9. ECONOMIC INSTRUMENTS23

9.1. Introduction

This section describes measures to control GHG emissions from more than one sector. The measures discussed include subsidies, taxes, tradable quotas and permits, and joint implementation.24 

Climate change policy must be considered in the context of existing economies. In the real world, climate change is only one of many externalities; competition is not perfect; information and markets are not complete; and distorting taxes and transfers are widespread. These observations are important because many analyses of climate change policy assume that the externality of climate change is the only distortion that exists. The conclusions of such analyses may be misleading or incorrect (SAR III, 11.3).

This section first discusses national-level economic instruments, which are relevant when a country either acts unilaterally to reduce its GHG emissions or joins other countries in an international agreement to do so. These instruments include subsidies, taxes, and tradable permits. Next, international-level economic instruments - international tax agreements, tradable emission quotas, and joint implementation - are discussed.25 

9.2. National-Level Economic Instruments

9.2.1. Subsidies and Subsidy Elimination

An activity can be subsidized in many ways. A government may transfer funds to an enterprise, provide preferential tax treatment, supply commodities at below market prices, or restrict competing products to assist a particular activity. Many countries currently subsidize some activities that emit GHGs (e.g., subsidies that reduce the prices of fossil fuels). Eliminating permanent subsidies that encourage fossil fuel use would reduce GHG emissions and increase real incomes in the long run.

On the other hand, temporary subsidies could be offered for particular activities aimed at limiting GHG emissions. Such subsidies might be directed at fostering adoption of emission abatement technologies, creating additional sinks, or stimulating development of improved GHG mitigation technologies.

Eliminating subsidies changes the incomes of affected groups. Compensation for groups whose incomes are adversely affected may need to be considered. In the case of financial subsidies, the net effect depends on how the revenues are redistributed. Raising distortionary taxes to finance the subsidies increases the cost of this option (SAR III, 11.3.1.1).

9.2.2. Domestic Taxes26  (SAR III, 11.5.1)

Under an emission tax system, sources that produce GHG emissions must pay a tax per unit of emissions.27  To ensure that the cost of a given emission abatement is minimized, all emissions should be taxed at the same rate per unit of contribution to climate change. The tax rate needed to achieve a particular emission target must be found by trial and error over a number of years.

A tax on the carbon content of fossil fuels - a carbon tax - is generally proposed in lieu of a tax on the CO2 emissions from fossil fuel use, since it has a similar impact and is much simpler to administer. A CO2 emissions tax would require every source that uses fossil fuels to monitor its emissions and to pay the corresponding taxes. A carbon tax would affect the same emissions, but would involve only the fuel producers or distributors, most of which already are involved in the collection of other energy-related taxes. In practice, existing excises on energy products complicate the design of a carbon tax that changes prices in proportion to CO2 emissions.

A carbon tax is a more efficient instrument for reducing energy-related CO2 emissions than are taxes levied on some other bases, such as the energy content of fuels or the value of energy products (ad valorem  energy tax). Model simulations for the United States indicate that for an equivalent reduction in emissions, an energy tax would cost 20 - 40% more than a carbon tax, and an ad valorem  tax would be 2 to 3 times more costly. This is because an energy tax raises the price of all forms of energy, whether or not they contribute to CO2 emissions, whereas a carbon tax changes relative costs, and so provides incentives for fuel switching.

Analysts agree that actions to respond to climate change should include all GHGs (taking into consideration their heat-trapping potentials and atmospheric lifetimes) and carbon sinks. A carbon tax on fossil fuels (or a tax on fossil fuel CO2 emissions) could therefore be complemented by emissions taxes on non-energy sources of CO2, emissions taxes on other GHGs, and tax rebates or subsidies for carbon sequestration. The administrative challenges and difficulties of monitoring emissions (sequestration) by these diverse sources may make the use of taxes (rebates/subsidies) impractical in some or all of these situations.

9.2.3. Tradable Permits28  (SAR III, 11.5.2)

A country committed to limiting its GHG emissions could implement such a policy using tradable permits for energy-related CO2 emissions, non-energy sources of CO2, emissions of other GHGs, and carbon sequestration. Energy-related CO2 emissions could be controlled by a system of tradable permits for the carbon content of fossil fuels consumed. Under such a scheme, regulated sources are given (or must buy) permits for the carbon content of the fossil fuel. Tradable permits could also be applied to actual energy-related CO2 emissions.29  Participants are free to sell surplus permits or to buy permits to achieve regulatory compliance. Downstream of the permit system, the effect is comparable to that of a carbon tax.

In principle, tradable permit systems could also be used to regulate non-energy CO2 emissions, emissions of other GHGs, and carbon sequestration. Permits earned for carbon sequestration could be sold to sources that need permits for their emissions. The difficulties of monitoring emissions (sequestration) may make the use of tradable permits impractical in some or all of these situations. Considerations such as the number of participants, the share of total emissions covered, industry structure, and enforcement will influence the choice among alternative trading system designs.

Regardless of the specific design, a number of factors can adversely affect the performance of emissions trading systems, including situations where a few participants can influence the permit market or where a few firms can influence the output market, transaction costs, non-profit maximizing behavior, the pre-existing regulatory environment, and the degree of monitoring and enforcement required. Some of these factors also affect the performance of other policies and measures.

A government may choose one of two main ways to distribute permits to participating sources. Sources could be allocated permits gratis  based on an agreed allocation rule, such as emissions during some historical period, or the government could sell the permits at auction, although the latter approach has never yet been adopted. Combinations of these two approaches also may be feasible.

These approaches differ primarily in two respects. First, allocating permits gratis transfers wealth to the regulated sources, while selling permits at auction transfers this wealth to the government. Second, allocating permits gratis  may increase the wealth of existing sources, thus reducing the rate of entry of new firms and slowing technological change, although mechanisms can be designed to reduce such potential impacts.

Allowing permits to be banked for use at a later date is important for both the efficiency and the political acceptability of a tradable permit scheme. Without a banking option, permit-liable sources would be confronted with greater end-of-period permit price uncertainty. Banking also facilitates adjustments to lower emission caps.

Both taxes and tradable permits tend to equate the marginal cost of emissions abatement for all affected sources. The difference is that the tax is set by the government, and the level of emissions is determined by the responses of the affected sources; whereas in a tradable permit system, the government determines the overall level of emissions, and permit prices are determined by the market.

9.2.4. Revenue Recycling and Tax Substitution (SAR III, 11.3.2)

Auctioned permits have the same distributional implications as a carbon tax-leading to the same emissions level when auction and tax revenues are not redistributed to permit buyers/taxpayers, respectively. At the other extreme, permits distributed gratis  have the same distributional implications as a carbon tax, if the tax revenue is redistributed according to the rule used for the distribution of the permits. Parties other than regulated sources may be affected by GHG limitation actions and may need to be compensated. Revenue from a carbon tax or sale of permits could be used for this purpose.

The effect of a carbon tax, or an equivalent tradable permit system, on an economy will depend in part on what is done with the net government revenue, if any. There is widespread agreement that this revenue can be used to reduce pre-existing distortionary taxes, hence significantly lower the costs of emission reduction. Some researchers have suggested that it may be possible to increase national income by using the revenue to replace or reduce more distortionary existing taxes. However, others argue that this is an argument for general reform of the tax system rather than for the introduction of a carbon tax (or a corresponding tradable permit system) per se.

9.3. International-Level Economic Instruments

International cooperation will be required to meet a global emission target at least cost. Economic instruments such as international taxes, harmonized domestic taxes, tradable quotas, and joint implementation can help achieve a global target, but require - or would benefit from - international cooperation.

9.3.1. International Taxes and Harmonized Domestic Taxes (SAR III, 11.5.3)

At the international level, a GHG emissions tax could be implemented in one of two ways. Countries could agree to create an international agency that would impose a GHG emissions tax on participating countries. Alternatively, countries could agree that each would levy comparable GHG emissions taxes domestically. The agreement to create an international GHG emissions tax agency would need to specify both the tax rate(s) and a formula for distributing the revenues from the tax.30

A harmonized tax requires that each country impose the same tax rate. Due to differences in resource endowments, consumption patterns, climate change impacts, and other factors, this tax rate may not be the most appropriate from a national perspective, thus side-payments are likely to be required to secure broad participation. Under a harmonized tax system, the reallocation of tax revenues could involve lump-sum payments; whereas under the international tax system, the agreement could specify what shares of the international tax revenues would go to each participating country. In principle, international transfers could be negotiated to yield the same international distribution of the tax in either case. A GHG emissions tax imposed by an international agency would impinge on national sovereignty and would therefore be difficult to negotiate.

A uniform tax rate for all countries is required for reasons of cost- effectiveness but, given different existing energy tax regimes in participating countries, this could become very complex.

9.3.2. Tradable Quotas 31  (SAR III, 11.5.4)

Countries could negotiate national limits on emissions of GHGs - either voluntary or legally binding targets/quotas - to be achieved by specific dates. These could be negotiated for a single gas, for a group of gases, or as an aggregate CO2 equivalent. A more comprehensive approach allows more flexibility and larger cost savings.

Given differences in marginal emission control costs among countries, allowing international trade of emission quota would reduce the cost of achieving compliance with national emission limits regardless of the initial allocation. Each country would be expected either to reduce its emissions, or to purchase quota from other countries so that the sum of these two was not more than its national emission limit.

The national quota allocations can be used to address distributional issues and to draw countries into the agreement. Most proposals for allocating emission quota among countries envisage proportionately higher reductions in national emissions by industrialized countries, and slower rates of emission growth by developing countries. Thus, international negotiations will seek quota allocations that do not harm Annex I countries with economies in transition and non-Annex I countries, and that distribute the burden equitably among Annex I countries.

An international tradable quota system presupposes the existence of one or more markets where quota can be traded. For a trading scheme to be effective in controlling emissions, it is clear that there must be a reasonable probability of detecting and penalizing those responsible for unauthorized emissions. This, however, does not distinguish a tradable quota system from any other international agreement on emissions reductions.

Under an international tradable quota system, participating countries could use whatever domestic policies they preferred to achieve compliance. For example, a country might employ tradable permits, a domestic tax, or regulations. Where a domestic tradable permit system exists, the government could allow permit holders to trade directly on the international market. If a domestic carbon tax is used, the efficient tax rate for the coming period would be the (unknown) quota price for that period.

There is some experience with the use of tradable permit schemes within countries, whereas international tradable quota systems so far have been applied only on a small scale (e.g., the international CFC production quota trade and the CFC consumption quota trade within the European Union).

Under an international tax agreement, the tax rate is known but the effect on emissions is uncertain and the international transfer payments may or may not be known, depending on how they are defined in the agreement. Except for the effects of carbon leakage, a tradable quota system has a known effect on emissions, but quota prices and the distributional effects of the quota trade are uncertain, so protection against unfavorable price movements may need to be provided.32  This means that the benefits of known effects on emissions in a tradable quota system must be bought at the price of some distributional uncertainty.

9.3.3. Joint Implementation (SAR III, 11.5.5)

Joint implementation, provided for by Article 4.2(a) of the FCCC, involves cooperation between countries to meet the goals of the Convention. One country (or firm in that country) funds emission reduction actions in a second country that are additional to the reductions that would otherwise occur. Following the Berlin meeting (COP 1, March-April 1995), pilot projects now are being undertaken on activities implemented jointly by a number of countries.

The potential economic merits and demerits of joint implementation proposals have been widely discussed. In essence, there are three possible roles for joint implementation: (i) As a cost-effective option for developed countries to fund GHG emission reduction projects in other countries, while meeting local development needs; (ii) as the first step toward establishing an international tradable quota system for GHGs among parties that have made a firm commitment to limit their emissions; and (iii) as a means for exploring when it is cost-effective to bring new emission sources or sinks into an existing international GHG management system.

The potential driving force behind joint implementation is that both buyer and seller countries benefit from the trade. However, for case (i) in particular, monitoring and high transactions costs could become problems in using joint implementation as a means of achieving significant cost-effective reductions of GHG emissions. In addition, according to present international agreements, investors in joint implementation projects cannot credit the emission reductions from these projects against national commitments.

9.3.4. Policies to Reduce Free Riding and Emission Leakage

Can a unilateral policy by one country alone or by a group of countries prove effective in abating global GHG emissions? The answer depends on how the other countries respond to the policies adopted by the cooperating countries. These responses in turn reflect two phenomena: "Leakage" and "free riding." Free riding arises when countries that benefit from global abatement do not bear their share of the costs of its provision. Leakage arises when abatement actions by the cooperating countries cause emissions in other countries to increase.

9.3.4.1. Policies to Reduce Free Riding

As long as participation in an international greenhouse management policy is voluntary, countries will have incentives to free ride. None of the existing empirical models has been used to estimate the magnitude of potential free riding; however, some insights into the gains from full cooperation have been explored.

The stability of the group of countries acting to control GHGs will depend on the ability of the cooperating countries to punish countries that might withdraw and to reward countries that might join. To be effective, such punishments and rewards must be both substantial and credible. One example of such a punishment is the threat of a ban on trade of carbon-based fuels and products with non-cooperating countries, once a threshold number of countries agrees to participate (SAR III, 11.6.4.1).

9.3.4.2. Policies to Reduce Leakage

Emission leakage is the net result of a number of effects, some of which counteract each other. First, the implementation of a carbon abatement policy by a country or group of cooperating countries could shift production of carbon-intensive goods toward other countries, thus increasing their emissions. Second, the mitigation actions would lower world demand for carbon-intensive fuels and reduce the world price for such fuels - hence increase the use of (thus the emissions from) these fuels in non-participating countries. Third, the abatement actions could affect incomes in cooperating countries and so reduce imports from other countries which could, in turn, lower their income and emissions. Fourth, investment flows and exchange rates also could be affected, with unpredictable impacts on emissions.

Leakage is measured in terms of net GHG emissions relative to the emissions reduction in cooperating countries; estimates vary widely (SAR III, 11.6.4.2).

What can be done to reduce emission leakage? Basic trade theory suggests that (treating the cooperating countries as a single entity and the rest of the world as another single entity) a tariff should be imposed on imports of carbon-intensive products, or their exports should be subsidized, depending on whether the cooperating countries are net importers or net exporters before the mitigation actions are implemented. Alternatively, a production subsidy (tax) and consumption tax (subsidy) could be implemented in the cooperating countries instead of the import tariff (export subsidy).33

Application of border tax adjustments, such as import tariffs or export subsidies, while theoretically appropriate for reducing leakage, pose a number of practical problems. Determining the emissions associated with the manufacture of a particular product, hence the border tax adjustment, is likely to be very complex because of differences in the fuel mix and production techniques used in different regions. Furthermore, the appropriate border tax adjustments may not be compatible with current multilateral trading rules. Likewise, implementing production and consumption subsidies and taxes at the appropriate level in all cooperating countries, given the differences in their existing tax systems, is likely to prove practically impossible (SAR III, 11.6.4.3).

9.4. Assessment of Economic Instruments

This section evaluates economic instruments against the criteria discussed in the Introduction (see Table 19). This evaluation focuses on taxes and tradable permits/quotas in both the domestic and international context. First, it is important to recognize that countries differ in their institutional structures, economic structures, and existing policy structures and that the choice of policy instruments will be made in a political environment. As a result, the ability to enforce the different instruments is likely to vary across nations. Second, adoption of any international instruments will have some impact on the distribution of wealth among countries, as will domestic instruments on the distribution of wealth within them. All instruments can, and probably will have to, be connected with compensatory measures such as side-payments or specific permit/quota allocations; no differences arise among instruments in this regard.

9.4.1. Environmental Results

Tradable permit/quota systems can be designed to achieve national/international GHG emission targets. Achieving a specified emission target with a carbon/emissions tax requires trial and error adjustment of the tax rate. Both tax and tradable permit/quota systems assume effective monitoring and enforcement and, if the international agreement is non-global, insignificant carbon leakage.

9.4.2. Economic and Social Effects (SAR III, 11.5.6)

Conceptually, both taxes and tradable permit/quota systems encourage implementation of the most cost-effective reduction measures. To achieve a given emissions target, the tax and the market price for permits/quotas should be the same, assuming that both apply to the same sources; that transactions costs are comparable; and that trades are not arbitrarily restricted.

Tradable permits can be allocated free of charge or sold at auction. Similarly, tax revenue can be redistributed to sources that would otherwise receive permits gratis , or can remain with the government. The way in which the net revenue from a carbon tax or the sale of permits is recycled can have significant macro-economic effects.

There is an extensive literature on the distributional impacts of carbon taxes, emission taxes, gasoline taxes, and energy taxes in Annex I countries. These taxes are usually portrayed as regressive, because expenditures on fossil fuel consumption as a proportion of current annual personal income tend to fall as incomes rise. However, recent studies using U.S. and European data show that carbon taxes are considerably less regressive relative to lifetime income or annual consumption expenditures than to annual income.

Very few studies of the distributional effects of tradable permit systems are available. If the permits are sold, then the distributional implications are similar to those of an equivalent tax. If permits are allocated gratis, the initial allocation determines the distributional impacts.

Equity across countries is determined by the quota allocations in the case of a tradable quota system, the revenue sharing agreement negotiated for an international tax, or the transfer payments negotiated as part of a harmonized domestic carbon tax system. Reaching agreement on equitable quota allocations or revenue sharing arrangements should take account of the fact that mitigation actions by any country have economic impacts on other countries.

9.4.3. Administrative, Institutional, and Political Issues (SAR III, 11.6.2, 11.6.3)

Administrative and transaction costs can vary widely for both taxes and tradable permits. Proper design can reduce these costs significantly. In some countries, it has proven to be possible to implement a carbon tax at relatively low cost by relying heavily on existing energy tax collection systems; in other countries, it has proven to be politically difficult to introduce any energy-related taxes. Trading systems that use government-issued permits (such as the sulfur dioxide allowance trading system in the U.S.) have lower transactions costs than do systems that use self-defined credits. Permits appear to have a distinct advantage in creating the basis for a futures market that could enable more efficient spreading of the risks associated with changing emissions targets. For a tradable permit system to work effectively, relatively competitive conditions must exist in the permit (and product) market. Should a firm control a significant share of the total number of permits, it might attempt to manipulate permit prices to improve its position in the permit or product market (e.g., by withholding permits, thus forcing others to cut production or keeping new entrants out). These risks can be reduced by government auctioning of permits and other mechanisms. Little information is available on the administrative costs for monitoring, enforcement, and management of an international tax system, internationally harmonized taxes, or a tradable quota system.

9.5. Comparing Tradable Permit/Quota and Tax Systems (SAR III, 11.7.2, 11.7.3)

Both taxes and tradable permits impose costs on industry and consumers. Sources will experience financial outlays, either through expenditures on emission controls or through cash payments to buy permits or pay taxes.34  In either case, they will seek to minimize these costs through investment in new facilities and equipment.

Under a GHG tax, the tax rate is known but the effect on emissions is uncertain, and the distributional effects may or may not be known. A tradable permit system has a known effect on emissions, but permit prices and the distributional effects through trade are uncertain. A system of harmonized domestic taxes could involve an agreement about compensatory international financial transfers, as well as about adjustments required to compensate for differences in pre-existing tax structures. To be effective, a system of harmonized domestic taxes also requires that participants not be allowed to implement policies that indirectly increase GHG emissions.

A tradable quota scheme allows each participant to decide what domestic policy to use. The initial allocation of quota among countries addresses distributional considerations, but the exact distributional implications cannot be known beforehand, since the quota price will only be known after trading begins. Under a tradable quota scheme, the resulting global emissions will be known with certainty for a global agreement and, net of carbon leakage, for a non-global agreement.


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