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An Introduction to the Economics of Climate Change Policy

An Introduction to the Economics of Climate Change Policy

Prepared for the Pew Center on Global Climate Change
July 2000

John P. Weyant , Stanford University

Press Release

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Eileen Claussen, President, Pew Center on Global Climate Change

What are the potential costs of cutting greenhouse gas emissions? Can such reductions be achieved without sacrificing economic growth or the standard of living we have come to enjoy? These are important questions, and they come up again and again as the United States and other nations consider what actions are needed in response to climate change.

Many participants in the climate change debate — in government, industry, academia, and non-governmental organizations — have conducted economic assessments to determine the costs of taking various actions to address climate change, with the number of economic assessments increasing exponentially in recent years. Differences among their quality and predicted cost of action, or inaction, have also grown, making it difficult to have faith in any one analysis.

The primary example of varying model results can be seen among the numerous reports predicting the domestic costs of complying with the Kyoto Protocol. Some have concluded the United States can reduce its emissions significantly below its Kyoto target (7 percent below 1990 levels), with net economic savings. Others have predicted dire effects on the U.S. economy. The truth most likely lies somewhere in-between.

Behind each analysis is an economic model with its own set of assumptions, its own definitions of how the economy works, and its own data sets. Unfortunately, these models often seem to be impenetrable "black boxes" allowing only a select few to decipher and interpret their results.

Fortunately, along with the rise in economic modeling there has also been a focus on identifying the differences among models. Professor John Weyant of Stanford University, the author of this report, has been at the forefront of these efforts as Director of the Energy Modeling Forum of Stanford University (EMF). His EMF working group convenes the world’s leading energy and climate modelers to discuss and model current energy policy topics.

In this report, Professor Weyant identifies the five determinants that together explain the majority of differences in modeling cost estimates. This is great news for those engaged in the climate change policy arena who are consumers of economic modeling results. Five key questions can be raised to help policy-makers understand the projected costs of climate change policy: What level of greenhouse gas emissions are projected under current policies? What climate policies are assumed to be put in place to achieve emissions reductions? What assumptions are made about how advances in technology might affect these emissions? To what extent are environmental impacts of climate change included? And is the full set of choices that firms and consumers have when presented with rising energy prices accounted for?

This paper would not have been possible without the assistance of numerous individuals. The author and the Pew Center would like to thank Ev Ehrlich, Judi Greenwald, Larry Goulder, Henry Jacoby, Rich Richels, Dick Goettle, Bill Nordhaus, and Bob Shackelton for their thoughtful comments on previous drafts of this paper.

We acknowledge the use of material from a background paper prepared by Robert Repetto, Duncan Austin and Gwen Parker at World Resources Institute.

Executive Summary

This paper is an introduction to the economics of climate change policy. The goal is to help the reader understand how analysts use computer models to make projections of mitigation costs and climate change impacts, and why projections made by different groups differ. In order to accomplish this goal, the paper will describe five key determinants of greenhouse gas (GHG) mitigation cost estimates.

The paper starts with a discussion of how the economy would adjust to restrictions on GHG emissions, especially carbon dioxide, the dominant, and easiest to measure GHG produced in the United States. Combustion of fossil fuels — oil, gas, and coal — produces large amounts of carbon dioxide. Central to this discussion is the role of energy price increases in providing the incentives for corporations and individuals to reduce their consumption of these fuels.

Energy price increases cause producers to substitute among the inputs they use to make goods and services, and consumers to substitute among the products they buy. Simultaneously, these price increases provide incentives for the development of new technologies that consume less energy in providing the goods and services that people desire. How a model represents these substitution and innovation responses of the economy are important determinants of the economic impacts of restrictions on GHGs.

Three other factors are crucial to economic impact projections.

First, the projected level of baseline GHG emissions (i.e., without any control policies) determines the amount of emissions that must be reduced in order to achieve a particular emissions target. Thus, other things being equal, the higher the level of base case emissions, the greater the economic impacts of achieving a specific emissions target. The level of base case emissions depends, in turn, on how population, economic output, the availability of energy fuels, and technologies are expected to evolve over time without climate change policies.

The second factor is the policy regime considered, i.e., the rules that govern the possible adjustments that the economy might make. International or domestic trading of GHG emissions rights, inter-gas trading among all GHGs, inclusion of tree planting and carbon sequestration as mitigation options, and complementary economic policies (e.g., using carbon tax revenues to reduce the most distortionary taxes in the economy) are all elements of the policy regime. Other things being equal, the more flexibility provided in the policy regime under consideration, the smaller the economic impacts of achieving a particular emissions target.

The third factor is whether the benefits of reducing GHG emissions are explicitly considered. An analyst may subtract such benefits from the mitigation cost projection to get a “net” cost figure or produce a “gross” cost figure that policy-makers can weigh against a benefit estimate. The kind of cost figure produced often depends on whether the analyst is trying to do a cost-benefit analysis or an analysis focused on minimizing the cost of reaching a particular emissions target.

Thus, this paper will describe the major input assumptions and model features to look for in interpreting and comparing the available model-based projections of the costs and benefits of GHG reductions. Two of the five key determinants — (1) substitution, and (2) innovation — are structural features of the economic models used to make emissions projections. The other three determinants are external factors, or assumptions. They are: (3) the base case projections, (4) the policy regime considered, and (5) the extent to which emissions reduction benefits are considered.

The results summarized in this paper illustrate the importance of these five determinants and the large role played by the external factors or assumptions. Cost projections for a given set of assumptions can vary by a factor of two or four across models because of differences in the models’ representation of substitution and innovation processes. However, for an individual model, differences in assumptions about the baseline, policy regime, and emissions reduction benefits can easily lead to a factor of ten or more difference in the cost estimates. Together these five determinants explain the majority of differences in economic modeling results of climate policy.


Press Release: New Studies Highlight Opportunities for Reducing Emissions While Maintaining Economic Growth

For Immediate Release:
May 23, 2000

Contact: Juan Cortinas (202-777-3519)
             Katie Mandes (703-516-4146)

New Studies Highlight Opportunities for China, Brazil and Argentina to Reduce Emissions While Maintaining Economic Growth

WASHINGTON, D.C. — The Pew Center on Global Climate Change released today three new studies that outline realistic opportunities for China, Brazil and Argentina to address the challenge of climate change. The reports are part of a six report series that examines ways to reduce emissions in developing countries without compromising economic growth.

China, Brazil and Argentina are becoming leaders among developing nations in the international climate change debate and the case studies demonstrate the effectiveness of different policy approaches to emission reductions. In the latest reports, the authors use a linear programming model to conduct an assessment of the technological options available to each country for supplying new electric power generation through 2015.

"These reports are particularly noteworthy because of the geographical and economic importance of each nation examined. They highlight the different challenges and circumstances that developing nations face in addressing environmental problems," said Eileen Claussen, President of the Pew Center on Global Climate Change.

The three previous reports released in the series included an overview piece entitled Developing Countries and Global Climate Change: Electric Power Options for Growth and an examination of the electric power sectors of India and Korea.

Following is a brief overview of each report's findings, recommendations and conclusions:


The Developing Countries and Global Climate Change: Electric Power Options in China report was completed by the Beijing Energy Efficiency Center and the Battelle Advanced International Studies Unit. With annual releases of over 918 million metric tons of carbon dioxide into the atmosphere, Chinese decisions affecting energy development and emissions mitigation will significantly impact world climate. The report assesses the current and future state of the power sector to meet projected demand through 2015 under several scenarios

The Chinese analysis yielded several insights:

  • Due to the heavy reliance on coal-fired power generation, baseline carbon dioxide and sulfur dioxide emissions from thermal plants will more than double by 2015.
  • Increasing demand-side energy efficiency by 10 percent could reduce carbon dioxide and sulfur dioxide emissions by 19 and 13 percent, respectively, in 2015, while lowering costs.
  • Expanding the availability of low-cost natural gas through market reforms could reduce emissions of carbon dioxide and sulfur dioxide in the power sector by 14 and 35 percent, respectively, by 2015, and increase costs by only 4 percent compared to the baseline.
  • Accelerating the penetration of cleaner coal technologies could help China reduce sulfur dioxide and particulate emissions, but the associated impact on carbon emissions would be minimal and the cost would increase by 6 percent.


Developing Countries and Global Climate Change: Electric Power Options in Brazil, was developed by the Federal University of Rio de Janeiro, Energy Planning Program, Center for Technology, and the Battelle Advanced International Studies Unit. The study points out that Brazil produces relatively few greenhouse gas emissions relative to its size and population. This is mainly due to the dominant role of hydropower in electricity generation. Yet its greenhouse gas emissions could be expected to quadruple, as it changes its fuel mix over the next 20 years.

The Brazilian case study also revealed that:

  • Many new investors may favor natural gas-fired combined-cycle plants that would increase carbon dioxide emissions from 3.4 million tons in 1995 to 14.5 million tons in 2015.
  • Further tightening of local environmental regulations and adoption of renewable energy policies could reduce carbon dioxide and sulfur dioxide emissions by 82 percent and 75 percent, respectively, by 2015.
  • Creating a carbon-free power sector would require an additional $25 billion in cumulative costs by 2015.


The last report in the series is entitled Developing Countries and Global Climate Change: Electric Power Options in Argentina and was developed by the Bariloche Foundation also working with Battelle. The report finds that the market reforms the country has been implementing since the early 1990's provided mixed, but on balance, positive environmental results. The country's electric power demand is expected to more than triple over the next 15 years, yet its emissions of greenhouse gases, do not have to increase at the same rate. It finds that investments in natural gas combined-cycle plants and renewable energy sources could provide a prudent path for energy development and environmental protection.

The report also found several key opportunities, including:

  • Adopting policies that favor renewable energy sources and nuclear power would cost $32 billion by 2015 and would decrease carbon dioxide emissions from 14 million tons in the baseline to 11 million tons in 2015.
  • Increasing energy efficiency would reduce total costs by $6.3 billion and carbon dioxide, sulfur dioxide and nitrogen oxide emissions would all decline 20 percent compared to the baseline.

A complete copy of each report is available on the Pew Center's web site,

The Pew Center was established in May 1998 by the Pew Charitable Trusts, one of the nation's largest philanthropies and an influential voice in efforts to improve the quality of America's environment. The Pew Center supports businesses in developing marketplace solutions to reduce greenhouse gases, produces analytical reports on the science, economics and policies related to climate change, launches public education efforts, and promotes better understanding of market mechanisms globally. Eileen Claussen, former U.S. Assistant Secretary of State for Oceans and International Environmental and Scientific Affairs, is the President of the Pew Center.

The Pew Center includes the Business Environmental Leadership Council, which is composed of 21 major, largely Fortune 500 corporations all working with the Pew Center to address issues related to climate change. The companies do not contribute financially to the Pew Center - it is solely supported by contributions from charitable foundations.  

Press Release: Climate Change Conference Reveals Innovation and Progress

For Immediate Release :
April 25, 2000

Contact: Katie Mandes (703-516-4146)
             Kelly Sullivan (202-289-5900)

Climate Change Conference Reveals Innovation and Progress Across The Private Sector Worldwide and In Many Governments

WASHINGTON, D.C. — The opening of a two-day international conference today, sponsored by the Pew Center on Global Climate Change and the Chatham House/Royal Institute of International Affairs, served as a showcase for many of the most far-reaching innovations that businesses and governments are undertaking to address the challenge of global climate change.

"In the United States, climate change policies have been hotly debated but little action has been taken," said Eileen Claussen, President of the Pew Center on Global Climate Change. "Fortunately, there is substantial progress being made — by governments abroad, businesses here and around the world and by state and local governments here at home."

To complement the conference, the Pew Center on Global Climate Change also is publishing a special supplement on climate change in tomorrow's Washington Post. Significantly, the piece includes statements by 13 Chief Executive Officers (CEOs) of some of the world's leading companies, all members of the Pew Center on Global Climate Change's Business Environmental Leadership Council (BELC), acknowledging that climate change is a real problem that demands action by the public and private sector.

Among these statements are:

"Enron supports market-based initiatives that create efficient, cost-effective and environmentally sound energy systems," says Dr. Kenneth L. Lay, Chairman and CEO, ENRON. "As a company, we are taking steps to provide the world with clean energy solutions and implementing systems to manage greenhouse gas emissions. Our belief in the synergies between state of the art energy management practices and sound environmental policies have translated into effective pre-construction measures for our new headquarters building, which we expect will save $10 million and reduce greenhouse gas emissions by 34,000,000 lbs (or 17,000 tons) per year."

"Technology and innovation move us forward as people on earth," says George David, Chairman and CEO, United Technologies Corporation. "Environmentally benign fuel cells, built by United Technologies for every American space mission ever, may be the next great innovation to power our cars and our homes. A concerted public and private effort will make huge reductions in global climate change impacts for our nation and our world. All we need is the will."

Additional statements by the following CEOs are included in the supplement:

Göran Lindahl, President and CEO ABB Group, Dr. E. Linn Draper, Jr. Chairman of the Board, President and Chief Executive Officer American Electric Power, Harry M. Jansen Kraemer, Jr. Chairman and Chief Executive Officer Baxter International Inc., Ralph Peterson President and Chief Executive Officer CH2M Hill, Charles O. Holliday Chief Executive Officer DuPont, J. Wayne Leonard Chief Executive Officer, Entergy, Paul A. Yhouse President and CEO Holnam Inc., Robert D. Glynn, Jr. Chairman, CEO and President PG&E Corporation, Tag Taguchi, President, Toyota Motor North America, David R. Whitwam Chairman and CEO Whirlpool Corporation, Steven R. Rogel Chairman, President and CEO Weyerhaeuser Company Profiles.

Also included in the supplement are examples from these corporations highlighting their actions to mitigate climate change. Some examples include:

BP Amoco
BP Amoco believes in adopting a precautionary approach to climate change. BP Amoco intends to reduce its greenhouse gas emissions by 10 percent of 1990 levels by 2010 and has implemented a greenhouse gas emissions trading system across all its businesses to achieve this target cost effectively. Its portfolio of activities includes collaboration in research and policy development, growing its solar business and promoting flexible market instruments.

By 2010 DuPont intends to reduce global carbon equivalent greenhouse gas emissions by 65 percent and hold energy use flat - in both instances using 1990 as a base year. The company also plans to be using renewable resources for ten percent of global energy use by 2010.

Featured speakers at the conference include:

  • John Prescott, Deputy Prime Minister, United Kingdom
  • Jan Pronk, Minister of Housing, Spatial Planning and the Environment, The Netherlands
  • Robert Hill, Minister for the Environment and Heritage, Australia
  • Theodore Roosevelt, IV, Managing Director, Lehman Brothers, Inc.
  • Rodney Chase, Deputy Group Chief Executive, BP Amoco

T he Pew Center was established in May 1998 by the Pew Charitable Trusts, one of the nation's largest philanthropies and an influential voice in efforts to improve the quality of the U.S. environment. The Pew Center is conducting studies, launching public education efforts, promoting climate change solutions globally and working with businesses to develop marketplace solutions to reduce greenhouse gases. The Pew Center is led by Eileen Claussen, the former U.S. Assistant Secretary of State for Oceans and International Environmental and Scientific Affairs.

The Pew Center includes the Business Environmental Leadership Council, which is composed of 21 major, largely Fortune 500 corporations working with the Center to address issues related to climate change. The companies do not contribute financially to the Center, which is solely supported by charitable foundations.

More information on climate change and the Pew Center on Global Climate Change, can be found at

Innovative Policy Solutions to Global Climate Change Conference

Promoted in Energy Efficiency section: 

April 25-26, 2000 - Washington, D.C.

This conference featured high-level speakers presenting innovative policy measures being implemented by industrialized country governments and the private sector. Conference topics were common policy approaches (taxes, trading, negotiated agreements), cross-cutting issues (competitiveness and trade), energy and transportation sector policies, and state and local programs.  A conference summary is available in PDF format.

Featured speeches are available in PDF format:

  • John Prescott, Deputy Prime Minister, United Kingdom
  • Jan Pronk, Minister of Housing, Spatial Planning and the Environment, The Netherlands
  • Robert Hill, Minister for the Environment and Heritage, Australia
  • Theodore Roosevelt, IV, Managing Director, Lehman Brothers, Inc.
  • Rodney Chase, Deputy Group Chief Executive, BP Amoco

Conference Press Release


The conference was co-hosted by the Pew Center on Global Climate Change and the Chatham House / Royal Institute of International Affairs (RIIA), a leading institute for the analysis of international issues, based in London. The Royal Institute of International Affairs (RIIA), also known as Chatham House, is a leading institute for the analysis of international issues. Founded in 1920 in London, RIIA stimulates debate and research on political, business, security, and other key issues in the international arena, such as energy and environmental policy issues, primarily through its research, meetings, conferences, and publications. Visit for more information.

Roundtable Sponsors:

The Developing Country Perspectives Roundtable was co-sponsored by the Pew Center and the Shell Foundation Sustainable Energy Programme. The Sustainable Energy Programme (SEP) is the major grant-making programme of the Shell Foundation, both of which will be formally launching on June 5th, 2000. SEP provides grants to groups working in the public interest on projects that tackle two fundamental energy-related issues: the environmental impact of our dependence on fossil fuels, and the link between energy and poverty in developing countries. More information can be found at

International Emissions Trading & Global Climate Change: Impacts on the Cost of Greenhouse Gas Mitigation

International Emissions Trading & Global Climate Change:  Impacts on the Cost of Greenhouse Gas Mitigation

Prepared for the Pew Center on Global Climate Change
December 1999

Jae Edmonds, Michael J. Scott, Joseph M. Roop, and Christopher N. MacCracken, Battelle, Washington, DC

Press Release

Download Entire Report (pdf)


Eileen Claussen, President, Pew Center on Global Climate Change

Several factors influence the costs of greenhouse gas mitigation. This report illustrates the importance of one such factor—international emissions trading—in reducing the costs of carbon control. The authors find that an international greenhouse gas emissions trading regime will significantly lower global mitigation costs. Specifically, the report finds:

  • The costs of controlling carbon emissions would be significantly lower if trade is permitted than if each country is required to meet its obligations alone.
  • Providing greater flexibility in trading mechanisms—for example, allowing trading among various greenhouse gases and across emissions sources, and allowing trades to occur over time—lowers the costs.
  • Emissions trading reduces the potential for "leakage" of jobs, industry, and emissions compared to a control case with no trading because changes in world fuel prices would be moderated through the availability of trading.
  • While broader participation in trading is likely to yield greater benefits, any amount of trading will lower the costs for those participating. If a climate policy regime is in place that allows emissions trading, all parties—with or without obligations—are better off trading than not.
  • Issues of program design and institutional structure must be addressed carefully to realize the full economic potential of trading regimes.
  • By making transparent the core structure and assumptions of economic models, the Pew Center hopes to provide policy-makers and consumers of economic information with tools to better understand the important assumptions driving the models’ projections of costs.

This report is the first in a series designed to explore how economic models address the climate change issue. The first phase of this effort will make a direct and significant contribution to economic modeling in the following four areas: (1) review of existing models and identification of their key assumptions; (2) investigation of the models’ theoretical frameworks; (3) encouraging best practices in modeling specific aspects of the climate change issue; and (4) integrating innovative modeling practices into a state-of-the-art assessment of the costs of climate change and the policies used to address it.

The second phase of the Pew Center’s economics program will focus on how businesses react to climate change—and policies to ameliorate it—in the context of sound business strategy and practice. The Center is in a unique position to provide insight into the inner working of firms through the participation of our Business Environmental Leadership Council.

The Center and authors appreciate the valuable input of several reviewers of previous drafts of this paper, including Ev Ehrlich, Judi Greenwald, Eric Haites, Elizabeth Malone, and others.

Executive Summary

One of the earliest and most robust findings of economics is that, where relative costs of performing an activity differ among individuals, business firms, or regions, there are almost always potential gains from trade. In today’s jargon, trade can always be win-win. Traditional approaches to addressing environmental problems have generally not taken advantage of this potential. Rather, command and control regulatory policy instruments have been the tools of choice. While these tools can be effective in reaching an environmental goal, they can also be expensive. Recently environmental policy-makers have begun to explore ways of obtaining more environmental benefits per dollar expended, and the use of emissions trading has been on the cutting edge of these efforts. Because climate change is an issue that requires a sustained policy commitment over the course of a century, attention to the cost of policy intervention is especially important. This paper explores the degree to which trade among parties to an international agreement can reduce the cost of greenhouse gas reductions.

International trade holds the potential of reducing costs of controlling world emissions of greenhouse gases (GHGs) because the nations of the world experience very different costs for achieving emissions reductions on their own. However, the potential gains from trade, like the costs of compliance themselves, may be very unevenly distributed across the world’s participants. While all of the parties to an agreement stand to gain collectively under trade in emissions rights as compared with "independent compliance" (i.e., each country meeting its obligations alone), non-participants in the agreement may either benefit or not depending on their own particular circumstances. The detailed rules for trading affect how effective trading could be, as well as the level of gains that would be captured in practice. Details of the trading rules will influence both the total gains from trade and distribution of such gains. Key issues include definitions of the emissions rights to be traded, the rules for crediting carbon sinks, and regulations governing participation in the trading framework. In addition, there are economic uncertainties, such as the behavior of countries that have significant market power in supplying emissions credits, and the transaction costs associated with trading and enforcement. These effects could significantly increase the costs of mitigation compared to the most favorable case and could reduce the amount and benefits of trading.

A number of global economic models have been used to estimate the effects of emissions trading. Empirical results derived from these models can be summarized as follows:

  • Costs of controlling carbon emissions would be significantly lower if trade in carbon emissions allowances were permitted than if each nation had to meet its emissions reduction responsibilities alone. The broader the trade possibilities, the lower the costs of control.
  • All parties with GHG emissions mitigation obligations benefit from trade. Both permit buyers and permit sellers will benefit.
  • Parties without obligations may be better or worse off under a trading regime relative to a regime that does not allow trading. However, given a regime that allows trading among parties with obligations, parties without obligations will be better off trading (i.e., selling emissions reductions) than not trading.
  • Because the costs of fuels could be affected by emissions control and emissions trading, countries and regions may be affected whether or not they participate in emissions reduction and in emissions trading. Parties without obligations may be either better off or worse off after obligations are established for others. For example, if emissions trading is prohibited, the prices paid to fossil fuel producers are reduced, and the energy-exporting countries are worse off relative to a no-control case. Emissions trading mitigates this effect. Results for other non-participating regions are more ambiguous.
  • Gains from trade are sensitive to the difference between the base case and target emissions and to the difference in marginal (incremental) abatement costs among countries. For any limit to emissions, the higher the future level of emissions is expected to be without intervention, the more difficult and costly mitigation is expected to be. Although the gains from trade depend on the differences between countries’ marginal abatement costs, not their absolute level, the analysis in this paper shows that the gains from trade are larger for more ambitious emissions targets.
  • The actual cost savings from trade in emissions are likely to be less than the theoretical savings shown in most analyses performed with integrated assessment models because these models do not include the various measurement, verification, trading, and enforcement costs that would characterize any real trading system. Programs must be carefully designed to assure that the potential gains from trade are realized.
Christopher N. MacCracken
Jae Edmonds
Joseph M. Roop
Michael J. Scott

Early Action Conference

Promoted in Energy Efficiency section: 

Early Action Conference

The Pew Center on Global Climate Change, in cooperation with The H. John Heinz III Center for Science, Economics and the Environment, held a conference to explore the subject of credit for early action. The conference featured a keynote address by DuPont Executive Vice President and Chief Operating Officer, Dennis H. Reilley, announcing the company's rigorous new greenhouse gas reduction targets. Another conference highlight was luncheon speaker Robert Luft, Chairman of Entergy Corp., speaking on the importance of an early action crediting program in the United States to facilitate reductions in greenhouse gas emissions.

The conference offered an overview of the early action issue from the perspectives of various industry sectors (including oil and gas, and manufacturing), electric utility, Congressional staff, state and city government; a review of current proposals; and roundtable discussions of the legal, policy, and technical issues that confront the architects of early action programs. Valuable participation by the audience contributed to a balanced and well-informed discussion.

Keynote Address by Dennis H. Reilley
Executive Vice President and Chief Operating Officer, DuPont

DuPont Announcement Press Release

Luncheon Speech by Robert Luft
Chairman, Entergy Corp.

Pew Center Early Action Report

Economics and Integrated Assessment of Climate Change Workshop

Promoted in Energy Efficiency section: 

July 21-22, 1999
The Westin Hotel, Washington, DC

List of Attendees (pdf)

On July 21-22, 1999, the Pew Center on Global Climate Change held a Workshop on the Economics and Integrated Assessment of Climate Change. This workshop brought together leading economists, scientists, and others interested in climate change economics and policy. The purpose of the workshop was to examine the complex interactions between the climate change problem and the economy, focusing in particular on the integrated assessment modeling of climate change.

Market Mechanisms & Global Climate Change

Market Mechanisms & Global Climate Change

Annie Petsonk, Daniel J. Dudek and Joseph Goffman, Environmental Defense Fund,
in cooperation with the Pew Center on Global Climate Change.

Download Entire Report (pdf)


Eileen Claussen, Executive Director, Pew Center on Global Climate Change
There is growing evidence that providing businesses and consumers with market-based mechanisms for addressing environmental problems can achieve equal or better compliance while reducing costs and spurring technological innovation. In the context of climate change, countries have agreed to use several market-based mechanisms in implementing greenhouse gas emissions reductions-from emissions trading similar to that used in the United States to reduce sulfur dioxide emissions to more experimental measures such as joint implementation and the Clean Development Mechanism.

This report, which analyzes market-based environmental policy instruments, is the third in a series by the Center. The Pew Center was established in 1998 by the Pew Charitable Trusts, one of the nation's largest philanthropies and an influential voice in efforts to improve the quality of America's environment. The Center brings a new cooperative approach and critical scientific, economic and technological expertise to the global climate change debate. The report was prepared as an input for the participants of two international conferences designed to promote a trans-Atlantic dialogue on market-based instruments and their use in mitigating global climate change. Recognizing the critical role of business in both shaping and applying market-based mechanisms, the Pew Center is working to bring businesses from both the United States and Europe together to discuss ways to do so.

The report reviews U.S. and European experience with market-based mechanisms and the ways the Kyoto Protocol on Climate Change utilizes these mechanisms. The report finds that properly designed rules for the operation of these mechanisms can provide economic and environmental integrity and signal to business and governments that any trades undertaken in accordance with the system will be valid and of value. Key elements to the success of such a system will be measurement, transparency, accountability, fungibility and consistency.

The Pew Center and its Business Environmental Leadership Council believe that climate change is serious business. Implementing emissions trading and other market-based mechanisms will be part of a serious response to the climate change problem.

Executive Summary

This paper has been developed with a view toward promoting trans-Atlantic dialogues on market mechanisms for environmental protection. While the overarching topic for dialogue is the full panoply of environmental problems for which market mechanisms may be considered, this paper is prepared in the context of increasing global attention to the problem of climate change. The November 1998 Buenos Aires Conference of the Parties to the United Nations Framework Convention on Climate Change provides an example of the international focus on market mechanisms among governments, the private sector, and non-governmental organizations around the world.

This paper reviews market mechanisms for environmental protection, with special focus on emissions trading. Emissions trading programs place an overall limit on the amount of emissions that sources may emit, and then allow sources a degree of flexibility to determine where, when, and how to meet their total limits. Emissions trading programs provide this flexibility by allocating to sources a fixed amount of emissions allowances; any source that reduces emissions below allowable levels may save the resulting allowance increment to offset future emissions, or sell the increment to another source who may add the increment to its allowances. Compliance is determined solely by comparing actual emissions to allowable amounts.

The paper notes that five elements are essential for providing environmental and economic integrity in such programs: measurement, transparency, accountability, fungibility, and consistency. In reviewing the experiences of the U.S., New Zealand, and Europe, the paper finds that harnessing the competitive forces of the market-place in favor of pollution reduction can enable governments, industries, and non-governmental organizations (NGOs) to reach political consensus about pollution limits. Experience also indicates that when these elements are firmly in place, emissions trading programs can deliver powerful incentives to sources to innovate to develop more environmentally effective and more cost-effective ways of reducing emissions. Trading programs premised on these elements can achieve faster, deeper cuts in pollution, at far less cost than other regulatory instruments.

The 1997 Kyoto Protocol on Climate Change seeks to use market mechanisms to limit the emissions of greenhouse gases (GHGs) that are contributing to changes in the global climate. The paper examines the Kyoto Protocol framework for an innovative international market in GHG emissions reductions. The Protocol places a legally binding limit on the allowable amount of GHG emissions from most industrialized countries for the period 2008-2012. It then affords these nations the opportunity to trade allowable amounts of emissions, either directly or in conjunction with joint emissions reduction projects. It further allows these nations to implement their obligations collectively, through shared arrangements known as "bubbles" or "umbrellas."And the Protocol invites the participation of nations that have not adopted a legally binding GHG limit: it allows a limited form of trading between nations with limits and those without, where the trading involves emissions reductions obtained through cooperative projects in the latter group of nations.

The paper notes that the Kyoto Protocol respects the sovereignty of each participating nation to determine how best to implement its international obligations at the domestic level, and whether, in so doing, it should allow its private sector to participate in the international emissions trading market. The Protocol leaves open the development of internationally agreed rules to provide the transparency, the accountability, and-particularly in the case of trading with nations lacking limits on GHG emissions-the measurability that may be key to the Protocol's success. Further, the Protocol allows each nation that adopts emissions limits to decide whether to initiate programs prior to 2008 that will provide recognition and incentives for early actions to reduce emissions. The Protocol does not address the question of whether nations will, individually or collectively, place quantitative or qualitative restrictions on emissions trading.

After exploring the theory of market mechanisms, examining their implementation in selected cases, and analyzing the market elements of the Kyoto Protocol, the paper draws on lessons learned from practical experience in order to identify and evaluate options on the questions left open by the Protocol. The paper indicates that for environmental and economic effectiveness, experience weighs in favor of a limited set of rules-carefully drawn to foster measurement, transparency, accountability, fungibility, and consistency-and weighs against imposing further restrictions on the market mechanisms.

This paper includes a compilation and synthesis drawn from the sources and materials listed in Appendix I. The authors, Annie Petsonk, Daniel J. Dudek, and Joseph Goffman, are, respectively, International Counsel, Senior Economist, and Senior Attorney with the Environmental Defense Fund. The authors wish to acknowledge the insights gleaned from conversations with Christoph Bals, Marianne Ginsburg, Anke Herold, Jos Cozijnsen, Jennifer Morgan, Sascha Müller-Kraenner, Hermann Ott, John Schmitz, and Jonathan Wiener. Any errors or omissions are solely the responsibility of the authors.

This report was one input into two conferences on market-based mechanisms, which were held on 23 and 27 October, 1998, in Bonn and Paris. The conferences provided an important forum in which participants, including representatives of businesses, non-governmental organizations, and governments, shared practical experience about the use of market mechanisms, and provided valuable insights about the trans-Atlantic context for consideration of the report's findings.

Annie Petsonk
Daniel J. Dudek
Joseph Goffman
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