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

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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.