since developing countries are omitted, they are completely overlooked in the transfers. Although there have been few public pronouncements on the subject, it is inconceivable that the United States would agree to the enormous resource transfers to Russia and other countries that are envisioned by the Kyoto Protocol.9 Therefore, while the quantity plan looks advantageous because it contains implicit transfers, when the time comes actually to purchase substantial emissions reductions from Russia, the political glue might well come unstuck.

V. Sketch of a Price-Type Approach to Climate Change
Price-type approaches or hybrid approaches have been discussed in a handful of papers in the economics literature,10 but much careful analysis remains to be done. I will highlight a few of the details.
For concreteness, I will discuss harmonized carbon taxes (HCT). Under HTC, there are no international emissions limits; rather, countries would agree to penalize carbon emissions domestically at an agreed-upon and harmonized “carbon tax.” The carbon tax is determined by weighing environmental and economic objectives. This might involve aiming to limit GHG concentrations or keeping temperature changes below some level, or it might use some kind of cost-benefit approach.11 Unlike the quantitative approach under the Kyoto Protocol, there are no country emissions quotas, there is no emissions trading, and there are no base period emissions levels. Because carbon prices will be equalized, the approach will be spatially efficient among those countries that have a harmonized set of taxes. If the carbon tax trajectory follows the rules for “when efficiency,” then it would also satisfy intertemporal efficiency. Studies of efficient prices find that the real carbon prices would rise by between 2 and 4 percent per year depending upon the objective.
Details about burden sharing would require study and negotiations. It would be reasonable to allow participation to depend upon the level of economic development. For example, countries might be expected to participate fully when their incomes reach a given threshold (perhaps $10,000 per capita), and poor countries might receive transfers for early participation. The issues of sanctions, the location of taxation, international-trade treatment, and transfers to developing countries under an HCT are important details that are subject to discussion and refinement.12 If carbon prices are equalized across participating countries, there will be no need for tariffs or border tax adjustments among participants. I emphasize that much work would need to be done to flesh out these arrangements, but they are familiar terrain because countries have been dealing with problems of tariffs, subsidies, and differential tax treatment for many years.
Hybrid approaches
The literature on regulatory mechanisms entertains a much richer set of approaches than the polar quantity and price types that are examined here. An important variant is “prices in quantity clothes” –putting price ceilings and floors on the price emissions-trading permits.13 This was considered and rejected by the Clinton Administration in its preparation for the negotiations for the Kyoto Protocol.
The present discussion focuses on pure strains of the two systems partially to keep the analysis within manageable limits. Additionally, we may worry about the tendency of mixed systems to revert to their archetype. For example, even though the Kyoto Protocol was designed as a system with complete trading within the Annex I countries, there were strong pressures to limit trading. The EU implementation of the Kyoto Protocol allows full trading within the EU but limits the purchases of emissions permits from other countries. The lesson from foreign-trade barriers, where price and quantity limits have a much longer history, is that the quantity limits through quotas are extremely durable.
VI. Comparison of Price and Quantity Approaches

Quantity approaches are the norm in environmental policies today, and policies toward global warming are no exception. Policymakers, environmentalists, and economists are so accustomed to quantity constraints in environmental policy that the fundamental advantages of price-type approaches have been largely overlooked. This section reviews ten differences between quantity and price approaches with an emphasis on the advantages of the price-type mechanisms for climate-change policies.

1. The most fundamental defect of the Kyoto Protocol is that the policy lacks any connection to ultimate economic or environmental policy objectives. The approach of freezing emissions at a given historical level for a group of countries is not related to any identifiable goals for concentrations, temperature, costs, damages, or “dangerous interferences.” Nor does it bear any relation to an economically oriented strategy that would balance the costs and benefits of greenhouse-gas reductions. It is not inevitable that quantity-type arrangements are inefficient. In principle, they might be designed to choose an emissions path that meets some well-defined and well-designed economic and environmental objectives. However, in practice, quantity approaches tend to be technologically oriented.
Price-type systems such as taxes have a mixed record of efficiency. Nevertheless, in the long sweep of fiscal history, particularly in foreign trade interferences, countries have moved from the most inefficient forms of taxation to ones that are relatively more efficient. In this context, the ideal system is relatively simple, as has been described in the section on harmonized carbon taxes above, and is simply the efficient Pigovian tax.

2. A related issue concerns the baseline against which countries set their policies. Quantity limits are particularly troublesome in a world of growing economies, differential growth, and uncertain technological change. These problems have become evident under as the Kyoto Protocol. Under the Kyoto Protocol, the targets were set thirteen years before the control period and used baseline emissions from twenty years before the control period. Base year emissions have become increasingly obsolete as the economic and political fortunes of different countries have changed. The 1990 base year penalizes efficient countries (like Sweden) or rapidly growing countries (such as Korea and the United States). It also gives a premium to countries with slow growth or with historically high carbon-energy use (such as Britain, Russia, and Ukraine).


The baselines for future budget periods and for new participants are deep problem for the Kyoto Protocol. The natural baseline, and one that would probably be chosen were it feasible, is the zero-restraint level of emissions. That level is in practice impossible to calculate or predict with accuracy, particularly when abatement policies are in place. Problems would arise in the future as to how to adjust baselines for changing conditions and to take into account the extent of past emissions reductions.
Under a price plan, the natural baseline is a zero-carbon-tax level of emissions, which is easy to calculate for old and new countries. Countries’ efforts are then judged relative to that baseline. It is not necessary to construct a historical base year of emissions. Countries are not advantaged or disadvantaged by their past policies or the choice of arbitrary dates. Moreover, there is no asymmetry between early joiners and late joiners.14
3. One key difference between price and quantity instruments concerns the structure of the uncertainties — and uncertainty is clearly a central feature of climate-change policy. If the curvature of the benefit function is small relative to the curvature of the cost function, then price-type regulation is more efficient; conversely, if the benefit functions are highly nonlinear while the cost functions are close to linear, then quantity-type regulation is more efficient.
While this issue has received little attention in the design of climate-change policies, it would appear that the structure of the costs and damages in climate change gives a strong presumption to price-type approaches.15 The reason is that the benefits are related to the stock of greenhouse gases, while the costs are related to the flow of emissions. This implies that the marginal costs of emissions reductions are highly sensitive to the level of emissions, while the marginal benefits of emissions reductions are essentially invariant to the current level of emissions reductions. The key point is that where the damages are caused by stock externalities (as is the case for climate change because damages are a complicated function of the stock of greenhouse gases), then the damage function is likely to be close to linear with respect to current emissions. Abatement costs, by contrast, are likely to be highly nonlinear as a function of emissions. This combination of relative nonlinearities means that emissions fees or taxes are likely to be much more efficient than quantitative standards or auctionable quotas when there is considerable uncertainty, as is clearly the case for climate change.
4. Closely related to point about uncertainty is that quantity-type regulations are likely to show extremely volatile prices for the trading prices of carbon emissions. Carbon prices are likely to be extremely volatile because of the complete inelasticity of supply of permits in the quantity case along with the presumption of quite inelastic demand for permits in the short run.16
We have preliminary indications that European trading prices for CO2 are highly volatile, fluctuating in a band and + 50 percent over the last year. More extensive evidence comes from the history of the U.S. sulfur-emissions trading program. We can judge the potential volatility of prices in a quantity-type system from the recent history of the sulfur-emissions trading program. SO2 trading prices have varied from a low of $70 per ton in 1996 to $1550 per ton in late 2005. This is analogous to a carbon-trading program because the supply is virtually fixed and the demand is inelastic because of the low substitutability of other inputs for sulfur in the short run. Both programs build in some banking features, which can in principle moderate price volatility. The history of the SO2 program shows extreme volatility of the prices with an annual volatility of 43 percent over the last decade. Figure 7 shows that sulfur prices are much more volatile than oil prices or stock-market prices.
Such rapid fluctuations would be extremely undesirable, particularly for an input (carbon) whose aggregate costs might be as great as petroleum in the coming decades. An analogous situation occurred in the U.S. during the “monetarist” period of 1979-82, when the Federal Reserve targeted quantities (monetary aggregates) rather than prices (interest rates). During that period, interest rates were extremely volatile. In part due to the increased volatility, the Fed changed back to a price-type approach after a short period of experimentation. This experience suggests that a regime of strict quantity limits might become extremely unpopular with market participants and economic policymakers as price variability caused significant changes in price levels and import and export values.
5. A fourth advantage of tax mechanisms is the strong fiscal-policy preference for using revenue-raising measures rather than quantitative or regulatory measures. When prices are raised and real incomes are reduced by regulations, this increases the inefficiency losses from the overall tax system. This effect is the “double burden” of taxation (misnamed as the “double dividend” from green taxes).17 If the carbon constraints are imposed through taxes that are then rebated in taxes that have approximately the same marginal deadweight loss as the carbon taxes, then the overall efficiency loss from taxation will be unchanged. If the constraints under a quantity-based system are imposed by allocations that do not raise revenues, then the conventionally calculated abatement costs will underestimate the economic costs and the efficiency losses from the price-raising elements should be added to the abatement costs. The impacts are likely to be large.18
While it is possible that emissions permits will be auctioned (thereby retaining the revenues and removing the double burden of taxation), history and current proposals suggest that most or all of the permits are likely to be allocated at zero cost to “deserving” parties, or will be distributed to reduce political frictions. In the cases of SO2 allowances and CFC production allowances, all the permits were allocated to producers. The point here is that using tax approaches rather than quantity-type approaches will help promote a more efficient collection and recycling of the revenues from the carbon constraints.
6. An additional question applies particularly to international environmental agreements and concerns the administration of programs in a world of where governments vary in terms of honesty, transparency, and effective administration. One of the subtle overlooked problems with quantity-type systems is that they are much more susceptible to corruption than are price-type regimes. An emissions-trading system creates valuable tradable assets in the form of tradable emissions permits and allocates these to different countries. Limiting emissions creates a scarcity where none previously existed and in essence prints money for those in control of the permits. Such wealth creation is potentially dangerous because the value of the permits can be used by the country's leaders for non-environmental purposes rather than to reduce emissions. It would probably become common practice for dictators and corrupt administrators to sell part of their permits, pocket the proceeds, and enjoy wine, partners, and song along the Riviera.
A few examples will show the perils in the quantitative approach. A Russian scientist recently reported that people in Moscow were already considering how to profit from the “privatization” of the Russian carbon emissions permits. Simulations suggest that tens of billions of dollars of permits may be available for export from Russia under the Kyoto Protocol. Alternatively, consider the case of Nigeria, which had emissions of around 90 million tons of CO2 emissions in recent years. If Nigeria could sell its allowances for $20 per ton under a “clean development mechanism,” this would raise around $2 billion each year of hard currency. This is in a country whose non-oil exports in 2000 were around $600 million.
To prevent unacceptable diversions of funds, any broad-based emissions-trading plan would undoubtedly lead to a major monitoring system and might get bogged down in concerns about the diversion of funds to arms purchases, drugs, money laundering, and terrorism. It would be tempting to make receipt of any excess emissions permits conditional on “good behavior” with respect to terrorism, human rights, environmental concerns, child and prison labor, and other worthy causes du jour. Reducing emissions permits would be a tempting target for sanctions for countries which violate international norms. Of course, the more burdensome are the “ethical” restrictions on the sale of the permits, the less attractive participation becomes for countries, so the plan could easily founder.
A price approach gives less room for corruption because it does not create artificial scarcities and monopolies. There are no permits handed over to countries or leaders of countries, so they cannot be sold abroad for wine or guns. Any revenues would need to be raised by taxation on domestic consumption of fuels. In fact, a carbon tax would add absolutely nothing to the instruments that countries have today. The only difference would be the international approval of carbon taxes, which probably adds little to their acceptability in corrupt countries. The dangers of quantity as compared to price approaches have been shown frequently when quotas are compared to tariffs in international trade interventions.
7. A concern arises in the wake of the recent revelations of financial finagling in the world largest and, it used to be said, most transparent market economy. A cap-and-trade system relies upon accurate measurement of emissions by all relevant parties. If firm A (or country A) sells emissions permits to firm B (or country B), where both A and B are operating under emissions caps, then it is essential to monitor the emissions of A and B to make sure that their emissions are in fact within their specified limits. Indeed, if monitoring is ineffective in country A but effective in country B, a trading program could actually end up raising the level of global emissions because A’s emissions would be unchanged while B’s would rise.
It was generally supposed that monitoring would be relatively straightforward in countries with strong legal and enforcement systems such as the United States. This was probably naïve and overly optimistic. The accounting scandals of the last year have not been limited to dollar scandals, but these have also spilled over into emissions markets. They are not yet emissions scandals because the dollars involved has not crossed the nine-digit threshold of perception.
Some recent cases were described by Ruth Greenspan Bell:19
PSEG Fossil LLC, the biggest player in [New Jersey's emissions trading system], apparently had not installed necessary pollution controls or obtained proper permits. The U.S. Justice Department discovered this and brought an enforcement action, which was resolved in the form of a consent decree. PSEG, without admitting any wrongdoing, agreed to stop selling its credits to other firms and to stay out of the trading system. When PSEG was forced to withdraw, its sheer size and status as one of the largest “suppliers” of credits in New Jersey brought that state's system close to collapse.

[A]ccording to ... Electricity Daily, [authorities] are looking into charges that a Pasadena broker cheated several firms who paid for emissions credits that were never delivered.... A similar example from the United Kingdom was reported ... in an account of a government-sponsored auction in which participating companies bid by offering greenhouse gas reductions. An independent review by Environmental Data Services noted strong grounds to suspect that at least half of the claimed emissions reductions were not real, and blamed the inaccuracies on shortcomings in the Department of Environment, Food, and Rural Affairs regulatory controls and “poorly thought through rules.”



If emissions finagling takes place in countries with relatively solid legal systems like the United States and the United Kingdom, it would be foolish to overlook the likelihood of emissions cheating in Russia, Ukraine, and many developing countries.
Such cheating will probably be endemic in an emissions-trading system that involves large sums of money. There are very poor intrinsic incentives for honesty in a cap-and-trade system. The purchasing unit gets a permit whether or not any true reductions take place by the selling unit. Emissions evasion has even worse incentives than tax evasion. Unlike the emissions-permit case, the recipient of the tax wants the payer to dispense the funds just as much as the taxpayer dislikes dispensing the funds. Tax cheating is a zero-sum game for the two parties, while emissions evasion is a positive sum game for the two parties. If tax evasion in the U.S. is in the order of 10 or 20 percent of taxes due, is there reason to believe that emissions evasion in Ukraine or Romania would be substantially less?
8. The major problem with the price approach is whether it can be effectively administered. The issue has been analyzed by David Victor in his analysis of the Kyoto Protocol, and he writes as follows:
The third objection, however, may be fatal to the carbon tax approach. Monitoring and enforcement are extremely difficult. . . . In practice, it would be extremely difficult to estimate the practical effect of the tax, which is what matters. For example, countries could offset a tax on emissions with less visible compensatory policies that offer loopholes for energy-intensive and export-oriented firms that would be most adversely affected by the new carbon tax. The resulting goulash of prior distortions, new taxes, and political patches could harm the economy and also undermine the goal of making countries internalize the full cost of their greenhouse gas emissions.20
These and other concerns with the feasibility of the carbon-tax approach will require serious analysis, but I will sketch the reasons why I believe they can be overcome.
The major obstacle to enforcement is the measurement of “net carbon taxes.” It might be difficult to measure the net level of carbon taxes in the context of other fiscal policies (such as fuel taxes and coal subsidies). For example, suppose that Germany imposed a $50 carbon tax, which would fall primarily on coal. It might at the same time increase its coal subsidies or reduce its gasoline taxes to offset the carbon tax, thereby reducing the level of net carbon taxes. Alternatively, Canada might argue that it has met its carbon-tax obligations by raising provincial stumpage charges on timber. How can the carbon tax be calculated in such circumstances?
This problem actually has two parts: first, we would need for each country a full set of the relevant taxes and subsidies (primarily those relating to energy taxes); second, we would need an appropriate methodology for combining the different numbers into an overall carbon tax rate.
The first issue – obtaining tax rates – is relatively straightforward for market economies. One of the proponents of the tax approach, Richard Cooper, describes the monitoring issue as follows:
Monitoring the imposition of a common carbon tax would be easy. The tax’s enforcement would be more difficult to monitor, but all important countries except Cuba and North Korea hold annual consultations with the International Monetary Fund on their macroeconomic policies, including the overall level and composition of their tax revenues. The IMF could provide reports to the monitoring agent of the treaty governing greenhouse gas emissions. Such reports could be supplemented by international inspection both of the major taxpayers, such as electric utilities, and the tax agencies of participating countries.21
Countries cannot easily hide their subsidies, for there are powerful environmental interest groups in most countries that monitor internal developments and would alert “the authorities” if countries instituted hidden carbon subsidies. Moreover, in transparent market democracies, taxes and subsidies are part of the legislative process. On the other hand, countries with closed political systems might attempt to hide their subsidies. This problem would be particularly troublesome in non-market economies or sectors where fuels are allocated by quantitative measures rather than by the price mechanism.

The second issue, calculating the effective carbon tax from the underlying data, is complicated because it involves many technical economic issues. Calculations would require certain conventions about how to convert energy taxes into their carbon equivalent. Some of the calculations involve conversion ratios (from coal or oil to carbon equivalent) that underpin any carbon-based system, whether it be price-based or quantity-based. Others would use output data and input-output coefficients, which might not be universally available on a timely basis. On the whole, calculations of effective carbon tax rates are straightforward as long as they involve first-round or impact calculations (i.e., the rate of tax per unit of carbon emitted) and do not need to involve substitution effects.


To go beyond first-round calculations would require assumptions about supply and demand elasticities and cross-elasticities, might engender disputes among countries, and should be avoided if possible. The procedures would probably require mechanisms similar to those used in WTO deliberations, where technical experts would calculate effective taxes under a set of guidelines that would evolve under quasi-legal procedures.22 Overall, measurement and calculation of effective carbon tax rates seems more tedious than insuperable.
9. An important issue involves the question of how to count initial carbon taxes. Some countries — particularly those in Europe — would claim that they already have high carbon-equivalent taxes because of high taxes on gasoline. They would argue for taking existing taxes into account before requiring them to undergo further obligations.
While this looks like a subterfuge, counting pre-existing taxes as compliance is probably correct and is easily interpreted in the price framework. Therefore, the first step, and one absent from analysis of the Kyoto Protocol, would be a calculation of existing equivalent carbon taxes and subsidies. Our data suggest that, even without its CO2 taxes, Europe is taxing carbon at a rate of approximately $100 per ton carbon more than the United States.23 Given that disparity, it would make no economic sense to ask Europe to add, say, another $20 on top of its existing taxes with an equivalent expectation for the U.S. Moreover, the fact that Europe might be overtaxing carbon today would never come up in the quantity-type approach.
10. The deepest concern about price-type approaches is that they fundamentally fail to “solve” the climate-change problem because they do not limit emissions. This objection is akin to the fallacy that curing a sore throat requires injecting penicillin into the neck. It is misplaced because it forgets that the aim of policy is not to reduce emissions or get an agreement but to minimize the net damages of global warming. Adopting the Kyoto Protocol might turn out to be a Pyrrhic victory in which countries religiously meet their targets but there is virtually no impact on global temperature.
Policy should be aimed at balancing environmental and economic costs and benefits, not at limiting emissions. Emissions limitation is only an intermediate objective. It is preferable to steer policy toward the ultimate objectives of reducing concentration or temperature changes or limiting net environmental damages rather than at intermediate and intrinsically unimportant objectives like emissions. A control mechanism should allow iterative adjustment and movement toward evolving goals, which can be accomplished using either prices or quantities. However, while either prices or quantities can be used as a control mechanism, emissions taxes are more efficient because of the relative linearity of the benefits with respect to emissions and the resulting high volatility of prices under an emissions-targeting approach. In other cases, quantities would be more appropriate, but in the case at hand – with a stock externality – using quantity controls only gives the appearance of being a more direct approach.
Non-economists will probably always be uncomfortable with using indirect instruments like prices, just as patients may wonder how little yellow pills can cure their disease. Nonetheless, the fact that prices are more indirect than quantity restraints should not prevent us from recognizing their superior power as a coordinator and motivator.
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