International markets for greenhouse gas emission reduction policies—possibilities for integrating developing countries

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Energy Policy 33 (2005) 2313–2325 www.elsevier.com/locate/enpol

International markets for greenhouse gas emission reduction policies—possibilities for integrating developing countries Kirsten Halsnæs, Anne Olhoff UNEP Risoe Centre, Building 142, Box 49, 4000 Roskilde, Denmark

Abstract Greenhouse gas (GHG) emissions are affecting a global common: the climate, and as a global environmental problem with a public good character it provides attractive opportunities for minimising control costs through the use of emission trading markets. This paper introduces cost and benefit principles that can be applied to the assessment of global markets for GHG emission reduction options and evaluates the scope for and the potential economic gains of such markets. r 2004 Elsevier Ltd. All rights reserved. Keywords: GHG emission reduction; Costs and benefits; Developing countries

1. Introduction The international climate change cooperation based on the United Nations Framework Convention on Climate Change, UNFCCC, and the Kyoto Protocol includes a number of policy implementation mechanisms that can be used for considering how Greenhouse gas (GHG) emission trading markets potentially can work. However, the current international climate change agreements are limited in scope and in the number of participating countries, and therefore the agreements only offer some partial and limited experiences on how global market mechanisms for GHG emission reduction policies might work if more complete and far going international climate change policies were agreed on in the future. In this paper, special attention is given to the assessment of direct and indirect costs and benefits of implementing GHG emission reduction policies in developing countries. These countries are expected to be major future contributors to global GHG emissions, Corresponding author. Tel.: +45-46-77-51-12; fax: +45-46-32-19-

99. E-mail address: [email protected] (K. Halsnæs). 0301-4215/$ - see front matter r 2004 Elsevier Ltd. All rights reserved. doi:10.1016/j.enpol.2004.04.023

and cost effective international policies consequently require the participation of developing countries. The preliminary results of international studies furthermore suggest that there may be several synergies between development policies and GHG emission reduction that can make it attractive for developing countries to participate in climate change policies. Based on these results, the paper concludes that there is a potential for expanding future international markets for GHG emission reduction options, if the markets facilitate international financial cooperation about policies that both mitigate the global climate and support broader economic, social, and environmental development goals.

2. Climate change as a global pollution control problem Climate change exhibits a number of special characteristics as a global pollution control problem. The climate is a public good, as there is no rivalry in consumption, and consumers cannot be excluded. At the same time, the contribution of individual countries to climate change through GHG emissions does not have a significant impact on the climate, implying that only

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globally coordinated efforts will result in significant gains in the form of avoided climate change. It has been very difficult to establish an international agreement about climate change for various reasons. Climate change is characterised by large uncertainties, time lags, and large differences in costs and benefits around the world. Furthermore, climate change impacts a number of goods that are difficult to value, including ecosystem changes, biodiversity, and human life, and it has not been possible to establish meaningful and reliable economic estimates of climate change damages.1 International climate change agreements including the UNFCCC (1992) and the Kyoto Protocol (1997), therefore represent relatively small and preliminary policy agreements. However, the agreements include quantitative targets for GHG emission reductions to be implemented by industrialised countries and a number of policy mechanisms that facilitate global cost effectiveness. In the Kyoto protocol, these mechanisms include emission trading and project-based cooperation between industrialised countries and developing countries. A complicating factor in climate change policy is the fact that GHG emission reduction policies2 often interfere with more general economic structures and markets through changes in prices or taxes, implying that the policies cannot be seen as isolated marginal technical pollution control efforts. In many cases, GHG emission reduction policies also have a number of significant indirect impacts on other economic and environmental goods in addition to their direct impacts on climate change. Examples of such indirect impacts include employment generation, income distribution, and local and regional air pollution. The indirect economic and environmental impacts of GHG emission reduction policies emerge, because the control measures imply non-marginal changes to the major GHG emission sources and the economy. Consider, for example, a coal-based power production system. Substituting the coal with natural gas as a GHG emission reduction measure, will imply improved local air quality in addition to the primary policy objective, but may also decrease employment in the coal-mining sector to be considered as a loss to the stakeholders involved. Another example is the introduction of more efficient electrical industrial motors in industry. Depending on the source of power supply, this policy will reduce GHG emissions directly, and may have indirect impacts in the form of reduced energy costs of industry, 1 The assessment of costs and benefits of GHG emission reduction policies in this paper excludes the economic benefits of avoided climate change due to these difficulties. 2 The terminology GHG emission reduction options are used throughout the paper as a synonym for reduction and sequestration policies.

increased profits and employment, and reduced local air pollution from the power production. In principle, the marginal costs of GHG emission reduction policies should include an assessment of all direct and indirect costs and benefits to reflect the social costs of the policies. A number of international studies have made an attempt to develop and apply a methodological framework for assessing social cost aspects of GHG emission reduction policies. In particular, the assessment of indirect health impacts of GHG emission reduction policies has been covered in a number of studies. A review of a range of these studies by IPCC (2001), concludes that in particular studies for developing countries exhibit large potential synergies between GHG emission reduction studies and health benefits from improved local air quality. The existence of such synergies between GHG emission reduction and local air pollution control imply that social cost estimates including direct as well as indirect impacts of GHG emission reduction policies most often suggest a lower cost per unit of GHG emission reduction than estimates only including the direct costs. Given that there is some sort of an upper price ceiling for the costs that society is willing to pay for avoided climate change impacts and thereby GHG emission reduction, a lower estimate of GHG emission reduction costs will tend to expand the scope for international reduction policies. It should, however, be recognised that this does not imply that that policy options introduced primarily with the aim to curb local air pollution similarly offers large synergies in the form of GHG emission reductions (IPCC, 2001 Chapters 7 and 8, Eskeland and Xie, 1998). This is the case because local air pollution like for example urban SO2, NOx, and particulate matter emissions in many cases can be controlled by technical cleaning systems that only control the specific pollution and at the same time have lower cost than policy options that jointly reduce GHG emissions and local pollutants.

3. The economic principles of emission trading The guiding principle underlying emission trading systems is that markets are used to facilitate globally cost effective pollution control through the equalisation of marginal emission reduction costs across all reduction options. Climate change is a special pollution control case, since the damage in term of climate change is independent of the location of the GHG emission sources, and emission reduction costs therefore in a very simple way can be minimised through international mechanisms that facilitate offsets between all emission sources. The basic idea behind international emission reduction markets is that global cost effectiveness implies that

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all countries implement GHG emission reduction requirements domestically as long as their marginal cost of reduction is below the international market price of reduction. When domestic reduction prices are higher than this ceiling, the country can reduce its costs by buying GHG emission reduction options at international markets. The following Fig. 1 illustrates total global demand and supply curves for GHG emission reduction options, which can be generated based on horizontal summations of individual countries demand and supply curves. The figure includes two sets of demand and supply curves illustrating a direct cost basis versus a social costs basis. Fig. 1 illustrates the global demand for GHG emission reductions and the corresponding global supply in four alternative cases, reflecting different combinations of marginal supply and demand cost assumptions and specific quantitative targets that individual countries are committed to by international agreements. It is illustrated that the scope for international GHG emission reduction option markets varies with the cost concept underlying global demand and supply. A global market that is based on social costs of GHG emission reductions on the demand side of the market, like D2, and direct costs on the supply side of the market, like S1, will result in a relatively small quantity Q1 traded at the global market price pD2S1. This is the case since countries with a reduction commitment will implement relatively large quantities domestically, because they include indirect national benefits in their reduction cost basis. In this case,

S1

Reduction price

S2 pD1S1 pD2S1 pD1S2 pD2S2 D1 D2

Q1

Q2 Q3 Q4 Emission reduction

Fig. 1. Schematic representation of global GHG emission reduction markets based on direct costs and social costs, where D1 and D2 are the demand for GHG emission reductions based on, respectively, direct costs and social costs, and S1 and S2 are the supply of GHG emission reduction based on, respectively, direct costs and social costs.

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supply countries do not include such indirect benefits and will therefore supply GHG emission reduction options at a relatively high marginal cost. The picture is reversed if the demand side of the market bases its behaviour on direct costs only, and the supply side is based on social costs. In this case, a large emission quantity Q4 is traded on the international markets. The differences between global carbon prices in the four different case examples included in Fig. 1 depend on the slopes of the different demand and supply curves. The only general conclusion that can be drawn is that in a pair wise comparison of the demand and the supply side of the market, the global carbon prices will be lower when buyers base their demand on social costs rather than on direct costs, while the opposite will be the case when sellers base their supply on direct costs rather than social costs. The international literature includes a number of studies that have made an attempt at estimating the social costs of GHG emission reduction policies. A particular group of studies have focused on integrated studies of GHG emission reduction and health impacts arriving from reduced air local pollution (OECD, 2000; IPCC, 2001, Chapter 8). These studies predominantly include a number of energy sector studies for individual countries or urban areas, but relatively few general macroeconomic studies. There is therefore not yet a basis for establishing proper conclusions on how major social cost components can be integrated in global energy-economic models. Consequently, most international economic studies of GHG emission reduction costs are based on global energy-economic models that do not include all relevant social costing issues. These models do include investment costs and a number of general equilibrium impacts arriving from requiring relatively large capital flows to the energy sector in order to introduce low carbon emission technologies, but do not include synergies with other environmental policies and a number of other aspects that can be considered as social cost elements. IPCC (2001), chapters 7 and 8, include a review of the cost estimates provided by different modelling studies and additionally consider the consequences of including a broader set of impacts in the models. It is concluded that emerging research on indirect benefits of climate change policies suggests that the inclusion of these benefits tend to reduce the GHG emission reduction cost estimates. The implications of such reduced GHG emission reduction costs on global markets will subsequently be discussed in more detail in this paper based on empirical studies on direct costs and social costs and conclusions regarding the market scope and the distribution of costs and benefits will be drawn.

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4. Scope of international markets for GHG emission reductions The following section introduces alternative scenarios for international GHG emission reduction efforts that are consistent with climate change policy targets and considers the structure of international GHG emission markets, as these might emerge based on the Kyoto Protocol and subsequent more far going climate change policy agreements. 4.1. Long-term GHG emission trajectories and stabilisation targets International markets for GHG emission reduction options must be seen in the context of long-term climate change mitigation efforts that may be agreed on and implemented by the international community in the future. The Kyoto Protocol includes quantitative limits for GHG emission sources and sinks, but is only a small and very limited step in implementing the ultimate goal of the UNFCCC. The ultimate goal of the UNFCCC is in its Article 2 stated as ‘‘stabilisation of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system.’’ (UNFCCC, 1992, Article 2). Despite that the UNFCCC does not include any further specification of what ‘‘dangerous interference’’ with the climate system means, it must be expected that future climate negotiations will try to arrive at more far going long term GHG emission reduction targets, and the expectations about these targets are very important to the assessment of the scope of future GHG emission reduction markets. The international literature includes a number of scenario studies on the relationship between GHG emission patterns over the 21. Century, atmospheric concentration levels, and climate change impacts, which can be used as a basis for considering climate change policy goals and future emission reduction markets (IPCC, 2002; IPCC, 2001, Chapter 2). The studies include numerous combinations of scenarios for GHG emissions and climate change impacts, which taken together can be said to provide relevant information about the costs and benefits of international climate change agreements. It is beyond the scope of this paper to assess the full range of this wide scenario literature. Instead, the focus is on the assessment of a few examples of GHG emission scenario studies that are consistent with a stabilisation of GHG concentrations levels at 550 ppmv. This stabilisation level is by many authors considered to be a central estimate of climate change impacts and mitigation costs.3 3

IPCC (2002), Synthesis Report Question 6.

A large number of international energy-economic modellers have produced scenarios that assess the global GHG emission reduction efforts required over the next century in order to achieve a stabilisation of global GHG concentrations at 550 ppmv. The results of this assessment by one of the international modelling teams, the Message model by IIASA (Nakicenovic et al., 1998), will be briefly summarised in the following in order to highlight a number of key conclusions on potential synergies and trade-offs between alternative economic development patterns and the efforts required to achieve a goal of atmospheric stabilisation og GHG emission concentrations at 550 ppmv. The Message IPCC SRES work includes a study of how alternative assumptions on future technological change in low-carbon emitting energy technologies will influence GHG emission trajectories and the reduction policies required to meet a global stabilisation target of 550 ppmv (Morita et al., 2000). Despite the fact that all scenarios assume that the alternative technological development assumptions in the energy sector by definition exclude the consequences of dedicated climate change policy efforts, the assumptions reflect consequences of values given to green lifestyles and environmental policies. Some of the scenarios e.g. assume a fast technological development in renewable energy options and such a case is based on rather restrictive environmental policies in other areas than climate change. When these scenarios are used as reference cases for GHG emission reduction studies, climate change appears as an ancillary benefit to other environmental policy priorities. The Message study includes three different scenarios that are constructed based on uniform IPCC SRES A1 scenario family assumptions,4 but with different assumptions about technological change. The A1F1 case assumes that the energy system will be dominated by carbon intensive fossil fuel energy sources, the A1T case is based on optimistic assumptions about the availability of renewable energy technologies without carbon emissions, and the A1B scenario case finally balances the assumptions of the A1F1 and the A1T case. The following Fig. 2 shows GHG emission reference cases and emission profiles corresponding to stabilisation levels of 550 ppmv for the alternative scenario cases. The different global Message model GHG emission projections shown in Fig. 2 demonstrate the very large range of global GHG emission scenarios that arrive from different assumptions about technological development and underlying general environmental policy priorities. In particular, in the longer time horizon period from 2040 to 2100 there is a very large variation 4 The IPCC A1 scenario assumptions include high economic growth rates, low population growth, globalisation of markets, fast technological change and low priority of environmental goods and services.

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energy intensity and fast development of renewable energy options.

Bill. t. C

A1B 30

A1F1

25

A1B 550

2317

A1T

4.2. Regional structures of global GHG emission sources

A1F1550 A1T 550

20 15 10 5 0 1990

2000

2010

2020

2030

2040

2050

2070

2100

Year

Fig. 2. Global GHG emission projections for 1990 to 2100 based on three alternative sets of assumptions about the development of lowcarbon emitting energy technologies developed by the MESSAGE model.

between the high emission reference case A1F1, with global GHG emissions of as much as about 33 bill. t. C in 2100, to the A1B case with global emission of about 14 bill. t. C in 2100, and down to the A1T case with only about 5 bill. t. C. in 2100. The corresponding GHG emission reduction efforts that are required to achieve an atmospheric GHG stabilisation level of 550 ppmv given these scenarios vary from being about 9 bill. t. C in 2050 and about 27 bill. t. C in 2100 in the A1F1 case, to about 4 bill. t. C in 2050 and about 9 bill. t. C in 2100 in the A1B case, and finally only about 0.25 bill. t. C in 2050 and about 0.03 bill. t. C in 2100 in the A1 T case. Except in the A1T case, where already in the reference scenario it is assumed that GHG emission will decrease significantly without the introduction of climate change policy efforts, the Message study demonstrates that very large future GHG emission reduction efforts will be required to establish stabilisation levels at 550 ppmv atmospheric GHG levels if a fast technological development in renewable energy is not initiated with high priorities to environmental policies. A lesson that can be taught from the Message study is that alternative assumptions about economic growth patterns and the corresponding environmental policy priorities in the reference case scenarios have large influences on GHG emissions and the efforts that are required to meet specific climate change policy goals. This result, on one hand, suggests that climate change policies seem to be highly influenced by general economic development patterns and environmental policies beyond climate change. An important policy conclusion arriving from this is that climate change mitigation policies need to be less far going in terms of reduction requirements to meet specific stabilisation goals, if the policies are embedded in other policies implying economic development patterns with low-

The close interrelationship between economic development patterns and climate change, suggested by the Message study, is further emphasised when the regional structure of global GHG emission sources is studied in more detail. Over the next century large growth in GHG emissions is expected to take place in developing countries as a consequence of economic development and energy system investments. Already within the next 15–20 years, developing countries together will emit more GHGs than industrialised countries (IPCC, 2001, Table 1.1). There are of course major uncertainties related to making such GHG emission growth projections, since they rely on a lot of background assumptions about economic development, energy consumption, and land-use structure. However, the tendency of developing countries to get a larger share of global GHG emissions is difficult to ignore, due to the present very low levels of energy consumption and the high global population share in this group of countries. The high future share of developing countries’ emissions in global GHG emissions will be in contrast to past GHG emissions, where the fast development in industrialised countries over the last 100 years has been the major contributor to the emerging climate change.5 The following Table 1 shows a regional projection of CO2 emissions6 from 1990 to 2020. The total global CO2 emissions, as shown in Table 1, are projected to grow from around 5.8 bill t. C in 1990 to 9.8 bill t. C in 2020, corresponding to an annual average growth of 2.1% from 1996 to 2020. Total developed countries, Eastern Europe and the Former Soviet Union contributed about 70% of the CO2 emissions in 1990, but their share is projected to decrease to being about 50% of the global total in 2020. Developing countries, in particular Central- and South America, are expected to have high future growth in CO2 emissions with annual growth rates over the period of as much as 4.8%. Developing Asia is projected to have annual average CO2 growth rates between 3.2% and 3.9%, while Africa and the Middle East are assumed to have a somewhat slower growth in CO2 emissions amounting to, respectively, 2.1% and 2.8% per year in average from 1996 to 2020. One consequence of this structural change is that in the future significant reductions in GHG emissions 5 Climate change is characterised by long time lags, where some GHGs as for example CO2 have an atmospheric lifetime of up to 100 years. 6 CO2 emissions contributed 68 % of total GHG emissions in 2000 (own calculations based on IPCC, 2000).

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Table 1 Global and regional CO2 emission projections from 1990 to 2020 1990

1996

2000

2010

2020

Annual % change 1996–2020

North America USA Canada Western Europe Industrialised Asia Japan Austrailasia Total developed

1550 1346 126 936 364 274 90 2850

1687 1463 140 904 389 291 99 2980

1833 1585 151 947 377 273 103 3157

2079 1790 162 1021 435 322 113 3535

2314 1975 182 1114 479 358 122 3907

1.3 1.3 1.1 0.9 0.9 0.9 0.9 1.1

Former SU Eastern Europe Total FSU/EE Developing Asia China India Middle East Africa Central and South America Total developing World

991 299 1290 1065 620 153 229 178 174 1646 5786

613 228 842 1474 805 230 283 198 206 2161 5983

583 243 827 1659 930 273 323 214 251 2447 6430

666 270 935 2426 1391 386 434 270 418 3547 8018

746 277 1024 3377 2031 494 555 325 629 4886 9817

0.8 0.8 0.8 3.5 3.9 3.2 2.8 2.1 4.8 3.5 2.1

Source: IPCC (2001) Table 1.1, p. 97.

can only be achieved with some degree of GHG emission reduction policies implemented both in industrialised countries and in developing countries. The establishment of international markets for GHG emission reductions is one way of facilitating international collaboration about climate change policies and the following section discusses how the Flexibility Mechanisms of the Kyoto Protocol can facilitate the establishment of such policies in a short-term perspective. 4.3. The Kyoto Protocol as a framework for international GHG emission markets The short-term markets for international trading in GHG emissions are shaped by the reduction commitments constituted by the Kyoto Protocol and the potential GHG emission reduction options that can be supplied by different groups of countries. Given the structure of the Kyoto Protocol, GHG emission reduction options that can be used by countries with a reduction commitment7 include domestic options, options that are implemented in other countries with a reduction commitment, and options implemented in 7

Countries with a reduction commitment are termed Annex I countries in the Kyoto Protocol, and countries without such commitments are termed Non-Annex I countries. The Annex I countries of the Protocol is the group of industrialised countries— see a specific list of countries in the Annex of the protocol (UNFCCC, 1997).

countries without a reduction commitment.8 The upper boundary of the supply of the GHG emission reduction options obviously is set by the total GHG emissions of the countries. The Kyoto Protocol includes GHG emission reduction commitments for industrialised countries. The targets are defined as maximum average annual quantities of GHG emissions that must not be exceeded in the Kyoto budget period from 2008 to 2012. The emission target levels are defined in relation to 1990 base year emission levels. On average, all the GHG emissions of industrialised countries should be 5.2% below the 1990 level in 2008–2012 according to the protocol.9 There is a wide variety in the specific GHG emission reduction commitments that countries are assigned to in the Kyoto Protocol. The following Table 2 shows alternative projections for the GHG emission reduction quantities that industrialised countries have to implement in order to meet the Kyoto targets. The projections of GHG emission reductions required in industrialised countries to meet the Kyoto Protocol targets as shown in Table 2, exhibit a large variation in 8 The Kyoto Protocol includes three so-called flexibility mechanisms that can be used to offset GHG emission reduction commitments across countries namely; emission trading between Annex I countries, Joint Implementation projects between Annex I countries, and Clean Development Mechanism projects between Annex I and Non-Annex I countries. 9 Including all Annex I countries that have signed the Protocol.

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Table 2 Alternative forecasts of GHG emission reductions required to meet the Kyoto Protocola 1990 level GHG emissions in mill.t. Cb

Reduction requirements to meet Kyoto targets measured in relation to 2010 emission levels ( mill.t. C) Based on national communicationsb

Western Europe Japan Australia New Zealand Canada Norway Iceland Switzerland United States Eastern Europe Former Soviet Union Total without excess emissions Total emissions without excess emissions and without USA

1159.5 337.2 113.3 19.8 163.0 15.0 0.8 14.6 1634.4 368.4 1113.5

30.5 71.2 21.7 22.9 29.2 2.1 0.1 1.1 423.9 15.8 80.5 618.5 194.1

MITc

Energy information administrationd

307 144 171

192.5 91.7 93.6

572 118 111 1312 740

594.7 322.8 972.5 377.8

a

The Kyoto Protocol includes targets for six GHGs. Based on national communications to the climate secretariat (Halsnæs, 2002a, b). c Based on Ellermann and Decaux (1998). d Based on Jotzo and Michaelowa (2002). b

the actual country specific emission reduction requirements. A country like the USA will have to implement relatively large GHG emission reductions in 2010 in the order of magnitude of 25–35% of 1990 GHG emission levels to meet the Protocol. Other countries with a relatively large reduction commitment are Japan, Australia, and Canada who will have to implement GHG emissions reductions of about 20–25% measured in relation to 1990 levels. The high levels of emission reductions required for these countries reflect that a fast growth in GHG emissions is expected from 1990 to the time of the Kyoto budget period, 2008–2012, and is not a consequence of particularly high country specific Kyoto reduction targets.10 The GHG emission reduction requirements shown in Table 2 look very different in the three forecasts presented for Western European countries and a major reason for this difference is that the modelling study by MIT and the forecast by the Energy Administration Information do not include GHG emission reduction policies implemented in Europe after 1990, while the national communication based study includes such options. Consequently, the estimate that is based on official national communications by the countries projects a very small GHG emission requirement in 2010 for Western European countries of only about 30 mill.t. C or 3% of 1990 emission levels, while the two 10

USA, Japan, Australia, and Canada have Kyoto targets of budget period 2008–2012 emissions to be respectively 7%, 6%, 8%, and 6% below 1990 levels.

model-based forecasts come up with 6–10 times higher forecasts. Despite these basic differences in the approaches that have been used to generate the three forecasts shown in Table 2, all of them expect that Western European GHG emission reduction efforts to meet Kyoto will be relatively small compared with countries like the USA. Eastern European Countries as a group will have to implement rather small GHG emission reductions to meet the Kyoto Protocol and like the Former Soviet Union has excess emissions, since the Kyoto target goals for some countries are below expected baseline GHG emission trends. In general, the total GHG emission reduction requirements that will be needed to meet the Kyoto Protocol seem to be small compared with the total expected global GHG emissions as previously illustrated in Table 1, and the scope for GHG emission markets and project based mechanisms like JI and CDM is therefore limited in this first step of international climate change agreements. As shown in Table 2, the emission reduction requirements to meet the Kyoto Protocol, excluding USA and Australia that have withdrawn from the Protocol, are only projected to be between about 200 mill.t. C and 700 mill.t. in 2008–2012. 4.4. Conclusions Through its flexibility mechanisms, the Kyoto Protocol has initiated the development of an international market for GHG emission reduction options. However,

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this market is rather small of size and scope compared with the reduction efforts that will be needed to achieve climate policy goals like the stabilisation of atmospheric GHG concentrations at 550 ppmv. Despite the fact that climate change in the next century will arise primarily from past emissions from industrialised countries, developing countries will have to be integrated in international GHG emission reduction policies, if these are to be effective and sustainable in a longer-term perspective. This is the case because developing countries will contribute an increasing share of future GHG emissions and since globally cost effective mitigation policies will require a coordination of actions across all countries. International GHG emission reduction markets are one instrument for achieving such gains and the extent and economic consequences of such markets will be examined in more detail in the following section.

5. Marginal emission reduction costs in different parts of the world The basic principles behind global cost effectiveness gains of international GHG emission trading mechanisms were introduced previously. The actual market structure and the associated gains depend on the allocation of GHG emissions and reduction costs in different parts of the world. In order to get more insights into how an international GHG emission reduction option market may work, the following section includes a detailed discussion of such a market mechanism, based on data provided by an international study of marginal costs of CO2 emission reduction in the energy sector.11 The study that is used is the MIT EPPA model study, which includes data on marginal GHG emission reduction costs for 12 regions and countries (Ellerman and Decaux, 1998). The EPPA model is a multisectoral CGE model with five vintages of capital and the carbon reduction costs calculated in the model reflect the costs of substituting investments with more expensive energy sector investments and technology use with lower carbon emissions. The EPPA model cost estimates include the costs of allocating increasing investments to the energy sector to meet GHG emission reduction targets, but do not include indirect impacts on these energy sector policies on local pollution. The cost data of the EPPA model has been used to calculate marginal costs of emission reduction (MAC) curves for 2010 as shown in Fig. 3, where emission 11 A number of international energy-economic models have generated cost estimates for GHG emission reduction policies in the energy sector and studied the costs of meting Kyoto targets as well as more far going stabilisation targets (Weyant, 1999; The Energy Journal, IPCC, 2001, Chapter 8).

USA

3000

JPN EEC

2500

OOE EET

Costs $ per t. C

2320

FSU

2000

EEX CHN

1500

IND DAE ROW

1000

BRA

500

0 0

100

200

300

400

500

600

700

800

900

1000

Emission Reduction mill. t.C

Fig. 3. Marginal costs of CO2 emission reductions in 2010 based on the EPPA model. Data is in 1998 prices for USA, Japan (JPN), EEC, the rest of the OECD (OOE), Eastern Europe (EET), Former Soviet Union (FSU), Energy Exporting Countries (EEX), China (CHN), India (IND), Dynamic Asian Countries (DAE), and the Rest of the World (ROW).

reduction quantities are depicted on the x-axis and the marginal costs of the reductions are depicted on the y-axis.12 The marginal costs of CO2 emission reductions reveal that there is a large variation between the countries and regions included in Fig. 3, both in terms of the size of the emission reduction potential and the related costs. USA and China have very large carbon emission reduction potentials of more than 800 mill.t. C, with a marginal cost below $400 per t. C. in the case of USA and below $100 in the case of China. India is also among the countries with a low cost potential amounting to about 150 mill.t. C at a cost below $100 per t. C. The EEC and the Former Soviet Union have emission reduction costs rather similar to India up to a reduction potential of about 150 mill.t. C, but also have a larger potential with higher costs. Some countries, in particular Japan, are projected to have very high reduction costs in the EPPA model. A global GHG emission reduction option market will be based on the total supply of reduction options of all parts of the world and the following Fig. 413 shows such a global CO2 emission reduction supply curve for the energy sector, generated as a horizontal summation of the regional and country specific marginal cost curves of 12 The MAC curves are calculated by the authors on the basis of data provided by Ellerman and Decaux (1998), and it is assumed that the cost curve information is valid for GHG emission reductions that amounts to up to about 40% reductions of the projected 2010 emissions. The cost curve information presented here assumes that the marginal costs of reduction in one country are not influenced by efforts in other countries, which could arise from e.g. trade impacts. 13 Here, industrialised countries include USA, JPN, EEC OOE, EET and FSU, and developing countries include EEX, CHN, IND, DAE, BRA, and ROW, see the definition of the acronyms in the notes to Fig. 5.

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20 18

1200

Industrialised countries Developing countries China

1000

Total

12

1400

16 14

$ per t. C

1600

$ per t. C

2321

800

10

600

8

400

6

200

4

0

2

Industrialised countries Developing countries China 0

1000

2000 3000 Mill. t. C

4000

5000

Total

0 0

Fig. 4. Marginal costs of CO2 emission reductions in 2010 for the world, Industrialised countries, developing countries, and a separate cost curve for China.

the EPPA model that are shown in Fig. 3. Fig. 4 also includes separate marginal cost curves for Industrialised countries, Developing countries, and China in order to illustrate some aspects of the potential allocation of emission reduction projects across the world required to meet specific GHG emission reductions. The total global cost curve of CO2 emission reduction in Fig. 4 reveals that very large potential emission reductions are available at low costs compared with the Kyoto target levels, which as previously mentioned have been assessed to be a reduction of between 200 mill.t. C and approximately 740 mill.t. C in the budget period from 2008 to 2012. More specifically, the total global EPPA-based cost curve indicates that emissions reductions of about 1000 mill.t. C can be achieved at a cost of around $ 19 per t. of C, and reductions of 2000 mill.t. C can be achieved for a cost around $ 57 per t. C in 2010, if a global trading system establishes a fully cost effective market. The corresponding marginal cost would be around $100 per t. of C for emission reduction of 1000 mill.t. C, and around $480 per t. of C. for reductions of 2000 mill.t. C, if industrialised countries were constrained to trade among themselves. The case example of a total CO2 emission reduction of 1000 mill.t. C in 2010 is illustrated in more detail in Fig. 5 below. It is seen that a reduction of this magnitude if implemented through full global trading, would imply that industrialised countries would implement around 37% of the commitment, while developing countries would implement approximately 63%. Eastern Europe and the Former Soviet Union are in this case projected to implement as much as about 136 mill.t. C, and China and India are projected to implement as much as 380 and 90 mill.t. C, respectively. The USA is

200

400

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Fig. 5. Regional allocation of emission reduction quantities in the 1000 mill.t. C reduction case.

projected to be another big ‘‘actor’’ in the implementation of the 1000 mill.t. C reduction case, contributing with a reduction of 125 mill.t. C in the cost effective case. A general conclusion that can be drawn from these trading cases is that abatement costs are significantly reduced through trading and that the resulting allocation of emission reduction efforts shows a tendency to re-allocation of large reduction quantities between industrialised countries and even larger re-allocation of reduction quantities between industrialised countries and developing countries. Furthermore, a few large GHG emitters can play a major role on the markets. These emitters include the USA, the Former Soviet Union, India, and in particular China. Global GHG emission trading systems can imply significant reductions in abatement costs as illustrated in the EPPA model study. Ellerman and Decaux (1998), project that the total costs of OECD countries14 of meeting the Kyoto requirements in 2010 would be $115 bill., if trading systems were excluded. These costs are reduced down to $54 bill., if trading between Annex I countries are included, and down to only $11 bill. if full global trading is included. The implementation of GHG emission reduction projects in developing countries is projected to play an important role in cost effective international abatement efforts in the 2010 EPPA case example and this role is potentially larger in future scenarios that include more far going abatement efforts as a consequence of structural changes in the composition of GHG emission sources and sinks. The following section will consider the costs and benefits of developing 14 This scenario includes all OECD countries and thereby also USA and Australia that have decided not to ratify the Kyoto Protocol.

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countries in more details, as a basis for assessing their role in international GHG emission reduction policies.

A number of international studies have assessed the costs and benefits of GHG emission reduction policies in developing countries including direct and indirect impacts on economic growth, investments, employment, income distribution, and the local environment. An overview of these studies is provided by IPCC (2001), Chapter 8, OECD (2000), and in Halsnæs (2002). In general, the studies conclude that developing countries offer a large GHG emission reduction potential at a relatively low marginal cost, which is in line with the MIT EPPA study conclusions. Compared with industrialised countries, developing countries have a relatively large potential for GHG emission reductions through energy efficiency improvements, including both demand side and supply side options. In many cases, such policies offer significant energy cost savings, because they substitute existing technology use that is often very inefficient in developing countries. In addition to energy cost savings, a number of studies have also included an assessment of indirect impacts on air quality, health, income distribution, and employment of implementing GHG emission reduction options in developing countries. In particular the assessment of local health benefits from reduced air pollution and synergies with GHG emission reduction policies have been studied extensively (OECD, 2000). A framework for assessing indirect impacts of GHG emission reduction policies is developed and tested by Halsnæs and Markandya (2002). The approach is to use a cost benefit analysis to evaluate the financial and social costs of GHG emission reduction projects and the approach is applied to an evaluation of case examples in Zimbabwe, Botswana, and Thailand (Halsnæs et al., 2002). In this context, financial costs are defined as reflecting the investment and maintenance costs based on market prices of implementing GHG emission reduction projects, while the social costs are based on opportunity costs of using specific resources in the project implementation plus values assigned to indirect health impacts of reduced local air pollution and employment generation. The financial and social cost assessment for the GHG emission reduction case example projects demonstrate that there are large synergies between GHG emission reduction policy priorities and broader policy priorities. This means that the financial costs of most of the projects considered are larger than the net social benefits, and that the projects in this way generate a net social surplus. The existence of a potential for GHG

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6. Costs and benefits of implementing GHG emission reduction policies in developing countries

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Thailand

50 0 0

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Fig. 6. Financial costs and net benefits of GHG emission reduction projects in Zimbabwe, Botswana, and Thailand.

emission reduction options that have negative social costs has been widely discussed in the literature (see an overview provided by IPCC, 2001, Chapter 7, Section 7.3.4.2). It has been concluded that the existence of negative cost options that have not been implemented despite their social benefits rely on the assumption of the existence of some market distortions or other barriers that prevent their implementation. These barriers can be e.g. price distortions, capital constraints, limited information, and institutional weaknesses. The results of the case study analysis for Zimbabwe, Botswana, and Thailand by Halsnæs et al. (2002), are in line with the conclusions by IPCC (2001), Chapter 8, Table 8.5 and Fig. 8.10 on ancillary health impacts of GHG emission reduction policies in developing countries. The financial and social costs of the projects for Zimbabwe, Botswana, and Thailand measured per unit of GHG emission reduction are shown in Fig. 6. At present, the available studies of direct and indirect costs and benefits of GHG emission reduction policies in developing countries can only be recognised as providing preliminary conclusions about the marginal abatement costs in this group of countries. The preliminary state of the conclusions reflects that the number of available empirical studies is limited, relatively few countries are covered, and that there are several methodological complexities involved in assessing the more general relationships between development policies and GHG emission reduction policies.15 In this way, there is not as yet a basis for providing comprehensive empirical estimates of the social costs of 15 The methodological complexities include various issues such as the special character of markets in developing countries, non-marginal impacts of GHG emission reduction policies, interactions between the formal- and the informal sector in the countries, and various other issues (see IPCC, 2001, Chapter 7, Section 7.5.1 for a more detailed discussion).

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GHG emission reduction policies in developing countries as the basis for generating marginal abatement cost curves that can be used in general studies of direct and indirect costs of international GHG emission reduction markets. However, there is a case for expecting that marginal abatement costs based on social costs of GHG emission reduction would be lower than the costs that have so far been included in international energyeconomic models and the implications of this in relation to climate policies are further discussed in the next section.

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Vehicle inspection

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Efficient industrial boilers

Paved roads Power factor correction

Efficient household lighting

Central PV

Petroleum pipeline

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6.1. Discussion of the consequences of including social cost estimates in international GHG emission reduction markets The paper has previously discussed the consequences of basing estimates of international GHG emission reduction markets on social costs rather than on more narrow cost concepts that only include direct economic impacts. Assuming that the social costs of GHG emission reduction projects would tend to be lower than direct costs as illustrated in Fig. 1, marginal abatement cost curves based on social costs would increase the low cost abatement potential supplied to international markets and would decrease the demand for such projects compared with behavior that is based on direct costs. As previously stated, developing countries often face significant barriers that prevent the implementation of socially attractive policies consistent with international GHG emission reduction policy objectives and in this way international markets for GHG emission reduction options can help to bring down these implementation costs. Marginal abatement cost curves that integrate social indirect benefits of GHG emission reduction policies is one way of looking at the global costs and benefits of international GHG emission reduction markets. Another approach is to consider indirect social benefits of GHG emission reductions as a side benefit to the countries supplying such options to international markets. This would be consistent with assuming that international markets will be based on supply curves generated on the basis of direct GHG emission reduction costs. Given this assumption, many developing countries have opportunities for using international markets to create synergistic impacts on national development policies. In the case of the Botswana projects assessed by Halsnæs et al. (2002), the projects examined offer a number of net domestic benefits, which in five of the seven project case examples results in a negative social cost of implementing the project, implying that the projects have a net social surplus. The social cost results for Botswana are shown in Fig. 7. As illustrated in Fig. 7, five of the projects examined for Botswana were assessed to have a social surplus and

Fig. 7. Social costs per unit of GHG emission reduction for Botswana Projects, $ per t. of C.

they therefore should be implemented even without an international market for GHG emission reduction to support part of the project cost. However, developing countries like Botswana will often face a number of market constraints and other implementation barriers that prevent socially attractive policy options to be implemented. In such cases, internationally coordinated climate policies as for example based on market mechanisms can help overcoming such barriers through the supply of finance and technology, etc. and can in this way generate joint benefits to the global environment and to local societies.

7. Conclusions Climate change is an example of a global pollution control problem, where large potential economic gains can be achieved if policies are coordinated globally according to cost effectiveness principles. The establishment of markets for GHG emission reduction options is a good example of a policy mechanism that can facilitate these economic principles. Curbing future climate change requires large GHG emission reduction efforts going far beyond the efforts currently initiated by the UNFCCC and the Kyoto Protocol. The efforts will have to be ambitious both in terms of scale and in terms of structural allocation of quantitative GHG emission reductions as well as of mitigation costs and benefits. International studies expect that the contribution of developing countries to global GHG emissions in the future will increase faster than the contribution from developing countries, and both these groups of countries therefore need to be part of any global cost effective policies. The integration of developing countries in international GHG emission reduction efforts simultaneously encompasses a number of difficulties and opportunities. First of all, developing countries claim that climate

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Table 3 Financial and social costs of UNEP case study analysis Financial costs $ per t. of CO2 equivalent reduction Botswana Vehicle inspection Efficient industrial boilers Paved roads Power factor correction Efficient household lighting Central PV Petroleum pipeline Zimbabwe Efficient tobacco barn Biogas for rural kitchens Efficient industrial boilers Efficient household lighthing Efficient furnaces in manufacture Thailand Efficient wood fuel stoves Efficient motors in industry Efficient vehicles Biomass co-generation

Social costs $ per t. of CO2 equivalent reduction

Net benefits: Social costs minus financial costs, $ per t. CO2

1.7 5.0 13.0 14.3 67.5 86.6 181.1

1.2 57.6 140.3 78.1 133.3 5.8 79.6

0.5 62.6 153.3 92.4 200.8 80.8 101.5

3.8 5.3 16.1 44.3 57.8

63.3 24.6 31.4 41.1 44.9

67.1 29.9 47.5 85.4 102.7

2.8 13.4 56.9 141.4

145.3 100.4 74.8 17.8

148.1 113.8 131.7 123.6

change in the next century is caused by past emissions from industrialised countries and that these countries therefore have to carry the major burden of GHG emission reduction policies. On the other hand, the future development in GHG emission sources as well as the marginal reduction costs, assessed in a range of international studies, suggest that large low cost reduction options exist in these countries. In line with this, estimates by the global energy-economic model EPPA demonstrate that the costs of OECD countries including USA and Australia to implement the Kyoto Protocol could decrease from being $115 billion if only domestic GHG emission reduction options were allowed, while the cost would be only $11 if emission trade between industrialised countries and developing countries were allowed. In addition to total global economic savings, GHG emission reduction markets are also assessed to offer a number of social benefits to countries that implement the policies. Studies reviewed by IPCC and case studies for developing countries by Halsnæs and Markandya provide a preliminary basis for concluding that GHG emission reduction policies in developing countries may offer indirect social benefits that in many cases will be at least as large as the direct cost of policy implementation. International modelling studies like the EPPA study have concluded that large CO2 emission reduction efforts of as much as 63% of the global effort in implementing a total of 1000 mill.t. C reductions would

take place in developing countries. In addition to the large global direct cost savings by coordinated policies, the corresponding GHG emission reduction in developing countries would also be associated with large indirect social benefits. The existence of indirect benefits of GHG emission reduction policies in developing countries implies that the scale of the international GHG emission reduction efforts in future global climate change agreements could be expanded. At the same time, the inclusion of local benefits in developing countries in GHG emission reduction efforts will also create stronger incentives for the countries to participate in international climate change policies.

Appendix A Case study data on projects in Botswana, Zimbabwe, and Thailand is shown in Table 3. References Ellerman, D., Decaux, A., 1998. Analysis of Post-Kyoto CO2 emissions trading using marginal abatement curves. MIT Report #40. Eskeland, G.S., Xie, J., 1998. Acting globally while thinking locally. Is the global environment protected by transport emission control programmes? World Bank Policy Research Working Paper, 1975.

ARTICLE IN PRESS K. Halsnæs, A. Olhoff / Energy Policy 33 (2005) 2313–2325 Halsnaes, K., 2000. A review of the literature on climate change and sustainable development. In: Markandya, A., Halsnaes, K. (Eds.), Climate Change and Sustainable Development. Prospects for Developing Countries. Earthscan Publications Ltd., London, pp. 49–72. Halsnæs, K., 2000. Market potential for Kyoto mechanisms— estimation of global market potential for co-oeprative greenhouse gas emission reduction policies. Energy Policy 30, 13–32. Halsnæs, K., Markandya, A., 2002. Analytical approaches for decision-making, sustainable development and greenhouse gas emission-reduction policies. In: Markandya, A., Halsnæs, K. (Eds.), Climate Change and Sustainable Development. Prospects for Developing Countries. Earthscan Publications Ltd., London, pp. 129–162. Halsnæs, K., Markandya, A., Taylor, T., 2002. Case studies for Zimbabwe, Botswana, Mauritius and Thailand. In: Markandya, A., Halsnæs, K. (Eds.), Climate Change and Sustainable Development. Prospects for Developing Countries. Earthscan Publications Ltd., London, pp. 202–246. IPCC, 2000. Special Report on Emission Scenarios. A Special Report of Working Group III of the Intergovernmental Panel on Climate Change. Cambridge University Press, Cambridge. IPCC, 2001. Climate Change 2001: Mitigation, Contribution of Working Group III to the Third Assessment Report of the

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Intergovernmental Panel on Climate Change, Chapters 1, 2, 7, and 8. Cambridge University Press, Cambridge. IPCC, 2002. Climate Change 2001: Synthesis Report. Cambridge University Press, Cambridge. Jotzo, F., Michaelowa, A., 2002. Estimating the CDM market under the Marrakech Accords. Climate Policy 2, 179–196. Morita, T., Nakicenovic, N., Robinson, J., 2000. The Relationship between Technological Development Paths and the Stabilisation of Atmospheric Greenhouse Gas Concentrations in Global Emissions Scenarios. National Institute for Environmental Studies, Japan. Working Paper. Nakicenovic, N., Gru¨bler, A., McDonald, A. (Eds.), 1998, Global Energy Perspectives. Cambridge University Press, Cambridge. OECD, 2000. Ancillary benefits and costs of greenhouse gas mitigation. Proceedings of an IPCC Co-Sponsored Workshop, Washington, DC, OECD, Paris, 27–29 March. UN, 1992. United Nations framework convention on climate change. International Legal Materials 31, 849–873. UNFCCC, 1997. Kyoto Protocol to the United Nations framework convention on climate change (UNFCCC), FCCC/CP/1997/L.7/ Add.1, Bonn. Weyant, J.P., (Ed.), 1999. The costs of the Kyoto Protocol: A multimodel evaluation. The Energy Journal, Special Issue.