Economic Incentives in a New Climate Agreement

Prepared for The Climate Dialogue, Hosted by the Prime Minister of Denmark, May 7–8, 2008, Copenhagen, Denmark

Note

The Harvard Project on International Climate Agreements has agreed to help the Office of the Danish Prime Minister, in its role as incoming President of the 2009 Conference of the Parties, to prepare background papers and on-site briefings for a series of very high-level dialogues on climate change policy, hosted by the Prime Minister. These dialogues will each include about 25 participants, including CEOs of European and U.S. corporations, key officials from national governments and intergovernmental organizations, and leaders of major environmental NGOs. This paper on the subject of economic incentives was prepared by the Harvard Project leadership for the first dialogue.

Virtually every aspect of economic activity results in greenhouse gas emissions, so meaningful climate policies will need to alter the fossil fuel foundation of economies over the long term. Climate change policy will likely cost more, benefit more, and require more changes in behavior by firms and individuals than any other environmental policy. The magnitude of this challenge has drawn attention to the potential use of market-based or economic-incentive instruments to ensure that polluters face direct cost incentives to mitigate emissions at the lowest possible cost. The first section describes various economic-incentive policy instruments and the second section discusses their potential application in the design of an international climate policy agreement.

The market-based instruments most appropriate for climate policy are taxes and cap-and-trade. Under an emission tax, a government imposes a charge per unit of pollutant discharge, or it could set a tax on the carbon content of fossil fuels. Under a cap-and-trade scheme, the government sets an overall cap on emissions, allocates emission allowances — that in sum equal the cap — to firms in the economy, and allows trade in these allowances among firms. Under a variant of emission trading — an emission-reduction-credit system — firms generate credits for reducing their emissions that they can sell into a cap-and-trade system.

Climate change is truly a global commons problem: the location of greenhouse gas emissions has no effect on the global distribution of damages. Hence, free-riding problems plague unilateral and multilateral approaches. Further, nations will not benefit proportionately from greenhouse gas mitigation policies. Thus, mitigation costs may exceed benefits for some countries, at least in the near term. Cost-effective international policies — insuring that countries get the most environmental benefit out of their mitigation investments — will help promote participation in an international climate policy regime.

In principle, internationally-employed market-based instruments can achieve overall cost effectiveness. Three basic routes stand out. First, countries could agree to apply the same tax on carbon (harmonized domestic taxes) or adopt a uniform international tax. Second, the international policy community could establish a system of international tradable permits, — effectively a nation-state level cap-and-trade program. In its simplest form, this represents the Kyoto Protocol’s Annex B emission targets and the Article 17 trading mechanism. Third, a more decentralized system of internationally-linked domestic cap-and-trade programs could also ensure internationally cost-effective emission mitigation.