Key developments related to GHG trading

The world society is concerned about negative changes of global climate. We are able to predict now only some of the possible consequences of global climate change, their negative impact on the national economies and world's economy. We also realize that numerous island countries may be completely wiped out of the face of the Earth.

Are there any credible scientific data to substantiate these apocalyptic predictions? Yes, there are. We carefully analysed chemical content of the Earth's atmosphere for the last 300 million years and correspondingly the dynamics and intensity of change of chemical content of the atmosphere during this period. We are quite positive now about the unprecedented rate of increase of CO₂ concentration which is recorded during the last 100 years. Such a change was never recorded in the past 300 million years. The reason for such a change is obvious: it is antropogenic emission of carbon dioxide, which is accompanied by emission of other by-products of technogenic civilization, including several greenhouse gases.

Are these changes dangerous indeed? There are many answers to this. The most common answer stems from the well-known " greenhouse" model of the Earth's climate. This model, I think, needs to be carefully examined, but it is not quite convincing. To say the truth, no one can prove yet that the Earth's climate changes because of increase of greenhouse gases emission in the atmosphere according to the greenhouse model. We need at least another ten years of observation and modelling to be quite positive about the nature of global climate change.

But I am hundred-per-cent sure that during the last 100 years the Earth's atmosphere and climate deviated from their equilibrium states. The supporting back-of-the-envelope calculations were presented in numerous scientific reports. In the past, both biota of oceans and surface biota were net absorbers of CO₂. Now only the oceans retained this function. Surface eco-systems (including humans) now emit more CO₂ than they absorb. Worse of all, antropogenically changed land’s eco-systems (or exited eco-systems, as physicists say) have became net emitters of CO₂.

The increase of greenhouse gases concentration in the atmosphere is not the only result of human activity, wich causes the changes in the climatic system balance. Changes in the moisture rotation (first of all, because of the mass forest cut down) and the albedo-change are also to be pointed.

These deviations from equilibrium state are quite hazardous. Irrespective of the particular scenario of global climate change, human civilization will have to cope with catastrophic consequences of equilibrium loss, if this process will not be stopped. The loss of global equilibrium is a matter of grave concern, even if greenhouse model should be replaced by some other yet unknown scientific paradigm. It is imperative that the causes of global climatic equilibrium loss should be blocked away.

The principal aim of Global Climate Change Convention is restoration of balance of chemical composition of the Earth's atmosphere. Around this ambitious task were centered numerous international debates held in preparation of the Convention for the Conference in Rio and subsequent events - Conferences in Berlin, Kyoto, Buenos-Aires.

Obviously, climate change is a global problem in all its aspects. First, no one will avoid the consequences of Earth's climate equilibrium loss. Second, all countries, all people triggered this profound change. We, humans, are causes and victims of this complicated process. Third, this problem can be solved only internationally. It requires global effort and global co-ordination.

One has to admit regretfully that humanity is yet to learn how to initiate global effort and co-ordinate it. With numerous global problems we face now, there is no uniform mechanism have been developed to solve them. Our efforts and approaches vary greatly with locality and particular context, no matter how one would measure the effort - in costs or results, no matter how one would aggregate it - per square kilometre, per dollar invested, or per capita.

How we should proceed with co-ordination of our efforts to solve international problems? The logic is simple to grasp and difficult to implement. The idea is to assess the resources needed in principle to solve the problem, and then to apportion the resources among the countries according to their economic capacity. Next step is to channel available resources where they can produce most benefit, i.e. to use them most effectively.

According to this elementary logic, one may solve the problem of GHG emission reduction in two steps: the first step is " budgeting", one needs to assess how much resources is required, the second step is " bargaining", where to get the required resources? The answer to the first question is still not quite clear. The second question leaves no doubt: rich countries are to pay. After all, they are relatively more responsible for distorting the Earth's climatic balance. The collected revenues should be directed where one may get the greatest environmental benefit per each dollar spent. Environmental benefit is not difficult to measure: it is GHG emission reduction or sequestration volume. The results of reduction and ecosystem sequestration are equivalent however different the mechanisms are. To achieve emission reduction, certain measures are to be taken in the real sector of economy. To sequester greenhouse gases one needs to increase assimilative capacity of ecosystems, which means restoration of their virgin (natural) state.

It is my opinion that that idea of emission trading remains now the only adequate mechanism of addressing global problems. This idea belongs not only to the environmental field. It may be broadened out to address other global problems as well.

Emission trading is a bright idea which offers a mechanism of practical realization of international co-operation in solving global problems. It has several important advantages. To put this mechanism into work, all countries have to accept certain obligations to reduce their emissions of greenhouse gases, most importantly CO₂. Without binding obligations there will be no emission trading.

What does this mean - to take obligations? This means accepting certain responsibilities with respect to international community. This demonstrates a country's good will. If humans, countries, international community are unable to take this step, our future will be undoubtfully miserable. Our chance to survive on the planet we're only beginning to destroy depends upon the free will to accept such obligations, to take the first step.

This first step immediately translates into purely economic measures. Certain economic targets ensue, certain resources are needed. Because of global nature of climate change, we don't have to limit countries' obligations to their own territory. Emission reductions and/or GHG sequestration may be achieved in any country, any climate zone. The only requirement should be environmental effectiveness of such measures. The important conclusion is that the country which accepted obligations doesn't necessarily implement them on its own territory.

If we agreed on this, formation of global emission reduction market comes in quite naturally. A country which accepted obligation to achieve emission reductions will have to do so in a least expensive way. This means to identify a measure with maximal environmental effect per dollar invested. This is what market is all about. It solves profit maximization problem every moment it exists. No doubt, emission reduction quota market has its specific features. First of all, it is international market. Secondly, its effectiveness is measured by environmental indicators. Thirdly, participating countries must enter into legally-binding emission reduction agreements. But the underlying mechanism is market-based. It seems suitable even for a priori non-market problems.

This mechanism was formulated in the process of designing the solutions for global environmental problems; it is called " joint implementation". Emission trading presents a brilliant example of a market-based JI mechanism. This is why I think that emission trading beats all other tangible mechanisms of solving global problems.

The idea of joint implementation is not altogether new. If there's anything new in it - it is the particular field of its implementation: international obligations. If two countries (or more) agreed to accept certain mutual obligations then the easiest way to implement them is to act co-operatively. The individual obligations (e. g. emission reduction targets) should be summed up to the " common benchmark". This idea, however not new, has been rarely realized in practice. World community still has an unused resource of international relations.

Let us take climate change policy as an example. Economists will find this primer quite elementary. I beg their pardon in advance, because my intention is to explain the matter to non-economists who are interested in quota market.

Assume county A has to reduce its emissions by a tonnes, while country B has a target of b tonnes. Because country A has already invested a lot in energy-saving technologies, any new investments will have very little effect (all low-cost measures have already been taken). Its marginal cost of emission reduction is m dollars per ton.

Country B have not invested in energy-saving yet, therefore its marginal cost of emission reduction is n, where n < < m.

If the two countries act independently, they will both spend am + bn dollars on emission reduction (for simplicity we assume linearity in calculation of total costs of emission reduction). If the two countries act jointly, all emission reductions will be achieved in country B (where it is cheaper to do), and the total costs will be (a+b)n dollars. The total " savings" with respect to the first scenario will be a(m-n) dollars.

It is likely that country A will choose to spend an dollars abroad instead of spending am dollars home to achieve the same environmental effect. It means that country B will get an dollars in investment, while country A will save a(m-n) dollars achieving its international obligation.

Country B will benefit from the investment because introduction of new technologies will have positive systemic effect on its economy. This is why country B may be willing to participate in the technology transfer. In this case the cost breaks down: country A pays only a fraction k, where 0< k < 1 while country B pays remaining (1- k). This will result in the following break-down of implementation costs: to achieve reduction of emissions by a tonnes country A will pay kan dollars and country B will pay (1-k)an dollars.

Of course, this would give rise to criticisms in country B: critics will say the developed country A robbed poor developing B which " despite its hardships had to pay (1-k)an dollars to help a rich country A to fulfil its obligations". We leave these claims unanswered. Besides, foreign investment may combine with domestic emission reduction measures in country B (it would have to spend bn dollars to comply with international treaty). In this case country B will spend less than bn, and will attract kan dollars of foreign investment.

This trivial example illustrates one simple but tremendously important point: environmental co-operation (and not only environmental) may be profitable for both counties. However, even with demonstrated good will two problems will remain.

First problem is to create legal basis for JI projects, to " write them up" in the Protocol. This means to allow the parties to the protocol to achieve their obligations by direct or indirect participation in emission reduction projects abroad. Global climate will benefit from all such projects no matter where they take place. This is, so to speak, our common endowment. This problem already got attention of legal experts, they provided the solution.

Second problem is to create the procedures for verification of compliance, and for determination of financial burdens for all participating countries. These procedures have to be objective, regular, convincing, and fair. Only market procedures are known to satisfy these requirements. Therefore, we need to put market procedures to work in the above said context. GHG emission trading provides the solution for this problem.

A simplest illustration of emission trading stems from the above example. It may be interpreted as follows: country A instead of domestic implementation finances emission reduction measures in country B. In doing so, country A purchases an emission reduction quota of a tonnes from country B at the price of kn dollars per ton. (We ignore a whole range of financing details here).

Other schemes of emission trading may be contemplated as well. For instance, country may have an " emission pool" if its emission cap has not been reached yet. This situation is observed in Russia, Ukraine and some other post-communist countries. Then the difference between the actual emissions and emission limit is defined as quota which may be freely sold out this year. The country-seller however will not be able to use the revenues at its discretion. The revenues from such transactions may be spent only on energy-saving technologies or other GHG-related environmental projects.

Principal actors on the GHG quota market will be enterprises and firms (countries and groups of countries may also participate in principle). It is not clear yet how to translate national emission quotas into obligations of individual buyers and sellers on this market. The restrictions on revenue use should also be specified more carefully. Special monitoring measures are needed to control the actual emission levels and ensure compliance during transactions. Without such monitoring GHG emission trading market will not achieve its principal objective. But most importantly, when procedures and rules are specified, the price of GHG quotas will be determined by the market itself, matching supply and demand.

Some critics of market approach to GHG emission reduction offer imposition of greenhouse emission tax as an alternative approach to climate change problem. This instrument has been thoroughly studied by ecologists and economists. It was discussed during the conference " Environment for Europe" held in 1994 in Lucerne. At first this idea seemed attractive and easy to implement. But carbon tax has not been implemented ever since, and the interest has lowered considerably. What is the reason?

Let us consider carbon dioxide - the most important of greenhouse gases. (Water vapour is not considered here). Other greenhouse gases even taken together pose less global warming danger. Besides, chlorofluorocarbons are regulated by other treaties, nitrous oxides are being taxed separately as toxic substances. Industrial methane is a valuable fuel source and for this reason it is economically viable for industry not to waste it. Agricultural methane on the other hand is difficult to monitor or regulate, this is why it cannot be seriously analysed in economic context of various emission reduction instruments.

Carbon dioxide emissions are proportional to the amount of fuel burned. This is a remarkable fact: to determine the emission levels one just needs to account for fuel use which is less difficult to do than monitoring emissions. On the other hand, CO₂ emission charge becomes an additional tax on fuels (with all the objections which a newly imposed tax can provoke). Fuel taxation may in principle stimulate energy saving, but this effect is quite small, as the economic analysis of pollution charges showed. Setting emission limits proved to be more effective tool especially when combined with economic cushioning measures. By the way, emission quota market is an example of such a cushion if used in combination with emission caps. These caps were actually set for the parties by accepting legally binding obligations to reduce carbon dioxide emissions.

There is no clear vision of how to use proceeds from carbon tax. Tax revenues should be used for energy saving, but how exactly it should be done? Centralized planning is certainly not an effective mechanism of income redistribution.

Let us compare carbon tax (or environmental tax on fuel use) with emission trading. It is my opinion that in every respect emission trading is preferable.

Indeed, emission trading helps all countries achieve their emission reduction targets. This principal objective is not directly connected to imposition of a carbon tax. The link between carbon tax and specified emission reduction volume is rather tenuous.

Another advantage of emission trading is that the countries-parties to the protocol are free to trade. The principle of voluntariness is very important for international treaties although one cannot completely exclude national ambitions, competition among countries, attempts to exert political force.

Yet another aspect is ability to use market mechanisms. While emission trade scheme offers all advantages of free market operation, carbon tax as a fiscal instrument distorts operation of markets.

I already mentioned the direct link between emission limits and quota trading. Carbon tax by itself will not ensure compliance with agreed emission limits. This compliance may be achieved by a complex feedback mechanism. To set up such a mechanism on international scale, a concerted international bureaucratic effort is needed, involving scores of responsible, honest and qualified public servants. It is extremely difficult to make them accept common rules, procedures, philosophy towards fiscal policies, climate change policies, international disputes.

It is worth adding that a whole army of fiscal officers is needed to collect a new massive tax on a national level. A strong feature of emission trading is its decentralised character. It would take considerably less administration costs. Only a handful of controllers will be needed to monitor the performance of quota market on international level because emission trading will be effectively administered nationally by market forces themselves.

I can hardly think of a single advantage of a carbon tax compared to emission trading. International trade in emission allowances offers a fruitful ground for practical realisation of joint implementation mechanism which has been actively propagated on recent international fora. JI mechanism, to my opinion, is an important achievement of our collective thought, it turns a new page in international relations.

Let me point out once again that emission trading does not serve self-centered national ambitions of any single country. It offers a solution for our common problem. This solution incorporates individual interests of all participating countries. Without taking into account economic interests of all countries no international problem can be solved. This is the reality.

There are many unresolved issues concerning operation of emission quota market. Who should be its players? I think that both firms and counties, and groups of countries should participate as buyers and sellers. The less restrictions we impose on market structure the more effectively it will operate. We should strive for maximum economic freedom within the scope of this market.

I, as an economist, have been interested in this problem for a long time, at least for the last thirty years. There was much discussion in the former Soviet Union how to harness market forces to make them work in the command economy. I always pointed out that instead of " harnessing" we should let market forces act freely within well defined economic space.

We should carefully define the scope of the market, and not interfere with its operation within the defined limits. In this presentation, I talked about some of these limits, but not all. Let me stress once again that once the market is defined ant set in place, our task will be to let it go, not to help the market forces manifest themselves. I foresee a really free market within clearly defined boundaries. Because market mechanism proved to be the most effective economic mechanism which can make the most use of limited resources, and can achieve tremendous results which no one could have ever expected in advance.