Climate Cooperation with Technology Investments and Border Carbon Adjustment

SUMMARY FOR POLICYMAKERS

OVERVIEW

Addressing the problem of anthropogenic climate change requires a binding agreement that encompasses a large number of countries and specifies significant emission-reduction targets for its members. In addition, to achieve those targets at a reasonable cost, investments in low-carbon technologies are required. However, the so-called "free-rider incentive" is an impediment to the emergence of an effective climate treaty. It arises because all countries benefit from the reduction of greenhouse gas emissions, but only the signatories of a climate treaty are committed to significant emission-reduction targets and, therefore, incur substantial abatement costs. Hence, each individual country generally prefers to stay out of a treaty. Accordingly, the literature has been mostly pessimistic about the prospects of climate cooperation. We modify the "classical" climate cooperation game by allowing countries to protect their international competitiveness via border carbon adjustments (BCA).

We demonstrate that this alleviates the free-rider problem. As a result, the number of signatories of a climate treaty is often larger than without BCA, and the coalition implements higher abatement targets.

Furthermore, we introduce investments in low-carbon technologies into our theoretical model, which are made prior to countries' decisions whether to join the climate coalition. We find that countries usually invest too little in technologies. Although BCA alleviates the free-rider incentive in the formation of a climate coalition, it is still present in our model, and it becomes stronger when countries invest more. Therefore, countries strategically reduce their investments. This leads to higher participation in the climate coalition, but implies that future abatement costs are inefficiently high.

BACKGROUND

The "classical" climate coalition formation game that is the most widely used in the literature was introduced by Barrett (1994). According to this model, countries in a first stage decide non-cooperatively whether they want to join the coalition or not. In the second stage, the "signatories" of the treaty collectively determine their abatement efforts. Finally, in the third stage, the non-signatories who did not join the coalition determine their abatement efforts non-cooperatively.

We modify this game by assuming that firms located in a signatory country that export their goods to a non-signatory are partially exempted from the local emissions tax. Furthermore, firms in non-signatory countries that export to signatories have to pay a carbon tariff that adjusts their overall emission price to that of a signatory country. These BCA measures induce transfers to signatories, and give exporting firms in non-signatory countries an incentive to reduce their emissions even when their local government does not implement an emissions tax. The free-rider incentive is, thus, alleviated, and more countries enter the coalition than without BCA.

By treating the participation level in the coalition as a continuous variable, we obtain a simpler concept of coalitional stability than in the standard literature. This allows us to analyze this game in a non-parametric way, and to extend the analysis to countries' decisions to invest into low-carbon technologies — something that few papers have done so far in the climate-coalition-formation literature. We assume that these investment decisions take place before countries play the climate-coalition-formation game. The idea behind this is that technology decisions are time-consuming, so that strategic effects upon the later climate cooperation game arise.

KEY FINDINGS AND RECOMMENDATIONS

Border carbon adjustments can be useful in guiding countries into a more effective climate coalition. This policy instrument levels the playing field for competition when countries introduce different carbon prices. It also improves the prospects of cooperation because it makes the option to join a climate coalition more attractive.

Early technology investments can have negative effects upon the formation of a climate coalition. While these investments reduce future abatement costs, they also aggravate the free-rider incentive. This latter effect can be so strong that countries benefit from lowering their R&D efforts. This problem persists even if countries choose their R&D effort cooperatively, despite its public good nature.

The timing of R&D investments and abatement decisions matters. Sufficiently high R&D efforts are a necessary requirement for an effective climate treaty. However, by focusing exclusively on R&D investments while postponing decisions about abatement into the future, countries may achieve at most one target, associated with either R&D or abatement.

CONCLUSIONS

In order to tackle the issue of climate change, countries must undertake costly actions to reduce their greenhouse gas emissions. They must also invest in low-carbon technologies in order to achieve their abatement targets at a reasonable cost. If a global agreement that fixes countries' abatement and R&D efforts is currently not feasible, then the question arises whether early action in the development of low-carbon technologies may pave the way towards a more effective outcome in the future. Using a stylized cooperation model, we show that border-carbon adjustments can be quite effective in guiding countries into a climate coalition. By contrast, early investments in low-carbon technologies do not necessarily improve the outcome of a future climate agreement, as they aggravate the free-rider incentive. Notwithstanding, the potential gains of cooperation are larger when abatement costs are reduced. Hence, our results may challenge policy makers to try even harder to reach an agreement.

Carsten Helm, University of Oldenburg

Robert C. Schmidt, Humboldt University